Externalities, Open Access, and Public Goods Chapter Eighteen Externalities, Open Access, and Public Goods

Externalities, Open Access, and Public Goods In this chapter, we examine six main topics Externalities The inefficiency of competition with externalities Market structure and externalities Allocating property rights to reduce externalities Open-access common property Public goods © 2007 Pearson Addison-Wesley. All rights reserved.

Externalities Externality The direct effect of the actions of a person or firm on another person’s well-being or a firm’s production capability rather than an indirect effect through changes in prices. © 2007 Pearson Addison-Wesley. All rights reserved.

Externalities Externalities may either help or harm others. An externality that harms someone is called a negative externality. A positive externality benefits others. © 2007 Pearson Addison-Wesley. All rights reserved.

The inefficiency of competition with externalities Competitive firms and consumers do not have to pay for the harms of their negative externalities, so they create excessive amounts. Because producers are not compensated for the benefits of a positive externality, too little of such externalities is produced. © 2007 Pearson Addison-Wesley. All rights reserved.

The inefficiency of competition with externalities Private cost The cost of production only, not including externalities Social cost The private cost plus the cost of the harms from externalities © 2007 Pearson Addison-Wesley. All rights reserved.

Supply-and-Demand Analysis We use a supply-and-demand diagram to illustrate that a competitive market produces excessive pollution because the firms’ private cost is less than their social cost. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.1 Welfare Effects of Pollution in a Competitive Market The competitive equilibrium, , is determined by the intersection of the demand curve and the competitive supply or private marginal cost curve, , which ignores the cost of pollution. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.1 Welfare Effects of Pollution in a Competitive Market The social optimum, , is at the intersection of the demand curve and the social marginal cost curve, , where is the marginal cost of the pollution (gunk). Private producer surplus is based on curve, and social producer surplus is based on the curve. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.1 Welfare Effects of Pollution in a Competitive Market 450 MC s = MC p + MC g A e MC p s p E s = 282 B C D p c = 240 e H c 198 G MC p MC g F 84 MC g 30 Demand Q s = 84 Q c = 105 225 Q , Tons of paper per day © 2007 Pearson Addison-Wesley. All rights reserved.

Supply-and-Demand Analysis The figure illustrates two main results with respect to negative externalities. First, a competitive market produces excessive negative externalities. Second, the optimal amount of pollution is greater than zero. © 2007 Pearson Addison-Wesley. All rights reserved.

Reducing Externalities Because competitive markets produce too many negative externalities, government intervention may provide a social gain. © 2007 Pearson Addison-Wesley. All rights reserved.

Table 18.1 Industrial CO2 Emissions, 2002 © 2007 Pearson Addison-Wesley. All rights reserved.

Reducing Externalities If a government has sufficient knowledge about pollution damage, the demand curve, costs, and the production technology, it can force a competitive market to produce the social optimum. © 2007 Pearson Addison-Wesley. All rights reserved.

Reducing Externalities A governmental limit on the amount of air or water pollution that may be released is called an emission standard. A tax on air pollution is called an emissions fee, and a tax on discharges into the air or waterways is an effluent charge. © 2007 Pearson Addison-Wesley. All rights reserved.

Reducing Externalities Internalize the externality To bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others) © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.2 Taxes to Control Pollution Placing a tax on the firms equal to the harm the gunk, , causes them to internalize the externality, so their private marginal cost is the same as the social marginal cost, . As a result, the competitive after-tax equilibrium is the same as the social optimum, . © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.2 Taxes to Control Pollution Alternatively, applying a specific tax of per ton of paper, which is the marginal harm from the gunk at , also results in the social optimum. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.2 Taxes to Control Pollution 450 MC s = MC p + t ( Q ) MC p + t e s MC p p = 282 s t = 84 MC p = 198 MC g MC g = 84 Demand Q = s 84 225 Q , Tons of paper per day © 2007 Pearson Addison-Wesley. All rights reserved.

Cost-Benefit Analysis By using a cost-benefit analysis, we obtain another interpretation of the pollution problem in terms of the marginal cost and benefit of the pollution itself. © 2007 Pearson Addison-Wesley. All rights reserved.

