The Role of Government in Microeconomics Externalities

What happens when the firms’ marginal cost of production is not equal to the marginal cost to society?. Marginal social cost MSC is cost to society = MC + externality.. •The term “pollu

What Does It Mean To Me?

Part VI:

The Role of Government in Microeconomics/ Externalities

Economic functions of Government:

1) Enforce laws and contracts.

5) Correct Market Failures

-provide market information -correct negative externalities -subsidize goods with positive

externalities 6) Stabilize the economy

- fight unemployment

- encourage price stability

- promote economic growth

EXTERNALITIES

When one person’s actions imposes a cost or benefit on the well-being of a

bystander

Externalities

usually result in market failure

Externalities can be:

1) Positive:Positive: an

external benefit is

imposed on someone (examples: gardens, restored historic buildings, research)

2) Negative:Negative: an

external cost is

imposed on someone (examples: exhaust from autos, barking dogs, noise from

airplanes)

Externalities cause markets to allocate resources inefficiently.

This happens through:

1) CONSUMPTION: consuming a good

(ie, gardens)

Are there benefits for other people in the parking lot when someone puts

their car alarm on?

Yes, because thieves don’t

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?

No because the thief

can SEE the club.

Your neighbor puts in a nice garden Are you receiving a benefit?

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.

What if you lived next door to this?

Do you receive a

benefit?

PROPERTY RIGHTS is the issue?

Who owns the air? The rivers? The parks?

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.

The tendency for a society to overuse and therefore

abuse common resources is called:

TRAGEDY OF THE COMMONS

QuickTim e™ and a TIFF (Uncom pressed) decom pressor are needed to see this picture.

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)

What defines

What defines property rights property rights ?

Property rights are established by

Property rights are established by formal and formal and

informal rules about the privileges and limitations

on the

on the ownership ownership , use, and transfer , use, and transfer of goods and

resources These rights are specified in various municipal ordinances, other legislation, court decisions (common law), tradition and custom.

Property rights need to be: 1) clearly defined

2) exclusive

3) enforceable

4) transferable

Consider each of the items below:

What is a free-rider?

Someone who uses the good but doesn’t pay for

it.

Free riders occur when there are nonexclusion

and shared consumption.

Spraying for mosquitoes Police & fire protection

National defense Street lights

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 doesn’t use all the water he claims a right to, he permanently loses his right to the portion he doesn’t use.

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 interest>” Laws and courts define “public interest” as

things like protecting an economic area or environment or public health and safety.

Even though water is essential for life and diamonds are not, water

is cheap and diamonds

are expensive?

Why?

It has to do with the elasticity of the supply curve and the

amount of consumer/producer surplus

S

Q

P P

D D

With DIAMONDS,

supply is very inelastic. With WATER, supply is very elastic.

Why would a farmer in the desert of Southern California grow rice a crop that requires a

great deal of water?

How much water do you NEED to live per day?

Answer:

Answer: 1 1/2 liters 1 1/2 liters

What is the average per capita consumption of

water per day in the State of Florida?

Answer:

Answer: 169 gallons 169 gallons

Compare this to

130 gal/day in Massachusetts and Rhode

Island And

325 gal/day in Nevada

What are some other ways to conserve water?

Night watering Safflower oil

QuickTime™ and a TIFF (Uncompressed) decompressor

are needed to see this picture.

If I were your neighbor, what could you do to stop me from

polluting?

What if we decide it’s YOUR property?

1) Call the police

2) Assault and battery??

3) Pay me to stop. -You’ve upped my

opportunity cost -at some point it’s worth it to

me to stop.

What if we decide it’s 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?)

People’s use responds to incentives.

Consider the following taxing methods to control

water usage:

Mayor asks bill = $.002/gal.

Flat fee = $10/month

Flat fee = $30/month

MC = 0

Billed at $.01/gal.

Billed at $.05/gal. MC >MB

The government has dealt effectively with most water

issues.

BUT .what about

GARDENS???

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?

Today, there are thousands of lawsuits over condos and owner’s rights or trees loosing leaves

in your neighbor’s yard.

If your cat is in your neighbor’s

yard, is it your neighbor’s cat?

