externalities&publicgoods

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2

Defining Externalities

An externality is the effect of one party¶s

economic activities on another party that is nottaken into account by the price system.

Externalities can occur between any twoeconomic actors.

Externalities can be beneficial or harmful.



3

Defining Externalities (cont.)

If social costs are greater than private costs, then anegative externality is present. Environmental pollution

is an example of a social cost that is seldom bornecompletely by the polluter thereby creating a negativeexternality.

If private costs are greater than social costs, then apositive externality exists. An example is when a

supplier of educational services indirectly benefitssociety as a whole but only received payment for thedirect benefit received by the recipient of theeducation: the benefit to society of an educatedpopulace is a positive externality.



4

Negative Externalities

± Automobile exhaust

± Cigarette smoking

± Barking dogs (loud pets)

± Loud stereos in an apartment building



5

Positive Externalities

± Immunizations ± Restored historic buildings

± Research into new technologies



6

Externalities between Firms

Consider two firms--one producing eyeglasses,

and another producing charcoal. The production of charcoal is said to have an

external effect on the production of eyeglassesif the output of eyeglasses depends not only on

the amount of inputs chosen by the eyeglassfirm but also on the level of production of charcoal.



7


Suppose the eyeglass firm is near and

downwind from the charcoal company. The amount of eyeglasses may depend upon

the amount of charcoal in the air which affectsthe precision grinding wheels.

The level of eyeglass production is partiallydetermined by the amount of charcoalproduced, with more charcoal reducing theamount of eyeglasses.



8


One of the most famous beneficial externalities

between firms involves one firm producinghoney and the other producing apples.

± Bees feed on apple blossoms, which increases theproduction of honey, and

± Bees pollinate apple crops, which increases theproduction of apples.



9

Externalities

Firms can generate air, water, and other

types of pollution when producing products. Alternatively, auto pollution, graffiti, and noise

are some externalities imposed by people onfirms.

When people do things that harm others, likeplaying their radios loudly, or help, likeshoveling their sidewalk, they can imposeexternalities on other people.



10

Reciprocal Nature of Externalities

In dealing with externalities it is important to

recognize that both parties are needed for anexternality to exist.

± If the eyeglass producer was not located near thecharcoal factory, there would be no externality.

± If another person was not around, no one would bebothered when someone plays their radio loudly.



11

APPLICATION 16.1: Secondhand Smoke

Secondhand smoke (officially, environmental

tobacco smoke, or ETS ), refers to the effects of smokers¶ consumption of cigarettes and other tobacco products on third-party bystanders.

The harm of ETS is controversial, but the

Environmental Protection Agency estimatesapproximately 2,200 deaths annually.



12

APPLICATION 16.1: Reciprocal Natureof the ETS Externality

Smokers potentially harm bystanders, but

limiting the ³rights´ of smokers imposeinconveniences as well.

± One study suggests that workplace restrictions onsmoking results in a loss of approximately $20

billion per year in consumer surplus. Such estimates, like those of the harms of ETS, are controversial.



13

APPLICATION 16.1: Private Action andPublic Actions

Many private decisions have limited smoking in

the workplace and in public areas. The Occupational Safety and Health

Administration has proposed banning allworkplace smoking.

Many question whether governmental action isnecessary given the private actions alreadytaken.



14

Externalities and AllocationalEfficiency

The presence of externalities can cause amarket to operate inefficiently.

± In the previous example an externality affected theproduction of eyeglasses.

± The firm producing charcoal did not take into

account the negative effect its production had on theproduction of eyeglasses.



15

Social Costs

Social costs are the costs of production that

include both input costs and costs of theexternalities that production may cause.

± In the previous example, by not recognizing theexternality in its production, the charcoal firm

produced too much. ± Society would be better-off by reallocating

resources away from charcoal production andtoward the production of other goods.



16

A Graphical Demonstration

Assume the charcoal producer is a price taker

so that its demand curve is horizontal, asshown in Figure 16.1.

± The firm maximizes profits, given the prevailingmarket price, by producing q* where price(P*) equals

marginal cost(MC

). ± Due to the externality, however, the social marginal

cost (MCS) exceeds MC.



