Transcript Public goods

Chapter 18
Externalities and
Public Goods
© 2006 Thomson Learning/South-Western
Defining Externalities



2
An externality is the effect of one party’s
economic activities on another party that is
not taken into account by the price
system.
Externalities can occur between any two
economic actors.
Externalities can be beneficial or harmful.
Externalities between Firms

One of the most famous beneficial
externalities between firms involves one
firm producing honey and the other
producing apples.


3
Bees feed on apple blossoms, which
increases the production of honey, and
Bees pollinate apple crops, which increases
the production of apples.
Externalities



4
Firms can generate air, water, and other
types of pollution when producing products.
Alternatively, auto pollution, graffiti, and noise
are some externalities imposed by people on
firms.
When people do things that harm others, like
playing their radios loudly, or help, like
shoveling their sidewalk, they can impose
externalities on other people.
Reciprocal Nature of Externalities

In dealing with externalities it is important
to recognize that both parties are needed
for an externality to exist.


5
If the eyeglass producer was not located
near the charcoal factory, there would be no
externality.
If another person was not around, no one
would be bothered when someone plays
their radio loudly.
Externalities and Allocational
Efficiency

The presence of externalities can cause a
market to operate inefficiently.


6
In the previous example an externality
affected the production of eyeglasses.
The firm producing charcoal did not take into
account the negative effect its production had
on the production of eyeglasses.
Social Costs

Social costs are the costs of
production that include both input costs
and costs of the externalities that
production may cause.


7
In the previous example, by not
recognizing the externality in its production,
the charcoal firm produced too much.
Society would be better-off by reallocating
resources away from charcoal production
and toward the production of other goods.
A Graphical Demonstration

Assume the charcoal producer is a price
taker so that its demand curve is
horizontal, as shown in Figure 18-1.


8
The firm maximizes profits, given the
prevailing market price, by producing q*
where price(P*) equals marginal cost(MC).
Due to the externality, however, the social
marginal cost (MCS) exceeds MC.
A Graphical Demonstration




9
The cost of the externality is shown by the vertical
distance between MSC and MC.
At q* the social marginal cost exceeds what people
are willing to pay for the charcoal, P*.
Resources are misallocated and production should be
reduced to q’ where MSC equals P*.
The reduced total social costs (area ABq*q’) exceed
the reduced total spending (area AEq*q’).
FIGURE 18-1: An Externality in Charcoal
Production Causes an Inefficient Allocation
of Resources
MCS
Price,
costs of
charcoal
B
A
P*
MC
E
C
0
10
q’
q*
Charcoal
per week
Property Rights



11
Property rights are the legal specification
of who owns a good and the trades the
owner is allowed to make with it.
Common property is property that may
be used by anyone without cost.
Private property is property that is owned
by specific people who may prevent others
from using it.
Costless Bargaining and
Competitive Markets

Considering the charcoal-eyeglass
externality, suppose property rights were
defined so as to give sole rights to use the
air to one of the firms.


12
The firms were then free to bargain over how
the air might be used.
If bargaining is costless the two parties
might arrive at q’ on their own.
Ownership by the Polluting Firm

If the charcoal firm owns the land, it must
add these ownership costs to its total
costs.


13
The costs of polluting the air are what
someone else is willing to pay for this
resource (clean air) in its best alternative use.
The eyeglass company would be willing to
pay the an amount equal to the external cost
the charcoal company is imposing.
Ownership by the Polluting Firm


14
The charcoal company’s marginal cost will be
MSC, and it will produce q’.
The charcoal company will sell the remaining
air use rights to the eyeglass maker for a fee
of some amount between AEC (the lost profits
of producing q’ rather than q*) and ABEC (the
maximum amount the eyeglass maker would
be willing to pay to avoid having the charcoal
producer increase production to q*.
Ownership by the Injured Firm

If the eyeglass maker owns the air, the
charcoal firm will offer a payment to use
the air associated with output level q’.


15
The eyeglass owner will not sell rights to
pollute beyond this because the price that
the charcoal maker would be willing to pay
(P* - MC) falls short of the cost of this
additional pollution (MCS - MC).
The socially optimal charcoal output, q’,
is produced in this case as well.
The Coase Theorem


16
The Coase theorem (first proposed by
Ronal Coase) states that, if bargaining is
costless, the social cost of an externality
will be taken into account by the parties,
and the allocation of resources will be the
same no matter how property rights are
assigned.
In the previous example, q’ was produced
regardless of who owned the air.
Distributional Effects

The assignment of property rights does affect
the distribution of the benefits.



