Externalities and Public Goods

Chapter 18
Externalities and Public Goods
Topics to be Discussed
Externalities Ways of Correcting Market Failure Externalities and Property Rights Common Property Resources Public Goods Private Preferences for Public Goods
2005 Pearson Education, Inc.
Chapter 18
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
Externalities
Negative
Action by one party imposes a cost on another party
Plant
dumps waste in a river, affecting those downstream The firm has no incentive to account for the external costs that it imposes on those downstream
Chapter 18
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
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

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 given by the intersection of supply and demand
Chapter 18

The MC curve for the firm is the marginal cost of production Firm maximizes profit by producing where MC equals price in a competitive firm As firm output increases, external costs on fishermen also increase, measured by the marginal external cost curve From a social point of view, the firm produces too much output
Chapter 18
External Costs
Price
MSC
Price
There is MEC of production from Firm will produce q1 at P1. The profit maximizing firm the waste released. The MSC produces at q1 while the is true cost of production. efficient output level is q*.
MC
MSCI
S = MCI
P* P1 P1 MEC D MECI
q*
q1
Firm output
Chapter 18
Q* Q1
Industry output
9
External Costs
Price
MSC MC
Price
MSCI
By not producing at the efficient level, there is a social cost on society.
S = MCI
Aggregate social cost of negative externality
P* P1 P1
MECI MEC D
q* q1
Firm output
Chapter 18
Q*
Q1
Industry output
10
External Cost
Negative externalities encourage inefficient firms to remain in the industry and create excessive production in the long run
Chapter 18
11
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
Shown by the Marginal External Benefit curve (MEB) Marginal Social Benefit (MSB) curve adds MEB +D
2005 Pearson Education, Inc. Chapter 18 12
External Benefits
Value MSB
When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits (MSB) are higher than marginal benefits (D).
D P1
MC
A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair.
P*
MEB
q1
q*
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Repair Level
13
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
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14

MCA is marginal cost of abating emissions
Additional cost to firm of controlling pollution Downward sloping because when emissions are high, there is little cost to controlling them
Large
reductions require costly changes in production process
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15

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
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16
The Efficient Level of Emissions

Dollars/ Unit of Emissions
MSC
At Eo the marginal cost of abating emissions is greater than the marginal social cost.
At E1 the marginal social cost is greater than the marginal benefit.
2 MCA
E0 0 2 4 6 8 10
The efficient level of emissions is where MCA = MSC.
E* 12 14
16
E1 18 20
22
24
26
Level of Emissions
17
Chapter 18

Firms can be encouraged to reduce emissions to the efficient level in three ways:
1. Emissions standards 2. Emissions fees 3. Transferable emissions permits
Chapter 18
18

Options for Reducing Emissions to E*
1. Emissions 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
2. Emissions Fee
Charge levied on each unit of emission
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19
Standards and Fees

MSC
Standard
Fee
MCA
E*
12
2005 Pearson Education, Inc. Chapter 18
Level of Emissions
20
Standards and Fees

MSC
Cost is less than the fee if emissions were not reduced.

Fee
E*
Total Fee of Abatement
Total Abatement Cost
MCA
Level of Emissions
21
12
2005 Pearson Education, Inc. Chapter 18

Standards Versus Fees
Assumptions
Policymakers
have asymmetric information Administrative costs require the same fee or standard for all firms
Chapter 18
22
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
The Case for Fees

Fee per Unit of Emissions
6 5 4 3 2
MCA1 MCA2
The cost minimizing solution would be an abatement of 6 for Firm 1 and 8 for Firm 2 and MCA1= MCA2 = $3.
1 0 1 2 3 4 5 6 7 8 9 10 11 12
13
Level of 14 Emissions
24
Chapter 18
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
The Case for Fees

Fee per Unit of Emissions
6 5 4 3.75 3 2.50 2
Firm 1s Increased Abatement Costs
MCA1 MCA2
The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA2 < MCA1.
1 0 1
Firm 2s Reduced Abatement Costs
10
11
12
13
Level of 14 Emissions
26
Chapter 18

Advantages of Fees
When equal standards must be used, fees achieve the same emission abatement at a lower cost Fees create an incentive to install equipment that would reduce emissions further
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27
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
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28

What if standard is used instead and has the same percentage mistake?
Standard set at 9 instead of 8 Increase in social costs and decrease in abatement costs Net increase in social costs is smaller than with fees
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29

Fee per Unit of 16 Emissions
C
Marginal Social Cost
Based on incomplete information, fee is $7 (12.5% decrease). Emission increases to 11. ABC is the increase in social cost less the decrease in abatement cost.
14
12 10 8 6 4 2 0 2 4
E A D
Based on incomplete information, standard is 9 (12.5% decrease). ADE < ABC
Marginal Cost of Abatement
10
12
14
16
Level of Emissions
30
Chapter 18

Summary: Fees vs. Standards
Standards are preferred when MSC is steep and MCA is flat Standards (incomplete information) yield more certainty on emissions levels and less certainty on the cost of abatement
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31

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
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32

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
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33

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
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34
The Costs and Benefits of Reduced Sulfur Dioxide Emissions

Costs of Reducing Emissions
Conversion to natural gas from coal and oil Emission control equipment
Benefits of Reducing Emissions

Health Reduction in corrosion Aesthetic
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35
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
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36
Sulfur Dioxide Emissions Reductions

