THE ECONOMICS OF THE PUBLIC SECTOR 4 THE ECONOMICS OF THE PUBLIC SECTOR

Market Failure Recall from Chapter 7: Adam Smith had argued that the “invisible hand” of the marketplace leads self-interested buyers and sellers to an outcome in which the total surplus of society is maximized. But that requires properly functioning markets In reality, markets can fail When markets fail, government intervention may help CHAPTER 10 EXTERNALITIES

10 Externalities

EXTERNALITIES AND MARKET INEFFICIENCY An externality is the uncompensated impact of one person’s actions on the well-being of a bystander. CHAPTER 10 EXTERNALITIES

EXTERNALITIES AND MARKET INEFFICIENCY An externality is the uncompensated impact of one person’s actions on the well-being of a bystander. Al’s action may affect the well-being of Betty, a bystander, in a negative or positive way. If Al pays no compensation (when his action has a negative effect on Betty) nor receives a reward (when his action has a positive effect on Betty), the effect of Al’s action on Betty is called an externality. CHAPTER 10 EXTERNALITIES

Government intervention may be able to increase total surplus In this case, Al will ignore the effects of his action on Betty when deciding whether or not to take the action Therefore, Al may take this action even if it is undesirable for society And, conversely, Al may refuse to take this action even if it is desirable for society In other words, when actions have external effects, society’s total surplus might not be maximized in the free market equilibrium Government intervention may be able to increase total surplus CHAPTER 10 EXTERNALITIES

Externalities, negative and positive When the impact of a person’s action on a bystander is harmful, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality. CHAPTER 10 EXTERNALITIES

Negative Externalities Automobile exhaust Cigarette smoking Barking dogs (loud pets) Loud stereos in an apartment building The Club, an anti-theft device for cars CHAPTER 10 EXTERNALITIES

Dealing with negative externalities Should we completely ban an activity that has negative externalities? Should we ban all cars? Should we ban all smoking in public spaces? Should we muzzle all dogs? Should we ban stereos in apartment buildings? Should we ban The Club? CHAPTER 10 EXTERNALITIES

Positive Externalities Immunizations Education Restored historic buildings Research into new technologies LoJack, an anti-theft device for cars CHAPTER 10 EXTERNALITIES

Dealing with positive externalities Should we take all activities that have positive externalities to the max? Should we force everybody to take flu shots? Should we require everybody to get a PhD? Should we restore all historic buildings? Should we pay for every research project scientists want to do? Should we require every car owner to use LoJack? CHAPTER 10 EXTERNALITIES

Dealing with negative externalities How should we determine the extent to which activities that have negative externalities should be tolerated? We can evaluate virtually any policy proposal by asking how it would affect total surplus. Recall from Chapter 7, the concept of total surplus. CHAPTER 10 EXTERNALITIES

EXTERNALITIES AND MARKET INEFFICIENCY Externalities can cause markets to become inefficient. We saw in chapter 7 that total surplus is maximized in a perfectly competitive economy. But when there are externalities, this is no longer true: total surplus might be less than the maximum achievable. This might provide a justification for government intervention. CHAPTER 10 EXTERNALITIES

EXTERNALITIES AND MARKET INEFFICIENCY Negative externalities from the production or consumption of a good can cause markets to produce more than is socially desirable. Positive externalities cause markets to produce less than is socially desirable. If and when markets fail (to produce the socially desirable quantity), government intervention may be necessary. CHAPTER 10 EXTERNALITIES

Figure 1 The Market for Aluminum Ch. 7 Recap: Assume there are no externalities in aluminum consumption. Then, the height of the demand curve at, say, the 11th unit of aluminum is the benefit obtainable from the 11th unit when all 11 units are distributed among aluminum consumers so as to maximize the total benefit. Price of Aluminum Supply (private cost) Demand (private benefit) $10 QMARKET Equilibrium 11 Quantity of Aluminum

Figure 1 The Market for Aluminum Ch. 7 Recap: Assume there are no externalities in aluminum production. Then, the height of the supply curve at, the 11th unit of aluminum is the cost of the 11th unit when all 11 units are distributed among aluminum producers so as to minimize the total cost. Price of Aluminum Supply (private cost) Demand (private benefit) $10 QMARKET Equilibrium $3 11 Quantity of Aluminum

