Lecture Principles of Microeconomics: Chapter 13 - James D. Miller

The main contents of the chapter consist of the following: Annuities: ordinary annuity and annuity due (find future value), present value of an ordinary annuity (find present value), sinking funds (find periodic payments).

Chapter 13

Challenge To Market Effectiveness 3: Externalities And The Environment

Learning Objectives

• What are negative and positive externalities?

• What is the pollution problem?

• What are the methods of reducing the pollution problem?

• What is the challenge of global warming?

• What are the methods of reducing traffic jams?

• What role does politics play in externalities?

• What are the environmental problems caused by the government?

• What are technological spillovers?

The Pollution Problem

• Without government assistance, Adam

Smith’s invisible hand does little to reduce pollution

• As pollution is created by imperfect

markets and regulated by imperfect

governments, there is no ultimate pollution solution.

• Positive externalities are benefits received by people

other than the buyer and seller of a good

• Self-interested individuals will buy less than the socially optimal number of positive externality goods, e.g

vaccine and perfumes

Externalities and Anti-Theft Devices

• The Club is a metal “club” that locks through a

steering wheel, preventing a thief from turning the wheel

• One car owner’s use of The Club therefore

decreases the chance of his car getting stolen, but increases the chance of another car being pilfered: Negative externality

• LoJack is a tiny electronic locator When a car with LoJack is stolen, the locator is activated, signaling the car’s location to the police

• Widespread use of LoJack makes it less likely that thieves will steal any car since they don’t know

Methods of Reducing the Harm of Pollution

Forbidding all pollution:

• Many valuable economic activities

create pollution If the government banned all types of pollution, it would drastically reduce economic

production

Command and control approach:

• The government tells each firm how much it can pollute

and what kind of pollution-reducing technologies it must employ

This approach suffers from two problems:

1 Information Deficiencies

• Markets excel at gathering and organizing information

whereas government bureaucrats tend to be

informationally challenged

2 Governmental Corruption

• Self-interested politicians are most often motivated to

protect their supporters rather than enacting socially

optimal pollution regulation

Methods of Reducing the Harm of Pollution

Methods of Reducing

the Harm of Pollution

Pigouvian taxes:

• According to Arthur Pigou, governments should tax goods that

create negative externalities

• Such “Pigouvian taxes” reduce individual’s incentives to use such

goods

The advantages of Pigouvian taxes over command and control approach:

• Taxation allows firms to pick their own level of pollution.

• Firms have an incentive to reduce their pollution since less

pollution means lower taxes

• Taxation gives firms flexibility in deciding how to reduce pollution

Pollution taxes create incentives for firms to use the most cost efficient pollution-reducing methods.

• Taxation creates incentives for pollution technological innovation

Supply, Demand, and Pigouvian Taxes

• Externalities, by

definition, don’t affect

consumers or producers

directly

• Externalities don’t have

any direct effect on

supply and demand

curves

• However, externalities

create deadweight loss

• The Pigouvian tax

$13

Pollution externality =$3

Supply with tax

Pigouvian tax =$3

Externality and Pigouvian Taxes

• Pigouvian taxes force people and firms to internalize any externalities they cause

• Internalizing Externalities means forcing someone to fully take into account the harm his externalities cause when deciding how much of the product to use

• By forcing the creators of externalities to pay a tax equal

to the harm caused to others by their activity, Pigouvian taxes cause consumers and firms to engage in

externality-causing activities only when the benefit of the activity exceeds the total social cost of the activity

• However, the government can’t set limits on the total

amount of pollution with Pigouvian taxation Pigouvian taxation works best when the harm of pollution is always proportional to the amount of pollution

Methods of Reducing the Harm of Pollution

Tradable permits:

