externalities and public goods

How might the government improve market outcomes in the case of public goods or common resources?. – market quantity smaller than socially desirable  To remedy the problem, or “interna

Session VII

Externalities and Public Goods

Principles of Economics

Overview

What is an externality?

Why do externalities make market outcomes inefficient?

What public policies aim to solve the problem of

externalities?

How can people sometimes solve the problem of

externalities on their own? Why do such private

solutions not always work?

1

Overview (cont’d)

What are public goods? What are common resources?

Give examples of each

Why do markets generally fail to provide the efficient

amounts of these goods?

How might the government improve market outcomes

in the case of public goods or common resources?

2

Learning Objectives

By the end of this session, students should

understand:

– what an externality is

– why externalities can make market outcomes

inefficient

– the various government policies aimed at solving

the problem of externalities

– how people can sometimes solve the problem of

externalities on their own

– why private solutions to externalities sometimes

do not work

3

Learning Objectives (cont’d)

By the end of this session, students should

understand:

– the defining characteristics of public goods and

common resources

– why private markets fail to provide public goods

– some of the important public goods in our economy

– why the cost–benefit analysis of public goods is both necessary and difficult

– why people tend to use common resources too

much

– some of the important common resources in our

Externalities and Public Goods

Part I Effects of Externalities

6

Introduction

One of the principles from Session 1:

Markets are usually a good way

to organize economy activity

In absence of market failures, the competitive market

outcome is efficient, maximizes total surplus

One type of market failure:

externality

Externalities can be negative or positive

7

Introduction (cont’d)

Self-interested buyers and sellers

 market outcome is not efficient

Another principle from Session 1:

Governments can sometimes

improve market outcomes

In presence of externalities, public policy can improve efficiency

8

Examples of Negative Externalities

Air pollution from a factory

Late-night stereo blasting from the dorm room next to yours

Health risk to others from second-hand smoke

$ The market for gasoline

Supply (private cost)

The socially optimal quantity is

20 gallons

25 Source: Mankiw (2011)

Market equilibrium

(Q = 25)

is greater than social optimum

13

Internalizing the Externality

Internalizing the externality

In our example, the $1/gallon tax on sellers

 sellers’ costs = social costs

When market participants must pay social costs,

market equilibrium = social optimum

14

Examples of Positive Externalities

Being vaccinated against contagious diseases

R&D

Education

And more…

Source: Mankiw (2011)

Exercise VII-1 Answers:

Analysis of a Positive Externality

17

B. Socially optimal Q

= 25 shots

C To internalize the externality, use subsidy

25 Source: Mankiw (2011)

– market quantity smaller than socially desirable

 To remedy the problem, or “internalize the externality,” – tax goods with negative externalities

– subsidize goods with positive externalities

Externalities and Public Goods

Part II Public Policies toward

Externalities

Market-based policies provide incentives so that

private decision-makers will choose to solve the

problem on their own

– E.g corrective taxes and subsidies

– tradable pollution permits

21

Corrective Taxes & Subsidies

Corrective tax: a tax designed to induce private

decision-makers to take account of the social costs

that arise from a negative externality

– Also called Pigouvian taxes after Arthur Pigou

(1877-1959)

The ideal corrective tax = external cost

For activities with positive externalities,

ideal corrective subsidy = external benefit

22

Corrective Taxes vs Regulations

Different firms have different costs of pollution

abatement

Efficient outcome?

A pollution tax is efficient:

– Firms with low abatement costs  reduce pollution

– Firms with high abatement costs  pay tax

In contrast, a regulation requiring all firms to reduce

pollution by a specific amount NOT efficient

Exercise VII-1: Lowering SO2

Emissions

Acme and US Electric run coal-burning power plants

Each emits 40 tons of sulfur dioxide per month,

total emissions = 80 tons/month

Goal: Reduce SO2 emissions 25%, to 60 tons/month

Cost of reducing emissions:

$100/ton for Acme, $200/ton for USE

23 Source: Mankiw (2011)

Exercise VII-1: Lowering SO2

Emissions by Regulation

Policy option 1: Regulation

Every firm must cut its emissions 25% (10 tons)

Your task: Compute the cost to each firm and

total cost of achieving goal using this policy

24

Exercise VII-1 Answer: Lowering

SO2 Emissions by Regulation

Each firm must reduce emissions by 10 tons

Cost of reducing emissions:

$100/ton for Acme, $200/ton for USE

Compute cost of achieving goal with this policy:

Cost to Acme: (10 tons) x ($100/ton) = $1000

Cost to USE: (10 tons) x ($200/ton) = $2000

Total cost of achieving goal = $3000

25

Exercise VII-2: Lowering SO2

Emissions by Tradable pollution permits

Policy option 2: Tradable pollution permits

Issue 60 permits, each allows one ton SO2 emissions

Give 30 permits to each firm

Establish market for trading permits

Each firm may use all its permits to emit 30 tons,

may emit < 30 tons and sell leftover permits,

or may purchase extra permits to emit > 30 tons

Your task: Compute cost of achieving goal if Acme

uses 20 permits and sells 10 to USE for $150 each

26

Exercise VII-2 Answer: Lowering SO2

Emissions by Tradable pollution permits

Goal: reduce emissions from 80 to 60 tons

Cost of reducing emissions:

$100/ton for Acme, $200/ton for USE

Compute cost of achieving goal:

Acme

– sells 10 permits to USE for $150 each, gets $1500

– uses 20 permits, emits 20 tons SO2

– spends $2000 to reduce emissions by 20 tons

– net cost to Acme: $2000 - $1500 = $500

continued…

27

Exercise VII-2 Answer: Lowering SO2

Emissions by Tradable pollution permits (cont;d)

Goal: reduce emissions from 80 to 60 tons

Cost of reducing emissions:

$100/ton for Acme, $200/ton for USE

USE

– buys 10 permits from Acme, spends $1500

– uses these 10 plus original 30 permits, emits 40 tons

– spends nothing on abatement

– net cost to USE = $1500

Total cost of achieving goal = $500 + $1500 = $2000

Using tradable permits, goal is achieved at lower total cost

and lower cost to each firm than using regulation!

28

29

Tradable Pollution Permits

A tradable pollution permits system reduces pollution

at lower cost than regulation

Who sell permits? Who buy permits?

Result: Pollution reduction is concentrated among

those firms with lowest costs

30

Corrective Taxes vs

Tradable Pollution Permits

When firms’ demand for the ability to pollute is a

downward-sloping,

– A tradable permits system restricts the supply of

pollution rights, has the same effect as the corrective tax

When policymakers do not know the position of this

demand curve,

– The permits system achieves pollution reduction

targets more precisely

Externalities and Public Goods

Part III Private Solution to

Externalities

32

Private Solutions to Externalities

Types of private solutions:

Moral codes and social sanctions,

e.g., the “Golden Rule”

Charities, e.g., the Sierra Club

Contracts between market participants and the

affected bystanders

33

Private Solutions to Externalities

The Coase theorem:

If private parties can costlessly bargain over the

allocation of resources, they can solve the externalities problem on their own

34

The Coase Theorem: An Example

Dick owns a dog named Spot

Negative externality:

Spot’s barking disturbs Jane, Dick’s neighbor

The socially efficient outcome

maximizes Dick’s + Jane’s well-being

– If Dick values having Spot more than Jane values

peace & quiet, the dog should stay

Coase theorem: The private market will reach the

efficient outcome on its own…

Source: Mankiw (2011)

35

The Coase Theorem: An Example

 CASE 1:

Dick has the right to keep Spot

Benefit to Dick of having Spot = $500

Cost to Jane of Spot’s barking = $800

 Socially efficient outcome:

Spot goes bye-bye

 Private outcome:

Jane pays Dick $600 to get rid of Spot,

both Jane and Dick are better off

 Private outcome = efficient outcome

36

The Coase Theorem: An Example

 CASE 2:

Dick has the right to keep Spot

Benefit to Dick of having Spot = $1000

Cost to Jane of Spot’s barking = $800

 Socially efficient outcome: See Spot stay

 Private outcome:

Jane not willing to pay more than $800,

Dick not willing to accept less than $1000,

so Spot stays

 Private outcome = efficient outcome

37

The Coase Theorem: An Example

 CASE 3:

Jane has the legal right to peace & quiet

Benefit to Dick of having Spot = $800

Cost to Jane of Spot’s barking = $500

 Socially efficient outcome: Dick keeps Spot

 Private outcome: Dick pays Jane $600 to put up with Spot’s

barking

 Private outcome = efficient outcome

The private market achieves the efficient outcome

regardless of the initial distribution of rights

Exercise VII-3: Applying Coase

Collectively, the 1000 residents of Green Valley value

swimming in Blue Lake at $100,000

A nearby factory pollutes the lake water, and would

have to pay $50,000 for non-polluting equipment

A Describe a Coase-like private solution

B Can you think of any reasons why this solution

might not work in the real world?