17
If the charcoal maker receives the property rights,
the fees from the eyeglass producer will make it at
least as well off as if it produced q*.
If the eyeglass producer receives the property
rights, the fees from the charcoal producer will at
least cover the pollution damage.
Factors, such as equity may be important.
The Role of Transactions Costs



18
The Coase theorem relies heavily on the
assumption of zero transactions costs.
If bargaining costs are high, the voluntary
exchange may break down so the efficient
outcome may not be realized.
This may be particularly true concerning
environmental externalities.
Externalities with High
Transactions Costs



19
When transactions costs are high, externalities
may cause real losses in economic welfare.
The fundamental problem is that, with high
transactions costs, economic actors face no
pressure to recognize the third-party effects
they have.
All solutions to externality problems in these
cases must therefore find some way to get the
actors to “internalize” the third-party effects
they cause.
Legal Redress



20
The operation of the law may sometimes provide
a way for taking externalities into account.
If the charcoal producer in Figure 18-1 can be
sued for the harm it does to eyeglass makers,
payment of damages will increase the costs
associated with charcoal production.
Hence, the charcoal MC curve will shift upward
to MCS and an efficient allocation of resources
will be achieved.
Taxation



21
A Pigovian tax (first proposed by A. C.
Pigou) is a tax or subsidy on an externality
that brings about an equality of private and
social marginal costs.
Figure 18-2 is similar to Figure 18-1, except
that an excise tax of amount t is shown that
reduces the net price to P* - t.
This causes the firm to produce the socially
optimal level of output, q’.
FIGURE 18-2: Taxation Solution to
the Externality Problem
MCS
Price,
costs of
charcoal
B
A
P*
P* - t
0
22
MC
E
C
q’
q*
Charcoal
per week
Regulation of Externalities



An alternative to taxation is regulation.
The horizontal axis in Figure 18-3 shows
percentage reductions in pollution that
would exist without regulation.
The curve MB shows the marginal benefit
by reducing pollution by one unit.

23
The shape comes from the assumption of
diminishing returns.
FIGURE 18-3: Optimal Pollution
Abatement
MC
Marginal
benefit,
cost
f*
MB
0
24
R*
100
Reduction
in emission
Regulation of Externalities

The curve MC reflects the marginal costs
in reducing environmental emissions
including foregone profits and the costs of
antipollution equipment.


25
The positive slope reflects the assumption of
increasing marginal costs.
R* is the optimal level of pollution where
the marginal benefits equal marginal
costs.
Fees, Permits, and Direct
Controls

Three general ways to reduce emissions
to R* through environmental policy.



26
A Pigovian-type effluent fee for each percent
of pollution not reduced.
Governmental regulators could issue permits
to produce emission levels.
Direct controls of the amount of pollution
allowed.
Fees

An “effluent fee”,f*in Figure 18-3, is
charged for each percent that pollution
is not reduced.



27
For reductions less than R*, the fee
exceeds marginal cost, so firms will choose
abatement.
Reductions greater than R* would not be
profitable.
The firm is free to choose its method to
reduce pollution.
FIGURE 18-3: Optimal Pollution
Abatement
MC
Marginal
benefit,
cost
f*
MB
0
28
RL
R*
RH
100
Reduction
in emission
Permits



29
Government issued permits would allow firms
to “produce” (100 - R*) percent of their
unregulated emission levels.
As shown in Figure 18-3, freely traded
permits would sell for a price of f*.
A competitive market will ensure that the
optimal level of emissions reductions will be
attained at minimal social cost.
Direct Controls

Governments can tell firms the level of
emissions they would be allowed, and, in
many cases, are accompanied by
specification of the precise mechanism by
which R* is to be achieved.


30
This is a common approach in the U.S.
Specification of the mechanism of reduction
may reduce the cost-minimization incentive.
京都議定書
２００５年２月１６日，《京都議定書》正式生效。這是人類歷史
上首次以法規的形式限制溫室氣體排放。為了促進各國完成溫室氣
體減排目標，議定書允許採取以下四種減排方式：
1. 兩個發達國家之間可以進行排放額度買賣的“排放權交易”，
即難以完成削減任務的國家，可以花錢從超額完成任務的國家
買進超出的額度。
2. 以“凈排放量”計算溫室氣體排放量，即從本國實際排放量中
扣除森林所吸收的二氧化碳的數量。
3. 可以採用綠色開發機制，促使發達國家和發展中國家共同減排
溫室氣體。
4. 可以採用“集團方式”，即歐盟內部的許多國家可視為一個整
體，採取有的國家削減、有的國家增加的方法，在總體上完成
減排任務
31
Attributes of Public Goods

Nonexclusive goods are goods that
provide benefits that no one can be
excluded from enjoying.


