GLS1e_Chapter16

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Externalities andPublic Goods

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16

!"sert i#$ge o% te&t 'over(

Chapter Outline

16.1 Externalities

16.2 Fixing Externalities

16.3 Further Topics inExternalities and Their Remedies

16.4 Public Goods

16.5 Conclusion

16-1


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Introduction

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16Pollution is a major act o lie around the !orld

• "n the #nited $tates% there are areas &notabl' urban( struggling!ith air )ualit' issues% !ith the resulting health costs estimated ato*er +1,, billion per 'ear

• uch pollution is due to coal-.red po!er plants operating bothdomesticall' and abroad

/ther orms o 0pollution are also common

• The noise o 'our neighbors part'

• The person smo3ing a cigar next to 'ou• The mess in 'our neighbors la!n


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Introduction


16 These outcomes are e*idence o a mar3et ailure

• ar3ets are e5cient !hen all transactions that positi*el' bene.tsociet' ta3e place

• n e5cient mar3et ta3es all costs and bene.ts% both pri*ate andsocial% into account

• $imilarl'% the smo3er in the par3 is onl' concerned !ith hisenjo'ment% and not the costs imposed on other people in the par3

• n e5cient mar3et ta3es these additional costs into account

s'mmetric inormation is a source o mar3et ailure that !econsidered in the last chapter7 8ere% !e discuss t!o urthersources

• Externalities

• Public goods


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16.1


Externalities – cost or bene.t that a:ects a third part' notdirectl' in*ol*ed in an economic transaction

e!ati"e externalit# – cost imposed on a third part' not

directl' in*ol*ed in an economic transaction• Example; ir pollution rom coal-.red po!er plants

Positi"e externalit# – bene.t conerred on a third part' notdirectl' in*ol*ed in an economic transaction

• Example; bee3eepers bees not onl' produce hone'% but can help

neighboring armers b' pollinating crops

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16.1

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Econo$ic Ine%ciencies &ro$ Externalities

"n the presence o externalities% societ's bene.t or cost roman economic transaction is di:erent rom the pri*ate bene.t or

cost to those !ho are part' to the transactionFor example% a smo3ers pri*ate costs o smo3ing are &in part(;

• The cost o purchasing cigarettes

• $mell' clothing% 'ello! teeth% etc7

• Pri*ate health costs

$ocietal costs are &in part(;

• $econd-hand smo3e health e:ects

• n' smoker health costs that are borne b' societ'

• The noxious smell imposed on nonsmo3ers

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16.1



• External $ar!inal cost – The cost imposed on a third part'!hen an additional unit o a good is produced or consumed

• External $ar!inal bene't – The bene.t conerred on a thirdpart' !hen an additional unit o a good is produced or consumed

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16.1

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>hen there are no externalities% societ's costs and bene.tsalign !ith the costs and bene.ts o the pri*ate parties to a

transaction>hen there are externalities% the social costs and socialbene'ts !ill di:er rom the pri*ate costs and pri*ate bene.ts

• (ocial cost) The cost o an economic transaction to societ'% e)ualto the pri*ate cost plus the external marginal cost

• (ocial bene't) The bene.t o an economic transaction to societ'%e)ual to the pri*ate bene.t plus the external marginal bene.t

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16.1

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e!ati"e Externalities) *oo +uch o& a ,ad *hin!

@egati*e externalities occur !hen a mar3et transactionimposes an external cost on societ'

Consider the example o a coal-.red po!er plant• The po!er plant produces electricit'% !hich is good% but in the

process% pollutants are released into the air; particulate matter%nitrogen oxides &@/x(% and sulur dioxide &$/2(

• These pollutants both directl' and indirectl' impact human and

en*ironmental health% leading to !elare losses

The costs o operating the plant are borne b' the plant% but thehealth e:ects are external costs% borne b' societ'

Consider a competiti*e mar3et or electricit'

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16.1

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Figure 1671 @egati*e Externalities in a Competiti*eElectricit' ar3et

16Externalities

Price (ocial $ar!inal cost-/0+

h

SMC = MCI + EMC

eadei!ht loss&ro$ externalit#

(uppl#- S MCI

AP*

BPMKT

EMC

External $ar!inalcost- EMC

e$and- D

uantit# o& Q* QMKT electricit# +h

7 per&ectl# co$petiti"eelectricit# $ar8et producesQ

MKT

at $ar8et price PMKT

-

here S MCI D.7t this 9uantit#- the industr#i$poses external $ar!inal

cost EMC.SMC e9uals the su$ o& MCI

and EMC.*otal surplus is $axi$i:ed at

Q*; QMKT - here price P* e9uals SMC.

