Externalities and Inefficiency: Negative and Positive Effects

1. Chapter 18 Externalities and Public Goods

2. Externalities • Externalities arise between producers, between consumers, or between producers and consumers • Externalities are the effects of production and consumption activities not directly reflected in the market • They can be negative or positive Chapter 18

3. Externalities • Negative • Action by one party imposes a cost on another party • Plant dumps waste in a river, affecting those downstream • The firm has no incentive to account for the external costs that it imposes on those downstream Chapter 18

4. Externalities • Positive • Action by one party benefits another party • Homeowner plants a beautiful garden where all the neighbors benefit from it • Homeowner did not take their benefits into account when deciding to plant • Immunizations another example • Education…. Chapter 18

5. Negative Externalities and Inefficiency • Scenario – plant dumping waste • Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production • Marginal Social Cost (MSC) is MC plus MEC • We can show the competitive market firm decision and the market demand and supply curves Chapter 18

6. Negative Externalities and Inefficiency • The MC curve for the firm is the marginal cost of production • Firm maximizes profit by producing where MC equals price in a competitive firm • As firm output increases, external costs on fishermen also increase, measured by the marginal external cost curve • From a social point of view, the firm produces too much output Chapter 18

7. MSC MC MSCI S = MCI P* P1 P1 MECI MEC D q* q1 Q* Q1 External Costs There is MEC of production from the waste released. The MSC is true cost of production. Firm will produce q1 at P1. The profit maximizing firm produces at q1 while the efficient output level is q*. Price Price Industry output Firm output Chapter 18

8. Aggregate social cost of negative externality MSC Price Price MSCI MC S = MCI P* P1 P1 MECI MEC D q* q1 Q* Q1 Industry output Firm output External Costs By not producing at the efficient level, there is a social cost on society. Chapter 18

9. External Cost • Negative externalities encourage inefficient firms to remain in the industry and create excessive production in the long run Chapter 18

10. Positive Externalities and Inefficiency • Externalities can also result in too little production, as can be shown in an example of immunizations • Immunizations generate external benefits to the neighbors, community, etc. • Shown by the Marginal External Benefit curve (MEB) • Marginal Social Benefit (MSB) curve adds MEB +D Chapter 18

11. MSB D P1 MC P* MEB q1 q* External Benefits Value When there are positive externalities (the benefits of immunizations to others), marginal social benefits (MSB) are higher than marginal private benefits (D). A self-interested individual invests q1 in immunizations. The efficient level of immunizations q* is higher. The higher price P1 discourages them. Immunizations Chapter 18

12. Ways of Correcting Market Failure • Assumption: The market failure is pollution • Output decision and emissions decision are independent • Firm has chosen its profit-maximizing output level • MSC is marginal social cost of emissions • Equivalent to MEC from before • Upward sloping because of substantially increasing harm as pollution increases Chapter 18

13. MSC MCA E0 E1 E* 0 2 4 6 8 10 12 14 16 18 20 22 24 26 Level of Emissions The Efficient Level of Emissions Dollars/ Unit of Emissions 6 At Eo the marginal cost of abating emissions is greater than the marginal social cost. 4 At E1 the marginal social cost is greater than the marginal cost of abatement. The efficient level of emissions is where MCA = MSC. 2 Chapter 18

14. Ways of Correcting Market Failure • MCA is marginal cost of abating emissions • Additional cost to firm of controlling pollution • Downward sloping because when emissions are high, there is little cost to controlling them • Large reductions require costly changes in production process Chapter 18

15. Ways of Correcting Market Failure • If the firm does not consider abatement, their profit maximizing level is 26 units of emissions • Level where MCA is zero • The socially efficient level of emissions is 12 where the MSC equals the MCA Chapter 18

16. MSC MCA E0 E1 E* 0 2 4 6 8 10 12 14 16 18 20 22 24 26 Level of Emissions The Efficient Level of Emissions Dollars/ Unit of Emissions 6 At Eo the marginal cost of abating emissions is greater than the marginal social cost. 4 At E1 the marginal social cost is greater than the marginal cost of abatement. The efficient level of emissions is where MCA = MSC. 2 Chapter 18

17. Ways of Correcting Market Failure • Firms can be encouraged to reduce emissions to the efficient level in three ways: • Emissions standards • Emissions fees • Transferable emissions permits Chapter 18

