topic 4 externalities and public goods

Public Economics 2013-‐2014 Manon Cuylits

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Topic 4: Externalities and public goods The 2 mains problems we have regarding climate change are public goods and externalities.

1. Public goods

1.1. Definition A good is called “pure public good” if it is characterized by non-‐rivalry and non-‐excludability in consumption. The 2 criteria are:

• Non-‐rivalry: once it has been provided, the additional resource cost of another person consuming the good is zero. We have the good, we can consume a 100% and someone else also can, with the same good.

• Non-‐excludability: to prevent anyone from consuming the good is either impossible or very expensive

Example: lighthouse, national defence, education è Education:

• Rivalry: there can’t be 300 students in a room for 20 students • Excludability: some people can actually be excluded

So education can be a public good to some extent.

Remarks:

• The consumption of the public good need to be valued equally by all (although everyone consumes the same quantity)

• Degree of publicness: classification as a public good depends on market conditions and technology è from few public goods to many public goods = degree of publicness

• Private goods are not necessarily provided exclusively by the private sector è ex: house and services (logements sociaux) is a private good provided by the public sector. You might have private goods provided by the public sector: public good ≠ public sector

• Public provision of a good does not necessarily mean public production of that good (e.g.: refuse collection) è garbage collection = thing organized by public authorities but it’s often the case that it’s made by private companies, though it’s public money.


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1.2. Efficient provision of public goods

Public goods: vertical summation of individual demand curves. è Vertical summation because if a public good is provided, it means everyone can consume it. Intuition: firework example Fireworks are done for one person but that’s the same cost if it is done for more people: everyone can see it, it’s difficult to forbid people to watch it. è We decide to make a firework:

-‐ How much will it cost? -‐ How much did we like it? -‐ Should we have a firework with another rocket? An additional one?

• 19 rockets – 5€/rocket • Valuation of an additional rocket (in €)

Case I II III By Alice 4 6 1 By Bob 6 3 2 Provision? Yes Yes No

What if we had 1 additional rocket?

♥ Alice values it 4 ♥ Bob values it 6 ♥ Total valuation = 4+6 = 10.

10 is above the cost (5€ per rocket), so we decide that we should have an additional rocket. What about 2 additional rockets? The total valuation = 6, so we should have 2 additional rockets. However, 3 additional rockets would not be worth it. Indeed, the benefit of it would be lower than its price. Thus: provide public good such that the sum of each person’s marginal valuation on the last unit just equals the marginal cost.

Here we have the supply and demand of a good (food). The supply comes from companies while the demand comes from consumers.

Private good: horizontal summation of individual demand curves è demand for A, B, etc.: each consumers are not asking the same things, we have to sum for each level of the price, the demand for each consumer. Property: MRTD,F = MRSAD,F = MRSBD,F


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1.3. The free-‐rider problem Incentive to avoid paying for the public good (let the others pay for it, still enjoy it). When everyone does so, the public good is underprovided. Sometimes, public goods are underprovided. If there’s no one to put people together and to build the roads, there are free-‐riders4 benefiting from the people doing something. Ex: should we build a swimming pool? :

ü How much do we value it? ü How much will we pay to have it?

Some people will answer: “I’m not that much interested in having a swimming pool” while they actually are interested. It’s the same when we build roads: some people say they are not really interested but they will use roads once they are build though. 2 contexts:

♥ Free-‐riders under authority (government): possibility to hide preferences è It’s difficult, even if there’s a government, a municipality, etc.: in this case you just hide your preferences. Free-‐rider just hide their preferences when there’s an authority.

♥ Free-‐riders under no authority (e.g.: international/global public goods): additional problem: lack of incentives to cooperate. Thus, how to enforce the efficient level of the public good? (See topic on international negotiations) è When there’s no authority, we meet other kinds of free-‐riding: here there’s a lack of incentive to cooperate, it’s not like in the 1st case where you just hide your preferences. You know that if you cooperate with the others, it will be better for everyone, but if you have an incentive to not cooperate, and you don’t, finally it will be worse for both parts.

• Private good: no incentive to misreveal preferences (valuation) • Public good: incentive to hide true preferences (valuation) to avoid paying for

the provision of the good while consuming it

4 free riders = passagers clandestins

Public good: vertical sum on individual demand curves. Property: MRTD,F = MRSAD,F = MRSBD,F

Satisfaction: what one person is ready to pay + The satisfaction of another person.


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è Firework example: Valuation statement Alice 4 1 Bob 6 2 Total 10 3 Provision Yes No

2. Externalities

2.1. Definition and analysis Externality = an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism. Examples:

• Emissions of pollutants due to road traffic are responsible for health problems è externality: efficiency is affected

• The presence of European Institutions in Brussels is responsible for an increase in the price of housing thus increasing the welfare of property owners è not an externality: efficiency is not necessarily affected; however, equity is affected by a change in distribution of real income

The lake or river example5 • Nobody owns the lake

o Alice uses to fish and swim in the lake o Bob operates a factory that discharges pollutants in the lake

• Thus Bob’s activities make Alice worse off: externality • Water is scarce resource but it has no price • Consequently, Bob uses the water as an input with zero-‐price, that is in

inefficiently large quantities. • Other inputs: price reflects the value of their alternative uses; Bob has to pay the

price, otherwise the owners of those inputs sell them to others people. An externality is the consequence of the lack of property right:

• If Alice owns the lake, she could charge Bob for polluting the lake; Bob would then account for the price of this input in his production decisions

• If Bob owns the lake, he could charge Alice for fishing in the lake; Bob knows he can ask her a higher price when he discharge less pollutants

Thus, as long as someone owns the resource, its price reflects the value for alternative uses.

