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Chapter 5: Externalities, Environmental Policy, and Public Goods
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.
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Chapter 5: Externalities, Environmental Policy, and Public Goods
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.
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CHAPTER
5
Chapter 5: Externalities, Environmental Policy, and Public Goods
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?
Prepared by:
Fernando Quijano
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CHAPTER
5
Chapter Outline and
Learning Objectives
Chapter 5: Externalities, Environmental Policy, and Public Goods
Externalities,
Environmental Policy,
and Public Goods
5.1
Externalities and Economic Efficiency
Identify examples of positive and negative
externalities and use graphs to show how
externalities affect economic efficiency.
5.2
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.
5.3
Government Policies to Deal with
Externalities
Analyze government policies to achieve
economic efficiency in a market with an
externality.
Four Categories of Goods
Explain 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.
5.4
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Chapter 5: Externalities, Environmental Policy, and Public Goods
Externalities, Environmental Policy, and Public Goods
Externality A benefit or cost that affects
someone who is not directly involved in
the production or consumption of a good
or service.
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5.1 LEARNING OBJECTIVE
Externalities and Economic Efficiency
Identify examples of positive and
negative externalities and use
graphs to show how externalities
affect economic efficiency.
The Effect of Externalities
Chapter 5: 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.
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5.1 LEARNING OBJECTIVE
Externalities and Economic Efficiency
Identify examples of positive and
negative externalities and use
graphs to show how externalities
affect economic efficiency.
The Effect of Externalities
How a Negative Externality in Production Reduces Economic Efficiency
Chapter 5: Externalities, Environmental Policy, and Public Goods
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
deadweight loss equal to the area of the
yellow triangle. Because of the deadweight
loss, this equilibrium is not efficient.
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5.1 LEARNING OBJECTIVE
Externalities and Economic Efficiency
Identify examples of positive and
negative externalities and use
graphs to show how externalities
affect economic efficiency.
The Effect of Externalities
How a Positive Externality in Consumption Reduces Economic Efficiency
Chapter 5: Externalities, Environmental Policy, and Public Goods
FIGURE 5-2
The Effect of a Positive
Externality on Efficiency
People 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.
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 deadweight loss equal to the area
of the yellow triangle.
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5.1 LEARNING OBJECTIVE
Externalities and Economic Efficiency
Identify examples of positive and
negative externalities and use
graphs to show how externalities
affect economic efficiency.
Chapter 5: Externalities, Environmental Policy, and Public Goods
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.
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Private Solutions to Externalities:
The Coase Theorem
5.2 LEARNING OBJECTIVE
Discuss the Coase theorem and
explain how private bargaining
can lead to economic efficiency in
a market with an externality.
The Economically Efficient Level of Pollution Reduction
FIGURE 5-3
Chapter 5: Externalities, Environmental Policy, and Public Goods
The Marginal Benefit from
Pollution Reduction Should
Equal the Marginal Cost
If the reduction of sulfur dioxide
emissions is at 7.0 million tons per
year, the marginal benefit of $250 per
ton is greater than the marginal cost
of $175 per ton. Further reductions in
emissions will increase the net benefit
to society.
If the reduction of sulfur dioxide
emissions is at 10.0 million tons, the
marginal cost of $225 per ton is
greater than the marginal benefit of
$150 per ton. An increase in sulfur
dioxide emissions will increase the net
benefit to society.
Only when the reduction is at 8.5
million tons is the marginal benefit
equal to the marginal cost. This level
is the economically efficient level of
pollution reduction.
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5.2 LEARNING OBJECTIVE
Making
the
Chapter 5: Externalities, Environmental Policy, and Public Goods
Connection
The Clean Air Act:
How a Government Policy
Reduced Infant Mortality
Discuss the Coase theorem and
explain how private bargaining
can lead to economic efficiency in
a market with an externality.
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
YOUR TURN: Test your understanding by doing related problem 2.8 at the end of
this chapter.
