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ECONOMICS
What Does It Mean To Me?
Part VI:
The Role of
Government in
Microeconomics/
Externalities
Economic functions of Government:
1) Enforce laws and contracts.
2) Maintain competition.
3) Redistribute income--providing an
economic safety net.
4) Provide public goods
-nonexclusion
-shared consumption
5) Correct Market Failures
-provide market information
-correct negative externalities
-subsidize goods with positive
externalities
6) Stabilize the economy
- fight unemployment
- encourage price stability
- promote economic growth
EXTERNALITIES
Externality
When one person’s
actions imposes a
cost or benefit on the
well-being of a
bystander.
Externalities usually
result in market
failure.
Externalities can be:
1) Positive: an external
benefit is imposed on
someone. (examples: gardens,
restored historic buildings,
research)
2) Negative: an external
cost is imposed on
someone. (examples: exhaust
from autos, barking dogs, noise
from airplanes)
Externalities cause markets
to allocate resources
inefficiently.
This happens through:
1) CONSUMPTION: consuming a good
results in externality.
2) PRODUCTION: producing a good results in
externality.
In general, an external cost means the market
overproduces the good (ie, paint). An external
benefit means the market underproduces the
good (ie, gardens)
Are there benefits for other
people in the parking lot when
someone puts their car alarm on?
ANSWER:
Yes, because thieves don’t
know which cars have
alarms.
What about the club?
Are there benefits for other people in
the parking lot when someone puts
the club on their car?
ANSWER:
No . . .because the thief
can SEE the club.
Your neighbor puts in a
nice garden. Are you
receiving a benefit?
When you admit you are receiving a
positive benefit, your neighbor asks you
to pay him $100 a month for the benefit.
When you say no, he
puts up a fence.
What if you lived
next door to this?
Do you receive a
benefit?
PROPERTY RIGHTS is the issue?
Who owns the air? The rivers? The
parks?
If we can figure out who pollutes the
stream, we punish the offender because
we are not sure who owns the stream, but
we DO know who pollutes it.
We get into trouble when we use this
criteria regarding the air.
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
The tendency for a society to overuse and
therefore abuse common resources is called:
TRAGEDY OF THE COMMONS
What is the difference between a public good
and a private good?
Exclusion vs. non-exclusion
and
Shared consumption (rival good)
vs.
non-shared consumption (non-rival
good)
What defines property rights?
Property rights are established by formal
and informal rules about the privileges and
limitations on the ownership, use, and
transfer of goods and resources. These
rights are specified in various municipal
ordinances, other legislation, court
decisions (common law), tradition and
custom.
Property rights need to be:
1) clearly defined
2) exclusive
3) enforceable
4) transferable
Consider each of the items below:
Are they . . . . .?
Clearly
Defined? Exclusive?
skateboard
gun
library book
hamburger
Garden view
Bottled water
Lake water
Stream water
Transferable?
Enforceable?
What is a free-rider?
Someone who uses the good but doesn’t
pay for it.
Free riders occur when there are
nonexclusion and shared consumption.
Spraying for mosquitoes
Police & fire protection
National defense
Street lights
An Overview of U.S. Water Law
Riparian Common Law - people who own land along streams, lakes
and springs have a right to “reasonable use” of the water.
First -in-time, First-in-right - the first person to divert water and use
it has the first right. People who come later can take what is left.
Use-it or Lose-it - If a person with water rights doesn’t use all the
water he claims a right to, he permanently loses his right to the
portion he doesn’t use.
An Overview of U.S. Water Law (cont.)
Salvaged water rule - If a person is able to save water (I.e. by better
irrigation system), he cannot sell the extra water or even keep his
right to it.
Beneficial use - People may not establish water rights unless they
are using the water for “beneficial use”. (I.e.) Agriculture is
recognized in all states, but only a few states recognize recreation
or fishing.
Public Interest - Water rights--especially the right to transfer--are
limited by the “public interest>” Laws and courts define “public
interest” as things like protecting an economic area or
environment or public health and safety.
