Externalities AKA Spillovers

When Markets Work (a) Producers are responsible for all costs & those costs are reflected in the price of the good or service. P S =Marginal Social Cost (MSC) =Marginal Private Cost (MPC) P The private costs and social costs are both reflected in the supply curve Everything we’ve learned up until now assumes that the market is working to produce the Market equilibrium which is the most efficient level of Price and Quantity. However, reality Is always messier than our economic models and sometimes markets do not produce the Optimal P&Q. When that happens we call it a market failure. Externalities are a form of Market failure. Basically an externality occurs when there is additional benefit or cost to society that is not covered by the price of the product. But, to understand what goes wrong we have to take a quick look at the details f a working market so we can understand what isn’t working. First, (CLICK), when markets work.. Read (a) When condition A is met, (CLICK) read blue text The private cost is the cost to the firm, the social cost is the cost to other people/society (CLICK) Cost are always associated with the supply curve (CLICK) D =Marginal Social Benefit (MSB) =Marginal Private Benefit (MPB) Q Q

When Markets Work (a) Producers are responsible for all costs & those costs are reflected in the price of the good or service. (b) Paying customers are the only beneficiaries of the good or service. P S=Marginal Social Cost (MSC) =Marginal Private Cost (MPC) The private benefits and social benefits are both reflected in the demand curve P Second, (CLICK), when markets work.. Read (b) When condition B is met, (CLICK) read blue text The private benefit is the benefit to the individual/customer, the social benefit is the benefit to other people/society (CLICK) Benefits are always associated with the Demand curve (CLICK) D =Marginal Social Benefit (MSB) =Marginal Private Benefit (MPB) Q Q

When Markets Don’t Work Market Failure Externalities When someone other than the buyer and seller receives a cost or benefit for which they didn’t ask/pay When markets don’t work, it’s called Market Failure (CLICK) One type of market failure is when there is an externality. (CLICK) Read Slide (CLICK) Give time for students to copy

When Markets Don’t Work Market Failure Externalities AKA Spillover or Third Party These are sometimes also called spillover or third party cost/benefits Give students time to write AKA names Costs/Benefits

Negative Externality (or spillover) Example: Factory pollution contaminating water supply Let’s start with Negative externalities. When social costs are greater than the private cost it’s called a Negative Externality Or negative spillover (CLICK) For Example: (CLICK) read slide, (CLICK) Read slide The firm is passing on – externalizing- the cost to villagers

Negative Externality Example: Factory Pollution MSC > MPC Marginal Social Cost (MSC) Psocial Qso MSC > MPC P Marginal Private Cost (MPC) There is an OVERALLOCATION (making too much) of the good at too low a price Pmarket Lets look at the graph (CLICK) The marginal social cost is greater than the marginal private cost This means (CLICK) there is an over allocation of the good, they are Making too much of the good at too low a price D =Marginal Social Benefit (MSB) =Marginal Private Benefit (MPB) Qm Q

Negative Externality Why is this bad? Deadweight loss MSC P MPC TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET Pso Pm Why is this bad? (CLICK) it creates a deadweight loss to society (CLICK) read instructions on how to find the area MSB Qso Qm Q

Why does this happen? Negative Externality Why is this bad? Deadweight loss MSC P MPC TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET Pso Pm MSB Qso Qm Q

Where there is no clear ownership of rights to a natural resource, Tragedy of the Commons Where there is no clear ownership of rights to a natural resource, the users of the resource are likely to overexploit it.

Tragedy of the Commons Drilling for Oil

http://www.petroleum.co.uk/geograph/page4.htm

Tragedy of the Commons Pump as much oil as fast as you can to get the oil before someone else does--

Private Bathroom in Doctor’s office Private property Private Bathroom in Doctor’s office

Access is restricted

Clean, decorated, well stocked

Public High School Bathroom

Tragedy of the Commons

Negative Externality Possible Solutions: Property Rights: establishing ownership can provide motivation to include external costs into the price

Buffaloes used to roam the west. But hunters started over hunting them

Tragedy of the Commons The herds get smaller. The hunters shoot http://ens.lycos.com/ens/oct2000/2000L-10-16-15.html The hunters shoot the buffalo. http://www.fayettevilleobserver.com/news/archives/1998/tx98aug/n19buff.htm You better quick and hunt them before someone beats you to the punch.