Cost-Benefit Analysis Welfare is maximized by reducing output and pollution until the marginal benefit from less pollution equals the marginal cost of less output. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.3 Cost-Benefit Analysis of Pollution The benefit curve reflects the reduction in harm from pollution as the amount of gunk falls from the competitive level. The cost of reducing the amount of gunk is the fall in output, which reduces consumer surplus and private producer surplus. Welfare is maximized at 84 tons of paper and 84 units of gunk, the quantities at which the difference between the benefit and cost curves, the net benefit, is greatest. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.3 Cost-Benefit Analysis of Pollution The net benefit is maximized where the marginal benefit, , which is the slope of the benefit curve, equals the marginal cost, , the slope of the cost curve. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.3 Cost-Benefit Analysis of Pollution (a) Cost and Benefit 4,000 Cost: less paper Benefit: less gunk 2,000 Maximum net benefit 105 84 63 Q , Tons of paper per day G , Units of gunk per day (b) Marginal Cost and Marginal Benefit 105 MC 84 MB 105 84 Q , Tons of paper per day © 2007 Pearson Addison-Wesley. All rights reserved. G , Units of gunk per day

Market Structure and Externalities Two of our main results concerning competitive markets and negative externalities—that too much pollution is produced and that a tax equal to the marginal social cost of the externality solves the problem—do not hold for other market structures. © 2007 Pearson Addison-Wesley. All rights reserved.

Monopoly and Externalities Although the competitive market with an externality always produces more output than the social optimum, a monopoly may produce more than, the same as, or less than the social optimum. © 2007 Pearson Addison-Wesley. All rights reserved.

Monopoly and Externalities Which effect dominates depends on the elasticity of demand for the output and on the extent of the marginal damage the pollution causes. © 2007 Pearson Addison-Wesley. All rights reserved.

Monopoly Versus Competitive Welfare with Externalities In the absence of externalities, welfare is greater under competition than under an unregulated monopoly. However, with an externality, welfare may be greater with monopoly than with competition. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.4 Monopoly, Competition, and Social Optimum with Pollution At the competitive equilibrium, , more is produced than at the social optimum, . As a result, the deadweight loss in the competitive market is . The monopoly equilibrium, , is determined by the intersection of the marginal revenue and the private marginal cost, , curves. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.4 Monopoly, Competition, and Social Optimum with Pollution The social welfare (based on the marginal social cost, , curve) under monopoly is . Here the deadweight loss of monopoly, , is less than the deadweight loss under competition, . © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.4 Monopoly, Competition, and Social Optimum with Pollution 450 MC s = MC p + MC g e t 330 e m 310 e s D MC p 282 A B C 240 e c MC g 30 MR Demand 60 70 84 105 225 Q , Tons of paper per day © 2007 Pearson Addison-Wesley. All rights reserved.

Taxing Externalities in Noncompetitive Markets Trying to solve a negative externality problem is more complex in a noncompetitive market than in a competitive market. © 2007 Pearson Addison-Wesley. All rights reserved.

Taxing Externalities in Noncompetitive Markets To achieve a social optimum in a competitive market, the government only has to reduce the externality, possibly by decreasing output. In a noncompetitive market, the government must eliminate problems arising from both externalities and the exercise of market power. © 2007 Pearson Addison-Wesley. All rights reserved.

Allocating Property Rights to Reduce Externalities Instead of controlling externalities directly through emissions fees and emissions standards, the government may take an indirect approach by assigning a property right: an exclusive privilege to use an asset. © 2007 Pearson Addison-Wesley. All rights reserved.

Allocating Property Rights to Reduce Externalities If no one holds a property right for a good or a bad, the good or bad is unlikely to have a price. © 2007 Pearson Addison-Wesley. All rights reserved.

Allocating Property Rights to Reduce Externalities For many bads, such as pollution, and for some goods, property rights are not clearly defined. No one has exclusive property rights to the sir we breathe. Because of this lack of a price, a polluter’s private marginal cost of production is less than the full social marginal cost. © 2007 Pearson Addison-Wesley. All rights reserved.

Coase Theorem According to the Coase Theorem (Coase, 1960), the optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined. © 2007 Pearson Addison-Wesley. All rights reserved.

Table 18.2 (a,b) Property Rights and Bargaining © 2007 Pearson Addison-Wesley. All rights reserved.

Table 18.2 (c) Property Rights and Bargaining © 2007 Pearson Addison-Wesley. All rights reserved.

Coase Theorem If there are no impediments to bargaining, assigning property rights results in the efficient outcome at which joint profits are maximized. Efficiency is achieved regardless of who receives the property rights. © 2007 Pearson Addison-Wesley. All rights reserved.

Coase Theorem Who gets the property rights affects the income distribution. The property rights are valuable. The party with the property rights may be compensated by the other party. © 2007 Pearson Addison-Wesley. All rights reserved.

Problems with the Coase Approach First, if transaction costs are very high, it might not pay for the two sides to meet. Second, if firms engage in strategic bargaining behavior, an agreement may not be reached. Third, if either side lacks information about the costs or benefits or reducing pollution, a nonefficient outcome may occur. © 2007 Pearson Addison-Wesley. All rights reserved.

