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Market Failures: External Costs and Benefits In its broadest definitional sense, collective action is the enactment and enforcement of law.. Now, using the principles and graphic analys

Chapter 6 Reasons for Firm Incentives 49

the cost will be borne by the employers Nothing is free in business, especially education No matter what the form, someone will pay the piper

Concluding Comments

Our message in this chapter and repeated elsewhere in this textbook, repeated and reinforced

with analysis and anecdotes is simple: Incentives are important They are worthy of serious reflection But that doesn’t mean to suggest that incentives are all that matter Surely, many

things matter As noted earlier, leadership, product design, and customer service, as well as company adaptability, culture, and goals, also matter However, we suspect that all of those good things in business might not matter very much or for long if the incentives are not right In their effort to get incentives right, it is altogether understandable why some firms will cover the cost of the MBA degree program for some of their workers (and not others) In general, firms can be expected to cover the cost of an MBA when they, the firms, can expect to capture the benefits On the other hand, the workers themselves can be expected to pay for their own degree expenses when they, the workers, expect to capture the benefits

We hope our discussion of the importance of incentives in understanding the

organization and performance of firms serves as an incentive to spend more time thinking and

reading about incentives, a subject to which we will return later in the book and course

Review Questions

1 Why are some firms “large” and other firms “small”? Use the concepts of “coordinating

costs” in your answer

2 Suppose firms get smaller Why might that happen?

3 If worker-monitoring costs go down, what will happen to the size of the firm?

4 What have been the various effects of the computer/telecommunication revolution on the

sizes of firms?

5 Why would a firm hire its own accountants to keep the books but, at the same time, use

outside lawyers to do its legal work?

6 If your firm fears being “held up” by an outside supplier of a critical part to your

production process, what can your firm do to reduce the chance of a hold up?

Market Failures: External

Costs and Benefits

In its broadest definitional sense, collective action is the enactment and enforcement of law The justification for all collective action, for government, lies in its ability to make men better off This is where any discussion of the bases for collective action must begin

ow much should government involve itself in the marketplace? How much does

business want government involvement.” These questions touch on one of the

most important economic issues of our time: the division of responsibility

between the public and private sectors In general, economic principles would suggest

that government undertake only functions that it can perform more efficiently than the

market As we will see, businesses are not always opposed to government involvement

in the economy Indeed, many businesses have incentives to try to make sure that

government is more involved in the economy than is “efficient.”

Economics provides a method for evaluating the relative efficiency of government

and the marketplace It enables the United States to identify which goods and services

the market will fail to produce altogether, and which it will produce inefficiently We

saw in an earlier chapter that such market failures have three sources: monopoly power,

external costs, and external benefits Now, using the principles and graphic analyses

developed in earlier chapters, we will take a closer look at external costs and benefits and

at government attempts to capture them and correct market failures (See later chapters

on monopoly and monopsony power.)

External Costs and Benefits, Again

In a competitive market, producers must minimize their production costs in order to

lower their prices, increase their production levels, and improve the quality of their

products Consumers must demonstrate how much they will pay for a product, and in

what amount they will buy it In a competitive market, production will move toward the

intersection of the market supply and demand curves Q1 in Figure 7.1 At that point

the marginal cost of the last unit produced will equal its marginal benefit to consumers

To the extent that the market moves toward equilibrium in supply and demand, it is efficient in a very special sense As long as the marginal benefit of anything people do is

greater than the marginal cost, people are presumed to be better off if quantity increases

In Figure 7.1, for each loaf of bread up to Q1, the marginal benefit of consumption (as

H

Chapter 7 Market Failures: External Costs

And Benefits

2

shown by the demand curve) exceeds the marginal cost of production (as shown by the

supply curve) Because the marginal cost of a loaf of bread is the value of the most

attractive alternative forgone, people must be getting more value out of each of those

loaves than they could from any alternative good By producing exactly Q1 loaves—no

more and no less—the market extracts the possible surplus or excess benefits from

production (see shaded area on the graph) and divides them among buyers and sellers In this sense, production and distribution of economic resources can be said to be efficient

