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McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Chapter 16: Externalities.

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Presentation on theme: "McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Chapter 16: Externalities."— Presentation transcript:

1 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Chapter 16: Externalities

2 16-2 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Objectives After studying this chapter, you will be able to:  Explain how externalities arise  Explain why negative externalities lead to overproduction and how property rights, emission charges, marketable permits, and taxes can be used to achieve a more efficient outcome  Explain why positive externalities lead to underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome

3 16-3 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Greener and Smarter  Environmental issues are at the same time everybody’s problem and nobody’s problem.  Human beings are learning more and more every day.  But are we learning more at a fast enough pace?  How can we ensure that we use resources efficiently in the face of externalities?

4 16-4 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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 an external cost and a positive externality creates an external benefit.

5 16-5 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Externalities in Our Lives  The four possible types of externality are:  Negative production externalities  Positive production externalities  Negative consumption externalities  Positive consumption externalities

6 16-6 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Externalities in Our Lives  Negative Production Externalities  Negative production externalities are common.  Examples are noise from aircraft, logging and clearing of forests, and pollution

7 16-7 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Externalities in Our Lives  Positive Production Externalities  Positive production externalities are less common than negative externalities.  Example: a beekeeper locates beehives in an orange- growing area

8 16-8 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Externalities in Our Lives  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.

9 16-9 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Externalities in Our Lives  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 benefits.

10 16-10 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Pollution is an old problem and is faced by both rich industrial countries and poor developing countries.  It is an economic problem that is coped with by balancing benefits and costs.

11 16-11 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  The Demand for a Pollution-Free Environment  The demand for a pollution-free environment is expressed through the political process. This demand has increased for two reasons:  Higher incomes: A high-quality environment is a “normal good,” the demand for which increases with income.  Greater awareness: greater knowledge about the causes of environmental problems raise understanding of environmental issues.

12 16-12 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  The Sources of Pollution  Economic activity pollutes air, water, and land, and these individual areas of pollution interact through the ecosystem.  Air pollution  Emissions causing greenhouse gases are a tough problem to tackle  Water pollution  Output of sewage treatment plants, the use of herbicides, pesticides, and fertilisers  Land pollution  Toxic waste and ordinary household garbage

13 16-13 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Trends in Air Pollution

14 16-14 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Private Costs and Social Costs  A private cost of production is a cost that is borne by the producer, and 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.

15 16-15 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Private Costs and Social Costs  Marginal social cost (MSC) is the marginal cost incurred by the entire society and is the sum of marginal private cost and marginal external cost. MSC = MC + Marginal external cost.  Marginal private cost, marginal external cost, and marginal social cost increase with output.

16 16-16 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia MC Marginal External cost MSC An External Cost 2 75 100 150 225 300 46 Marginal Private cost Marginal Social cost Quantity (thousands of tonnes per month) Cost ( dollars per tonne) Figure 16.2

17 16-17 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Production and Pollution: How Much?  In an unregulated market with an externality, the pollution created depends on the market equilibrium price and quantity of the good produced.

18 16-18 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Deadweight loss D=MSB S= MC MSC Inefficient Market equilibrium Inefficiency with an External Cost 2 75 100 150 225 300 46 Quantity (thousands of tonnes per month) Price and cost ( dollars per tonne) Marginal Social cost Marginal Social Benefit Efficient quantity Efficient equilibrium Figure 16.3

19 16-19 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Property Rights  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.  Establishment of property rights achieves an efficient outcome.

20 16-20 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Cost of pollution Borne by polluter D=MSB S = MC =MSC MC excluding pollution cost Property Rights Achieve an Efficient Outcome 2 75 100 150 225 300 46 Quantity (thousands of tonnes per month) Price and cost ( dollars per tonne) Price equals marginal social cost and MSB Efficient market equilibrium Figure 16.4

21 16-21 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  The Coase Theorem  The Coase theorem is a proposition that if property rights exist, if only a small number of parties are involved, and if 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.