Figure 1 The Market for Aluminum Ch. 7 Recap: When there are no externalities in aluminum production or consumption, the equilibrium quantity (QMARKET) maximizes social surplus. Price of Aluminum Supply (private cost) Demand (private benefit) QMARKET Equilibrium This might be a good time to recap the derivation of the supply and demand curves in chapter 7 to explain why Supply is also called Private Cost and Demand is also called Private Value. Quantity of Aluminum

Welfare Economics Without Externalities: A Recap When there are no externalities, the equilibrium quantity: is efficient maximizes total surplus Total surplus = total benefits – total costs is the socially desirable quantity CHAPTER 10 EXTERNALITIES

Social, private, and external costs When the production of aluminum causes pollution … Social cost of aluminum = private cost + external cost Private cost is the cost to aluminum producers of the raw materials and labor used in production External cost is the cost to bystanders of having to deal with the effects of pollution CHAPTER 10 EXTERNALITIES

Figure 2 Pollution and the Social Optimum Price of Social cost Aluminum Unit Cost of pollution Demand (private value) Supply (private cost) Optimum QOPTIMUM Equilibrium QMARKET Quantity of Aluminum

Public Policies toward Negative Externalities We just saw that when there are negative externalities, the equilibrium quantity is larger than the optimum quantity In other words, we have market failure Can public policy fix the market failure? Command-and-Control Policy: Regulation Market-Based Policy: Corrective Taxes Market-Based Policy: Tradable Pollution Permits CHAPTER 10 EXTERNALITIES

PUBLIC POLICY: Command-and-Control Policies Such policies usually take the form of regulations: Forbid certain behaviors. Require certain behaviors. Examples: Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). CHAPTER 10 EXTERNALITIES

PUBLIC POLICY TOWARD POLLUTION: Command-and-Control If the EPA decides it wants to reduce the amount of pollution coming from a specific plant, it could… tell the firm to reduce its pollution by a specific amount (i.e. regulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). CHAPTER 10 EXTERNALITIES

Public Policies for Negative Externalities: Market-Based Policy: Corrective Taxes Price Demand Price buyers pay Tax Supply Price without tax Ch. 6 Recap Price sellers receive Quantity after tax Quantity before tax Quantity

Public Policies for Negative Externalities: Market-Based Policy: Corrective Taxes We saw in Ch. 6 that a tax (on either buyers or sellers of aluminum) will reduce the quantity bought and sold in the aluminum market. If the per-unit tax is set equal to the per unit external cost, the quantity bought and sold will be reduced to exactly the optimum amount. Problem solved! Equilibrium Quantity of Aluminum Price of Demand (private value) Supply (private cost) Social cost QOPTIMUM Optimum QMARKET Equilibrium Quantity of Aluminum Price Demand Supply QOPTIMUM QMARKET Per-unit External Cost Corrective Tax

Market-Based Policy: Put a Tax on Negative Externalities A corrective tax solves the problem caused by negative externalities by forcing the consumers and producers of aluminum to internalize the pollution externality of aluminum production Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. Corrective taxes are also called Pigovian taxes. They were originally proposed by the British economist, A. C. Pigou. CHAPTER 10 EXTERNALITIES

The government can do the following: Public Policies for Negative Externalities: Market-Based Policy: Tradable Pollution Permits The government can do the following: require permits for aluminum production issue QOPTIMUM permits by auctioning them off Each permit will sell for a price equal to the unit cost of pollution The effect will be identical to a corrective tax equal to the unit cost of pollution CHAPTER 10 EXTERNALITIES

Tradable Pollution Permits The price of each tradable pollution permit will be equal to the unit cost of pollution Why? CHAPTER 10 EXTERNALITIES

PUBLIC POLICY TOWARD POLLUTION: Market-Based Pigovian Taxes on the producers or consumers of pollution Tradable pollution permits that allow the voluntary transfer of the right to pollute from one firm to another. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. CHAPTER 10 EXTERNALITIES

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

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. I need to add material on cap-and-trade and on the cost-reduction aspect of pollution permits. Quantity of 1. Pollution permits set the quantity of pollution . . . Pollution

Public Policies toward Positive Externalities A technology spillover is a positive externality that is created when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. Education benefits the student and also all members of society who are affected by the student CHAPTER 10 EXTERNALITIES

