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Chapter 18 Externalities and Public Goods. ©2005 Pearson Education, Inc.Chapter 182 Topics to be Discussed Externalities Ways of Correcting Market Failure.

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Presentation on theme: "Chapter 18 Externalities and Public Goods. ©2005 Pearson Education, Inc.Chapter 182 Topics to be Discussed Externalities Ways of Correcting Market Failure."— Presentation transcript:

1 Chapter 18 Externalities and Public Goods

2 ©2005 Pearson Education, Inc.Chapter 182 Topics to be Discussed Externalities Ways of Correcting Market Failure Externalities and Property Rights Common Property Resources Public Goods Private Preferences for Public Goods

3 ©2005 Pearson Education, Inc.Chapter 183 Externalities Externalities arise between producers, between consumers, or between producers and consumers Externalities are the effects of production and consumption activities not directly reflected in the market They can be negative or positive

4 ©2005 Pearson Education, Inc.Chapter 184 Externalities Negative Action by one party imposes a cost on another party Plant dumps waste in a river, affecting those downstream The firm has no incentive to account for the external costs that it imposes on those downstream

5 ©2005 Pearson Education, Inc.Chapter 185 Externalities Positive 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

6 ©2005 Pearson Education, Inc.Chapter 186 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 We can show the competitive market firm decision and the market demand and supply curves

7 ©2005 Pearson Education, Inc.Chapter 187 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 given by the intersection of supply and demand

8 ©2005 Pearson Education, Inc.Chapter 188 Negative Externalities and Inefficiency The MC curve for the firm is the marginal cost of production Firm maximizes profit by producing where MC equals price in a competitive firm As firm output increases, external costs on fishermen also increase, measured by the marginal external cost curve From a social point of view, the firm produces too much output

9 ©2005 Pearson Education, Inc.Chapter 189 External Costs MC S = MC I P1P1 q1q1 P1P1 Q1Q1 MSC MSC I Firm output Price Industry output Price MEC MEC I q* P* Q* D Firm will produce q1 at P1. There is MEC of production from the waste released. The MSC is true cost of production. The profit maximizing firm produces at q 1 while the efficient output level is q*.

10 ©2005 Pearson Education, Inc.Chapter 1810 External Costs Aggregate social cost of negative externality By not producing at the efficient level, there is a social cost on society. MC S = MC I D P1P1 P1P1 q1q1 Q1Q1 MSC MSC I Firm output Price Industry output Price MEC MEC I q* P* Q*

11 ©2005 Pearson Education, Inc.Chapter 1811 External Cost Negative externalities encourage inefficient firms to remain in the industry and create excessive production in the long run

12 ©2005 Pearson Education, Inc.Chapter 1812 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 Shown by the Marginal External Benefit curve (MEB) Marginal Social Benefit (MSB) curve adds MEB +D

13 ©2005 Pearson Education, Inc.Chapter 1813 MC P1P1 External Benefits Repair Level Value D 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.

14 ©2005 Pearson Education, Inc.Chapter 1814 Ways of Correcting Market Failure Assumption: The market failure is pollution Output decision and emissions decision are independent Firm has chosen its profit-maximizing output level MSC is marginal social cost of emissions Equivalent to MEC from before Upward sloping because of substantially increasing harm as pollution increases

15 ©2005 Pearson Education, Inc.Chapter 1815 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, there is little cost to controlling them Large reductions require costly changes in production process

16 ©2005 Pearson Education, Inc.Chapter 1816 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

17 ©2005 Pearson Education, Inc.Chapter 1817 The Efficient Level of Emissions Dollars/ Unit of Emissions Level of Emissions MSC MCA E* The efficient level of emissions is where MCA = MSC. 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

18 ©2005 Pearson Education, Inc.Chapter 1818 Ways of Correcting Market Failure Firms can be encouraged to reduce emissions to the efficient level in three ways: 1.Emissions standards 2.Emissions fees 3.Transferable emissions permits

