Practice Problem From Ch' 3

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Practice Problem From Ch. 3

• Supply P 100 0.1Q
• Demand P 1000 0.05Q
• Plot equations on a fully labeled diagram
• Solve for equilibrium P and Q
• Compute CS, PS, and total surplus
• Can Q and P be rearranged in a way that would
  increase total surplus?

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Practice Problem Solution

• There is one price P where QS QD ?
• 100 0.1Q 1000 0.05Q
• -100 0.05Q -100 0.05Q
• 0.15Q 900, ? Q 6000
• P 100 0.16000 700 1000 - .056000

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CS 900,000 PS 1,800,000 TS CS PS
2,700,000
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Practice Problem

• Cannot re-arrange P and Q and generate larger
  total surplus, given existing supply and demand

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Chapter 4 Externalities, Market Failures, and
Policy Interventions

• Evaluate positive and negative externalities in
  the context of an otherwise well-functioning
  competitive market.
• Identify inefficiencies caused by externalities
  possible policy interventions.

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Positive Externalities

• Illustrative example Open space, viewshed,
  wildlife habitat, watershed benefits of
  pastureland
• Suppose that pastureland is bought and sold in
  otherwise well-functioning competitive markets
  for land
• What happens if market demand only reflects the
  benefits to the private landowner?

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Positive Externalities

• What is a positive externality?

An unpaid-for benefit to other members of society
generated as a side effect or consequence of an
economic exchange, such as between a buyer and a
seller
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Positive Externalities

• How might there be unpaid-for benefits to society
  in the previous agricultural land example?

Nearby residents and visitors enjoy the open
space, views, wildlife, and watershed benefits
but do not have to pay for them
Why is this a problem?
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Positive Externalities

• Unpaid for benefits are wonderful things. That
  isnt the problem

The problem is that the market will not allocate
enough resources to produce the socially optimal
quantity of the thing (pastureland) if only the
farmers benefits are reflected in
willingness-to-pay
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Positive Externalities
Note MEB is marginal external benefit, the
external benefit per acre of land in this case
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Positive Externalities

• Thus too much ag. land gets allocated to housing
  and commercial development rather than kept as
  pastureland under market allocation because
  external benefits are not internalized into the
  market demand curve

What are some possible interventions that could
help secure the socially optimal quantity of
pastureland in a market process?
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Positive Externalities

• One common government intervention is to provide
  subsidies to those who provide society with
  positive externalities

• Williamson Act tax credits for preserving ag.
  land, public funding to acquire conservation
  easements
• Subsidized vaccinations
• Other examples?

Note that altruistic non-government groups like
land trusts or public health organizations can
fulfill some of this intervention function
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Property Rights and Externalities

• Society can also decide that neighboring
  residents have a property right to some of the
  external benefits described previously, and thus
  that landowners do not have an unlimited right to
  develop their land

How does this tie in with the 5th Constitutional
Amendment concerning takings?
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Property Rights and Externalities

• One can see that the way that property rights are
  allocated has a huge impact on the way that
  externalities are addressed by social policy

What are the five key categories of property
right and the four ownership regimes?
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Property Rights and Externalities

• Access Non-extractive right to enjoy benefits of
  property. Authorized entrants have access rights,
  such as permission to bike on timber company
  roads.

Withdrawal Right to extract or remove some or
all of the product of the property. Authorized
users have access and withdrawal rights, such as
those with valid CA fishing licenses.
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Property Rights and Externalities

• Management Right to regulate use (access,
  withdrawal) and improvements. Claimants such as
  farmers who participate in the management of
  government-owned irrigation systems hold these
  rights.

Exclusion Right to exclude others from access,
withdrawal, and management. Proprietors who
collectively govern common-property (ex condo
swimming pool) hold exclusion rights.
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Property Rights and Externalities

• Alienation Right to sell (alienate) property
  to someone else. Owners of cars have the right to
  sell their cars to someone else.

Access and withdrawal are considered use rights,
while management, exclusion, and alienation are
rights of control over the resource.
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Property Rights and Externalities
Frequently, we hold limited property rights to
many different things. A usufruct refers to
certain access and withdrawal rights granted to
property that is owned by others, implying that
the usufructuary is an authorized user of the
resource. A usufruct is an open-ended access
withdrawal right that may run with the land
(riparian law) or may cover treaty rights (ex
Indian fishing rights). State may be owner in
public trust capacity.
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Property Rights

• When American Indian nations ceded lands to the
  United States, they generally understood the
  treaties to mean that they held permanent
  usufructuary rights to fish, hunt, and gather on
  ceded lands.
• Ex Minnesota v. Mille Lacs Band of Chippewa
  Indians, 526 U.S. 172 (1999).

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Property Rights and Externalities

• Ownership Regimes

• Private property
• Common property
• Government (state) property
• Open access (no propertyres nullius

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Property Rights and Externalities

• The issue of who holds what property right
  determines how law and public policy addresses
  externalities

What is the common law, and what is it designed
to protect and enforce?
The term common law refers to the body of legal
principles which evolve through the
interpretation of law by judges, as distinct from
the body of law created through legislation. The
term originally referred to the common law of
England -- general rules applicable to the whole
country, as distinct from local customs.
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Property Rights and Externalities

• The common law evolved to protect life, property,
  contractual rights and responsibilities, etc.

