1. Chapter 18 Externalities and Public Goods

2. Chapter 18Slide 2 Topics to be Discussed Externalities Ways of Correcting Market Failure Externalities and Property Rights Common Property Resources

3. Chapter 18Slide 3 Topics to be Discussed Public Goods Private Preferences for Public Goods

4. Chapter 18Slide 4 Externalities Negative Action by one party imposes a cost on another party Positive Action by one party benefits another party

5. Chapter 18Slide 5 External Cost Scenario Steel plant dumping waste in a river The entire steel market effluent can be reduced by lowering output (fixed proportions production function)

6. Chapter 18Slide 6 External Cost Scenario Marginal External Cost (MEC) is the cost imposed on others for each level of production. Marginal Social Cost (MSC) is MC plus MEC.

7. MC S = MC I D P1P1 Aggregate social cost of negative externality P1P1 q1q1 Q1Q1 MSC MSC I When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. External Costs Firm output Price Industry output Price MEC MEC I The differences is the marginal external cost MEC. q* P* Q* The industry competitive output is Q 1 while the efficient level is Q*. The profit maximizing firm produces at q1 while the efficient output level is q*.

8. Chapter 18Slide 8 External Cost Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

9. Chapter 18Slide 9 Externalities Positive Externalities and Inefficiency Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.

10. Chapter 18Slide 10 MC P1P1 External Benefits Repair Level Value D Is research and development discouraged by positive externalities? q1q1 MSB MEB When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. q*q* P* A self-interested home owner invests q 1 in repairs. The efficient level of repairs q* is higher. The higher price P 1 discourages repair.

11. Chapter 18Slide 11 Ways of Correcting Market Failure Assumption: The market failure is pollution Fixed-proportion production technology  Must reduce output to reduce emissions  Use an output tax to reduce output Input substitution possible by altering technology

12. Chapter 18Slide 12 The Efficient Level of Emissions Level of Emissions 2 4 6 Dollars per unit of Emissions 02468101214161820222426 MSC MCA E* The efficient level of emissions is 12 (E*) where MCA = MSC. Assume: 1) Competitive market 2) Output and emissions decisions are independent 3) Profit maximizing output chosen At E o the marginal cost of abating emissions is greater than the marginal social cost. E0E0 At E 1 the marginal social cost is greater than the marginal benefit. E1E1 Why is this more efficient than zero emissions?

13. Chapter 18Slide 13 Ways of Correcting Market Failure Options for Reducing Emissions to E* Emission Standard  Set a legal limit on emissions at E* (12)  Enforced by monetary and criminal penalties  Increases the cost of production and the threshold price to enter the industry

14. Chapter 18Slide 14 Standards and Fees Level of Emissions Dollars per unit of Emissions MSC MCA 3 12 E* Standard Fee

15. Chapter 18Slide 15 Options for Reducing Emissions to E* Emissions Fee  Charge levied on each unit of emission Ways of Correcting Market Failure

16. Chapter 18Slide 16 Total Abatement Cost Cost is less than the fee if emissions were not reduced. Total Fee of Abatement Standards and Fees Level of Emissions Dollars per unit of Emissions MSC MCA 3 12 E* Fee

17. Chapter 18Slide 17 Standards Versus Fees Assumptions  Policymakers have asymmetric information  Administrative costs require the same fee or standard for all firms Ways of Correcting Market Failure

18. Chapter 18Slide 18 Firm 2’s Reduced Abatement Costs Firm 1’s Increased Abatement Costs MCA 1 MCA 2 The Case for Fees Level of Emissions 2 4 6 Fee per Unit of Emissions 0123456789101112 13 1 3 5 14 The cost minimizing solution would be an abatement of 6 for firm 1 and 8 for firm 2 and MCA 1 = MCA 2 = $3. 3.75 2.50 The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA 2 < MCA 1. If a fee of $3 was imposed Firm 1 emissions would fall by 6 to 8. Firm 2 emissions would fall by 8 to 6. MCA 1 = MCA 2 : efficient solution.

19. Chapter 18Slide 19 Advantages of Fees When equal standards must be used, fees achieve the same emission abatement at lower cost. Fees create an incentive to install equipment that would reduce emissions further. Ways of Correcting Market Failure

20. Chapter 18Slide 20 ABC is the increase in social cost less the decrease in abatement cost. Marginal Social Cost Marginal Cost of Abatement The Case for Standards Level of Emissions Fee per Unit of Emissions 024681012 1416 2 4 6 8 10 12 14 16 E Based on incomplete information standard is 9 (12.5% decrease). ADE < ABC D A B C Based on incomplete information fee is $7 (12.5% reduction). Emission increases to 11.

