chapter 181 externalities and public goods. chapter 182 topics to be discussed externalities ways of...

Chapter 18 1

Chapter 18

Externalities and Public Goods

Chapter 18 2

Topics to be Discussed

ExternalitiesWays of Correcting Market FailureExternalities and Property RightsCommon Property ResourcesPublic GoodsPrivate Preferences for Public Goods

Chapter 18 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

Externalities

Negative Action by one party imposes a cost on

another partyPlant dumps waste in a river affecting those

downstreamThe 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 7


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


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

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*.

Chapter 18 10

External Costs

Aggregate social cost of

negativeexternality

By no 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*

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 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

MCP1

External Benefits

Repair Level

Value

D

q1

MSB

MEB

When there are positiveexternalities (the benefitsof repairs to neighbors),marginal social benefits

MSB are higher thanmarginal benefits D.

q*

P* A self-interested home ownerinvests q1 in repairs. Theefficient level of repairs

q* is higher. The higher priceP1 discourages repair.

Chapter 18 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 beforeUpward sloping because of substantially

increasing harm as pollution increases

Chapter 18 15


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 themLarge reductions require costly changes in

production process

Chapter 18 16


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

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 benefit.

E1

Chapter 18 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 19


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 20

Standards and Fees

Level of Emissions

Dollars/ unitof Emissions MSC

MCA

3

12

E*

Standard

Fee

Chapter 18 21

TotalAbatement Cost

Cost is less than thefee if emissions were

not reduced.

Standards and Fees

Level of Emissions

Dollars/ unitof Emissions

3

Total Feeof Abatement

12

Fee

MSC

MCA

E*

Chapter 18 22


Standards Versus Fees Assumptions

Policymakers have asymmetric informationAdministrative costs require the same fee or

standard for all firms

Chapter 18 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

If a fee of $3 was imposedFirm 1 emissions would fallby 6 to 8. Firm 2 emissions

would fall by 8 to 6.MCA1 = MCA2: efficient

solution.

MCA1

MCA2

The Case for Fees

2

4

6

Fee perUnit of

Emissions

1

3

5

Level of Emissions0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

The cost minimizing solutionwould be an abatement of 6for firm 1 and 8 for firm 2 andMCA1= MCA2 = $3.

Chapter 18 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 Case for Fees

2

4

6

Fee perUnit of

Emissions

1

3

5

Level of Emissions0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

MCA1

MCA2

The impact of a standard ofabatement of 7 for both firms

is illustrated.Not efficient because

MCA2 < MCA1.

3.75

2.50

Firm 2’s ReducedAbatement

Costs

Firm 1’s IncreasedAbatement Costs

Chapter 18 27


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 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


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

ABC is the increasein social cost less thedecrease in abatement

cost.


Level of Emissions0 2 4 6 8 10 12 14 16

Fee perUnit of

Emissions

2

4

6

8

10

12

14

16

Based on incompleteinformation standard is 9

(12.5% decrease).ADE < ABC

Based on incompleteinformation fee is $7

(12.5% decrease).Emission increases to 11.

MarginalSocialCost

Marginal Costof Abatement

B

C

E

DA

Chapter 18 31


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 32


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 33


Transferable Emissions Permits Permits help develop a competitive market

for externalities.Agency determines the level of emissions and

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

cost firms

Chapter 18 34


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 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 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 37

Sulfur Dioxide Emissions Reductions

Sulfur dioxide concentration (ppm)

20

40

60

0

Dollarsper

unit ofreduction

0.02 0.04 0.06 0.08

Marginal Social Cost

Marginal Abatement Cost

Observations•MAC = MSC @ .0275•.0275 is slightly below actual emission level•Economic efficiency improved

Chapter 18 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 39


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 40


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 41

Price of Tradable Emissions Permits

Chapter 18 42


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 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 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 disposalSupply 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

Amount of Glass

$

D

Price falls to P’ and the amount of recycled glass increases to M*.

Sv

Sr

S

The supply of glass is the sum of the supply

of virgin glass (Sr) and the supply of recycled

glass (Sr).

M1

P

Without refunds the price of glass is P and

Sr is M1.S’r

S’

P’

M*

With refunds Sr increasesto S’r and S increases to S’.

Chapter 18 47

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 control upstream emissions.

Chapter 18 48


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 49

Profits Under AlternativeEmissions Choices (Daily)

Chapter 18 50


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 51

Bargaining with Alternative Property Rights

Chapter 18 52


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 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 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 waterFactory has two options

No filter, pay damagesProfit = $100 ($500 - $400)

Filter, no damagesProfit = $300 ($500 - $200)

Chapter 18 56

A Legal Solution – Suing for Damages – Example

Factory has the right to emit effluentFishermen have three options

Put in treatment plantProfit = $200

Filter and pay damagesProfit = $300 ($500 - $200)

No plant, no filterProfit = $100

A suit for damages results in an efficient outcome.

Chapter 18 57

The Coase Theorem at Work

Negotiating an Efficient Solution 1987 – New York garbage spill (200 tons)

littered the New Jersey beachesThe potential cost of litigation resulted in a

solution that was mutually beneficial to both parties.

Chapter 18 58

Common Property Resources

Characteristics Everyone has free access. Likely to be overutilized Examples

Air and waterFish and animal populationsMinerals

Chapter 18 59


Consider a lake where people fishEach 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


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

61


Fish per Month

Benefits,Costs($ per

fish)

Demand (MB)

However, private costsunderestimate true cost.

The efficient level of fish/month is F* where

MSC = MB (D)


F*

Private Cost

FC

Without control the numberof fish/month is FC where

PC = MB.

Chapter 18 62


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 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 = 0.401 = 0.0064F

MSC C = -5.645 + 0.6509F

PC C = -0.357 + 0.0573F

Efficient Catch D = MSC 9.2 million pounds

Chapter 18 65

Crawfish Catch(millions of pounds)

Cost($/pound)

Demand


Private Cost

Crawfish as a CommonProperty Resource

11.9

2.10

9.2

0.325

Chapter 18 66

Public Goods

Characteristics Nonrival

For any given level of production the marginal cost of providing it to an additional consumer is zero.

NonexclusivePeople cannot be excluded from consuming the

good. Example – use of lighthouse by a ship

Chapter 18 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 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

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.

Chapter 18 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 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 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 73


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 74


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

Chapter 18 75


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 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 77


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 Levelof Educational Spending

Educational spendingper pupil$0

Willingnessto pay

$

$1200$600 $1800 $2400

AW

The efficient level of educational spending is determined by summing thewillingness to pay for education for each

of three citizens.

Will majority rule yield an efficient outcome?•W1 will vote for $600•W2 and W3 will vote for $1200The median vote will always win in a majorityrule election.

W2W3W1

Chapter 18 79


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 80


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 181 externalities and public goods. chapter 182 topics to be discussed externalities ways of...

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