Principles of Economics, Case and Fair,8e

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(No Transcript)
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Overview

• Externalities and Environmental Economics
• Marginal Social Cost and Marginal Social Benefit
• Private Choices and External Effects
• Internalizing Externalities
• Public (Social) Goods
• The Characteristics of Public Goods
• Public Provision of Public Goods
• Imperfect Information
• Adverse Selection Asymmetric Information
• Moral Hazard
• Government Solutions
• Market Solutions

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EXTERNALITIES, PUBLIC GOODS, IMPERFECT INFORMATION

• market failure Occurs when resources are
  misallocated or allocated inefficiently.
• The existence of externalities, public goods, and
  imperfect information are examples of market
  failure.

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EXTERNALITIES

• Externality
• When the action of one individual either
  adversely or positively affects the welfare of
  another individual, and that cost or benefit is
  not taken into consideration.
• Positive externality When the action of one
  individual positively affects the welfare of
  another individual
• Negative externality When the action of one
  individual negatively affects the welfare of
  another individual
• Externalities lead to inefficient outcomes.

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EXTERNALITIES

• MARGINAL SOCIAL COST (MSC)
• The total cost to society of producing an
  additional unit of a good or service.
• MSC is equal to the sum of the marginal costs
  (supply) of producing the product and the
  correctly measured damage costs involved in the
  process of production.

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EXTERNALITIES

• MARGINAL SOCIAL BENEFIT (MSB)
• The total benefit to society of producing an
  additional unit of a good or service.
• MSB is equal to the sum of the marginal benefits
  of consuming the product (demand) and the
  correctly measured positive external benefits
  involved in the process of production.

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EXTERNALITIES

• An efficient market outcome is where the MSCMSB.
  Otherwise, social surplus may be increased by
  changing the amount produced.
• For instance, if MSCgtMSB, then by decreasing
  production the reduction in costs will outweigh
  the reduction in social benefits.
• Similarly, if MSBgtMSC, then by increasing
  production, the increase in benefits will
  outweigh the increase in costs making society
  better off.

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EXTERNALITIES

• Consider the case of a positive externality
• Example A bee keepers bees help pollinate a
  neighbors apple orchard.
• In this case, the beekeeper does not consider the
  effect his bees have on his neighbors business,
  because he is not compensated for this benefit.
• The apple orchard owner does not compensate the
  bee keeper because they are freely provided.
• The market demand curve which represents the
  consumers maximum willingness to pay, does not
  take into consideration what the apple orchard
  owner would be willing to pay to the beekeeper if
  he was forced to compensate him.
• Demand curve is below the true Social Marginal
  Benefit curve.

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EXTERNALITIES
The result of a positive externality is
underproduction relative to the efficient level.

P
SMSC
MSB
D
QEFFICIENT
QEQM
Q
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EXTERNALITIES

• Consider the case of a negative externality
• Example A polluting tire manufacturer dumps
  waste in a nearby river, killing fish and
  devaluing the properties of landowners
  downstream.
• In this case, the tire manufacturer does not
  consider the effect his pollution has on the
  welfare of landowners downstream. Because he is
  not forced to compensate them for their losses,
  he does not take into consideration the effects
  of his actions.
• The supply curve which represents the producers
  minimum willingness to sell, does not reflect
  these additional costs he inflicts.
• Supply curve is higher than (to the right of) the
  true Social Marginal Cost curve.

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EXTERNALITIES
The result of a negative externality is
overproduction relative to the efficient level.

P
MSC
SMC
DMSB
QEFFICIENT
QEQM
Q
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ENVIRONMENTAL ECONOMICS

• Environmental Economics studies how the
  government may remedy the negative externalities
  arising from pollution and environmental damage
  when firms do not consider this costs in their
  own decision making.

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EXTERNALITIES

• How does the government remedy externalities?
  How does the government get the private market to
  produce the efficient quantity.
• INTERNALIZING EXTERNALITIES
• Five approaches have been taken to solving the
  problem of externalities
• government-imposed taxes and subsidies
• (2) private bargaining and negotiation
• (3) legal rules and procedures
• (4) sale or auctioning of rights to impose
  externalities

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EXTERNALITIES government-imposed taxes and
subsidies

• government-imposed taxes and subsidies
• Example Suppose that for every tire that is
  produced, the environmental damage caused by the
  pollution is 2.
• Here the government forces the producers to
  internalize the cost of the pollution in the form
  of a tax.

