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Externalities and Public Goods Lecture 7 – academic year 2013/14 Introduction to Economics Fabio Landini.

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Presentation on theme: "Externalities and Public Goods Lecture 7 – academic year 2013/14 Introduction to Economics Fabio Landini."— Presentation transcript:

1 Externalities and Public Goods Lecture 7 – academic year 2013/14 Introduction to Economics Fabio Landini

2 Where we are… Lecture 1 : Demand and supply model Lecture 2: Elasticity and its application Lecture 4: Demand, Supply and economic policy Lecture 5: Demand, Supply and economic efficiency Lecture 5: Surplus of consumers and producer

3 What do we do today? The external effects of economic activities How do we internalize externalities? The different typologies of economic goods: private goods, public goods, common resources and natural monopolies 3

4 The KYOTO Protocol – since 1997 The Kyoto Protocol, signed in December 1997 at the UNFCCC COP3 (Conference Of Parties), represents the executive instruments of the Framework Convention The countries that are subject to the emission constraint are 39 and they include the European countries (including the East countries), Japan, Russia, United States, Canada, Australia and New Zealand 4

5 The European Directive 2003/87/CE Emissions Trading regulate the exchange of quotas for the emission of greenhouse gas. The final aim is to establish an European market for the emission quotas. During the first three years ( ), the emissions of large combustion plants, such as oil refineries, plants for the production of ferrous metal, mineral goods (concrete, lime, etc.) and the plants for the production of paper and cartboard 5 The KYOTO Protocol – since 1997

6 Market efficiency: A brief recap In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus. The invisible hand (of the market) maximize the total benefit of society Markets are usually good instruments to organize the economic activity Sometimes, however: markets fail 6

7 Externalities: definition and effects When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality. Whenever they do not take into account the third party, the equilibrium prices and quantities are not efficient. Therefore the externalities cause an inefficient allocation of resources, i.e. market failure. 7

8 The effects of externalities on society In the presence of externalities: Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market). The externalities can be negative or positive However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged optimal quantity. 8

9 Negative externalities Costs on other individuals (consumers or producers) that are not directly involved in the market exchange. Example: smoke of cigarettes, cars exhaust gas 9

10 Positive externalities Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange. Example: Vaccines, restoration of a piece of Art, investment in new technologies. 10

11 Externalities and market inefficiency Negative externalities in production Q market > Q optimum (socially desirable quantity) social costs > private costs Positive externalities in production Q market < Q optimum social costs < private costs 11

12 Negative externalities in consumption Q market > Q optimum (socially desirable quantity) Social benefit < private benefit Positive externalities in consumption Q market < Q optimum Social benefit > private benefit 12 Externalities and market inefficiency

13 Negative externalities in production 13 Equilibrium 0 Price of aluminium Q MARKET Demand (private value) Supply (private cost) Social cost Cost of pollution Q OPTIMUM Optimum Quantity of aluminium

14 Positive externalities in production 14 Quantity of Robot of Robot 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private cost) Q MARKET Value of technological diffusion Equilibrium Social cost Optimum

15 Negative externalities in consumption 15 Quantity of alcoholic drinks 0 Price of alcoholic drinks Demand (private value) Supply (private cost) Q MARKET Equilibrium Q OPTIMUM Optimum Social value

16 Positive externalities in consumption 16 Quantity of education 0 Price of education Demand (private value) Supply (private cost) Q MARKET Equilibrium Q OPTIMUM Optimum Social value

17 How to obtain Q optimum ? 1. Government intervention Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities. To internalize an externality means to alter market incentive with subsidies and taxes, so as to induce individuals to take adequately into account the external effects of their actions. 17

18 Obtaining optimal production If the externality is negative: internalization through a tax – the tax reduces the quantity that is exchanged in equilibrium until the social optimum obtains If the externality is positive: internalization through a subsidy – the subsidy increase the quantity that is exchanged in equilibrium until the social optimum obtains 18

19 Public intervention is not always either necessary or efficacious to deal with externalities. Example of private solutions: Ethical codes and social sanctions. NGOs (in the no-profit sector). Integration of different types of activities. System of contracts (Coases theorem). 19 How to obtain Q optimum ? 2. Private solution

20 Externalities and public goods A case in which externalities are of particular relevance is when we deal with specific types of economic goods, called public goods and common resources Example: knowledge (technological spillover), environment (pollution) What are public goods and common resources? 20

21 21 Typologies of economic goods The goods available in our economy can be distinguished along two dimensions: Excludability and Rivalry

