1. Externalities and Public Goods
Chapter 18
Externalities and Public Goods
Chapter 18

2. Externalities
Externalities are the effects of production and consumption activities not directly reflected in the market
They can be negative or positive
Chapter 18 4

3. Negative Externalities
Action by one party imposes a cost on another party
Plant dumps waste in a river affecting those downstream
The firm has not incentive to account for the external costs that it imposes on those downstream
Chapter 18

4. Positive Externalities
Action by one party benefits another party
Homeowner plants a beautiful garden where all the neighbors benefit from it
Homeowner did not take their benefits into account when deciding to plant
Chapter 18

5. Negative Externalities and Inefficiency
Scenario – plant dumping waste
Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production.
Marginal Social Cost (MSC) is MC plus MEC.
Chapter 18 6

6. Negative Externalities and Inefficiency
Assume the firm has a fixed proportions production function and cannot alter its input combinations
The only way to reduce waste is to reduce output
Price of steel and quantity of steel initially produced is at the intersection of supply and demand
Chapter 18

7. Negative Externalities and Inefficiency
The MC curve for the firm is the marginal costs of production
Firm maximizes profit by producing where MC equals Price in a competitive firm
As firm output increase, external cost on fishermen increases measured by the marginal external cost curve
From a social point of view, the firm produces too much output
Chapter 18

8. The profit maximizing firm efficient output level is q*.
External Costs
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
There is MEC of production from the waste released. The MSC is true cost of production.
Firm will produce q1 at P1.
MSC
Price
Price MC
MSCI D
S = MCI P* Q* P1 P1 Q1 q* q1
MECI
MEC
Firm output
Industry output
Chapter 18

9. External Costs MC S = MCI D P1 q1 Q1 MSC MSCI MEC MECI q* P* Q* Price
By no producing at the efficient level, there is a social cost on society MC
S = MCI D P1 q1 Q1
MSC
MSCI
Firm output
Price
Industry output
MEC
MECI q* P* Q*
Aggregate
social cost of
negative
externality
Chapter 18

10. External Cost
Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.
Chapter 18 17

11. Positive Externalities and Inefficiency
Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.
Repairs generate external benefits to the neighbors
Show by the Marginal External Benefit curve (MEB)
Marginal Social Benefit (MSB) curve adds MEB +D
Chapter 18

12. External Benefits Value MSB D P1 MC P* MEB Repair Level q1 q*
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D. D MC P1 q* P* q1
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MEB
Repair Level
Chapter 18 25

13. Ways of Correcting Market Failure
Assumption: The market failure due to pollution
Firm has chosen its profit-maximizing output level
MSC is marginal social cost of emissions
Chapter 18 26

14. Ways of Correcting Market Failure
MCA is marginal cost of abating emissions
Additional cost to firm of controlling pollution
Downward sloping because when emissions are high, little cost to controlling them
Chapter 18

15. Ways of Correcting Market Failure
If the firm does not consider abatement, their profit maximizing level is 26 units of emissions
Level where MCA is zero
The socially efficient level of emissions is 12 where the MSC equals the MCA
Chapter 18

16. The Efficient Level of Emissions
Dollars/ unit
of Emissions
MSC
MCA E0 6
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost. 4
At E1 the marginal
social cost is greater
than the marginal benefit. E1
The efficient level of
emissions is where
MCA = MSC. E* 2
Level of Emissions 2 4 6 8 10 12 14 16 18 20 22 24 26
Chapter 18 34

17. Ways of Correcting Market Failure
Firms can be encouraged to reduce emissions to the efficient level in three ways
Emissions standards
Emissions fees
Transferable emissions permits
Chapter 18

18. 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
Emissions Fee
Charge levied on each unit of emission
Chapter 18 35

19. Standards and Fees MSC 3 MCA E* 12 Standard Fee Dollars/ unit
of Emissions
MSC
MCA 3 12 E*
Standard
Fee
Level of Emissions
Chapter 18 38

20. Standards and Fees MSC E* 3 MCA 12 Cost is less than the
Dollars/ unit
of Emissions
MSC
MCA
Cost is less than the
fee if emissions were
not reduced. E*
Fee 3
Total Fee
of Abatement
Total
Abatement Cost 12
Level of Emissions
Chapter 18 42

21. Ways of Correcting Market Failure
Standards Versus Fees
Assumptions
Policymakers have asymmetric information
Administrative costs require the same fee or standard for all firms
Chapter 18 43

22. The Case for Fees Assume two firms
Same marginal social cost curve
Different marginal abatement cost curves
MCA1 and MCA2
Emissions fees are preferable to standards in this case
We want to reduce total emissions by 14 units
The cheapest way to do that is for firm 1 to reduce by 6 and firm 2 by 8 units
Chapter 18

23. Firm 1 emissions would fall MCA1 = MCA2: efficient solution.
The Case for Fees 2 4 6
Fee per
Unit of
Emissions 1 3 5
MCA1
MCA2
The cost minimizing solution
would be an abatement of 6
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
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.
MCA1 = MCA2: efficient solution.
Level of
Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Chapter 18 48

24. The Case for Fines
What if the regulatory agency forces each firm to cut emissions by 7 units
MAC for firm 1 increases to $3.75
MAC for firm 2 decreases to $2.50
This is not cost minimizing because one firm can reduce emissions at a lower cost than the other firm
Marginal cost of abatement must be equal between firms for reductions to occur at minimum cost
Chapter 18

