MicroeconomicsECON 2302Spring 2011

Marilyn Spencer, Ph.D.

Professor of Economics

Chapter 5

CHAPTER 5

Externalities, Environmental Policy, and Public Goods

How should government policy deal with the problem of pollution?Can economic analysis help in

formulating more efficient pollution policies?

5.1 Externalities and Economic EfficiencyIdentify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

5.2 Private Solutions to Externalities: The Coase TheoremDiscuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.

5.3 Government Policies to Deal with ExternalitiesAnalyze government policies to achieve economic efficiency in a market with an externality.

5.4 Four Categories of GoodsExplain how goods can be categorized on the basis of whether they are rival or excludable, and use graphs to illustrate the efficient quantities of public goods and common resources.

Chapter Outline and Learning Objectives

Externalities, Environmental Policy & Public Goods

CHAPTER 5

Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

Externalities, Environmental Policy, and Public Goods

Private cost The cost borne by the producer of a good or service.

Social cost The total cost of producing a good, including both the private cost and any external cost.

Private benefit The benefit received by the consumer of a good or service.

Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit.

Externalities and Economic EfficiencyThe Effect of Externalities

Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

5.1 LEARNING OBJECTIVE

The Effect of Externalities: How a Negative Externality in Production Reduces Economic Efficiency

FIGURE 5-1 The Effect of Pollution on

Economic Efficiency

Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level. Supply curve S1

represents just the marginal private cost that the utility has to pay.

Supply curve S2 represents

the marginal social cost, which includes the costs to those affected by acid rain.

If the supply curve were S2,

rather than S1, market

equilibrium would occur at price PEfficient and quantity

QEfficient, the economically

efficient level of output. But when the supply curve is S1, the market equilibrium occurs at price PMarket and quantity QMarket, where there is a DWL equal to the area of the yellow triangle. Because of the deadweight loss, this equilibrium is not efficient.

FIGURE 5-2 The Effect of a Positive Externality on EfficiencyPeople who do not consume

college educations can still benefit from them. As a result, the marginal social benefit from a college education is greater than the marginal private benefit seen by college students.

Because only the marginal private benefit is represented in the market demand curve D1, the

quantity of college educations produced, QMarket,

is too low.

The Effect of Externalities: How a Positive Externality in Consumption Reduces Economic Efficiency

If the market demand curve were D2 instead of D1, the level of college educations produced would be QEfficient, which is the efficient level. At the market equilibrium of QMarket, there is a DWL equal to the area of the yellow triangle.

Externalities and Economic Efficiency

Externalities and Market Failure:

Market failure A situation in which the market fails to produce the efficient level of output.

What Causes Externalities?

Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

The Coase Theorem

Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

The Problem of Transactions Costs

Coase theorem The argument of economist Ronald Coase that if (1) transactions costs are low AND (2) all interested parties can be identified, then private bargaining will result in an efficient solution to the problem of externalities.

Private Solutions to Externalities: The Coase Theorem

Discuss the Coase Theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.

5.2 LEARNING OBJECTIVE

Makingthe

ConnectionThe Fable of the Bees

Some apple growers and beekeepers make private arrangements to arrive at an economically efficient outcome.

If there are positive externalities in both apple growing and bee-keeping, the market may not supply enough apple trees and beehives.

Government intervention, however, may not be necessary because beekeepers and apple growers arrive at private agreements.

Government Policies to Deal with Externalities

FIGURE 5-5 When There Is a Negative Externality, a Tax Can Bring about the Efficient Level of Output

Analyze government policies to achieve economic efficiency in a market with an externality.

5.3 LEARNING OBJECTIVE

Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level. If the government imposes a tax equal to the cost of acid rain, the utilities will internalize the externality. As a consequence, the supply curve will shift up, from S1 to

S2.

The market equilibrium quantity changes from QMarket,

where an inefficiently high level of electricity is produced, to QEfficient, the economically

efficient equilibrium quantity. The price of electricity will rise from PMarket—which does not include the cost of acid rain

—to PEfficient—which does include the cost. Consumers pay the price PEfficient, while

producers receive a price P, which is equal to PEfficient minus the amount of the tax.

