Principles of Microeconomics, Prof. Maclachlan, Spring 2006 1 Externalities, Public Goods and Common Resources Chapters 10, 11.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Externalities, Public Goods and Common Resources

Chapters 10, 11

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Externality

The uncompensated impact of one person’s actions on the well-being of a bystander.

Examples: automobile exhaust, historic buildings, barking dogs, R&D.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Social Optimum

Point at which the marginal benefit equals marginal cost.

Figure 1 The Market for Aluminum

Copyright © 2004 South-Western

Quantity ofAluminum

0

Price ofAluminum

Equilibrium

Demand(private value)

Supply(private cost)

QMARKET

Figure 2 Pollution and the Social Optimum

Copyright © 2004 South-Western

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand(private value)

Supply(private cost)

Socialcost

QOPTIMUM

Optimum

Cost ofpollution

QMARKET

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Positive Externalities

Beneficial third party effects.

Figure 3 Education and the Social Optimum

Copyright © 2004 South-Western

Quantity ofEducation

0

Price ofEducation

Demand(private value)

Socialvalue

Supply(private cost)

QMARKET QOPTIMUM

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Internalizing the Externality

Altering incentives so that people take account of the external effects of their actions.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Private Solutions

• Moral codes.

• Private charities.

• Contracts (Coase theorem)

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Coase Theorem

In the absence of transactions costs, private economic actors can solve the problem of externalities among themselves.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Public Policies to Deal with Externalities

• Regulation specifying maximum allowable level of a negative externality.

• Taxes (for negative externalities) & subsidies (for positive externalities).

• Permits (licenses).

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Pigovian Taxes

• Arthur Pigou (1877-1959), Professor of Economics, Cambridge University

• Tax the good that creates the negative externality.

• Reduces Q to optimal level.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Figure 1 The Effects of a Tax

Copyright © 2004 South-Western

Size of tax

Quantity0

Price

Price buyerspay

Price sellersreceive

Demand

Supply

Pricewithout tax

Quantitywithout tax

Quantitywith tax

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Tradable Pollution Permits

Environmental agency decides the appropriate level of pollutants and issues (or auctions off) permits for exactly that level.

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits

Copyright © 2004 South-Western

Quantity ofPollution

0

Price ofPollution

Demand forpollution rights

P Pigoviantax

(a) Pigovian Tax

2. . . . which, togetherwith the demand curve,determines the quantityof pollution.

1. A Pigoviantax sets theprice ofpollution . . .

Q

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits

Copyright © 2004 South-Western

Quantity ofPollution

0

Demand forpollution rights

Q

Supply ofpollution permits

(b) Pollution Permits

Price ofPollution

2. . . . which, togetherwith the demand curve,determines the priceof pollution.

1. Pollutionpermits setthe quantityof pollution . . .

P

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Summary

• When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality.

• Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity.

• Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Summary

• When private parties cannot adequately deal with externalities, then the government steps in.

• The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Firm Pollution

Level

Unit cost to reduce

A 70 units $20

B 80 $25

C 50 $10

The government gives each firm 40 tradable pollution permits to reduce aggregate pollution level to 120 units.1. What is the total cost of reducing pollution?2. What would be the cost if the permits were not tradable?

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Public Goods & Common Resources

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Definitions

Excludability: the property of a good whereby a person can be prevented from using it.

Rivalry: the property of a good whereby one person’s use diminishes other people’s use.

Figure 1 Four Types of Goods

Copyright © 2004 South-Western

Rival?

Yes

Yes

• Ice-cream cones• Clothing• Congested toll roads

• Fire protection• Cable TV• Uncongested toll roads

No

Private Goods Natural Monopolies

No

Excludable?

• Fish in the ocean• The environment• Congested nontoll roads

• Tornado siren• National defense• Uncongested nontoll roads

Common Resources Public Goods

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Free Rider Problem

Receiving the benefit of a good without paying for it.

e.g. viewer of public television

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Tragedy of the Commons

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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Question.

Why is the commercial value of ivory a threat to the elephant, while the commercial value of beef is a guardian of the cow?

Principles of Microeconomics, Prof. Maclachlan, Spring 2006

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BEIJING, March 4 (Reuters) - China is to change its constitution to protect private property in a revolutionary manoeuvre that waters down its core Communist ideology to raise the status of entrepreneurs once deemed the running dogs of capitalism.

Five decades after seizing power, nationalising private property and waging bloody campaigns against landlords, China's parliament is set to amend the state constitution to add the words, "private property obtained legally is inviolable".

One aim of the amendments, to be ratified during the annual session of the National People's Congress that opens on Friday, is to give further impetus to the burgeoning private sector that is fuelling China's breakneck economic growth.