,ecause the $ar8et does notta8e external $ar!inal cost

into account hen settin! its9uantit# o& output- it ends up

producin! $ore electricit#QMKT than is the sociall#

opti$al 9uantit# Q*-resultin! in a deadei!ht

loss &ro$ o"erproductione9ual to the shaded trian!le.


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figure it outLeather Tanning

$uppose leather is sold in a perectl' competiti*e industr'7 The

industr' short-run suppl' cur*e &marginal cost cur*e( is P DMC D 4Q% !here Q is measured in millions o hides per 'ear7 The in*erse demand or leather hides is gi*en b' P D 6, =Q7

7nser the &olloin! 9uestions)

1 7 Fi nd t he e )u il ib ri um m ar 3e t p ri ce a nd )u an ti t' so ld 7

27 $uppose that leather tanning is a polluting acti*it' that releases chromium and other pollutants into local !ater!a's7 The external marginal cost is estimated to be +9 or each hide produced7 Calculate the sociall' optimal le*el o output and price or the leather tanning industr'7


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17 To .nd the competiti*e outcome% set the in*erse demand

and suppl' cur*es e)ual to one another

#sing the suppl' cur*e to sol*e or the e)uilibrium price 'ields

27 The social marginal cost is e)ual to the industr' marginal cost plus the external marginal cost;

To .nd the social optimum% e)uate $C !ith the in*erse demand

nd the sociall' optimal price is;

hides#illio)

)010

*)03

=

=

−=

Q

Q

QQ

1+,3 == Q P

3 -SMC MC EMC Q= + = +

)./

/)10

*)0-3

=

=

−=+

Q

Q

QQ

3 -.00 1).+ - ,20.+ P Q= + = + =


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16.1


Positi"e Externalities) ot Enou!h o& a Good *hin!

Positi*e externalities exist !hen an economic acti*it' has aspillo*er bene.t enjo'ed b' third parties

• arginal social bene.t o an economic acti*it' is higher than thepri*ate marginal bene.t &i7e7% the demand cur*e(

The classic example o a positi*e externalit' is education

• Education is associated !ith pri*ate bene.ts &as seen in Chapter1e can examine positi*e externalities !ith a .gure

16Externalities


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16.2

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Competiti*e mar3ets !ith externalities produce more or lessthan that !hich is sociall' e5cient7 There are a number omar3et inter*entions a*ailable to go*ernments and regulatorsthat can help .x externalities

• $ome !or3 through their e:ect on prices &e7g7% taxes(

• $ome target the )uantit' produced and consumed

First% determine the siBe o the externalit'% and thus theamount b' !hich production must be changed to reach the

sociall' e5cient outcome

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16.2


Exa$ple) *he E%cient =e"el o& Pollution

The goal is to determine the sociall' e%cient le"el o&pollution

• The le*el o emissions necessar' to produce the e5cient )uantit'o the good tied to the externalit'

• The resulting le*el o production occurs !here the marginal bene.to production o a good &!illingness to pa'( is e)ual to the marginalcost &pri*ate external(

• This also implies that the marginal costs o pollution &health costs%etc7( are e)ui*alent to the marginal bene.ts o pollution &increasedproduction o goods andHor ser*ices(

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16.2

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Figure 1679 The E5cient Ie*el o Pollution

16PPOLL

+ar!inal bene't o& pollution- MBP $ar!inalabate$ent cost- MAC

uantit# o& POLL*pollution

*he e%cient le"el o&pollution POLL>- PPOLL *

occurs here the$ar!inal cost o& pollution

MCP e9uals the$ar!inal bene't or

$ar!inal abate$ent costo& pollution MBP = MAC.


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16.2

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*he E%cient =e"el o& Pollution

h# does the $ar!inal cost o& pollution cur"e MCPslope upard?

• t lo! le*els o pollution% the damage associated !ith an additionalunit o pollution is relati*el' lo!

