Externalities and Public Goods

1
Chapter 18

• Externalities and Public Goods

2
Topics to be Discussed

• Externalities
• Ways of Correcting Market Failure
• Externalities and Property Rights
• Common Property Resources
• Public Goods
• Private Preferences for Public Goods

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

4
Externalities

• Negative
• Action by one party imposes a cost on another
  party
• Plant dumps waste in a river affecting those
  downstream
• The firm has not incentive to account for the
  external costs that it imposes on those downstream

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

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

7
Negative Externalities and Inefficiency

• 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

8
Negative Externalities and Inefficiency

• 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

9
External Costs
The profit maximizing firm produces at q1 while
the efficient output level is q.
Firm will produce q1 at P1.
There is MEC of production from the waste
released. The MSC is true cost of production.
Price
Price
Industry output
Firm output
10
External Costs
By no producing at the efficient level, there is
a social cost on society
11
External Cost

• Negative Externalities encourage inefficient
  firms to remain in the industry and create
  excessive production in the long run.

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

13
External Benefits
Value
When there are positive externalities (the
benefits of repairs to neighbors), marginal
social benefits MSB are higher than marginal
benefits D.
A self-interested home owner invests q1 in
repairs. The efficient level of repairs q is
higher. The higher price P1 discourages repair.
Repair Level
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 before
• Upward sloping because of substantially
  increasing harm as pollution increases

15
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,
  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
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 benefit.
The efficient level of emissions is where MCA
MSC.
2
18
Ways of Correcting Market Failure

• Firms can be encouraged to reduce emissions to
  the efficient level in three ways
• Emissions standards
• Emissions fees
• Transferable emissions permits

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Ways of Correcting Market Failure

• Options for Reducing Emissions to E
• 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
• Emissions Fee
• Charge levied on each unit of emission

20
Standards and Fees
Dollars/ unit of Emissions
Level of Emissions
21
Standards and Fees
Dollars/ unit of Emissions
Cost is less than the fee if emissions were not
reduced.
3
12
Level of Emissions
22
Ways of Correcting Market Failure

• Standards Versus Fees
• Assumptions
• Policymakers have asymmetric information
• Administrative costs require the same fee or
  standard for all firms

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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

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The Case for Fees
The cost minimizing solution would be an
abatement of 6 for firm 1 and 8 for firm 2
and MCA1 MCA2 3.
If a fee of 3 was imposed Firm 1 emissions would
fall by 6 to 8. Firm 2 emissions would fall by 8
to 6. MCA1 MCA2 efficient solution.
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

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The Case for Fees
The impact of a standard of abatement of 7 for
both firms is illustrated. Not efficient
because MCA2 lt MCA1.
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Ways of Correcting Market Failure

• 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.

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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

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The Case for Standards

• 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

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The Case for Standards
Based on incomplete information fee is 7 (12.5
decrease). Emission increases to 11.
ABC is the increase in social cost less
the decrease in abatement cost.
Based on incomplete information standard is
9 (12.5 decrease). ADE lt ABC
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Ways of Correcting Market Failure

• 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.

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Ways of Correcting Market Failure

• 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.

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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.
• 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.

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

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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

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Sulfur Dioxide Emissions Reductions
60
Dollars per unit of reduction

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

40
20
Sulfur dioxide concentration (ppm)
0
0.02
0.04
0.06
0.08
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

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Emissions Trading and Clean Air

• 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)

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Emissions Trading and Clean Air

• 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

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Price of Tradable Emissions Permits
42
Ways of Correcting Market Failure

• 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.

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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 gt m
• With refundable deposit, MC increases and MC
  MSC MCR

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The Efficient Amount of Recycling
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 disposal
• Supply of glass comes from new glass and recycled
  glass
• Increasing deposit increase supply of recycled
  glass and lowers price of glass

46
Refundable Deposits
Sr
The supply of glass is the sum of the supply of
virgin glass (Sr) and the supply of
recycled glass (Sr).
Without refunds the price of glass is P and Sr
is M1.

Sr
Sv
With refunds Sr increases to Sr and S increases
to S.
Price falls to P and the amount of recycled
glass increases to M.
S
S
P
P
Amount of Glass
M1
M
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.

48
Externalities and Property Rights

• 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.

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Profits Under AlternativeEmissions Choices
(Daily)
50
Externalities and Property Rights

• Assumptions
• Factory pays for the filter
• Fishermen pay for the treatment plant
• Efficient Solution
• Buy the filter and do not build the plant

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Bargaining with Alternative Property Rights
52
Externalities and Property Rights

• 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.

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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

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

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A Legal Solution Suing for Damages Example

• Fishermen have the right to clean water
• Factory has two options
• No filter, pay damages
• Profit 100 (500 - 400)
• Filter, no damages
• Profit 300 (500 - 200)

56
A Legal Solution Suing for Damages Example

• Factory has the right to emit effluent
• Fishermen have three options
• Put in treatment plant
• Profit 200
• Filter and pay damages
• Profit 300 (500 - 200)
• No plant, no filter
• Profit 100
• A suit for damages results in an efficient
  outcome.

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The Coase Theorem at Work

• Negotiating an Efficient Solution
• 1987 New York garbage spill (200 tons) littered
  the New Jersey beaches
• The potential cost of litigation resulted in a
  solution that was mutually beneficial to both
  parties.

58
Common Property Resources

• Characteristics
• Everyone has free access.
• Likely to be overutilized
• Examples
• Air and water
• Fish and animal populations
• Minerals

59
Common Property Resources

• Consider a lake where people fish
• Each 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

60
Common Property Resources

• 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

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Common Property Resources
Without control the number of fish/month is FC
where PC MB.
Benefits, Costs ( per fish)
However, private costs underestimate true
cost. The efficient level of fish/month is F
where MSC MB (D)
Fish per Month
62
Common Property Resources

• 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

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

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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

65
Crawfish as a CommonProperty Resource
Cost (/pound)
Crawfish Catch (millions of pounds)
66
Public Goods

• Characteristics
• Nonrival
• For any given level of production the marginal
  cost of providing it to an additional consumer is
  zero.
• Nonexclusive
• People cannot be excluded from consuming the
  good.
• Example use of lighthouse by a ship

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

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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

69
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
5.50
4.00
Efficient output occurs where MC total MB 2
units of output. MB is 1.50 4.00 or 5.50.
1.50
Output
0
1
2
3
4
5
6
7
8
10
9
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.

71
Public Goods and Market Failure

• Establishing a mosquito abatement company
• How do you measure output?
• Who do you charge?
• A mosquito meter?

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

73
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.

74
The Demand for Clean Air
Dollars
3000
2500
2000
1500
1000
500
Nitrogen Oxides (pphm)
0
1
2
3
4
5
6
7
8
10
9
75
The Demand for Clean Air

• 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.

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.

77
Private Preferences for Public Goods

• Can represents different citizens 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

78
Determining the Levelof Educational Spending
Willingness to pay

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

The efficient level of educational spending is
determined by summing the willingness to pay for
education for each of three citizens.
Educational spending per pupil
0
1200
600
1800
2400
79
Private Preferences for Public Goods

• 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.

80
Private Preferences for Public Goods

• Majority rule is inefficient because it weighs
  each citizens preference equally
• The efficient outcome weighs each citizens vote
  by his or her strength of preference.