Did barb wire help or hurt the buffalo population? Barb wire saved the buffalo by establishing property rights at a relatively low cost. Prior to barb wire, it was too expensive to establish property rights.

But, this often isn’t a plausible option Negative Externality Possible Solutions: Property Rights: establishing ownership can provide motivation to include external costs into the price Coase Theorem: as long as transaction costs are low, it doesn’t matter which party has property rights, they will negotiate a solution to the externality without the need for gov’t intervention. There are several solutions that might correct a negative externality (CLICK) Property rights are incredible important for the market to work properly If someone owns the problem area, they will be motivated to fix it Logically, you’d want to give the property rights to the producer, So they will fix it and incorporate the cost into the price (CLICK) But, Ronald Coase came up with an interesting theory that it doesn’t matter who gets the property rights….. Read slide Let’s take the factory pollution example: If the factory gets property rights to the river, they will be motivated to install a filtration system If the Villagers get property rights, they will either build the filter/negotiate or be able to take Legal action against the company to make them do it. (CLICK) Read slide … take the next slide for example (click) Ronald H. Coase But, this often isn’t a plausible option

Property rights of smoking have changed over the years. Read slides It used to be, “Would you like a smoke”? Then it became, “Do you mind if I smoke”?

Then it became, “Thank you for not smoking.” Finally, an outright ban on smoking.

Negative Externality Possible Solutions: Government intervention: 1. Tax – could pay for fixing extra cost – or at least decrease Q 2. Q Restriction – establish a law to force correction 3. Price Control – establish an effective price floor 4. Permits – i.e.. pollution permits that can be bought and sold among polluters

Pass out Negative Externalities Homework & do example together & do example together

Start with a base S/D graph, except label supply MPC and demand MSB ABC Plastics is polluting the ground water surrounding it’s factory. The Gov’t decides to tax their product and use the $ to treat the area. Graph the externality including the tax. Start with a base S/D graph, except label supply MPC and demand MSB Label P&Q - Pm & Qm P MPC Pm MSB Qm Q

Add in the social cost (MSC) line ABC Plastics is polluting the ground water surrounding it’s factory. The Gov’t decides to tax their product and use the $ to treat the area. Graph the externality including the tax. MSC Add the externality P MPC Add in the social cost (MSC) line Pso Draw social equilibrium lines and labels Pso & Qso Pm MSB Add arrow to show direction of change in cost lines, P’s and Q’s Qso Qm Q

You have drawn the Externality, now add the tax ABC Plastics is polluting the ground water surrounding it’s factory. The Gov’t decides to tax their product and use the $ to treat the area. Graph the externality including the tax. MSC You have drawn the Externality, now add the tax P MPC TAX Pso 4. Shade in the area of the tax and label it You can either write it inside the shaded area or outside with an arrow Pm MSB Qso Qm Q

Positive Externality (or spillover) Market Failure When Markets Don’t Work Example: Getting a vaccine for a contagious disease Ask the students When markets don’t work, what is it called? (CLICK) Market Failure Now we are going to talk about positive externalities. (CLICK) They are when the social benefits are greater than the private benefits For Example: (CLICK) read slide, (CLICK) Read slide The rest of the population benefits from the protect, but doesn’t pay for it.

