1. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 1 Externalities, Public Goods and Common Resources Chapters 10, 11

2. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 2

3. 3 Externality The uncompensated impact of one person’s actions on the well-being of a bystander. Examples: automobile exhaust, historic buildings, barking dogs, R&D.

4. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 4 Social Optimum Point at which the marginal benefit equals marginal cost.

5. Figure 1 The Market for Aluminum Copyright © 2004 South-Western Quantity of Aluminum 0 Price of Aluminum Equilibrium Demand (private value) Supply (private cost) Q MARKET

6. Figure 2 Pollution and the Social Optimum Copyright © 2004 South-Western Equilibrium Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q OPTIMUM Optimum Cost of pollution Q MARKET

7. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 7 Positive Externalities Beneficial third party effects.

8. Figure 3 Education and the Social Optimum Copyright © 2004 South-Western Quantity of Education 0 Price of Education Demand (private value) Social value Supply (private cost) Q MARKET Q OPTIMUM

9. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 9 Internalizing the Externality Altering incentives so that people take account of the external effects of their actions.

10. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 10 Private Solutions Moral codes. Private charities. Contracts (Coase theorem)

11. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 11 Coase Theorem In the absence of transactions costs, private economic actors can solve the problem of externalities among themselves.

12. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 12 Public Policies to Deal with Externalities Regulation specifying maximum allowable level of a negative externality. Taxes (for negative externalities) & subsidies (for positive externalities). Permits (licenses).

13. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 13 Pigovian Taxes Arthur Pigou (1877- 1959), Professor of Economics, Cambridge University Tax the good that creates the negative externality. Reduces Q to optimal level.

14. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 14 Figure 1 The Effects of a Tax Copyright © 2004 South-Western Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

15. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 15 Tradable Pollution Permits Environmental agency decides the appropriate level of pollutants and issues (or auctions off) permits for exactly that level.

16. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits Copyright © 2004 South-Western Quantity of Pollution 0 Price of Pollution Demand for pollution rights P Pigovian tax (a) Pigovian Tax 2.... which, together with the demand curve, determines the quantity of pollution. 1.A Pigovian tax sets the price of pollution... Q

17. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits Copyright © 2004 South-Western Quantity of Pollution 0 Demand for pollution rights Q Supply of pollution permits (b) Pollution Permits Price of Pollution 2.... which, together with the demand curve, determines the price of pollution. 1.Pollution permits set the quantity of pollution... P

18. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 18 Summary When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

19. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 19 Summary When private parties cannot adequately deal with externalities, then the government steps in. The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

20. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 20 FirmPollution Level Unit cost to reduce A70 units$20 B80 $25 C50 $10 The government gives each firm 40 tradable pollution permits to reduce aggregate pollution level to 120 units. 1. What is the total cost of reducing pollution? 2. What would be the cost if the permits were not tradable?

21. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 21 Public Goods & Common Resources

22. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 22 Definitions Excludability: the property of a good whereby a person can be prevented from using it. Rivalry: the property of a good whereby one person’s use diminishes other people’s use.

23. Figure 1 Four Types of Goods Copyright © 2004 South-Western Rival? Yes Ice-cream cones Clothing Congested toll roads Fire protection Cable TV Uncongested toll roads No Private GoodsNatural Monopolies No Excludable? Fish in the ocean The environment Congested nontoll roads Tornado siren National defense Uncongested nontoll roads Common ResourcesPublic Goods

24. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 24 Free Rider Problem Receiving the benefit of a good without paying for it. e.g. viewer of public television

25. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 25 Tragedy of the Commons

26. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 26 Question. Why is the commercial value of ivory a threat to the elephant, while the commercial value of beef is a guardian of the cow?

27. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 27

28. Principles of Microeconomics, Prof. Maclachlan, Spring 2006 28 BEIJING, March 4 (Reuters) - China is to change its constitution to protect private property in a revolutionary manoeuvre that waters down its core Communist ideology to raise the status of entrepreneurs once deemed the running dogs of capitalism. Five decades after seizing power, nationalising private property and waging bloody campaigns against landlords, China's parliament is set to amend the state constitution to add the words, "private property obtained legally is inviolable". One aim of the amendments, to be ratified during the annual session of the National People's Congress that opens on Friday, is to give further impetus to the burgeoning private sector that is fuelling China's breakneck economic growth.