21. Chapter 18Slide 21 Summary: Fees vs. Standards Standards are preferred when MSC is steep and MCA is flat. Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement. Ways of Correcting Market Failure

22. Chapter 18Slide 22 Summary: Fees vs. Standards Fees have certainty on cost and uncertainty on emissions. Preferred policy depends on the nature of uncertainty and the slopes of the cost curves. Ways of Correcting Market Failure

23. Chapter 18Slide 23 Transferable Emissions Permits Permits help develop a competitive market for externalities.  Agency determines the level of emissions and number of permits  Permits are marketable  High cost firm will purchase permits from low cost firms Ways of Correcting Market Failure

24. Chapter 18Slide 24 Externalities and Property Rights Property Rights Legal rules describing what people or firms may do with their property For example  If residents downstream owned the river (clean water) they control upstream emissions.

25. Chapter 18Slide 25 Bargaining and Economic Efficiency Economic efficiency can be achieved without government intervention when the externality affects relatively few parties and when property rights are well specified. Externalities and Property Rights

26. Chapter 18Slide 26 Profits Under Alternative Emissions Choices (Daily) No filter, not treatment plant500100600 Filter, no treatment plant300500800 No filter, treatment plant500200700 Filter, treatment plant300300600 Factory’sFishermen’sTotal ProfitProfitProfit

27. Chapter 18Slide 27 Assumptions Factory pays for the filter Fishermen pay for the treatment plant Efficient Solution Buy the filter and do not build the plant Externalities and Property Rights

28. Chapter 18Slide 28 Bargaining with Alternative Property Rights No Cooperation Profit of factory$500$300 Profit of fishermen$200$500 Cooperation Profit of factory$550$300 Profit of fishermen$250$500 Right to DumpRight to Clean Water

29. Chapter 18Slide 29 Conclusion: Coase Theorem When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified. Externalities and Property Rights

30. Chapter 18Slide 30 Costly Bargaining --- The Role of Strategic Behavior Bargaining requires clearly defined rules and property rights. Externalities and Property Rights

31. Chapter 18Slide 31 A Legal Solution --- Suing for Damages Fishermen have the right to clean water Factory has two options  No filter, pay damages Profit = $100 ($500 - $400)  Filter, no damages Profit = $300 ($500 - $200) Externalities and Property Rights

32. Chapter 18Slide 32 A Legal Solution --- Suing for Damages Factory has the right to emit effluent Fishermen have three options  Put in treatment plant Profit = $200  Filter and pay damages Profit = $300 ($500 - $200)  No plant, no filter Profit = $100 Externalities and Property Rights

33. Chapter 18Slide 33 Conclusion A suit for damages results in an efficient outcome. Question How would imperfect information impact the outcome? Externalities and Property Rights

34. Chapter 18Slide 34 The Coase Theorem at Work Negotiating an Efficient Solution 1987 --- New York garbage spill (200 tons) littered the New Jersey beaches  The potential cost of litigation resulted in a solution that was mutually beneficial to both parties.

35. Chapter 18Slide 35 Common Property Resources Common Property Resource Everyone has free access. Likely to be overutilized Examples  Air and water  Fish and animal populations  Minerals

36. Chapter 18Slide 36 Common Property Resources Fish per Month Benefits, Costs ($ per fish) Demand However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D) Marginal Social Cost F* Private Cost FCFC Without control the number of fish/month is F C where PC = MB.

37. Chapter 18Slide 37 Common Property Resources Solution Private ownership Question When would private ownership be impractical?

38. Chapter 18Slide 38 Crawfish Fishing in Lousiana Finding the Efficient Crawfish Catch F = crawfish catch in millions of pounds/yr C = cost in dollars/pound

39. Chapter 18Slide 39 Crawfish Fishing in Lousiana Demand C = 0.401 = 0.0064F MSC C = -5.645 + 0.6509F PC C = -0.357 + 0.0573F

40. Chapter 18Slide 40 Crawfish Fishing in Lousiana Efficient Catch 9.2 million pounds D = MSC

41. Chapter 18Slide 41 Crawfish Catch (millions of pounds) C Cost (dollars/pound) Demand Marginal Social Cost Private Cost Crawfish as a Common Property Resource 11.9 2.10 9.2 0.325

42. Chapter 18Slide 42 Public Goods Question When should government replace firms as the producer of goods and services?

43. Chapter 18Slide 43 Public Goods Public Good Characteristics Nonrival  For any given level of production the marginal cost of providing it to an additional consumer is zero. Nonexclusive  People cannot be excluded from consuming the good.