Figure 7.1 Marginal Benefit versus Marginal Cost

The demand curve reflects the marginal benefits of

each loaf of bread produced The supply curve

reflects the marginal cost of producing each loaf

For each loaf of bread up to Q1, the marginal

benefits exceed the marginal cost The shaded area

shows the maximum welfare that can be gained

from the production of bread When the market is at

equilibrium (when supply equals demand), all those

benefits will be realized

These results cannot be achieved unless competition is intense, buyers receive all

the product’s benefits, and producers pay all the costs of production If such optimum

conditions are not achieved, the market fails Part of the excess benefits shown by the

shaded area in the figure will not be realized by either buyers or sellers

When exchanges between buyers and sellers affect people who are not directly

involved in the trades, they are said to have external effects, or to generate externalities

Externalities are the positive or negative effects that exchanges may have on people who

are not in the market They are third-party effects When such effects are pleasurable

they are called external benefits When they are unpleasant, or impose a cost on people

other than the buyers or sellers, they are called external costs The effects of external

costs and benefits on production and market efficiency can be seen with the aid of supply and demand curves

External Costs

Figure 7.2 represents the market for a paper product The market demand curve, D,

indicates the benefits consumers receive from the product To make paper, the producers

must pay the costs of labor, chemicals, and pulpwood The industry supply curve, S1,

shows the cost on which paper manufacturers must base their production decisions In a

perfectly competitive market, the quantity of the paper product that is bought will be Q2,

and the price paid by consumers will be P1

FIGURE 7.2 External Costs

Ignoring the external costs associated with the

manufacture of paper products, firms will base their

production and pricing decisions on supply curve S1

If they consider external costs, such as the cost of

pollution, they would operate on the basis of supply

curve S2, producing Q1 instead of Q2 units The

shaded area shows the amount by which the marginal

cost of production of Q2 Q1 units exceeds the

marginal benefits to consumers It indicates the

inefficiency of the private market when external costs

are not borne by producers

_

Producers may not bear all the costs associated with production, however A

by-product of the by-production process may be solid or gaseous waste dumped into rivers or

emitted into the atmosphere The stench of production may pervade the surrounding

community Towns located downstream may have to clean up the water People may

have to paint their houses more frequently or seek medical attention for eye irritation

Homeowners may have to accept lower prices than usual for their property All these

costs are imposed on people not directly involved in the production, consumption, or

exchange of the paper product Nonetheless, these external costs are part of the total cost

of production to society

In a perfectly competitive market, in which all participants act independently,

survival may require that a producer impose external costs on others An individual

producer who voluntarily installs equipment to clean up pollution will incur costs higher

than those of its competitors It will not be able to match price cuts, and so in the long

run may be out of business and some producers may not care whether they cause harm

to others by polluting the environment Even socially concerned producers cannot afford

to care too much about the environment

The supply curve S2 incorporates both the external production costs of pollution and the private costs borne by producers If producers have to bear all those costs, the price

of the product will be higher (P2 rather than P1), and consumers will buy a small quantity

(Q1 rather than Q2) Thus the true marginal cost of each unit of paper between Q1 and Q2

is greater than the marginal benefit to consumers If consumers have to pay for external

costs, they will value other goods more highly than those units In a sense, then, the

paper manufacturers are overproducing, by Q2 Q1 units The marginal cost of those

units exceeds their marginal benefit by the shaded triangular area

Chapter 7 Market Failures: External Costs

And Benefits

4

Other examples of external costs that encourage overproduction are the highway

congestion created by automobiles and the noise created by airplanes in and around

airports The argument can also be extended to include less obvious costs, like the death and destruction caused by speeding and reckless driving If government does not

penalize such negligent behaviors, people will produce them, at a potentially high

external costs to others In the same way, adult bookstores, X-rated movie houses, and massage parlors impose costs on neighboring businesses Their sordid appearance drives away many people who might otherwise patronize legitimate businesses in the area

