© Pearson Education, 2005 Policy, Externalities and Public Goods LUBS1940: Topic 8

Objectives © Pearson Education, 2005 After studying this topic, you will able to  Explain why and how governments regulate monopoly and oligopoly and distinguish between the social interest and capture theories of regulation  Explain how regulation affects prices, outputs, profits, and the distribution of the gains from trade between consumers and producers  Explain how monopoly control laws are applied in Europe  Explain how public ownership affects prices, output and allocative efficiency  Identify the four types of externalities  Explain how property rights can sometimes be used to overcome externalities and how emission charges, marketable permits and taxes can be used to achieve efficiency in the face of external costs  Explain how subsidies, public provision and property rights can be used to achieve efficiency in the face of external benefits  Distinguish among private goods, public goods and common resources.  Explain how the free-rider problem arises and how the quantity of public goods is determined  Explain the problem of the commons and its possible solutions

© Pearson Education, 2005 Why are the firms that produce our drinking water, electric power, phone service, rail transport and pharmaceutical drugs regulated? Does regulation work in the interest of all—the social interest—or in the interest of the regulated—special interests? Can EU regulation make our markets more efficient? Social Interest or Special Interest

© Pearson Education, 2005 The economic theory of government explains why governments exist, the economic choices they make and the consequences of those choices. Governments exist for three main economic reasons: 1.To establish property rights 2.To provide a non-market mechanism for allocating scarce resources 3.To redistribute income and wealth The Economic Theory of Government

© Pearson Education, 2005 The market economy sometimes brings inefficiency—a situation called a market failure. Some government intervention seeks to correct market failure. The market economy also brings inequality that most people think unfair. Achieving an equitable distribution requires some redistribution. The Economic Theory of Government

© Pearson Education, 2005 In Chapters 14, 15, 16 and 18, you will study the economic roles of government in five areas:  Monopoly and oligopoly regulation  Externalities regulation  Provision of public goods  Use of common resources  Income redistribution The Economic Theory of Government

© Pearson Education, 2005 Monopoly and Oligopoly Regulation Monopoly and oligopoly, and the rent seeking to which they give rise, prevent the allocation of resources from being efficient and redistribute the consumer surplus to producers. The Economic Theory of Government

© Pearson Education, 2005 Externalities Regulation External costs and benefits are consequences of an economic transaction between two parties that are borne or enjoyed by a third party. A chemical factory that dumps waste into a river that kills the fish imposes an external cost. A bank that builds a beautiful office building creates an external benefit. Externalities create inefficiency. The Economic Theory of Government

© Pearson Education, 2005 Provision of Public Goods Public goods are goods that are consumed by everyone and from which no one can be excluded Examples are national defence, law and order, and sewage and waste disposal services. The market economy under produces these goods because it is impossible to exclude non- payers from enjoying them—called the free-rider problem. The Economic Theory of Government

© Pearson Education, 2005 Use of Common Resources Some resources are owned by no one and used by everyone. Examples are fish in the ocean and the lakes and rivers. The market economy over uses these resources because no one has an incentive to conserve them—called the problem of the commons. The Economic Theory of Government

© Pearson Education, 2005 Income Redistribution The market economy delivers an unequal distribution of income and wealth. Progressive income taxes pay for public goods and redistribute income. Social programs and welfare benefits also redistribute income. The Economic Theory of Government

© Pearson Education, 2005 Public Choice and the Political Marketplace Public choice theory applies the economic way of thinking to the choices that people make in a political marketplace. The actors in the political marketplace are:  Voters  Firms  Politicians  Civil servants The Economic Theory of Government

© Pearson Education, 2005 Figure 14.1 illustrates the political market place. Voters and firms are the “consumers” in the political marketplace. Politicians are the “entrepreneurs” of the political marketplace. Civil servants are the producers, or firms, of the political marketplace. The Economic Theory of Government

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Voters and firms express their preferences for publicly provided goods and services by allocating their votes, making campaign contributions, and lobbying. They also pay the taxes that provide the funds that pay for public goods and services. The Economic Theory of Government