Dollars per unit of reduction
60
Observations MAC = MSC @ .0275 .0275 is slightly below actual emission level Economic efficiency improved
40
20
Marginal Abatement Cost
0
0.02
0.04
Chapter 18
0.06
0.08
Sulfur dioxide concentration (ppm)
37
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
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38

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)
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39

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
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40
Price of Tradable Emissions Permits
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41

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
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42
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 scrap will be at m and m1 > m* With refundable deposit, MC increases and MC = MSC = MCR
The Efficient Amount of Recycling
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44
Refundable Deposits
Deposit is paid when bottle is purchased and then refunded when bottle returned Can choose 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 increases supply of recycled glass and lowers price of glass
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45
Refundable Deposits
$
The supply of glass is the sum of the supply of virgin glass (SV) and the supply of recycled glass (Sr).
Sr Sr
Without refunds the price of glass is P and Sr is M1.
Sv
With refunds Sr increases to Sr and S increases to S.
S S
Price falls to P and the amount of recycled glass increases to M*.
P P
D M1 M* Inc. 2005 Pearson Education,

Chapter 18
Amount of Glass
46
Externalities and Property Rights

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 would control upstream emissions
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47

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
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48
Profits Under Alternative Emissions Choices (Daily)
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49

Assumptions
Factory pays for the filter Fishermen pay for the treatment plant
Efficient Solution
Buy the filter and do not build the plant
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50
Bargaining with Alternative Property Rights
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51

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
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52
Costly Bargaining The Role of Strategic Behavior

Bargaining requires clearly defined rules and property rights
If property rights were not clear, the other party might not be willing to pay as much and the 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
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53
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
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54
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) = $300 ($500 - $200)
Filter, no damages
Profit
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55
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

The Coase Theorem at Work

Negotiating an Efficient Solution
1987 New York garbage spill (200 tons) littered New Jersey beaches
The
potential cost of litigation resulted in a solution that was mutually beneficial to both parties
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57
Common Property Resources

Characteristics
Everyone has free access Likely to be overutilized Examples
Air
and water Fish and animal populations Minerals
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58

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
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59

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
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60

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

61

Solution
Private ownership Owner will set fee for use 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 when private ownership is not possible, the government steps in
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62
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
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63
Crawfish Fishing in Louisiana

Demand
C = 0.401 = 0.0064F
MSC
C = -5.645 + 0.6509F
PC
C = -0.357 + 0.0573F
Efficient Catch
D = MSC 9.2 million pounds
Crawfish as a Common Property Resource

Cost ($/pound) 2.10
Private Cost
0.325
Demand
9.2
11.9
Crawfish Catch (millions of pounds)
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65
Public Goods
Characteristics
Nonrival
For
any given level of production, the marginal cost of providing it to an additional consumer is zero cannot be excluded from consuming the
Nonexclusive
People
good
Example use of lighthouse by a ship
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66
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
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67
Efficiency and Public 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
Efficient Public Good Provision

Benefits (dollars)
$7.00
$5.50 D2
D1 is demand for consumer 1. D2 is demand for consumer 2. D is total demand for all consumers.
MC
$4.00
D $1.50
Efficient output occurs where MC = total MB 2 units of output. MB is $1.50 + $4.00 or $5.50.
D1
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10
Output
69
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
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70
Public Goods and Market Failure

Establishing a mosquito abatement company
How do you measure output? Who do you charge? A mosquito meter?
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71
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
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72

Choosing where to live
Study in Boston correlates housing prices with the quality of air and other characteristics of the houses and their neighborhoods
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73

Dollars 3000 2500
High Income
Middle Income
2000 1500 1000 500 0 1 2 3 4 5 6 7 8 9 10
Low Income
Nitrogen Oxides (pphm)

74
Chapter 18

Findings
The amount of people who 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
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
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76

Can represent different citizens 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
Determining the Level of Educational Spending

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

78

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
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79

Majority rule is inefficient because it weighs each citizens preference equally
The efficient outcome weighs each citizens vote by his or her strength of preference
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80

Externalities and Public Goods

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Chapter 18

Externalities and Public Goods

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Negative Externalities and Inefficiency

2005 Pearson Education, Inc.

Negative Externalities and Inefficiency

2005 Pearson Education, Inc.

Negative Externalities and Inefficiency

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

By not producing at the efficient level, there is a social cost on society.

2005 Pearson Education, Inc.

Positive Externalities and Inefficiency

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

reductions require costly changes in production process

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

The Efficient Level of Emissions

The efficient level of emissions is where MCA = MSC.

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

Charge levied on each unit of emission

2005 Pearson Education, Inc.

Standards and Fees

Standards and Fees

Cost is less than the fee if emissions were not reduced.

Total Fee of Abatement

Total Abatement Cost

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

The Case for Fees

Emissions fees are preferable to standards in this case

The Case for Fees

2005 Pearson Education, Inc.

The Case for Fines

The Case for Fees

Firm 2s Reduced Abatement Costs

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

The Case for Standards

2005 Pearson Education, Inc.

The Case for Standards

2005 Pearson Education, Inc.

The Case for Standards

Based on incomplete information, standard is 9 (12.5% decrease). ADE < ABC

Marginal Cost of Abatement

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

Ways of Correcting Market Failure

2005 Pearson Education, Inc.

Ways of Correcting Market Failure