PowerPoint Presentation - EXTERNALITIES

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ECONOMICS
What Does It Mean To Me?
Part VI The Role of Government in
Microeconomics/ Externalities
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Economic functions of Government
1) Enforce laws and contracts. 2) Maintain
competition. 3) Redistribute income--providing an
economic safety net. 4) Provide public
goods -nonexclusion -shared consumption
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5) Correct Market Failures -provide market
information -correct negative externalities -sub
sidize goods with positive externalities 6)
Stabilize the economy - fight unemployment -
encourage price stability - promote economic
growth
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EXTERNALITIES
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Externality When one persons actions imposes a
cost or benefit on the well-being of a bystander.
Externalities usually result in market failure.
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Externalities can be 1) Positive an external
benefit is imposed on someone. (examples
gardens, restored historic buildings,
research) 2) Negative an external cost is
imposed on someone. (examples exhaust from
autos, barking dogs, noise from airplanes)
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Externalities cause markets to allocate resources
inefficiently.
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This happens through 1) CONSUMPTION consuming
a good results in externality. 2) PRODUCTION
producing a good results in externality.
In general, an external cost means the market
overproduces the good (ie, paint). An external
benefit means the market underproduces the good
(ie, gardens)
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Are there benefits for other people in the
parking lot when someone puts their car alarm on?
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ANSWER Yes, because thieves dont know which
cars have alarms.
What about the club?
Are there benefits for other people in the
parking lot when someone puts the club on their
car?
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ANSWER No . . .because the thief can SEE the
club.
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Your neighbor puts in a nice garden. Are you
receiving a benefit?
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When you admit you are receiving a positive
benefit, your neighbor asks you to pay him 100 a
month for the benefit.
When you say no, he puts up a fence.
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What if you lived next door to this? Do you
receive a benefit?
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PROPERTY RIGHTS is the issue? Who owns the air?
The rivers? The parks?
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If we can figure out who pollutes the stream, we
punish the offender because we are not sure who
owns the stream, but we DO know who pollutes
it. We get into trouble when we use this
criteria regarding the air.
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The tendency for a society to overuse and
therefore abuse common resources is
called TRAGEDY OF THE COMMONS
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What is the difference between a public good and
a private good?
Exclusion vs. non-exclusion
and Shared consumption (rival good) vs.
non-shared consumption (non-rival good)
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What defines property rights?
Property rights are established by formal and
informal rules about the privileges and
limitations on the ownership, use, and transfer
of goods and resources. These rights are
specified in various municipal ordinances, other
legislation, court decisions (common law),
tradition and custom.
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Property rights need to be 1) clearly defined 2)
exclusive 3) enforceable 4) transferable
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Consider each of the items below Are they . . .
. .?
Clearly Defined? Exclusive? Transferable?
Enforceable?
skateboard
gun
library book
hamburger
Garden view
Bottled water
Lake water
Stream water
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What is a free-rider?
Someone who uses the good but doesnt pay for it.
Free riders occur when there are nonexclusion and
shared consumption. Spraying for
mosquitoes Police fire protection National
defense Street lights
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An Overview of U.S. Water Law
Riparian Common Law - people who own land along
streams, lakes and springs have a right to
reasonable use of the water.
First -in-time, First-in-right - the first person
to divert water and use it has the first right.
People who come later can take what is left.
Use-it or Lose-it - If a person with water rights
doesnt use all the water he claims a right to,
he permanently loses his right to the portion he
doesnt use.
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An Overview of U.S. Water Law (cont.)
Salvaged water rule - If a person is able to save
water (I.e. by better irrigation system), he
cannot sell the extra water or even keep his
right to it.
Beneficial use - People may not establish water
rights unless they are using the water for
beneficial use. (I.e.) Agriculture is
recognized in all states, but only a few states
recognize recreation or fishing.
Public Interest - Water rights--especially the
right to transfer--are limited by the public
interestgt Laws and courts define public
interest as things like protecting an economic
area or environment or public health and safety.