22 22 Excludability An individual can be prevented from using a good (e.g. laws usually recognize the private property of a good) Typologies of economic goods

23 23 Rivalry The consumption of a good by an individual prevents the simultaneous consumption of the same good by other individuals Typologies of economic goods

24 24 A bridge connects two shores of a river Given a certain dimension of the bridge, if the n. of people using the bridge increases (congestion): consumption rivalry If there is a fee for the bridge (those who dont pay cannot use it): consumption excludability Example of a public good: A bridge

25 25 Rivalrous Non-rivalrous N. people Many Few Free access Example of the bridge

26 26 Excludable Non- excludable Fee yesNo Given number of people Example of the bridge

27 27 Excludable Rivalrous Non-excludable Rivalrous Excludable Non-rivalrous Non-excludable Non-rivalrous YesNo N. people Many Few Example of the bridge: two-ways table Fee

28 28 Excludable Rivalrous (PRIVATE GOODS) Non-excludable Rivalrous (COMMONS) Excludabe Non-rivalrous (NATURAL MONOPOLY) Non-excludable Non-rivalrous (PUBLIC GOODS) YesNo N. people Many Few Example of the bridge: two-ways table Fee

29 29 Four types of economic goods (1) Private goods Both excludable and rivalrous Example: ice-cream, CDs, etc. Public goods Neither excludable nor rivalrous Example: national defence, scientific knowledge

30 30 Commons Rivalrous, but non-excludable Example: sea fishes Natural monopoly Excludable, but non-rivalrous Example: drinkable water Four types of economic goods (1)

31 31 Public goods and externalities Non-excludable goods all can benefit without paying the price, p = 0 Access to the good cannot be limited; private value = 0, social value > 0 But: production costs > 0 (scarce resources) Who is it going to produce the good, if not paid? Therefore: positive externalities of a public good (autonomously, market produces too few).

32 32 The problem of free riding A free rider is a person who can enjoy the benefit of a good without paying the price

33 33 The bridge is built The bridge is not built I contribute (I pay 10) I do not contribute (I dont pay) In order to build the bridge, a voluntary contribution equal to 10 is requested….. It is convenient for me NOT to pay!!!

34 34 The problem of free riding Since public goods are non-excludable, each individual can refuse to pay the good, hoping that other people will pay in his/her place. If everybody reasons the same, the good is not produced. IMPORTANT: the presence of free riding makes it impossible to rely on the market to supply public goods.

35 35 Solution of the free riding problem If the benefits > costs (social value > 0), public authorities can produce the good by relying on taxes. Example: fireworks by Moenas Municipality – 500 inhabitants; value for each inhabitant =10 ; cost of fireworks = – Fireworks tax for each inhabitant = 2, it covers the costs. – Consumer surplus = 8 (= ).

36 36 The need for a State to produces public goods, whose cost is financed via taxes, represents the main economic justification for the existence of taxation (and thus for the fight against tax evasion): that is the minimum State.

37 37 Common resources Common resources are non-excludable They are freely available for anybody to exploit But they are rival: the consumption of the good by one individual reduces the possibility for other individual to consume

38 38 Examples of common resources Air and clean water Congested streets Fishes, whale and other wild species

39 39 The tragedy of the commons When an individual, by using a resource, diminishes the availability of the resource for others we encounter the tragedy of the commons. Common resources tend to be over-exploited This generates a negative externality.

40 40 The public administration can: Impose a tax on usage; Regulate the use of the resource; Transform the common resource in a private good (by defining and enforcing individual property rights on the resource. The tragedy of the commons

41 41 The importance of property rights When the absence of property rights is the cause of market failures, public intervention can potentially solve the problem in 3 ways 1)By defining property rights, which enable the market to operate efficiently; 2)By regulating individual behaviour; 3)By producing a good that the market does not supply.

42 Conclusion When the transaction between consumer and producer has effects on a third party, there is an externality. Negative (positive) externalities imply that the quantity exchanged in the market equilibrium is superior (inferior) to the social optimum. The solution to the problem of externalities can be pursued both by private parties and public intervention 42

43 43 Economic goods differ in terms of excludability and rivalry. The market can function when goods are private i.e. both excludable and rivalrous. Public goods are neither excludable nor rivalrous, hence the market does not function well. In because of free riding, it is the public sector who is responsible to supply public goods. Conclusion

44 44 Conclusion Collective resources are rivalrous but not excludable. Since individuals do not pay for the use of the resource, there is a tendency toward over- exploitation. Public administration may limit the use of common resources via access regulation and taxes


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