4 THE ECONOMICS OF THE PUBLIC SECTOR

1. 4 THE ECONOMICS OF THE PUBLIC SECTOR

2. 10 Externalities

3. Market Failure • Recall from Chapter 7: • Adam Smith had argued that the “invisible hand” of the marketplace leads self-interested buyers and sellers to an outcome in which the total surplus of society is maximized. But markets can fail. Why? CHAPTER 10 EXTERNALITIES

4. EXTERNALITIES AND MARKET INEFFICIENCY • An externality is the uncompensated impact of one person’s actions on the well-being of a bystander. • Al’s action may affect the well-being of Betty, a bystander. • If Al pays no compensation (when his action has a negative effect on Betty) nor receives a reward (when his action has a positive effect on Betty), the effect of Al’s action on Betty is called an externality. CHAPTER 10 EXTERNALITIES

5. In this case, Al will ignore the effects of his action on Betty when deciding whether or not to take the action • Therefore, Al may take this action even if it is undesirable for society • And, conversely, Al may refuse to take this action even if it is desirable for society • In other words, when actions have external effects, society’s total surplus might not be maximized in the free market equilibrium • Government intervention may be able to increase total surplus CHAPTER 10 EXTERNALITIES

6. EXTERNALITIES AND MARKET INEFFICIENCY • When the impact of a person’s action on a bystander is harmful, the externality is called a negative externality. • When the impact on the bystander is beneficial, the externality is called a positive externality. CHAPTER 10 EXTERNALITIES

7. Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs (loud pets) • Loud stereos in an apartment building • The Club, an anti-theft device for cars CHAPTER 10 EXTERNALITIES

8. Dealing with negative externalities • Should we completely ban an activity that has negative externalities? • Should we ban all cars? • Should we ban all smoking in public spaces? • Should we muzzle all dogs? • Should we ban stereos in apartment buildings? • Should we ban The Club? CHAPTER 10 EXTERNALITIES

9. Dealing with negative externalities • How should we determine the extent to which activities that have negative externalities should be tolerated? • We can evaluate virtually any policy proposal by asking how it would affect total surplus. • Recall from Chapter 7, the concept of total surplus. CHAPTER 10 EXTERNALITIES

10. Positive Externalities • Immunizations • Education • Restored historic buildings • Research into new technologies • LoJack, an anti-theft device for cars CHAPTER 10 EXTERNALITIES

11. EXTERNALITIES AND MARKET INEFFICIENCY • Externalities can cause markets to become inefficient. • We saw in chapter 7 that total surplus is maximized in a perfectly competitive economy. • But when there are externalities, this is no longer true: • total surplus might be less than the maximum achievable. • This might provide a justification for government intervention. CHAPTER 10 EXTERNALITIES

12. EXTERNALITIES AND MARKET INEFFICIENCY • Negative externalities from the production or consumption of a good can cause markets to produce more than is socially desirable. • Positive externalities cause markets to produce less than is socially desirable. • If and when markets fail (to produce the socially desirable quantity), government intervention may be necessary. CHAPTER 10 EXTERNALITIES

13. Supply (private cost) Equilibrium Demand (private value) QMARKET When there are no externalities in aluminum production or consumption, the equilibrium quantity (QMARKET) maximizes social surplus. Figure 1 The Market for Aluminum Price of Aluminum Quantity of 0 Aluminum

14. Welfare Economics Without Externalities: A Recap • When there are no externalities, the equilibrium quantity: • is efficient • maximizes total surplus • Total surplus = total benefits – total costs • is the socially desirable quantity CHAPTER 10 EXTERNALITIES

15. Social, private, and external costs • When the production of aluminum causes pollution … • Social cost of aluminum = private cost + external cost • Private cost is the cost to aluminum producers of the raw materials and labor used in production • External cost is the cost to bystanders of having to deal with the effects of pollution CHAPTER 10 EXTERNALITIES

16. Social cost Unit Cost of pollution Supply (private cost) Optimum Equilibrium Demand (private value) QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum Quantity of 0 Aluminum

17. Social cost Unit Cost of pollution Supply (private cost) Equilibrium Demand (private value) QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum Optimum A G E F B I H C D J K L Quantity of 0 Aluminum