32
National defense is an example since,
once an army or navy is set up, everyone
in the country receives protection whether
they pay or not.
Alternatively, a hamburger is exclusive
since, someone can be excluded from
consuming if they do not pay for it.
Attributes of Public Goods

Nonrival goods are goods that additional
consumers may use at zero marginal cost.

33
For example, one more person crossing an
already existing bridge during an off-peak
period requires no additional resources and
does not reduce consumption of anything
else.
Public Goods


34
Public goods provide nonexclusive
benefits to everyone in a group and that
can be provided to one more user at zero
marginal cost.
Table 18-1 presents a cross-classification
of goods by their possibilities for exclusion
and rivalry.
TABLE 18-1: Types of Public and
Private Goods
Exclusive
Yes
Rival
No
35
Yes
Hot dogs, automobiles,
houses
Bridges, swimming
pools, scrambled
satellite television
signals
No
Fishing grounds, public
grazing land, clean air
National defense,
mosquito control, justice
Public Goods and Market Failure


36
In buying a public good, any one person
will not be able to appropriate all the
benefits the good offers.
Since others can not be excluded they can
use the good at zero marginal cost,
society’s benefits from the public good
exceed the benefits to the single buyer.
Public Goods and Market Failure



37
However, the buyer will not take societies
benefits into consideration.
As a result, private markets will tend to
underallocate resources to public goods.
Figure 18-4 shows a situation two people
have a demand for a public good. The total
demand for the public good is the vertical
sum of each persons demand curve.
FIGURE 18-4: Derivation of the
Demand for a Public Good
Willingness
to pay
Total demand



Demand by
person 2
Demand by
person 1

[  , ] Denotes equal distances
38
Quantity of
public good
per week
Public Goods and Market Failure


39
Each point on the total demand curve
shows what persons 1 and 2, together, are
willing to pay for a particular level of the
public good.
Because each individual’s demand curve
is below the total demand curve, no single
buyer is willing to pay what the good is
worth to society.
Voluntary Solutions for Public
Goods

Since public goods cannot be traded
efficiently in competitive markets, one
approach deals with whether an efficient
allocation might come out voluntarily.


40
Would people agree to be taxed in exchange
for the benefits the public good provides?
One solution was proposed by Erik
Lindahl in 1919.
The Lindahl Equilibrium

In Figure 18-5, the curve labeled SS
shows one person’s (Smith) demand for a
particular public good.


41
The vertical axis measures the share of the
public good’s cost that Smith must pay.
The negative slope of SS indicates that, at a
higher tax “price” for the public good, Smith’s
quantity demanded is smaller.
FIGURE 18-5: Lindahl Equilibrium in
the Demand for a Public Good
Share of cost 100
paid by Smith
S
S
0
Quantity of
public good
42
The Lindahl Equilibrium

The second individual’s (Jones) public
good demand curve is derived similarly,
but the proportion paid by Jones is shown
on the right axis.


43
The right axis is reverse scale so that moving
up the axis results in a lower tax paid by
Jones.
Given this convention, Jones’s demand curve
(JJ) has a positive slope.
FIGURE 18-5: Lindahl Equilibrium in
the Demand for a Public Good
Share of cost
paid by Smith 100
0
J
S
J
S
0
100
Quantity of
public good
44
Share of cost
paid by Jones
The Lindahl Equilibrium

The two demand curves intersect at C with
an output level OE of the public good.


45
At this output level Smith is willing to pay 60
percent of the good’s cost whereas Jones
willingly pays 40 percent.
At outputs below OE, the two people
combines are willing to pay more than 100
percent of the cost of the public good.
FIGURE 18-5: Lindahl Equilibrium in
the Demand for a Public Good
Share of cost
paid by Smith 100
Share of cost
0 paid by Jones
J
S
C
60
40
J
S
0
100
E
46
Quantity of
public good
The Lindahl Equilibrium


Output level OE is a Lindahl equilibrium
which is a balance between people’s
demand for public goods and the tax
shares that each must pay for them.

47
For output levels greater than OE, people are
not willing to pay the total cost of the good.
The tax shares are “pseudo prices,” and the
outcome can be shown to be efficient.
Revealing the Demand for Public
Goods


The voting patterns of people generally do
not provide enough information to permit
Lindahl’s tax share to be computed.
Alternatively, governments might ask
people how much they are willing to pay
for a particular package of public goods.

48
It is likely that this poll would prove to be
extremely inaccurate because of free riders.