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Chapter 18 Externalities and Public Goods © 2006 Thomson Learning/South-Western Defining Externalities 2 An externality is the effect of one party’s economic activities on another party that is not taken into account by the price system. Externalities can occur between any two economic actors. Externalities can be beneficial or harmful. Externalities between Firms One of the most famous beneficial externalities between firms involves one firm producing honey and the other producing apples. 3 Bees feed on apple blossoms, which increases the production of honey, and Bees pollinate apple crops, which increases the production of apples. Externalities 4 Firms can generate air, water, and other types of pollution when producing products. Alternatively, auto pollution, graffiti, and noise are some externalities imposed by people on firms. When people do things that harm others, like playing their radios loudly, or help, like shoveling their sidewalk, they can impose externalities on other people. Reciprocal Nature of Externalities In dealing with externalities it is important to recognize that both parties are needed for an externality to exist. 5 If the eyeglass producer was not located near the charcoal factory, there would be no externality. If another person was not around, no one would be bothered when someone plays their radio loudly. Externalities and Allocational Efficiency The presence of externalities can cause a market to operate inefficiently. 6 In the previous example an externality affected the production of eyeglasses. The firm producing charcoal did not take into account the negative effect its production had on the production of eyeglasses. Social Costs Social costs are the costs of production that include both input costs and costs of the externalities that production may cause. 7 In the previous example, by not recognizing the externality in its production, the charcoal firm produced too much. Society would be better-off by reallocating resources away from charcoal production and toward the production of other goods. A Graphical Demonstration Assume the charcoal producer is a price taker so that its demand curve is horizontal, as shown in Figure 18-1. 8 The firm maximizes profits, given the prevailing market price, by producing q* where price(P*) equals marginal cost(MC). Due to the externality, however, the social marginal cost (MCS) exceeds MC. A Graphical Demonstration 9 The cost of the externality is shown by the vertical distance between MSC and MC. At q* the social marginal cost exceeds what people are willing to pay for the charcoal, P*. Resources are misallocated and production should be reduced to q’ where MSC equals P*. The reduced total social costs (area ABq*q’) exceed the reduced total spending (area AEq*q’). FIGURE 18-1: An Externality in Charcoal Production Causes an Inefficient Allocation of Resources MCS Price, costs of charcoal B A P* MC E C 0 10 q’ q* Charcoal per week Property Rights 11 Property rights are the legal specification of who owns a good and the trades the owner is allowed to make with it. Common property is property that may be used by anyone without cost. Private property is property that is owned by specific people who may prevent others from using it. Costless Bargaining and Competitive Markets Considering the charcoal-eyeglass externality, suppose property rights were defined so as to give sole rights to use the air to one of the firms. 12 The firms were then free to bargain over how the air might be used. If bargaining is costless the two parties might arrive at q’ on their own. Ownership by the Polluting Firm If the charcoal firm owns the land, it must add these ownership costs to its total costs. 13 The costs of polluting the air are what someone else is willing to pay for this resource (clean air) in its best alternative use. The eyeglass company would be willing to pay the an amount equal to the external cost the charcoal company is imposing. Ownership by the Polluting Firm 14 The charcoal company’s marginal cost will be MSC, and it will produce q’. The charcoal company will sell the remaining air use rights to the eyeglass maker for a fee of some amount between AEC (the lost profits of producing q’ rather than q*) and ABEC (the maximum amount the eyeglass maker would be willing to pay to avoid having the charcoal producer increase production to q*. Ownership by the Injured Firm If the eyeglass maker owns the air, the charcoal firm will offer a payment to use the air associated with output level q’. 