Economic Efficiency III

8/3/2019 Economic Efficiency III

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Externalities

When a private action has side effects thataffect other people in important ways, wehave the problem of externalities

By-product of a good or activity that affectssomeone not immediately involved intransaction


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The Private Solution to a NegativeExternality

Under certain conditions, inefficiency thatwould be caused by a negative externalitywill automatically be resolved by the parties

themselves

The outcome is the efficient outcome

Achieves maximization of total net benefits possible

in the situation


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The Coase Theorem

What if building a theater would create$100,000 of benefits for some but $70,000worth of harm for others?

Whether the theater will or will not be builtdepends entirely on whether it is theefficient or inefficient outcome

Regardless of who holds the legal rights Negative externality is solved by market

No government intervention is required, otherthan the initial assignment of legal rights


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The Coase Theorem

The Coase Theoremnamed aftereconomist Ronald Coase

States that private market will solve externalityproblem on its own, always arriving at theefficient outcome

When side payments can be negotiated andarranged without cost

While initial distribution of legal rights willdetermine allocation of gains and losses amongthe parties, it will not affect action taken


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The Coase Theorem

Requires that side payments can be arranged without costor, inpractice, that cost is so low relative to gains or losses at stake that itdoesnt matter This requirement is most likely to be satisfied when all of the following

conditions are present

Legal rights are clearly established Legal rights can be easily transferred

The number of people involved is very small

Unfortunately, many real world situations do not satisfy theseconditions

Biggest problem is applying Coase theorem to many real-worldexternalities is the third condition Often, a large number of people are involved

When many people are involved, achieving efficiency with sidepayments is plagued by an often insoluble problem Free rider problem


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The Free Rider Problem

Occurs when efficient outcome requires a sidepayment but individual gainerseach obligated topay a small share of the side paymentwill notcontribute

If extensive enoughcan shrink the side paymentuntil it isnt large enough to compensate losersand still leave gainers better off

Stands in the way of many Pareto improvements One of the main reasons why we typically turn togovernment to deal with important externalities thataffect many people


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Market Externalities andGovernment Solutions

A competitive market has many buyers and sellers When a negative externality affects a market, the private solution is

unlikely to work

A market with a negative externality associated with

producing or consuming a good will produce more than theefficient quantity Creating a welfare loss

Unfortunately, with so many people involved, it would taketoo much time and trouble for individual producers and

consumers to arrange appropriate side payments andproduction cutbacks In any case, free rider problem would effectively destroy the

arrangement

Efficient outcome requires government intervention in the market


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Figure 11a: A Tax on Producers toCorrect a Negative Externality

100 125

D

S

$1.00A

MSC

C $0.50B

(a)

Millions of Gallonsper Period

Dollars

2. The efficient quantity is here . . .

3. but the equilibriumquantity is here.

4. In equilibrium, the welfareloss is triangle ABC.

1. This market has a negativeexternality of $0.50 per unit.


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Figure 11b: A Tax on Producers toCorrect a Negative Externality

100 125

D

$1.00

$0.50B

(b)

Millions of Gallonsper Period

Dollars

$1.30

$0.80

SBefore Tax

SAfter Tax

6. shifts the supply curve upward . . .

7. and moves theequilibrium to theefficient quantity.

5. A tax per unit on producers, equalto the negative externality per unit,

A


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Taxing a Negative Externality

Government could use a tax on producers to move gasoline market to point B

Payment of the externality tax is shared between consumers and producers,as is the payment of any tax, and will depend on elasticities of supply anddemand A tax on each unit of a good, equal to the external harm it causes, can correct a

negative externality and bring market to an efficient output level

Consider the logic of this result Tax cures the inefficiency because it forces market to internalize the externality

To take account of the harm caused by gasoline

Suggests that a tax on consumers of gasoline would work just as well as a taxon producers

Taxes to correct negative externalities have been used in countries around theworld In United States, however, taxes designed to correct negative externalities are less

common


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Regulation and Tradable Permits

A tax is not only way to correct a negative externality Government can also use regulation to move a market closer to

the efficient point

In last two decades, U.S. government has relied

increasingly on an innovative technique to reduce severaltypes of pollution Tradable permits

License that allows a company to release a unit of pollution into theenvironment over some period of time

Firms can trade their permits in an organized market Left to itself, a market with a negative externality will

produce too much output Taxes, regulation, and tradable permits are examples of

government intervention to decrease output toward efficient level


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Dealing with a Positive Externality

What about the case of a positive externality? By-product of an activity or a service benefits other

parties, rather than harms them

A market with a positive externality associatedwith producing or consuming a good will produceless than the efficient quantity, creating a welfareloss

A subsidy on each unit of a good, equal to theexternal benefits it creates, can correct a positiveexternality and bring the market to an efficientoutput level


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Figure 12a: A Subsidy for Consumers toCorrect a Positive Externality

800,000 1,000,000

D

S

$100,000MSB

C

A

$30,000

2. The equilibrium quantity is here . . .

3. but the efficientquantity is here.