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The objective of politicians is to get elected to office and remain in office. Votes to a politician are like profits to a firm, so they propose policies that they expect to attract enough votes to get elected. Civil servants produce the public goods and services. The Economic Theory of Government

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A political equilibrium emerges in which the choices of voters, firms, politicians and civil servants are all compatible and in which no group can improve its position my making a different choice. The Economic Theory of Government

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Monopoly and Oligopoly Regulation The economic theory of monopoly and oligopoly regulation is an application of the broader theory of public choice. Regulation is influenced by the demands of voters and firms, the supply by politicians and civil servants, and the equilibrium that balances the two sides of the political market place. The Economic Theory of Government

© Pearson Education, 2005 The Demand for Regulation The demand for regulation by people and firms, expressed through votes, lobbying and campaign contributions, depends on: The consumer and producer surplus that might be gained or lost The number of people and firms that stand to gain or lose The cost of organizing the potential gainers and losers as an effective political force. The Economic Theory of Government

© Pearson Education, 2005 The Supply of Regulation The supply of regulation by politicians and civil servants, expressed in the laws and regulations they pass and enforce, depends on: The number of votes a measure might gain or lose. The amount of campaign funding a measure might gain or lose The effect on the budget of a government department— civil servants support budget-maximizing measures. The Economic Theory of Government

© Pearson Education, 2005 Equilibrium Regulation Equilibrium regulation might be in the social interest or in the self-interest of producers. The social interest theory is that regulations are supplied to satisfy the demand of consumers and producers to maximize the sum of consumer and producer surplus—to attain efficiency. The Economic Theory of Government

© Pearson Education, 2005 The capture theory is that the regulations are supplied to satisfy the demand of producers to maximize producer surplus—to maximize economic profit. In this case, regulation seeks to maximize profits. Because the public interest and the special interest of the producer are in conflict, the political process cannot satisfy both groups in any particular industry. The highest bidder gets the regulation it wants. The Economic Theory of Government

© Pearson Education, 2005 Alternative Intervention Methods Government intervenes in monopoly and oligopoly markets to influence prices, quantities produced, and the distribution of the gains from economic activity. It intervenes in three main ways:  Regulation  Monopoly control laws  Public ownership The Economic Theory of Government

© Pearson Education, 2005 Regulation consists of rules administered by government agency to influence economic activity by determining prices, product standards and types, and the conditions under which new firms may enter an industry. Deregulation is the process of reversing previous regulation. The Economic Theory of Government

© Pearson Education, 2005 Monopoly control laws are laws that regulate or prohibits certain kinds of market behaviour, such as monopoly and monopolistic practices. These laws cover practices that create barriers to entry, collusion over prices, restriction of consumer choice and mergers to enhance market power. The Economic Theory of Government

© Pearson Education, 2005 Public ownership is the ownership (and sometimes operation) of a firm or an industry by a government department or a government controlled agency. Public ownership was at its peak during the 1940s and 1950s. Privatization is the sale of government-owned firms and industries. The Economic Theory of Government

© Pearson Education, 2005 The Scope of Regulation Some of the main agencies are:  The World Trade Organization  The European Commission  The Monopolies and Mergers Commission  The Finance and Securities Agency  The Office of Gas and Electricity Markets  The Office of Water Services Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 The Regulatory Process Regulatory agencies differ in many detailed ways, but all have features in common: Each agency is run by people who are experts in the industry it regulates (often recruited from the industry) and who appointed by government. Each agency adopts a set of rules and practices designed to control the prices and other aspects of economic behaviour in the industry it regulates. Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Natural Monopoly Natural monopoly occurs when one firm can supply the entire market at a lower price than two or more firms can. Figure 14.2 shows the demand curve, marginal cost, MC, curve and average total cost, ATC, curve of a natural monopoly. Regulating and Deregulating Monopoly and Oligopoly

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A natural monopoly’s ATC curve falls throughout the relevant range of production so that the firm’s MC curve is below its ATC curve when the MC curve crosses the demand curve. Regulating and Deregulating Monopoly and Oligopoly

