Download Lecture 2 Public goods and externalities

Lecture 2
Public goods and externalities
Environmental Economics, Politecnico di Milano, Academic Year
2015-2016
Giovanni Marin
IRCrES-CNR, Milano
e-mail: [email protected]
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Outline of the lecture
• Definition of market failure
• Public goods
• Definition
• Optimality
• Free riding problem
• Partial equilibrium analysis
• Externalities
• Definition
• Market failure in presence of externalities
• Optimality in presence of externalities
• Coase theorem
• Pigouvian tax
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Assumption for markets leading to efficient allocations:
1. Markets exist for all goods and services produced and consumed
2. All markets are perfectly competitive ⇒ agents are price takers
3. All agents have perfect information
4. Private property rights are fully assigned on all resources and
commodities
5. All agents are maximizers
• In reality, markets often depart from one or more of these
assumptions ⇒ market failures
• Public goods and externalities arise because of the failure of
conditions 1 and 4
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Public goods - Introduction
• Goods can be classified according to two different dimensions
• Rivalry in consumption
• Excludability
• Rivalry
• One agent’s consumption does (not) prevent other agents to consume
the good ⇒ Ice cream vs view of a beautiful landscape
• Excludability
• Agents can(not) be excluded from the consumption of the good ⇒
Clean air vs wilderness area
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Some classical examples
• Defence
• Lighthouse
• Clean air
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Taxonomy of goods
Excludable
Non-excludable
Rivalrous
Pure Private Good
Ice cream
Open Access Resource
Ocean fishery
(non-territorial waters)
Non-rivalrous
Congestible Resource
Wilderness area
Pure Public Good
Defence
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Private and public goods
• Pure private goods exhibit both rivalry and excludability
• These are ’ordinary’ goods and services, such as ice cream
• For a given amount of ice cream available, any increase in consumption
by A must be at the expense of consumption by others (rivalry)
• Any individual can be excluded from ice cream consumption
• Pure public goods are nor rivalry or excludable
• An example is the services of the national defence force
• Open access (or common) natural resources
• There is rivalry in consumption
• Excludability is impossible or characterized by prohibitive costs
• Example: ocean fisheries outside territorial waters of any country
• Congestible resources exhibit excludability but not (up to the point of
congestion) rivalry
• Example: wilderness area
• The area is excludable (enforcing limit to access are feasible)
• No rivalry exists up to the point of congestion (after which nobody can
‘consume’ the good)
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Public goods in market economies
• Non-rivalry implies that all individuals consume the same amount of
the public good
• The quantity that is consumed by any individuals is the same, but
they do not necessarily value the public good equally at the margin ⇒
efficiency will not require that MRUS(A) = MRUS(B) as in the case
of private goods
• As the marginal cost of providing the public good to all individuals
does not depend on the number of individuals that consume the
good, efficiency requires that in equilibrium marginal costs should be
equal to the sum of marginal
willingness to pay)
Pvaluations (marginal
P
of all individuals ⇒ MC = i MRUS(i) = i MWTP(i)
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Optimal provision of public good
Euro
MC=MRT
MRUSA+MRUSB=MWTPA+MWTPB
MRUSB
MRUSA
X*
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X=public good
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The problem with public goods...
• Choose four people
• Give everyone 1 euro
• Each person privately chooses how much to contribute ⇒ ci
• I take the ‘pot’ and double it ⇒ Ptot = 2
P4
i=1 ci
• I then distribute the pot equally to the four people ⇒ Ptot /4
• How much do you contribute?
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The problem with public goods...