External Benefits

Sometimes market inefficiencies are created by external benefits Market demand does

not always reflect all the benefits received from a good Instead, people not directly

involved in the production, consumption, or exchange of the good receive some of its

benefits

To see the effects of external benefits on the allocation of resources, consider the

market for flu shots The cost of producing vaccine includes labor, research and

production equipment, materials, and transportation Assuming that all those costs are

borne by the producers, the market supply curve will be S in Figure 7.3

Figure 7.3 External Benefits

Ignoring the external benefits of getting flu shots,

consumers will base their purchases on demand

curve D1 instead of D2 Fewer shots will be

purchased than could be justified economically Q1

instead of Q2 Because the marginal benefit of each

shot between Q1 and Q2 (as shown by demand curve

D2) exceeds it marginal cost of production, external

benefits are not being realized The shaded area abc

indicates market inefficiency

_

Individuals receive important personal benefits from flu shots The fact that many

millions of people pay for them every year shows that there is a demand, illustrated by

curve D1 in Figure 7.3 In getting shots for themselves, however, people also provide

external benefits for others By protecting themselves, they reduce the probability that

the flu will spread to others When others escape the medical expenses and lost work

time associated with flu, those benefits are not captured in the market demand curve, D1.

Only in the higher societal demand curve, labeled D2, are those benefits realized

Left to itself, a perfectly competitive market will produce at the intersection of the

market supply and market demand curves (S and D1), or at point c At that point the

equilibrium price will be P1 and the quantity produced will be Q1 If external benefits are considered in the production decision, however, the marginal benefit of flu shots between

Q1 and Q2 (shown by the demand curve D2) will exceed their marginal cost of production (shown by the supply curve) In other words, if all benefits, both private and external,

were considered, Q2 shots would be produced and purchased at a price of P2 At Q2, the marginal cost of the last shot would equal its marginal benefit Social welfare would rise

by an amount equal to the triangular shaded area abc

Because a free market can fail to capture such external benefits, government action

to subsidize flu shots may be justified On such grounds governments all over the world

have mounted programs to inoculate people against diseases like smallpox The external benefits argument has also been used to justify government support of medical research

It can also be extended to services such as public transportation City buses provide

direct benefits to the general population An informed and articulate citizenry raises both

the level of public discourse and the general standard of living.1 Public parks and

environmental programs can also provide external benefits that are not likely to be

realized privately, because of their high cost to individuals Again, government action

may be required to supplement private efforts

The Pros and Cons of Government Action

More often than not, exchanges between buyers and sellers affect others People buy

clothes partly to keep warm in the winter and dry in the rain, but most people value the

appearance of clothing at least as much as its comfort We choose clothing because we

want others to be pleased or impressed (or perhaps irritated) The same can be said about the cars we purchase, the places we go to eat, the records we buy, even the colleges we attend We impose the external effects of our actions deliberately as well as accidentally

The presence of externalities in economic transactions does not necessarily mean that government should intervene First, the economic distortions created by externalities are often quite small, if not inconsequential So far our examples of external costs and

benefits involved possibly significant distortions of market forces In Figure 7.4,

however, the supply curve S2, which incorporates both private and external costs, lies

only slightly to the left of the market supply curve, S1 The difference between the

market output level, Q2, and the optimum output level, Q1, is small, as is the market

inefficiency, shown by the shaded triangular area Therefore little can be gained by

government intervention

1

The ratio of public to private benefits varies by educational levels Elementary school education develops crucial social and communication skills; its private benefits are virtually side effects At the college level, however, the private benefits to students may dominate the public benefits Thus elementary education is supported almost entirely by public sources, while college education is only partially subsidized

Chapter 7 Market Failures: External Costs

And Benefits

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This limited benefit must be weighed against the cost of government action

Whenever government intervenes in any situation, agencies are set up, employees are

hired, papers are shuffled, and reports are filed Almost invariably, suits are brought

against firms and individuals who have violated government rules In short, significant

costs can be incurred in correcting small market inefficiencies If the cost of government

intervention exceeds the cost of the market’s inefficiencies, government action will

actually increase inefficiency

A second reason for limiting government action is that it generates external costs

of its own If government dictates the construction methods to be used in building

homes, the way mothers deliver their babies, or the hair lengths of government workers,

the people who set the standards impose a cost—which may be external to them—on

those who do not share their standards We may agree with some government rules, but strenuously object to others On balance, such government intervention is as likely to

hurt us as help us

Figure 7.4 Is Government Action Justified?

