2Objectives After studying this chapter, you will be able to: Explain how externalities ariseExplain why negative externalities lead to overproduction and how property rights, emission charges, marketable permits, and taxes can be used to achieve a more efficient outcomeExplain why positive externalities lead to underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome
3Greener and SmarterEnvironmental 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?
4Externalities 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.No man (or woman) is an island.The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency:Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, causing too much of the activity creating the externality to be produced.Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, causing too little of the activity that creates the externality to be produced.There are some correcting policies that the government can use to increase efficiency, but some are more effective than others.
5Externalities in Our Lives The four possible types of externality are:Negative production externalitiesPositive production externalitiesNegative consumption externalitiesPositive consumption externalities
6Externalities in Our Lives Negative Production ExternalitiesNegative production externalities are common.Examples are noise from aircraft, logging and clearing of forests, and pollution
7Externalities in Our Lives Positive Production ExternalitiesPositive production externalities are less common than negative externalities.Example: a beekeeper locates beehives in an orange-growing area
8Externalities in Our Lives Negative Consumption ExternalitiesNegative 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.
9Externalities in Our Lives Positive Consumption ExternalitiesPositive 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.
10Negative 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.
11Negative Externalities: Pollution The Demand for a Pollution-Free EnvironmentThe 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.
12Negative Externalities: Pollution The Sources of PollutionEconomic activity pollutes air, water, and land, and these individual areas of pollution interact through the ecosystem.Air pollutionEmissions causing greenhouse gases are a tough problem to tackleWater pollutionOutput of sewage treatment plants, the use of herbicides, pesticides, and fertilisersLand pollutionToxic waste and ordinary household garbage
14Negative Externalities: Pollution Private Costs and Social CostsA 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.
15Negative Externalities: Pollution Private Costs and Social CostsMarginal 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.
16Cost ( dollars per tonne) An External CostFigure 16.2300MarginalSocial costMSC225Marginal ExternalcostCost ( dollars per tonne)150MC10075MarginalPrivate cost246Quantity (thousands of tonnes per month)
17Negative 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.
18Inefficiency with an External Cost Figure 16.3300MarginalSocial costSocialBenefitMSC225InefficientMarketequilibriumDeadweight lossEfficientequilibriumD=MSBPrice and cost ( dollars per tonne)150S= MC10075Efficientquantity246Quantity (thousands of tonnes per month)
19Negative Externalities: Pollution Property RightsExternalities 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.
20Property Rights Achieve an Efficient Outcome Figure 16.4300Price equalsmarginal socialcost and MSBS = MC =MSC225Cost of pollutionBorne by polluterEfficient marketequilibriumD=MSBPrice and cost ( dollars per tonne)MC excludingpollution cost15010075246Quantity (thousands of tonnes per month)
21Negative Externalities: Pollution The Coase TheoremThe 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.
22Negative 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
23Negative Externalities: Pollution Government Actions in the Face of External CostsThere are three main methods that the government uses to cope with external costs:TaxesEmission chargesLicences and marketable permitsThe best government policies emulate, rather than replace, the market process. Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it.Make the polluters discover (and bear) the social costs of pollution. In the case of cost externalities like pollution, the government can choose from three policies: emissions charges, pollution taxes, or marketable pollution permits. All three policies require the government to initially assess the social marginal costs and benefits from pollution activities to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.
24Negative Externalities: Pollution TaxesThe 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.
25Price and cost ( dollars per tonne) A Pollution TaxFigure 16.5300Marginal socialcost and MSBS = MC + tax = MSC225Pollution taxEfficient marketequilibriumD=MSBPrice and cost ( dollars per tonne)150TaxrevenueMC8875246Quantity (thousands of tonnes per month)
26Negative Externalities: Pollution Emissions ChargesThe 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.
27Negative Externalities: Pollution Marketable PermitsEach 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.
28Positive Externalities: Knowledge Private Benefits and Social BenefitsA 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.
29Positive 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.
30Price (thousands of dollars per student per year) An External BenefitFigure 16.640MSBMarginalSocial benefitExternalbenefitPrivate3025Price (thousands of dollars per student per year)20MB1050100150200300Quantity (thousands of students per year)
31Inefficiency With an External Benefit Figure 16.740MSBS=MSCDeadweightloss38InefficientMarketequilibriumMarginalSocialbenefit3025Price (thousands of dollars per student per year)Efficient quantity20D=MB15MarginalSocial cost1050100150200300Quantity (thousands of students per year)
32Positive Externalities: Knowledge Government Action in the Face of External BenefitsThere are four main methods that the government uses to cope with external benefits:Public provisionPrivate subsidiesVouchersPatents and copyrightsConsumers Versus Private Producers Versus Government as Monitor in the Face of an Externality. In the case of benefit externalities like education, the government has three policy choices: public provision, subsidize private producer, subsidize private consumer with vouchers. All three policies require the government to initially assess the social marginal costs and benefits to find the optimal level of education to be consumed. But only the public provision policy forces the government to continually assess what type of education should be provided in a dynamic world of ever-changing technology. The policies of private education subsidies or educational vouchers force schools or students to determine what types of education would be best, because they now face an opportunity cost for their decisions as to what school to attend. An informed and motivated clientele, armed with vouchers to allocate across the different qualifying educational institutions, would drive the composition of educational opportunities supply by the different educational institutions.
33Positive Externalities: Knowledge Public ProvisionUnder 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
34Public Provision to Achieve an Efficient Outcome Figure 16.8(a)40MSBS=MSC38Efficientmarketequilibrium30MSB = MSC25Efficient quantityPaid by taxpayerPrice and costs (thousands of dollars per student per year)20D=MB1510Tuition50100150200300Quantity (thousands of students per year)
35Positive Externalities: Knowledge Private SubsidiesA 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 outputIf 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.
36Private Subsidy to Achieve an Efficient Outcome Figure 16.8(b)40MSBS=MSCS=MSC38EfficientmarketequilibriumS=MSC-subsidy30MSB = MSC25Efficient quantitySubsidy of $15,000 per studentPrice and costs (thousands of dollars per student per year)20D=MB1510Dollar price50100150200300Quantity (thousands of students per year)
37Positive Externalities: Knowledge VouchersA 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.
38Vouchers Achieve Efficiency Figure 16.940MSBS=MSCS=MSC38Efficientmarketequilibrium30MSB = MSC25Value of voucherPrice and costs (thousands of dollars per student per year)20D=MB1510Dollar price50100150200300Quantity (thousands of students per year)
39Positive Externalities: Knowledge Patents and CopyrightsKnowledge 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.