• Under this system, firms are given permits to pollute

only up to the amount covered by the permits

• A firm can use its permit, buy permits from other firms

or sell its permits to other firms

The advantages of tradable permits are identical to those of Pigouvian taxes

• They give tremendous flexibility to firms in deciding

how to combat pollution

• They ensure that only firms that place a relatively high

value on pollution end up polluting

• They create a market for pollution-reduction

Tradable Permits vs Pigouvian

Taxation

• Only tradable permits allow the government to set the

total amount of pollution that will be generated

• If the government can determine the optimal level of

pollution, then tradable permits are socially superior to Pigouvian taxes

• If the government doesn’t know the optimal level of

pollution, then the government should use Pigouvian

taxes to allow the market to set the optimal level of

pollution

• A tradable permit system allows environmentalists to buy and then not use pollution permits

Methods of Reducing

the Harm of Pollution

The Coase Theorem:

• The government should do nothing and allow the

Coase Theorem to work

• According to the Coase Theorem, if parties can

negotiate without any barriers, they will always be able

to eliminate wealth-destroying negative externalities

• However, there are often many barriers to negotiation

• The Coase Theorem indicates that only when a small

group of people are harmed by an externality they can remedy the situation through negotiations

Pollution and Poor Countries

• A clean environment is a normal good, meaning that the richer someone is, the greater monetary value they place on it

• Polluting the air of a poor country may cause

less harm (measured in dollars) than polluting the air of a rich country

• As a result, everyone could benefit if rich

countries exported their polluting industries to

poor nations and compensated these poor

countries for the pollution externalities.

Global Warming

• Most climate scientists believe that the

greenhouse gases created burning fuel are

causing the temperature of the earth to rise

• If global warming is a threat to humanity, then

burning fuels creates a global negative

externality

• The best way to reduce greenhouse gas

emissions is to tax them or set up a system of tradable greenhouse gas emission permits.

Global Warming

A Technological Argument for Doing Nothing About Global Warming:

• There is a huge lag between greenhouse gas emissions and the earth’s

temperature

• So, any efforts we take today to reduce greenhouse gases won’t have much effect on the earth’s temperature for a few decades.

• In a few decades, humanity will have vastly better technology that will

probably make it cheaper to end global warming

A Technological Argument for Taking Immediate Action Against Global

Warming:

• Technological innovation can be a long and costly process

• To find a long-term technological solution to global warming, perhaps we should start taxing greenhouse gases today.

• The best long-term environmental strategy to protect us from global

warming is to keep increasing the wealth of humanity

Traffic Jams

• Each vehicle on a crowded road increases the time it takes other cars to reach their destination.

• Traffic delay is a negative externality of driving

• Very few motorists are altruistic enough to take into account their negative traffic externalities.

• We need to rely on the government to reduce

traffic jams

Methods to Reduce Traffic Jams

Gas taxes:

• Gas taxes raise the cost of driving and so

reduce the total amount of driving and traffic jams

• But they fail to induce motorists to switch to

driving at times or on roads where there is little traffic

• Under some circumstances, gas taxes can

even increase traffic congestion

Methods to Reduce Traffic Jams

Toll roads:

• Tolls can force drivers to internalize their

negative traffic externalities

• Governments can impose tolls only on

motorists driving over busy roads

• Unfortunately, most U.S states use toll roads

as a source of revenue, not for traffic

management.

Methods to Reduce Traffic Jams

Subsidize Mass Transportation:

• On crowded roads in equilibrium, drivers receive zero

economic profit

• When the government initially subsidizes mass

transport, the number of drivers on a busy road

decreases

• But this decline in traffic reduces the opportunity cost

of driving and creates a disequilibrium because drivers

on this slightly less busy road now receive positive

profits

• These profits attract new drivers and so increase the

delay

• In equilibrium, drivers must again receive zero profit

and face the exact same delay they did before the

mass transport system was built.

Methods to Reduce Traffic Jams

Building more roads:

• Building additional roads attracts new drivers

Road construction therefore often doesn’t

reduce traffic congestion.