19 ©2005 Pearson Education, Inc.Chapter 1819 Ways of Correcting Market Failure Options for Reducing Emissions to E* 1.Emissions 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 2.Emissions Fee Charge levied on each unit of emission

20 ©2005 Pearson Education, Inc.Chapter 1820 Standards and Fees Level of Emissions Dollars/ Unit of Emissions MSC MCA 3 12 E* Standard Fee

21 ©2005 Pearson Education, Inc.Chapter 1821 Total Abatement Cost Cost is less than the fee if emissions were not reduced. Standards and Fees Level of Emissions Dollars/ Unit of Emissions 3 Total Fee of Abatement 12 Fee MSC MCA E*

22 ©2005 Pearson Education, Inc.Chapter 1822 Ways of Correcting Market Failure Standards Versus Fees Assumptions Policymakers have asymmetric information Administrative costs require the same fee or standard for all firms

23 ©2005 Pearson Education, Inc.Chapter 1823 The Case for Fees Assume two firms Same marginal social cost curve Different marginal abatement cost curves MCA 1 and MCA 2 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

24 ©2005 Pearson Education, Inc.Chapter 1824 MCA 1 MCA 2 The Case for Fees Fee per Unit of Emissions Level of Emissions The cost minimizing solution would be an abatement of 6 for Firm 1 and 8 for Firm 2 and MCA 1 = MCA 2 = $3.

25 ©2005 Pearson Education, Inc.Chapter 1825 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

26 ©2005 Pearson Education, Inc.Chapter 1826 The Case for Fees Fee per Unit of Emissions Level of Emissions MCA 1 MCA 2 The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA 2 < MCA Firm 2s Reduced Abatement Costs Firm 1s Increased Abatement Costs

27 ©2005 Pearson Education, Inc.Chapter 1827 Ways of Correcting Market Failure Advantages of Fees When equal standards must be used, fees achieve the same emission abatement at a lower cost Fees create an incentive to install equipment that would reduce emissions further

28 ©2005 Pearson Education, Inc.Chapter 1828 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

29 ©2005 Pearson Education, Inc.Chapter 1829 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 costs and decrease in abatement costs Net increase in social costs is smaller than with fees

30 ©2005 Pearson Education, Inc.Chapter 1830 ABC is the increase in social cost less the decrease in abatement cost. The Case for Standards Level of Emissions Fee per Unit of Emissions Based on incomplete information, standard is 9 (12.5% decrease). ADE < ABC Based on incomplete information, fee is $7 (12.5% decrease). Emission increases to 11. Marginal Social Cost Marginal Cost of Abatement B C E D A

31 ©2005 Pearson Education, Inc.Chapter 1831 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 emissions levels and less certainty on the cost of abatement

32 ©2005 Pearson Education, Inc.Chapter 1832 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

33 ©2005 Pearson Education, Inc.Chapter 1833 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

34 ©2005 Pearson Education, Inc.Chapter 1834 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

35 ©2005 Pearson Education, Inc.Chapter 1835 The Costs and Benefits of Reduced Sulfur Dioxide Emissions Costs of Reducing Emissions Conversion to natural gas from coal and oil Emission control equipment Benefits of Reducing Emissions Health Reduction in corrosion Aesthetic

36 ©2005 Pearson Education, Inc.Chapter 1836 The Costs and Benefits of Reduced Sulfur Dioxide Emissions The efficient sulfur dioxide concentration equates the marginal abatement cost to the marginal social cost Can show the marginal abatement cost curve in a series of steps, each representing a different abatement technology

37 ©2005 Pearson Education, Inc.Chapter 1837 Sulfur Dioxide Emissions Reductions Sulfur dioxide concentration (ppm) Dollars per unit of reduction Marginal Social Cost Marginal Abatement Cost Observations MAC = is slightly below actual emission level Economic efficiency improved