18. Social cost Supply (private cost) Optimum Equilibrium Demand (private value) QOPTIMUM QMARKET Public Policies for Negative Externalities Price of Aluminum • What can be done to get the market to reduce production to the socially optimal level? Quantity of 0 Aluminum CHAPTER 10 EXTERNALITIES

19. Market-Based Policy: Put a Tax on Negative Externalities • Either the producers or the consumers (or both) of aluminum can be taxed • We saw in chapter 6 that a tax reduces the equilibrium output, and that is exactly what we want. • A tax solves the problem by forcing the consumers and producers of aluminum to internalize the externality of aluminum • Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. CHAPTER 10 EXTERNALITIES

20. Price buyers pay Supply Tax Price without tax Price sellers receive Demand Recall: The Effect of a Tax Price Quantity before tax Quantity after tax Quantity 0

21. Negative externalities should be taxed • When there are negative externalities, the free market equilibrium output exceeds the socially optimum output • Therefore, it is socially desirable to reduce output • A tax would reduce output • Therefore, a tax is a socially desirable response to a negative externality • But how big should the tax be? CHAPTER 10 EXTERNALITIES

22. Social cost Unit Cost of pollution Supply (private cost) Optimum Tax Equilibrium Demand (private value) QOPTIMUM QMARKET Tax > External Cost is too much Price of Aluminum Desired output reduction Quantity of 0 The tax is too large and reduces output too much Aluminum

23. Social cost Unit Cost of pollution Supply (private cost) Optimum Tax Equilibrium Demand (private value) QOPTIMUM QMARKET Tax < External Cost is too little Price of Aluminum Desired output reduction The tax is too small and reduces output too little Quantity of 0 Aluminum

24. Social cost Unit Cost of pollution Supply (private cost) Optimum Tax Equilibrium Demand (private value) QOPTIMUM QMARKET Tax = External Cost solves the problem! Price of Aluminum We saw earlier that reducing output from QMARKET to QOPTIMUM increases total surplus. Now we see that a tax can do this. (So, unlike what we saw in Chapter 8, not all taxes reduce total surplus.) This is a Pigovian tax. Now the tax is exactly equal to the external cost. It reduces the quantity by exactly the ideal amount. Quantity of 0 Aluminum

25. Social cost Unit Cost of pollution Supply (private cost) Optimum Equilibrium Demand (private value) QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum Another way to ensure that QOPTIMUM is produced is to use tradable pollution permits. Quantity of 0 Aluminum

26. Tradable Pollution Permits • The government can do the following: • require permits for aluminum production • issue QOPTIMUM permits by auctioning them off • Each permit will sell for a price equal to the unit cost of pollution • The effect will be identical to a Pigovian tax equal to the unit cost of pollution CHAPTER 10 EXTERNALITIES

27. Tradable Pollution Permits • The price of each tradable pollution permit will be equal to the unit cost of pollution • Why? CHAPTER 10 EXTERNALITIES

28. Positive Externalities: Examples • A technology spillover is a positive externality that is created when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. • Education benefits the student and also all members of society who are affected by the student CHAPTER 10 EXTERNALITIES

29. Supply (private cost) Equilibrium Optimum Social value Demand (private value) QOPTIMUM QMARKET Figure 3 Education and the Social Optimum Price of Education Quantity of 0 Education

30. Supply (private cost) Optimum Social value Demand (private value) QOPTIMUM QMARKET Figure 3 Education and the Social Optimum Price of Education A F E Equilibrium D C B Quantity of 0 Education

31. Supply-Demand and Positive Externalities • The intersection of the supply curve and the social-value curve determines the optimal output level. • The optimal output level is more than the equilibrium quantity. • The market produces a smaller quantity than is socially desirable. • The social value of the good exceeds the private value of the good. CHAPTER 10 EXTERNALITIES

32. Subsidies for positive externalities • What can be done to get the market to increase education to the optimal level? • A subsidy for either students (buyers of education) or educational institutions (sellers) will work. • A subsidy will make students and educational institutions internalize the positive externality of education CHAPTER 10 EXTERNALITIES

33. Subsidies for Positive Externalities: example • Recall that technology spillovers are positive externalities • Therefore, the equilibrium level of spending on research will be less than the socially desirable level • Government intervention may promote technology-enhancing industries • Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. • The patent is then said to internalize the externality. CHAPTER 10 EXTERNALITIES