17

MCS

MC

EP*

Charcoalper week

0 q*

Price,

costs of

charcoal

FIGURE 16.1: An Externality in Charcoal ProductionCauses an Inefficient Allocation of Resources



18

A Graphical Demonstration

± The cost of the externality is shown by the vertical

distance betweenMSC

andMC

. ± At q* the social marginal cost exceeds what people

are willing to pay for the charcoal, P*.

± Resources are misallocated and production shouldbe reduced to q¶ where MSC equals P*.

± The reduced total social costs (area ABq*q¶) exceedthe reduced total spending (area AEq*q¶).



19

MCS

MC

E

B

A

C

P*

Charcoalper week

0q¶ q*

Price,

costs of

charcoal

FIGURE 16.1: An Externality in Charcoal ProductionCauses an Inefficient Allocation of Resources



20

Property Rights

Property rights are the legal specification of

who owns a good and the trades the owner isallowed to make with it.

Common property is property that may beused by anyone without cost.

Private property is property that is owned byspecific people who may prevent others fromusing it.



21

Costless Bargaining andCompetitive Markets

Considering the charcoal-eyeglass externality,

suppose property rights were defined so as togive sole rights to use the air to one of thefirms.

± The firms were then free to bargain over how the air

might be used. If bargaining is costless the two parties might

arrive at q¶ on their own.



22

Ownership by the Polluting Firm

If the charcoal firm owns the land, it must add

these ownership costs to its total costs. ± The costs of polluting the air are what someone else

is willing to pay for this resource (clean air) in itsbest alternative use.

±

The eyeglass company would be willing to pay thean amount equal to the external cost the charcoalcompany is imposing.



23

Ownership by the Polluting Firm

± The charcoal company¶s marginal cost will be MSC,

and it will produce q¶. ± The charcoal company will sell the remaining air use

rights to the eyeglass maker for a fee of someamount between AEC (the lost profits of producingq¶ rather than q*) and ABEC (the maximum amount

the eyeglass maker would be willing to pay to avoidhaving the charcoal producer increase production toq*.



24

Ownership by the Injured Firm

If the eyeglass maker owns the air, the

charcoal firm will offer a payment to use theair associated with output level q¶.

± The eyeglass owner will not sell rights to pollutebeyond this because the price that the charcoal

maker would be willing to pay (P*

-MC

) falls shortof the cost of this additional pollution (MCS - MC).

The socially optimal charcoal output, q¶, isproduced in this case as well.



25

The Coase Theorem

The Coase theorem (first proposed by Ronal

Coase) states that, if bargaining is costless,the social cost of an externality will be takeninto account by the parties, and the allocationof resources will be the same no matter how

property rights are assigned. In the previous example, q¶ was produced

regardless of who owned the air.



26

Distributional Effects

The assignment of property rights does affect

the distribution of the benefits. ± If the charcoal maker receives the property rights,

the fees from the eyeglass producer will make it atleast as well off as if it produced q*.

± If the eyeglass producer receives the propertyrights, the fees from the charcoal producer will atleast cover the pollution damage.

Factors, such as equity may be important.



28

APPLICATION 16.2: Property Rights inNature²Bees and Apples

In many locales contractual bargaining

between beekeepers and orchard ownersprovide for renting bees for the pollination of many crops.

Rents appear to accurately reflect the value of

honey that is yielded with higher rents for clover growers because apple blossoms yieldless honey.



29

APPLICATION 16.2: Property Rights inNature²Shellfish

Overfishing creates an externality since no

single fisher takes into account the fact that hisor her catch with reduce others catches.

Coastal situations allow property rights soowners can consider harvesting practices.

± One study suggests that oyster yields were higher inVirginia because it made it easier to enforceproperty rights.



30

APPLICATION 16.2: Property Rights inNature²Elephants

In the past, ivory hunters have lead to a decline

of over 50 percent of the population in East African countries.

Recently, villages received property rights toelephants and sold limited numbers of

elephants for hunting. Elephants populations in these areas are on

the rise.



31

Externalities with High

Transactions Costs

When transactions costs are high, externalities

may cause real losses in economic welfare. The fundamental problem is that, with high

transactions costs, economic actors face nopressure to recognize the third-party effectsthey have.