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Property Rights and Externalities

• Thus we might ask, did common law adequately
  address or externalities?

Key problem If harms are done to an open-access
resource, who has legal standing to sue under
common-law, which protects property?
Moreover, even if it is clear that you were
harmed by pollution to an open-access resource,
it may not be possible to assign liability to a
particular source of emissions if there are many
sources.
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Property Rights and Externalities
In a few rare cases, 19th century judges
recognized that water pollution impacted
downstream usufructuary rights holders. Until
the Mineral King decision, however, users of open
access natural resources were not widely
recognized as having the necessary legal standing
to sue. Thus common law was largely ineffectual
in protecting the environment.
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Justice William O. Douglas in Sierra Club v.
Morton (Mineral King), 405 US 727 (1972)
"The critical question of 'standing' would be
simplified and also put neatly in focus if we
fashioned a federal rule that allowed
environmental issues to be litigated before
federal agencies or federal courts in the name of
the inanimate object about to be despoiled,
defaced, or invaded by roads and bulldozers and
where injury is the subject of public outrage.
Contemporary public concern for protecting
nature's ecological equilibrium should lead to
the conferral of standing upon environmental
objects to sue for their own preservation The
voice of the inanimate object, therefore, should
not be stilled. That does not mean that the
judiciary takes over the managerial functions
from the federal agency. It merely means that
before these priceless bits of Americana (such as
a valley, an alpine meadow, a river, or a lake)
are forever lost or are so transformed as to be
reduced to the eventual rubble of our urban
environment, the voice of the existing
beneficiaries of these environmental wonders
should be heard."
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Property Rights and Externalities

• Note Environmental regulations essentially make
  the government a proprietor of air, water,
  fisheries, wildlife, and other former open-access
  resources in a public trust capacity.

Alternatively, land and other non-fugitive
resources can become private property and be
protected under the common law
Alternatively, many resources can become common
property and be protected under common law
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Negative Externalities
What is a negative externality?
An uncompensated cost borne by members of society
(or the aspects of the natural world they care
about) that comes about as a byproduct of
economic exchange, such as through market
transactions.
Examples?
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Negative Externalities
Assertion When production of a good or service
generates significant negative externalities,
profit-maximizing firms in a competitive market
will supply too much of that good or service.
Consumers will pay a subsidized price and so will
consume too much.
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Negative Externalities
Recall from Chapter 3 that in a well-functioning
competitive market the firms marginal cost curve
is its supply curve.
So, why should we care about all of this cost
curve analysis?
Because in an unregulated competitive market
external costs are not accounted for in the
firms marginal cost, which means that the firms
supply decision ignores external costs.
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Negative Externalities
Marginal social cost
Marginal private cost (borne by the firm)

Marginal external cost (MEC, borne by the
environment and society)
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Example Empirical Estimate of Marginal External
Cost
According to a study by Richard Tol (Energy
Policy 33 (2005), the mean estimated value of
external cost (aka damage cost) for anthropogenic
greenhouse gas emissions from the peer-reviewed
literature is 50/tC. tC stands for metric tons
of carbon-equivalent emissions.
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Example

• 1 tC 3.67t CO2.
• Thus 50/tC damage cost ? 183.50/tCO2 damage
  cost.
• Gasoline market CO2 emissions from a gallon of
  gasoline 2,421 grams x 0.99 x (44/12) 8,788
  grams 8.8 kg/gallon 19.4 pounds/gallon
  0.0097 tons/gallon.
• ? MEC 0.485/gallon of gasoline.

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Negative Externalities
Thus there are two supply curves
The supply curve based on marginal private cost.
This is the supply curve that firms supply along
in the absence of environmental regulation or
reputational enforcement.
The supply curve based on marginal social cost.
This is the supply curve that reflects the full
social cost of production.
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Gasoline Market
P gasoline
Social Cost Supply ? MSC
Private Cost Supply ? MPC
MEC/gallon (0.485/gallon)
Q gasoline
KEY MEC marginal external cost MPC marginal
private cost MSC MEC MPC marginal social
cost.
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Negative Externalities
Theory of Efficiency-Enhancing Policy
Interventions
Pigouvian (aka Pigovian) tax (named after English
economist A.C. Pigou) Tax per unit of output
(e.g., electricity) equal to marginal external
cost, with tax revenues being used to compensate
those harmed and/or fix environmental harms.
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Theory of Efficiency-Enhancing Policy
Interventions
What happens if the Pigouvian tax is less than
the cost per unit of reducing emissions? Relate
to benefit/cost analysis.
What happens if the Pigouvian tax is greater than
the cost per unit of reducing emissions? Relate
to benefit/cost analysis.
How does a Pigouvian tax (or environmental tax in
general) affect the market viability of less
polluting alternatives, and research and
development to find clean alternatives?
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Theory of Efficiency-Enhancing Policy
Interventions

