1 externalities, public goods and common resources chapters 10, 11
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1
Externalities, Public Goods and Common Resources
Chapters 10, 11
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Externality
The uncompensated impact of one person’s actions on the well-being of a bystander.
Examples: automobile exhaust, historic buildings, barking dogs, R&D.
4
Social Optimum
Point at which the marginal benefit equals marginal cost.
Figure 1 The Market for Aluminum
Copyright © 2004 South-Western
Quantity ofAluminum
0
Price ofAluminum
Equilibrium
Demand(private value)
Supply(private cost)
QMARKET
Figure 2 Pollution and the Social Optimum
Copyright © 2004 South-Western
Equilibrium
Quantity ofAluminum
0
Price ofAluminum
Demand(private value)
Supply(private cost)
Socialcost
QOPTIMUM
Optimum
Cost ofpollution
QMARKET
7
Positive Externalities
Beneficial third party effects.
Figure 3 Education and the Social Optimum
Copyright © 2004 South-Western
Quantity ofEducation
0
Price ofEducation
Demand(private value)
Socialvalue
Supply(private cost)
QMARKET QOPTIMUM
9
Internalizing the Externality
Altering incentives so that people take account of the external effects of their actions.
10
Private Solutions
• Moral codes.
• Private charities.
• Contracts (Coase theorem)
11
Coase Theorem
In the absence of transactions costs, private economic actors can solve the problem of externalities among themselves.
12
Public Policies to Deal with Externalities
• Regulation specifying maximum allowable level of a negative externality.
• Taxes (for negative externalities) & subsidies (for positive externalities).
• Permits (licenses).
13
Pigovian Taxes
• Arthur Pigou (1877-1959), Professor of Economics, Cambridge University
• Tax the good that creates the negative externality.
• Reduces Q to optimal level.
14
How would you model a subsidy paid to providers of a positive
externality?
15
Figure 1 The Effects of a Tax
Copyright © 2004 South-Western
Size of tax
Quantity0
Price
Price buyerspay
Price sellersreceive
Demand
Supply
Pricewithout tax
Quantitywithout tax
Quantitywith tax
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Tradable Pollution Permits
Environmental agency decides the appropriate level of pollutants and issues (or auctions off) permits for exactly that level.
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
Copyright © 2004 South-Western
Quantity ofPollution
0
Price ofPollution
Demand forpollution rights
P Pigoviantax
(a) Pigovian Tax
2. . . . which, togetherwith the demand curve,determines the quantityof pollution.
1. A Pigoviantax sets theprice ofpollution . . .
Q
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
Copyright © 2004 South-Western
Quantity ofPollution
0
Demand forpollution rights
Q
Supply ofpollution permits
(b) Pollution Permits
Price ofPollution
2. . . . which, togetherwith the demand curve,determines the priceof pollution.
1. Pollutionpermits setthe quantityof pollution . . .
P
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Summary
• When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality.
• Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity.
• Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.
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Summary
• When private parties cannot adequately deal with externalities, then the government steps in.
• The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.
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Firm Pollution
Level
Unit cost to reduce
A 70 units $20
B 80 $25
C 50 $10
The government gives each firm 40 tradable pollution permits to reduce aggregate pollution level to 120 units.1. What is the total cost of reducing pollution?2. What would be the cost if the permits were not tradable?
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Public Goods & Common Resources
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Definitions
Excludability: the property of a good whereby a person can be prevented from using it.
Rivalry: the property of a good whereby one person’s use diminishes other people’s use.
Figure 1 Four Types of Goods
Copyright © 2004 South-Western
Rival?
Yes
Yes
• Ice-cream cones• Clothing• Congested toll roads
• Fire protection• Cable TV• Uncongested toll roads
No
Private Goods Natural Monopolies
No
Excludable?
• Fish in the ocean• The environment• Congested nontoll roads
• Tornado siren• National defense• Uncongested nontoll roads
Common Resources Public Goods
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Free Rider Problem
Receiving the benefit of a good without paying for it.
e.g. viewer of public television
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Tragedy of the Commons
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Question.
Why is the commercial value of ivory a threat to the elephant, while the commercial value of beef is a guardian of the cow?
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BEIJING, March 4 (Reuters) - China is to change its constitution to protect private property in a revolutionary manoeuvre that waters down its core Communist ideology to raise the status of entrepreneurs once deemed the running dogs of capitalism.
Five decades after seizing power, nationalising private property and waging bloody campaigns against landlords, China's parliament is set to amend the state constitution to add the words, "private property obtained legally is inviolable".
One aim of the amendments, to be ratified during the annual session of the National People's Congress that opens on Friday, is to give further impetus to the burgeoning private sector that is fuelling China's breakneck economic growth.
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