38 ©2005 Pearson Education, Inc.Chapter 1838 Emissions Trading and Clean Air Bubbles Firm can adjust pollution controls for individual sources of pollutants as long as a total pollutant limit is not exceeded Offsets New emissions must be offset by reducing existing emissions 2000 offsets since 1979

39 ©2005 Pearson Education, Inc.Chapter 1839 Emissions Trading and Clean Air Cost of achieving an 85% reduction in hydrocarbon emissions for DuPont Three Options 85% reduction at each source plant (total cost = $105.7 million) 85% reduction at each plant with internal trading (total cost = $42.6 million) 85% reduction at all plants with internal and external trading (total cost = $14.6 million)

40 ©2005 Pearson Education, Inc.Chapter 1840 Emissions Trading and Clean Air 1990 Clean Air Act Since 1990, the cost of the permits has fallen from an expected $300 to below $100 Causes of the drop in permit prices More efficient abatement techniques Price of low sulfur coal has fallen

41 ©2005 Pearson Education, Inc.Chapter 1841 Price of Tradable Emissions Permits

42 ©2005 Pearson Education, Inc.Chapter 1842 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

43 ©2005 Pearson Education, Inc.Chapter 1843 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 scrap will be at m and m 1 > m* With refundable deposit, MC increases and MC = MSC = MCR

44 ©2005 Pearson Education, Inc.Chapter 1844 The Efficient Amount of Recycling

45 ©2005 Pearson Education, Inc.Chapter 1845 Refundable Deposits Deposit is paid when bottle is purchased and then refunded when bottle returned Can choose 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 increases supply of recycled glass and lowers price of glass

46 ©2005 Pearson Education, Inc.Chapter 1846 Refundable Deposits Amount of Glass $ D Price falls to P and the amount of recycled glass increases to M*. SvSv SrSr S The supply of glass is the sum of the supply of virgin glass (S V ) and the supply of recycled glass (S r ). M1M1 P Without refunds the price of glass is P and S r is M 1. SrSr S P M* With refunds S r increases to S r and S increases to S.

47 ©2005 Pearson Education, Inc.Chapter 1847 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 would control upstream emissions

48 ©2005 Pearson Education, Inc.Chapter 1848 Externalities and Property Rights 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

49 ©2005 Pearson Education, Inc.Chapter 1849 Profits Under Alternative Emissions Choices (Daily)

50 ©2005 Pearson Education, Inc.Chapter 1850 Externalities and Property Rights Assumptions Factory pays for the filter Fishermen pay for the treatment plant Efficient Solution Buy the filter and do not build the plant

51 ©2005 Pearson Education, Inc.Chapter 1851 Bargaining with Alternative Property Rights

52 ©2005 Pearson Education, Inc.Chapter 1852 Externalities and Property Rights 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

53 ©2005 Pearson Education, Inc.Chapter 1853 Costly Bargaining – The Role of Strategic Behavior Bargaining requires clearly defined rules and property rights If property rights were not clear, the other party might not be willing to pay as much and the bargaining process would break down One party might incorrectly assume the other party will eventually break down and accept less Problems also arise when there are many parties affected

54 ©2005 Pearson Education, Inc.Chapter 1854 A Legal Solution – Suing for Damages In many situations involving externalities, one party is harmed (victim) They can recover monetary damages equal to harm suffered A suit for damages is different than effluent fee since the victim, not the government, is paid

55 ©2005 Pearson Education, Inc.Chapter 1855 A Legal Solution – Suing for Damages – Example 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)

56 ©2005 Pearson Education, Inc.Chapter 1856 A Legal Solution – Suing for Damages – Example 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 A suit for damages results in an efficient outcome

57 ©2005 Pearson Education, Inc.Chapter 1857 The Coase Theorem at Work Negotiating an Efficient Solution 1987 – New York garbage spill (200 tons) littered New Jersey beaches The potential cost of litigation resulted in a solution that was mutually beneficial to both parties

58 ©2005 Pearson Education, Inc.Chapter 1858 Common Property Resources Characteristics Everyone has free access Likely to be overutilized Examples Air and water Fish and animal populations Minerals

59 ©2005 Pearson Education, Inc.Chapter 1859 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

60 ©2005 Pearson Education, Inc.Chapter 1860 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

61 ©2005 Pearson Education, Inc.Chapter 1861 Common Property Resources Fish per Month Benefits, Costs ($ per fish) Demand (MB) 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.