• t higher le*els o pollution% health e:ects become more se*ere%and additional units o pollution are more costl' to societ'

h# does the $ar!inal bene't o& pollution cur"e

MBP slope donard?• 8igh le*els o pollution are associated !ith high le*els o

production% and thereore lo!er mar3et prices7 s pollution isreduced% so is production% and the orgone consumer and producersurplus is an opportunit' cost

• s pollution is reduced% the cost o reducing pollution e*en urtherincreases because eas' pollution-reduction methods are exhausted

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16.2

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*he E%cient =e"el o& Pollution

+ar!inal abate$ent cost – The cost o reducing emissionsb' one unit% including technological costs and orgone

production The pre*ious .gure is *er' similar to the suppl' and demand.gures !e ha*e been using throughout this class

• JP is demand or pollutionK MCP is the marginal societal cost% orsuppl'

• This represents a h'pothetical mar3et or pollution% !ith a resultingoptimal price and )uantit' placed on pollution

• $ince this mar3et doesnt exist in the real !orld% !hat can be doneto induce pri*ate parties to produceHconsume at the sociall'e5cient le*elL

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16.2

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@sin! Prices to


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16.2


Figure 167< Pigou*ian Tax Corrects or a @egati*eExternalit'

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@sin! Prices to


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16.2


Figure 1676 Pigou*ian $ubsid' Corrects or aPositi*e Externalit'

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Returning to our example o leather tanning% suppose the

go*ernment imposes a tax o +97,, on e*er' hide o leathersold7 The industr' short-run suppl' cur*e &marginal cost cur*e(is P D MC D 4Q% !here Q is measured in millions o hides per'ear7 The in*erse demand or leather hides is gi*en b' P D 6, =Q &remember% the externalit' !as e)ual to +9 per hide(7nser the &olloin! 9uestion)

8o! man' leather hides !ould be sold% !hat price !ould bu'ers pa'% and !hat price !ould sellers recei*e &net o the tax(L


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To sol*e this problem% !e use the method rom Chapter 4%

!here the price paid b' bu'ers% PB% is e)ual to the pricerecei*ed b' sellers% PS% plus the tax% T 7 Thereore% PB D PB 9.The inverse demand and supply curves are given by

To e)uate the t!o in*erse demand cur*es% ho!e*er% re)uires us to re!rite the suppl' cur*e in terms o PB

$ol*ing or the e)uilibrium )uantit'%

nd the prices paid b' bu'ers and sellers are;

Q P

Q P

B

S

*)0

3

−=

=

)./

/)10

*)0-3

=

=

−=+

Q

Q

QQ

+.1),3

+.20,-3

==

=+=

Q P

Q P

S

B

-3- +=+= Q P P S B


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16.2


uantit# +echanis$s to


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Figure 167= The E:ects o a Muota on a ar3et !ith a@egati*e Externalit'

16- intersectin! the social

$ar!inal cost SMC at thesociall# opti$al 9uantit# Q>

and price P> point A.


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ABationali:ation in


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ABationali:ation in


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ABationali:ation in


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16.2


PriceD,ased "ersus uantit#D,ased Inter"entions ith@ncertaint#

>ith perect inormation% price and )uantit' instruments are

e)uall' e:ecti*e in controlling externalities>ithout perect inormation% there are signi.cant inormationalproblems acing regulators

• The costs o controlling externalities &marginal abatement costs(are oten di5cult to ascertain ex ante

• The bene.ts o controlling externalities &marginal pollution costs(are similarl' di5cult to estimate &in the case o pollution% *aluingchanges to human health% ecos'stems% etc7(

>hen there is uncertaint' in marginal abatement costs% priceand )uantit' mechanisms are not e)ui*alent

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16.2



The e)ui*alence bet!een price and )uantit' instruments

brea3s do!n under uncertaint' because o a simple di:erencebet!een the t!o

• Price instruments .x the price o pollution &e7g7% a pollution taximposes a .xed cost on polluters or each unit emitted(

• Muantit' instruments .x the quantity o pollution

Consider the case !hen marginal abatement costs turn out tobe larger than expected

• #nder a pollution permit s'stem% .rms are orced to abate a .xedamount o pollution

• #nder a pollution tax s'stem% .rms !ill abate less pollution &the'

!ill limit pollution until the additional cost o reducing one moreunit o pollution is e)ual to the tax% and then the' !ill simpl' pa'

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16.2



hat happens to the outco$es under taxes and

per$its hen the $ar!inal b#$#%ts o& reducin!pollution MCP are !reater than expected?