Even though water is
essential for life and
diamonds are not,
water is cheap and
diamonds are
expensive?
Why?
It has to do with the elasticity of the supply curve and
the amount of consumer/producer surplus
With DIAMONDS,
supply is very
inelastic.
S
P
With WATER, supply
is very elastic.
Consumer
Surplus
Producer
Surplus
S
P
D
Q
Quantity
D
Q
Quantity
Why would a farmer in the desert of
Southern California grow rice--a crop that
requires a great deal of water?
How much water do you NEED to live per
day?
Answer: 1 1/2 liters
What is the average per capita consumption
of water per day in the State of Florida?
Answer: 169 gallons
Compare this to
130 gal/day in Massachusetts and Rhode
Island
And
325 gal/day in Nevada
When is a
basketball an
alternative to
water?
When is coal an
alternative to a
waterfall?
What are some other ways to conserve water?
Xeriscape
Drip irrigation
Rocks
Compost
Massage
Night watering
Broom
Safflower oil
Denim
Mulch
If I were your neighbor,
what could you do to stop
me from polluting?
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
What if we decide it’s YOUR property?
1) Call the police
2) Assault and battery??
3) Pay me to stop.---You’ve upped my
opportunity cost---at some point it’s worth
it to me to stop.
What if we decide it’s MY property?
1) Outdo my Opportunity Cost (money,
friendship)
2) Petition or threaten (fine, tax)
3) You can PAY me to stop (what is it worth to
you?)
People’s use responds to incentives.
Consider the following taxing methods to
control water usage:
Mayor asks bill = $.002/gal.
Flat fee = $10/month
MC = 0
Flat fee = $30/month
Billed at $.01/gal.
Billed at $.05/gal.
MC >MB
The government has dealt effectively with most
water issues.
BUT. . . . .what about
GARDENS???
So . . .
Your neighbor plants a garden and it is beautiful.
But 5 years later, the garden has grown and you can no
longer see the lake.
Do you have a right to your view?
Today, there are thousands of lawsuits over
condos and owner’s rights or trees loosing
leaves in your neighbor’s yard.
If your cat is in your neighbor’s
yard, is it your neighbor’s cat?
What if your cat kills a bird in
your neighbor’s yard?
Coase Theorem
The proposition that if private parties can
bargain without cost over the allocation of
resources, they can solve the problem of
externalities on their own.
Is this pollution?
Exercise
In review:
Externalities
Positive
Negative
(+benefit)
(+cost)
Consumption
Consumption
(cigarettes)
(education)
Production
(honey)
Production
(pollution)
What is efficient?
Efficiency occurs
when MC = MB for
society.
For a perfectly
competitive market
with no externalities
and for a good that is
not a public good, the
market is efficient.
P
R
I
C
E
S = MC to
Society
D = MB to Society
QUANTITY
What is efficient?
Another way to
measure efficiency
would be where
Profit Maximizing
Output is found
where P = MC
MC
P
RI
C
E
Market Price
QUANTITY
What happens when the firms’
marginal cost of production is not
equal to the marginal cost to
society?
Or if the marginal benefit to
consumers is not equal to the
marginal benefit to society?
NEGATIVE EXTERNALITY IN
PRODUCTION:
Example: Pollution
Because of the externality,
the cost to society is larger
than the cost to producers.
MC is the private cost to the
firm.
Marginal social cost (MSC) is
cost to society = MC +
externality.
MSC
P
RI
C
E
S = MPC to
Firm
D = MB to Society
QUANTITY
The market overproduces and charges a price
that is too low.
POSITIVE EXTERNALITY IN
PRODUCTION:
Example: Honey
MPC to firm
P
RI
C
E
S = MSC
MC is the private cost to the
firm.
Marginal social cost (MSC) is
cost to society = MC +
externality.
D = MB to Society
QUANTITY
The market underproduces and charges a price
that is too high.
NEGATIVE EXTERNALITY IN
CONSUMPTION:
Example: Cigarettes
Overproduction in this
case raises MC.
D gives the private
benefit in
consumption.
