Chapter 17 Externalities and Public Goods

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Chapter 17Externalities and Public Goods

• 17.1 Introduction
• 17.2 Externalities
• 17.3 Public Goods

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17.1 Introduction

• First Fundamental Theorem of Welfare Economics
• IF
• All consumers and producers act as perfect
  competitors (no one has market power)
• and
• 2) A market exists for each and every commodity
• Then
• Resource allocation is Pareto Efficient

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17.1 Introduction

• An EXTERNALITY occurs when
• The activity of one agent directly affects the
  welfare of another agent
• And
• 2) This affect is not transmitted by market
  prices
• Therefore no perfect competition
• Therefore the First Fundamental Theorem of
  Welfare Economics doesnt hold

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17.1 Introduction

• A PURE PUBLIC GOOD has two features
• Nonrival once provided, another person can
  consume it at no additional cost
• Nonexcludable once provided, it is impossible
  or highly expensive to prevent anyone from
  consuming it
• Perfectly competitive markets cant exist for
  these goods
• Therefore the First Fundamental Theorem of
  Welfare Economics doesnt hold

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17.2 Externalities

• IF Externalities Exist,
• THEN
• Social marginal cost ? private marginal cost,
• AND
• 1st Fundamental Theorem of Welfare Economics
  Fails
• THEREFORE
• Government could intervene

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17.2 Externalities

• What is an Externality?
• Graphical Analysis of Externalities
• Private Responses to Externalities
• Public Responses to Externalities
• Implications for Income Distribution
• Positive Externalities

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Theory - What is an Externality?

• An EXTERNALITY occurs when
• The activity of one agent directly affects the
  welfare of another agent
• And
• 2) This affect is not transmitted by market
  prices

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Externality Examples

• Externalities
• -A firm pollutes the air through production
• -A dorm student uses up all the bandwidth
  downloading So You Think You Can Dance
• -neighborhood dogs make your house safer
• Not Externalities
• -A store with noisy country music must reduce
  price to keep customers
• -Subway has a sale, forcing Mr. Sub to have a
  sale also

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Theory - Externality Features

• Externalities carry a variety of rarely
  considered features
• EXTERNALITIES CAN BE PRODUCED BY CONSUMERS AS
  WELL AS FIRMS
• EXTERNALITIES ARE RECIPROCAL IN NATURE
• EXTERNALITIES CAN BE POSITIVE OR NEGATIVE
• PUBLIC GOODS AND EXERNALITIES CAN BE SIMILAR

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1) EXTERNALITIES CAN BE PRODUCED BY CONSUMERS AS
WELL AS FIRMS

• Examples
• -a student using bandwidth
• -a smoker
• -a neighborhood watch patrol
• -a cell phone loud-talker

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2) EXTERNALITIES ARE RECIPROCAL IN NATURE

• -all parties using a good affected by
  externalities affect each other
• -the roommate downloading movies and the
  roommate downloading papers
• -person using a cell phone beside 2 people
  talking
• -which is worse is a biased value judgment

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3) EXTERNALITIES CAN BE POSITIVE OR NEGATIVE

• -As previously stated, externalities can also be
  positive
• -negative externalities tend to be overproduced,
  and positive externalities tend to be
  underproduced
• -ie shoveling your snow makes winter easier on
  your neighbors, owning a guard dog protects your
  neighbors, washing your hands prevents other from
  getting sick

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4) PUBLIC GOODS AND EXERNALITIES CAN BE SIMILAR

• -Externalities are unintended costs or benefits
  to the community, whereas public goods have
  intended benefits to the community (Mishan 1971)
• -ie If you hire security, it has externalities.
  If your block hires security, it is a public
  good
• -It is still useful to examine them independently
  in practice

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Graphical Analysis of Externalities

When an agent consumes a good with a negative
externality, he only equates marginal benefit
(MBD) and his Marginal Private Cost (MPC) and
consumes at Q1.
MSCMPCMEC

Society, however, experiences Marginal External
Costs (MEC), and therefore Marginal Social Cost
(MSC) is higher than MPC.
MPC
MEC
MB
Q
Q
Q1
Efficient consumption therefore occurs where
MSCMB, at point Q. There is overconsumption.
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Graphical Notes

• -The marginal benefit curve slopes down
• 1) due to diminishing marginal benefit
• or
• 2) As a reflection of the demand curve and
  market price decreasing with quantity
• -Costs tend to increase with output, therefore
  MPC is upward sloping

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Graphical Notes

• -Typically as output increases, the negative
  externality also increases, causing the MEC curve
  to be upward sloping
• -(2 barking dogs is more annoying than one)
• -The distance between the MSC and the MPC is
  always the MEC.