All solutions to externality problems in thesecases must therefore find some way to get theactors to ³internalize´ the third-party effectsthey cause.



32

Legal Redress

The operation of the law may sometimes provide

a way for taking ex

ternalities into account. If the charcoal producer in Figure 16.1 can be

sued for the harm it does to eyeglass makers,payment of damages will increase the costs

associated with charcoal production. Hence, the charcoal MC curve will shift upward

to MCS and an efficient allocation of resourceswill be achieved.



34

MCS

MC

E

B

A

C

P*

Charcoalper week

0q¶ q*

Price,

costs of

charcoal

FIGURE 16.2: Taxation Solution to theExternality Problem

P* - t



35

Regulation of Externalities

An alternative to taxation is regulation.

The horizontal axis in Figure 16.3 showspercentage reductions in pollution that wouldexist without regulation.

The curve MB shows the marginal benefit by

reducing pollution by one unit. ± The shape comes from the assumption of

diminishing returns.



36

MB

MC

f*

Reduction

in emission

0 100R*

Marginal

benefit,

cost

FIGURE 16.3: Optimal PollutionAbatement



37

Regulation of Externalities

The curve MC reflects the marginal costs in

reducing environmental emissions includingforegone profits and the costs of antipollutionequipment.

± The positive slope reflects the assumption of

increasing marginal costs. R* is the optimal level of pollution where the

marginal benefits equal marginal costs.



39

Fees

An ³effluent fee´,f *in Figure 16.3, is charged

for each percent that pollution is not reduced. ± For reductions less than R*, the fee exceeds

marginal cost, so firms will choose abatement.

± Reductions greater than R* would not be

profitable. The firm is free to choose its method to

reduce pollution.



40

MB

MC

f*

Reductionin emission

0 RL RH 100R*

Marginal

benefit,

cost

FIGURE 16.3: Optimal PollutionAbatement



41

Permits

Government issued permits would allow firms

to ³produce´ (100 - R*

) percent of their unregulated emission levels.

As shown in Figure 16.3, freely traded permitswould sell for a price of f *.

A competitive market will ensure that theoptimal level of emissions reductions will beattained at minimal social cost.



42

Direct Controls

Governments can tell firms the level of

emissions they would be allowed, and, in manycases, are accompanied by specification of theprecise mechanism by which R* is to beachieved.

± This is a common approach in the U.S. ± Specification of the mechanism of reduction may

reduce the cost-minimization incentive.



43

APPLICATION 16.3: Regulating Power Plant Emissions

Many electric power plants burn coal for fuel.

This generates some byproducts includingsulfuric acid which is associated with thecreation of ³acid rain´ which harms lakes andforests.

± Acid rain is found in the eastern U.S. and Canadaas well as Europe, Russia, and China.



44

APPLICATION 16.3: Regulation of Production Technology

The U.S. has used a ³command-and-control´

(C AC) approach. Air quality standards are defined by law and

plants are required to install specificequipment; with most requiring ³scrubbers´ that

clean exhaust fumes in their stacks. Studies suggest that these costs exceed

minimum costs by a factor of two.



45

APPLICATION 16.3: Emission Charges

A more efficient alternative would be to impose

a Pigouvian tax on emissions. ± Firms could choose any technology that gives

emission reductions at a marginal cost that is lessthan or equal to the tax.

± S

tudies suggest this is considerable more costeffective, but will decrease the demand for easternU.S. coal (with employment losses), which is notpolitically popular.



46

APPLICATION 16.3: Emissions Trading

The Clean Air Act amendments of 1990 allow

power plants who reduce their pollution levelsbelow specified standards to sell credits toother firms.

± This allows other firms to subsidize the reductions

of emissions by those firms who can achieve lowpollution with the least cost.

± This has achieved savings of approximately 50percent over regular C AC approaches.



48

Attributes of Public Goods

Nonexclusive goods are goods that provide

benefits that no one can be excluded fromenjoying.

± National defense is an example since, once anarmy or navy is set up, everyone in the country

receives protection whether they pay or not. ± Alternatively, a hamburger is exclusive since,

someone can be excluded from consuming if theydo not pay for it.



