1. ECONOMICS Part VI: The Role of Government in Microeconomics/
What Does It Mean To Me?
Part VI:
The Role of Government in Microeconomics/
Externalities

2. Economic functions of Government:
1) Enforce laws and contracts.
2) Maintain competition.
3) Redistribute income--providing an economic safety net.
4) Provide public goods
-nonexclusion
-shared consumption

3. 5) Correct Market Failures
-provide market information
-correct negative externalities
-subsidize goods with positive
externalities
6) Stabilize the economy
- fight unemployment
- encourage price stability
- promote economic growth

4. EXTERNALITIES

5. Externalities usually result in market failure.
Externality
When one person’s actions imposes a cost or benefit on the well-being of a bystander.
Externalities usually result in market failure.

6. Externalities can be:
1) Positive: an external benefit is imposed on someone. (examples: gardens, restored historic buildings, research)
2) Negative: an external cost is imposed on someone. (examples: exhaust from autos, barking dogs, noise from airplanes)

7. Externalities cause markets to allocate resources inefficiently.

8. This happens through:
1) CONSUMPTION: consuming a good results in externality.
2) PRODUCTION: producing a good results in externality.
In general, an external cost means the market overproduces the good (ie, paint). An external benefit means the market underproduces the good (ie, gardens)

9. Are there benefits for other people in the parking lot when someone puts their car alarm on?

10. Yes, because thieves don’t know which cars have alarms.
ANSWER:
Yes, because thieves don’t know which cars have alarms.
What about the club?
Are there benefits for other people in the parking lot when someone puts the club on their car?

11. No . . .because the thief can SEE the club.
ANSWER:
No . . .because the thief can SEE the club.

12. Your neighbor puts in a nice garden. Are you receiving a benefit?

13. When you admit you are receiving a positive benefit, your neighbor asks you to pay him $100 a month for the benefit.
When you say no, he puts up a fence.

14. What if you lived next door to this? Do you receive a benefit?

15. PROPERTY RIGHTS is the issue? Who owns the air? The rivers? The parks?

16. We get into trouble when we use this criteria regarding the air.
If we can figure out who pollutes the stream, we punish the offender because we are not sure who owns the stream, but we DO know who pollutes it.
We get into trouble when we use this criteria regarding the air.

17. The tendency for a society to overuse and therefore abuse common resources is called:
TRAGEDY OF THE COMMONS

18. What is the difference between a public good and a private good?
Exclusion vs. non-exclusion
and
Shared consumption (rival good)
vs.
non-shared consumption (non-rival good)

19. What defines property rights?
Property rights are established by formal and informal rules about the privileges and limitations on the ownership, use, and transfer of goods and resources. These rights are specified in various municipal ordinances, other legislation, court decisions (common law), tradition and custom.

20. Property rights need to be:
1) clearly defined
2) exclusive
3) enforceable
4) transferable

21. Consider each of the items below:
Are they ?
Clearly
Defined? Exclusive? Transferable? Enforceable?
skateboard
gun
library book
hamburger
Garden view
Bottled water
Lake water
Stream water

22. Someone who uses the good but doesn’t pay for it.
What is a free-rider?
Someone who uses the good but doesn’t pay for it.
Free riders occur when there are nonexclusion and shared consumption.
Spraying for mosquitoes
Police & fire protection
National defense
Street lights

23. An Overview of U.S. Water Law
Riparian Common Law - people who own land along streams, lakes and springs have a right to “reasonable use” of the water.
First -in-time, First-in-right - the first person to divert water and use it has the first right. People who come later can take what is left.
Use-it or Lose-it - If a person with water rights doesn’t use all the water he claims a right to, he permanently loses his right to the portion he doesn’t use.

24. An Overview of U.S. Water Law (cont.)
Salvaged water rule - If a person is able to save water (I.e. by better irrigation system), he cannot sell the extra water or even keep his right to it.
Beneficial use - People may not establish water rights unless they are using the water for “beneficial use”. (I.e.) Agriculture is recognized in all states, but only a few states recognize recreation or fishing.
Public Interest - Water rights--especially the right to transfer--are limited by the “public interest>” Laws and courts define “public interest” as things like protecting an economic area or environment or public health and safety.