15 The eyeglass owner will not sell rights to pollute beyond this because the price that the charcoal maker would be willing to pay (P* - MC) falls short of the cost of this additional pollution (MCS - MC). The socially optimal charcoal output, q’, is produced in this case as well. The Coase Theorem 16 The Coase theorem (first proposed by Ronal Coase) states that, if bargaining is costless, the social cost of an externality will be taken into account by the parties, and the allocation of resources will be the same no matter how property rights are assigned. In the previous example, q’ was produced regardless of who owned the air. Distributional Effects The assignment of property rights does affect the distribution of the benefits. 17 If the charcoal maker receives the property rights, the fees from the eyeglass producer will make it at least as well off as if it produced q*. If the eyeglass producer receives the property rights, the fees from the charcoal producer will at least cover the pollution damage. Factors, such as equity may be important. The Role of Transactions Costs 18 The Coase theorem relies heavily on the assumption of zero transactions costs. If bargaining costs are high, the voluntary exchange may break down so the efficient outcome may not be realized. This may be particularly true concerning environmental externalities. Externalities with High Transactions Costs 19 When transactions costs are high, externalities may cause real losses in economic welfare. The fundamental problem is that, with high transactions costs, economic actors face no pressure to recognize the third-party effects they have. All solutions to externality problems in these cases must therefore find some way to get the actors to “internalize” the third-party effects they cause. Legal Redress 20 The operation of the law may sometimes provide a way for taking externalities into account. If the charcoal producer in Figure 18-1 can be sued for the harm it does to eyeglass makers, payment of damages will increase the costs associated with charcoal production. Hence, the charcoal MC curve will shift upward to MCS and an efficient allocation of resources will be achieved. Taxation 21 A Pigovian tax (first proposed by A. C. Pigou) is a tax or subsidy on an externality that brings about an equality of private and social marginal costs. Figure 18-2 is similar to Figure 18-1, except that an excise tax of amount t is shown that reduces the net price to P* - t. This causes the firm to produce the socially optimal level of output, q’. FIGURE 18-2: Taxation Solution to the Externality Problem MCS Price, costs of charcoal B A P* P* - t 0 22 MC E C q’ q* Charcoal per week Regulation of Externalities An alternative to taxation is regulation. The horizontal axis in Figure 18-3 shows percentage reductions in pollution that would exist without regulation. The curve MB shows the marginal benefit by reducing pollution by one unit. 23 The shape comes from the assumption of diminishing returns. FIGURE 18-3: Optimal Pollution Abatement MC Marginal benefit, cost f* MB 0 24 R* 100 Reduction in emission Regulation of Externalities The curve MC reflects the marginal costs in reducing environmental emissions including foregone profits and the costs of antipollution equipment. 25 The positive slope reflects the assumption of increasing marginal costs. R* is the optimal level of pollution where the marginal benefits equal marginal costs. Fees, Permits, and Direct Controls Three general ways to reduce emissions to R* through environmental policy. 26 A Pigovian-type effluent fee for each percent of pollution not reduced. Governmental regulators could issue permits to produce emission levels. Direct controls of the amount of pollution allowed. Fees An “effluent fee”,f*in Figure 18-3, is charged for each percent that pollution is not reduced. 27 For reductions less than R*, the fee exceeds marginal cost, so firms will choose abatement. Reductions greater than R* would not be profitable. The firm is free to choose its method to reduce pollution. FIGURE 18-3: Optimal Pollution Abatement MC Marginal benefit, cost f* MB 0 28 RL R* RH 100 Reduction in emission Permits 29 Government issued permits would allow firms to “produce” (100 - R*) percent of their unregulated emission levels. As shown in Figure 18-3, freely traded permits would sell for a price of f*. A competitive market will ensure that the optimal level of emissions reductions will be attained at minimal social cost. Direct Controls Governments can tell firms the level of emissions they would be allowed, and, in many cases, are accompanied by specification of the precise mechanism by which R* is to be achieved. 30 This is a common approach in the U.S. Specification of the mechanism of reduction may reduce the cost-minimization incentive. 京都議定書 2005年2月16日,《京都議定書》正式生效。這是人類歷史 上首次以法規的形式限制溫室氣體排放。為了促進各國完成溫室氣 體減排目標,議定書允許採取以下四種減排方式: 1. 兩個發達國家之間可以進行排放額度買賣的“排放權交易”, 即難以完成削減任務的國家,可以花錢從超額完成任務的國家 買進超出的額度。 2. 以“凈排放量”計算溫室氣體排放量,即從本國實際排放量中 扣除森林所吸收的二氧化碳的數量。 3. 可以採用綠色開發機制,促使發達國家和發展中國家共同減排 溫室氣體。 4. 