49

Attributes of Public Goods

Nonrival goods are goods that additional

consumers may use at zero marginal cost. ± For example, one more person crossing an already

existing bridge during an off-peak period requires noadditional resources and does not reduceconsumption of anything else.



50

Public Goods

Public goods provide nonexclusive benefits to

everyone in a group and that can be providedto one more user at zero marginal cost.

Table 16.1 presents a cross-classification of goods by their possibilities for exclusion and

rivalry.



52

Public Goods and Market Failure

In buying a public good, any one person will

not be able to appropriate all the benefits thegood offers.

Since others can not be excluded they can usethe good at zero marginal cost, society¶s

benefits from the public good exceed thebenefits to the single buyer.



53


However, the buyer will not take societiesbenefits into consideration.

As a result, private markets will tend tounderallocate resources to public goods.

Figure 16.4 shows a situation two people

have a demand for a public good. The totaldemand for the public good is the vertical

sum of each persons demand curve.



54

Total demand

Demand by

person 2

Demand by

person 1

Quantity of

public goodper week[ , ] Denotes equal distances

Willingness

to pay

|

|

|

!

!

!

FIGURE 16.4: Derivation of the Demand

for a Public Good



55


Each point on the total demand curve shows

what persons 1 and 2, together, are willing topay for a particular level of the public good.

Because each individual¶s demand curve isbelow the total demand curve, no single buyer

is willing to pay what the good is worth tosociety.



56

Voluntary Solutions for Public

Goods

Since public goods cannot be traded efficiently

in competitive markets, one approach dealswith whether an efficient allocation might comeout voluntarily.

± Would people agree to be taxed in exchange for the

benefits the public good provides? One solution was proposed by Erik Lindahl in

1919.



57

The Lindahl Equilibrium

In Figure 16.5, the curve labeled SS shows

one person¶s (S

mith) demand for a particular public good.

± The vertical axis measures the share of the publicgood¶s cost that Smith must pay.

±

The negative slope of SS

indicates that, at a higher tax ³price´ for the public good, Smith¶s quantitydemanded is smaller.



58

S

S

Quantity of

public good

Share of cost

paid by Smith100

0

FIGURE 16.5: Lindahl Equilibrium in the

Demand for a Public Good



59


The second individual¶s (Jones) public good

demand curve is derived similarly, but theproportion paid by Jones is shown on the rightaxis.

± The right axis is reverse scale so that moving up the

ax

is results in a lower tax

paid by Jones. ± Given this convention, Jones¶s demand curve (JJ)

has a positive slope.



60

SJ

S

J

Quantity of

public good

Share of cost

paid by Smith 100

0 100

Share of cost

paid by Jones0





61


The two demand curves intersect at C with an

output levelOE

of the public good. ± At this output level Smith is willing to pay 60 percent

of the good¶s cost whereas Jones willingly pays 40percent.

± At outputs below OE, the two people combines arewilling to pay more than 100 percent of the cost of the public good.



62

C

SJ

S

J

60

Quantity of

public goodE

Share of cost

paid by Smith 100

40

0 100

Share of cost

paid by Jones0





63


± For output levels greater than OE, people are notwilling to pay the total cost of the good.

Output level OE is a Lindahl equilibrium

which is a balance between people¶s demandfor public goods and the tax shares that each

must pay for them. ± The tax shares are ³pseudo prices,´ and the

outcome can be shown to be efficient.



64

Revealing the Demand for Public

Goods: The Free Rider Problem

The voting patterns of people generally do not

provide enough information to permitLindahl¶stax share to be computed.

Alternatively, governments might ask peoplehow much they are willing to pay for a

particular package of public goods. ± It is likely that this poll would prove to be extremely

inaccurate because of free riders.



65

The Free Rider Problem

People may feel that they should understate

their true preferences to reduce their tax liability with the hope that others will be willing

to bear the burden of paying the taxes for thepublic good.

A free rider is a consumer of a nonexclusivegood who does not pay for it in the hope thatother consumers will.



66

APPLICATION 16.4: Why is There So

Much Fund-Raising Public Broadcasting?

The public radio and television broadcasting

corporations in the U.S

. were intended to besupported primarily by listeners and viewersthrough voluntary contributions.