• Maximum net benefit attainable if ci = 1∀i ⇒ 4×2
4 −1=1
• Net benefit for me if all except me contribute 1 ⇒ 3×2
4 − 0 = 1.5
while the others will get
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3×2
4
− 1 = 0.5
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Free rider problem
• People want to consume a public good, but they do not want to
contribute (as they cannot be excluded)
• Everyone hopes that someone else will contribute, and they the will
consume the public good thanks to other people’s contribution
• People do not want to contribute to avoid the upfront cost of
contribution and because other people benefit from their contribution
• How do we solve the free rider problem? ⇒ public provision of the
public good
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Declared and actual WTP for public goods
WTP
Actual WTP for public good
Declared WTP for public good
X=public good
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Public provision is not easy
• Taxation that finances the public provision of public goods is usually
distortionary (e.g. income and consumption taxes)
• Optimal level of the public good is still unknown to the government
⇒ not easy to quantify the aggregate sum MRUS
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Simple ‘partial equilibrium’ representation
• In partial equilibrium, we just consider good X taking the level of Y
as fixed/given
Consumers
• Utility (consumer benefits) is increasing in the consumption of good
X , but at a decreasing rate ⇒ B(X )
• dB/dX > 0; ddB/ddX < 0
• dB/dX > 0 can be also seen as the (marginal) willingness to pay,
MWTP(X ), for being able to consume an additional unit of X ⇒ it
corresponds to the marginal benefits arising from the consumption of
X ⇒ MB(X )
Producers
• Total production costs, C (X ), are increasing more than proportionally
in the production of X
• dC /dX > 0; ddC /ddX > 0
• dC /dX > 0 can be also seen as the marginal costs, that is the cost of
producing an additional unit of X
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Benefits and costs
B(X)
C(X)
Max B(X)-C(X)
X*
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Simple ‘partial equilibrium’ representation
• Consumers will purchase X up to the point in which the price (P X )
equals the marginal benefit from consumption ⇒ MB(X )
• Producer will produce X up to the point in which the price equals the
marginal cost of producing X ⇒ MC (X )
• Welfare is maximized when marginal benefits equal marginal costs
(and both equal prices) ⇒ MC (X ∗ ) = MB(X ∗ ) = P X
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Maximization of welfare
MC(X)
Max B(X)-C(X)
MB(X)
X*
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Consumers’ surplus and producers’ surplus
Consumer’s surplus
MC(X)
Producer’s surplus
P*
Max B(X)-C(X)
MB(X)
X*
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Externalities
• An externality occurs when the production or consumption decisions
of one agent have an impact on the utility or profit of another agent
in an unintended way, and when no compensation/payment is made
by the generator of the impact to the affected party
• Consumption and production behaviours often affect in
uncompensated/unpaid ways the utility gained by other consumers or
the output produced, and profit earned, by other producers
• Externalities can be either positive or negative
• Externalities are a source of market failure
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Externalities
• A decision that benefits someone else (with no market transactions)
generates a positive externality
• Vaccines prevent an individual from getting a disease, but also has the
positive effect of the individual not being able to spread the disease to
others
• A decision that harms someone else (with no market transactions)
generates a negative externality
• A steel producing factory releases pollution in the air. The factory pays
for labour and capital needed to produce steel, while the individuals
living near to the factory are harmed by the pollution (higher medical
expenses, poorer quality of life, etc). The production of steel by the
factory generates a damage for individuals living near the factory and in
absence of specificic actions the factory will not compensate for the
damage it generates
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Externalities
• Given that all of the other institutional conditions for a pure market
system to realize an efficient allocation hold, if there is:
• a positive externality, the market will produce too little of it in relation
to the requirements of allocative efficiency
• a negative externality, the market will produce more of it than the
amount required by allocative efficiency
• Why?
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Negative externalities: private vs social costs
• Private costs for a producer of a good, service, or activity include the
costs the firm pays to purchase/rent capital equipment, compensate
labour, and buy materials and other intermediate inputs
• Social costs include both the private costs and any other external
costs imposted on the society as a consequence of the production or
consumption of a good or service
• An external cost is the economic harm imposed on others due to the
presence of a negative externality
• The private costs of driving a car include fuel consumption,
maintenance costs, depreciation, time spent by the driver while driving
the car
• The social costs include all these private costs as well as the costs
imposed on other people other than the driver in terms of congestion
and air pollution induced by the use of the car
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Negative externalities: private vs social costs
• The private costs of producing output include the cost of labour,
capital and other inputs ⇒ ‘conventional’ upward-sloped marginal
cost function (MC )
• The social costs of producing output include all these private costs
(labour, capital and other inputs, MC ) and also the costs imposed on
other people (external marginal cost, MEC , or marginal damage,
MD) ⇒ marginal social cost MSC = MC + MEC = MC + MD
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Negative externalities: private vs social costs
• In presence of negative externalities, competitive markets deliver
‘poor’ performance (in terms of allocative efficiency) because:
1. Firms in competitive markets decide how many units of output to
produce by balancing private gains and costs (P 0 = MC 0 )
