1. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 5 Externalities, Environmental Policy, and Public Goods

2. 2 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Economic Policy and the Environment 5.1Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency. 5.2Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality. 5.3Analyze government policies to achieve economic efficiency in a market with an externality. 5.4 Explain how goods can be categorized on the basis of whether they are rival or excludable, and use graphs to illustrate the efficient quantities of public goods and common resources. Learning Objectives Pollution is a part of economic life.

3. Chapter 5: Externalities, Environmental Policy, and Public Goods 3 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Externalities, Environmental Policy, and Public Goods

4. Chapter 5: Externalities, Environmental Policy, and Public Goods 4 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.1 Private cost The cost borne by the producer of a good or service. Social cost The total cost of producing a good, including both the private cost and any external cost. Private benefit The benefit received by the consumer of a good or service. Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit. Externalities and Economic Efficiency The Effect of Externalities

5. Chapter 5: Externalities, Environmental Policy, and Public Goods 5 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.1 Externalities and Economic Efficiency The Effect of Externalities FIGURE 5-1 The Effect of Pollution on Economic Efficiency How a Negative Externality in Production Reduces Economic Efficiency

6. Chapter 5: Externalities, Environmental Policy, and Public Goods 6 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.1 Externalities and Economic Efficiency The Effect of Externalities How a Positive Externality in Consumption Reduces Economic Efficiency FIGURE 5-2 The Effect of a Positive Externality on Efficiency

7. Chapter 5: Externalities, Environmental Policy, and Public Goods 7 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.1 Externalities and Economic Efficiency Externalities May Result in Market Failure Market failure A situation in which the market fails to produce the efficient level of output. What Causes Externalities? Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

8. Chapter 5: Externalities, Environmental Policy, and Public Goods 8 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.2 Private Solutions to Externalities: The Coase Theorem The Economically Efficient Level of Pollution Reduction FIGURE 5.3 The Marginal Benefit from Pollution Reduction Should Equal the Marginal Cost

9. Chapter 5: Externalities, Environmental Policy, and Public Goods 9 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.2 Making the Connection The Clean Air Act: How a Government Policy Reduced Infant Mortality

10. Chapter 5: Externalities, Environmental Policy, and Public Goods 10 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Private Solutions to Externalities: The Coase Theorem FIGURE 5.4 The Benefits of Reducing Pollution to the Optimal Level Are Greater Than the Costs Learning Objective 5.2 The Basis for Private Solutions to Externalities Don’t Let This Happen to YOU! Remember That It’s the Net Benefit That Counts

11. Chapter 5: Externalities, Environmental Policy, and Public Goods 11 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.2 Making the Connection The Fable of the Bees Some apple growers and beekeepers make private arrangements to arrive at an economically efficient outcome.

12. Chapter 5: Externalities, Environmental Policy, and Public Goods 12 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Private Solutions to Externalities: The Coase Theorem Learning Objective 5.2 Do Property Rights Matter? The Coase Theorem Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. The Problem of Transactions Costs Coase theorem The argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities.

13. Chapter 5: Externalities, Environmental Policy, and Public Goods 13 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Government Policies to Deal with Externalities Learning Objective 5.3 FIGURE 5.5 When There Is a Negative Externality, a Tax Can Bring about the Efficient Level of Output

14. Chapter 5: Externalities, Environmental Policy, and Public Goods 14 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 5-3 Using a Tax to Deal with a Negative Externality Learning Objective 5.3

15. Chapter 5: Externalities, Environmental Policy, and Public Goods 15 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Government Policies to Deal with Externalities Learning Objective 5.3 FIGURE 5.6 When There Is a Positive Externality, a Subsidy Can Bring about the Efficient Level of Output

16. Chapter 5: Externalities, Environmental Policy, and Public Goods 16 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.3 Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities. Command and Control versus Tradable Emissions Allowances Command and control approach An approach that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices. Government Policies to Deal with Externalities

17. Chapter 5: Externalities, Environmental Policy, and Public Goods 17 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.3 Command and Control versus Tradable missions Allowances FIGURE 5.7 Estimated Cost of the Acid Rain Program in 2010 Government Policies to Deal with Externalities

18. Chapter 5: Externalities, Environmental Policy, and Public Goods 18 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.3 Making the Connection Can Tradable Permits Reduce Global Warming?

19. Chapter 5: Externalities, Environmental Policy, and Public Goods 19 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Four Categories of Goods Learning Objective 5.4 Rivalry The situation that occurs when one person’s consuming a unit of a good means no one else can consume it. Excludability The situation in which anyone who does not pay for a good cannot consume it.

20. Chapter 5: Externalities, Environmental Policy, and Public Goods 20 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.4 FIGURE 5.8 Four Categories of Goods

21. Chapter 5: Externalities, Environmental Policy, and Public Goods 21 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Four Categories of Goods Learning Objective 5.4 1Private good. A good that is both rival and excludable. 2Public good. A good that is both nonrivalrous and nonexcludable. Free riding Benefiting from a good without paying for it. 3Quasi-public goods. Goods that are excludable but not rival. 4Common resource. A good that is rival but not excludable.

22. Chapter 5: Externalities, Environmental Policy, and Public Goods 22 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.4 Making the Connection Should the Government Run the Health Care System?

23. Chapter 5: Externalities, Environmental Policy, and Public Goods 23 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Four Categories of Goods Learning Objective 5.4 The Demand for a Public Good FIGURE 5.9 Constructing the Market Demand Curve for a Private Good

24. Chapter 5: Externalities, Environmental Policy, and Public Goods 24 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.4 FIGURE 5.10 Constructing the Market Demand Curve for a Public Good Four Categories of Goods The Demand for a Public Good

25. Chapter 5: Externalities, Environmental Policy, and Public Goods 25 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Four Categories of Goods Learning Objective 5.4 FIGURE 5.11 The Optimal Quantity of a Public Good

26. Chapter 5: Externalities, Environmental Policy, and Public Goods 26 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 5-5 Determining the Optimal Level of Public Goods Learning Objective 5.4 DEMAND OR MARGINAL SOCIAL BENEFIT PRICE (DOLLARS PER HOUR) QUANTITY (HOURS OF PROTECTION) $381 342 303 264 225 186 147 108 69 JILL QUANITY (HOURS OF PROTECTION) 1 2 3 4 5 6 7 8 9 10 SUPPLY PRICE (DOLLARS PER HOUR) QUANTITY (HOURS OF PROTECTION) $81 102 123 144 165 186 207 228 249 JOE PRICE (DOLLARS PER HOUR) QUANTITY (HOURS OF PROTECTION) $200 181 162 143 124 105 86 67 48 29 +=

27. Chapter 5: Externalities, Environmental Policy, and Public Goods 27 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 5.4 Four Categories of Goods Common Resources The Tragedy of the Commons Tragedy of the commons The tendency for a common resource to be overused. FIGURE 5.12 Overuse of a Common Resource

28. Chapter 5: Externalities, Environmental Policy, and Public Goods 28 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. An Inside LOOK Problems with Carbon Trading Next Carbon Trading Phase Promises to Clean Up Anomalies

29. Chapter 5: Externalities, Environmental Policy, and Public Goods 29 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Coase theorem Command and control approach Common resource Excludability Externality Free riding Market failure Pigovian taxes and subsidies Private benefit Private cost Private good Property rights Public good Rivalry Social benefit Social cost Tragedy of the commons Transactions costs K e y T e r m s