25. Even though water is essential for life and diamonds are not, water is cheap and diamonds are expensive?
Why?

26. With DIAMONDS, supply is very inelastic.
It has to do with the elasticity of the supply curve and the amount of consumer/producer surplus
With DIAMONDS, supply is very inelastic.
With WATER, supply is very elastic. S
Consumer Surplus P
Price
Price
Producer Surplus S P D D Q Q
Quantity
Quantity

27. Why would a farmer in the desert of Southern California grow rice--a crop that requires a great deal of water?

28. How much water do you NEED to live per day?
Answer: 1 1/2 liters
What is the average per capita consumption of water per day in the State of Florida?
Answer: 169 gallons

29. 130 gal/day in Massachusetts and Rhode Island
Compare this to
130 gal/day in Massachusetts and Rhode Island
And
325 gal/day in Nevada

30. When is a basketball an alternative to water?
When is coal an alternative to a waterfall?

31. What are some other ways to conserve water?
Drip irrigation
Compost
Night watering
Safflower oil
Xeriscape
Rocks
Massage
Broom
Denim
Mulch

32. If I were your neighbor, what could you do to stop me from polluting?

33. What if we decide it’s YOUR property?
1) Call the police
2) Assault and battery??
3) Pay me to stop.---You’ve upped my opportunity cost---at some point it’s worth it to me to stop.

34. What if we decide it’s MY property?
1) Outdo my Opportunity Cost (money, friendship)
2) Petition or threaten (fine, tax)
3) You can PAY me to stop (what is it worth to you?)

35. Consider the following taxing methods to control water usage:
People’s use responds to incentives.
Consider the following taxing methods to control water usage:
Mayor asks bill = $.002/gal.
Flat fee = $10/month
MC = 0
Flat fee = $30/month
Billed at $.01/gal.
MC >MB
Billed at $.05/gal.

36. The government has dealt effectively with most water issues.
BUT what about GARDENS???

37. Do you have a right to your view?
So . . .
Your neighbor plants a garden and it is beautiful.
But 5 years later, the garden has grown and you can no longer see the lake.
Do you have a right to your view?

38. If your cat is in your neighbor’s yard, is it your neighbor’s cat?
Today, there are thousands of lawsuits over condos and owner’s rights or trees loosing leaves in your neighbor’s yard.
If your cat is in your neighbor’s yard, is it your neighbor’s cat?
What if your cat kills a bird in your neighbor’s yard?

39. Coase Theorem
The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

40. Is this pollution?

41. Exercise

42. Externalities Positive (+benefit) Negative (+cost)
In review:
Externalities
Positive (+benefit)
Negative (+cost)
Consumption (cigarettes)
Consumption (education)
Production (pollution)
Production (honey)

43. Efficiency occurs when MC = MB for society.
What is efficient?
Efficiency occurs when MC = MB for society.
PRICE
S = MC to Society
For a perfectly competitive market with no externalities and for a good that is not a public good, the market is efficient.
D = MB to Society
QUANTITY

44. Another way to measure efficiency would be where
What is efficient?
Another way to measure efficiency would be where
Profit Maximizing Output is found where P = MC MC
PRICE
Market Price
QUANTITY

45. What happens when the firms’ marginal cost of production is not equal to the marginal cost to society?
Or if the marginal benefit to consumers is not equal to the marginal benefit to society?

46. NEGATIVE EXTERNALITY IN PRODUCTION:
Example: Pollution
Because of the externality, the cost to society is larger than the cost to producers.
MSC
PRICE
S = MPC to Firm
MC is the private cost to the firm.
Marginal social cost (MSC) is cost to society = MC + externality.
D = MB to Society
QUANTITY
Qmarket
Qoptimum
The market overproduces and charges a price that is too low.

47. POSITIVE EXTERNALITY IN PRODUCTION:
Example: Honey
MPC to firm
PRICE
S = MSC
MC is the private cost to the firm.
Marginal social cost (MSC) is cost to society = MC + externality.
D = MB to Society
QUANTITY
Qoptimum
Qmarket
The market underproduces and charges a price that is too high.