Since users can not be excluded from using

what is ³on the air´ and costs do not increase if another user tunes in, broad-casting appearsto be a pure public good.



67



However, thriving commercial markets suggest

that broadcasting may not be underproduced. Viewed as a mechanism for delivering

advertising messages, broadcasting is bothexclusive (advertisers must pay) and rival (only

one advertiser can use a time slot).



68



An alternative justification is that certain types

of broadcasting will be unattractive toadvertisers (for example, cultural) and will beunderprovided in private markets.

However, the free rider problem tends to

undermine voluntary support. ± Fewer than 10 percent of the viewers of public

television make voluntary contributions.



71

Direct Voting and Resource

Allocation

In some situations, people vote directly on

policy questions. While majority rule is a common criteria, many

cases require even greater amounts (even 100percent in Quaker meetings) to win in a voting

situation. ± However, for what follows, majority rule is assumed.



72

TABLE 16.3: Preferences That Produce

the Paradox of Voting

Voter Order of Pref erencesSmith A B C

Jones B C A

Fudd C A B



73

The Paradox of Voting

Majority-rule voting systems may not arrive at

an equilibrium but instead may cycle amongalternative options.

This paradox is illustrated in Table 16.3.

± Suppose there are three voters (Smith, Jones, and

Fudd) choosing among three policy optionsregarding spending on a particular public good (A =low, B = medium, and C = high).



74

The Paradox of Voting

± Preferences of the three voters are indicated by theorder listed in the table. For example, Smith prefers A to B and B to C.

± In a vote between A and B option A would win.

± Similarly, a vote between A and C would result inoption C winning.

± But, a vote between C and B would find B (whichlost to A above, and A lost to C) winning.



75

Single-Peaked Preferences and the

Median Voter Theorem

Equilibrium voting outcomes can always occur

in cases where the issue being voted upon isone-dimensional and where voters¶preferences are ³single-peaked.´

In Figure 16.6, the preferences that give rise to

the paradox of voting are shown by assigninghypothetical utility levels to A, B, and C.



76

Single-Peaked Preferences and the

Median Voter Theorem

The preferences of Smith and Jones are

single-peaked--as levels of public goods¶expenditures rise, there is only one local utilitymaximizing choice (A for Smith, B for Jones.

Fudd has two local peaks (A and C).

± If Fudd¶s preferences were represented by thedashed line, option B would defeat both A and C.



77

Quantity of

public good

FuddFudd (alternate)

Jones

Smith

A CB

Utility

FIGURE 16.6: Single-Peaked Preferences and

the Median Voter Theorem



79

APPLICATION 16.5: Referenda on

Public Spending

California¶s Proposition 13, passed in 1977,

required that property inC

alifornia be tax

ed ata maximum rate of 1 percent of the 1975 fair market value.

± It also imposed sharp limits on tax increases infuture years.

± Local property tax revenues declined by nearly 60percent between fiscal 1978 and 1979.



80


Public Spending

One explanation for the passage of this law

was a demand for changing the sources of local tax revenues.

± Citizens were largely content with existing levelsof local services but wanted state tax sources(income and sales, primarily) to take over a larger share of the burden.



82

APPLICATION 16.5: Referenda on Public

Spending--Massachusetts and Michigan

In Massachusetts, the 1980 passage of Proposition 2½, similar to Proposition 13, wasfueled by a preference for ³greater efficiency´in government.

The Michigan ³Headler Amendment,´ which

proposed to limit state taxes, also appeared tostem from preferences for more efficiency.



83


Public Spending --Home Rule in Illinois

³Home Rule,´ which eliminates state-levelrestrictions on spending, was adopted bycommunities in Illinois. ± More heterogeneous groups appeared to want to

limit local spending.

± More homogeneous groups wanted to forsake the

spending restrictions.

± The homogeneous groups have similar interestswith respect to government size and functions.



Representative Government and

Bureaucracies

In a representative government, individuals

vote for directly for candidates, not policies. This raises the issue of whether or not

representatives will actually vote the way their constituents want and present the possibility

for rent-seeking behavior where firms or individuals influence government policy toincrease their own welfare.

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