Because of external costs, the market illustrated

produces more than the efficient output Market

inefficiency, represented by the shaded triangular

area, is quite small—so small that government

intervention may not be justified on economic

grounds alone

Government dictates in educational institutions have sometimes imposed onerous costs on students For instance, until the late 1960s, the University of Virginia had a

dress code that required male students to wear coats and ties Colleges routinely set the hours by which students should return to their dormitories and expelled those who

rebelled At the University of California, students were once forbidden to engage in

on-campus political activity Costs are imposed on those who must obey such rules The

more centralized the government that is setting the standards, the less opportunity people will have to escape the rules by moving elsewhere

In certain markets, government action may not be necessary Over the long run, some of the external costs and benefits that cause market distortions may be internalized That is, they may become private costs and benefits Suppose the development of a park would generate external benefits for all businesses in a shopping district More

customers would be attracted to the district, and more sales would be made An alert

entrepreneur could internalize those benefits by building a shopping mall with a park in

the middle Because the mall would attract more customers than other shopping areas,

the owner could benefit from higher rents When shopping centers can internalize such

externalities, economic efficiency will be enhanced—without government intervention

When Walt Disney built Disneyland, he conferred benefits on merchants in the

Anaheim area Other businesses quickly moved in to take advantage of the external

benefits –the crowds of visitors—spilling over from the amusement park Disney did not make the same mistake twice When he built Disney World in Orlando, he bought

enough land so that most of the benefits of the amusement park would stay within the

Disney domain Inside the more than six thousand acres of Disney-owned land in

Florida, development has been controlled and profits captured by the Disney Corporation Although other businesses have established themselves on the perimeters of Disney

World, their distance from its center makes it more difficult for them to capture external

benefits from the amusement park

Methods of Reducing Externalities

Government action can undoubtedly guarantee that certain goods and services will be

produced more efficiently The benefits of such action may be substantial, even when

compared with the costs In such cases, only the form of government intervention

remains to be determined Government action can take several forms; persuasion;

assignment of communal property rights to individuals; government production of goods

and services; regulation of production through published standards; and control of

product prices through taxes, fines, and subsidies Economists generally argue that if

government is going to intervene, it should choose the least costly means sufficient for

the task at hand

Persuasion

External costs arise partly because we do not consider the welfare of others in our

decisions Indeed, if we fully recognized the adverse effects of our actions on others,

external cost would not exist Our production decisions would be based as much as

possible on the total costs of production to society

Thus government can alleviate market distortions by persuading citizens to

consider how their behavior affects others Forest Service advertisements urge people

not to litter or to risk forest fires when camping Other government campaigns encourage people not to drive if they drink, to cultivate their land so as to minimize erosion, and to

conserve water and gas Although such efforts are limited in their effect, they may be

more acceptable than other approaches, given political constraints

Persuasion can take the form of publicity The government can publish studies

demonstrating that particular products or activities have external costs or benefits The

resultant publicity may in turn encourage those activities with external benefits and

discourage those activities with external costs The government has, for example, used

this method in the case of cigarettes, publishing studies showing the external costs of

smoking

Chapter 7 Market Failures: External Costs

And Benefits

8

Assignment of Property Rights

As we saw in Chapter 1, when property rights are held communally or left unassigned,

property tends to be overused As long as no one else is already using the property,

anyone can use it without paying for its use Costs that are not borne by users, of course, are passed on to others as external costs When public land was open to grazing in the

West 150 years ago, for instance, ranchers allowed their herds to overgraze The external cost of their indiscriminate use of the land has been borne by later generations, who have inherited a barren, wasted environment

