© 2010 Pearson Education CanadaChapter Chapter 10 Acid Rain on Others’ Parades © 2010 Pearson Education Canada

Chapter Acid Rain on Others’ Parades Externalities, Carbon Taxes, Free Riders & Public Goods

© 2010 Pearson Education CanadaChapter LEARNING OBJECTIVES 10.1Identify how government subsidies can internalize positive externalities to create smart social choices 10.2Describe how externalities make smart private choices different from smart social choices 10.3Explain the rule for coordinating private choices that cause negative externalities with smart social choices continued…

© 2010 Pearson Education CanadaChapter Identify how government policies can internalize externalities for polluters to create smart social choices 10.5Explain how positive externalities create the free-rider problem and cause markets to fail

© 2010 Pearson Education CanadaChapter HANDCUFFING THE INVISIBLE HAND MARKET FAILURE WITH EXTERNALITIES Negative or positive externalities make smart private choices different from smart social choices.

© 2010 Pearson Education CanadaChapter MARKET FAILURE WITH EXTERNALITIES Smart choices require that all additional benefits and additional opportunity costs — including externalities — are counted – negative externalities (external costs) costs to society from your private choice that affect others, but you do not pay – positive externalities (external benefits) benefits to society from your private choice that affect others, but others do not pay you for continued…

© 2010 Pearson Education CanadaChapter Negative externalities Social Costs Private (Opportunity) Costs External (Opportunity) Costs += continued…

© 2010 Pearson Education CanadaChapter Positive externalities Social Benefits Private Benefits External Benefits += continued…

© 2010 Pearson Education CanadaChapter Externalities occur when no clear property rights With externalities, prices don’t reflect all social costs and benefits, preventing markets from coordinating private smart choices with social smart choices Externalities cause market failures – produce too many things with negative externalities (pollution, traffic jams) – produce too few things with positive externalities (vaccinations, education)

© 2010 Pearson Education CanadaChapter WHY RADICAL ENVIRONMENTALISTS DISLIKE ECONOMISTS NEGATIVE EXTERNALITIES & EFFICIENT POLLUTION To coordinate smart private choices that generate negative externalities with smart social choices, choose the quantity of output where marginal social cost equals marginal social benefit.

© 2010 Pearson Education CanadaChapter NEGATIVE EXTERNALITIES & EFFICIENT POLLUTION “Efficient pollution” balances additional environmental benefits with additional opportunity costs of reduced living standards Socially desirable amount of pollution is not zero – at some point additional opportunity costs of reductions in pollution are greater than additional benefits continued…

© 2010 Pearson Education CanadaChapter Smart choice rule: choose quantity of output where marginal social cost equals marginal social benefit continued… Marginal Social Cost (MSC) Marginal Private Cost Marginal External Cost += Marginal Social Benefit (MSB) Marginal Private Benefit Marginal External Benefit +=

© 2010 Pearson Education CanadaChapter Figure 10.1Demand, Supply & Externalities DemandSupply OutputMPBMSBOutputMPCMSC 1$140 1$50$80 2$120 2$60$90 3$100 3$70$100 4$80 4 $110 5$60 5$90$120

© 2010 Pearson Education CanadaChapter Markets overproduce products/services with negative externalities – price too low because does not include external costs

© 2010 Pearson Education CanadaChapter LIBERATING THE INVISIBLE HAND POLICIES TO INTERNALIZE THE EXTERNALITY Government policies can force polluters to pay the marginal external costs of their pollution. As a result, polluters internalize externalities/costs into their private choices, creating smart social choices.

© 2010 Pearson Education CanadaChapter MARKET FAILURE WITH EXTERNALITIES Without property rights to the environment, businesses have incentives to save money and improve profits by ignoring external costs like pollution and global warming Governments can remedy market failures from externalities by creating social property rights to environment, making polluting illegal, penalizing polluters – emissions tax tax to pay for external costs of emissions continued…

© 2010 Pearson Education CanadaChapter Figure 10.2 Pulp Market with $30/T Emissions Tax DemandSupply OutputMPBMSBOutputMPCMPC + Tax 1$140 1$50$80 2$120 2$60$90 3$100 3$70$100 4$80 4 $110 5$60 5$90$120

© 2010 Pearson Education CanadaChapter – carbon tax emissions tax on carbon-based fossil fuels – cap-and-trade system limits emissions businesses can release into environment Internalize the externality transform external costs into costs producer must pay privately to government continued…

© 2010 Pearson Education CanadaChapter By giving pollution a price reflecting marginal external cost of damage done, smart private choices become smart social choices Carbon taxes and cap-and-trade systems are smart policies for efficient pollution, but may also be inequitable, hurting lower-income consumers most

© 2010 Pearson Education CanadaChapter WHY LIGHTHOUSES WON’T MAKE YOU RICH FREE-RIDING ON POSITIVE EXTERNALITIES Market clearing price too high for buyers to be willing to buy socially best quantity of output, and too low for sellers to be willing to supply. Positive externalities create a free-rider problem when neither buyers nor sellers are paid for external benefits their exchange creates.