25. The impact of a standard of abatement of 7 for both firms
The Case for Fees 2 4 6
Fee per
Unit of
Emissions 1 3 5
MCA1
MCA2
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
3.75
2.50
Firm 1’s Increased
Abatement Costs
Firm 2’s Reduced
Abatement
Costs
Level of
Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Chapter 18 48

26. Ways of Correcting Market Failure
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.
Chapter 18 50

27. The Case for Standards Assume we have Steep marginal social cost curve
Flat marginal cost of abatement
An emissions fee of $8 would be efficient but because of limited information, fee is set at $7
Firms emissions increase and with steep MSC, this will lead to significant additional social costs
Chapter 18

28. The Case for Standards
What if standard is used instead and has the same percentage mistake
Standard set at 9 instead of 8
Increase in social cost and decrease in abatement costs
Net increase in social costs is smaller than with fees
Chapter 18

29. information fee is $7 (12.5% decrease). information standard is 9
The Case for Standards
Fee per
Unit of
Emissions 2 4 6 8 10 12 14 16 B C
Based on incomplete
information fee is $7 (12.5% decrease).
Emission increases to 11.
Marginal
Social
Cost
ABC is the increase
in social cost less the
decrease in abatement
cost. E D A
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
Marginal Cost
of Abatement
Level of Emissions 2 4 6 8 10 12 14 16
Chapter 18 56

30. Ways of Correcting Market Failure
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.
Chapter 18 57

31. Ways of Correcting Market Failure
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.
Chapter 18 58

32. Ways of Correcting Market Failure
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
Chapter 18 59

33. Ways of Correcting Market Failure
The market for externalities is appealing since it combines the system of standards with the system of fees.
The agency who administers the system determines the total number of permits and therefore the total amount of emissions
Marketability of the permits allows pollution abatement to be achieved at minimum cost.
Chapter 18 60

34. Ways of Correcting Market Failure
Recycling
Households can dispose of glass and other garbage at very low cost.
The low cost of disposal creates a divergence between the private and the social cost of disposal.
Chapter 18 70

35. Recycling
Marginal private cost likely constant for fixed amount of garbage
Social cost of disposal includes the harm to environment from littering and injuries caused by litter
Without market intervention, the level of crap will be at m and m1 > m*
With refundable deposit, MC increases and MC = MSC = MCR
Chapter 18

36. The Efficient Amount of Recycling
Chapter 18 75

37. Refundable Deposits
Deposit is paid when bottle is purchased and then refunded when bottle returned.
Can chose the deposit to give household incentive to recycle more
Deposit increases private cost of disposal
Supply of glass comes from new glass and recycled glass
Increasing deposit increase supply of recycled glass and lowers price of glass
Chapter 18

38. Refundable Deposits Sr $ S’r Sv D S S’ P P’ M1 M* Amount of Glass
The supply of glass is
the sum of the supply
of virgin glass (Sr) and
the supply of recycled
glass (Sr). Sr
Without refunds the
price of glass is P and
Sr is M1. $
S’r Sv
With refunds Sr increases
to S’r and S increases to S’. D S
Price falls to P’ and
the amount of
recycled glass
increases to M*. S’ P P’ M1 M*
Chapter 18
Amount of Glass 80

39. Common Property Resources
Characteristics
Everyone has free access.
Likely to be overutilized
Examples
Air and water
Fish and animal populations
Minerals
Chapter 18 94

40. Common Property Resources
Consider a lake where people fish
Each fisherperson takes fish up to the point where the marginal benefit to them equals the marginal cost
There is no reason that any one fisherperson take into account how their taking fish affects others experience
Chapter 18

41. Common Property Resources
Private cost underestimates the true cost to society
More fishing reduces the stock of fish
Less is available to others and too low of a stock will completely deplete the fish
Too many fish are caught
Chapter 18

42. Common Property Resources
Benefits,
Costs
($ per
fish)
Without control the number
of fish/month is FC where
PC = MB.
Marginal Social Cost
However, private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Private Cost
Demand (MB) F* FC
Fish per Month 98

43. Common Property Resources
Solution
Private ownership
Owner will set fee for sue of resource equal to the marginal cost of depleting the stock
Fishermen will no longer find it profitable to catch more than the efficient amount of fish
It is often the case that private ownership is not possible, the government steps in
Chapter 18 99

44. Public Goods Characteristics Nonrival Nonexclusive
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.
Example – use of lighthouse by a ship
Chapter 18
101

45. Public Goods Nonexclusive goods
Goods that people cannot be excluded from consuming, so that it is difficult or impossible to charge for their use
Example: fireworks, national defense
Chapter 18
102

46. Efficiency and Pubic Goods
Efficient level of private good is where marginal benefit equals marginal cost
For a public good, the value of each person must be considered
Can add demand of all those who value good
Must equate the sum of these marginal benefits to the marginal cost of production
Chapter 18

47. Efficient Public Good Provision
Benefits
(dollars)
D1 is demand for consumer 1
D2 is demand for consumer 2
D is total demand for all consumers D
$7.00
$5.50 MC D2
$4.00
Efficient output occurs
where MC = total MB
2 units of output.
MB is $ $4.00 or $5.50. D1
$1.50
Output 1 2 3
Chapter 18 4 5 6 7 8 9 10
105

48. Public Goods and Market Failure
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.
Chapter 18
107