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Regulating in the public interest—efficient regulation—is achieved using the marginal cost pricing rule, which sets price equal to marginal cost: P = MC. The sum of consumer surplus and producer surplus—total surplus in the figure—is maximized. Regulating and Deregulating Monopoly and Oligopoly

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With marginal cost pricing, the firm incurs an economic loss. Regulating and Deregulating Monopoly and Oligopoly

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The firm might be able to cover its economic loss by price discrimination. An example is the hook- up fee cable TV companies charge their subscribers. The government might pay the firm a subsidy. But the taxes that generate the revenue for the subsidy create a deadweight loss in other markets. Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Deadweight loss might be minimized by allowing the firm to use the average cost pricing rule, which sets price equal to average total cost. Figure 14.3 illustrates the average cost pricing rule. Regulating and Deregulating Monopoly and Oligopoly

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Implementing the marginal cost and average cost pricing rules is difficult because the regulator doesn’t know the firm’s cost curves. Two practical rules that regulators use are:  Rate of return regulation  Price cap regulation Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Under rate of return regulation, a regulated firm must justify its price by showing that the price enables it to earn a specified target percent rate of return on its capital. The target rate of return is set at that of a competitive market and with accurate cost observation is this type of regulation is equivalent to average cost pricing. Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Managers have an incentive to use more capital than the efficient quantity so that total returns increase. Managers also have an incentive to inflate depreciation charges and other costs and deflate reported profits. Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Figure 14.4 shows the maximum economic profit that a firm can earn when its managers inflate capital costs under rate of return regulation. Regulating and Deregulating Monopoly and Oligopoly

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A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize cost because there is no limit on the rate of return they are permitted to earn. Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Figure 14.5 shows the effects of price cap regulation. Unregulated, the monopoly maximizes profit by producing the quantity at which MR = MC. A price cap is imposed that enables the firm to earn zero economic profit. Regulating and Deregulating Monopoly and Oligopoly

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The price cap lowers the price and increases output. This outcome contrasts with a price cap in a competitive market. In monopoly, the profit- maximizing quantity is less than the efficient quantity and the price cap provides an incentive to increase output to avoid economic loss. Regulating and Deregulating Monopoly and Oligopoly

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Cartel Regulation A cartel is a collusive agreement among a number of firms that is designed to restrict output and achieve a higher profit for cartel members. Cartels are illegal in the UK and EU and in most other countries. A cartel that acts like a monopoly earns maximum economic profit, but there is an incentive for each member of a cartel to cheat and cut price. Regulating and Deregulating Monopoly and Oligopoly

© Pearson Education, 2005 Regulating and Deregulating Monopoly and Oligopoly Figure 14.6 shows two possible outcomes of cartel regulation. If the regulation is in the public interest, price and quantity will equal their competitive levels and the outcome will be efficient.

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Regulating and Deregulating Monopoly and Oligopoly If the cartel captures the regulator, it uses regulation to prevent cheating and price and output equal their monopoly levels and the outcome is inefficient.

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European monopoly control laws cover three aspects of firm activity:  Monopoly  Mergers  Restrictive practices Monopoly Control Laws

© Pearson Education, 2005 Monopoly Monopoly control law began in the United Kingdom with the Monopolies and Restrictive Practices Act of Today, monopoly is defined (in the law) as a firm that has a 25 per cent or greater market share. The government has the power under the current law to break up and or impose restrictions on a monopoly. Monopoly Control Laws

© Pearson Education, 2005 Mergers A merger occurs when the assets of two or more firms are combined to form a single new firm. Since 1965, the UK Monopolies and Mergers Commission has had the power to investigate any merger likely to create a monopoly or that might lead to abuse of market power. The goal of the legislation is to promote effective competition. Monopoly Control Laws

© Pearson Education, 2005 Mergers The EU Merger Control Regulation of 1990 allows the European Commission to investigate mergers of firms that have dominant positions in the European market. The Commission permits only those mergers that do not lead to a reduction in competition. Monopoly Control Laws

