Market Failure

All pollution should be eliminated a) Strongly Agree b) Agree c) Neutral d) Disagree e) Strongly Disagree

Market Failure  When the market does not efficiently allocate resources  Either too much or too little is produced Monopoly Externalities Public goods Justification for government intervention?

Externalities  Occur when decision makers do not consider all costs (or benefits) of their actions  Two views A. C. PigouRonald Coase “Spillover effects”

Pigouvian Approach Social Cost = Private Cost + External Cost Drinking Alcohol Price of beer Hangover Damage to others Boorish behavior

Cashmere Externalities

Pollution  Free Market: P 1, Q 1  Optimal Outcome: P 2, Q 2 steel $ D1D1 S private Q1Q1 P1P1 P2P2 Q2Q2 S social External cost How can society achieve social optimum?  Impose tax = marginal external cost Free market overproduces goods that generate a negative externality Internalize the externality! “Pigou tax”

The efficient output will be less than the free market output when: a)Marginal social cost and marginal private cost are equal b)Marginal social cost is greater than marginal private cost c)Marginal social benefit and marginal private benefit are equal d)Marginal social benefit is greater than marginal private benefit

Education  Free Market: P 1, Q 1  Optimal Outcome: P 2, Q 2 Years of College $ D private S1S1 Q1Q1 P1P1 P2P2 Q2Q2 D social External benefit How can society achieve social optimum?  Provide subsidy = marginal external benefit Free market underproduces goods that generate a positive externality

If there is a positive externality, the: a)social benefits will be greater than the private benefits b)external benefits will be greater than the social benefits c)social benefits will be equal to the private benefits d)private benefits will be greater than the social benefits a)social benefits will be greater than the private benefits b)external benefits will be greater than the social benefits c)social benefits will be equal to the private benefits d)private benefits will be greater than the social benefits 12345

a)greater; greater. b)greater; less. c)less; less. d)less; greater. a)greater; greater. b)greater; less. c)less; less. d)less; greater. A consequence of a negative consumption externality is that social benefits are ______ than private benefits, and the socially optimal level of output is ______ than the private level of output

Pollution Worksheet  Optimal pollution for Marietta-Parkersburg area is 60,000 units of emissions  Abatement Cost Cars: $5 Utilities: $10 Factories: $20  Controlling pollution through: Standards Taxes Tradable Permits

Standards SOURCEEMISSIONS ABATED ABATEMENT COSTS CARS UTILITIES FACTORIES TOTAL Set a maximum emissions of 20,000 units per source: 20,000 60, ,000 20,000 30,000 0 $100,000 $400,000 $500,000  “Command-and-Control” approach Emission standards Technology standards

Standards SOURCEEMISSIONS ABATED ABATEMENT COSTS CARS UTILITIES FACTORIES TOTAL Require each source to cut emissions by 10,000 units: 10,000 20,000 30,000 60,000 10,000 30,000 $50,000 $100,000 $200,000 $350,000

SOURCEEMISSIONS ABATED ABATEMENT COSTS CARS UTILITIES FACTORIES TOTAL Require each source to cut emissions by 1/3: $ 33,335 $100,000 $266,660 $399,995 13,333 20,000 26,667 60,000 6,667 10,000 13,333 30,000 Standards

SOURCEEMISSIONS ABATED ABATEMENT COSTS CARS UTILITIES FACTORIES TOTAL Cost minimizing strategy of reducing emissions by 30,000 units. 0 20,000 40,000 60,000 20,000 10, ,000 $100,000 0 $200,000 “$200,000 Solution” Standards

Taxes SOURCEEMISSIONS ABATED ABATEMENT COSTS TAX COSTS CARS UTILITIES FACTORIES TOTAL 0 30,000 40,000 70,000 20, $100, A tax of t = $6 per unit of pollution is imposed: $180,000 $240,000 $420,000 0

SOURCEEMISSIONS ABATED ABATEMENT COSTS TAX COSTS CARS UTILITIES FACTORIES TOTAL ,000 20,000 30, ,000 $100,000 $300,000 0 $400,000 A tax of t = $11 per unit of pollution is imposed: 0 $440,000 0 Taxes

