ppt prs econ ch16 9e

8/4/2019 Ppt Prs Econ Ch16 9e

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Public 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 49

PowerPoint Lectures for

Principles of Economics,9e

By

Karl E. Case,Ray C. Fair &Sharon M. Oster

; ;


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2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

16PART III MARKET IMPERFECTIONS AND

THE ROLE OF GOVERNMENT

Externalities, PublicGoods, and Social Choice

Fernando & Yvonn Quijano

Prepared by:


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16

Externalities and EnvironmentalEconomicsMarginal Social Cost and Marginal-Cost

PricingPrivate Choices and External EffectsInternalizing Externalities

Public (Social) GoodsThe Characteristics of Public GoodsIncome Distribution as a Public Good?Public Provision of Public GoodsOptimal Provision of Public Goods

Local Provision of Public Goods: TieboutHypothesis

Mixed Goods

Social ChoiceThe Voting ParadoxGovernment Inefficiency: Theory of Public

ChoiceRent-Seeking Revisited

Government and the Market

CHAPTER OUTLINE

Externalities, PublicGoods, and Social Choice

PART III MARKET IMPERFECTIONS AND

THE ROLE OF GOVERNMENT


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Externalities, Public Goods, and Social Choice

market failure Occurs when resources aremisallocated or allocated inefficiently.

Externalities and Environmental Economics

externality A cost or benefit imposed or bestowedon an individual or a group that is outside, orexternal to, the transaction.


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Find the statement below that is incorrectabout the study ofexternalities?

a. Externalities are also called spillover, orneighborhood effects.b. The study of externalities is a major concern ofenvironmentaleconomics.

c. Externalities are limited to free market economies.

d. When people closer together, externalities become moreimportant.

e. None of the above. All of the statements above are correct.


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Find the statement below that is incorrectabout the study ofexternalities?

a. Externalities are also called spillover, orneighborhood effects.

b. The study of externalities is a major concern ofenvironmentaleconomics.

c.c. Externalities are limited to free market economies.Externalities are limited to free market economies.

d. When people closer together, externalities become moreimportant.

e. None of the above. All of the statements above are correct.


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marginal social cost (MSC) The total cost tosociety of producing an additional unit of a good orservice. MSCis equal to the sum of the marginalcosts of producing the product and the correctlymeasured damage costs involved in the process of

production.

Marginal Social Cost and Marginal-Cost Pricing


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FIGURE 16.1 Profit-MaximizingPerfectly Competitive Firms WillProduce Up to the Point That PriceEquals Marginal Cost(P = MC)

If we assume that the current

price reflects what consumers arewilling to pay for a product at the

margin, firms that create external

costs without weighing them in

their decisions are likely to

produce too much.

At q*, marginal social cost

exceeds the price paid by

consumers.


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For every unit produced beyond the level at which P= MC:

a. Society uses up resources that have a value (or cost) in excess ofthe benefits that consumers place on that unit.

b. Society uses up resources that have a value (or cost) that is lessthan the benefits that consumers place on that unit.

c. Society begins to enjoy the benefits of additional production.

d. Society stops enjoying the benefits of additional production.


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For every unit produced beyond the level at which P= MC:

a.a. Society uses up resources that have a value (or cost) in excess ofSociety uses up resources that have a value (or cost) in excess of

the benefits that consumers place on that unit.the benefits that consumers place on that unit.

b. Society uses up resources that have a value (or cost) that is lessthan the benefits that consumers place on that unit.

c. Society begins to enjoy the benefits of additional production.

d. Society stops enjoying the benefits of additional production.


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Acid Rain and the Clean Air Act

Acid rain is an excellent example of an externalityand of the issues and conflicts involved in dealingwith externalities.

The case of acid rain highlights the fact thatefficiency analysis ignores the distribution of gainsand losses. That is, to establish efficiency, weneed only demonstrate that the total value of thegains exceeds the total value of the losses.


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Other Externalities

Other examples of external effects are all aroundus. When people drive their cars into the center ofthe city at rush hour, they contribute to thecongestion and impose costs (in the form of losttime and auto emissions) on others.

Clearly, the most significant and hotly debatedissue of externalities is global warming.


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Some Examples of Positive Externalities

Thus far we have described a series of negativeexternalities. But externalities can also be positive.In some cases, when other people or firms engagein an activity, there are side benefits from thatactivity. From an economics perspective, there areproblems with positive externalities as well.

The problem with positive externalities is that theindividuals in charge have too little incentive to

engage in the activity.


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Private Choices and External Effects

FIGURE 16.2 Externalities in a College DormitoryThe marginal benefits to Harry exceed the marginal costs he must bear to play his stereo system for a period of up to 8hours. When the stereo is playing, a cost is being imposed on Jake.

When we add the costs borne by Harry to the damage costs imposed on Jake, we get the full cost of the stereo to the two-

person society made up of Harry and Jake.Playing the stereo more than 5 hours is inefficient because the benefits to Harry are less than the social cost for every

hour above 5. If Harry considers only his private costs, he will play the stereo for too long a time from societys point of

view.