© Pearson Education, 2005 Restrictive Practices The UK Fair Trading Act of 1973 defines a restrictive practice as an agreement between firms on prices, terms and conditions of sale and market share. The Restrictive Practices Court decides whether a practice is illegal using a test of eight possible defences. Monopoly Control Laws

© Pearson Education, 2005 Restrictive Practices Under EU law, restrictive practices are illegal unless they improve production and distribution or technical progress and do not reduce competition. The EU regularly fines companies for restrictive practices that raise prices. Monopoly Control Laws

© Pearson Education, 2005 Social or Special Interest? The intent of monopoly control law has been to protect consumers and pursue allocative efficiency. On balance, the overall thrust of the law seems to have worked effectively towards this goal. Monopoly Control Laws

© Pearson Education, 2005 Public ownership is another way in which government can influence the behaviour of a natural monopoly. Public ownership might lead to an efficient allocation of resources. But it might also lead to waste and other problems. Public Ownership and Privatization

© Pearson Education, 2005 Efficient Public Ownership Figure 14.7(a) shows how public ownership might lead to an efficient allocation of resources. The public company produces the quantity at which price equals marginal cost. Public Ownership and Privatization

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Consumer surplus is maximized. Public Ownership and Privatization But the firm incurs an economic loss that must be covered by a subsidy paid for by taxes.

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A Bureaucratic Model of Public Ownership A basic assumption of the economic theory of bureaucracy is that civil servants (and managers of public companies) aim to maximize their department’s (or firm’s) budgets. Consider two cases:  Budget maximization with marginal cost pricing  Budget maximization at a zero price Public Ownership and Privatization

© Pearson Education, 2005 Figure 14.7(b) shows how public ownership might lead to inefficient budget maximization. The public company produces the quantity at which price equals marginal cost. Public Ownership and Privatization

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But the managers of the public company inflate their costs and waste resources. The ATC curve shifts upward above the true minimum cost curve. Public Ownership and Privatization

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If the public firm provides is output to the market at a zero price, the quantity demanded exceeds the quantity produced and queues or lotteries or some other device is needed to allocate the resources. Waste is even greater. Public Ownership and Privatization

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Privatization Privatization with regulation might overcome some of the problems of public ownership. Privatization works best when the public company is not a natural monopoly. Public Ownership and Privatization

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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?

© Pearson Education, 2005 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.

© Pearson Education, 2005 Externalities in Our Lives So the four possible types of externality are:  Negative production externalities  Positive production externalities  Negative consumption externalities  Positive consumption externalities

© Pearson Education, 2005 Externalities in Our Lives Negative Production Externalities Negative production externalities are common. Some examples are noise from aircraft and trucks, polluted rivers and lakes, the destruction of animal habitat and air pollution in major cities from car exhaust.

© Pearson Education, 2005 Externalities in Our Lives Positive Production Externalities Positive production externalities are less common that negative externalities. Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit production gets an external benefit from the bees, which pollinate the fruit orchards boost fruit output; and honey production gets an external benefit from the orchards.

© Pearson Education, 2005 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.

© Pearson Education, 2005 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 gets pleasure.

© Pearson Education, 2005 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.

© Pearson Education, 2005 Negative Externalities: Pollution The Demand for a Pollution-free Environment The demand for a pollution-free environment is greater today than it has ever been. 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.

© Pearson Education, 2005 Negative Externalities: Pollution The Sources of Pollution There are three sources of environmental pollution problems:  Air pollution  Water pollution  Land pollution

© Pearson Education, 2005 Negative Externalities: Pollution Air Pollution Figure 15.1 shows the emissions of carbon dioxide in the United Kingdom from 1970 to 2004 with projection to Other problems are global warming and ozone layer depletion.

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Negative Externalities: Pollution Water Pollution The largest source of water pollution is the dumping of industrial waste and treated sewerage into lakes and rivers and run-off from fertilizers. Marginal private cost, marginal external cost, and marginal social cost increase with output. Land Pollution Land pollution arises from dumping toxic waste products.

