1. Chapter Eighteen Externalities, Open- Access, and Public Goods

2. © 2009 Pearson Addison-Wesley. All rights reserved. 18-2 Topics  Externalities.  The Inefficiency of Competition with Externalities.  Market Structure and Externalities.  Allocating Property Rights to Reduce Externalities.  Open-Access Common Property.  Public Goods.

3. © 2009 Pearson Addison-Wesley. All rights reserved. 18-3 Externalities  externality - the direct effect of the actions of a person or firm on another person’s wellbeing or a firm’s production capability rather than an indirect effect through changes in prices.  negative externality - an externality that harms someone.  positive externality – an externality that benefits other.

4. © 2009 Pearson Addison-Wesley. All rights reserved. 18-4 The Inefficiency of Competition with Externalities  Firms produce paper and by-products of the production process—such as air and water pollution—that harm people who live near paper mills.  we’ll call the pollution gunk.  each ton of paper that is produced increases the amount of gunk by one unit,  the only way to decrease the volume of gunk is to reduce the amount of paper manufactured.  no less-polluting technologies are available,  it is not possible to locate plants where the gunk bothers no one.

5. © 2009 Pearson Addison-Wesley. All rights reserved. 18-5 The Inefficiency of Competition with Externalities (cont).  private cost - the cost of production only, not including externalities.  social cost - the private cost plus the cost of the harms from externalities

6. © 2009 Pearson Addison-Wesley. All rights reserved. 18-6 Figure 18.1 Welfare Effects of Pollution in a Competitive Market P r ice of pape r, p, $ per ton Demand 450 p c = 240 30 Q c = 1052250 e c Q,Tons of paper per day MC p

7. © 2009 Pearson Addison-Wesley. All rights reserved. 18-7 The Inefficiency of Competition with Externalities (cont).  social marginal cost (MCs) - is the cost of manufacturing one more ton of paper to the paper firms plus the additional externality damage to people in the community from producing this last ton of paper.

8. © 2009 Pearson Addison-Wesley. All rights reserved. 18-8 Figure 18.1 Welfare Effects of Pollution in a Competitive Market P r ice of pape r, p, $ per ton Demand MC p g g s = p + g 450 p s = 282 p c = 240 30 84 198 Q c = 105 Q s = 84 2250 e c e s A B F C D E H G Q,Tons of paper per day MC p

9. © 2009 Pearson Addison-Wesley. All rights reserved. 18-9 Figure 18.1 Welfare Effects of Pollution in a Competitive Market (cont.)

10. © 2009 Pearson Addison-Wesley. All rights reserved. 18-10 The Inefficiency of Competition with Externalities (cont). A deadweight loss results because the competitive market equates price with private marginal cost instead of with social marginal cost.

11. © 2009 Pearson Addison-Wesley. All rights reserved. 18-11 The Inefficiency of Competition with Externalities (cont).  A competitive market produces excessive negative externalities.  The optimal amount of pollution is greater than zero.

12. © 2009 Pearson Addison-Wesley. All rights reserved. 18-12 Table 18.1 Industrial CO 2 Emissions, 2004

13. © 2009 Pearson Addison-Wesley. All rights reserved. 18-13 Reducing Externalities.  Kyoto agreement.  Reached in Kyoto, Japan, in 1997  required most industrialized nations to reduce CO 2 emissions by an average of 5.2% below 1990 levels by 2008–2012.  To achieve this goal, the United States, Europe, and Japan need to curb their CO 2 emissions by 31%, 22%, and 35%, respectively, from the levels that would have been attained in the absence of a reduction policy.  The Bush administration rejected this agreement.

14. © 2009 Pearson Addison-Wesley. All rights reserved. 18-14 Reducing Externalities (cont).  The government:  might control pollution directly by restricting the amount of pollution that firms may produce  emissions standard  by taxing them for pollution they create. A governmental limit on the amount of air or water pollution  emissions fee – tax on air pollution  effluent charge - tax on discharges into the air

15. © 2009 Pearson Addison-Wesley. All rights reserved. 18-15 Emissions Fee.  The government may impose costs on polluters by taxing their output or the amount of pollution produced.  internalize the externality - to bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others)

16. © 2009 Pearson Addison-Wesley. All rights reserved. 18-16 Figure 18.2 Taxes to Control Pollution P r ice of pape r, p, $ per ton Demand MC p g s = p + t(Q) MC p +   = 84 450 p s = 282 MC p = 198 MC g = 84 Q s = 84 2250 e s Q,Tons of paper per day

17. © 2009 Pearson Addison-Wesley. All rights reserved. 18-17 Solved Problem 18.1  For the market with pollution in Figure 18.1, what constant, specific tax, τ, on output could the government set to maximize welfare?