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Private Solutions to Externalities:
The Coase Theorem
5.2 LEARNING OBJECTIVE
Discuss the Coase theorem and
explain how private bargaining
can lead to economic efficiency in
a market with an externality.
The Basis for Private Solutions to Externalities
FIGURE 5-4
Chapter 5: Externalities, Environmental Policy, and Public Goods
The Benefits of Reducing Pollution to
the Optimal Level Are Greater Than the
Costs
Increasing the reduction in sulfur dioxide emissions
from 7.0 million tons to 8.5 million tons results in
total benefits equal to the sum of the areas A and B
under the marginal benefits curve.
The total cost of this decrease in pollution is equal
to the area B under the marginal cost curve.
The total benefits are greater than the total costs by
an amount equal to the area of triangle A.
Because the total benefits from reducing pollution
are greater than the total costs, 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
YOUR TURN: Test your understanding by doing related problem 2.6 at the end of this
chapter.
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5.2 LEARNING OBJECTIVE
Making
the
The Fable of the Bees
Discuss the Coase theorem and
explain how private bargaining
can lead to economic efficiency in
a market with an externality.
Chapter 5: Externalities, Environmental Policy, and Public Goods
Connection
If there are positive externalities in
both apple growing and beekeeping, 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.
Some apple growers and beekeepers
make private arrangements to arrive
at an economically efficient outcome.
YOUR TURN: Test your understanding by doing related problem 2.9 at the end of
this chapter.
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5.2 LEARNING OBJECTIVE
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.
Chapter 5: Externalities, Environmental Policy, and Public Goods
The Problem of Transactions Costs
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 Coase Theorem
Coase theorem The argument of economist
Ronald Coase that if transactions costs are low,
private bargaining will result in an efficient
solution to the problem of externalities.
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5.3 LEARNING OBJECTIVE
Government Policies
to Deal with Externalities
Analyze government policies to
achieve economic efficiency in a
market with an externality.
FIGURE 5-5
Chapter 5: Externalities, Environmental Policy, and Public Goods
When There Is a Negative
Externality, a Tax Can Bring about
the Efficient Level of Output
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.
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5.3 LEARNING OBJECTIVE
Solved Problem
5-3
Chapter 5: Externalities, Environmental Policy, and Public Goods
Using a Tax to Deal with
a Negative Externality
Analyze government policies to
achieve economic efficiency in a
market with an externality.
YOUR TURN: For more practice do related problem 3.7 at the end of this chapter.
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Government Policies
to Deal with Externalities
5.3 LEARNING OBJECTIVE
Analyze government policies to
achieve economic efficiency in a
market with an externality.
FIGURE 5-6
Chapter 5: Externalities, Environmental Policy, and Public Goods
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 greater than 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.
Producers receive the price PEfficient, while
consumers pay a price P, which is equal
to PEfficient minus the amount of the
subsidy.
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Chapter 5: Externalities, Environmental Policy, and Public Goods
Government Policies
to Deal with Externalities
5.3 LEARNING OBJECTIVE
Analyze government policies to
achieve economic efficiency in a
market with an externality.
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 versus Market-Based Approaches
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.
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5.3 LEARNING OBJECTIVE
Making
the
Chapter 5: Externalities, Environmental Policy, and Public Goods
Connection
Can a Cap-and-Trade System
Reduce Global Warming?
Analyze government policies to
achieve economic efficiency in a
market with an externality.
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 sulfur dioxide discussed earlier in this
chapter.
YOUR TURN: Test your understanding by doing related problem 3.11 at the end
of this chapter.
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5.4 LEARNING OBJECTIVE
Chapter 5: Externalities, Environmental Policy, and Public Goods
Four Categories of Goods
Explain 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.
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.
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5.4 LEARNING OBJECTIVE
Four Categories of Goods
Explain 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.
FIGURE 5-7
Chapter 5: Externalities, Environmental Policy, and Public Goods
Four Categories of Goods
Goods 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.
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5.4 LEARNING OBJECTIVE
Four Categories of Goods
Explain 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 5: Externalities, Environmental Policy, and Public Goods
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.
