Transcript Chapter 18

Chapter 18
Externalities and Public Goods
Chapter 18
1
Externalities
 Externalities are the effects of production
and consumption activities not directly
reflected in the market
 They can be negative or positive
Chapter 18
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Negative Externalities
 Action by one party imposes a cost on
another party
Plant dumps waste in a river affecting those
downstream
The firm has not incentive to account for the
external costs that it imposes on those
downstream
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Positive Externalities
 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
Chapter 18
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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.
Chapter 18
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Negative Externalities and
Inefficiency
 Assume the firm has a fixed proportions
production function and cannot alter its
input combinations
The only way to reduce waste is to reduce
output
 Price of steel and quantity of steel initially
produced is at the intersection of supply
and demand
Chapter 18
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Negative Externalities and
Inefficiency
 The MC curve for the firm is the marginal costs
of production
 Firm maximizes profit by producing where MC
equals Price in a competitive firm
 As firm output increase, external cost on
fishermen increases measured by the marginal
external cost curve
 From a social point of view, the firm produces
too much output
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External Costs
MSC
Price
Price
Theis
profit
maximizing
firmfrom
There
MEC
of production
Firm
will
produce
q1 at P1.
at q1 while
theproduces
waste released.
The the
MSC is
efficient
output
level
is
q*.
true cost of production.
MC
MSCI
S = MCI
P*
P1
P1
MECI
MEC
D
q*
q1
Firm output
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Q* Q1
Industry output
8
External Costs
MSC
Price
Price
MSCI
MC
By no producing
at the efficient
level, there is a
social cost on
society
S = MCI
Aggregate
social cost of
negative
externality
P*
P1
P1
MECI
MEC
D
q* q1
Firm output
Chapter 18
Q*
Q1
Industry output
9
External Cost
 Negative Externalities encourage
inefficient firms to remain in the industry
and create excessive production in the
long run.
Chapter 18
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Positive Externalities and
Inefficiency
 Externalities can also result in too little
production, as can be shown in an
example of home repair and landscaping.
 Repairs generate external benefits to the
neighbors
Show by the Marginal External Benefit curve
(MEB)
Marginal Social Benefit (MSB) curve adds
MEB +D
Chapter 18
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External Benefits
Value
MSB
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
D
P1
MC
P*
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MEB
q1
Repair Level
q*
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Ways of Correcting Market
Failure
 Assumption: The market failure due to
pollution
Firm has chosen its profit-maximizing output
level
MSC is marginal social cost of emissions
Chapter 18
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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, little cost to controlling them
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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
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The Efficient Level of Emissions
Dollars/ unit
of Emissions
MSC
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 benefit.
The efficient level of
emissions is where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
E*
12 14
16
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E1
18 20
22
24
26
Level of Emissions
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Ways of Correcting Market
Failure
 Firms can be encouraged to reduce
emissions to the efficient level in three
ways
1. Emissions standards
2. Emissions fees
3. Transferable emissions permits
Chapter 18
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Public Goods
 Characteristics
Nonrival
 For
any given level of production the marginal
cost of providing it to an additional consumer is
zero.
Nonexclusive
 People
cannot be excluded from consuming the
good.
Example – use of lighthouse by a ship
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Public Goods
 Nonexclusive goods
Goods that people cannot be excluded from
consuming, so that it is difficult or impossible
to charge for their use
Example: fireworks, national defense
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Efficiency and Pubic Goods
 Efficient level of private good is where
marginal benefit equals marginal cost
 For a public good, the value of each
person must be considered
Can add demand of all those who value good
 Must equate the sum of these marginal
benefits to the marginal cost of
production
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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
MC
$5.50
D2
$4.00
Efficient output occurs
where MC = total MB
2 units of output.
MB is $1.50 + $4.00 or $5.50.
D
$1.50
D1
0
1
2
3
4
5
6
7
Chapter 18
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9
10
Output
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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.
Chapter 18
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