© 2010 Pearson Education CanadaChapter FREE-RIDING ON POSITIVE EXTERNALITIES Public goods provide external benefits consumed simultaneously by everyone; no one can be excluded – public goods like lighthouses and national defence are extreme examples of positive externalities – free-rider someone who does not have to pay for external benefits continued…

© 2010 Pearson Education CanadaChapter Smart choice rule: choose quantity of output where marginal social cost equals marginal social benefit Because of free-rider problem – markets underproduce products/services with positive externalities – price charged to buyers is too high – price received by sellers is too low – market price does not incorporate external benefits

© 2010 Pearson Education CanadaChapter Figure 10.3 Post-Secondary Market DemandSupply OutputMPBMSBOutputMPCMSC 100$7000$ $ $6000$ $ $5000$ $ $4000$ $ $3000$ $ $2000$ $ $1000$ $5500

© 2010 Pearson Education CanadaChapter WHY YOUR TUITION IS CHEAP (REALLY!) SUBSIDIES FOR THE PUBLIC GOOD Government policies can reward businesses and individuals creating positive externalities. As a result, they internalize the externalities/ rewards, turning smart private choices into smart social choices.

© 2010 Pearson Education CanadaChapter SUBSIDIES AND PUBLIC GOODS Government policy tools to get all to voluntarily choose output where marginal social benefit equals marginal social cost – subsidy payment to those creating positive externalities – public provision government provision products/services with positive externalities, financed by tax revenue Subsidies and public provision remove the wedge positive externalities drive between prices for buyers and for sellers, inducing voluntary choice of output best for society continued…

© 2010 Pearson Education CanadaChapter Figure 10.4 Post-Secondary Market with $3000 Subsidy DemandSupply OutputMPBMSBOutputMPC MPC — Subsidy 100$7000$ $2500-$ $6000$ $3000$0 300$5000$ $3500$ $4000$ $4000$ $3000$ $4500$ $2000$ $5000$ $1000$ $5500$2500

© 2010 Pearson Education CanadaChapter Chapter 10 Refresh Slides

© 2010 Pearson Education CanadaChapter MARKET FAILURE WITH EXTERNALITIES 1.What is a negative externality? a positive externality? 2.Talking in large lecture halls is a problem both for instructors who can’t concentrate and attentive students who can’t hear. Can you explain this problem in terms of externalities? Why is this problem hard to solve? continued…

© 2010 Pearson Education CanadaChapter Many condominiums have strict rules about the colour of window-coverings. Why do these rules arise? Is it fair to restrict the choices of property owners in this way?

© 2010 Pearson Education CanadaChapter NEGATIVE EXTERNALITIES & EFFICIENT POLLUTION 1.What is the rule for finding efficient combinations of output and pollution? 2.If the marginal external cost of pollution in Figure 10.1 were $60 per tonne instead of $30 per tonne, what would be the smart choice for society of pulp output? What would be the smart price of a tonne of pulp? continued…

© 2010 Pearson Education CanadaChapter What position on DDT do you support (see story from Economics Out There, page 245)? What additional information do you need before you decide?

© 2010 Pearson Education CanadaChapter POLICIES TO INTERNALIZE THE EXTERNALITY 1.What is a carbon tax, and how does it “internalize the externality” for a polluting business? 2.Some environmental groups try to expose businesses that pollute while supporting environmentally friendly businesses by posting information and photos on public websites (for example, Explain the strategy and how this may “internalize the externality” for the polluters even without government action. continued…

© 2010 Pearson Education CanadaChapter While carbon taxes and cap-and-trade systems have the same objective, governments and political parties differ in which policy they support. What are the positions of the Conservatives, the Liberals, the NDP, and the Green Party? Which position makes the most sense to you?

© 2010 Pearson Education CanadaChapter FREE-RIDERS & POSITIVE EXTERNALITIES 1.What is the free-rider problem? Why is free-riding a problem? 2.Smart students often don’t like group projects. Explain why, using the concept of free-riding. 3.Two physically identical houses can have very different values depending on their neighbourhoods. How do positive (or negative) externalities help explain property values?

© 2010 Pearson Education CanadaChapter SUBSIDIES & PUBLIC GOODS 1.What should the amount of a smart government subsidy be equal to? Why? 2.What if the government gave the $3000 subsidy from Figure 10.4 directly to students instead of to schools? Construct a table like Figure 10.3 and discover whether the students’ private choices would still be the same as the smart choice for society? [Hint: The Marginal Private Benefit column shows willingness to pay. Create a new column showing willingness to pay with the subsidy (Marginal Private Benefit + Subsidy).] continued…

© 2010 Pearson Education CanadaChapter Some European countries have free tuition for post-secondary education. If you were a member of parliament who wanted to defend this policy (knowing that any money needed to support education had to be raised by new taxes), what arguments would you make? If you wanted to defend the Canadian system, where students must pay some tuition, what arguments would you make?