Download Lecture11.ExternalitiesandPublicGoods

Week 12 – ECMC02
Externalities and Public Goods
Adam Smith:
Self-interest (i.e., greed) can be harnessed to
serve the social interest
- if markets are competitive
- if goods are consumed by individuals
- if consumers can weigh up all the benefits
and the costs of consumption when they
make their decisions
- if producers can weigh up all the benefits
and costs of production when they make
their decisions
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But, if not, there will be “market failure”
Special role for government when markets
fail
1.
Natural monopoly – government role in
regulating privately-owned monopoly to
deliver greater GTS (electricity,
telephone, natural gas pipelines)
2. Positive and negative externalities –
spillover effects, not just consumers
and producers (positive - education,
raising bees, caring for your children;
negative - industrial pollution, secondhand smoke, noisy activities)
3. Public goods – goods which are
consumed collectively (lighthouse,
national defence, mosquito control,
public health)
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Positive and Negative Externalities
Positive:
- education
- beautiful garden
- well-kept house
- raising bees
- raising well-behaved, well-educated
children
Negative:
- pollution
- second-hand smoke
- noisy activities
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Problem:
When there are external effects
(externalities), markets do not receive the
right signals, and therefore make the wrong
decisions.
Market price does not correctly reflect social
value
Consumers and/or producers do not receive
all the benefits and pay all the costs (some of
the costs or benefits are received by others).
Therefore, consumers and producers do not
face the correct incentives.
They will consume and/or produce too much or
too little of the good.
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Consider the production of wood pulp (an
input to the production of paper). A toxic
process using sulphur and other chemicals,
producing air and water pollution. These are
“external costs”.
Two possible situations:
Pigou
Let us imagine that every extra ton of wood
pulp produced also produces a fixed amount
of air and water pollution – a fixedproportions production function (i.e., there is
no technological fix for the pollution problem
– therefore, firm must be encouraged to
produce less output to reduce pollution).
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Price
($/Q)
MSC (marginal
social cost)
Supply or MC
(marginal private
cost)
MEC
(marginal
external
cost)
Demand for Wood
Pulp (marginal private
benefit)
0
Qopt
(optimum
quantity)
Q* (market
quantity)
Market for Wood Pulp
(MPC + MEC = MSC)
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Quantity
(tons/year)
What is the gain to society (GTS) from
producing wood pulp? What is the efficiency
loss from producing the market quantity
(instead of the optimum quantity)?
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Price
($/Q)
MSC (marginal
social cost)
Supply or MC
(marginal private
cost)
MEC
(marginal
external
cost)
Demand for Wood
Pulp (marginal private
benefit)
Qopt
(optimum
quantity)
Q* (market
quantity)
Market for Wood Pulp
(MPC + MEC = MSC)
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Quantity
(tons/year)
Problem can be viewed as incorrect pricing of
the product, giving the wrong signals to
producers and consumers.
Can a tax provide the right signals?
How much tax?
Difficulty of calculating appropriate amount
of tax.
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Think of “carbon” tax – tax on fossil fuels
Global warming
CO2 emissions (fossil-fuel-burning power
plants, cars and fossil fuels)
Effects of global warming on U.S.





Melting glaciers, early snowmelt and severe
droughts will cause more dramatic water
shortages in the American West.
Rising sea levels will lead to coastal flooding on
the Eastern seaboard, in Florida, and in other
areas, such as the Gulf of Mexico.
Warmer sea surface temperatures will fuel
more intense hurricanes in the southeastern
Atlantic and Gulf coasts.
Forests, farms and cities will face troublesome
new pests and more mosquito-borne diseases.
Disruption of habitats such as coral reefs and
alpine meadows could drive many plant and
animal species to extinction.
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But does production have to decline? Or are
there substitutions for fossil fuels? Are
there new technologies?
Assume substitution possible (not fixedproportions production function)
Focus attention on Marginal Cost of
Abatement (MCA), which is a function of the
level of pollution (of greenhouse gas
emission). This is the marginal cost of
cleaning up pollution
Also focus on the Marginal Social Cost (MSC)
of pollution, which is also a function of the
level of pollution. This is the marginal benefit
of cleaning up pollution.
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$ per
unit of
emissions
MSC
MB, MC
MCA
0
“optimal”
level of
emissions
CO2 emissions
per year
Fossil fuels for electricity production and cars
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Public policy objective is to find the amount
of emissions such that the marginal benefit
from pollution reduction just equals the
marginal cost of pollution reduction.
Of course, many things affect both the
marginal benefit and the marginal cost.
3 possible public policy solutions
1. Emissions standard
2. Emissions fee or tax for each unit of
pollution emitted
3. Transferable emissions permits
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Emissions standard sets a legal limit on the
amount of emissions. Emissions must be
observable and measurable. Must be fine or
jail term imposed if standard is not met.