© Pearson Education, 2005 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 and marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

© Pearson Education, 2005 Negative Externalities: Pollution Marginal social cost is the marginal cost incurred by the entire society  by the producer and by everyone else on whom the cost falls  and is the sum of marginal private cost and marginal external cost. That is: MSC = MC + Marginal external cost.

© Pearson Education, 2005 Negative Externalities: Pollution We express costs in pounds. But we must remember that cost is an opportunity cost  what we give up to get something. Marginal external cost is what some one other than the producers of a good or services must give up when the producers makes one more unit of the item. Marginal private cost, marginal external cost, and marginal social cost increase with output.

© Pearson Education, 2005 Negative Externalities: Pollution Figure 15.2 illustrates the MC curve, the MSC curve, and marginal external cost as the vertical distance between the MC and MSC curves.

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Negative Externalities: Pollution Production and Pollution: How Much? In an unregulated market with an externality, the pollution created depends on the market equilibrium quantity of the good produced.

© Pearson Education, 2005 Negative Externalities: Pollution Figure 15.3 shows the equilibrium in the presence of external costs. The quantity produced is where marginal private cost equals marginal benefit.

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Negative Externalities: Pollution MB is less than MSC in the market equilibrium, so the market equilibrium is inefficient. The efficient quantity is where marginal social cost equals marginal benefit. The competitive market overproduces and creates a deadweight loss.

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Negative Externalities: Pollution Property Rights Sometimes inefficiency from an externality arises 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.

© Pearson Education, 2005 Negative Externalities: Pollution Figure 15.4 illustrates how the establishment of property rights achieves an efficient outcome. The polluter bears all the costs and the polluter’s supply curve becomes the curve S = MC = MSC. At the market equilibrium, MSC = MC = MB and it is efficient.

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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 all the costs and benefits involved. Also the outcome doesn’t depend on who has the property rights.

© Pearson Education, 2005 Negative Externalities: Pollution Transactions costs are the cost of conducting a transaction. An example is the transactions costs of buying a home include fees for an estate agent and a lawyer. When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality.

© Pearson Education, 2005 Negative Externalities: Pollution Government Actions in the Face of External Costs The three main methods that governments use to cope with external costs are:  Taxes  Emission charges  Marketable permits

© Pearson Education, 2005 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 the 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.

© Pearson Education, 2005 Negative Externalities: Pollution Figure 15.5 shows how the efficient level of production can be generated with a pollution tax.

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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 needs a lot of information that is rarely available. In Europe, water polluters pay emission charges.

© Pearson Education, 2005 Negative Externalities: Pollution Marketable Permits Each firm is assigned a permitted amount of pollution per period and firms can trade permits. The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome. This method was used successfully to decrease lead pollution in the United States.

© Pearson Education, 2005 Positive Externalities: Knowledge Knowledge comes from education and research and creates external benefits. 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.

© Pearson Education, 2005 Positive Externalities: Knowledge 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 of the good enjoy.

© Pearson Education, 2005 Positive Externalities: Knowledge Marginal social benefit (MSB) is the marginal benefit enjoyed by the entire society  by the consumer and by everyone else on whom the benefit falls  and is the sum of marginal private benefit and marginal external benefit. That is: MSB = MB + Marginal external benefit.

© Pearson Education, 2005 Positive Externalities: Knowledge Figure 15.6 illustrates the MB curve, marginal external benefit, and MSB curve. It identifies marginal external benefit as the vertical distance between the MB and MSB curves.

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Positive Externalities: Knowledge Figure 15.7 shows how a private market under- produces an item that generates an external benefit and creates a deadweight loss.

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Positive Externalities: Knowledge Government Actions in the Face of External Benefits Four devices that governments can use to achieve an more efficient allocation of resources in the presence of external benefits are:  Public provision  Private subsidies  Vouchers  Patents and copyrights

© Pearson Education, 2005 Positive Externalities: Knowledge Public provision Under public provision, a public authority that receives its revenue from the government produces the good or service. The public authority sells the quantity of the good or service at which marginal cost equals marginal social benefit.

