Externalities (Spillovers) Chapter 13: Positive Externalities and Public Goods Externalities (Spillovers) Externalities - the market fails to register fully costs and benefits. External costs: When the actions of an individual or group incur a cost to 3rd party. External benefits: Present when the actions of an individual or group generate benefits for 3rd parties.

External Benefit The demand curve understates the total value of the output. Price D2(including external benefits) Ideal price and output S1 P2 Actual price and output P1 D1 Quantity/time Q1 Q2 From the viewpoint of efficiency, too few units may be produced.

The Effect of Externalities Private cost The cost borne by the producer of a good or service. Social cost The total cost of producing a good or service, including both the private cost and any external cost. Private benefit The benefit received by the consumer of a good or service. Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit.

The Positive Externalities of New Technology If a firm builds a factory or buys a piece of equipment, the firm receives all the economic benefits that result from the investments. When a firm invests in new technology, the private benefits, or profits, that the firm receives are only a portion of the overall social benefits. The social benefits of an innovation take into account the value of all the positive externalities of the new idea or product, whether enjoyed by other companies or society as a whole, as well as the private benefits received by the firm that developed the new technology.

The Clean Air Act: How a Government Policy Reduced Infant Mortality The benefit of reducing air pollution in 1970 was much higher than the benefit from a proportional reduction in air pollution would be today, when the level of pollution is much lower. In the two years following passage of the Clean Air Act, there was a sharp reduction in air pollution and also a reduction in infant mortality.

Technological breakthroughs of the 2000s: • GPS (2000) • Toyota Prius (2000) • AT&T texting (2000) • Wikipedia (2001) • Napster (2001) • Friendster (2003) • Human Genome (2003) • Search engines (2003) • Nintendo Wii (2006) • Apple iPhone (2007)

private firms in a market economy under invest in research and technology Rate of Return D Private (million $) D Social (million $) 2% $72 $84 4% $52 6% $38 $62 8% $30 10% $26 $44

High School Degree, no College Why Invest in Human Capital? 1. private rate of return -the estimated returns to education going to the individual worker. 2. social rate of return -the estimated returns to education going to society from a better educated workforce. Less than High School High School Degree, no College Bachelor’s Degree Median Full-Time Earnings (over 25) $479 $659 $1,174

When There Is a Positive Externality, a Subsidy Can Bring About the Efficient Level of Output People who do not consume college educations can benefit from them. As a result, the social benefit from a college education is greater than the private benefit to college students. If the government pays a subsidy equal to the external benefit, students will internalize the externality.

When There Is a Positive Externality, a Subsidy Can Bring About the Efficient Level of Output The subsidy will cause the demand curve to shift up, from D1 to D2. As a result, the market equilibrium quantity will shift from QMarket, where an inefficiently low level of college educations is supplied, to QEfficient, the economically efficient equilibrium quantity. Producers receive the price PEfficient, while consumers pay a price P, which is equal to PEfficient minus the amount of the subsidy.

How Governments Can Encourage Innovation 1. Intellectual property rights a. guaranteeing the innovator an exclusive right to that new product or process b. include 1) patents - giving the inventor the exclusive legal right to make, use, or sell the invention for a limited time. 2) copyright laws - giving the author an exclusive legal right over works of literature, music, film/video, and pictures.

Patents Filed and Granted, 1981–2008

2. Government Spending on Research and Development Sources of R & D Funding Amount ($ billions) Percent of Total Federal Government $103.7 26.08% Industry $267.8 67.35% Universities and Colleges $10.6 2.67% Non-profits $12 3.02% Non-federal government $3.5 .88% Total $397.67 100% U.S. Research and Development Expenditures, 2008

3. Tax Breaks for Research and Development giving firms a reduction in taxes depending on how much research and development they do. - referred to as the research and experimentation (R&E) tax credit. 4. Cooperative Research - State and federal governments support research in a variety of ways - National Institutes of Health National Academy of Scientists National Academy of Engineers, The Agriculture and Food Research Initiative (AFRI) at USDA

The Public Goods Problem Private remedies to environmental degradation (eg law suits) run into what economists call the public goods problem Public goods are goods enjoyed in common – non-rivalrous (e.g. the warning service provided by a lighthouse) Another characteristic of public goods is that they are “non-excludable”

Rivalry The situation that occurs when one person’s consuming a unit of a good means no one else can consume it. Excludability The situation in which anyone who does not pay for a good cannot consume it.

1. Which of the following goods or services are non-excludable? Yes No a. police protection b. streaming music from satellite transmission programs c. Roads d. primary education e. cellphone service 2. Are the following goods non-rivalrous in consumption? Yes No a. slice of pizza b. laptop computer c. public radio d. Ice cream cone

Private good. A good that is both rival and excludable. Four Categories of Goods Goods and services can be divided into four categories on the basis of whether people can be excluded from consuming them and whether they are rival in consumption.d or service is rival in consumption if one person consuming a unit of a good means that another person cannot consume that unit. Private good. A good that is both rival and excludable. Public good. A good that is both nonrival and nonexcludable. Free riding Benefiting from a good without paying for it. Quasi-public goods. Goods that are excludable but not rival. Common resource. A good that is rival but not excludable.

Which of the four categories for these? TV broadcast home mail delivery (c) education in a public school (d) education in a private school (e) hiking in a park surrounded by a fence (f) hiking in a park without a fence (g) an apple.

The four categories: 1. Private goods are goods that are both rival and excludable. (b) home mail delivery (you’ll be excluded if you don’t use a stamp), (d) education in a private school, (g) an apple.

