1. Externalities and Public Goods
Chapter 18
Externalities and Public Goods
Chapter 18

2. Topics to be Discussed Externalities Ways of Correcting Market Failure
Externalities and Property Rights
Common Property Resources
Public Goods
Private Preferences for Public Goods
Chapter 18 2

3. Externalities
Externalities arise between producers, between consumers or between producers and consumers
Externalities are the effects of production and consumption activities not directly reflected in the market
They can be negative or positive
Chapter 18 4

4. Externalities Negative
Action by one party imposes a cost on another party
Plant dumps waste in a river affecting those downstream
The firm has not incentive to account for the external costs that it imposes on those downstream
Chapter 18

5. Externalities Positive Action by one party benefits another party
Homeowner plants a beautiful garden where all the neighbors benefit from it
Homeowner did not take their benefits into account when deciding to plant
Chapter 18

6. Negative Externalities and Inefficiency
Scenario – plant dumping waste
Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production.
Marginal Social Cost (MSC) is MC plus MEC.
We can show the competitive market firm decision and the market demand and supply curves
Chapter 18 6

7. Negative Externalities and Inefficiency
Assume the firm has a fixed proportions production function and cannot alter its input combinations
The only way to reduce waste is to reduce output
Price of steel and quantity of steel initially produced is at the intersection of supply and demand
Chapter 18

8. Negative Externalities and Inefficiency
The MC curve for the firm is the marginal costs of production
Firm maximizes profit by producing where MC equals Price in a competitive firm
As firm output increase, external cost on fishermen increases measured by the marginal external cost curve
From a social point of view, the firm produces too much output
Chapter 18

9. The profit maximizing firm efficient output level is q*.
External Costs
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
There is MEC of production from the waste released. The MSC is true cost of production.
Firm will produce q1 at P1.
MSC
Price
Price MC
MSCI D
S = MCI P* Q* P1 P1 Q1 q* q1
MECI
MEC
Firm output
Industry output
Chapter 18

10. External Costs MC S = MCI D P1 q1 Q1 MSC MSCI MEC MECI q* P* Q* Price
By no producing at the efficient level, there is a social cost on society MC
S = MCI D P1 q1 Q1
MSC
MSCI
Firm output
Price
Industry output
MEC
MECI q* P* Q*
Aggregate
social cost of
negative
externality
Chapter 18

11. External Cost
Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.
Chapter 18 17

12. Positive Externalities and Inefficiency
Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.
Repairs generate external benefits to the neighbors
Show by the Marginal External Benefit curve (MEB)
Marginal Social Benefit (MSB) curve adds MEB +D
Chapter 18

13. External Benefits Value MSB D P1 MC P* MEB Repair Level q1 q*
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D. D MC P1 q* P* q1
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MEB
Repair Level
Chapter 18 25

14. Ways of Correcting Market Failure
Assumption: The market failure is pollution
Output decision and emissions decision are independent
Firm has chosen its profit-maximizing output level
MSC is marginal social cost of emissions
Equivalent to MEC from before
Upward sloping because of substantially increasing harm as pollution increases
Chapter 18 26

15. Ways of Correcting Market Failure
MCA is marginal cost of abating emissions
Additional cost to firm of controlling pollution
Downward sloping because when emissions are high, little cost to controlling them
Large reductions require costly changes in production process
Chapter 18

16. Ways of Correcting Market Failure
If the firm does not consider abatement, their profit maximizing level is 26 units of emissions
Level where MCA is zero
The socially efficient level of emissions is 12 where the MSC equals the MCA
Chapter 18

17. The Efficient Level of Emissions
Dollars/ unit
of Emissions
MSC
MCA E0 6
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost. 4
At E1 the marginal
social cost is greater
than the marginal benefit. E1
The efficient level of
emissions is where
MCA = MSC. E* 2
Level of Emissions 2 4 6 8 10 12 14 16 18 20 22 24 26
Chapter 18 34