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Even though water is essential for life and
diamonds are not, water is cheap and diamonds are
expensive? Why?
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It has to do with the elasticity of the supply
curve and the amount of consumer/producer surplus
With DIAMONDS, supply is very inelastic.
With WATER, supply is very elastic.
S
Consumer Surplus
P
Price
Price
Producer Surplus
S
P
D
D
Q
Q
Quantity
Quantity
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Why would a farmer in the desert of Southern
California grow rice--a crop that requires a
great deal of water?
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How much water do you NEED to live per day?
Answer 1 1/2 liters
What is the average per capita consumption of
water per day in the State of Florida?
Answer 169 gallons
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Compare this to 130 gal/day in Massachusetts
and Rhode Island And 325 gal/day in Nevada
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When is a basketball an alternative to water?
When is coal an alternative to a waterfall?
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What are some other ways to conserve water?
Drip irrigation Compost Night watering Safflower
oil
Xeriscape Rocks Massage Broom Denim Mulch
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If I were your neighbor, what could you do to
stop me from polluting?
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What if we decide its YOUR property?
1) Call the police
2) Assault and battery??
3) Pay me to stop.---Youve upped my opportunity
cost---at some point its worth it to me to stop.
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What if we decide its MY property?
1) Outdo my Opportunity Cost (money, friendship)
2) Petition or threaten (fine, tax)
3) You can PAY me to stop (what is it worth to
you?)
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Peoples use responds to incentives.
Consider the following taxing methods to control
water usage
Mayor asks bill .002/gal.
Flat fee 10/month
MC 0
Flat fee 30/month
Billed at .01/gal.
MC gtMB
Billed at .05/gal.
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The government has dealt effectively with most
water issues.
BUT. . . . .what about GARDENS???
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So . . . Your neighbor plants a garden and it is
beautiful. But 5 years later, the garden has
grown and you can no longer see the lake. Do you
have a right to your view?
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Today, there are thousands of lawsuits over
condos and owners rights or trees loosing leaves
in your neighbors yard.
If your cat is in your neighbors yard, is it
your neighbors cat? What if your cat kills a
bird in your neighbors yard?
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Coase Theorem The proposition that if private
parties can bargain without cost over the
allocation of resources, they can solve the
problem of externalities on their own.
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Is this pollution?
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Exercise
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In review
Externalities
Negative (cost)
Positive (benefit)
Consumption (cigarettes)
Consumption (education)
Production (pollution)
Production (honey)
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What is efficient?
Efficiency occurs when MC MB for society.
PRICE
S MC to Society
For a perfectly competitive market with no
externalities and for a good that is not a public
good, the market is efficient.
D MB to Society
QUANTITY
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What is efficient?
Another way to measure efficiency would be
where Profit Maximizing Output is found where P
MC
MC
PRICE
Market Price
QUANTITY
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What happens when the firms marginal cost of
production is not equal to the marginal cost to
society? Or if the marginal benefit to consumers
is not equal to the marginal benefit to society?
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NEGATIVE EXTERNALITY IN PRODUCTION
Example Pollution
Because of the externality, the cost to society
is larger than the cost to producers.
MSC
PRICE
S MPC to Firm
MC is the private cost to the firm. Marginal
social cost (MSC) is cost to society MC
externality.
D MB to Society
QUANTITY
Qmarket
Qoptimum
The market overproduces and charges a price that
is too low.
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POSITIVE EXTERNALITY IN PRODUCTION
Example Honey
MPC to firm
PRICE
S MSC
MC is the private cost to the firm. Marginal
social cost (MSC) is cost to society MC
externality.
D MB to Society
QUANTITY
Qoptimum
Qmarket
The market underproduces and charges a price that
is too high.
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NEGATIVE EXTERNALITY IN CONSUMPTION
Example Cigarettes
Overproduction in this case raises MC.
D gives the private benefit in consumption.
Marginal social benefit (MSB) D externality.