18. Ways of Correcting Market Failure • Options for Reducing Emissions to E* • Emissions Standard • Set a legal limit on emissions at E* (12) • Enforced by monetary and criminal penalties • Increases the cost of production and the threshold price to enter the industry • Emissions Fee • Charge levied on each unit of emission Chapter 18

19. MSC Standard Fee 3 MCA E* 12 Standards and Fees Dollars/ Unit of Emissions Level of Emissions Chapter 18

20. MSC Total Fee of Abatement Fee E* MCA Total Abatement Cost Standards and Fees Dollars/ Unit of Emissions Cost is less than the fee if emissions were not reduced. 3 12 Level of Emissions Chapter 18

21. Ways of Correcting Market Failure • Fees vs. Standards • Standards yield more certainty on emissions levels and less certainty on the cost of abatement Chapter 18

22. Ways of Correcting Market Failure • Fees vs. Standards • Fees have certainty on cost and uncertainty on emissions • Preferred policy depends on the nature of uncertainty and the slopes of the cost curves • What if we don’t know costs and benefits AND if firms costs vary? Chapter 18

23. Ways of Correcting Market Failure • Transferable Emissions Permits • Permits help develop a competitive market for externalities • Agency determines the level of emissions and number of permits • Permits are marketable • High cost firm will purchase permits from low cost firms Chapter 18

24. Ways of Correcting Market Failure • The market for externalities is appealing since it combines the system of standards with the system of fees (as well as its use of the market) • The agency who administers the system determines the total number of permits and therefore the total amount of emissions • Marketability of the permits allows pollution abatement to be achieved at minimum cost • Don’t need to know firm’s individual costs --- those with high costs will buy permits from lower cost firms Chapter 18

25. In Sum • The total cost of abatement for the industry is reduced • Not every firm is subject to a standard • The entire industry is subject to a standard • Results in minimizing abatement costs from the point of view of the industry as a whole Chapter 18

26. Public Goods • Characteristics • Nonrival: fireworks display • For any given level of production, the marginal cost of providing it to an additional consumer is zero • One person’s consumption of the good does not preclude another • Nonexclusive • People cannot be excluded from consuming the good – makes it difficult or impossible to charge for their use • Example – lighthouse, national defense Chapter 18

27. Public Goods • Non-rival but exclusive • TV signal • Bridge • Concert • Nonexclusive but rival • Ocean in some respects like fishing • National Forests & logging • Don’t confuse positive externalities with public goods (education?) Chapter 18

28. Efficiency and Public Goods • Efficient level of private good is where marginal benefit equals marginal cost: S = D • Same principle applies to pubic goods – just measured differently • For a public good, the value of each person must be considered • Can add demand of all those who value good • Calculated differently than for private goods • Must equate the sum of these marginal benefits to the marginal cost of production • Previously added quantities at each price: NOW – add prices at each quantity • Vertical addition as opposed to horizontal addition Chapter 18

29. MC D2 D D1 Efficient Public Good Provision Benefits (dollars) D1 is demand for consumer 1. D2 is demand for consumer 2. D is total demand for all consumers. $7.00 $5.50 $4.00 Efficient output occurs where MC = total MB 2 units of output. MB is $1.50 + $4.00 or $5.50. $1.50 Output 0 1 2 3 4 5 6 7 8 9 10 Chapter 18

30. Public Goods and Market Failure • Free Riders • There is no way to provide some goods and services without benefiting everyone • Households do not have the incentive to pay what the item is worth to them • Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it • Public goods thus provided by governments if to be produced efficiently Chapter 18

31. The Demand for Clean Air • Clean Air is a public good • Nonexclusive and nonrival • No market and no observable price at which people are willing to trade clean air for other goods Chapter 18

32. The Demand for Clean Air • Choosing where to live • Study in Boston correlates housing prices with the quality of air and other characteristics of the houses and their neighborhoods Chapter 18

33. High Income Middle Income Low Income The Demand for Clean Air Dollars 3000 2500 2000 1500 1000 500 Nitrogen Oxides (pphm) 0 1 2 3 4 5 6 7 8 9 10 Chapter 18

34. The Demand for Clean Air • Findings • The amount of people who are willing to pay for clean air increases substantially as pollution increases • Higher income earners are willing to pay more (the gap between the demand curves widen) • National Academy of Sciences found that a 10% reduction in auto emissions yielded a benefit of $2 billion---somewhat greater than the cost Chapter 18