22 16-22 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Transactions costs are the opportunity cost of conducting a transaction.  Example: the transactions costs of buying a home include fees for a real estate agent, and the legal cost associated with the transfer.  When a large number of people are involved and transactions costs are high, the Coase solution is not available

23 16-23 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Government Actions in the Face of External Costs  There are three main methods that the government uses to cope with external costs:  Taxes  Emission charges  Licences and marketable permits

24 16-24 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Taxes  The government can set a tax equal to the 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 honour of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.

25 16-25 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Tax revenue Pollution tax D=MSB S = MC + tax = MSC A Pollution Tax 2 75 88 150 225 300 46 Quantity (thousands of tonnes per month) Price and cost ( dollars per tonne) Marginal social cost and MSB Efficient market equilibrium MC Figure 16.5

26 16-26 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: 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.

27 16-27 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Negative Externalities: Pollution  Marketable Permits  Each firm is assigned a permitted amount of pollution per time 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.

28 16-28 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Private Benefits and Social Benefits  A private benefit is a benefit that the consumer of a good or service receives. 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.

29 16-29 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Marginal social benefit is the marginal benefit enjoyed by the entire society and is the sum of marginal private benefit and marginal external benefit. That is:  MSB = MB + Marginal external benefit.

30 16-30 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia MSB MB 10 20 25 30 40 050100150 200 300 An External Benefit Marginal Social benefit Marginal External benefit Marginal Private benefit Quantity (thousands of students per year) Price (thousands of dollars per student per year) Figure 16.6

31 16-31 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia S=MSC Deadweight loss MSB D=MB 10 20 25 30 40 050100150 200 300 Inefficiency With an External Benefit Marginal Social benefit Quantity (thousands of students per year) Price (thousands of dollars per student per year) Marginal Social cost 15 38 Efficient quantity Inefficient Market equilibrium Figure 16.7

32 16-32 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Government Action in the Face of External Benefits  There are four main methods that the government uses to cope with external benefits:  Public provision  Private subsidies  Vouchers  Patents and copyrights

33 16-33 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Public Provision  Under public provision, a public authority that receives its revenue from the government produces the good or service.  Education services produced by the public universities and schools are examples of public provision

34 16-34 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia S=MSC MSB D=MB 10 20 25 30 40 050100150 200 300 Public Provision to Achieve an Efficient Outcome MSB = MSC Quantity (thousands of students per year) Price and costs (thousands of dollars per student per year) 15 38 Tuition Efficient market equilibrium Efficient quantity Paid by taxpayer Figure 16.8(a)

35 16-35 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Private Subsidies  A subsidy is a payment by the government to private producers. The government can induce private decision makers to consider external benefits by making the subsidy depend on the level of output  If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced increases to that at which marginal cost equals marginal social benefit—an efficient outcome.

36 16-36 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia S=MSC S=MSC-subsidy S=MSC MSB D=MB 10 20 25 30 40 050100150 200 300 Private Subsidy to Achieve an Efficient Outcome MSB = MSC Quantity (thousands of students per year) Price and costs (thousands of dollars per student per year) 15 38 Efficient market equilibrium Efficient quantity Subsidy of $15,000 per student Dollar price Figure 16.8(b)

37 16-37 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Vouchers  A voucher is a token that the government provides to households, which can be used to buy specified goods or services.  A school voucher allows parents to choose the school their children will attend and to use the voucher to pay part of the cost. The school cashes the voucher to pay its bills.

38 16-38 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia S=MSC MSB D=MB 10 20 25 30 40 050100150 200 300 Vouchers Achieve Efficiency MSB = MSC Quantity (thousands of students per year) Price and costs (thousands of dollars per student per year) 15 38 Efficient market equilibrium Value of voucher Dollar price Figure 16.9

39 16-39 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Positive Externalities: Knowledge  Patents and Copyrights  Knowledge is productive and generates external benefits and public policies are required to ensure an efficient level of effort.  Intellectual property rights give the creator of knowledge the property right to the use of that knowledge.  The legal device for granting intellectual property rights are through patent or copyright.

40 16-40 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia END CHAPTER 16


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