1. THE ECONOMICS OF THE PUBLIC SECTOR4
THE ECONOMICS OF THE PUBLIC SECTOR

2. Market Failure Recall from Chapter 7:
Adam Smith had argued that the “invisible hand” of the marketplace leads self-interested buyers and sellers to an outcome in which the total surplus of society is maximized.
But that requires properly functioning markets
In reality, markets can fail
When markets fail, government intervention may help
CHAPTER 10 EXTERNALITIES

3. 10
Externalities

4. EXTERNALITIES AND MARKET INEFFICIENCY
An externality is the uncompensated impact of one person’s actions on the well-being of a bystander.
CHAPTER 10 EXTERNALITIES

5. EXTERNALITIES AND MARKET INEFFICIENCY
An externality is the uncompensated impact of one person’s actions on the well-being of a bystander.
Al’s action may affect the well-being of Betty, a bystander, in a negative or positive way.
If Al pays no compensation (when his action has a negative effect on Betty) nor receives a reward (when his action has a positive effect on Betty), the effect of Al’s action on Betty is called an externality.
CHAPTER 10 EXTERNALITIES

6. Government intervention may be able to increase total surplus
In this case, Al will ignore the effects of his action on Betty when deciding whether or not to take the action
Therefore, Al may take this action even if it is undesirable for society
And, conversely, Al may refuse to take this action even if it is desirable for society
In other words, when actions have external effects, society’s total surplus might not be maximized in the free market equilibrium
Government intervention may be able to increase total surplus
CHAPTER 10 EXTERNALITIES

7. Externalities, negative and positive
When the impact of a person’s action on a bystander is harmful, the externality is called a negative externality.
When the impact on the bystander is beneficial, the externality is called a positive externality.
CHAPTER 10 EXTERNALITIES

8. Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
The Club, an anti-theft device for cars
CHAPTER 10 EXTERNALITIES

9. Dealing with negative externalities
Should we completely ban an activity that has negative externalities?
Should we ban all cars?
Should we ban all smoking in public spaces?
Should we muzzle all dogs?
Should we ban stereos in apartment buildings?
Should we ban The Club?
CHAPTER 10 EXTERNALITIES

10. Positive Externalities
Immunizations
Education
Restored historic buildings
Research into new technologies
LoJack, an anti-theft device for cars
CHAPTER 10 EXTERNALITIES

11. Dealing with positive externalities
Should we take all activities that have positive externalities to the max?
Should we force everybody to take flu shots?
Should we require everybody to get a PhD?
Should we restore all historic buildings?
Should we pay for every research project scientists want to do?
Should we require every car owner to use LoJack?
CHAPTER 10 EXTERNALITIES

12. Dealing with negative externalities
How should we determine the extent to which activities that have negative externalities should be tolerated?
We can evaluate virtually any policy proposal by asking how it would affect total surplus.
Recall from Chapter 7, the concept of total surplus.
CHAPTER 10 EXTERNALITIES

13. EXTERNALITIES AND MARKET INEFFICIENCY
Externalities can cause markets to become inefficient.
We saw in chapter 7 that total surplus is maximized in a perfectly competitive economy.
But when there are externalities, this is no longer true:
total surplus might be less than the maximum achievable.
This might provide a justification for government intervention.
CHAPTER 10 EXTERNALITIES

14. EXTERNALITIES AND MARKET INEFFICIENCY
Negative externalities from the production or consumption of a good can cause markets to produce more than is socially desirable.
Positive externalities cause markets to produce less than is socially desirable.
If and when markets fail (to produce the socially desirable quantity), government intervention may be necessary.
CHAPTER 10 EXTERNALITIES

15. Figure 1 The Market for Aluminum
Ch. 7 Recap: Assume there are no externalities in aluminum consumption. Then, the height of the demand curve at, say, the 11th unit of aluminum is the benefit obtainable from the 11th unit when all 11 units are distributed among aluminum consumers so as to maximize the total benefit.
Price of
Aluminum
Supply
(private cost)
Demand
(private benefit)
$10
QMARKET
Equilibrium 11
Quantity of
Aluminum

16. Figure 1 The Market for Aluminum
Ch. 7 Recap: Assume there are no externalities in aluminum production. Then, the height of the supply curve at, the 11th unit of aluminum is the cost of the 11th unit when all 11 units are distributed among aluminum producers so as to minimize the total cost.
Price of
Aluminum
Supply
(private cost)
Demand
(private benefit)
$10
QMARKET
Equilibrium $3 11
Quantity of
Aluminum

17. Figure 1 The Market for Aluminum
Ch. 7 Recap: When there are no externalities in aluminum production or consumption, the equilibrium quantity (QMARKET) maximizes social surplus.
Price of
Aluminum
Supply
(private cost)
Demand
(private benefit)
QMARKET
Equilibrium
This might be a good time to recap the derivation of the supply and demand curves in chapter 7 to explain why Supply is also called Private Cost and Demand is also called Private Value.
Quantity of
Aluminum