Will provide incentives to produce emissions
at optimal level. Will force all firms to obey
the same standard – is this efficient?
Standard can be set on “scientific” grounds
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$ per
unit of
emissions
MSC
MB, MC
MCA
0
“optimal”
level of
emissions
CO2 emissions
per year
Fossil fuels for electricity production and cars
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Emissions fee (tax on emissions) will force
firms/individuals to pay for emissions.
Emissions must be observable and measurable.
Fee must be set at the right level, but this is
difficult given uncertainty about the MCA and
MSC.
Firms will have incentive to avoid paying fee on
all units of emissions for which the fine is
cheaper.
If different firms have different costs of
abatement, this encourages firms with cheap
costs of abatement to reduce emissions by
greater amount. Fees give strong incentives
to find and install new technology.
However, amount of emissions allowed is
uncertain. If MCA is flat and MSC is steep, a
small error in fee-setting (too low) will be very
costly.
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$ per
unit of
emissions
MSC
MB, MC
MCA
0
“optimal”
level of
emissions
CO2 emissions
per year
Fossil fuels for electricity production and cars
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Transferable emissions permits
Each firm is allocated certain number of
emission permits each year. These permits
may be used or traded. Firms who have the
highest costs of abatement will seek to buy
extra permits. Firms who have low costs of
abatement will seek to sell permits. Demand
and supply for permits will establish
equilibrium price of fixed amount of pollution
permits.
Has some benefits of both other systems.
Public authority will determine amount of
emissions that are allowed.
Since the market sets the price of the
emissions permits, there is, in effect, a fee
for polluting (which allows different firms to
make different decisions). Therefore, more
efficient distribution of adjusting emissions
to new level.
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Creates a “market” for externalities.
Internalizes the external cost.
1990 U.S. Congress Clean Air Act established
tradeable permits for acid rain. Sulphur
dioxide emissions now cost about $150 per
ton.
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$ per
unit of
emissions
MSC
MB, MC
MCA
0
“optimal”
level of
emissions
CO2 emissions
per year
Fossil fuels for electricity production and cars
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Many external cost situations arise when
there is a “common property” resource.
Resource is owned in common and can be used
without payment. Leads to overutilization of
the free resource.
Examples: overfishing in a common pond, too
much extraction of oil from a common pool of
oil.
With fishers (formerly, fishermen), fishing
continues until MR = MC, ignoring the social
costs of depleting the stock of fish.
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Example:
Island of Pago-Pago
2 lakes, 20 fishers
Fishers get to keep average amount of fish
taken from that lake.
“Production” functions for fishing are:
On Lake X: FX = 10LX – ½ LX2
On Lake Y: FY = 5LY
In each case, L refers to number of fishers on
lake.
Sketch these production functions to get a
sense of what is driving this problem.
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If fishers can fish where they like (individual
choice), what will happen?
Fishers will fish where the average product is
highest, since they get to keep average
amount.
Average product on Lake X is:
FX/LX = (10LX – ½ LX2)/LX
Average product on Lake Y is:
FY/LY = (5LY)/LY = 5
Fishers will fish on each lake until
FX/LX = FY/LY
Or (10LX – ½ LX2)/LX = 5
Therefore, in equilibrium, LX = 10
And LY = 10
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What is the optimum number of fishers on
each lake? What distribution of fishers will
maximize fish output (fully taking into account
the diminishing marginal returns)?
Should equalize the marginal product on each
lake, rather than average product.
FX = 10LX – ½ LX2
So dFX/dLX = 10 - LX
And
FY = 5LY
So dFY/dLY = 5
Equating marginal products:
10 - LX = 5 or LX = 5
Therefore, LY = 15
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Compare the total number of fish caught,
using the production functions
With individual decision making about which
lake to fish on, we have:
(10 x 10) – ½ (10 x 10) + (5 x 10) = 100
At the optimum distribution, we have:
(10 x 5) – ½ (5 x 5) + (5 x 15) = 112.5
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Public Goods
- non-rival (marginal cost of extra consumer
= 0)
- non-excludable (free rider problem –
consumers cannot be excluded)
- therefore, market failure
Chocolate Bar
Movie
Highway
Mosquito control
System of justice
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How much of a public good?
John’s
MU
100
Frank’s
MU
100
100
100
Quantity of
Public Good
Quantity of
Public Good
Overall MU
100
Quantity of Public
27Good
100
If Frank has MUF = 100 - QF
And John has MUJ = 100 – QJ
And MC = 2Q
What is the optimum value of Q
This is a public good
Overall demand for public good
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Marginal benefit = marginal cost
How would government determine MU’s?
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Non-excludability is what causes market to
fail. Many goods are not “pure” public goods
but it is difficult or inconvenient or costly to
exclude consumers.
-
police
fire fighting
bridges
highways
clean air
parks
Questions:
How will the public good be financed?
Who will provide the public good?
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