Chapter 20 Externalities and Public Goods Copyright © 2014 McGraw-Hill Education. All rights...

chapter 20

Externalities and Public Goods

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-2

Learning Objectives

• Explain why competitive markets may not allocate resources efficiently when externalities are present.

• Discuss the nature and limitations of private negotiation as a remedy for market failures associated with externalities.

• Evaluate various public policies that are designed to address externalities.

• Understand why common property resources tend to be overused, and analyze ways that such problems can be corrected.

• Identify the characteristics of a good that can justify public provision.


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Overview

• Externalities: When our choices directly affect the well being of others not involved in the transaction, competitive markets may allocate resources inefficiently

• Private parties have strong incentives to identify inefficiencies and negotiate mutually beneficial solutions

• When the private sector fails to address externalities, appropriate government policies can potentially improve economic efficiency

• Common property resources tend to be overused, though that problem can be corrected

• The government provision of public goods is sometimes beneficial


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Externalities

• Externality: when an action affects someone with whom the decision maker has not engaged in a related market transaction– Negative externality: when such an action harms

someone else – Positive externality: when such an action benefits

someone else• External cost: the economic harm that a negative

externality imposes on others• External benefit: the economic gain that a positive

externality provides to others


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Inefficiency in Competitive Markets

• When an externality is present, the private costs and/or benefits of an activity to the party who performs it differ from the social costs and/or benefits of that activity

• When a consumption or production activity creates an externality, competitive markets will usually allocate resources inefficiently


Competitive Equilibrium with a Negative Externality

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 20-6

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Competitive Equilibrium with a Positive Externality


Monopoly with a Negative Externality


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Remedies for Externalities

• Private sector– Property rights and negotiation

• Public sector– Policies that support markets – Quantity controls– Taxes, fees, subsidies– Liability rules

• Hybrid market approaches – Tradable permits


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Property Rights and Negotiation

• The outcome of any negotiation depends on the allocation of property rights– The party who holds the relevant property rights is

in a stronger bargaining position • Coase Theorem: if bargaining is frictionless, then

regardless of how property rights are assigned, voluntary agreements between private parties will remedy the market failures associated with externalities and restore economic efficiency


Property Rights and Negotiation


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Limitations of Bargaining

• Bargaining can be impractical, requiring substantial time and effort

• The assignment of property rights may be ambiguous• Parties may have limited information about each

others’ costs and benefits• Efficient contracts may be difficult to monitor and

enforce


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Remedies for Externalities: The Public Sector

• Public sector– Policies that support markets – Quantity controls– Taxes, fees, subsidies– Liability rules


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Policies That Support Markets

• When private negotiations fail to remedy the market failures associated with externalities, appropriate government policies can potentially improve economic efficiency

• In some situations, governments can address externalities by helping the private sector create the necessary markets– Establish clear property rights, pass laws that

protect those rights, and enforce contracts– Governments can even create and operate a market


Quantity Controls

• Emissions standard: legal limit on the amount of pollution that a person or company can produce when engaged in a particular activity

Socially efficient


Taxes, Fees, and Subsidies

• Pigouvian taxation: the use of taxes or fees to remedy negative externalities

• Pigouvian subsidization: the use of subsidies to remedy positive externalities


Liability Rules

• Liability rule: a legal principle requiring a party who takes an action that harms others to compensate the affected parties for some or all of their losses


Pitfall for Liability Rules and Pigouvian Taxes

• Efforts to correct private incentives can lead to high levels of inefficiency because they might lead the affected parties to engage in wasteful behaviors


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Consequences of Policy Errors

• Government information and choices are frequently imperfect

• Errors in setting a tax and a standard may have different implications, depending on the slopes of the curves


Consequences of Policy Errors for a Noise Standard and a Noise Tax


Minimizing the Total Cost of Abatement

• With a tax on SO2 emissions, each firm will pollute up to the point at which the marginal cost of abatement equals the tax rate– The firms will produce

different amounts of pollution, yet they will share the same marginal cost of abatement