Positive Externality Example: Vaccinations MSB > MPB Marginal Social Benefit (MSB) Qso Psocial Marginal Social Cost (MSC) There is an UNDERALLOCATION (making too little) of the good at too high a price Pmarket Lets look at the graph (CLICK) The marginal social benefit is greater than the marginal private benefit This means (CLICK) there is an under allocation of the good, they are Making too little of the good at too high a price Marginal Private Benefit (MPB) Qm Q

Positive Externality Why is this bad? Deadweight loss P MSC TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET Pso Pm Why is this bad? (CLICK) it creates a deadweight loss to society (CLICK) read instructions on how to find the area MSB MPB Qm Qso Q

Why does this happen? Positive Externality Why is this bad? Deadweight loss P MSC TO FIND THE AREA OF THE DEADWEIGHT LOSS FOLLOW THE MARKET Q UP TO THE MSC CURVE. IT’S THE AREA BETWEEN MSC, MSB AND QMARKET Pso Pm Why is this bad? (CLICK) it creates a deadweight loss to society (CLICK) read instructions on how to find the area MSB MPB Qm Qso Q

"Free" Rider Problem When the accessible and desirable nature of public goods inclines people to use these goods, sometimes without paying for the privilege

Public vs. Private Goods "Free" Rider Problem Public vs. Private Goods Private goods 1. Exclusionary – owner can exclude those who don’t pay for it 2. Rival – consuming it prevents others from doing the same Example: Can of soda

Public vs. Private Goods "Free" Rider Problem Public vs. Private Goods Public goods 1. Non-exclusionary – owner cannot exclude those who don’t pay for it 2. Nonrival – consuming it doesn’t prevent others from doing the same

Public vs. Private Goods "Free" Rider Problem Public vs. Private Goods Public goods Examples: Lighthouses All the captains use it to keep from crashing, but they don’t pay for it and there isn’t a good way to make them

Public vs. Private Goods "Free" Rider Problem Public vs. Private Goods Public goods Examples: Street Light Systems Anyone walking by benefits from the light, but does not have to pay for the benefit

Public vs. Private Goods "Free" Rider Problem Public vs. Private Goods Public goods The market will not provide optimum amounts of these good, or provide them at all because there is no way to make a profit from them. The production of public goods results in positive externalities which are not paid for, so there is less incentive to produce it.

In a family of four, there are two cops and two robbers. Who are the “free” riders and why?

What’s Wrong with this picture? It wouldn’t work because Sunsets are a non-excludable good, in that non-payers can't be prevented from enjoying them. 

Interstate Highway System Positive Externality Possible Solutions: 1. Government Production: have the gov’t produce the good using tax dollars Examples: Interstate Highway System National Defense

Why do governments pay for mosquito spraying of neighborhoods? Why isn’t this privatized?

Free Rider Problem

Positive Externality Possible Solutions: 1. Government Production: have the gov’t produce the good using tax dollars 2. Subsidy: to either producer or consumer of the product 3. Legal Mandate: legally require consumption or production of the good

Positive Externality Possible Solutions: Example: Education – all 3 are used The more education a person has, the less likely they are commit crimes & the more likely they are to solve problems, help people….contribute to society

Positive Externality Possible Solutions: Example: Education – all 3 are used Education produces a positive externality It is under produced or underallocated at too high a price

Positive Externality Possible Solutions: Example: Education – all 3 are used The gov’t produces it (public schools) They subsidize consumers (low cost student loans & scholarships) They subsidize producers (fed grants) Require it 5-18yrs olds

Pass out Negative Externalities Homework & do example together & do example together

Start with a base S/D graph, except label supply MSC and demand MPB The government decides to subsidize consumers for tuberculosis vaccinations by issuing discount coupons to parents of school children. Graph the externality including the subsidy. Start with a base S/D graph, except label supply MSC and demand MPB Label P&Q - Pm & Qm P MSC Pm MPB Qm Q

Add in the social benefit (MSB) line The government decides to subsidize consumers for tuberculosis vaccinations by issuing discount coupons to parents of school children. Graph the externality including the subsidy. Add the externality P Add in the social benefit (MSB) line MSB MSC Add arrow to show direction of change in lines, P’s and Q’s Draw social equilibrium lines and labels Pso & Qso Qso Pso Pm Qm Q

You have drawn the Externality, now add the subsidy The government decides to subsidize consumers for tuberculosis vaccinations by issuing discount coupons to parents of school children. Graph the externality including the subsidy. You have drawn the Externality, now add the subsidy P MSC Pso 4. Shade in the area of the subsidy and label it You can either write it inside the shaded area or outside with an arrow Pm SUBSIDY MSB Qm Qso Q