18. Ways of Correcting Market Failure
Firms can be encouraged to reduce emissions to the efficient level in three ways
Emissions standards
Emissions fees
Transferable emissions permits
Chapter 18

19. Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emission Standard
Set a legal limit on emissions at E* (12)
Enforced by monetary and criminal penalties
Increases the cost of production and the threshold price to enter the industry
Emissions Fee
Charge levied on each unit of emission
Chapter 18 35

20. Standards and Fees MSC 3 MCA E* 12 Standard Fee Dollars/ unit
of Emissions
MSC
MCA 3 12 E*
Standard
Fee
Level of Emissions
Chapter 18 38

21. Standards and Fees MSC E* 3 MCA 12 Cost is less than the
Dollars/ unit
of Emissions
MSC
MCA
Cost is less than the
fee if emissions were
not reduced. E*
Fee 3
Total Fee
of Abatement
Total
Abatement Cost 12
Level of Emissions
Chapter 18 42

22. Ways of Correcting Market Failure
Standards Versus Fees
Assumptions
Policymakers have asymmetric information
Administrative costs require the same fee or standard for all firms
Chapter 18 43

23. The Case for Fees Assume two firms
Same marginal social cost curve
Different marginal abatement cost curves
MCA1 and MCA2
Emissions fees are preferable to standards in this case
We want to reduce total emissions by 14 units
The cheapest way to do that is for firm 1 to reduce by 6 and firm 2 by 8 units
Chapter 18

24. Firm 1 emissions would fall MCA1 = MCA2: efficient solution.
The Case for Fees 2 4 6
Fee per
Unit of
Emissions 1 3 5
MCA1
MCA2
The cost minimizing solution
would be an abatement of 6
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
If a fee of $3 was imposed
Firm 1 emissions would fall
by 6 to 8. Firm 2 emissions
would fall by 8 to 6.
MCA1 = MCA2: efficient solution.
Level of
Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Chapter 18 48

25. The Case for Fines
What if the regulatory agency forces each firm to cut emissions by 7 units
MAC for firm 1 increases to $3.75
MAC for firm 2 decreases to $2.50
This is not cost minimizing because one firm can reduce emissions at a lower cost than the other firm
Marginal cost of abatement must be equal between firms for reductions to occur at minimum cost
Chapter 18

26. The impact of a standard of abatement of 7 for both firms
The Case for Fees 2 4 6
Fee per
Unit of
Emissions 1 3 5
MCA1
MCA2
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
3.75
2.50
Firm 1’s Increased
Abatement Costs
Firm 2’s Reduced
Abatement
Costs
Level of
Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Chapter 18 48

27. Ways of Correcting Market Failure
Advantages of Fees
When equal standards must be used, fees achieve the same emission abatement at lower cost.
Fees create an incentive to install equipment that would reduce emissions further.
Chapter 18 50

28. The Case for Standards Assume we have Steep marginal social cost curve
Flat marginal cost of abatement
An emissions fee of $8 would be efficient but because of limited information, fee is set at $7
Firms emissions increase and with steep MSC, this will lead to significant additional social costs
Chapter 18

29. The Case for Standards
What if standard is used instead and has the same percentage mistake
Standard set at 9 instead of 8
Increase in social cost and decrease in abatement costs
Net increase in social costs is smaller than with fees
Chapter 18

30. information fee is $7 (12.5% decrease). information standard is 9
The Case for Standards
Fee per
Unit of
Emissions 2 4 6 8 10 12 14 16 B C
Based on incomplete
information fee is $7 (12.5% decrease).
Emission increases to 11.
Marginal
Social
Cost
ABC is the increase
in social cost less the
decrease in abatement
cost. E D A
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
Marginal Cost
of Abatement
Level of Emissions 2 4 6 8 10 12 14 16
Chapter 18 56