2. As they do not bear the external costs of their activity, the will fully
disregard external effects
3. Welfare-maximizing output level would be such that social gains and
costs would be equal (P ∗ = MSC ∗ )
4. As MSC > MC , firms in competitive markets produce too much
output thus generating too much negative externality
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Externality
MSC(X)
=MC(X)+MEC(X)
=MC(X)+MD(X)
Efficient
equilibrium
Competitive
equilibrium
MC(X)
P*
P’
MEC(X)=MD(X)
MB(X)
X*
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Externality: competitive equilibrium
External
cost
Consumer’s
surplus
MSC(X)
Producer’s
surplus
MC(X)
P*
P’
MEC(X)=MD(X)
MB(X)
X*
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Externality: competitive equilibrium
External
cost
Consumer’s
surplus
MSC(X)
Producer’s
surplus
MC(X)
P*
P’
MEC(X)=MD(X)
MB(X)
X*
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Externality: social optimum
MSC(X)
MC(X)
P*
P’
MEC(X)=MD(X)
MB(X)
X*
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Positive externalities: private vs social benefits
• Private benefits for a producer (or a consumer) of a good or service
include the gains (i.e. surplus) of the producer (or the consumer)
obtains when she produces (or uses) the good or service
• Social benefits include the private benefits and any other external
benefit to society that arises from the production (or consumption) of
a good or service
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Positive externalities: private vs social benefits
• The private benefit for a bee-keeper is the money he earns from
selling honey
• For each unit of output, this corresponds to the conventional market
price. More generally, we may refer to the private benefits of each unit
of production (or consumption) as marginal benefits (MB)
• The social benefits include all the private benefits and also the
benefits by people other than the bee-keeper as a consequence of
honey production, for example farmers whose fields are pollinated by
the bees
• For each unit of output this is the marginal social benefit (MSB)
• The additional benefit due to pollination is the marginal external
benefit (MEB)
• MSB = MB + MEB
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Positive externality
Competitive
equilibrium
Social
optimum
MB(X)
MC(X)
P*
P’
MSB(X)=MB(X)+MEB(X)
ME(X)
MB(X)
X’
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Private remedies to externalities
• Although externalities generate inefficiencies in markets, direct
intervention by the government is not necessarily needed to solve the
problem
• In some specific circumstances people can develop private solutions
1. Moral codes and social sanctions
2. Mergers & Acquisitions
3. Enforcement of property rights coupled with negotiation/bargaining
(Coase solution):
• Externalities emerge because property rights are not well defined
• To obtain efficient allocations it is indifferent to attribute the property
right to one party or to the other
• Public intervention should be limited, in this case, to the assignment
and enforcement of property rights
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Example: noise pollution
• A lives in a flat next to B
• A plays the saxophone and enjoys it
• A gets tired while playing the saxophone ⇒ decreasing marginal
benefits
• B does not like listening to A playing the saxophone
• The irritation of B is small for the first hours, and gets larger for each
additional hour of saxophone playing ⇒ increasing marginal external
costs
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Optimal level of saxophone playing
€
MEC
MB
0
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Hours of
music
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Solution: assign property rights over ‘silence’
• The government may enforce property rights over silence
• Rights may be assigned to either A or B
• A and B can bargain over property rights
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Property rights assigned to A (player)
€
MEC
MB
0
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Hours of
music
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Property rights assigned to B (listener)
€
MEC
MB
0
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Coase theroem: problems
• Problems with property rights and negotiation
• Bargaining can be impractical: it can require substantial time and effort
• Transaction costs and incentive to free ride (when the group of
damaged agents is large)
• The assignment of property rights may be ambiguous
• Parties involved in the negotiation may have limited information on
costs, benefits, and may not be able to monitor the compliance with
the terms of the agreement of the other party (asymmetric information)
• Possible income effects ⇒ if the compensation (given or received) is a
large share of income, bargaining is biased
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Remedies to externality: public solutions
• Pigouvian taxes (negative externalities)
• The idea is to increase the private marginal cost for the party that
generates the negative externality by imposing a tax such that
MC (X ∗ ) + Tax = MSC (X ∗ )
• Pigouvian subsidies (positive externalities)
• The idea is to compensate the party that generates the positive
externality with a subsidy on the top of private marginal benefit such
that MB(X ∗ ) + Subsidy = MSB(X ∗ )
• Regulation
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Pigouvian tax
• Principle: the party that pollutes should pay for the external cost of
pollution (polluter-pays principle)
• Suppose A produces good X , obtaining a marginal benefit
• MB(X ) = marginal benefit enjoyed by A
• The production of good X causes a damage do B
• MD(X ) = MEC (X ) = marginal damage suffered by B
• The negative externality is proportional to X
• Suppose that the government levies a Pigouvian tax, t
• The cost incurred by the producer now shifts upward ⇒ MC (X ) + t
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Pigouvian tax
MC(X)+t*
MSC(X)
MC(X)
P*
t*
MEC(X)
MB(X)
X*
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Examples of Pigouvian taxes
• Gas taxes
• Landfill taxes
• Water pollution taxes
• Carbon tax
• Problem with Pigouvian taxes ⇒ setting the optimal Pigouvian tax
(i.e. equal to marginal damage at the social optimum)
• The government should have information on marginal costs, marginal
external costs and marginal benefits to set the optimal tax
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