5 Manque notes jusqu’à la fin du chapitre


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Other remarks: • Externalities can be produced by consumers as well as by firms

From… To… Example Consumer Consumer Ex: smoking Consumer Firm Ex: Forests Firm Consumer Ex: Lake Firm Firm Ex: Industrial areas

• Externalities can be positive or negative

o Ex: positive: vaccination o Ex: negative: pollution

• Public goods can be viewed as a special kind of externality: externality with

effects on every person in the economy • Ex: greenhouse gas emissions

Graphical analysis – Lake example


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Notes:

• MB is ‘horizontal’ if Bob sells the output on a competitive market (price-‐taker) • Implicit assumption in graphical analysis: fixed amount of pollution per unit of

output

2.2. Private response to externalities Bargaining

• Provided that transaction costs are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independant of who is assigned those rights (Coase Theorem)

• Thus, only when few parties are involved and the sources of the externality are well defined

• Graphical analysis: lake example Mergers (firms)

• ‘Internalisation’ of the externality by combining the involved parties (only one decision maker; takes into account the impact of one activity on another)

Note: social conventions as a form of merger (individuals)

2.3. Public response to externalities

• Establishing property rights: See bargaining

• Taxes and subsidies: Government sets the price (‘pigouvian’ taxation)

• Tradable permits (or cap-‐and-‐trade) Government sets the quantity

• Regulations: Technology standards, performance standards (non-‐tradable permits), ... è This will be analyzed in topic 6


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Setting the price (tax-‐subsidy): Pigouvian taxation Tax t* on output Q is equal to marginal damage at the efficient level (Q*)

Subsidy Subsidy s* on non-‐produced output is equal to marginal damage at the efficient level (Q*)

Remark on subsidy • Reduction in output must be measured w.r.t. a baseline • Above example: baseline = Q1 • Any other baseline (to the right of Q*) could be used • Difficulties with baselines: possible incentive for firms to overproduce if future

baseline depends on current output (Note: link with discussion on allocation of tradable permits)


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Setting the quantity (permits) Permits Q equal to the efficient level of production (Q*)

3. Climate change as a market failure

3.1. Introduction Human-‐induced climate change is an externality

• Activities involve the emission of greenhouse gases • As GHGs accumulate in the atmosphere, temperatures increase, and the climatic

changes that result impose costs (and some benefits) on society. • Full costs of GHG emissions, in terms of climate change, are not borne by the

emitter è no economic incentive to reduce emissions • Emitters do not have to compensate those who lose out because of climate

change (no ‘correction’ through any institution or market unless policies are implemented)

• Thus human-‐induced climate change is an externality

Climate is a public good The climate is a public good:

• Those who fail to pay for it cannot be excluded from enjoying its benefits • One person’s enjoyment of the climate does not diminish the capacity of others

to enjoy it Underproviding of public goods by the markets in the absence of public policy because limited or no returns to private investors for doing so. In other words, “in this case, markets for relevant goods and services (energy, land use, innovation, etc) do not reflect the consequences of different consumption and investment choices for the climate” (Stern, 2006) Thus, climate change is an example of market failure involving externalities and public goods.


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Special features of the externality Special features that together distinguish it from other externalities (Stern, 2006):

• It is global in its causes and consequences • The impacts of climate change are long-‐term and persistent • Uncertainties and risks in the economic impacts are pervasive • There is a serious risk of major, irreversible change with non-‐marginal

economic effects So, basic theory of externalities and public goods is a good starting point but one has to go much deeper into the analysis. è The following slides show how these special features affect the overall framework/approach for the economic analysis of climate change; these are a starting point for deeper analyses provided in topics 5 to 12

Optimal level of emissions in a given period

This analysis is thus similar to the “Lake” example (section 2)

3.2. Dynamics and uncertainty However, it is not so simple...

• Computation of SCC curve must be based on assumptions over the whole pathway (future periods); let us assume that it is computed on the optimal pathway, that is knowing future MACs ...

• Also, MAC curve lowers with technological progress; let us assume this is anticipated and included in the computation of the optimal pathway ...


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How the path for the social cost of carbon drives the extent of abatement

• So, a good understanding of the dynamics is key • This also illustrates the role of uncertainty: when technological progress is more

important than expected, this leads to a revision of the optimal path (with more abatement), and consequently a revision of the SCC curve (downward because of a lower stock of GHGs)

3.3. Standard welfare economics and ethics Climate change impacts mostly poor countries and poor people in any country. Thus ethical dimension is key The welfare economics framework allows for the inclusion of many dimensions (☺)

• Can include goods appearing at different dates and in different circumstances. Thus the theory covers time and uncertainty.

