Externalities, Public Goods and Common Resources Chapters 10, 11

Externality The uncompensated impact of one person’s actions on the well-being of a bystander. Examples: automobile exhaust, historic buildings, barking dogs, R&D.

Social Optimum Point at which the marginal benefit equals marginal cost.

Figure 1 The Market for Aluminum Price of Aluminum Supply (private cost) Demand (private value) QMARKET Equilibrium Quantity of Aluminum Copyright © 2004 South-Western

Figure 2 Pollution and the Social Optimum Price of Social cost Aluminum Cost of pollution Demand (private value) Supply (private cost) Optimum QOPTIMUM Equilibrium QMARKET Quantity of Aluminum Copyright © 2004 South-Western

Positive Externalities Beneficial third party effects.

Figure 3 Education and the Social Optimum Price of Education Social value Supply (private cost) Demand (private value) QOPTIMUM QMARKET Quantity of Education Copyright © 2004 South-Western

Internalizing the Externality Altering incentives so that people take account of the external effects of their actions.

Private Solutions Moral codes. Private charities. Contracts (Coase theorem)

Coase Theorem In the absence of transactions costs, private economic actors can solve the problem of externalities among themselves.

Public Policies to Deal with Externalities Regulation specifying maximum allowable level of a negative externality. Taxes (for negative externalities) & subsidies (for positive externalities). Permits (licenses).

Pigovian Taxes Arthur Pigou (1877-1959), Professor of Economics, Cambridge University Tax the good that creates the negative externality. Reduces Q to optimal level.

How would you model a subsidy paid to providers of a positive externality?

Figure 1 The Effects of a Tax Price Demand Supply Price buyers pay Price sellers receive Quantity with tax Size of tax Price without tax Quantity Quantity Copyright © 2004 South-Western

Tradable Pollution Permits Environmental agency decides the appropriate level of pollutants and issues (or auctions off) permits for exactly that level.

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (a) Pigovian Tax Price of Pollution Demand for pollution rights P Pigovian tax Q 1. A Pigovian tax sets the price of pollution . . . Quantity of 2. . . . which, together with the demand curve, determines the quantity of pollution. Pollution Copyright © 2004 South-Western

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (b) Pollution Permits Price of Q Supply of pollution permits Pollution Demand for pollution rights P 2. . . . which, together with the demand curve, determines the price of pollution. Quantity of 1. Pollution permits set the quantity of pollution . . . Pollution Copyright © 2004 South-Western

Summary When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

Summary When private parties cannot adequately deal with externalities, then the government steps in. The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

Firm Pollution Level Unit cost to reduce A 70 units $20 B 80 $25 C 50 $10 The government gives each firm 40 tradable pollution permits to reduce aggregate pollution level to 120 units. 1. What is the total cost of reducing pollution? 2. What would be the cost if the permits were not tradable?

Public Goods & Common Resources

Definitions Excludability: the property of a good whereby a person can be prevented from using it. Rivalry: the property of a good whereby one person’s use diminishes other people’s use.

Figure 1 Four Types of Goods Rival? Yes No Private Goods Natural Monopolies • Ice-cream cones Clothing Congested toll roads • Fire protection Cable TV Uncongested toll roads Yes Excludable? Common Resources Public Goods • Fish in the ocean The environment Congested nontoll roads • Tornado siren National defense Uncongested nontoll roads No Copyright © 2004 South-Western

Free Rider Problem Receiving the benefit of a good without paying for it. e.g. viewer of public television

Tragedy of the Commons

Question. Why is the commercial value of ivory a threat to the elephant, while the commercial value of beef is a guardian of the cow?

BEIJING, March 4 (Reuters) - China is to change its constitution to protect private property in a revolutionary manoeuvre that waters down its core Communist ideology to raise the status of entrepreneurs once deemed the running dogs of capitalism. Five decades after seizing power, nationalising private property and waging bloody campaigns against landlords, China's parliament is set to amend the state constitution to add the words, "private property obtained legally is inviolable". One aim of the amendments, to be ratified during the annual session of the National People's Congress that opens on Friday, is to give further impetus to the burgeoning private sector that is fuelling China's breakneck economic growth.