• Setting the same emissions standard for both firms would be highly inefficient


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Flexibility

• A quantity standard sometimes offers greater flexibility than a tax– E.g., the government can ban smoking in the workplace

while permitting it in bars, but would have difficulty taxing cigarettes differently according to where smokers consume them

• However, a tax also sometimes offers greater practical flexibility than a quantity standard– E.g., the government would have difficulty monitoring

compliance with a limit on the number of cigarettes a person can smoke, but can easily vary the tax rate on cigarettes


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Pigouvian Subsidy for College Tuition

With Pigouvian subsidy


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Economic Justification for Compulsory Schooling


Tradable Permits Promote Low-Cost Abatement

• Tradable emissions permit: entitles a firm to generate a specified amount of a given pollutant. It is also transferrable; one firm can sell it to another.

• Total emissions are limited by the number of permits the government chooses to issue. Tradable permits achieve any given reduction in total emissions at the lowest possible abatement cost. Permits allocated to each firm

Trade

- 2.5 + 2.5


Common Property Resources and Overfishing

• Common property resource: a resource that more than one person is free to use without payment • Lakes, rivers, parks,

air• People tend to

overuse such resources, creating a negative externality


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Public Good

• A good is nonrival if more than one person can consume it at the same time without affecting its value to others

• A good is nonexcludable if there is no way to prevent a person from consuming it

• Public good: a good that is nonrival and nonexcludable

• Private good: a good for which consumption involves perfect rivalry and that is completely excludable


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Public Goods

Private solution

Socially efficient outcome


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Public Goods and Market Failure

• If the provision of a public good is left entirely to the independent actions of private parties, the level of production will usually be inefficiently low

• A free rider contributes little or nothing to a public good while benefitting from others’ contributions


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Public Policy toward Public Goods

• Provide some public goods– Example: national defense

• Contribute to nonprofit organizations that provide other public goods– Example: public radio

• Subsidize private contributions to many public goods– Example: environmental protection


Groves MechanismGroves mechanism: a procedure for setting the level of the public good that induces everyone to report their preferences correctly, producing a socially efficient outcome

All MB minus one individual

Self-reported marginal benefits

Optimal contribution of that individual


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Public Decision Making

• To determine whether public intervention is justified, we must weigh the consequences of a market failure against the likely consequence of a government failure

• Political economy: examines the economic consequences of public sector decision making


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Majority Rule and the Level of a Public Good


Maximum total social benefit Median voter: with majority rule, his ideal policy will be chosen

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Majority Rule and the Level of a Public Good

• A voter’s preferences are single-peaked if her net benefit from an activity increases with the activity’s level until her ideal is reached, and declines thereafter

• The median voter is the voter who has the median ideal policy among all voters

• The median voter theorem states that, if voters have single-peaked preferences, a majority of them prefer the median ideal policy to all other policies


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Review

• When an activity creates an externality, competitive markets will allocate resources inefficiently.

• Externalities result from missing markets. Negotiations can substitute for those markets.

• If bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will lead to an efficient outcome.

• Governments can remedy some externalities through policies that help the private sector create the necessary markets, or by creating and operating those markets, or by regulating the level of activities, or by correcting private incentives through taxes, fees, subsidies, or liability rules.


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Review

• People tend to overuse common property resources, thereby creating negative externalities.

• To determine whether public intervention is justified, we must weigh the consequences of market failure against the likely consequence of government failure.


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Looking Forward

• Next, we will switch our attention to situations where one party to a transaction has more information than the other.

• Among other phenomena, we will study the effect of adverse selection and moral hazard on economic behavior and efficiency.


Chapter 20 Externalities and Public Goods Copyright © 2014 McGraw-Hill Education. All rights...

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Transcript of Chapter 20 Externalities and Public Goods Copyright © 2014 McGraw-Hill Education. All rights...