Market Failure and the Role of Government: Externalities and Public Policy

1. Market Failure and theRole of Government:Externalities and Public Policy AP Economics Mr. Bordelon

2. Public Policies • The U.S. is a mixed economy, a free market economy with government intervention. As such, the government has developed specific public policies to deal with pollution and polluters. • Environmental standards • Emissions taxes • Tradable emissions permits

3. Environmental Standards • Environmental standards. Rules that protect the environment by specifying limits or actions for producers and consumers. • Also known as “command and control” measures for reducing pollution. • Early legislation was written with a heavy dose of thou shalt not pollute more than X amount of stuff in the air, water, and/or soil. This was definitely a vast improvement on the unregulated free market, and sparked the environmental movement. Economists, however, see these as inefficient, which you’ll see why. • AP Examples: • Cars required to pass emissions inspections before license plate renewal. • Sewage must be treated before release back into the environment.

4. Emissions Taxes Emissions Tax. Tax that depends on the amount of pollution a firm produces. Looking back at the MSC/MSB graph, the socially optimal quantity of pollution is at QOPT, but the free market would push pollution to QMKT. Solution? Tax it, baby. If the polluter would be required to pay a tax of $200 per ton of emissions, their marginal cost would increase to $200 per ton, and they would now have an incentive to reduce emissions to QOPT. Key point: An emissions tax equal to the marginal social cost at the socially optimal quantity of pollution induces polluters to internalize the externality (to suck it up, if you will).

5. Emissions Taxes • Why is this more efficient than environmental standards? • An emissions tax ensures that the marginal benefit of pollution is equal for all sources of pollution, but environmental standards do not. • Pigouvian taxes. Named after economist A.C. Pigou. Taxes designed to reduce external costs.

6. Emissions Taxes Let’s look at it from the environmental standards perspective first. This is a hypothetical industry with two plants, A and B. Plant A uses newer technology and has a lower cost of reducing pollution. As a result, Plant A’s marginal benefit of pollution curve, MBA, falls below that of Plant B, MBB. Because it is more costly for plant B to reduce pollution at any output quantity, an additional ton of pollution is worth more to plant B than to plant A.

7. Emissions Taxes Without government intervention, polluters will pollute until MSB of an addition unit of emission is zero. The MSB is the cost savings to polluters of an additional unit. This corresponds to an emissions quantity of 600 tons for both A and B. The government enacts an environmental standard requiring overall pollution to be cut in half to 600 tons total, or 300 tons each. Plant A now produces at point SA, with a marginal benefit of pollution at $150. Plant B now produces at point SB, with a marginal benefit of pollution at $300, twice as high.

8. Emissions Taxes This means that the same quantity of pollution can be achieved at a lower total cost by allowing Plant B to pollute more than 300 tons, and having Plant A pollute less. After all, it costs A half as much as B. A better way would be to reduce pollution on an industry wide level, where the marginal benefit of pollution is the same for all. When each plant values a unit of production equally, there is no way to rearrange pollution reduction among the various plants which would achieve the optimal quantity of pollution at a lower total cost.

9. Emissions Taxes To see that outcome, look at this graph based with an emission tax in place rather than an environmental standard. Here, an emissions tax of $200 has been placed on all producers industry-wide. The marginal cost of an additional ton of emissions to each plant is now $200 rather than zero. Plant A produces at TA, at 200 tons, and Plant B produces at TB, at 400 tons, for a total of 600 tons.

10. Pigouvian Taxes • Just to be clear, emissions taxes are not the only solution to external costs, including pollution. • Pigou’s idea was that taxes can be used to discourage any activity that generates negative externalities. • The main concern behind emissions taxes is that government officials usually aren’t sure at what level the tax should be set, and this uncertainty can not be eliminated.

11. Tradable Emissions Permits • Tradable emissions permits. Licenses to emit limited quantities of pollutants that can be bought and sold by polluters. Issued to polluting firms according to formula reflecting polluting history. • Key point: Permits are tradable. Firms with differing costs of reducing pollution can now engage in mutually beneficial transactions. Firms will use transactions in permits to reallocate pollution reduction among themselves, so that in the end, those with the lowest cost will reduce their pollution the most, and those with the highest cost will reduce their pollution the least. • Also known as “cap and trade”.

12. Tradable Emissions Permits • Tradable permits provide the incentive polluters need to take the MSC of pollution into account. • Assume that the market price of a permit to emit one ton is $200. Every plant has an incentive to limits its emissions to the point where its marginal benefit of emission is $200. • If a plant must pay $200 for the right to pollute, it faces the same incentives as a plant facing an emissions tax of $200 per ton. • Plants that have more permits than they can use have an advantage. By not emitting, the plant frees up a permit it can sell for $200. • The opportunity cost for a ton of emissions to the plant’s owner is $200.

13. Tradable Emissions Permits • Like emissions taxes, tradable emissions permits ensures that those who can reduce pollution most cheaply are the ones to do so, rather than a one size fits all environmental standard. • If the government issues permits at QOPT, where one permit allows the release of one ton of emissions, then the equilibrium market price of a permit among producers will be $200 as in the first graph on emissions taxes.