4. In equilibrium, the welfare loss is triangle ABC.

(a)

Number ofDegrees per Year

Dollars

1.This market has a positive externalityof $30,000 per college degree.

B


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Figure 12b: A Subsidy for Consumers toCorrect a Positive Externality

S

800,000 1,000,000

$100,000

B

A

$30,000

Number ofDegrees per Year

Dollars

(b)

$114,000

$84,000

DBefore Subsidy

DAfter Subsidy

6. shifts the demand curve upward . . .

5. A subsidy per unit for consumers equalto the positive externality per unit . . .

7. and moves the

market to theefficient quantity


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Public Goods

Pure private good One that is both rivalrous and excludable

In absence of any significant market failure, private firms will provide thesegoods at close to efficient levels

When a good is nonexcludable, people have an incentive to become

free riders To let others pay for the good, so they can enjoy it without paying When a good is nonexcludable, private sector will generally be unable

to provide it In most cases, if we want such a good, government must provide it

When a good or service is nonrivalrous, market cannot provide it

efficiently Rather, to achieve economic efficiency, good or service would have to be

provided free of charge

Pure public good One that is both nonrivalrous and nonexcludable


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Figure 13: Pure Private, Pure Publicand Mixed Goods

MoreNonexcludable

More Excludable

More Rival More Nonrival

Mixed Good

Pure Private Good Mixed Good

Pure Public Good

food, clothing,housing

sold-out movie

crowdedhighway

newspaper

software

movie with emptyseats

uncrowded highway downloaded

music file cable

television

urban park

national defense,legal system

police and fire

protection crowdedcity streets fish in international

waters


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Mixed Goods

Goods that appear in upper right and lowerleft corners of Figure 13 can be calledmixed goods

Share features of both public and private goods

These goods are becoming increasinglyimportant in our society

Are responsible for some growing tension andcontroversy


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Excludable But Nonrivalrous Goods

Goods near lower left hand corner are excludable butnonrivalrous Includes most information products

Software is an essentially nonrivalrous good, but an excludable

one Neither pure public nor pure private

Digital music files are another example of this type of mixed good Currently, music remains somewhat excludable

It is against the law to make copyrighted music available online

Many peopleeither because of respect for the law, fear of getting caught,

lack of technical expertise, or scarce timestill prefer to buy their musicfrom a store or online shipping service

Music industry is desperately looking for ways to achieve greaterexcludability

Has not yet found a good solution


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Nonexcludable But Rivalrous Goods

Tragedy of commons occurs when rivalrous but nonexcludable goodsare overuse to detriment of all

An economy with well-functioning, perfectly competitive markets tendsto be economically efficient

Many types of government involvement are needed to ensure that marketsfunction well and to deal with market failures

Cases of government involvement are not without controversy

Debates about public education, Social Security, international trade, andimmigration center on questions of proper role for government

Some of the disagreement is over governments role in bringing abouta more fair economy

Also debate about the governments role in bringing about economic

efficiency


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Nonexcludable But Rivalrous Goods

Information problems While government may be able to move us closer to efficiency, it can also fall short

or overshoot based on inaccurate information

Incentive problems for government Government officials are agents of the general public, and are supposed to serve

public interest

However, they can be influenced by lobbies for special interest groups

In order for government to have the funds it needs to support markets and doother things, it must raise revenue through taxes

Inherent problem with provision of public goods that almost guaranteesdissatisfaction about them

Other important roles for government besides fostering efficiency Equity, fairness, justice, and more

Anyone studying role of government in the economies is struck by one glaringfact Most economic activity is carried out among private individuals


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Using the Theory: Traffic as aMarket Failure

Almost everyone in United States has been caught in atraffic jam in some large town or city at some point in theirlives

Problem in most cities is getting worse Consider London, for example

Traffic congestion has worsened dramatically in recent decades,especially in the historic inner city

Traffic is an externality problem When you decide to take your car onto a city street, your decision

is based on the costs and benefits to you

Traffic can be viewed as a mixed good Can the government solve the problem?

Some cities, such as New York, do charge tolls for cars that enter viabridges or tunnels

But entry tolls are problematic, and are rarely set high enough to solve theproblem

U i h Th T ffi


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Using the Theory: Traffic as aMarket Failure

A bigger problem Political damage to any elected representative who would propose

a fee high enough to be efficient for a good that has traditionallybeen free

All of this conventional political wisdom may have changedin early 2003 In early 2003, Ken Livingstone, the Mayor of London, decided to

take a chance His administration established a 5 (about $8) per day user fee on any

automobile that appeared in the 8 square mile boundary of Londonsinner city

On the first day the fee applied, traffic dropped about 25% 60,000 fewer cars entered the area than on a normal day

Officials in New York, Paris, Los Angeles, and other large citiesaround the world have been studying Londons success

Economic Efficiency III

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