38

Example VII-3 Answer:

Applying Coase

A A good Coasian solution would be for each of the

1000 residents to chip in $75, so the town can offer

$75,000 to the factory to stop polluting

B A list of reasons(transaction costs, stubbornness,

coordination problems, etc.) why it might be

difficult to implement Coase-like solutions in the

real world

39

40

Why Private Solutions Do Not

Always Work

1 Transaction costs:

The costs parties incur in the process of

agreeing to and following through on a bargain

These costs may make it impossible to reach a mutually

beneficial agreement

2 Stubbornness:

Even if a beneficial agreement is possible,

each party may hold out for a better deal

3 Coordination problems:

If # of parties is very large, coordinating them may be costly,

difficult, or impossible.(free-ride)

Externalities and Public Goods

Part IV Public Goods and Common Resources

42

Introduction

We consume many goods without paying:

parks, national defense, clean air, etc

When goods have no prices, the market forces that

normally allocate resources are absent

The private market may fail to provide the socially

efficient quantity of such goods

One of the Ten Principles:

Governments can sometimes

improve market outcomes

43

Important Characteristics of Goods

A good is excludable if the consumer must purchase

before being able to use it

– Excludable: a slice of pizza, wireless internet access

– Not excludable: FM radio signals, national defense

A good is rival in consumption if one person’s

use of it diminishes others’ use

– Rival: a slice of pizza

– Not rival: an information good such as

an MP3 file of Pharrelle Williams’ “Happy”, national

defense

44

The Different Kinds of Goods

Private goods: excludable, rival in consumption

Example: food

Public goods: not excludable, not rival

Example: national defense

Common resources: rival but not excludable

Example: fish in the ocean, congested road

Natural monopolies (club goods): excludable but not

rival

Example: cable TV, country clubs

Exercise VII-4:

Categorizing Roads

A road is which of the four kinds of goods?

Hint: The answer depends on whether the road is

congested or not, and whether it’s a toll road or not

Consider the different cases

45

Exercise VII-4 Answer:

Categorizing Roads

Rival in consumption? Only if congested

Excludable? Only if a toll road

Four possibilities:

Uncongested non-toll road: public good

Uncongested toll road: natural monopoly (club goods)

Congested non-toll road: common resource

Congested toll road: private good

46

The Different Kinds of Goods:

47 Source: Mankiw (2011)

48

Public Goods

Public goods are difficult for private markets to

provide Why?

Free rider: a person who receives the benefit of a

good but avoids paying for it

Result: The good is not produced!

49

Public Goods

Solution: A tax on people who benefit

Problem: Measuring the benefit is usually difficult

Use cost-benefit analysis

– Cost-benefit analysis: a study that compares

the costs and benefits of providing a public good

– Analyses are imprecise

– So the efficient provision of public goods is more

difficult than that of private goods

50

Common Resources

Like public goods, common resources are not

excludable

– Cannot prevent free riders from using

– Little incentive for firms to provide

– Role for govt: seeing that they are provided

Additional problem with common resources:

– As the population grows, the # of sheep grows

– The amount of land is fixed,

the grass begins to disappear from overgrazing

The private incentives (using the land for free) outweigh the social incentives (using it carefully)

Result: People can no longer raise sheep

Exercise VII-5:

Policy Options for Common Resources

What could the townspeople (or their government)

have done to prevent the tragedy?

Try to think of two or three options

52

Exercise VII-5 Answer:

Policy Options for Common Resources

Regulate use of the land (the “command-and-control” approach)

Impose a corrective tax on the use of the land

to “internalize the externality.”

Auction off permits allowing use of the land

Divide the land, sell lots to individual families; each

family will have incentive not to overgraze its own

land

53

54

Case Study

– Some firms use spam emails

to advertise their products

– Spam is not excludable:

Firms cannot be prevented from spamming

– Spam is rival: As more

companies use spam, it becomes less effective

– Thus, spam is a common resource

– Like most common resources, spam is overused –

which is why we get so much of it!

Source: Mankiw (2011)

Quiz: True or False?

1. The least expensive way to clean up the environment

is for all firms to reduce pollution by an equal

percentage

2. Aristotle writes, “What is common to many is taken

least care of, for all men have greater regard for what

is their own than for what they possess in common with others.” In this statement, Aristotle is referring

to the free-rider problem that occurs when a person receives the benefit of a good without paying for it

Quiz Answer: True or False?

1. The least expensive way to clean up the environment

is for all firms to reduce pollution by an equal

percentage  False, Market based policy achieves more efficiency than direct regulation