Transcript Chapter Ten
Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS. Copyright © 2004 South-Western Market Failure Recall • Adam Smith’s “invisible hand” leads self-interested buyers & sellers in a market to maximize the total benefit for society. But market failures can still happen! • An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. Copyright © 2004 South-Western EXTERNALITIES AND MARKETS • When the impact on the bystander is adverse, the externality is called a negative externality. • When the impact on the bystander is beneficial, the externality is called a positive externality. • Externalities cause markets to be inefficient. Copyright © 2004 South-Western Negative Externalities • • • • • • • • • Automobile exhaust Factory pollution Cigarette smoking Barking dogs (loud pets) Airplanes (landing/take-off) Landfills Chicken litter Over-fishing/grazing/driving B.O. Copyright © 2004 South-Western Coal-Fired Power Plant • The owner of the plant bears the costs of the labor, land, concrete, steel, etc. used in production but does NOT pay for the clean air used. • People also agree to buy electricity (electric bill). • Social Cost > Private Cost • Price does not reflect true cost! Copyright © 2004 South-Western A Voluntary Exchange between a willing buyer and seller Copyright © 2004 South-Western But….. • Although the car owner has paid for the gasoline, he has NOT paid for the clean air used as he drives. • Price does not reflect true cost! . . . COSTS that spill over onto people who don’t receive the benefits. Copyright © 2004 South-Western Property Rights • The incentives are not correct! • Auto/factory pollution could be solved….. • tailpipe • smokestack Copyright © 2004 South-Western Positive Externalities • Immunizations • Landscaping/Home Maintenance • Research & Development • Education • Green space • Rainforests • Species Copyright © 2004 South-Western Equilibrium = Balance Price Supply Consumer surplus Equilibrium price • MB = MC = P* • Qs = Qd • Allocative efficiency Producer surplus Demand Equilibrium quantity Quantity Copyright © 2004 South-Western EXTERNALITIES AND MARKET INEFFICIENCY • Negative externalities lead markets to produce and consume a quantity greater than the socially optimal quantity. • Positive externalities lead markets to produce and consume a quantity less than the socially optimal quantity. Copyright © 2004 South-Western The Market for Aluminum • The quantity produced & consumed at the market equilibrium is efficient in the sense that it maximizes the benefits to market participants (buyers & sellers). • If the aluminum factories emit pollution then the cost to society of producing aluminum is larger than the cost to aluminum producers. • For each unit of aluminum produced, the social cost includes the private costs of the producers plus the damage to those bystanders adversely affected by the pollution. Copyright © 2004 South-Western Figure 2 Pollution and the Social Optimum Price of Aluminum Social cost Cost of pollution Supply (private cost) Optimum Equilibrium Demand (private value) 0 QOPTIMUM QMARKET Quantity of Aluminum Copyright © 2004 South-Western Negative Production Externality • social cost > private cost • The intersection of the demand curve and the social-cost curve determines the optimal output level. • The private market outcome over-produces and consumes aluminum at the market equilibrium quantity. Copyright © 2004 South-Western The Market for Education • When an externality benefits the bystanders, a positive externality exists…..the social value of the good exceeds the private value. • Education can be considered a positive externality • Educated children are more likely to become good citizens (voters, productive workers, less crime). • Benefits spill over to general public beyond the benefit to individual students. Copyright © 2004 South-Western Figure 3 Education and the Social Optimum Price of Education Supply (private cost) Social value Demand (private value) 0 QMARKET QOPTIMUM Quantity of Education Copyright © 2004 South-Western Positive Consumption Externality • social benefit > private benefit • The intersection of the supply curve and the socialvalue curve determines the optimal output level. • The private market outcome under produces and consumes education at the market equilibrium quantity. Copyright © 2004 South-Western Solving (addressing) Externalities • Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. • The government can internalize an externality by imposing a tax/subsidy to reduce/increase the equilibrium quantity to the socially optimal level. • Patents & Copyrights Copyright © 2004 South-Western Getting an Education Provides Great Benefits (even for those not in school) • Social Value > Private Value • Private market will under-do it. • Mandate and subsidize! • What would society look like if we left all education up to the private market? Copyright © 2004 South-Western Immunizations Reduce the Likelihood of Disease (even for people who don’t get immunized) • Social Value > Private Value • Private market will under-do it. • Mandate and subsidize! • What would society look like if we left all immunizations up to the private market? Copyright © 2004 South-Western Taxing Activities with Negative Externalities • Cigarettes • Alcohol • Soda/Junk Food • Gasoline • Carbon Copyright © 2004 South-Western Government action is not always needed to solve the problem of externalities. • The Coase Theorem proposes that if property rights are clearly defined and protected private parties can negotiate without cost, then they can solve the problem of externalities on their own. • Transaction costs are the costs that parties incur in the process of agreeing to and following through on a negotiated settlement. Copyright © 2004 South-Western The Citrus Farmer & The Fisherman The Coase Theorem citrus farmer profits per week fisherman profits per week high output $2,000 $100 low output $300 $600 Copyright © 2004 South-Western The Coase Theorem citrus farmer profits per week fisherman profits per week high output $2,000 $1,000 low output $300 $6,000 Copyright © 2004 South-Western 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 (taxes, pollution permits) Copyright © 2004 South-Western More Examples • • • • • Chickens and chicken litter Burning or hauling leaves/brush and debris Airport runways Over-fishing, over-grazing Microwave ovens • Green space (woods, parks) • The Brazilian Rainforest Copyright © 2004 South-Western PUBLIC POLICY TOWARD EXTERNALITIES Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS. 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