Thus the assignment of property rights can eliminate some externalities If land

rights are assigned to individuals, they will bear the cost of their own neglect If owners

allow their cattle to strip a range of its grass, they will no longer be able to raise their

cattle there—and the price of the land will decline with its productivity

Some resources, such as air and water, cannot always be divided into parcels In those cases, the property rights solution will work poorly, if at all

Government Production

Through nationalization of some industries, government can attempt to internalize

external costs The argument is that because government is concerned with social

consequences, it will consider the total costs of production, both internal and external

On the basis of that argument, governments in the United States operate schools, public

health services, national and state parks, transportation systems, harbors, and electric

power plants In other nations, government also operates major industries, such as the

steel and automobile industries

Government production can be a mixed blessing When other producers remain

in the market, government participation may increase competition Sometimes it means

the elimination of competition Consider the U.S Postal Service, which has exclusive

rights to the delivery of first-class mail As a government agency, the Post Office is not

permitted to make a profit that can be turnover to shareholders Because of its market

position with little competition for home delivery of mail, however, it may tolerate higher

costs and lower work standards than competitive firms

Some government production, such as the provision of public goods like national defense, is unavoidable In most cases, however, direct ownership and production may

not be necessary Instead of producing goods with which externalities are associated,

government could simply contract with private firms for the business That is precisely

how most states handle road construction, how several states handle the penal system,

and how a few city governments provide ambulance, police, and firefighting services

Taxes and Subsidies

Government can deal with some external costs by taxing producers Pollution can be

discouraged by a tax on either the pollution itself or the final product Taxing the

pollution emitted by firms internalizes external costs, increasing total costs to the

producer Imposing such taxes should have a twofold effect in reducing pollution First,

many producers would find the cost of pollution control cheaper than the pollution tax

Second, the tax would raise the prices of final products, reducing the number of units

consumed and hence reducing the level of pollution

The size of the tax can be adjusted to achieve whatever level of pollution is

judged acceptable If a tax on $1 per unit produced does not reduce pollution

sufficiently, the tax can be raised to $2 In terms of Figure 7.2, the ideal tax would be

just enough to encourage producers to view their supply curve as S2 instead of S1 The

resulting cutback in production from Q2 to Q1 would eliminate market inefficiency,

represented by the shaded area abc

Theoretically, the government could achieve the same result by subsidizing firms

in their efforts to eliminate pollution It could give tax credits for the installation of

pollution controls or pay firms outright to install the equipment In fact, until 1985, the

federal government used tax credits to encourage the installation of fuel-saving devices,

which indirectly reduced pollution

Production Standards

Alternatively, the government could simply impose standards on all producers It could

rule, for example, that polluters may not emit more than a certain amount of pollutants

during a given period Offenders would either have to pay for a cleanup or risk a fine A firm that flagrantly violated the standard might be forced to shut down

Choosing the Most Efficient Remedy for Externalities

Selecting the most efficient method of minimizing externalities can be a complicated

process To illustrate, we will compare the costs of two approaches to controlling

pollution, government standards versus property rights

Suppose five firms are emitting sulfur dioxide, a pollutant that causes acid rain

The reduction of the unwanted emissions can be thought of as an economic good whose

production involves a cost We can assume that the marginal cost of reducing sulfur

dioxide emissions will rise as more and more units are eliminated We can also assume

that such costs will differ from firm to firm Table 7.1 incorporates these assumptions

Firm A, for example, must pay $100 to eliminate the first unit of sulfur dioxide and $200

to eliminate the second Firm B must pay $200 for the first unit and $600 for the second Although the information in the table is hypothetical, it reflects the structure of real-world

pollution clean-up costs The technological fact of increasing marginal costs faces firms

when they clean up the air as well as when they produce goods and services

Suppose the Environmental Protection Agency (EPA) decides that the maximum acceptable level of sulfur dioxide is ten units To achieve that level, the EPA prohibits

firms from emitting more than two units of sulfur dioxide each If each firm were

emitting five units, each would have to reduce its emissions by three units The total cost