Transcript Chapter 18

Chapter 18
Externalities and Public Goods
Chapter 18
1
Externalities
 Externalities are the effects of production
and consumption activities not directly
reflected in the market
 They can be negative or positive
Chapter 18
2
Negative Externalities
 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
3
Positive Externalities
 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
4
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.
Chapter 18
5
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
6
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
7
External Costs
MSC
Price
Price
Theis
profit
maximizing
firmfrom
There
MEC
of production
Firm
will
produce
q1 at P1.
at q1 while
theproduces
waste released.
The the
MSC is
efficient
output
level
is
q*.
true cost of production.
MC
MSCI
S = MCI
P*
P1
P1
MECI
MEC
D
q*
q1
Firm output
Chapter 18
Q* Q1
Industry output
8
External Costs
MSC
Price
Price
MSCI
MC
By no 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
9
External Cost
 Negative Externalities encourage
inefficient firms to remain in the industry
and create excessive production in the
long run.
Chapter 18
10
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
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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
P*
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MEB
q1
Repair Level
q*
Chapter 18
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Ways of Correcting Market
Failure
 Assumption: The market failure due to
pollution
Firm has chosen its profit-maximizing output
level
MSC is marginal social cost of emissions
Chapter 18
13
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
Chapter 18
14
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
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The Efficient Level of Emissions
Dollars/ unit
of Emissions
MSC
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.
The efficient level of
emissions is where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
E*
12 14
16
Chapter 18
E1
18 20
22
24
26
Level of Emissions
16
Ways of Correcting Market
Failure
 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
17
Ways of Correcting Market
Failure
 Options for Reducing Emissions to E*
1. 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
2. Emissions Fee

Charge levied on each unit of emission
Chapter 18
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Standards and Fees
Dollars/ unit
of Emissions
MSC
Standard
Fee
3
MCA
E*
12
Chapter 18
Level of Emissions
19
Standards and Fees
Dollars/ unit
of Emissions
MSC
Cost is less than the
fee if emissions were
not reduced.
Fee
E*
3
Total Fee
of Abatement
Total
Abatement Cost
12
Chapter 18
MCA
Level of Emissions
20
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
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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
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The Case for Fees
Fee per
Unit of
Emissions
MCA1
MCA2
a feeminimizing
of $3 was imposed
TheIfcost
Firm 1 emissions would fall
solution
by 6 be
to 8.
2 emissions
would
anFirm
abatement
of 6
would fall by 8 to 6.
for firm 1 and 8 for firm 2
MCA1 = MCA2: efficient
and
solution.
MCA1= MCA2 = $3.
6
5
4
3
2
1
0
1
2
3
4
5
6
7
8
Chapter 18
9
10
11
12
13
Level of
14 Emissions
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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
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The Case for Fees
Fee per
Unit of
Emissions
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
MCA1
MCA2
6
5
4
3.75
Firm 1’s Increased
Abatement Costs
3
2.50
2
Firm 2’s Reduced
Abatement
Costs
1
0
1
2
3
4
5
6
7
8
Chapter 18
9
10
11
12
13
Level of
14 Emissions
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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
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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
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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
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The Case for Standards
C
Fee per
Unit of 16
Emissions
Based on incomplete
information fee is $7
(12.5% decrease).
Emission increases to 11.
Marginal
Social
Cost
14
12
ABC is the increase
in social cost less the
decrease in abatement
cost.
E
10
A
D
8
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
B
6
4
Marginal Cost
of Abatement
2
0
2
4
6
8
10
12
Chapter 18
14
16
Level of Emissions
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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
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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
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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
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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
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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
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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
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The Efficient Amount of
Recycling
Chapter 18
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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
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Refundable Deposits
$
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’.
S
S’
Price falls to P’ and
the amount of
recycled glass
increases to M*.
P
P’
D
M1 M*
Chapter 18
Amount of Glass
38
Common Property Resources
 Characteristics
Everyone has free access.
Likely to be overutilized
Examples
 Air
and water
 Fish and animal populations
 Minerals
Chapter 18
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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
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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
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Common Property Resources
Benefits,
Costs
($ per
fish)
Without control the number
of fish/month is FC where
PC = MB.
Marginal Social Cost
Private Cost
However, private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Demand (MB)
F*
FC
Fish per Month
42
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
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Public Goods
 Characteristics
Nonrival
 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
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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
45
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
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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
$7.00
MC
$5.50
D2
$4.00
Efficient output occurs
where MC = total MB
2 units of output.
MB is $1.50 + $4.00 or $5.50.
D
$1.50
D1
0
1
2
3
4
5
6
7
Chapter 18
8
9
10
Output
47
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
48