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5.4 LEARNING OBJECTIVE
Making
the
Chapter 5: Externalities, Environmental Policy, and Public Goods
Connection
Should the Government
Run the Health Care System?
Explain 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.
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.
YOUR TURN: Test your understanding by doing related problem 4.9 at the end of
this chapter.
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5.4 LEARNING OBJECTIVE
Four Categories of Goods
The Demand for a Public Good
Explain 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.
FIGURE 5-9
Chapter 5: Externalities, Environmental Policy, and Public Goods
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).
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Four Categories of Goods
The Demand for
a Public Good
5.4 LEARNING OBJECTIVE
Explain 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.
FIGURE 5-10
Chapter 5: Externalities, Environmental Policy, and Public Goods
Constructing the
Market Demand Curve
for a Public Good
To find the demand curve for
a public good, we add up the
price at which each consumer
is willing to purchase each
quantity of the good.
In panel (a), Jill is willing to
pay $8 per hour for a security
guard to provide 10 hours of
protection. In panel (b), Joe is
willing to pay $10 for that level
of protection. 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.
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5.4 LEARNING OBJECTIVE
Four Categories of Goods
The Optimal Quantity of a Public Good
Explain 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.
FIGURE 5-10
Chapter 5: Externalities, Environmental Policy, and Public Goods
The 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 demand
curve intersects the supply
curve.
In this case, the optimal quantity
of security guard services is 15
hours, at a price of $9 per hour.
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5.4 LEARNING OBJECTIVE
Solved Problem
Explain 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.
5-4
Determining the Optimal
Level of Public Goods
JOE
Chapter 5: Externalities, Environmental Policy, and Public Goods
PRICE
(DOLLARS PER HOUR)
$20
18
16
14
12
10
8
6
4
2
JILL
QUANTITY (HOURS
OF PROTECTION)
0
1
2
3
4
5
6
7
8
9
PRICE
(DOLLARS PER HOUR)
QUANITY (HOURS
OF PROTECTION)
$20
1
18
16
14
12
10
8
6
4
2
2
3
4
5
6
7
8
9
10
DEMAND OR MARGINAL SOCIAL BENEFIT
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
PRICE
(DOLLARS PER HOUR)
$38
34
30
26
22
18
14
10
6
QUANTITY (HOURS
OF PROTECTION)
1
2
3
4
5
6
7
8
9
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5.4 LEARNING OBJECTIVE
Solved Problem
5-4
Determining the Optimal
Level of Public Goods (continued)
Explain 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.
DEMAND OR MARGINAL SOCIAL BENEFIT
Chapter 5: Externalities, Environmental Policy, and Public Goods
PRICE
(DOLLARS PER HOUR)
QUANTITY (HOURS
OF PROTECTION)
$38
34
30
26
22
18
14
10
6
1
2
3
4
5
6
7
8
9
SUPPLY
PRICE
(DOLLARS PER HOUR)
QUANTITY (HOURS
OF PROTECTION)
$8
1
10
2
12
3
14
4
16
5
18
6
20
7
22
8
24
9
YOUR TURN: For more practice, do related problem 4.4 at the end of this chapter.
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5.4 LEARNING OBJECTIVE
Four Categories of Goods
Common Resources
Explain 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.
Tragedy of the commons The tendency for a
common resource to be overused.
Chapter 5: Externalities, Environmental Policy, and Public Goods
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 demand
curve—which represents the
marginal benefit received by
consumers—and S2, which
represents the marginal social
cost of 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.
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Chapter 5: Externalities, Environmental Policy, and Public Goods
AN INSIDE
LOOK
>> The Carbon Cap Dilemma
Using a carbon tax to reduce CO2 emissions.
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Chapter 5: Externalities, Environmental Policy, and Public Goods
KEY TERMS
Coase theorem
Command-and-control
approach
Common resource
Excludability
Externality
Free riding
Market failure
Pigovian taxes and subsidies
Private benefit
Private cost
Private good
Property rights
Public good
Rivalry
Social benefit
Social cost
Tragedy of the commons
Transactions costs
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