MC
P
RI
C
E
Marginal social benefit
(MSB) = D + externality.
MSB
D = MB to
Buyer
QUANTITY
The market overproduces and charges a price
that is too high.
POSITIVE EXTERNALITY IN
CONSUMPTION:
Examples: Education, Charities
The social value of
education is greater than
the private value.
D gives the private benefit in
consumption.
Marginal social benefit (MSB) =
D + externality.
Underproduction in this
case lowers MC.
P
RI
C
E
MC
MSB
D = MB to
Buyer
QUANTITY
The market underproduces and charges a price
that is too low.
SOLUTIONS:
1) Assign property rights =>
externality
internalize
(Negotiate if mutually beneficial)
2) Government involvement
Tax on negative externality
(Pigovian tax)
Subsidy for positive externality
Permits
Pigovian Tax
Named after economist, Arthur Pigou
•A tax on firms based on the external costs they
generate.
•Internalizes the externality and reimburses
society for the external costs.
•The term “pollution tax” is used when the tax
may not be equal to marginal external cost.
A Pigovian tax sets the
price of pollution…….
Pollution permits sets the
quantity of pollution…..
……which, together with
the demand curve
determines the quantity
of pollution.
……which, together
with the demand curve
determines the price of
pollution.
Supply of
pollution
permits
Pigovian Tax
P
P
Demand for
Pollution Rights
Q
Quantity of Pollution
Demand for
Pollution Rights
Q
Quantity of Pollution
Notice that in both cases, price and
quantity are the same. . . .
Supply of
pollution
permits
Pigovian Tax
P
P
Demand for
Pollution Rights
Q
Quantity of Pollution
Demand for
Pollution Rights
Q
Quantity of Pollution
Notice also that the pigovian tax line is
perfectly elastic--firms can pollute as much
as they want as long as they pay a tax. . .
Supply of
pollution
permits
Pigovian Tax
P
P
Demand for
Pollution Rights
Q
Quantity of Pollution
Demand for
Pollution Rights
Q
Quantity of Pollution
. . .while in the second panel, the EPA sets the
quantity of pollution, and the supply of
pollution is completely inelastic.
Supply of
pollution
permits
Pigovian Tax
P
P
Demand for
Pollution Rights
Q
Quantity of Pollution
Demand for
Pollution Rights
Q
Quantity of Pollution
Economists usually prefer pigovian taxes to
regulation as a way to deal with pollution
because they reduce pollution at a lower cost
to society.
Using pigovian taxes to internalize
externalities will cause market price to reflect
the true social costs of production and force
firms to bear the full social cost of their
production activities.
Now, suppose that two firms are awarded
permits and have met the government
standard.
Firm 1 then decides it wants to increase its
emissions by 100 tons and firm 2 agrees to
reduce its emissions by 100 tons if firm 1
pays it $5 million.
Should the government allow two factories
to make this deal?
If the EPA allows the firms to make this
deal, it will have created a new scarce
resource: pollution permits.
A market to trade these permits will
develop and that market will be
governed by the forces of supply and
demand.
The CLEAN AIR
ACT of 1990
established the right
to buy and sell
emission rights for
sulfur-dioxide
pollution.
CO2 emission permits have been
traded since 1995 on the Chicago
Exchange.
Carbon emissions trading has been steadily
increasing in recent years. According to the World
Bank's Carbon Finance Unit, 374 million metric
tonnes of carbon dioxide equivalent (tCO2e) were
exchanged through projects in 2005, a 240%
increase relative to 2004 (110 mtCO2e), which was
itself a 41% increase relative to 2003 (78 mtCO2e).
The world's only mandatory carbon trading
program is the European Union
Emissions Trading Scheme (or EUETS).
Created in conjunction with the Kyoto
Protocol, a 1997 international treaty that
took effect in 2005, it caps the amount of
carbon dioxide that can be emitted from
large installations, such as power plants and
factories, in the EU's 25 member countries.
Source: Wikipedia
NASH EQUILIBRIUM is
a situation where economic
actors interacting with each
other each choose their best
strategy given the strategies
that others have chosen.