• For a Pigouvian tax to fully resolve the
  inefficiency due to negative externalities, the
  following must hold
• Ability to accurately measure marginal external
  cost
• Ability of the political system to produce an
  efficient environmental policy
• Ability to monitor emissions, charge appropriate
  tax, and enforce this system

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Theory of Efficiency-Enhancing Policy
Interventions
In Chapter 8 we will investigate political
economy, an area of study that uses economic
methods to analyze political (legislative,
administrative) outcomes. In Chapter 9 we will
look at economic issues associated with promoting
compliance with environmental and NR law.
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Practice Problem, Negative Externalities

• Demand P 1500 0.1Q
• Private-cost supply P 100 0.1Q
• Marginal external cost 200
• Social-cost supply P 300 0.1Q
• Solve for equilibrium P, Q, and total gross gains
  from trade assuming no regulation (use
  private-cost supply)
• Solve for total external cost under 1 above
• Solve for the true or net gains from trade under
  1 above (total gross gains from trade total
  external cost)
• Solve for equilibrium P, Q, and total gains from
  trade assuming a Pigouvian tax (use the
  social-cost supply). Compare with 3 above. By
  how much does the Pigouvian tax enhance
  efficiency (net gains from trade)?

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Practice Problem, Negative Externalities

• Demand P 1500 0.1Q
• Private-cost supply P 100 0.1Q
• Marginal external cost 200
• Social-cost supply P 300 0.1Q
• Solve for equilibrium P, Q, and total gross gains
  from trade assuming no regulation (use
  private-cost supply)
• 1500 0.1Q 100 0.1Q ? Q 7000, P 800
• CS (1500-800)7000/2 2,450,000
• PS (800-100)7000/2 2,450,000
• Total gross gains from trade CSPS 4,900,000

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Practice Problem, Negative Externalities

• Demand P 1500 0.1Q
• Private-cost supply P 100 0.1Q
• Marginal external cost 200
• Social-cost supply P 300 0.1Q
• 2. Solve for total external cost under 1 above
• Since marginal external cost is a constant 200,
• Total external cost 200Q 2007000
  1,400,000

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Practice Problem, Negative Externalities

• Demand P 1500 0.1Q
• Private-cost supply P 100 0.1Q
• Marginal external cost 200
• Social-cost supply P 300 0.1Q
• 3. Solve for the true or net gains from trade
  under 1 above (total gross gains from trade
  total external cost)
• Total gross gains from trade CSPS 4,900,000
• Total external cost 200Q 2007,000
  1,400,000
• Total net gains from trade 3,500,000

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Practice Problem, Negative Externalities

• Demand P 1500 0.1Q
• Private-cost supply P 100 0.1Q
• Marginal external cost 200
• Social-cost supply P 300 0.1Q
• 4. Solve for equilibrium P, Q, and total gains
  from trade assuming a Pigouvian tax (use the
  social-cost supply). Compare with 3 above. By
  how much does the Pigouvian tax enhance
  efficiency (net gains from trade)?
• 1500 0.1Q 300 0.1Q ? Q 6,000, P 900
• CS (1500-900)6,000/2 1,800,000
• PS (900-300)6000/2 1,800,000
• Total gains from trade 3,600,000, which is
  100,000 larger than in the free market without
  the Pigouvian tax.

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Practice Problem, Negative Externalities

• Demand P 1500 0.1Q
• Private-cost supply P 100 0.1Q
• Marginal external cost 200
• Social-cost supply P 300 0.1Q
• 4. Solve for equilibrium P, Q, and total gains
  from trade assuming a Pigouvian tax (use the
  social-cost supply). Compare with 3 above. By
  how much does the Pigouvian tax enhance
  efficiency (net gains from trade)?
• Also note that in the free market without the
  Pigouvian tax, consumers are pay a subsidized
  price of 800, which is 100 below the price that
  is based on the full marginal social cost of
  production.

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Practice Problem, Positive Externalities
Second problem Suppose that supply is given by
the equation p 100 2q Private-benefit demand
is given by the equation p 1000
q Social-benefit demand is given by the equation
p 2000 q 1. Derive the free market
equilibrium values for p and q, and calculate
gross gains from trade. 2. Calculate total
external benefits under the free market
equilibrium above. 3. Calculate true net gains
from trade and deadweight loss. 4. Derive the
socially optimal equilibrium values for p and
q, under the assumption that all externalities
are internalized, and calculate total gains from
trade. 5. How much would society have to
subsidize each unit of this good in order to
fully internalize the positive externality?
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Practice Problem, Negative Externalities
Third problem Suppose that private-cost supply
is given by the equation p 100 2q Social-cost
supply is given by the equation p 500
2q Suppose that the supply curve based on the use
of clean, non-polluting technology is given by
the equation p 400 2q Suppose that demand is
given by the equation p 2000 q. 1. What is
the dollar value for marginal external cost? 2.
If regulators charge firms that pollute a
Pigouvian tax, which of the supply curves above
will prevail in the market? What will be the
equilibrium p and q? 3. How would this change if
the supply curve based on the use of clean,
non-polluting technology was given by the
equation p 600 2q?