MC
PRICE
D MB to Buyer
MSB
QUANTITY
Qmarket
The market overproduces and charges a price that
is too high.
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POSITIVE EXTERNALITY IN CONSUMPTION
Examples Education, Charities
The social value of education is greater than the
private value.
Underproduction in this case lowers MC.
MC
PRICE
D gives the private benefit in consumption.
Marginal social benefit (MSB) D externality.
MSB
D MB to Buyer
QUANTITY
Qoptimum
Qmarket
The market underproduces and charges a price that
is too low.
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SOLUTIONS 1) Assign property rights gt
internalize externality (Negotiate if mutually
beneficial) 2) Government involvement Tax on
negative externality (Pigovian tax) Subsidy
for positive externality Permits
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• Pigovian Tax
• Named after economist, Arthur Pigou
• A tax on firms based on the external costs they
  generate.
• Internalizes the externality and reimburses
  society for the external costs.
• The term pollution tax is used when the tax may
  not be equal to marginal external cost.

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A Pigovian tax sets the price of pollution.
Pollution permits sets the quantity of
pollution..
which, together with the demand curve
determines the quantity of pollution.
which, together with the demand curve
determines the price of pollution.
Supply of pollution permits
Pigovian Tax
Price of Pollution
Price of Pollution
P
P
Demand for Pollution Rights
Demand for Pollution Rights
Q
Q
Quantity of Pollution
Quantity of Pollution
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Notice that in both cases, price and quantity are
the same. . . .
Supply of pollution permits
Pigovian Tax
Price of Pollution
Price of Pollution
P
P
Demand for Pollution Rights
Demand for Pollution Rights
Q
Q
Quantity of Pollution
Quantity of Pollution
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Notice also that the pigovian tax line is
perfectly elastic--firms can pollute as much as
they want as long as they pay a tax. . .
Supply of pollution permits
Pigovian Tax
Price of Pollution
Price of Pollution
P
P
Demand for Pollution Rights
Demand for Pollution Rights
Q
Q
Quantity of Pollution
Quantity of Pollution
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. . .while in the second panel, the EPA sets the
quantity of pollution, and the supply of
pollution is completely inelastic.
Supply of pollution permits
Pigovian Tax
Price of Pollution
Price of Pollution
P
P
Demand for Pollution Rights
Demand for Pollution Rights
Q
Q
Quantity of Pollution
Quantity of Pollution
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Economists usually prefer pigovian taxes to
regulation as a way to deal with pollution
because they reduce pollution at a lower cost to
society. Using pigovian taxes to internalize
externalities will cause market price to reflect
the true social costs of production and force
firms to bear the full social cost of their
production activities.
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Now, suppose that two firms are awarded permits
and have met the government standard. Firm 1
then decides it wants to increase its emissions
by 100 tons and firm 2 agrees to reduce its
emissions by 100 tons if firm 1 pays it 5
million. Should the government allow two
factories to make this deal?
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If the EPA allows the firms to make this deal, it
will have created a new scarce resource
pollution permits. A market to trade these
permits will develop and that market will be
governed by the forces of supply and demand.
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The CLEAN AIR ACT of 1990 established the right
to buy and sell emission rights for
sulfur-dioxide pollution.
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CO2 emission permits have been traded since 1995
on the Chicago Exchange.
Carbon emissions trading has been steadily
increasing in recent years. According to the
World Bank's Carbon Finance Unit, 374 million
metric tonnes of carbon dioxide equivalent
(tCO2e) were exchanged through projects in 2005,
a 240 increase relative to 2004 (110 mtCO2e),
which was itself a 41 increase relative to 2003
(78 mtCO2e).
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The world's only mandatory carbon trading program
is the European Union Emissions Trading Scheme
(or EUETS). Created in conjunction with the
Kyoto Protocol, a 1997 international treaty that
took effect in 2005, it caps the amount of carbon
dioxide that can be emitted from large
installations, such as power plants and
factories, in the EU's 25 member countries.