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Graphical Implications

• -Private markets will overproduce when negative
  externalities exist
• -without a market for externalities, this is a
  RATIONAL action
• -Note that optimal amount of the externality IS
  NOT ZERO (ie pollution is a cost, but some level
  is acceptable for the benefit)
• -Overproduction causes a deadweight loss to
  society

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Producer and Consumer Surplus


MSC
MPC
Producer Surplus
P
MEC
P
ConsumerSurplus
MBD
Q
Q
Q
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Externality Cost


MSC
ExternalityCost
MPC
P
MEC
P
MBD
Q
Q
Q
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Deadweight Loss


MSC
Deadweight Loss
MPC
P
MEC
P
MBD
Q
Q
Q
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Graphical Example

• Assume a city starts buying dogs that bark at
  night. Let
• MECQ
• MB350-Q
• MPC50Q
• Therefore
• MSCMPCMEC
• MSC50QQ
• MSC502Q

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Graphical Example

• MECQ MB350-Q
• MPC50Q MSC502Q
• Individual
• MBMPC
• 350-Q50Q
• 3002Q
• 150Q1
• P1350-Q
• P1350-150
• P1200

Society MBMSC 350-Q502Q 3003Q 100Q P350-Q
P350-100 P250
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Graphical Example


MSC502Q
MPC50Q
250
MECQ
200
MB350-Q
100
150
Q
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Deadweight loss

• To calculate deadweight loss, we need 2 more
  points in the graph
• MSC502Q1
• MSC502(150)
• MSC350
• MPC50Q
• MPC50100
• MPC150

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Graphical Example


MSC502Q
MPC50Q
350
250
MECQ
200
150
MB350-Q
100
150
Q
Obviously, this graph is not to scale.
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Benefit of reducing output

• If we were to move from our individual optimum to
  our social optimum
• Society would gain area AB, (which is equal to
  area C).
• The individual would lose profits or utility
  equal to area B
• Therefore, assuming everyone is equal in society
  the net gain is area A

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Graphical Example


SMC502Q
PMC50Q
350
250
A
B
MDQ
200
150
MB350-Q
C
100
150
Q
Obviously, this graph is not to scale.
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Deadweight loss

• A(1/2)bh
• A(1/2)(350-200)(150-100)
• A7,500
• Net benefit to society if production is reduced
• OR
• Deadweight loss of extra production

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Deadweight loss, broken down

• B(1/2)bh
• B(1/2)(250-150)(150-100)
• B5,000
• Loss to individual from lower Q
• AB12,500
• Gain to society from lower Q

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Theory - Real World Calculation Difficulties

• Utility and demand are hard to measure, making MB
  hard to define
• 2) The Marginal External Cost (MEC) can be hard
  to identify, quantify, and value
• a) What activities produce pollutants?
• b) Which pollutants do harm?
• c) What is the value of the damage done?

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2a) WHAT ACTIVITIES PRODUCE POLLUTANTS?

• Smog has been linked to many health concerns, and
  depends on factors such as production causing
  particulates and gases, temperature, and wind.
• -But these particulates and gases can travel
  large distances before causing smog
• -This makes smog production hard to pin down
• -Greenhouse gases have a greater transborder
  effect

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2b) WHICH POLLUTANTS DO HARM?

• -Scientists cant do randomized studies on
  pollution (take 50 people and expose them to
  pollution and compare them to 50 kept away from
  pollution)
• -CORRELATION can be found, but CAUSATION is more
  difficult to prove
• -It is also possible that an outside variable is
  increasing both pollution and health problems
• -ie Low income may lead to lower healthcare
  and lower removal of pollution

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2c) WHAT IS THE VALUE OF THE DAMAGE DONE?

• -Assume we have perfect scientific information,
  and the amount of damage can be accurately
  assessed
• -What is the value of that damage?
• -One could compare house prices in polluted and
  non-polluted areas to estimate value
• -But what if people underestimate (or
  overestimate) the health impact?
• -Some effects may also be long-term

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MEC Difficulty Conclusion

• -Although the model is simple, the application is
  difficult
• -It requires biologists, engineers, ecologists,
  and doctors to work with economists
• -Long-term and transborder effects make this even
  more difficult
• -The economists tool of marginal analysis is
  essential in any policy, since zero pollution is
  never a possibility.

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MEC Examples

• Assume a new student moves into dorms and plays
  loud, bad music (country rap), long into the
  night. The average GPA of the floor goes from a
  3.1 in Fall to a 2.8 in Winter. What are the
  marginal external costs?
• A new Styrofoam recycling plant opens up in
  Podunk (Population 200,000). Cancer rates rise
  from 10 in 2000 to 15 in 2010. What are the
  marginal external costs?