• When a government builds new roads, it

initially reduces the commute time and so

subsidizes people living farther from their city jobs

• As workers move farther from their jobs they

drive more miles, creating more negative traffic externalities.

Politics and Externalities

• Governments play a huge role in regulating externalities.

Accidents and car weight:

• Since heavy cars create significant negative externalities, many

economists would prefer that governments discourage consumers from buying SUVs through either tax on SUVs or subsidies for small cars

• But for a period the U.S government provided massive subsidies for SUVs

Driving while elderly:

• Impaired elderly drivers create greater negative externalities as they are more likely to get into accident.

• However, the elderly have tremendous political power in the U.S.,

so politicians fear restricting the driving rights of the elderly

Politics and Externalities

Driving while drunk:

• The group Mothers Against Drunk Driving (MADD) has led a

successful long-term U.S political campaign to increase penalties for drunk drivers

• MADD shows that to get the government to take action against

negative externalities one must organize politically so that it

becomes in the self-interest of politicians to regulate the externality.

Driving while cell-phoning:

• Several studies have concluded that talking on a cell phone while driving is at least as dangerous as driving while drunk.

• However, there is no regulation against it because there has been

no organized political campaign against cell phone driving

Banning DDT:

• In the 1970s, the U.S and the Western European

nations not only banned DDT in their own borders but also used their foreign aid budgets to bully poor nations into banning the mosquito-killing insecticide DDT

Mosquito-born diseases are one of the greatest killers of humans

Government-Caused Environmental

Problems

Drying the Aral Sea:

• Among the environmental disasters caused by the

former Soviet Union was the drying out of the Aral Sea to obtain water to grow cotton

Killing Sparrows:

• Former Chinese dictator Mao Zedong decided to kill all

of China’s sparrows

Destroying Trees to Make Useless Steel:

• Mao Zedong forced Chinese peasants to set up small

steel furnaces all over China To feed these furnaces

peasants cut down all the trees on many mountains and

Technological Spillovers

• Innovation is the primary cause of economic growth

• On an average, around 80% of the gain from innovations goes to people other than the innovators

• Most of the wealth that people in rich countries have is due to these technological spillovers

• Even when firms succeed in profiting greatly from their innovations, they still create enormous spillovers

• Because innovation creates such enormous positive

externalities, firms engage in less than the socially

optimal level of innovation

Do You Know?

• Why are products with negative externalities overused?

A negative externality is a cost paid by people other than the buyer or seller of a good Self-interested buyers and sellers don’t take into account negative externalities in their decision-making and hence overuse the those

products

• What are Pigouvian taxes?

Pigouvian taxes are taxes on creating negative

externalities These taxes such as pollution taxes force people and firms to internalize any externalities they

cause

Do You Know?

• What are tradable pollution permits?

Tradable pollution permits are permits that allow firms to pollute only up to the amount covered by the permits A firm can use its permit, buy permits from other firms or sell its permits to other firms They give tremendous

flexibility to firms in deciding how to combat pollution

• What are technological spillovers?

Technological spillovers are the gains from innovations that go to people other than the innovators

Technological spillovers create positive externalities

Summary

• As pollution is created by imperfect markets and

regulated by imperfect governments, there is no ultimate pollution solution

• A negative externality is a cost paid by people other than the buyer or seller of a good

• Positive externalities are benefits received by people

other than the buyer and seller of a good

• Pigouvian taxes and tradable permits are the better

methods of reducing the harm of pollution among others

• Pigouvian taxes force people and firms to internalize any externalities they cause

• Tradable permits allow the government to set the total amount of pollution that will be generated

Summary

• Poor countries are under polluted

• The best long-term environmental strategy to protect us from global warming is to keep increasing the wealth of humanity while taxes or tradable permits for greenhouse gas emission can work in the short run

• We need to rely on the government to reduce the

negative externality of traffic jams

• Toll roads are one of the best methods of reducing traffic jams

• Politics influences governments’ role in regulating

Coming Up

What are property rights?