© Pearson Education, 2005 Positive Externalities: Knowledge Figure 15.8(a) shows how public provision can achieve an efficient outcome.

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Positive Externalities: Knowledge Private Subsidies A subsidy is a payment by the government to private producers. 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.

© Pearson Education, 2005 Positive Externalities: Knowledge Figure 15.8(b) shows how a subsidy can achieve an efficient outcome.

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Positive Externalities: Knowledge Vouchers A voucher is a token that the government provides to households, which they can use to buy specified goods or services Food stamps are an example. School vouchers have been advocated as a means of improving the quality of education.

© Pearson Education, 2005 Positive Externalities: Knowledge Figure 15.9 shows how vouchers can achieve an efficient outcome.

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Positive Externalities: Knowledge Patents and Copyrights Intellectual property rights give the creator of knowledge the property right to the use of that knowledge. The legal device for establishing an intellectual property right is the patent and copyright, which are government-sanctioned exclusive rights given to an inventor of a good, service or productive process to use to produce, use and sell the invention for a given number of years.

© Pearson Education, 2005 Government: the Solution or the Problem? Why does government provide some goods and services but not all? What determine the scope and scale of government? Ocean fish are a common resource that everyone is free to take. Are our fish stocks being depleted? What can we do to conserve the world’s fish?

© Pearson Education, 2005 What is the difference between: 1.Scotland Yard and Brinks security 2.Fish in the North Sea and fish in a fish farm 3.A live concert and a concert on television These and all goods and services can be classified according to whether they are excludable or non-excludable and rival or non- rival. Classifying Goods and Resources

© Pearson Education, 2005 Excludable A good, service or resource is excludable if it is possible to prevent a person from enjoying its benefits. Non-excludable A good, service or resource is non-excludable if it is impossible to prevent a person from enjoying its benefits. Classifying Goods and Resources

© Pearson Education, 2005 Examples of excludable items are: 1.The services of Brinks security 2.Fish in a fish farm 3.A live concert Examples of non-excludable items are: 1.The services of Scotland Yard 2.Fish in the North Sea 3.A broadcast television signal Classifying Goods and Resources

© Pearson Education, 2005 Rival A good, service or resource is rival if its consumption by one person decreases its consumption by other people. Non-rival A good, service or resource is non-rival if its consumption by one person does not decrease its consumption by other people. Classifying Goods and Resources

© Pearson Education, 2005 Examples of rival items are: 1.The services of Brinks security 2.Fish in both the North Sea and a fish farm 3.A seat at a live concert Examples of non-rival items are: 1.The protection provided by Scotland Yard 2.A broadcast television signal Classifying Goods and Resources

© Pearson Education, 2005 Classifying Goods and Resources A Four-Fold Classification Private Goods A private good is both rival and excludable  it can be consumed by only one person at a time and only by those who have bought it or own it. Public Goods A public good is both non-rival and non- excludable  it can be consumed by everyone at the same time and no one can be excluded.

© Pearson Education, 2005 Classifying Goods and Resources Common Resources A common resource is rival and non-excludable  it can be used only once but no one can be prevented from using what is available. Natural Monopolies A special case of natural monopoly has zero marginal cost. Buyers can be excluded but the good or service is non-rival.

© Pearson Education, 2005 Figure 16.1 shows this four- fold classification of goods and services. Classifying Goods and Resources

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Two Problems Public goods create a free-rider problem  the absence of an incentive for people to pay for what they consume. Common resources create the problem of the commons  the absence of incentives to prevent overuse and depletion of a resource. Classifying Goods and Resources

© Pearson Education, 2005 Public Goods and the Free-rider Problem The Benefit of a Public Good The value of a private good is the maximum amount that a person would pay for one more unit, which is shown by the person’s demand curve. The value of a public good is the maximum amount that all the people are willing to pay for one more unit of it.