Government Policies to Deal with Externalities: The Economically Efficient Level of Pollution Reduction

FIGURE 5-3If the reduction of SO2 emissions is at 7.0 M tons/year, the MB of $250 per ton is > the MC of $175/ton. Further reductions in emissions will increase the net benefit to society. If the reduction of SO2 emissions is at 10.0 M tons, the MC of $225/ton is > the MB of $150/ton. An increase in SO2 emissions will increase the net benefit to society. Only when the reduction is at 8.5 M tons is the MB = MC. This level is the economically efficient level of pollution reduction.

FIGURE 5-4Increasing the reduction in SO2 emissions from 7.0 M tons to 8.5 M tons results in total benefits equal to the sum of the areas A and B under the MB curve.

The TC of this decrease in pollution is equal to the area B under the MC curve.

TB > TC by an amount equal to the area of triangle A.

Because the TB from reducing pollution are > the TC, it’s possible for those receiving the benefits to arrive at a private agreement with polluters to pay them to reduce pollution.

Don’t Let This Happen to YOU!Remember That It’s the Net Benefit That Counts

Government Policies to Deal with Externalities: The Economically Efficient Level of Pollution Reduction

Makingthe

Connection

The Clean Air Act:How a Government PolicyReduced Infant Mortality

The benefit of reducing air pollution in 1970 was much higher than the benefit from a proportional reduction in air pollution would be today, when the level of pollution is much lower. In the two years following passage of the Clean Air Act, there was a sharp reduction in air pollution and also a reduction in infant mortality.

Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.

Command-and-control approach An approach that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices.

Government Policies to Deal with Externalities: Command and Control versus Market-Based Approaches

Solved Problem 5-3Using a Tax to Deal with a Negative Externality

FIGURE 5-6

When There Is a Positive Externality, a Subsidy Can Bring about the Efficient Level of Output

People who do not consume college educations can benefit from them. As a result, the social benefit from a college education is > the private benefit seen by college students. If the government pays a subsidy equal to the external benefit, students will internalize the externality. The subsidy will cause the demand curve to shift up, from D1 to D2. The result will

be that market equilibrium quantity shifts from QMarket,

where an inefficiently low level of college educations is supplied, to QEfficient, the

economically efficient equilibrium quantity.

Government Policies to Deal with Externalities: Using a Subsidy to Reach the Economically

Efficient Level of Higher Education

Producers receive the price PEfficient, while consumers pay a price P, which is equal to PEfficient minus the amount of the subsidy.

Makingthe

Connection

Can a Cap-and-Trade System

Reduce Global Warming?

Policymakers and economists have debated the mechanism by which reductions in CO2 emissions should occur. The United States has favored a global system of tradable emission permits for CO2 that would be similar to

the system for SO2 discussed earlier in this chapter.

Four Categories of Goods

Rivalry The situation that occurs when one person’s consuming a unit of a good means no one else can consume it.

Excludability The situation in which anyone who does not pay for a good cannot consume it.

Explain how goods can be categorized on the basis of whether they are rival or excludable, & use graphs to illustrate the efficient quantities of public goods & common resources.

5.4 LEARNING OBJECTIVE

FIGURE 5-7 Four Categories of Goods

Four Categories of GoodsGoods and services can be divided into four categories on the basis of whether people can be excluded from consuming them and whether they are rival in consumption.

A good or service is rival in consumption if one person consuming a unit of a good means that another person cannot consume that unit.

1. Private good A good that is both rival and excludable.

2. Public good A good that is both nonrivalrous and nonexcludable.

Free riding Benefiting from a good without paying for it.

3. Quasi-public goods Goods that are excludable but not rival.

4. Common resource A good that is rival but not excludable.

Four Categories of Goods

Makingthe

Connection

Should the GovernmentRun the Health Care System?

Because health care is so important to consumers and because health care spending looms so large in the U.S. economy, the role of the government in the health care system is likely to be the subject of intense debate for some time to come.

FIGURE 5-9 Constructing the Market Demand Curve for a Private Good

The market demand curve for private goods is determined by adding horizontally the quantity of the good demanded at each price by each consumer. For instance, in panel (a), Jill demands 2 hamburgers when the price is $4.00; and in panel (b), Joe demands 4 hamburgers when the price is $4.00. So, a quantity of 6 hamburgers and a price of $4.00 is a point on the market demand curve in panel (c).

Four Categories of Goods:The Demand for a Public Good

FIGURE 5-10

Constructing the Market Demand Curve for a

Public Good

To find the D curve for a public good, we add up the prices for all consumers, for their willing to purchase each Q of the good.