GAME
THEORY.
This is also called
Game Theory has
become a major tool for
dealing with pollution
problems.
John Nash
1994 Nobel Prize,
Economics
Game Theory can be illustrated by what is called
THE PRISONER’S DILEMMA.
The police have enough evidence to convict Bonnie
and Clyde of possession of an illegal firearm so that
each would spend 1 year in jail. But they suspect
that the two have pulled off some bank robberies
but they have no evidence. They put Bonnie and
Clyde in separate rooms and offer a deal.
“Right now, we can lock you up for one year.
But if you testify against your partner, we will
set you free and your partner will get 20
years in prison. If you both confess to the
crime, we can avoid the cost of a trial and
you both get 8 years.”
Each prisoner has two strategies, confess or remain
silent. However, the sentence that each gets
depends upon the actions of the other.
Bonnie’s Decision
confess
confess
Clyde’s
Decision
8 years each
Remain Bonnie goes free
silent Clyde - 20 yrs.
Remain silent
Bonnie - 20 yrs
Clyde goes free
1 year each
OR you can use the PAYOFF MATRIX
B: 8 years
C: 8 years
Clyde’s
Decison
B: free
Bonnie’s
Decison
C: 20 years
B: 20 years
Clyde’s
Decison
C: free
B: 1 year
C: 1 year
In the real world, this dilemma is played out by
real players. Once a negotiation is reached, each
country must decide whether they should keep
their agreement.
Iraq’s Decision
High prod.
Iran’s
Decision
High
prod.
$40 billion
each
Low Iraq - $60 billion
prod. Iran - $30 billion
Low prod.
Iraq - $30 billion
Iran - $60 billion
$50 billion
each
It can be used in the arms race…...
U.S.’s Decision
Arm.
Arm
USSR’s
Decision
Disarm
Both at risk
Disarm
US at risk
USSR safe
US safe
USSR at risk
Both safe
It can be used in the everyday economic
decisions……Consider 2 firms which must
decide whether to make a new product or not….
Firm 1
Yes
Yes
Firm 2
No
No
Firm 1: $1.5m
Firm 1: 0
Firm 2: $1.5m
Firm 2: $2m
Firm 1: $2m
Firm 1: 0
Firm 2: 0
Firm 2: 0
SAMPLE AP TEST QUESTION
The production of Good X creates an
externality.
Is this a negative
or positive
externality?
Price
Marginal Social
Cost
13
12
Negative
Marginal Private
Cost
7
Why?
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
MSC > MPC
The production of Good X creates an
externality.
Price
Identify the
socially optimum
output.
Marginal Social
Cost
13
12
Q2
Marginal Private
Cost
7
Why?
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
MSC=MSB
Suppose that good X is produced by a profitmaximizing monopoly.
Identify the
unregulated firm’s
output.
Price
Marginal Social
Cost
13
Q1
12
Why?
Marginal Private
Cost
7
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
At Q1, MPC =
MR
Suppose that good X is produced by a profitmaximizing monopoly.
Price
To produce socially optimum output,
should the government tax or subsidize
the firm?
Marginal Social
Cost
13
12
7
4
MR
0
Q1 Q2
Q3
subsidize
How much will it
be?
Marginal Private
Cost
$3
Why?
D-MSB
Optimum
Quantity at Q =
Quantity of
Good X
MR
Suppose that good X is produced in a perfectly
competitive industry.
Price
Identify equilibrium output in the absence
of regulation.
Q3
Marginal Social
Cost
13
12
Marginal Private
Cost
7
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
Why?
D=MPC or
MSB=MPC
Suppose that good X is produced in a perfectly
competitive industry.
Price
To produce at socially optimum output,
should the government tax or subsidize?
Tax
Marginal Social
Cost
13
12
Marginal Private
Cost
7
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
How much?
$5
The End
Created by:
Virginia Meachum, Economics Teacher, Coral Springs High
School
Sources:
FTE Economics of Water and the Environment
AP MicroEconomics Test Question (2005)