62 ©2005 Pearson Education, Inc.Chapter 1862 Common Property Resources Solution Private ownership Owner will set fee for use 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 when private ownership is not possible, the government steps in

63 ©2005 Pearson Education, Inc.Chapter 1863 Crawfish Fishing in Louisiana Crawfish has become very popular in restaurants As a common property resource, too many crawfish have been trapped, causing the population to fall below efficient level Finding the Efficient Crawfish Catch F = crawfish catch in millions of pounds/yr C = cost in dollars/pound

64 ©2005 Pearson Education, Inc.Chapter 1864 Crawfish Fishing in Louisiana Demand C = = F MSC C = F PC C = F Efficient Catch D = MSC 9.2 million pounds

65 ©2005 Pearson Education, Inc.Chapter 1865 Crawfish Catch (millions of pounds) Cost ($/pound) Demand Marginal Social Cost Private Cost Crawfish as a Common Property Resource

66 ©2005 Pearson Education, Inc.Chapter 1866 Public Goods 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 Example – use of lighthouse by a ship

67 ©2005 Pearson Education, Inc.Chapter 1867 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

68 ©2005 Pearson Education, Inc.Chapter 1868 Efficiency and Public 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

69 ©2005 Pearson Education, Inc.Chapter 1869 D1D1 D2D2 D D 1 is demand for consumer 1. D 2 is demand for consumer 2. D is total demand for all consumers. Efficient Public Good Provision Output 0 Benefits (dollars) $4.00 $5.50 $7.00 MC $1.50 Efficient output occurs where MC = total MB 2 units of output. MB is $ $4.00 or $5.50.

70 ©2005 Pearson Education, Inc.Chapter 1870 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

71 ©2005 Pearson Education, Inc.Chapter 1871 Public Goods and Market Failure Establishing a mosquito abatement company How do you measure output? Who do you charge? A mosquito meter?

72 ©2005 Pearson Education, Inc.Chapter 1872 The Demand for Clean Air Clean Air is a public good Nonexclusive and nonrival No market and no observable price at which people are willing to trade clean air for other goods

73 ©2005 Pearson Education, Inc.Chapter 1873 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

74 ©2005 Pearson Education, Inc.Chapter 1874 The Demand for Clean Air Nitrogen Oxides (pphm) 0 Dollars Low Income Middle Income High Income

75 ©2005 Pearson Education, Inc.Chapter 1875 The Demand for Clean Air Findings The amount of people who 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

76 ©2005 Pearson Education, Inc.Chapter 1876 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

77 ©2005 Pearson Education, Inc.Chapter 1877 Private Preferences for Public Goods Can represent different citizens willingness to pay for education minus any required tax payments In general, benefit from increased spending on education increases as spending increases Tax payments to provide more education increase as well

78 ©2005 Pearson Education, Inc.Chapter 1878 Determining the Level of Educational Spending Educational spending per pupil $0 Willingness to pay $ $1200 $600 $1800$2400 AW The efficient level of educational spending is determined by summing the willingness to pay for education for each of three citizens. 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. W2W2 W3W3 W1W1

79 ©2005 Pearson Education, Inc.Chapter 1879 Private Preferences for Public Goods Question Will the median voter selection always be efficient? Answer If two of the three preferred $1200, there would be over-investment If two of the three preferred $600, there would be under-investment

80 ©2005 Pearson Education, Inc.Chapter 1880 Private Preferences for Public Goods Majority rule is inefficient because it weighs each citizens preference equally The efficient outcome weighs each citizens vote by his or her strength of preference


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