18. © 2009 Pearson Addison-Wesley. All rights reserved. 18-18 Cost-Benefit Analysis  Result from the supply-and-demand analysis: a competitive market produces too much pollution because the price of output equals the marginal private cost rather than the marginal social cost.  Cost-benefit analysis offers another interpretation of the pollution problem in terms of the marginal cost and benefit of the pollution itself.

19. © 2009 Pearson Addison-Wesley. All rights reserved. 18-19 Figure 18.3 Cost-Benefit Analysis of Pollution

20. © 2009 Pearson Addison-Wesley. All rights reserved. 18-20 Cost-Benefit Analysis (cont). Welfare is maximized by reducing output and pollution until the marginal benefit from less pollution equals the marginal cost of less output.

21. © 2009 Pearson Addison-Wesley. All rights reserved. 18-21 Monopoly and Externalities The monopoly outcome may be less than the social optimum even with an externality.

22. © 2009 Pearson Addison-Wesley. All rights reserved. 18-22 Figure 18.4 Monopoly, Competition, and Social Optimum with Pollution

23. © 2009 Pearson Addison-Wesley. All rights reserved. 18-23 Monopoly and Externalities (cont).  The reason that a monopoly may produce too little or too much is that it faces two offsetting effects:  The monopoly tends to produce too little output because it sets its price above its marginal cost, but  the monopoly tends to produce too much output because its decisions depend on its private marginal cost instead of the social marginal cost

24. © 2009 Pearson Addison-Wesley. All rights reserved. 18-24 Solved Problem 18.2  In Figure 18.4, what is the effect on output, price, and welfare of taxing the monopoly an amount equal to the marginal harm of the externality?

25. © 2009 Pearson Addison-Wesley. All rights reserved. 18-25 Allocating Property Rights to Reduce Externalities  property right - the exclusive privilege to use an asset

26. © 2009 Pearson Addison-Wesley. All rights reserved. 18-26 Coase Theorem  Coase Theorem - the optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined.

27. © 2009 Pearson Addison-Wesley. All rights reserved. 18-27 Coase Theorem - Scenario  Two firms: a chemical plant and a boat rental company, that share a small lake.  The chemical manufacturer dumps its waste by- products, which smell bad but are otherwise harmless, into the lake. The chemical company can reduce pollution only by restricting its output; it has no other outlet for this waste.  The resulting pollution damages the boat rental firm’s business.  There are other lakes nearby where people can rent boats. Therefore, because they dislike the smell of the chemicals, people rent from this firm only if it charges a low enough price to compensate them fully for the smell.

28. © 2009 Pearson Addison-Wesley. All rights reserved. 18-28 No Property Rights.  If the firms do not negotiate, the chemical firm produces the output level that maximizes its profit, ignoring the effect on the boat rental firm.

29. © 2009 Pearson Addison-Wesley. All rights reserved. 18-29 Table 18.2 (a) Property Rights and Bargaining

30. © 2009 Pearson Addison-Wesley. All rights reserved. 18-30 Property Right to Be Free of Pollution.  If a court or the government grants the boat rental firm the property right to be free of pollution, the firm can prevent the chemical company from dumping at all.

31. © 2009 Pearson Addison-Wesley. All rights reserved. 18-31 Table 18.2 (b) Property Rights and Bargaining

32. © 2009 Pearson Addison-Wesley. All rights reserved. 18-32 Property Right to Pollute.  Now suppose that the chemical company has the property right to dump in the lake (for example, by paying a pollution tax).

33. © 2009 Pearson Addison-Wesley. All rights reserved. 18-33 Table 18.2 (c) Property Rights and Bargaining

34. © 2009 Pearson Addison-Wesley. All rights reserved. 18-34 Results from Coase Theorem  To summarize the results from the Coase Theorem:  If there are no impediments to bargaining, assigning property rights results in the efficient outcome at which joint profits are maximized.  Efficiency is achieved regardless of who receives the property rights.  Who gets the property rights affects the income distribution.  The property rights are valuable. The party with the property rights may be compensated by the other party.