Source Wikipedia
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NASH EQUILIBRIUM is a situation where economic
actors interacting with each other each choose
their best strategy given the strategies that
others have chosen. This is also called GAME
THEORY.
Game Theory has become a major tool for dealing
with pollution problems.
John Nash 1994 Nobel Prize, Economics
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Game Theory can be illustrated by what is called
THE PRISONERS DILEMMA.
The police have enough evidence to convict Bonnie
and Clyde of possession of an illegal firearm so
that each would spend 1 year in jail. But they
suspect that the two have pulled off some bank
robberies but they have no evidence. They put
Bonnie and Clyde in separate rooms and offer a
deal.
Right now, we can lock you up for one year. But
if you testify against your partner, we will set
you free and your partner will get 20 years in
prison. If you both confess to the crime, we can
avoid the cost of a trial and you both get 8
years.
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Each prisoner has two strategies, confess or
remain silent. However, the sentence that each
gets depends upon the actions of the other.
Bonnies Decision
confess
Remain silent
Bonnie - 20 yrs Clyde goes free
confess
8 years each
Clydes Decision
Bonnie goes free Clyde - 20 yrs.
Remain silent
1 year each
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OR you can use the PAYOFF MATRIX
B 8 years C 8 years
confess
Clydes Decison
Remain silent
confess
B free C 20 years
Bonnies Decison
Remain silent
B 20 years C free
confess
Clydes Decison
Remain silent
B 1 year C 1 year
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In the real world, this dilemma is played out by
real players. Once a negotiation is reached,
each country must decide whether they should keep
their agreement.
Iraqs Decision
High prod.
Low prod.
Iraq - 30 billion Iran - 60 billion
40 billion each
High prod.
Irans Decision
Iraq - 60 billion Iran - 30 billion
Low prod.
50 billion each
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It can be used in the arms race...
U.S.s Decision
Arm.
Disarm
US at risk USSR safe
Both at risk
Arm
USSRs Decision
US safe USSR at risk
Disarm
Both safe
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It can be used in the everyday economic
decisionsConsider 2 firms which must decide
whether to make a new product or not.
Firm 1
Yes
No
Firm 1 1.5m Firm 2 1.5m
Firm 1 0 Firm 2 2m
Yes
Firm 2
Firm 1 2m Firm 2 0
No
Firm 1 0 Firm 2 0
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SAMPLE AP TEST QUESTION
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The production of Good X creates an externality.
Is this a negative or positive externality?
Price
Marginal Social Cost
13 12 7 4 0
Negative
Marginal Private Cost
Why?
MSC gt MPC
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
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The production of Good X creates an externality.
Price
Identify the socially optimum output.
Marginal Social Cost
13 12 7 4 0
Q2
Marginal Private Cost
Why?
MSCMSB
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
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Suppose that good X is produced by a
profit-maximizing monopoly.
Identify the unregulated firms output.
Price
Q1
Marginal Social Cost
13 12 7 4 0
Why?
Marginal Private Cost
At Q1, MPC MR
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
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Suppose that good X is produced by a
profit-maximizing monopoly.
To produce socially optimum output, should the
government tax or subsidize the firm?
Price
subsidize
Marginal Social Cost
13 12 7 4 0
How much will it be?
Marginal Private Cost
3
Why?
Optimum Quantity at Q MR
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
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Suppose that good X is produced in a perfectly
competitive industry.
Identify equilibrium output in the absence of
regulation.
Price
Q3
Marginal Social Cost
13 12 7 4 0
Why?
DMPC or MSBMPC
Marginal Private Cost
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
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Suppose that good X is produced in a perfectly
competitive industry.
To produce at socially optimum output, should the
government tax or subsidize?
Price
Tax
Marginal Social Cost
13 12 7 4 0
How much?
5
Marginal Private Cost
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
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The End
Created by Virginia Meachum, Economics Teacher,
Coral Springs High School Sources FTE Economics
of Water and the Environment AP MicroEconomics
Test Question (2005)