18. Welfare Economics Without Externalities: A Recap
When there are no externalities, the equilibrium quantity:
is efficient
maximizes total surplus
Total surplus = total benefits – total costs
is the socially desirable quantity
CHAPTER 10 EXTERNALITIES

19. Social, private, and external costs
When the production of aluminum causes pollution …
Social cost of aluminum = private cost + external cost
Private cost is the cost to aluminum producers of the raw materials and labor used in production
External cost is the cost to bystanders of having to deal with the effects of pollution
CHAPTER 10 EXTERNALITIES

20. Figure 2 Pollution and the Social Optimum
Price of
Social
cost
Aluminum
Unit Cost of
pollution
Demand
(private value)
Supply
(private cost)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum

21. Public Policies toward Negative Externalities
We just saw that when there are negative externalities, the equilibrium quantity is larger than the optimum quantity
In other words, we have market failure
Can public policy fix the market failure?
Command-and-Control Policy: Regulation
Market-Based Policy: Corrective Taxes
Market-Based Policy: Tradable Pollution Permits
CHAPTER 10 EXTERNALITIES

22. PUBLIC POLICY: Command-and-Control Policies
Such policies usually take the form of regulations:
Forbid certain behaviors.
Require certain behaviors.
Examples:
Requirements that all students be immunized.
Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).
CHAPTER 10 EXTERNALITIES

23. PUBLIC POLICY TOWARD POLLUTION: Command-and-Control
If the EPA decides it wants to reduce the amount of pollution coming from a specific plant, it could…
tell the firm to reduce its pollution by a specific amount (i.e. regulation).
levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).
CHAPTER 10 EXTERNALITIES

24. Public Policies for Negative Externalities: Market-Based Policy: Corrective Taxes
Price
Demand
Price buyers pay
Tax
Supply
Price without tax
Ch. 6 Recap
Price sellers
receive
Quantity after tax
Quantity before tax
Quantity

25. Public Policies for Negative Externalities: Market-Based Policy: Corrective Taxes
We saw in Ch. 6 that a tax (on either buyers or sellers of aluminum) will reduce the quantity bought and sold in the aluminum market. If the per-unit tax is set equal to the per unit external cost, the quantity bought and sold will be reduced to exactly the optimum amount. Problem solved!
Equilibrium
Quantity of
Aluminum
Price of
Demand
(private value)
Supply
(private cost)
Social
cost
QOPTIMUM
Optimum
QMARKET
Equilibrium
Quantity of
Aluminum
Price
Demand
Supply
QOPTIMUM
QMARKET
Per-unit External Cost
Corrective Tax

26. Market-Based Policy: Put a Tax on Negative Externalities
A corrective tax solves the problem caused by negative externalities by forcing the consumers and producers of aluminum to internalize the pollution externality of aluminum production
Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.
Corrective taxes are also called Pigovian taxes.
They were originally proposed by the British economist, A. C. Pigou.
CHAPTER 10 EXTERNALITIES

27. The government can do the following:
Public Policies for Negative Externalities: Market-Based Policy: Tradable Pollution Permits
The government can do the following:
require permits for aluminum production
issue QOPTIMUM permits by auctioning them off
Each permit will sell for a price equal to the unit cost of pollution
The effect will be identical to a corrective tax equal to the unit cost of pollution
CHAPTER 10 EXTERNALITIES

28. Tradable Pollution Permits
The price of each tradable pollution permit will be equal to the unit cost of pollution
Why?
CHAPTER 10 EXTERNALITIES

29. PUBLIC POLICY TOWARD POLLUTION: Market-Based
Pigovian Taxes on the producers or consumers of pollution
Tradable pollution permits that allow the voluntary transfer of the right to pollute from one firm to another.
A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.
CHAPTER 10 EXTERNALITIES

30. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Demand for
pollution rights P
Pigovian
tax Q 1.
A Pigovian
tax sets the
price of
pollution . . .
Quantity of 2.
. . . which, together
with the demand curve,
determines the quantity
of pollution.
Pollution

31. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(b) Pollution Permits
Price of Q
Supply of
pollution permits
Pollution
Demand for
pollution rights P 2.
. . . which, together
with the demand curve,
determines the price
of pollution.
I need to add material on cap-and-trade and on the cost-reduction aspect of pollution permits.
Quantity of 1.
Pollution
permits set
the quantity
of pollution . . .
Pollution

32. Public Policies toward Positive Externalities
A technology spillover is a positive externality that is created when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.
Education benefits the student and also all members of society who are affected by the student
CHAPTER 10 EXTERNALITIES