48. NEGATIVE EXTERNALITY IN CONSUMPTION:
Example: Cigarettes
Overproduction in this case raises MC.
D gives the private benefit in consumption.
Marginal social benefit (MSB) = D + externality.
PRICE MC
D = MB to Buyer
MSB
QUANTITY
Qmarket
The market overproduces and charges a price that is too high.

49. POSITIVE EXTERNALITY IN CONSUMPTION:
Examples: Education, Charities
The social value of education is greater than the private value.
Underproduction in this case lowers MC.
PRICE MC
D gives the private benefit in consumption.
Marginal social benefit (MSB) = D + externality.
MSB
D = MB to Buyer
QUANTITY
Qoptimum
Qmarket
The market underproduces and charges a price that is too low.

50. (Negotiate if mutually beneficial)
SOLUTIONS:
1) Assign property rights => internalize externality
(Negotiate if mutually beneficial)
2) Government involvement
Tax on negative externality (Pigovian tax)
Subsidy for positive externality
Permits

51. A tax on firms based on the external costs they generate.
Pigovian Tax
Named after economist, Arthur Pigou
A tax on firms based on the external costs they generate.
Internalizes the externality and reimburses society for the external costs.
The term “pollution tax” is used when the tax may not be equal to marginal external cost.

52. P P Q Q A Pigovian tax sets the price of pollution…….
Pollution permits sets the quantity of pollution…..
……which, together with the demand curve determines the quantity of pollution.
……which, together with the demand curve determines the price of pollution.
Supply of pollution permits
Pigovian Tax
Price of Pollution P
Price of Pollution P
Demand for Pollution Rights
Demand for Pollution Rights Q Q
Quantity of Pollution
Quantity of Pollution

53. Notice that in both cases, price and quantity are the same. . . .
Supply of pollution permits
Pigovian Tax
Price of Pollution P
Price of Pollution P
Demand for Pollution Rights
Demand for Pollution Rights Q Q
Quantity of Pollution
Quantity of Pollution

54. Notice also that the pigovian tax line is perfectly elastic--firms can pollute as much as they want as long as they pay a tax. . .
Supply of pollution permits
Pigovian Tax
Price of Pollution P
Price of Pollution P
Demand for Pollution Rights
Demand for Pollution Rights Q Q
Quantity of Pollution
Quantity of Pollution

55. . . .while in the second panel, the EPA sets the quantity of pollution, and the supply of pollution is completely inelastic.
Supply of pollution permits
Pigovian Tax
Price of Pollution P
Price of Pollution P
Demand for Pollution Rights
Demand for Pollution Rights Q Q
Quantity of Pollution
Quantity of Pollution

56. Economists usually prefer pigovian taxes to regulation as a way to deal with pollution because they reduce pollution at a lower cost to society.
Using pigovian taxes to internalize externalities will cause market price to reflect the true social costs of production and force firms to bear the full social cost of their production activities.

57. Should the government allow two factories to make this deal?
Now, suppose that two firms are awarded permits and have met the government standard.
Firm 1 then decides it wants to increase its emissions by 100 tons and firm 2 agrees to reduce its emissions by 100 tons if firm 1 pays it $5 million.
Should the government allow two factories to make this deal?

58. If the EPA allows the firms to make this deal, it will have created a new scarce resource: pollution permits.
A market to trade these permits will develop and that market will be governed by the forces of supply and demand.

59. The CLEAN AIR ACT of 1990 established the right to buy and sell emission rights for sulfur-dioxide pollution.

60. CO2 emission permits have been traded since 1995 on the Chicago Exchange.
Carbon emissions trading has been steadily increasing in recent years. According to the World Bank's Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO2e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO2e), which was itself a 41% increase relative to 2003 (78 mtCO2e).

61. The world's only mandatory carbon trading program is the European Union Emissions Trading Scheme (or EUETS). Created in conjunction with the Kyoto Protocol, a 1997 international treaty that took effect in 2005, it caps the amount of carbon dioxide that can be emitted from large installations, such as power plants and factories, in the EU's 25 member countries.
Source: Wikipedia

62. NASH EQUILIBRIUM is a situation where economic actors interacting with each other each choose their best strategy given the strategies that others have chosen. This is also called GAME THEORY.
Game Theory has become a major tool for dealing with pollution problems.
John Nash
1994 Nobel Prize, Economics

63. Game Theory can be illustrated by what is called THE PRISONER’S DILEMMA.
The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that each would spend 1 year in jail. But they suspect that the two have pulled off some bank robberies but they have no evidence. They put Bonnie and Clyde in separate rooms and offer a deal.
“Right now, we can lock you up for one year. But if you testify against your partner, we will set you free and your partner will get 20 years in prison. If you both confess to the crime, we can avoid the cost of a trial and you both get 8 years.”