Figure 3 Education and the Social Optimum Price of Education Social benefit Supply (private cost) Demand (private benefit) Optimum QOPTIMUM Equilibrium QMARKET Quantity of Education

Public Policies toward Positive Externalities When an activity—such as education—has positive externalities: The social value of the good exceeds the private value of the good. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. CHAPTER 10 EXTERNALITIES

Public Policies toward Positive Externalities: Corrective Subsidies What can be done to get the market to increase education to the optimal level? A subsidy for either students (buyers of education) or educational institutions (sellers) will work. A subsidy will make students and educational institutions internalize the positive externality of education CHAPTER 10 EXTERNALITIES

Public Policies toward Positive Externalities: Corrective Subsidies Recall that technology spillovers are positive externalities Therefore, the equilibrium level of spending on research will be less than the socially desirable level Government intervention may promote technology-enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality. CHAPTER 10 EXTERNALITIES

PRIVATE SOLUTIONS TO EXTERNALITIES Government action is not always needed to solve the problem of externalities. In some cases, the free market ends up maximizing total surplus even when there are externalities CHAPTER 10 EXTERNALITIES

PRIVATE SOLUTIONS TO EXTERNALITIES Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting (bargaining, negotiations) between those causing the externalities and those affected by the externalities CHAPTER 10 EXTERNALITIES

The Coase Theorem The Coase Theorem is the proposition—due to Ronald Coase—that if people can bargain without transaction costs over the allocation of resources, they can solve the problem of externalities on their own. Transaction costs are the costs that people incur in the process of agreeing to and following through on a bargain. CHAPTER 10 EXTERNALITIES

Bob, Spot, and Jane and Ronald Coase Bob and Jane are room mates. Bob gets Spot, a noisy dog, as a birthday gift. Benefit = $500; Cost = $800 Benefit = $1000; Cost = $800 Social optimum Bob returns Spot Bob keeps Spot Government solution Bob forced to pay $800 tax. Bob returns Spot No action required. Bob keeps Spot Private solution: Jane has right to quiet Jane sues to enforce her right. Bob can’t afford to pay Jane a big enough bribe. Bob returns Spot Bob pays Jane $800. Bob keeps Spot Private solution: Bob has right to keep Spot Jane pays Bob $500. Bob returns Spot Jane can’t afford to pay Bob a big enough bribe. Bob keeps Spot The cost to Jane could be the dollar value of the loss caused by unpleasant noise or the cost of noise-cancelling headphones, whichever is cheaper. Coase Theorem: Private solutions to externalities can work

Bob, Spot, and Jane and Ronald Coase Note that when the free market outcome is not optimal, bargaining between Bob and Jane will bring about the optimal outcome, irrespective of who is favored by the law The law is important in other ways, however. For example, in one case in which the law favors Bob , Jane has to pay a $500 compensation to Bob to get him to return Spot CHAPTER 10 EXTERNALITIES

Coase Theorem: Exercise In the case of pollution by an aluminum factory, how might production of the socially desirable amount be brought about without taxation by the government? Why might Coase’s solution fail, as a practical matter, in this case? CHAPTER 10 EXTERNALITIES

Why Private Solutions Do Not Always Work Sometimes the private solution fails because transaction costs are so high that private agreement is not possible. Bob might get greedy and try to haggle with Jane for more than $500 Change the story by substituting three people (Jan, Jeanne and Joan) instead of Jane. Jan, Jeanne and Joan may find it hard to raise $500 for Bob’s compensation. Each might try to free ride on the others. CHAPTER 10 EXTERNALITIES

PUBLIC POLICY TOWARD EXTERNALITIES When externalities are significant and private solutions are not found, government may attempt to solve the problem through… command-and-control policies. market-based policies. CHAPTER 10 EXTERNALITIES

Policy Exercises Should we punish the use of SUV’s and promote the use of smaller cars? Should we force car makers to sell cars with higher mileage? Should we limit the use of gasoline by each car owner? Should we tax gasoline? Should we tax all fuels based on the damage each fuel causes? CHAPTER 10 EXTERNALITIES

Any Questions? CHAPTER 10 EXTERNALITIES

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. CHAPTER 10 EXTERNALITIES

Summary Those affected by externalities can sometimes solve the problem privately. The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. CHAPTER 10 EXTERNALITIES

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. CHAPTER 10 EXTERNALITIES