31. Ways of Correcting Market Failure
Summary: Fees vs. Standards
Standards are preferred when MSC is steep and MCA is flat.
Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement.
Chapter 18 57

32. Ways of Correcting Market Failure
Summary: Fees vs. Standards
Fees have certainty on cost and uncertainty on emissions.
Preferred policy depends on the nature of uncertainty and the slopes of the cost curves.
Chapter 18 58

33. Ways of Correcting Market Failure
Transferable Emissions Permits
Permits help develop a competitive market for externalities.
Agency determines the level of emissions and number of permits
Permits are marketable
High cost firm will purchase permits from low cost firms
Chapter 18 59

34. Ways of Correcting Market Failure
The market for externalities is appealing since it combines the system of standards with the system of fees.
The agency who administers the system determines the total number of permits and therefore the total amount of emissions
Marketability of the permits allows pollution abatement to be achieved at minimum cost.
Chapter 18 60

35. The Costs and Benefits of Reduced Sulfur Dioxide Emissions
Cost of Reducing Emissions
Conversion to natural gas from coal and oil
Emission control equipment
Benefits of Reducing Emissions
Health
Reduction in corrosion
Aesthetic
Chapter 18 61

36. The Costs and Benefits of Reduced Sulfur Dioxide Emissions
The efficient sulfur dioxide concentration equates the marginal abatement cost to the marginal social cost.
Can show the marginal abatement cost curve in a series of steps each representing a different abatement technology
Chapter 18 62

37. Sulfur Dioxide Emissions Reductions
Dollars
per
unit of
reduction 60
Marginal Abatement Cost
Observations
MAC = .0275
.0275 is slightly below actual emission level
Economic efficiency improved 40
Marginal Social Cost 20
Sulfur dioxide
concentration (ppm)
0.02
0.04
0.06
0.08
Chapter 18 65

38. Emissions Trading and Clean Air
Bubbles
Firm can adjust pollution controls for individual sources of pollutants as long as a total pollutant limit is not exceeded.
Offsets
New emissions must be offset by reducing existing emissions
2000 offsets since 1979
Chapter 18 67

39. Emissions Trading and Clean Air
Cost of achieving an 85% reduction in hydrocarbon emissions for DuPont
Three Options
85% reduction at each source plant (total cost = $105.7 million)
85% reduction at each plant with internal trading (total cost = $42.6 million)
85% reduction at all plants with internal and external trading (total cost = $14.6 million)
Chapter 18 68

40. Emissions Trading and Clean Air
1990 Clean Air Act
Since 1990, the cost of the permits has fallen from an expected $300 to below $100.
Causes of the drop in permit prices
More efficient abatement techniques
Price of low sulfur coal has fallen
Chapter 18 69

41. Price of Tradable Emissions Permits
Chapter 18

42. Ways of Correcting Market Failure
Recycling
Households can dispose of glass and other garbage at very low cost.
The low cost of disposal creates a divergence between the private and the social cost of disposal.
Chapter 18 70

43. Recycling
Marginal private cost likely constant for fixed amount of garbage
Social cost of disposal includes the harm to environment from littering and injuries caused by litter
Without market intervention, the level of crap will be at m and m1 > m*
With refundable deposit, MC increases and MC = MSC = MCR
Chapter 18

44. The Efficient Amount of Recycling
Chapter 18 75

45. Refundable Deposits
Deposit is paid when bottle is purchased and then refunded when bottle returned.
Can chose the deposit to give household incentive to recycle more
Deposit increases private cost of disposal
Supply of glass comes from new glass and recycled glass
Increasing deposit increase supply of recycled glass and lowers price of glass
Chapter 18

46. Refundable Deposits Sr $ S’r Sv D S S’ P P’ M1 M* Amount of Glass
The supply of glass is
the sum of the supply
of virgin glass (Sr) and
the supply of recycled
glass (Sr). Sr
Without refunds the
price of glass is P and
Sr is M1. $
S’r Sv
With refunds Sr increases
to S’r and S increases to S’. D S
Price falls to P’ and
the amount of
recycled glass
increases to M*. S’ P P’ M1 M*
Chapter 18
Amount of Glass 80