可以採用“集團方式”,即歐盟內部的許多國家可視為一個整 體,採取有的國家削減、有的國家增加的方法,在總體上完成 減排任務 31 Attributes of Public Goods Nonexclusive goods are goods that provide benefits that no one can be excluded from enjoying. 32 National defense is an example since, once an army or navy is set up, everyone in the country receives protection whether they pay or not. Alternatively, a hamburger is exclusive since, someone can be excluded from consuming if they do not pay for it. Attributes of Public Goods Nonrival goods are goods that additional consumers may use at zero marginal cost. 33 For example, one more person crossing an already existing bridge during an off-peak period requires no additional resources and does not reduce consumption of anything else. Public Goods 34 Public goods provide nonexclusive benefits to everyone in a group and that can be provided to one more user at zero marginal cost. Table 18-1 presents a cross-classification of goods by their possibilities for exclusion and rivalry. TABLE 18-1: Types of Public and Private Goods Exclusive Yes Rival No 35 Yes Hot dogs, automobiles, houses Bridges, swimming pools, scrambled satellite television signals No Fishing grounds, public grazing land, clean air National defense, mosquito control, justice Public Goods and Market Failure 36 In buying a public good, any one person will not be able to appropriate all the benefits the good offers. Since others can not be excluded they can use the good at zero marginal cost, society’s benefits from the public good exceed the benefits to the single buyer. Public Goods and Market Failure 37 However, the buyer will not take societies benefits into consideration. As a result, private markets will tend to underallocate resources to public goods. Figure 18-4 shows a situation two people have a demand for a public good. The total demand for the public good is the vertical sum of each persons demand curve. FIGURE 18-4: Derivation of the Demand for a Public Good Willingness to pay Total demand Demand by person 2 Demand by person 1 [ , ] Denotes equal distances 38 Quantity of public good per week Public Goods and Market Failure 39 Each point on the total demand curve shows what persons 1 and 2, together, are willing to pay for a particular level of the public good. Because each individual’s demand curve is below the total demand curve, no single buyer is willing to pay what the good is worth to society. Voluntary Solutions for Public Goods Since public goods cannot be traded efficiently in competitive markets, one approach deals with whether an efficient allocation might come out voluntarily. 40 Would people agree to be taxed in exchange for the benefits the public good provides? One solution was proposed by Erik Lindahl in 1919. The Lindahl Equilibrium In Figure 18-5, the curve labeled SS shows one person’s (Smith) demand for a particular public good. 41 The vertical axis measures the share of the public good’s cost that Smith must pay. The negative slope of SS indicates that, at a higher tax “price” for the public good, Smith’s quantity demanded is smaller. FIGURE 18-5: Lindahl Equilibrium in the Demand for a Public Good Share of cost 100 paid by Smith S S 0 Quantity of public good 42 The Lindahl Equilibrium The second individual’s (Jones) public good demand curve is derived similarly, but the proportion paid by Jones is shown on the right axis. 43 The right axis is reverse scale so that moving up the axis results in a lower tax paid by Jones. Given this convention, Jones’s demand curve (JJ) has a positive slope. FIGURE 18-5: Lindahl Equilibrium in the Demand for a Public Good Share of cost paid by Smith 100 0 J S J S 0 100 Quantity of public good 44 Share of cost paid by Jones The Lindahl Equilibrium The two demand curves intersect at C with an output level OE of the public good. 45 At this output level Smith is willing to pay 60 percent of the good’s cost whereas Jones willingly pays 40 percent. At outputs below OE, the two people combines are willing to pay more than 100 percent of the cost of the public good. FIGURE 18-5: Lindahl Equilibrium in the Demand for a Public Good Share of cost paid by Smith 100 Share of cost 0 paid by Jones J S C 60 40 J S 0 100 E 46 Quantity of public good The Lindahl Equilibrium Output level OE is a Lindahl equilibrium which is a balance between people’s demand for public goods and the tax shares that each must pay for them. 47 For output levels greater than OE, people are not willing to pay the total cost of the good. The tax shares are “pseudo prices,” and the outcome can be shown to be efficient. Revealing the Demand for Public Goods The voting patterns of people generally do not provide enough information to permit Lindahl’s tax share to be computed. Alternatively, governments might ask people how much they are willing to pay for a particular package of public goods. 48 It is likely that this poll would prove to be extremely inaccurate because of free riders.