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Theory - Private Responses to Externalities

• Government regulation isnt the only method to
  deal with externalities. Externalities can be
  dealt with through private individuals through
• The Coase Theorem (assigning property rights)
• Mergers
• Social Conventions

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1) Assigning Property Rights

• One way to privately deal with externalities is
  for one party to be given OWNERSHIP or PROPERTY
  RIGHTS of the market the externality exists in.
• Lets examine the case of internet bandwidth. We
  have 2 people sharing the internet, one for
  downloading movies (Mark), another for everyday
  use (Evan). As we see on the following graph,
  Marks downloading causes Marginal Damage to
  Evan

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Internet Example


MSC
MPC
MEC
MB
Q
Q1
Movie Downloads
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OPTION 1 Pollutor Given Rights

• Assume that Mark is given property rights over
  bandwidth.
• -Mark consumes up to Q1 because his MBgtMPC up to
  that point
• -Hed be willing to give up marginal consumption
  if Paymentgt(MB-MPC)
• -Evan is willing to pay up to his MEC
• -Since between Q1 and Q, MECgtMB-MPC, room for
  negotiating exists

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Internet Example


MSC
MPC
MEC
Payment
MB
Movie Downloads
q
The maximum payment Evan is willing to give Mark
to give up consumption point q is greater than
MB-MPC
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Option 2 Non-Polluter Given Rights

• Assume that Evan is given property rights over
  bandwidth
• -Consumption starts at zero
• -Evan is willing to allow downloading if the
  payment he receives is greater than MEC (which
  starts at zero)
• -Mark is willing to pay to download if the
  payment is less than his MB-MPC
• -To the left of Q1, this is the case

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Internet Example


MSC
MPC
MEC
Payment
MB
Payment
Movie Downloads
q
The minimum payment Evan is willing to accept to
allow consumption point q is less than MB-MPC
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Numerical Example

• Assume Mark and Evans problem is as follows
• Mark and Evan pay 1 per 10 Gig (Q) downloaded
  for internet. Marks monthly marginal internet
  benefit is 11-Q. Marks private optimum is
  expressed as
• MBMPC
• 11-Q1
• Q10

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Numerical Example

• Evans internet slows down because Mark downloads
  so much. His MECQ, therefore, the social
  optimum is
• MBMSCMPCMEC
• 11-Q1Q
• 2Q10
• Q5

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Download Example

MSC1Q
MECQ

MPC1
1
MB11-Q
10
Downloads (10s Gigs)
5
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Evans Max Payment

MSC1Q
MECQ

Note if Q10, MEC(10)1510
10
Note if Q5, MEC(5)5
5
Max Payment
MPC1
MB11-Q
10
Downloads (10s Gigs)
5
1
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Evans Max Payment

• Evans would pay up to his extra cost to reduce
  the overuse of the internet
• Evans Max CostBig triangle-Small triangle
• Max Pay(1/2)bh-(1/2)bh
• Max Pay(1/2)(10)(10)-(1/2)(5)(5)
• Max Pay50-12.5
• Max Pay37.5

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Marks Minimum Fee

MSC1Q
MECQ

Note if Q5, MSC(5)156
6
Min Fee
MPC1
1
MB11-Q
10
Downloads (10s Gigs)
5
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Marks Min. Fee

• Mark would accept anything above his excess
  benefit to reduce his overuse
• Marks Minimum Fee (1/2)bh
• Min Pay(1/2)(5)(6-1)
• Min Pay12.5
• Conclusion Evan will pay Mark between 12.50 and
  37.50 to reduce his internet use to the social
  optimum, 50 Gigs/month.

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Private Responses to Externalities

• For the above analysis to work
• Bargaining costs must be low
• Resource owners must be able to identify damages
  to their property and legally prevent them (ie
  Evan cutting off Marks internet)
• Note that since for most production points the
  willingness to pay gt willingness to accept, the
  actual payments are a function of bargaining
  ability.

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Theory - The Coase Theorem

• WHO receives property rights affects income
  distribution, but not outcome production moves
  to Q, where MBMSC
• THE COASE THEOREM implies that once property
  rights are established, no government
  intervention is required to deal with
  externalities. (Coase 1960)

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Of Coase Theres Problems

• The Coase Theorem works best in cases where few
  parties are involved and the sources of
  externalities are well-defined.
• -Often many people are involved (ie air
  polution)
• -Often the externalities are poorly defined (ie
  air pollution, noise pollution, etc)
• -Coasian assignment of property rights has been
  successful both in waterways of England and
  Scotland and elephant herds of Zimbabwe

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2) Private Response Merger

• One way to internalize an externality is to
  combine involved parties. For example, if one
  firms actions caused an externality to another,
  the two firms could merge (through buyout or a
  3rd party)
• -IE Bookstore buys out the Discotheque next
  door (externality noise)
• -The new, superfirm would then take their
  externality into account and move to Q
• -Since everything happens within one firm, one
  could argue it is no longer an externality

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3) Private Response Social Conventions

• Social conventions and moral precepts encourage
  people to take Marginal External Cost into
  account
• -you should recycle, if you dont youre a
  horrible person
• -you should respect others, and not litter or be
  noisy
• -you shouldnt bud in line, as it is rude and
  affects everyone else behind you

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3) Private Response Social Conventions

• The Golden Rule
• Do unto others as you would have them do unto
  you
• can be turned into economic terms as
• Always consider the external marginal benefits
  and marginal costs of an action
• -social conventions and moral precepts work to
  move MPC closer to MSC