33. Figure 3 Education and the Social Optimum
Price of
Education
Social
benefit
Supply
(private cost)
Demand
(private benefit)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Education

34. Public Policies toward Positive Externalities
When an activity—such as education—has positive externalities:
The social value of the good exceeds the private value of the good.
The optimal output level is more than the equilibrium quantity.
The market produces a smaller quantity than is socially desirable.
CHAPTER 10 EXTERNALITIES

35. Public Policies toward Positive Externalities: Corrective Subsidies
What can be done to get the market to increase education to the optimal level?
A subsidy for either students (buyers of education) or educational institutions (sellers) will work.
A subsidy will make students and educational institutions internalize the positive externality of education
CHAPTER 10 EXTERNALITIES

36. Public Policies toward Positive Externalities: Corrective Subsidies
Recall that technology spillovers are positive externalities
Therefore, the equilibrium level of spending on research will be less than the socially desirable level
Government intervention may promote technology-enhancing industries
Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention.
The patent is then said to internalize the externality.
CHAPTER 10 EXTERNALITIES

37. PRIVATE SOLUTIONS TO EXTERNALITIES
Government action is not always needed to solve the problem of externalities.
In some cases, the free market ends up maximizing total surplus even when there are externalities
CHAPTER 10 EXTERNALITIES

38. PRIVATE SOLUTIONS TO EXTERNALITIES
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting (bargaining, negotiations) between those causing the externalities and those affected by the externalities
CHAPTER 10 EXTERNALITIES

39. The Coase Theorem
The Coase Theorem is the proposition—due to Ronald Coase—that if people can bargain without transaction costs over the allocation of resources, they can solve the problem of externalities on their own.
Transaction costs are the costs that people incur in the process of agreeing to and following through on a bargain.
CHAPTER 10 EXTERNALITIES

40. Bob, Spot, and Jane and Ronald Coase
Bob and Jane are room mates. Bob gets Spot, a noisy dog, as a birthday gift.
Benefit = $500; Cost = $800
Benefit = $1000; Cost = $800
Social optimum
Bob returns Spot
Bob keeps Spot
Government solution
Bob forced to pay $800 tax. Bob returns Spot
No action required. Bob keeps Spot
Private solution: Jane has right to quiet
Jane sues to enforce her right. Bob can’t afford to pay Jane a big enough bribe. Bob returns Spot
Bob pays Jane $800. Bob keeps Spot
Private solution: Bob has right to keep Spot
Jane pays Bob $500. Bob returns Spot
Jane can’t afford to pay Bob a big enough bribe. Bob keeps Spot
The cost to Jane could be the dollar value of the loss caused by unpleasant noise or the cost of noise-cancelling headphones, whichever is cheaper.
Coase Theorem: Private solutions to externalities can work

41. Bob, Spot, and Jane and Ronald Coase
Note that when the free market outcome is not optimal, bargaining between Bob and Jane will bring about the optimal outcome, irrespective of who is favored by the law
The law is important in other ways, however. For example, in one case in which the law favors Bob , Jane has to pay a $500 compensation to Bob to get him to return Spot
CHAPTER 10 EXTERNALITIES

42. Coase Theorem: Exercise
In the case of pollution by an aluminum factory, how might production of the socially desirable amount be brought about without taxation by the government?
Why might Coase’s solution fail, as a practical matter, in this case?
CHAPTER 10 EXTERNALITIES

43. Why Private Solutions Do Not Always Work
Sometimes the private solution fails because transaction costs are so high that private agreement is not possible.
Bob might get greedy and try to haggle with Jane for more than $500
Change the story by substituting three people (Jan, Jeanne and Joan) instead of Jane. Jan, Jeanne and Joan may find it hard to raise $500 for Bob’s compensation. Each might try to free ride on the others.
CHAPTER 10 EXTERNALITIES

44. PUBLIC POLICY TOWARD EXTERNALITIES
When externalities are significant and private solutions are not found, government may attempt to solve the problem through…
command-and-control policies.
market-based policies.
CHAPTER 10 EXTERNALITIES

45. Policy Exercises
Should we punish the use of SUV’s and promote the use of smaller cars?
Should we force car makers to sell cars with higher mileage?
Should we limit the use of gasoline by each car owner?
Should we tax gasoline?
Should we tax all fuels based on the damage each fuel causes?
CHAPTER 10 EXTERNALITIES

46. Any Questions?
CHAPTER 10 EXTERNALITIES

47. Summary
When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality.
Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity.
Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.
CHAPTER 10 EXTERNALITIES

48. Summary
Those affected by externalities can sometimes solve the problem privately.
The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently.
CHAPTER 10 EXTERNALITIES

49. Summary
When private parties cannot adequately deal with externalities, then the government steps in.
The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.
CHAPTER 10 EXTERNALITIES