chapter 18 externalities and public goods. ©2005 pearson education, inc.chapter 182 externalities...

Chapter 18

Externalities and Public Goods

©2005 Pearson Education, Inc. Chapter 18 2

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


Externalities

Negative Action by one party imposes a cost on

another partyPlant dumps waste in a river, affecting those

downstreamThe firm has no incentive to account for the

external costs that it imposes on those downstream


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 exampleEducation….


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


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


External Costs

MC

S = MCI

P1

q1

P1

Q1

MSC

MSCI

Firm output

Price

Industry output

Price

MEC

MECI

q*

P*

Q*

D

Firm will produce q1 at P1. There is MEC of production from the waste released. The MSC is

true cost of production.

The profit maximizing firmproduces at q1 while the

efficient output level is q*.


External Costs

Aggregate social cost of

negativeexternality

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

society. MC

S = MCI

D

P1 P1

q1 Q1

MSC

MSCI

Firm output

Price

Industry output

Price

MEC

MECI

q*

P*

Q*


External Cost

Negative externalities encourage inefficient firms to remain in the industry and create excessive production in the long run


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


MCP1

External Benefits

Immunizations

Value

D

q1

MSB

MEB

When there are positiveexternalities (the benefits

of immunizations to others),marginal social benefits(MSB) are higher than

marginal private benefits (D).

q*

P* A self-interested individualinvests q1 in immunizations. Theefficient level of immunizationsq* is higher. The higher price

P1 discourages them.


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 beforeUpward sloping because of substantially

increasing harm as pollution increases


The Efficient Level of Emissions

2

4

6

Dollars/ Unitof Emissions

Level of Emissions0 2 4 6 8 10 12 14 16 18 20 22 24 26

MSC

MCA

E*

The efficient level ofemissions is where

MCA = MSC.

At Eo the marginalcost of abating emissions

is greater than themarginal social cost.

E0

At E1 the marginalsocial cost is greater

than the marginal cost of abatement.

E1



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 themLarge reductions require costly changes in

production process



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


The Efficient Level of Emissions

2

4

6


Level of Emissions0 2 4 6 8 10 12 14 16 18 20 22 24 26

MSC

MCA

E*

The efficient level ofemissions is where

MCA = MSC.

At Eo the marginalcost of abating emissions

is greater than themarginal social cost.

E0

At E1 the marginalsocial cost is greater

than the marginal cost of abatement.

E1



Firms can be encouraged to reduce emissions to the efficient level in three ways:

1. Emissions standards

2. Emissions fees

3. Transferable emissions permits



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


Standards and Fees

Level of Emissions

Dollars/ Unitof Emissions MSC

MCA

3

12

E*

Standard

Fee


TotalAbatement Cost

Cost is less than thefee if emissions were

not reduced.

Standards and Fees

Level of Emissions


3

Total Feeof Abatement

12

Fee

MSC

MCA

E*



Fees vs. Standards Standards yield more certainty on emissions

levels and less certainty on the cost of abatement



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?



Transferable Emissions Permits Permits help develop a competitive market

for externalitiesAgency determines the level of emissions and

number of permitsPermits are marketableHigh cost firm will purchase permits from low

cost firms



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


In Sum

The total cost of abatement for the industry is reduced

Not every firm is subject to a standardThe entire industry is subject to a

standardResults in minimizing abatement costs

from the point of view of the industry as a whole


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

NonexclusivePeople cannot be excluded from consuming the

good – makes it difficult or impossible to charge for their use

Example – lighthouse, national defense


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?)


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


D1

D2

D

D1 is demand for consumer 1.

D2 is demand for consumer 2.

D is total demand for all consumers.

Efficient Public Good Provision

Output0

Benefits(dollars)

1 2 3 4 5 6 7 8 109

$4.00

$5.50

$7.00

MC

$1.50

Efficient output occurswhere MC = total MB

2 units of output. MB is $1.50 + $4.00 or $5.50.


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


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



Choosing where to live Study in Boston correlates housing prices

with the quality of air and other characteristics of the houses and their neighborhoods



Nitrogen Oxides (pphm)0

Dollars

1 2 3 4 5 6 7 8 109

2000

2500

3000

500

1500

1000

Low Income

Middle Income

High Income



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

chapter 18 externalities and public goods. ©2005 pearson education, inc.chapter 182 externalities...

Documents