Markets for Pollution If high transaction costs preclude bargaining, we may be able to overcome this problem by using a market, which facilitates exchanges between individuals. © 2007 Pearson Addison-Wesley. All rights reserved.

Markets for Pollution Under this cap and trade system, the government gives firms permits, each of which confers the right to create a certain amount of pollution. Each firm may use its permits or sell them to other firms. © 2007 Pearson Addison-Wesley. All rights reserved.

Markets for Pollution Bu using a market, the government does not have to collect this type of detailed information to achieve efficiency. Its only decision concerns what total amount of pollution to allow. © 2007 Pearson Addison-Wesley. All rights reserved.

Open-Access Common Property Resources to which everyone has free access © 2007 Pearson Addison-Wesley. All rights reserved.

Overuse of Open-Access Common Property Because people do not have to pay to use open-access common property resources, they are overused. e.g. Common Pools. The Internet. Roads Fisheries. © 2007 Pearson Addison-Wesley. All rights reserved.

Solving the Commons Problem Government Regulation of Commons Overuse of a common resource occurs because individuals do not bear the full social cost. However, by applying a tax or fee equal to the externality harm that each individual imposes on others, a government forces each person to internalize the externality. © 2007 Pearson Addison-Wesley. All rights reserved.

Solving the Commons Problem Government Regulation of Commons Alternatively, the government can restrict access to the commons. One typical approach is to grant access on a first-come, first-served basis. © 2007 Pearson Addison-Wesley. All rights reserved.

Solving the Commons Problem Assigning Property Rights An alternative approach to resolving the commons problem is to assign private property rights. © 2007 Pearson Addison-Wesley. All rights reserved.

Public Goods Public Good A commodity or service whose consumption by one person does not preclude others from also consuming it © 2007 Pearson Addison-Wesley. All rights reserved.

Table 18.3 Rivalry and Exclusion Types of Goods Table 18.3 Rivalry and Exclusion © 2007 Pearson Addison-Wesley. All rights reserved.

Markets for Public Goods Markets for public goods exist only if nonpurchasers can be excluded from consuming them. Markets do not exist for nonexclusive public goods. If the government does not provide a nonexclusive public good, no one provides it. © 2007 Pearson Addison-Wesley. All rights reserved.

Demand for Public Goods Because a public good lacks rivalry, many people can get pleasure from the same unit of output. As a consequence, the social demand curve or willingness-to-pay curve for a public good is the vertical sum of the demand curves of each individual. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.5 Inadequate Provision of a Public Good Security guards protect both tenants of the mall. If each guard costs $10 per hour, the television store, with demand , is willing to hire four guards per hour. The ice-cream parlor, with demand , is not willing to hire any guards. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.5 Inadequate Provision of a Public Good Thus if everyone acts independently, the equilibrium is . The social demand for this public good is the vertical sum of the individual demand curves, . Thus the social optimum is , at which five guards are hired. © 2007 Pearson Addison-Wesley. All rights reserved.

Figure 18.5 Inadequate Provision of a Public Good 25 D D 18 1 13 e e p s 10 Supply, MC 8 7 D 2 3 2 4 5 7 9 Guards per hour © 2007 Pearson Addison-Wesley. All rights reserved.

Free Riding Many people are unwilling to pay for their share of a public good. They try to get others to pay for it, so they can free ride: benefit from the actions of others without paying. © 2007 Pearson Addison-Wesley. All rights reserved.

Table 18.4 Private Payments for a Public Good © 2007 Pearson Addison-Wesley. All rights reserved.

Free Riding In each of these games, the Nash equilibrium is for neither store to hire a guard because of free riding. The nonoptimal outcome occurs for the same reason as in other prisoners’ dilemma games: The stores don’t do what is best for them collectively when they act independently. © 2007 Pearson Addison-Wesley. All rights reserved.

Reducing Free Riding Governmental or other collective actions can reduce free riding. Methods that may be used include social pressure, merges, compulsion, and privatization. © 2007 Pearson Addison-Wesley. All rights reserved.

Valuing Public Goods To ensure that a nonexclusive public good is provided, a government usually produces it or compels others to do so. Issues that a government faces in providing such a public good include whether to provide it at all and, if so, how much to provide. © 2007 Pearson Addison-Wesley. All rights reserved.

Table 18.5 Voting on $300 Traffic Signals © 2007 Pearson Addison-Wesley. All rights reserved.

Valuing Public Goods The problem with yes-no votes is that they ignore the intensity of preferences. Thus such majority voting fails to value the public good fully and hence does not guarantee that it is efficiently provided. © 2007 Pearson Addison-Wesley. All rights reserved.