© Pearson Education, 2005 Public Goods and the Free-rider Problem The total benefit of a public good to an individual is the euro value that a person places on a given quantity of the good. The marginal benefit of a public good to an individual is the increase in total benefit that results from a one-unit increase in the quantity provided. The marginal benefit of a public good diminishes as more of the good provided.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Everyone can consume each unit of a public good, which means the marginal benefit for the economy is the sum of marginal benefits of all the people at each quantity.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Figure 16.2 shows how the marginal benefits of a public good are summed at each quantity of the good provided. Part (a) shows Lisa’s marginal benefit. Part (b) shows Max’s marginal benefit.

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Public Goods and the Free-rider Problem The economy’s marginal benefit of a public good is the sum of the individual marginal benefits at each quantity of the good provided. The economy’s marginal benefit curve for a public good is the vertical sum of the individual marginal benefit curves.

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Public Goods and the Free-rider Problem The marginal benefit curve of a public good contrasts with the demand curve for a private good, which is the horizontal sum of the individual demand curves at each price.

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Public Goods and the Free-rider Problem The Efficient Quantity of a Public Good The efficient quantity of a public good is the quantity that maximizes net benefit  total benefit minus total cost  which is the same as the quantity at which marginal benefit equals marginal cost. Figure 16.3 illustrates the efficient quantity.

© Pearson Education, 2005 Public Goods and the Free-rider Problem The total cost curve, TC, is like the total cost curve for a private good. The total benefit curve, TB, is the sum of the marginal benefit at each quantity. The efficient quantity is the quantity at which net benefit is maximized.

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Public Goods and the Free-rider Problem Equivalently, the efficient quantity of a public good is the quantity at which marginal benefit equals marginal cost.

© Pearson Education, 2005 Public Goods and the Free-rider Problem The marginal benefit curve, MB, is the one we’ve just derived. The marginal cost curve, MC, is just like the MC curve for a private good. The efficient quantity is where marginal benefit equals marginal cost.

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Public Goods and the Free-rider Problem Private Provision If a private firm tried to produce and sell a public good, almost no one would buy it. The free-rider problem results in too little of the good being produced by a private firm.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Public Provision Because the government can tax all consumers of the public good and force everyone to pay, public provision overcomes the free-rider problem. If two political parties compete, each is driven to propose the efficient quantity of a public good. A party that proposes either too much or too little can be beaten by the one that proposes the efficient amount because more people vote for an increase in net benefit.

© Pearson Education, 2005 Public Goods and the Free-rider Problem The Principle of Minimum Differentiation The attempt by politicians to appeal to a majority of voters leads them to the same policies, which is an example of the principle of minimum differentiation  the tendency for competitors to make themselves identical to appeal to the maximum number of clients (voters). (The same principle applies to competing firms such as McDonald’s and Burger King).

© Pearson Education, 2005 Public Goods and the Free-rider Problem The Role of Civil Servants Figure 16.4 shows the goal of civil servants, which is to seek the highest attainable budget for providing a public good.

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Public Goods and the Free-rider Problem Civil servants might provide the efficient quantity. But they try to increase their budget to equal the total benefit of the public good and drive the net benefit to zero. Civil servants might also try to over provide a public good.

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Public Goods and the Free-rider Problem Well-informed voters would ensure that the politicians prevented the civil servants from increasing their budget above the minimum total cost of producing the efficient quantity. But is it not rational for voters to be well informed.

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Public Goods and the Free-rider Problem Rational Ignorance Rational ignorance is the decision by a voter not to acquire information about a policy or the provision of a public good because the expected benefit to the voter from knowing the information is less than the cost of acquiring the information.

© Pearson Education, 2005 Public Goods and the Free-rider Problem For voters who consume but don’t produce a public good, it is rational to be ignorant about the costs and benefit. For voters who produce a public good, it is rational to be well informed. So the political equilibrium is one that favours the producer and civil servants and is an inefficient over-provision of public goods.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Two Types of Political Equilibrium The two types of political equilibrium  efficient provision and inefficient overprovision  correspond to two theories of government:  Social interest theory  Public choice theory

© Pearson Education, 2005 Public Goods and the Free-rider Problem Social Interest Theory Social interest theory predicts that governments make choices that achieve efficiency. This outcome occurs in a perfect political system in which voters are fully informed about the effects of policies.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Public Choice Theory Public choice theory predicts that governments make choices that result in inefficiency. This outcome occurs in political markets in which voters are rationally ignorant and base their votes only on the issues that they know will affect their own net benefit. The result is government failure that parallels market failure.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Why Government is Large and Grows Government grows because the demand for some public goods is income elastic. Government might be too large because of inefficient overprovision.