34. PRIVATE SOLUTIONS TO EXTERNALITIES • Government action is not always needed to solve the problem of externalities. • In some cases, the free market ends up maximizing total surplus even when there are externalities CHAPTER 10 EXTERNALITIES

35. PRIVATE SOLUTIONS TO EXTERNALITIES • Moral codes and social sanctions • Charitable organizations • Integrating different types of businesses • Contracting (bargaining, negotiations) between those causing the externalities and those affected by the externalities CHAPTER 10 EXTERNALITIES

36. The Coase Theorem • The Coase Theorem is the proposition—due to Ronald Coase—that if people can bargain without transaction costs over the allocation of resources, they can solve the problem of externalities on their own. • Transaction costs are the costs that people incur in the process of agreeing to and following through on a bargain. CHAPTER 10 EXTERNALITIES

37. Dick, Spot, and Jane and Ronald Coase Dick and Jane are room mates. Dick gets Spot, a noisy dog, as a birthday gift. Coase Theorem: Private solutions to externalities can work

38. Dick, Spot, and Jane and Ronald Coase • Note that when the free market outcome is not optimal, bargaining between Dick and Jane will bring about the optimal outcome, irrespective of who is favored by the law • The law is important in other ways, however. For example, in one case in which the law favors Dick, Jane has to pay a $500 compensation to Dick to get him to return Spot CHAPTER 10 EXTERNALITIES

39. Coase Theorem: Exercise • In the case of pollution by an aluminum factory, how might production of the socially desirable amount be brought about without taxation by the government? • Why might Coase’s solution fail, as a practical matter, in this case? CHAPTER 10 EXTERNALITIES

40. Why Private Solutions Do Not Always Work • Sometimes the private solution fails because transaction costs are so high that private agreement is not possible. • Dick might get greedy and try to haggle with Jane for more than $500 • Change the story by substituting three people (Jan, Jeanne and Joan) instead of Jane. Jan, Jeanne and Joan may find it hard to raise $500 for Dick’s compensation. Each might try to free ride on the others. CHAPTER 10 EXTERNALITIES

41. PUBLIC POLICY TOWARD EXTERNALITIES • When externalities are significant and private solutions are not found, government may attempt to solve the problem through… • command-and-control policies. • market-based policies. CHAPTER 10 EXTERNALITIES

42. PUBLIC POLICY: Command-and-Control Policies • Such policies usually take the form of regulations: • Forbid certain behaviors. • Require certain behaviors. • Examples: • Requirements that all students be immunized. • Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). CHAPTER 10 EXTERNALITIES

43. PUBLIC POLICY: MARKET-BASED POLICIES • Taxes and subsidies can align private incentives with social efficiency. • We have seen this already • These corrective taxes and subsidies are called Pigovian taxes and subsidies. • They were originally proposed by the British economist, A. C. Pigou. CHAPTER 10 EXTERNALITIES

44. PUBLIC POLICY TOWARD POLLUTION: Command-and-Control • If the EPA decides it wants to reduce the amount of pollution coming from a specific plant, it could… • tell the firm to reduce its pollution by a specific amount (i.e. regulation). • levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). CHAPTER 10 EXTERNALITIES

45. PUBLIC POLICY TOWARD POLLUTION: Market-Based • Pigovian Taxes on the producers or consumers of pollution • Tradable pollution permitsthatallow thevoluntary transfer of the right to pollute from one firm to another. • A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. CHAPTER 10 EXTERNALITIES

46. Pigovian P tax 1. A Pigovian tax sets the Demand for price of pollution rights pollution . . . Q 2. . . . which, together with the demand curve, determines the quantity of pollution. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (a) Pigovian Tax Price of Pollution Quantity of 0 Pollution

47. Supply of pollution permits P Demand for pollution rights Q 1. Pollution 2. . . . which, together permits set with the demand curve, the quantity determines the price of pollution . . . of pollution. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (b) Pollution Permits Price of Pollution Quantity of 0 Pollution

48. Policy Exercises • Should we punish the use of SUV’s and promote the use of smaller cars? • Should we force car makers to sell cars with higher mileage? • Should we limit the use of gasoline by each car owner? • Should we tax gasoline? • Should we tax all fuels based on the damage each fuel causes? CHAPTER 10 EXTERNALITIES

49. Any Questions? CHAPTER 10 EXTERNALITIES

50. Summary • When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. • Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. • Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. CHAPTER 10 EXTERNALITIES