35. © 2009 Pearson Addison-Wesley. All rights reserved. 18-35 Problems with the Coase Approach.  If transaction costs are very high, it might not pay for the two sides to meet.  If firms engage in strategic bargaining behavior, an agreement may not be reached.  If either side lacks information about the costs or benefits of reducing pollution, a nonefficient outcome may occur.

36. © 2009 Pearson Addison-Wesley. All rights reserved. 18-36 Markets for Pollution  cap-and-trade system - the government gives firms permits, each of which confers the right to create a certain amount of pollution. Each firm may use its permits or sell them to other firms.

37. © 2009 Pearson Addison-Wesley. All rights reserved. 18-37 Markets for Pollution (cont).  Suppose that the cost in terms of forgone output from eliminating each ton of pollution is $200 at one plant and $300 at another.  If the government tells both plants to reduce pollution by 1 ton,  TC = $500.  With tradable permits, the first plant can reduce its pollution by 2 tons and sell its allowance to the second plant, so the total social cost is only $400.

38. © 2009 Pearson Addison-Wesley. All rights reserved. 18-38 Open-Access Common Property  open-access common property - resources to which everyone has free access

39. © 2009 Pearson Addison-Wesley. All rights reserved. 18-39 Overuse of Open-Access Common Property  Common Pools.  The Internet.  Roads.  Fisheries.

40. © 2009 Pearson Addison-Wesley. All rights reserved. 18-40 Solving the Commons Problem  Government Regulation of Commons.  Assigning Property Rights.

41. © 2009 Pearson Addison-Wesley. All rights reserved. 18-41 Public Goods  public good - a commodity or service whose consumption by one person does not preclude others from also consuming it.  rivalry - only one person can consume the good  exclusion - means that others can be prevented from consuming the good.

42. © 2009 Pearson Addison-Wesley. All rights reserved. 18-42 Table 18.3 Rivalry and Exclusion

43. © 2009 Pearson Addison-Wesley. All rights reserved. 18-43 Public Goods (cont).  A public good produces a positive externality, and excluding anyone from consuming a public good is inefficient.

44. © 2009 Pearson Addison-Wesley. All rights reserved. 18-44 Markets for Public Goods  Markets for public goods exist only if nonpurchasers can be excluded from consuming them.  Thus, markets do not exist for nonexclusive public goods.  Usually, if the government does not provide a nonexclusive public good, no one provides it.

45. © 2009 Pearson Addison-Wesley. All rights reserved. 18-45 Demand for Public Goods.  Because a public good lacks rivalry, many people can get pleasure from the same unit of output.  As a consequence, the social demand curve or willingness-to-pay curve for a public good is the vertical sum of the demand curves of each individual.

46. © 2009 Pearson Addison-Wesley. All rights reserved. 18-46 Demand for Public Goods (cont).  Guards patrolling the mall provide a service without rivalry:  All the stores in the mall are simultaneously protected.  Each store’s demand for guards reflects its marginal benefit from a reduction in thefts due to the guards.

47. © 2009 Pearson Addison-Wesley. All rights reserved. 18-47 Figure 18.5 Inadequate Provision of a Public Good

48. © 2009 Pearson Addison-Wesley. All rights reserved. 18-48 Free Riding.  free ride - to benefit from the actions of others without paying.

49. © 2009 Pearson Addison-Wesley. All rights reserved. 18-49 Free Riding - Example  Two stores in a mall that are deciding whether to hire one guard or none.  The cost of hiring a guard is $10 per hour.  The benefit to each store is $8.  Because the collective benefit, $16, is greater than the cost of hiring a guard, the optimal solution is to hire the guard.

50. © 2009 Pearson Addison-Wesley. All rights reserved. 18-50 Table 18.4 Private Payments for a Public Good

51. © 2009 Pearson Addison-Wesley. All rights reserved. 18-51 Reducing Free Riding  Methods that may be used include  social pressure,  mergers,  compulsion,  privatization.

52. © 2009 Pearson Addison-Wesley. All rights reserved. 18-52 Valuing Public Goods  The government may try to determine the value that consumers place on the public good through:  surveys  voting results.

53. © 2009 Pearson Addison-Wesley. All rights reserved. 18-53 Table 18.5 Voting on $300 Traffic Signals

54. © 2009 Pearson Addison-Wesley. All rights reserved. 18-54 Cross Chapter Analysis: Emissions Fees Versus Standards Under Uncertainty

55. © 2009 Pearson Addison-Wesley. All rights reserved. 18-55 Appendix 18A: Welfare Effects of Pollution in a Competitive Market