14. Tradable Emissions Permits • Emissions taxes and tradable permits provide incentives to create and use technology that emits less pollution—new technology that lowers the socially optimal level of pollution. The main effect of the permit system for pollution has been to change how electricity is produced rather than to reduce the nation’s electricity output. • Problem is how many permits to issue? Governments may not be able to determine the optimal quantity of pollution adequately, and could issue too many or too few permits.

15. Direct Control orChange the Activity? • Government can’t always control the side effects, only the activities that cause them. Public policy in that case must be geared to changing the levels of production and consumption that create the externalities, which in turn changes the levels of the externalities themselves.

16. Private vs. Social Benefits • When you get a MMR vaccination, assuming your parents are not stupid like Jenny McCarthy and think vaccines are evil, you clearly get a benefit from not getting measles, mumps or rubella, or at least when you do get them, it’s not nearly as severe. • But the rest of society also gets a benefit. Because you won’t be contagious with these plagues, we can safely move around you, hold hands, play ring-around-the-rosie, do the Hokey-Pokey, and more. This is just one of the reasons why we require vaccinations for children to attend public school. • And it also saves us a boatload of fat wads of cash, to the tune of a few billion dollars a year.

17. Private vs. Social Benefits • But the government can’t control the external benefits of getting a MMR shot. If the government wants to influence the level of external benefits from MMR shots, it must target the original activity. • Thing is, when you get your MMR shot, you have no incentive to take into account the beneficial side effects generated by your vaccination. It’s all about you. And that you’re 5. • Without government intervention, it’s likely few kids would be vaccinated.

18. Private vs.Social Benefits In this graph, we have a typical demand and supply graph represented by D and S. Without government intervention, equilibrium will be at point EMKT, just like we’d expect, with a price and quantity of PMKT and QMKT respectively. Here, the marginal cost to society of another flu shot is equal to the marginal benefit gained by the individual consumer who purchases that flu shot, which is measured by the market price.

19. Private vs.Social Benefits Prior to this, we’ve looked at marginal benefit to the consumer as equal to the marginal benefit to society. Here though, we have a positive externality. With positive externalities, there is a difference between marginal benefit to the consumer (marginal private benefit), and the marginal benefit to society (marginal social benefit of a good/service). The difference between the MPB and the MSB equals the MEB which indicates the increase in external benefits to society from an additional unit. MSB = MPB + MEB

20. Private vs.Social Benefits The demand curve represents the marginal private benefit. It does not incorporate the societal benefit. That is represented by the MSB curve, which corresponds to the demand curve shifted upward by the amount of the MEB. In other words, D represents the individual, MSB represents society. With the MSB and S curves in place, the socially optimal quantity of a good corresponds to the new equilibrium at O, with QOPT and POPT. External benefit is not accounted for in market decisions. As such, QOPT is greater than QMKT. This is the quantity where marginal cost of the good (S) equals MSB.

21. Private vs.Social Benefits By itself, the free market will produce too little and society will consume too little. Without government action, the price to consumers of the activity is too high. At QMKT, the unregulated market price is PMKT and marginal benefit to consumers of an additional unit is lower than PMSB. The question is how do we get the market to produce at QOPT? Pigouvian subsidy. Payment designed to encourage activities that yield external benefits. Optimal Pigouvian subsidy equals the marginal external benefit of consuming another unit.

22. Private vs.Social Benefits With the subsidy, producers are now more willing to provide at the socially optimal level, O, with QOPT. The higher price for producers gives the incentive. At the same time, consumers will get a lower price on the demand curve, and will be willing to consume more. Consumers pay a price equal to the market price minus the subsidy.

23. Private vs. Social Benefits Putting them together, we can see that the graphs correspond to meet the socially optimal outcome desired.

24. Private vs. Social Costs • When focusing on negative externalities, there is a difference between the marginal cost to the firm (marginal private cost), and the marginal cost to society (marginal social cost of a good). The difference between the MPC and MSC equals the marginal external cost (MEC)—the increase in external costs to society from an additional unit of the good. • MSC = MPC + MEC

25. Private vs.Social Benefits Livestock poops. A lot. Lots of poop creates methane gas, which is a greenhouse gas. So not a good thing. Here, the goal is to lower QMKT to QOPT. Our focus here is on the industry supply. The QOPT is where MSB equals MSC, O. We can not use the demand curve for MSB because the D curve represents marginal private benefit to consumers. There are no external benefits to separate the marginal private benefit from the marginal social benefit. In other words, when MSC = D and there are no external benefits, then it must be that MSC = MPB = MSB.

26. Private vs.Social Benefits By itself, the free market produces too much of a good that generates an external cost in production, and the price to consumers is low. PMKT is less than PMSC, the marginal cost to society of another unit of livestock. How do we solve this? Pigouvian tax, baby.

27. Private vs.Social Costs Here, we place a tax at point O, equal to the marginal external cost. This moves the market to consume QOPT. Going back to the idea of socially optimal quantity, the key idea is MSB = MSC. The idea works here as well. When MSB = S, and there are no external costs, MSB = MPC = MSC.

28. Private vs. Social Costs Putting them together, we can see that the graphs correspond to meet the socially optimal outcome desired.

29. Network Externalities • Network externality. When the value to an individual of a good or service depends on how many other people use the same good or service. • Examples: telephones, computers, transportation, Twitter, Facebook. • Negative network externality: congestion • AP Note: This is a new topic for the AP Exam. It has shown up in multiple choice questions twice now, and it is possible that there is now enough material to do a basic FRQ.