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E EXTERNALITIES government-imposed taxes and
subsidies
If the externality is 2 per unit produced, then
the true MSC Curve is parallel to the industry
supply curve, but shifted up by 2.

P
MSC
S MC
2
DMSB
QEFFICIENT
QEQM
Q
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EXTERNALITIES government-imposed taxes and
subsidies

• If the government imposes a 2 per unit tax, then
  the new supply curve S(PD) will be the same as
  the true MSC curve.
• The efficient quantity will get produced.
• Both suppliers and demanders share the burden of
  the higher cost of production (price demanders
  pay increases and the price suppliers receive
  decreases)

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EXTERNALITIES government-imposed taxes and
subsidies
Both suppliers and demanders share the burden of
the higher cost of production.

P
S(PD)MSC
S(PS)
2
PD
D(PD)MSB
PS
QEFFICIENT
QEQM
Q
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EXTERNALITIES government-imposed taxes and
subsidies

• How does a subsidy remedy a positive externality?
• A per unit subsidy is a payment by the government
  to either a producer or consumer of a good for
  every unit produced/consumed.
• If the government subsidizes consumption or
  production of a good in which there is a positive
  externality, it can get that the efficient
  quantity will be produced.

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EXTERNALITIES bargaining and negotiations

• By allowing effected parties to bargain with each
  other about who should pay for the externality,
  an efficient allocation can be reached.
• Coase theorem Under certain conditions, when
  externalities are present, private parties can
  arrive at the efficient solution without
  government involvement.

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EXTERNALITIES bargaining and negotiations

• For this theorem to work, the rights of
  individuals must be clearly defined.
• For example, either the firm has the right to
  pollute, or the landowner has a right to
  pollution free water.
• If these rights are clearly understood, then
  parties may be able to come to an agreement about
  how to compensate the other.
• For example, if the landowner is given the right
  to have pollution free water, then the firm could
  pay the landowner 2 every time a tire is
  produced.
• This essentially would decrease the supply such
  that the new supply replicated the true MSC.

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EXTERNALITIES bargaining and negotiations
If property rights are clearly understood, then
bargaining can lead to an efficient outcome.

P
S1MSC (after bargaining)
2
P1
S0
DMSB
P0
Q1 QEFFICIENT
Q0 QEQM
Q
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EXTERNALITIES legal rules and procedures

• If property rights are not clearly understood,
  then the court may assign these rights as well as
  create a punishment mechanism for abuse of those
  rights.
• injunction A court order forbidding the
  continuation of behavior that leads to damages.
• liability rules Laws that require A to
  compensate B for damages already imposed.

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EXTERNALITIES sale or auctioning of rights to
impose externalities

• If there is a market for the sell or purchase of
  rights to pollute, then an efficient outcome can
  also be reached.
• For example, if a firm wants to produce another
  tire, if can do so if and only if it has
  purchased a right to pollute.
• In this way, a firm will pollute if and only if
  the additional revenues (price for a perfectly
  competitive firm) generated cover both the direct
  costs of production as well as the costs of the
  pollution right.

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PUBLIC (SOCIAL) GOODS

• public goods (social or collective goods)
• Goods that are nonrival in consumption and/or
  their benefits are nonexcludable

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PUBLIC (SOCIAL) GOODS

• Non-rival in consumption One persons enjoyment
  of the benefits of a public good does not
  interfere with anothers consumption of it.
• Example
• National Defense is non-rival in consumption.
  Once it is provided to one citizen, others can
  enjoy it as well and their ability to consume is
  not affected by how many others are consuming it.
• Private goods are rival in consumption. If one
  person eats a hamburger, no one else can eat it.