What if your cat kills a bird in

your neighbor’s yard?

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.

Is this pollution?

Exercise

What is efficient?

S = MC to Society

and for a good that

is not a public good,

the market is

efficient

P R I C E

QUANTITY

QUANTITY

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?

NEGATIVE EXTERNALITY IN

PRODUCTION:

Example: Pollution

S = MPC to Firm

D = MB to Society

P RI C E

QUANTITY

MSC

MC is the private cost to the firm

Marginal social cost (MSC) is cost

to society = MC + externality.

The market overproduces and charges a price that is

too low.

Because of the externality, the

cost to society is larger than the

cost to producers.

Q

opti mu m

opti mu m

Qm ark et

Qm ark et

MPC to firm

MC is the private cost to the firm

Marginal social cost (MSC) is cost

opti mu m

Qm ark et

Qm ark et

P RI C E

Qm ark et

P RI C E

The social value of education

is greater than the private

value.

Q

opti mu m

opti mu m

Qm ark et

Qm ark et

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

A Pigovian tax sets the

Pollution permits sets the quantity of pollution…

Supply of pollution permits

Q

P

……which, together with the demand curve determines the

determines the price price of

pollution.

Supply of pollution permits

Q

P

Notice that in both cases, price and

quantity are the same .

Supply of pollution permits

Q

P

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

Q

P

.while in the second panel, the EPA sets the

quantity of pollution, and the supply of pollution is completely inelastic.

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.

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?

If the EPA allows the firms to make this deal, it will have created a new scarce

resource:

resource: pollution permits pollution permits .

A market to trade these permits will develop and that market will be governed

by the forces of supply and demand.

The CLEAN AIR ACT of 1990

established the right to buy and sell emission rights for sulfur-dioxide pollution

CO 2 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

exchanged through projects in 2005, a 240%

The world's only mandatory carbon trading

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

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

John Nash

1994 Nobel Prize,

Economics

Game Theory has become a

major tool for dealing with

pollution problems.

Game Theory can be illustrated by what is called

THE PRISONER’S 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.”

Clyde’s

Decision

8 years each Bonnie - 20 yrs

Clyde goes free

Bonnie goes free Clyde - 20 yrs. 1 year each

Each prisoner has two strategies, confess or remain

silent However, the sentence that each gets

depends upon the actions of the other.

OR you can use the PAYOFF MATRIX

Bonnie’s

Decison

Clyde’s Decison

Clyde’s Decison

B: free C: 20 years

B: 20 years C: free

B: 1 year C: 1 year

Iraq’s Decision

High prod.

High prod.

Low prod.

Low prod.

Iraq - $60 billion Iran - $30 billion

$50 billion

each

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

It can be used in the arms race…

Firm 1: 0 Firm 2: $2m

It can be used in the everyday economic decisions……Consider 2 firms which must decide whether to make a new product or not….

Firm 1: $2m Firm 2: 0

Firm 1: 0 Firm 2: 0

SAMPLE AP TEST QUESTION

Quantity of Good X

D-MSB

MR

Marginal Social Cost

Marginal Private Cost

Negative

Why?

MSC > MPC The production of Good X creates an externality.

Quantity of Good X

D-MSB

MR

Marginal Social Cost

Marginal Private Cost

output.

Q2

Why?

MSC=MSB The production of Good X creates an externality.

Quantity of Good X

D-MSB

MR

Marginal Social Cost

Marginal Private Cost

maximizing monopoly.

Quantity of Good X

D-MSB

MR

Marginal Social Cost

Marginal Private Cost

MR

To produce socially optimum output, should

the government tax or subsidize the firm?

subsidize Suppose that good X is produced by a profit-

maximizing monopoly.

Quantity of Good X

D-MSB

MR

Marginal Social Cost

Marginal Private Cost

Identify equilibrium output in the absence of

regulation.

Q3 Suppose that good X is produced in a perfectly

competitive industry.

Quantity of Good X

D-MSB

MR

Marginal Social Cost

Marginal Private Cost

To produce at socially optimum output, should

the government tax or subsidize?

Tax Suppose that good X is produced in a perfectly

competitive industry.

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)