44. Chapter 18Slide 44 Public Goods Not all government produced goods are public goods Some are rival and nonexclusive  Education  Parks

45. Chapter 18Slide 45 D1D1 D2D2 D When a good is nonrival, the social marginal benefit of consumption (D), is determined by vertically summing the individual demand curves for the good. Efficient Public Good Provision Output 0 Benefits (dollars) 12345678109 $4.00 $5.50 $7.00 Marginal Cost $1.50 Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50.

46. Chapter 18Slide 46 Public Goods Public Goods and Market Failure How much national defense did you consume last week?

47. Chapter 18Slide 47 Public Goods Free Riders There is no way to provide some goods and services without benefiting everyone. Households do not have the incentive to pay what the item is worth to them. Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it.

48. Chapter 18Slide 48 Public Goods Establishing a mosquito abatement company How do you measure output? Who do you charge? A mosquito meter?

49. Chapter 18Slide 49 The Demand for Clean Air Clean Air is a public good Nonexclusive and nonrival What is the price of clean air?

50. Chapter 18Slide 50 The Demand for Clean Air Choosing where to live Study in Boston correlates housing prices with the quality of air and other characteristics of the houses and their neighborhoods.

51. Chapter 18Slide 51 The Demand for Clean Air Nitrogen Oxides (pphm) 0 Dollars 12345678109 2000 2500 3000 500 1500 1000 Low Income Middle Income High Income

52. Chapter 18Slide 52 The Demand for Clean Air Findings Amount people are willing to pay for clean air increases substantially as pollution increases. Higher income earners are willing to pay more (the gap between the demand curves widen) National Academy of Sciences found that a 10% reduction in auto emissions yielded a benefit of $2 billion---somewhat greater than the cost.

53. Chapter 18Slide 53 Private Preferences for Public Goods Government production of a public good is advantageous because the government can assess taxes or fees to pay for it. Determining how much of a public good to provide when free riders exist is difficult.

54. Chapter 18Slide 54 Determining the Level of Educational Spending Educational spending per pupil $0 Willingness to pay $ $1200 $600 $1800$2400 W1W1 W2W2 W3W3 AW The efficient level of educational spending is determined by summing the willingness to pay for education for each of three citizens.

55. Chapter 18Slide 55 Determining the Level of Educational Spending Educational spending per pupil $0 Willingness to pay $ $1200 $600 $1800$2400 W1W1 W2W2 W3W3 AW Will majority rule yield an efficient outcome? W 1 will vote for $600 W 2 and W 3 will vote for $1200 The median vote will always win in a majority rule election.

56. Chapter 18Slide 56 Question Will the median voter selection always be efficient? Answer If two of the three preferred $1200 there would be overinvestment. If two of the three preferred $600 there would be underinvestment. Private Preferences for Public Goods

57. Chapter 18Slide 57 Majority rule is inefficient because it weighs each citizen’s preference equally---the efficient outcome weighs each citizen’s vote by his or her strength of preference. Private Preferences for Public Goods

58. Chapter 18Slide 58 Summary There is an externality when a producer or a consumer affects the production or consumption activities of others in a manner that is not directly reflected in the market. Pollution can be corrected by emission standards, emissions fees, marketable emissions permits, or by encouraging recycling.

59. Chapter 18Slide 59 Summary Inefficiencies due to market failure may be eliminated through private bargaining among the affected parties. Common property resources are not controlled by a single person and can be used without a price being paid.

60. Chapter 18Slide 60 Summary Goods that private markets are not likely to produce efficiently are either nonrival or nonexclusive. Public goods are both. A public good is provided efficiently when the vertical sum of the individual demands for the public good is equal to the marginal cost of producing it.

61. Chapter 18Slide 61 Summary Under majority rule voting, the level of spending provided will be that preferred by the median voter---this need not be the efficient outcome.

62. End of Chapter 18 Externalities and Public Goods