47. Externalities and Property Rights
Legal rules describing what people or firms may do with their property
For example
If residents downstream owned the river (clean water) they control upstream emissions.
Chapter 18 81

48. Externalities and Property Rights
Bargaining and Economic Efficiency
Economic efficiency can be achieved without government intervention when the externality affects relatively few parties and when property rights are well specified.
Chapter 18 82

49. Profits Under Alternative Emissions Choices (Daily)
Chapter 18 84

50. Externalities and Property Rights
Assumptions
Factory pays for the filter
Fishermen pay for the treatment plant
Efficient Solution
Buy the filter and do not build the plant
Chapter 18 85

51. Bargaining with Alternative Property Rights
Chapter 18 87

52. Externalities and Property Rights
Conclusion: Coase Theorem
When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified.
Chapter 18 88

53. Costly Bargaining – The Role of Strategic Behavior
Bargaining requires clearly defined rules and property rights.
If property rights were not clear, other party might not be willing to pay as much and bargaining process would break down
One party might incorrectly assume the other party will eventually break down and accept less
Problems also arise when there are many parties affected
Chapter 18 89

54. A Legal Solution – Suing for Damages
In many situations involving externalities, one party is harmed (victim)
They can recover monetary damages equal to harm suffered
A suit for damages is different than effluent fee since the victim, not the government, is paid
Chapter 18

55. A Legal Solution – Suing for Damages – Example
Fishermen have the right to clean water
Factory has two options
No filter, pay damages
Profit = $100 ($500 - $400)
Filter, no damages
Profit = $300 ($500 - $200)
Chapter 18 90

56. A Legal Solution – Suing for Damages – Example
Factory has the right to emit effluent
Fishermen have three options
Put in treatment plant
Profit = $200
Filter and pay damages
Profit = $300 ($500 - $200)
No plant, no filter
Profit = $100
A suit for damages results in an efficient outcome.
Chapter 18 91

57. The Coase Theorem at Work
Negotiating an Efficient Solution
1987 – New York garbage spill (200 tons) littered the New Jersey beaches
The potential cost of litigation resulted in a solution that was mutually beneficial to both parties.
Chapter 18 93

58. Common Property Resources
Characteristics
Everyone has free access.
Likely to be overutilized
Examples
Air and water
Fish and animal populations
Minerals
Chapter 18 94

59. Common Property Resources
Consider a lake where people fish
Each fisherperson takes fish up to the point where the marginal benefit to them equals the marginal cost
There is no reason that any one fisherperson take into account how their taking fish affects others experience
Chapter 18

60. Common Property Resources
Private cost underestimates the true cost to society
More fishing reduces the stock of fish
Less is available to others and too low of a stock will completely deplete the fish
Too many fish are caught
Chapter 18

61. Common Property Resources
Benefits,
Costs
($ per
fish)
Without control the number
of fish/month is FC where
PC = MB.
Marginal Social Cost
However, private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Private Cost
Demand (MB) F* FC
Fish per Month 98

62. Common Property Resources
Solution
Private ownership
Owner will set fee for sue of resource equal to the marginal cost of depleting the stock
Fishermen will no longer find it profitable to catch more than the efficient amount of fish
It is often the case that private ownership is not possible, the government steps in
Chapter 18 99

63. Crawfish Fishing in Louisiana
Crawfish has become very popular in restaurants
As a common property resource, too many crawfish have been trapped causing the population to fall below efficient level
Finding the Efficient Crawfish Catch
F = crawfish catch in millions of pounds/yr
C = cost in dollars/pound
Chapter 18

64. Crawfish Fishing in Louisiana
Demand
C = = F
MSC
C = F PC
C = F
Efficient Catch
D = MSC
9.2 million pounds
Chapter 18