2. Public goods are goods that are both nonrival and nonexcludable : TV broadcast (f)hiking in a park without a fence Also National defense Free riding is benefiting from a good without paying for it.

3. Quasi-public goods are goods that are excludable but not rival : (e)Hiking in a park surrounded by a fence also Tennis courts

4. Common resource is a good that is rival but not excludable: (c)Education in a public school—at least for people within the school district who won’t be excluded. It is rival because as more students crowd into a classroom, the amount of attention the teacher gives to each student declines. In cases where it isn’t rival, it would be a public good for those who are eligible.

Public Goods Problems for the Free Market Public goods pose a problem to the free market for two reasons: Free riding: people benefit from public goods (like law suits) regardless of whether or not they pay for them. High Transaction Costs: public goods provision require groups of people to undertake action. In addition, information about environmental damages is costly for groups to obtain. These features add extra “transactions costs”.

Tragedy of the commons The tendency for a common resource to be overused. For a common resource such as wood from a forest, the efficient level of use, QEfficient, is determined by the intersection of the demand curve—which represents the marginal benefit received by consumers—and S2, which represents the marginal social cost of cutting the wood.

Tragedy of the commons The tendency for a common resource to be overused. Because each individual tree cutter ignores the external cost, the equilibrium quantity of wood cut is QActual, which is greater than the efficient quantity. At the equilibrium level of output, there is a deadweight loss, as shown by the yellow triangle.

Is There a Way Out of the Tragedy of the Commons? 1. With small area and small number of people involved, access to the commons can be restricted through community norms and laws. 2. If the area or the number of people involved is large, legal restrictions through taxes, quotas, and tradable permits on access to the commons are required.

1. Identify the following situations as an example of a negative or a positive externality: a. You are a birder (bird watcher), and your neighbor has put up several birdhouses in the yard as well as planting trees and flowers that attract birds. b. Your neighbor paints his house a hideous color. c. Investments in private education raise your country’s standard of living. d. Trash dumped upstream flows downstream right past your home. e. Your roommate is a smoker, but you are a nonsmoker.

2. Identify whether the market supply curve will shift right or left or will stay the same for the following: Firms in an industry are required to pay a fine for their emissions of carbon dioxide. b. Companies are sued for polluting the water in a river. c. Power plants in a specific city are not required to address the impact of their emissions on the quality of air. d. Companies that use fracking to remove oil and gas from rock are required to clean up the damage.

1) An externality is A) a benefit realized by the purchaser of a good or service. B) a cost paid for by the producer of a good or service. C) a benefit or cost experienced by someone who is not a producer or consumer of a good or service. D) anything that is external or not relevant to the production of a good or service.   2) What is a market failure? A) It refers to the inability of the market to allocate resources efficiently up to the point where marginal social benefit equals marginal social cost. B) It refers to the inability of the market to allocate resources efficiently up to the point where marginal social benefit equals marginal private cost. C) It refers to a situation where an entire sector of the economy (for example, the airline industry) collapses because of some unforeseen event. D) It refers to a breakdown in a market economy because of widespread corruption in government. 3) If you burn your trash in the back yard in spite of regulations against it, then you are A) acting economically irrationally and creating a social cost. B) avoiding the private costs associated with disposing your trash some other way and creating a social cost. C) acting rationally and creating a positive externality. D) saving landfill space and creating a social benefit.

4) Because producers do not bear the external cost of pollution A) the economically efficient level of production is achieved. B) private production is below the economically efficient level. C) private production exceeds the economically efficient level. D) the market price is too high.   5) If there is pollution in producing a product, then the market equilibrium price A) is too high and equilibrium quantity is too low. B) and equilibrium quantity are too low. C) and equilibrium quantity are too high. D) is too low and equilibrium quantity is too high. 6) What does the phrase "internalizing an external cost" mean? A) limiting the extent to which domestic firms can outsource production B) prohibiting economic activities that create externalities C) forcing producers to factor into their production costs the cost of the externalities created in the production of their output D) finding a way to address cross-border pollution

7) What is the rationale behind a marketable emission allowance scheme? A) to create of a market for externalities: the scheme brings together buyers and sellers of marketable permits B) to discipline polluting firms by specifying the maximum amount of emissions allowed and giving them permits to pollute up to their allowance C) to raise revenue for the government through the sale of emission permits and at the same time set an emissions target D) to provide firms with the incentive to consider less costly alternatives to pollution reduction by making firms pay for the right to pollute beyond their specified allowance 8) Which of the following displays these two characteristics: non-rivalry and non-excludability in consumption? A) public goods B) private goods C) quasi-public goods D) common resources

  9) Anyone can purchase sulfur dioxide emissions allowances on the Chicago Mercantile Exchange. Several environmental groups have raised money to buy allowances (which they subsequently destroy). As part of their fund-raising, these groups have urged contributors to buy the allowances as gifts. As one newspaper story put it, "For the environmentalist in your life, here's a gift that is sold by the ton, fits in an envelope and will last forever." Source for quote: Randall Edwards, "Dear Santa: Please Bring Me Sulfur Dioxide for Christmas," Columbus Dispatch, December 19, 1999. What would be the impact on the price of the emission allowances in the market? A) The price rises. B) The price falls to zero. C) The price falls but not to zero. D) The price remains unchanged because the allowances purchased by the environmental groups are destroyed. 10) In economics, the term "free rider" refers to A) a person who evades taxes. B) a supervisor who delegates menial time-consuming activities to others. C) one who volunteers her services. D) one who waits for others to produce a good and then enjoys its benefits without paying for it.