2. 16 Externalities

3. After studying this chapter you will be able to  Explain how externalities arise  Explain why negative externalities lead to inefficient overproduction and the actions that might achieve an efficient outcome  Explain why positive externalities lead to inefficient underproduction and the actions that might achieve an efficient outcome Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

4. We burn huge quantities of fossil fuels—coal, natural gas, and oil—that cause acid rain and global warming. We dump toxic waste into rivers, lakes, and oceans. These environmental issues are simultaneously everybody’s problem and nobody’s problem. The fish stocks in the world’s oceans are not owned by anyone. They are common resources that everyone is free to use. But we are overusing our fish stocks and brings some species into extinction. What can be done to conserve the world’s fish stocks? Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

5. Externalities in Our Lives An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer. A negative externality imposes a cost and a positive externality creates a benefit. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

6. The four types of externality are  Negative production externalities  Positive production externalities  Negative consumption externalities  Positive consumption externalities Externalities in Our Lives Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

7. Negative Production Externalities Negative production externalities are common. Some examples are noise from aircraft and trucks, polluted rivers and lakes, the destruction of animal habitat, and air pollution in major cities from auto exhaust. Externalities in Our Lives Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

8. Positive Production Externalities Positive production externalities are less common that negative externalities. Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit production gets an external benefit from the bees, which pollinate the fruit orchards and boost fruit output; and honey production gets an external benefit from the orchards. Externalities in Our Lives Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

9. Negative Consumption Externalities Negative consumption externalities are a common part of everyday life. Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others. Externalities in Our Lives Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

10. Positive Consumption Externalities Positive consumption externalities are also common. When you get a flu vaccination, everyone you come into contact with benefits. When the owner of an historic building restores it, everyone who sees the building gets pleasure. Externalities in Our Lives Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

11. Negative Externality: Pollution Private Cost and Social Cost of Pollution A private cost of production is a cost that is borne by the producer. Marginal private cost (MC) is the private cost of producing one more unit of a good or service. An external cost of production is a cost that is not borne by the producer but is borne by others. Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

12. Negative Externality: Pollution Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. Marginal social cost is the sum of marginal private cost and marginal external cost. MSC = MC + Marginal external cost We express costs in dollars but remember that the dollars represent the value of a forgone opportunity. Marginal private cost, marginal external cost, and marginal social cost increase with output. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

13. External Cost and Output Figure 16.1 illustrates the MC curve, … the MSC curve, … and marginal external cost as the vertical distance between the MC and MSC curves. Negative Externality: Pollution Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

15. Negative Externality: Pollution Production and Pollution: How Much? In the market for a good with an externality that is unregulated, the amount of pollution created depends on the equilibrium quantity of the good produced. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

16. Figure 16.2 shows the equilibrium in an unregulated market with an external cost. The quantity of the good produced is where marginal private cost (MC) equals marginal social benefit (MSB). Negative Externality: Pollution Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

18. At the market equilibrium, MSB is less than MSC, so the market produces an inefficient quantity of the good. At the efficient quantity of the good, MSC = MSB. With no regulation, the market produces too much of the good and creates a deadweight loss. Negative Externality: Pollution Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

19. Negative Externality: Pollution Property Rights Sometimes externalities arise because of the absence of property rights. Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

20. Figure 16.3 illustrates how the establishment of property rights achieves an efficient outcome. The producer of the good bears all the costs. The market outcome is efficient because at the quantity of the good produced MSC equals MSB. Negative Externality: Pollution Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

22. Negative Externality: Pollution The Coase Theorem The Coase theorem is a proposition that if property rights exist, only a small number of parties are involved, and transactions costs (defined below) are low, then private transactions are efficient. There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

23. Negative Externality: Pollution The Coase solution works only if transactions costs are low. Transactions costs are the cost of conducting a transaction. An example is the transactions costs of buying a home include fees for a realtor, a mortgage loan advisor, and legal assistance. When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

24. Negative Externality: Pollution Government Actions in a Market with External Costs There are three main methods that the government uses to cope with external costs:  Taxes  Emission charges  Cap-and-trade Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

25. Negative Externality: Pollution Taxes The government can set a tax equal marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost, MC + tax = MSC. This tax is called Pigovian tax, in honor of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

26. Figure 16.4 shows how a pollution tax equal to the marginal external cost can achieve an efficient outcome. At the quantity of the good produced, MSC = MSB. The government collect a tax revenue. Negative Externality: Pollution Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

28. Negative Externality: Pollution Emissions Charges The government sets a price per unit of pollution, so that the more a firm pollutes, the higher are its emissions charges. For the emissions charge to induce the firm to generate the efficient level of pollution, the government would need a lot of information that is usually unavailable. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

29. Negative Externality: Pollution Cap-and-Trade Each firm is assigned a permitted amount of pollution per period and firms trade permits. The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome. This method has been used successfully in the United States to decrease lead pollution. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

30. Positive Externality: Knowledge Knowledge comes from education and research and creates external benefits. Private Benefits and Social Benefits A private benefit is a benefit that the consumer of a good or service receives, and marginal private benefit (MB) is the private benefit from consuming one more unit of a good or service. An external benefit is a benefit that someone other than the consumer receives. Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

31. Marginal social benefit is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else on whom the benefit falls. Marginal social benefit is the sum of marginal private benefit and marginal external benefit. That is: MSB = MB + Marginal external benefit. Positive Externality: Knowledge Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

32. Positive Externality: Knowledge Figure 16.5 illustrates the marginal private benefit, … marginal external benefit, … and marginal social benefit. It identifies marginal external benefit as the vertical distance between the MB and MSB curves. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

34. Positive Externality: Knowledge Figure 16.6 shows how a private market underproduces an item that generates an external benefit … and creates a deadweight loss. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

36. Government Action in the Face of External Benefits Four devices that the government can use to achieve a more efficient allocation of resources in the presence of external benefits are  Public production  Private subsidies  Vouchers  Patents and copyrights Positive Externality: Knowledge Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

37. Positive Externality: Knowledge Public Production Under public production, a public authority that receives payment from the government produces the good or service. Figure 16.7(a) shows how public production can achieve an efficient outcome. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

39. Private Subsidies A subsidy is a payment by the government to private producers. If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced is efficient. Positive Externality: Knowledge Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

40. Positive Externality: Knowledge Figure 16.7(b) shows how a subsidy can achieve an efficient outcome. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

42. Positive Externality: Knowledge Vouchers A voucher is a token that the government provides to households, which they can use to buy specified goods or services. The figure shows how vouchers can achieve a more efficient outcome. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

44. Patents and Copyrights Intellectual property rights give the creator of knowledge the property right to the use of that knowledge. The legal device for establishing an intellectual property right is the patent or a copyright. A patent or copyright is a government-sanctioned exclusive right given to an inventor of a good, service or productive process to use to produce, use and sell the invention for a given number of years. Positive Externality: Knowledge Copyright © 2013 Pearson Canada Inc., Toronto, Ontario