© Pearson Education, 2005 Public Goods and the Free-rider Problem Voters Strike Back If government grows too large relative to the value voters place on public goods, there might be a voter backlash that leads politicians to propose smaller government. Privatization is one way of coping with overgrown government and is based on distinguishing between public provision and public production of public goods.

© Pearson Education, 2005 Common Resources The Problem of the Commons The problem of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. Examples include the North Sea cod stocks, South Pacific whales and the quality of the earth’s atmosphere. The traditional example from which the term derives is the common grazing land surrounding middle-age villages.

© Pearson Education, 2005 Common Resources Sustainable Production Figure 16.5 illustrates production possibilities from a common resource. As the number of boats increases, the quantity of fish caught increases to some maximum. Beyond that maximum, the sustainable catch decreases.

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Common Resources Overfishing Equilibrium Figure 16.6 shows why a common resource get overused. The average catch per boat, which is the marginal private benefit, MPB, falls as the number of boats increases. The marginal cost per boat is MC (assumed constant).

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Common Resources Equilibrium occurs where marginal private benefit, MPB, equals marginal cost, MC. In equilibrium, the resource is overused because no one takes into account the effects of her/his actions on other users of the resources.

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Common Resources The Efficient Use of the Commons The quantity of fish caught by each boat decreases as the number of boats increases. But no one has an incentive to take this fact into account when deciding whether to fish. The efficient use of a common resource requires marginal cost to equal marginal social benefit.

© Pearson Education, 2005 Common Resources Marginal Social Benefit Marginal social benefit is the increase in total fish catch that results from an additional boat, not the average catch per boat. The table on the next slide shows the calculation of marginal social benefit.

© Pearson Education, 2005 Common Resources BoatsTotal CatchMSB A00 90 B1 70 C D E4240

© Pearson Education, 2005 Common Resources Efficient Use Figure 16.7 illustrates the efficient use of a common resource. The marginal social benefit curve, MSB, is below the MPB curve. The resource is used efficiently when MSB equals MC.

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Common Resources Achieving an Efficient Outcome It is harder to achieve an efficient use of a common resource than to define the conditions under which it occurs. Three methods in use are:  Property rights  Quotas  Individual transferable quotas (ITQs)

© Pearson Education, 2005 Common Resources Property Rights By assigning property rights, common property becomes private property. When someone owns a resource, the owner is confronted with the full consequences of her/his actions in using that resources. The social benefits become the private benefits.

© Pearson Education, 2005 Common Resources In Figure 16.7, the marginal social benefit curve, MSB, becomes the marginal private benefit curve. The resource is used efficiently because the owner of the resources is best off when MSB equals MC.

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Common Resources Quotas By setting a production quota at the efficient quantity, a common resource might remain in common use but be used efficiently. Figure 16.8 shows this situation. It is hard to make a quota work.

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Common Resources Individual Transferable Quotas An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer the quota to someone else. A market in ITQs emerges. If the efficient quantity of ITQs is assigned, the market price of an ITQ confronts resource users with a marginal cost that equals MSB at the efficient quantity.

© Pearson Education, 2005 Common Resources Figure 16.9 shows the situation with an efficient number of ITQs. Marginal cost rises from MC 0 to MC 1. Resource users make marginal private benefit, MPB, equal to marginal private cost, MC 1, and the outcome is efficient.

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Common Resources Public Choice and Political Equilibrium It is easy for economists to agree that ITQs make it possible to achieve an efficient use of a common resource. It is difficult to get the political market place to deliver that outcome. In 1996, the U.S. Congress passed the Sustainable Fishing Act that puts a moratorium on ITQs  self-interest and capture of the political process sometimes beats the social interest.