Transcript Chapter 18

Chapter 18
Externalities and Public Goods
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
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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
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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
 Immunizations another example
 Education….
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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
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Negative Externalities and
Inefficiency
 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
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External Costs
MSC
Price
Price
There
MEC
of production
from
Firm
will
produce
q1 at P1.
Theis
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
MECI
MEC
D
q*
q1
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Firm output
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Q* Q1
Industry output
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External Costs
MSC
Price
Price
MSCI
MC
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
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Firm output
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Q*
Q1
Industry output
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External Cost
 Negative externalities encourage
inefficient firms to remain in the industry
and create excessive production in the
long run
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Positive Externalities and
Inefficiency
 Externalities can also result in too little
production, as can be shown in an
example of immunizations
 Immunizations generate external benefits
to the neighbors, community, etc.
Shown by the Marginal External Benefit
curve (MEB)
Marginal Social Benefit (MSB) curve adds
MEB +D
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External Benefits
Value
MSB
When there are positive
externalities (the benefits
of immunizations to others),
marginal social benefits
(MSB) are higher than
marginal private benefits (D).
D
P1
MC
P*
A self-interested individual
invests q1 in immunizations. The
efficient level of immunizations
q* is higher. The higher price
P1 discourages them.
MEB
q1
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Immunizations
q*
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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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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 cost of abateme
The efficient level of
emissions is where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
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E*
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E1
18 20
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Level of Emissions
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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, there is little cost to controlling them
 Large
reductions require costly changes in
production process
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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
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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 cost of abateme
The efficient level of
emissions is where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
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E*
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E1
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Level of Emissions
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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
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Ways of Correcting Market
Failure
 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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Standards and Fees
Dollars/ Unit
of Emissions
MSC
Standard
Fee
3
MCA
E*
12
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Level of Emissions
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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
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MCA
Level of Emissions
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Ways of Correcting Market
Failure
 Fees vs. Standards
Standards yield more certainty on emissions
levels and less certainty on the cost of
abatement
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Ways of Correcting Market
Failure
 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
 What if we don’t know costs and benefits
AND if firms costs vary?
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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
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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 (as well as its use of the market)
 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
 Don’t need to know firm’s individual costs --those with high costs will buy permits from lower
cost firms
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In Sum
 The total cost of abatement for the
industry is reduced
 Not every firm is subject to a standard
 The entire industry is subject to a
standard
 Results in minimizing abatement costs
from the point of view of the industry as a
whole
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Public Goods
 Characteristics
 Nonrival: fireworks display
 For any given level of production, the marginal cost
of providing it to an additional consumer is zero
 One person’s consumption of the good does not
preclude another
 Nonexclusive
 People cannot be excluded from consuming the
good – makes it difficult or impossible to charge for
their use
 Example – lighthouse, national defense
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Public Goods
 Non-rival but exclusive
TV signal
Bridge
Concert
 Nonexclusive but rival
Ocean in some respects like fishing
National Forests & logging
 Don’t confuse positive externalities with
public goods (education?)
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Efficiency and Public Goods
 Efficient level of private good is where marginal benefit
equals marginal cost: S = D
 Same principle applies to pubic goods – just measured
differently
 For a public good, the value of each person must be
considered
 Can add demand of all those who value good
 Calculated differently than for private goods
 Must equate the sum of these marginal benefits to the
marginal cost of production
 Previously added quantities at each price: NOW – add
prices at each quantity
 Vertical addition as opposed to horizontal addition
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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
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Output
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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
 Public goods thus provided by
governments if to be produced efficiently
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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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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
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The Demand for Clean Air
Dollars
High Income
3000
2500
Middle Income
2000
Low Income
1500
1000
500
0
1
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Nitrogen Oxides
(pphm)
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The Demand for Clean Air
 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
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