Therefore, in panel (c), the price of $18 per hour and the quantity of 10 hours will be a point on the market demand curve for security guard services.

In panel (a), Jill is willing to pay $8/hr for a security guard to provide 10 hrs of protection.

In panel (b), Joe is willing to pay $10 for that level of protection.

FIGURE 5-10The Optimal Quantity of a Public Good

The optimal quantity of a public good is produced where the sum of consumer surplus and producer surplus is maximized, which occurs where the D curve intersects the S curve.

Four Categories of Goods:The Optimal Quantity of a Public Good

In this case, the optimal quantity of security guard services is 15 hours, at a price of $9 per hour.

Solved Problem 5-4Determining the OptimalLevel of Public Goods

DEMAND OR MARGINAL SOCIAL BENEFIT

PRICE (DOLLARS PER HOUR)

QUANTITY (HOURSOF PROTECTION)

$38 1

34 2

30 3

26 4

22 5

18 6

14 7

10 8

6 9

JILL

PRICE (DOLLARS PER HOUR)

QUANITY (HOURS OF PROTECTION)

$20 1

18 2

16 3

14 4

12 5

10 6

8 7

6 8

4 9

2 10

JOE

PRICE (DOLLARS PER HOUR)

QUANTITY (HOURSOF PROTECTION)

$20 0

18 1

16 2

14 3

12 4

10 5

8 6

6 7

4 8

2 9

To calculate the marginal social benefit of guard services, we need to add the prices that Jill and Joe are willing to pay at each quantity.

Solved Problem 5-4Determining the OptimalLevel of Public Goods (continued)

DEMAND OR MARGINAL SOCIAL BENEFIT

PRICE (DOLLARS PER HOUR)

QUANTITY (HOURSOF PROTECTION)

$38 1

34 2

30 3

26 4

22 5

18 6

14 7

10 8

6 9

SUPPLY

PRICE (DOLLARS PER HOUR)

QUANTITY (HOURSOF PROTECTION)

$8 1

10 2

12 3

14 4

16 5

18 6

20 7

22 8

24 9

Common ResourcesTragedy of the commons The tendency for a common resource to be overused

FIGURE 5-11 Overuse of a Common Resource

For a common resource, such as wood from a forest, the efficient level of use, QEfficient, is

determined by the intersection of the D curve - which represents the MB received by consumers - and S2, which represents

the MSCof cutting the wood.

Because each individual tree cutter ignores the external cost, the equilibrium quantity of wood cut is QActual, which

is greater than the efficient quantity. At the equilibrium level of output, there is a deadweight loss, as shown by the yellow triangle.

The Carbon Cap DilemmaAN INSIDE LOOK

>>

Using a carbon tax to reduce CO2 emissions.

KEY TERMS

Coase theorem

Command-and-control approach

Common resource

Excludability

Externality

Free riding

Market failure

Pigovian taxes & subsidies

Private benefit

Private cost

Private good

Property rights

Public good

Rivalry

Social benefit

Social cost

Tragedy of the commons

Transactions costs

Before we begin Ch. 6 in class, pre-read Ch. 6, including: Review Questions: 3rd ed., p.194, 1.1-1.4; p 196 2.1, 2.2; p 198, 4.1,

4.2; p 200, 5.1; p 201, 6.1 and “If demand for orange juice (OJ) is inelastic, will a rise in the price of OJ increase or decrease the revenue received by orange juice sellers?” (2nd ed., p. 200, 1.1-1.4; p. 202, 2.1 & 2.2; p. 204, 4.1 & 4.2; pp. 205-6, 5.1; p. 206, 6.1; 1st edition: 1-10, p. 193);

Problems and Applications: 3rd ed., p196, 2.5; p 197, 3.3; p 200, 5.2; p 201, 6.6 and “During 2001 in Afghanistan, the Taliban outlawed growing poppies, from which opium is made. Opium output fell by 95%, and the price of opium rose from 2,000 rupees/kg to 40,000 rupees/kg. What was the price elasticity of demand for opium in Afghanistan?” (2nd ed., p. 202, 3.3; p. 206, 5.2; p. 202, 2.4; p. 207, 6.6; and 1st edition: 2, 3, 5, 6 & 18, pp. 193-195).