65. Crawfish as a Common Property Resource
Cost
($/pound)
Marginal Social Cost
Private Cost
11.9
2.10
9.2
0.325
Demand
Crawfish Catch
(millions of pounds)
Chapter 18 98

66. Public Goods Characteristics Nonrival Nonexclusive
For any given level of production the marginal cost of providing it to an additional consumer is zero.
Nonexclusive
People cannot be excluded from consuming the good.
Example – use of lighthouse by a ship
Chapter 18
101

67. Public Goods Nonexclusive goods
Goods that people cannot be excluded from consuming, so that it is difficult or impossible to charge for their use
Example: fireworks, national defense
Chapter 18
102

68. Efficiency and Pubic Goods
Efficient level of private good is where marginal benefit equals marginal cost
For a public good, the value of each person must be considered
Can add demand of all those who value good
Must equate the sum of these marginal benefits to the marginal cost of production
Chapter 18

69. Efficient Public Good Provision
Benefits
(dollars)
D1 is demand for consumer 1
D2 is demand for consumer 2
D is total demand for all consumers D
$7.00
$5.50 MC D2
$4.00
Efficient output occurs
where MC = total MB
2 units of output.
MB is $ $4.00 or $5.50. D1
$1.50
Output 1 2 3
Chapter 18 4 5 6 7 8 9 10
105

70. Public Goods and Market Failure
Free Riders
There is no way to provide some goods and services without benefiting everyone.
Households do not have the incentive to pay what the item is worth to them.
Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it.
Chapter 18
107

71. Public Goods and Market Failure
Establishing a mosquito abatement company
How do you measure output?
Who do you charge?
A mosquito meter?
Chapter 18
108

72. The Demand for Clean Air
Clean Air is a public good
Nonexclusive and nonrival
No market and no observable price at which people are willing to trade clean air for other goods
Chapter 18
109

73. The Demand for Clean Air
Choosing where to live
Study in Boston correlates housing prices with the quality of air and other characteristics of the houses and their neighborhoods.
Chapter 18
110

74. The Demand for Clean Air
Dollars
Low Income
Middle Income
High Income
3000
2500
2000
1500
1000
500
Nitrogen Oxides
(pphm) 1 2 3 4 5 6 7 8 9 10
Chapter 18
112

75. The Demand for Clean Air
Findings
Amount people are willing to pay for clean air increases substantially as pollution increases.
Higher income earners are willing to pay more (the gap between the demand curves widen)
National Academy of Sciences found that a 10% reduction in auto emissions yielded a benefit of $2 billion---somewhat greater than the cost.
Chapter 18
113

76. Private Preferences for Public Goods
Government production of a public good is advantageous because the government can assess taxes or fees to pay for it.
Determining how much of a public good to provide when free riders exist is difficult.
Chapter 18
114

77. Private Preferences for Public Goods
Can represents different citizen’s willingness to pay for education minus any required tax payments
In general benefit from increased spending on education increases as spending increases
Tax payments to provide more education increase as well
Chapter 18

78. Determining the Level of Educational Spending
Willingness
to pay $
Will majority rule yield an efficient outcome?
W1 will vote for $600
W2 and W3 will vote for $1200
The median vote will always win in a majority
rule election.
The efficient level of educational
spending is determined by summing the
willingness to pay for education for each
of three citizens. AW W3 W2 W1
Educational spending
per pupil $0
$600
Chapter 18
$1200
$1800
$2400
117

79. Private Preferences for Public Goods
Question
Will the median voter selection always be efficient?
Answer
If two of the three preferred $1200 there would be over-investment.
If two of the three preferred $600 there would be under-investment.
Chapter 18
119

80. Private Preferences for Public Goods
Majority rule is inefficient because it weighs each citizen’s preference equally
The efficient outcome weighs each citizen’s vote by his or her strength of preference.
Chapter 18
120