• @othing Polluting .rms operating under a pollution tax s'stem !illonl' change their pollution control e:orts in response to a changein the private costs o pollution control &marginal abatement costs(

• The bene.ts o reducing pollution are in the orm o reducedexternal costs. s these costs are not borne b' polluting .rms% thechoice o ho! much pollution to emit is not a:ected

• Jene.t uncertaint' does not alter the e)ui*alence bet!een priceand )uantit' inter*entions

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hen are priceDbased inter"entions pre&erable to

9uantit#Dbased inter"entions- and "iceD"ersa?>hen the marginal abatement cost &MAC( and marginalpollution cost &MCP( cur*es are linear% t!o actors determinethe relati*e superiorit' o on inter*ention o the other

• The slope o the MAC cur*e

• The slope o the MCP cur*e

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16.2


Figure 167? >hen Muantit' echanisms rePreerable to Price echanisms

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Figure 167A >hen Price echanisms re Preerableto Muantit' echanisms

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7 +ar8etDOriented 7pproach to Beducin! Externalities)*radable Per$its +ar8ets

#sing price or )uantit' inter*entions in*ol*es a lot o e:ort

• Firms ma' di:er dramaticall' in their abatement costs• /ten% pollution control regulations re)uire a .xed aggregate

emissions reductionK taxes ha*e di5cult' !ith this

"n response to these challenges% man' regulator' agenciesissue tradable per$its to control pollution

• go*ernment-issued permit that allo!s a .rm to emit a certainamount o pollution during production and that can be traded toother .rms

• "n theor'% the' are e:ecti*e in achie*ing allocati"e e%cienc#)marginal abatement costs e)ualiBed across .rms

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e 3no! that the totalpollution reduction must be e)ual to 4,

#sing this e)uation and the one abo*e% sol*e the .rst or eB% and then

substitute into the second

nd sol*ing or Jests emission reductions

The cost-minimiBing allocation o reduction is or cme to cut 1, tonsand Jest to cut 2,7 This ma3es senseK Jest is a more e5cient pollution

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figure it outNoise Pollution

Global Pac3age $er*ice &GP$( and ail S Parcel $er*ice &P$(

are cargo airlines using a small regional airport7 Their jets inictnoise pollution on a nearb' to!n7 t current production le*els%GP$ creates 6,, decibel-hours &dbh( o noise each da'% !hileP$ creates =


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17 " regulators re)uire each .rm to cut its noise pollution to


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47 #nder a s'stem o tradable permits% GP$ and P$ !ill split

the reduction in noise pollution in the most e5cient !a'7 Thisoccurs !hen their marginal abatement costs are e)ualiBed

Remembering that % !e can sol*e or the e5cient allocation o emission reductions

The price o a permit is e)ual to each .rms MAC7 #sing GP$;

MAC =MACM → 20+ -! = -0+)!M

! +!M = 3/0

! +!M = 30→ ! = 30−!M

20+ -! = -0+)!M

20+ - 30−!M( ) = -0+)!M

10!M =

1,3+0→

!M =

13+!b#! = 30−!M = 30−13+= 212!b#

Pri'e =MAC = 20+ -! = 20+ - 212( ) = +)+

fi it t


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97 The total cost o abatement is e)ual to the sum o the

abatement costs o the t!o .rms

This is signi.cantl' less than the +21A%


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16.3


*he *ra!ed# o& the Co$$ons – a common resource is usedmore intensi*el' than it !ould be i it !ere pri*atel' o!ned

• nother per*asi*e orm o a negati*e externalit'

• co$$on resource is an economic good that all indi*iduals canaccess reel' and !hose *alue to the indi*idual consumerdecreases as others use it

• an' la3e% ri*er% coastal% and ocean .sheries% public orests%reser*oirs% a)uiers% and other sources o !ater% the atmosphere

• Public air!a's% public bathrooms

• Oe' characteristic; nonexcludabilit# – consumers cannot bepre*ented rom consuming the good once it is a*ailable

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*he *ra!ed# o& the Co$$ons

@onexcludabilit' means that users ha*e little pri*ate incenti*eto protect the resource or others% since the' do not realiBe the

ull cost o o*eruseConsider the case o a la3e .sher' o!ned b' a single person

• $ubject to a e! assumptions about the price o .sh% the cost o.shing% and the biological gro!th o .sh% the o!ner !ill treat the.sher' li3e an asset

• 8e !ill recogniBe that remo*ing a .sh to sell toda' comes !iththree costs; the cost o catching the .sh% the opportunit' cost onot being able to catch the .sh in the uture% and an' lostreproduction or natural gro!th that !ould ha*e occurred

• $ince the resource is treated li3e an asset% it !ill earn a 0resourcerent% just as labor and capital each earn a rent &!age and interest%

respecti*el'(

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27 " Jarne' has the right to odor-ree air% !hat !ill the sociall' optimal outcome beL 8o! !ill it be reachedL >ill an' mone' change handsL