SOURCEEMISSIONS ABATED ABATEMENT COSTS TAX COSTS CARS UTILITIES FACTORIES TOTAL 20,000 30,000 40,000 90, A tax of t = $10.05 per unit of pollution is imposed only on factories for each unit of pollution over the 60,000 limit, regardless of the source. 0 $301,500 0 If transactions costs low enough, then $200,000 solution can be achieved through private bargaining. Taxes

Cap and Trade Program permits $ $20 $10 $ F U C D S 60 Abatement Cost 2008 Spot Auction yr Advance Auction P = $10 Q = 60,000 “$200,000 Solution”

Coasian Approach  Externalities are due to incomplete property rights assignment “It takes two to tango”

Aunt Linda and the Nudist Rifle River Aunt Linda Nudist Judge rules in favor of Aunt Linda Judge rules in favor of Nudist Fence comes down (Linda pays Nudist) 2 rulings $1500 $1000 $1200

Coasian Approach Coase Theorem If property rights are well-defined and transactions costs are low enough, then private bargaining can result in an efficient allocation of resources. Corollary Allocation of resources does not depend on initial assignment of property rights.  Externalities are due to incomplete assignment of property rights

Pollution Revisited

Cheshire, Ohio v. AEP  AEP paid $20 million to buy the 221-resident town in 2002

A factory's production process creates sludge that pours into a river. This sludge makes it difficult to fish in the river, increasing the costs of the local fishermen by $5000. The factory can install a water filter system for $4100, and the fishermen can utilize a weighted fishing net system (to get under the sludge) for $3250. Both systems would remedy the sludge damage to the fishermen. Factory Filter: $4100 Nets: $3250 Damage: $5000 a) Transactions costs low and factory is not liable for damage? b) Transactions costs low and factory is liable for damage? c) Transactions costs high and factory is liable for damage?

Characteristics of Goods Excludability: can you be excluded from consuming the good? Rivalry: does my consumption hinder your consumption? RivalNon-rival Excludable Non- Excludable Private Goods Artificially Scarce Goods Common Resources Public Goods

Government Provided Goods and Services  Schools  Roads  Police  Courts  Fire Department  Water  Library  Health Care  Transportation  Schools  Roads  Police  Courts  Fire Department  Water  Library  Health Care  Transportation  National Defense  Social Security  Medicare  Postal Service  FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC, NLRB, HUD  National Defense  Social Security  Medicare  Postal Service  FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC, NLRB, HUD

National Defense  Federal Government spent $670 billion in 2007 How do we pay for this? National Defense Telethon?  Taxes! Per capita expenditure

Public Goods  Problems “free-rider” problem Under-provision by free market  Social Optimum requires: MSB = MSC Must find some way to aggregate individual marginal benefits  Problems “free-rider” problem Under-provision by free market  Social Optimum requires: MSB = MSC Must find some way to aggregate individual marginal benefits

Fireworks in Marietta QuantityJulia’s MB Seita’s MB Leah’s MB ΣMBMCTotal Benefit Total Cost Net Benefits 10$8$5$9$22$10$22$10$12 20$7$4$8$19$10$41$20$21 30$6$3$6$15$10$56$30$26 40$5$2$4$11$10$67$40$27 50$4$1$2$7$10$74$50$24 60$3$0$1$4$10$78$60$18

The table below shows the marginal benefit from submarines for the only two citizens of a country. Submarines are a public good. If submarines cost $175 a piece to produce, what is the efficient quantity of submarines? KathyBobby Marginal benefit (dollars per sub) QuantityMarginal benefit (dollars per sub) a) 0 b) 1 c) 2 d) 3 e) 4 f) 5

Common Resources  Non-excludable  Rival in consumption  Examples Elephants in Africa Fish in the sea Bison in America * overuse * congestion CITES Campfire “Tragedy of the commons”

Artificially Scarce Goods  Excludable  Non-Rival  Examples Software Pay-per-view movies pharmaceuticals Marginal Cost of provision is zero D MC MR Q1Q1 P1P1 Q0Q0 Drugs $