64. Bonnie’s Decision Clyde’s Decision
Each prisoner has two strategies, confess or remain silent. However, the sentence that each gets depends upon the actions of the other.
Bonnie’s Decision
confess
Remain silent
Bonnie yrs
Clyde goes free
confess
8 years each
Clyde’s Decision
Bonnie goes free
Clyde - 20 yrs.
Remain silent
1 year each

65. Clyde’s Decison Bonnie’s Decison Clyde’s Decison
OR you can use the PAYOFF MATRIX
B: 8 years
C: 8 years
confess
Clyde’s Decison
Remain silent
confess
B: free
C: 20 years
Bonnie’s Decison
Remain silent
B: 20 years
C: free
confess
Clyde’s Decison
Remain silent
B: 1 year
C: 1 year

66. Iraq’s Decision Iran’s Decision
In the real world, this dilemma is played out by real players. Once a negotiation is reached, each country must decide whether they should keep their agreement.
Iraq’s Decision
High prod.
Low prod.
Iraq - $30 billion
Iran - $60 billion
$40 billion each
High prod.
Iran’s Decision
Iraq - $60 billion
Iran - $30 billion
Low prod.
$50 billion each

67. It can be used in the arms race…...
U.S.’s Decision
Arm.
Disarm
US at risk
USSR safe
Both at risk
Arm
USSR’s Decision
US safe
USSR at risk
Disarm
Both safe

68. It can be used in the everyday economic decisions……Consider 2 firms which must decide whether to make a new product or not….
Firm 1
Yes No
Firm 1: $1.5m
Firm 2: $1.5m
Firm 1: 0
Firm 2: $2m
Yes
Firm 2
Firm 1: $2m
Firm 2: 0 No
Firm 1: 0
Firm 2: 0

69. SAMPLE AP TEST QUESTION

70. The production of Good X creates an externality.
Is this a negative or positive externality?
Price
Marginal Social Cost 13 12 7 4
Negative
Marginal Private Cost
Why?
MSC > MPC
D-MSB MR
Quantity of Good X
Q1 Q2 Q3

71. The production of Good X creates an externality.
Price
Identify the socially optimum output.
Marginal Social Cost 13 12 7 4 Q2
Marginal Private Cost
Why?
MSC=MSB
D-MSB MR
Quantity of Good X
Q1 Q2 Q3

72. Suppose that good X is produced by a profit-maximizing monopoly.
Identify the unregulated firm’s output.
Price Q1
Marginal Social Cost 13 12 7 4
Why?
Marginal Private Cost
At Q1, MPC = MR
D-MSB MR
Quantity of Good X
Q1 Q2 Q3

73. Suppose that good X is produced by a profit-maximizing monopoly.
To produce socially optimum output, should the government tax or subsidize the firm?
Price
subsidize
Marginal Social Cost 13 12 7 4
How much will it be?
Marginal Private Cost $3
Why?
Optimum Quantity at Q = MR
D-MSB MR
Quantity of Good X
Q1 Q2 Q3

74. Suppose that good X is produced in a perfectly competitive industry.
Identify equilibrium output in the absence of regulation.
Price Q3
Marginal Social Cost 13 12 7 4
Why?
D=MPC or MSB=MPC
Marginal Private Cost
D-MSB MR
Quantity of Good X
Q1 Q2 Q3

75. Suppose that good X is produced in a perfectly competitive industry.
To produce at socially optimum output, should the government tax or subsidize?
Price
Tax
Marginal Social Cost 13 12 7 4
How much? $5
Marginal Private Cost
D-MSB MR
Quantity of Good X
Q1 Q2 Q3

76. The End
Created by:
Virginia Meachum, Economics Teacher, Coral Springs High School
Sources:
FTE Economics of Water and the Environment
AP MicroEconomics Test Question (2005)