• To the extent that individuals value the environment, that too is part of the analysis. (Many goods or services, including education, health and the environment, perform a dual role: individuals directly value them and they are inputs into the use or acquisition of other consumption goods.)

• The list of goods or services should include not only consumption (usually monetary or the equivalent), but also education, health and the environment (cfr. cross-‐country comparisons of living standards, such as, for example, in the World Development Indicators of the World Bank, the Human Development Report of the UNDP, and the Millennium Development Goals (MDGs)).

… But: (L)

• The ethical framework of standard welfare economics looks first only at the consequences of actions (an approach often described as ‘consequentialism’) and then assesses consequences in terms of impacts on ‘utility’ (an approach often described as ‘welfarism’).

• This standard welfare-‐economic approach has no room, for example, for ethical dimensions concerning the processes by which outcomes are reached. Some different notions of ethics, including those based on concepts of rights, justice and freedoms, do consider process. Others, such as sustainability and stewardship, emphasise particular aspects of the consequences of decisions for others and for the future.


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Nevertheless... • The consequences on which most of these notions would focus for each

generation often have strong similarities: above all, with respect to the attention they pay to consumption, education, health and the environment.

• And all the perspectives would take into account the distribution of outcomes within and across generations, together with the risks involved in different actions, now and over time.

So, from an ethical perspective, how policy-‐makers aggregate over consequences (i) within generations, (ii) over time, and (iii) according to risk will be crucial to policy design and choice:

• Aggregation requires being quantitative in comparing consequences of different kinds and for different people.

• In arriving at decisions, it is not, however, always necessary to derive a single number that gives full quantitative content and appropriate weight to all the dimensions and elements involved.

• The standard welfare-‐economics framework has a single criterion, and implicitly, a single governmental decision-‐maker. It can be useful in providing a benchmark for what a ‘good’ global policy would look like. But the global nature of climate change implies that the simple economic theory with one jurisdiction, one decision-‐maker, and one social welfare function cannot be taken literally. Instead, it is necessary to model how different players or countries will interact and to ask ethical questions about how people in one country or region should react to the impacts of their actions on those in another.

• This raises questions of how the welfare of people with very different standards of living should be assessed and combined in forming judgments on policy.

Aggregation within generations • Aggregation across education, health, income and environment raises profound

difficulties, particularly when comparisons are made across individuals. • A ‘numeraire’ is necessary: the most common way of expressing an aggregate

measure of wellbeing is in terms of real income • Nevertheless, there are significant difficulties inherent in the valuation of

health and the environment, many of which are magnified across countries where major differences in income affect individuals’ willingness and ability to pay for them.

è More on this in topic #10

Aggregation over time (across generations) • Long term effects of GHGs emitted today, thus need to aggregate across

generations. The ethical decisions on, and approaches to, this issue have major consequences for the assessment of policy.

è See the discussion on discounting, topic #8


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3.4. Risk and uncertainty

• There are large risks and uncertainties around costs and benefits of climate change

• Extension of the social welfare framework: standard expected utility theory; thus aggregation over possible ‘states of the world’ (probabilities used to weight those states)

• Difficulty: how to build those probabilities (distribution functions)? ‘subjective’ probability approach, i.e. a pragmatic response to the fact that many of the ‘true’ uncertainties around climate-‐change policy cannot themselves be observed and quantified precisely, as they can be in many engineering problems, for example.

• Risk aversion, derived from decreasing marginal utility, can be introduced. It is linked to the ‘precautionary principle’.

è More on this in Topic #9

3.5. Non-‐marginal impacts Without climate change mitigation, impacts on the overall economy could be very large (non-‐marginal)


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Appendix: a mechanism to reveal preferences

• Ask demand curve (valuation) • A Pareto efficient level of public good will be provided on the basis of all

demand curves • Contribution will be based on valuation of the other people

An increase of 1 unit of the public good raises tax bill of one person by the marginal cost of that unit, minus the value that everyone else puts on that unit

• Then every person has the incentive (is better off) by telling the truth !

Proof (see Rosen and Gayer, ch. 4) 2 persons: Alice and Bob MRTrd: additional cost of public good (r) ΔTA: change in Alice tax bill after increase 1 unit

Ø Best for Alice: public good provided up to ΔTA = MRSArd

i.e. marginal benefit from additional unit equals what she has to pay for that unit (i.e. tax bill)

Ø According to rule ΔTA = MRTrd -‐ MRSBrd

Ø Thus, with such a rule, if she says the truth:

MRTrd -‐ MRSBrd = MRSArd which corresponds to efficient level computed by gvt

Ø Same for Bob; thus both have incentives to tell truth.

Limit Implementation is difficult/costly

• when many people are involved • because demand schedule (not unique number) is required • because people might not understand the scheme

Suggested readings

• Rosen and Gayer (2010), ch.4, pp 54-‐72 • Rosen and Gayer (2010), ch.5, pp. 73-‐104 • Stern (2006), pp 23-‐40

topic 4 externalities and public goods

Economy & Finance