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*he Opti$al =e"el o& Public Goods

There are t!o reasons !h' mar3ets !ill underpro*ide publicgoods

The .rst is illustrated b' the .gure on the pre*ious slide• " indi*iduals are able to purchase the goods themsel*es% the' !ill

purchase onl' up until the point at !hich pri*ate marginal bene.te)uals marginal cost

• The e5cient le*el occurs !hen the total marginal bene.ts e)ualmarginal cost

second problem results rom the nonexcludabilit' o publicgoods

• This is called the &reeDrider proble$; source o ine5cienc'resulting rom indi*iduals consuming a public good or ser*ice

!ithout pa'ing or it• >h ta3e on an ri*ate costs !hen ou can sim l bene.t rom

16Public Goods

figure it outP bli G d


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figure it outPublic Goods

ale and Case' are neighbors in a rural area7 The' are

considering the joint installation o a large ountain near their jointpropert' line so that each can enjo' its beaut' and also impro*ethe *alue o his propert'7 ales marginal bene.t rom theountain is MB' D =, Q% !here Q measures the diameter o the

ountain &in eet(7 Case's marginal bene.t rom the ountain canbe represented as MBC D 9, 2Q7 ssume that the marginal cost

o producing the ountain is constant and e)ual to +?, per oot &indiameter(77nser the &olloin! 9uestions)

17 Find an e)uation to represent the total marginal bene.t o the ountain7

2 7 >hat i s t he social l' optima l s iBe o t he ounta inL

47 >ould 'ou expect ale and Case' to build the optimall' siBed ountainL Explain7

figure it outP bli G d


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figure it outPublic Goods

17 The total marginal bene.t is the *ertical summation o ales andCase's indi*idual marginal bene.t cur*es;

27 The sociall' optimal siBe o the ountain occurs !here MB T e)uals the

marginal cost o producing the ountain;

The sociall' optimal diameter or the ountain is 1, eet7

47 ale !ill not be !illing to build a ountain that is 1, eet in diameterbecause his pri*ate marginal bene.t is less than the marginal cost

Case' also !ill be un!illing to build a 1,-oot ountain because his pri*atemarginal bene.t rom a 1,-oot ountain is lo!er than the marginal cost;

Thereore% the optimall' siBed ountain !ill not be built7

MBT =MB' +MBC = *0−Q+ -0−2Q=110−3Q

MBT =MC→110−3Q= +0

30 = 3Q→Q=10

MB' = *0−Q= *0−10 = )0


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*he A7l Gore Eect) Koluntar# Pro"ision o&Public Goods

The global climate regulator' s'stem is a public good

• @onexcludable

• @onri*al

8o!e*er% b' contributing to the greenhouse e:ect% ourcarbon-based global econom' is degrading the abilit' oour atmosphere to regulate global temperatures

>ithout a global climate agreement in place% some

ad*ocates ha*e called or more e:ecti*e outreach to thepublic

• "nduce people to ma3e more climate-riendl'consumption decisions

• Encourage the purchase o 0carbon o:sets to reduceindi*idual carbon ootprints

16

Citation; acobsen% G77 2,117 The l Gore E:ect; n "ncon*enient Truth and Qoluntar' Carbon /:sets7 $ournal o% Environmental Economics an!Mana&ement ()*)+; 6==?7


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*he A7l Gore Eect) Koluntar# Pro"ision o&Public Goods

acobsen &2,11( in*estigated !hether the release o lGores .lm An ,nconvenient Trut# in 2,,6 corresponded

!ith an increase in the purchase o carbon o:sets• Examined households in Bip codes !ithin a 1,-mile

radius o theaters

The main .nding; households near theaters that screened An ,nconvenient Trut# !ere more li3el' to purchase o:sets

• "n the t!o months ollo!ing the .lms release%

households !ithin the radius experienced a


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16.5

"n this chapter% !e del*ed into the issues that de*elop !henmar3ets are missing or other!ise incomplete

• Externalities occur !hen costs andHor bene.ts are not completel'captured b' those ma3ing production and consumption decisions

• @onexcludable% common-pool goods su:er rom o*eruse andHorunderin*estment

• Public goods are underpro*ided b' pri*ate agents due to ree ridingand the misalignment o pri*ate and total marginal bene.ts

"n the .nal chapter% !e examine situations in !hich economic

actors &consumers and producers( ma' not appear to be therational% utilit'- and pro.t-maximiBing agents !e ha*e modeledthroughout this text

16Conclusion

GLS1e_Chapter16

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