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PUBLIC (SOCIAL) GOODS

• Nonexcludable
• Once a good is produced, no one can be excluded
  from enjoying its benefits.
• Example Once National Defense is provided to one
  citizen, no other citizens can be excluded from
  consuming it

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PUBLIC (SOCIAL) GOODS

• Problem with Public Goods
• Firms will not have an incentive to produce this
  good. The good will not be produced in the
  private market.
• Why?
• free-rider problem
• If no one can be excluded from enjoying the good,
  then there is no way to force everyone that
  consumes the good to pay it.
• Consumers acting in their own self-interest have
  no incentive to contribute voluntarily to the
  production of public goods.

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PUBLIC (SOCIAL) GOODS

• drop-in-the-bucket problem
• Even though the firm may be able to charge the
  first consumer, it is unlikely that one person
  would be willing or able to pay for the full cost
  of production.

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PUBLIC (SOCIAL) GOODS

• Remedy of Public Goods
• The government will provide the good, and then
  force everyone to contribute to the cost of
  production by taxation.

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IMPERFECT INFORMATION

• If consumers and producers do not have full
  information about the prices of products or
  inputs then this will lead to mistakes in their
  decision making.
• Some exchanges do not take place that would have
  taken place under full information.

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IMPERFECT INFORMATION

• For example, a used car dealer sells a car for
  2,000 but the true value of the car is not known
  to the purchaser.
• Even if the true value was 2,000, if the
  consumer feared that the true value was lower,
  then the consumer may not purchase the car.
  However, if there was full information this
  transaction might have taken place.
• In general, imperfect information leads to a
  lower quantity of transactions then the efficient
  level because consumers are afraid of being
  defrauded.

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IMPERFECT INFORMATION

• Two other inefficient outcomes occur due to
  asymmetric information (when only one party has
  full information and the other has only imperfect
  information)
• Adverse Selection
• As a result of imperfect information, only the
  bad quality items get sold or bought.

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IMPERFECT INFORMATION

• Adverse Selection
• Example Suppose there are two types of cars,
  high and low quality. The high quality car is
  worth 5000 and the low quality is worth 1000.
  There are 50 of each car in the market. Consumers
  do not know the quality until after the purchase.
• The probability of finding a high quality car is
  50, so consumers are not going to be willing to
  pay a full 5000. Consequently, producers will
  not sell the high quality car because no
  consumers would be willing to pay 5000.

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IMPERFECT INFORMATION

• Adverse Selection
• Another example, is in the car insurance market.
• Safe drivers who know it is unlikely that they
  will have an accident will not opt to get full
  coverage because the cost will not be worth it to
  them.
• Unsafe drivers who know it is likely that they
  will have an accident, will opt for full
  coverage.
• The good quality driver (safe) is under insured.

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IMPERFECT INFORMATION

• moral hazard
• When as a result of a contract, one of the
  parties changes behavior in a negative way.
• Example
• Insurance Markets
• This will occur if once a person is insured, they
  start engaging in riskier behavior.

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IMPERFECT INFORMATION

• How do insurance firms avoid adverse selection
  and moral hazard?
• Adverse Selection
• Offer a high premium and a low deductible or
• A low premium and a high deductible.
• Which will the bad quality consumer choose?
• Moral hazard
• Insurance companies base premiums on current
  behavior. If you get a lot of tickets, have a
  wreck, etc, your premiums go up. This is an
  incentive to not engage in a riskier behavior
  even when you are insured.

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IMPERFECT INFORMATION

• GOVERNMENT SOLUTIONS to imperfect information
• The Government provides information on the
  quality of a good or a firm
• When information is very costly for individuals
  to collect and disperse, it may be cheaper for
  government to produce it once for everybody.
• Ex. Better Business Bureau, Consumer Survey
  Reports, Food and Drug Administration, etc.
• The government forces firms to disclose the
  quality of the products or to compensate buyers
  if a product breaks down.
• For example, many states require used-car
  dealers to buy back or repair used cars that
  experience serious problems

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IMPERFECT INFORMATION

• MARKET SOLUTIONS for imperfect information
• Warranties
• Firms may also want to issue warranties on their
  products so that consumers know that their good
  is high quality, and so they can sell it for a
  higher prices.