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Private Choices and External Effects

marginal private cost (MPC) The amount that aconsumer pays to consume an additional unit of aparticular good.

marginal damage cost (MDC) The additional harmdone by increasing the level of an externality-producing activity by 1 unit. If producing productXpollutes the water in a river, MDC is the additionalcost imposed by the added pollution that resultsfrom increasing output by 1 unit ofXper period.


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In the case of a negative externality, the socially efficient level of outputis set where marginal benefit equals:

a. Marginal social cost.

b. Marginal private cost.

c. Marginal damage cost.

d. Marginal cost.


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In the case of a negative externality, the socially efficient level of outputis set where marginal benefit equals:

a.a. Marginal social cost.Marginal social cost.

b. Marginal private cost.

c. Marginal damage cost.

d. Marginal cost.


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Internalizing Externalities

Five approaches have been taken to solving theproblem of externalities:

(1) government imposed taxes and subsidies,

(2) private bargaining and negotiation,

(3) legal rules and procedures,(4) sale or auctioning of rights to impose

externalities, and

(5) direct government regulation.

While each is best suited for a different set of

circumstances, all five provide decision makerswith an incentive to weigh the external effects oftheir decisions.


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Taxes and Subsidies

FIGURE 16.3 Tax Imposed on a Firm Equal to Marginal Damage Cost

If a per-unit tax exactly equal to marginal damage costs is imposed on a firm, the firm will weigh the tax, and

thus the damage costs, in its decisions. At the new equilibrium price, P1, consumers will be paying an amount

sufficient to cover full resource costs as well as the cost of damage imposed. The efficient level of output for

the firm is q1.


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When a tax is used to internalize an externality, the tax should be setequal to:


b. Marginal private cost.c. Marginal damage cost.

d. Marginal cost.


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When a tax is used to internalize an externality, the tax should be setequal to:


b. Marginal private cost.c.c. Marginal damage cost.Marginal damage cost.

d. Marginal cost.


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Taxes and SubsidiesMeasuring Damages

The biggest problem with using taxes andsubsidies is that damages must be estimated in

financial terms.


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Taxes and SubsidiesReducing Damages to an Efficient Level

Taxes also provide firms with an incentive to usethe most efficient technology for dealing with

damage.

The Incentive to Take Care and to Avoid Harm

You should understand that all externalities

involve at least two parties and that it is not alwaysclear which party is causing the damage.


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Taxes and SubsidiesSubsidizing External Benefits

Sometimes activities or decisions generateexternal benefits instead of costs.

Externalities Are All AroundUs

Abominable Snowmen: TheWar on Lawn Decorations

Wall Street Journal


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ublic 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 49



Bargaining and Negotiation

Coase theorem Under certain conditions, whenexternalities are present, private parties can arriveat the efficient solution without governmentinvolvement.

Legal Rules and Procedures

injunction A court order forbidding thecontinuation of behavior that leads to damages.

liability rules Laws that require A to compensate Bfor damages imposed.


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According to the Coase theorem, in order to arrive at an efficientsolution to an externality problem associated with a given activity:

a. No party should be given the right to that activity prior to

negotiation; otherwise, that party would have no incentive tobargain.

b. The right to an activity must be decided during the negotiationprocess.

c. It doesnt matter which party is initially assigned the right to thatactivity.

d. Both parties must feel that they have equal rights to the activityprior to negotiation.


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According to the Coase theorem, in order to arrive at an efficientsolution to an externality problem associated with a given activity:

a. No party should be given the right to that activity prior to

negotiation; otherwise, that party would have no incentive tobargain.

b. The right to an activity must be decided during the negotiationprocess.

c.c. It doesnt matter which party is initially assigned the right to thatIt doesnt matter which party is initially assigned the right to that

activity.activity.

d. Both parties must feel that they have equal rights to the activityprior to negotiation.


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Selling or Auctioning Pollution Rights

TABLE 16.1 Permit Trading

Firm A Firm A Firm A Firm B Firm B Firm B

Reduction of pollutionby Firm A (in units of

pollution)

MC of reducingpollution for Firm

A

TC of reducingpollution for Firm

A

Reduction of pollutionby Firm B (in units of

pollution)

MC of reducingpollution for Firm

B

TC of reducing

pollution for Firm

B

1 $ 5 $ 5 1 $ 8 $ 8

2 7 12 2 14 22

3 9 21 3 23 45

4 12 33 4 35 80

5 17 50 5 50 130


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Direct Regulation of Externalities

The Debate Over GlobalWarming

One of the most hotlydebated issues involvingexternalities is the potentialcost of global warming.

The Kyoto Protocol is an international treaty on global warmingnegotiated by the United Nations in the 1990s. It came intoforce after being ratified by Russia in February 2005. A total of141 countries have ratified the agreement, which commitsthem to reduce their emissions of carbon dioxide and five othergreenhouse gases or to engage in emissions trading. The

United States has not ratified the treaty.


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Public (Social) Goods

The Characteristics of Public Goods

public goods (social or collective goods) Goods

that are nonrival in consumption and/or theirbenefits are nonexcludable.

nonrival in consumption A characteristic of publicgoods: One persons enjoyment of the benefits ofa public good does not interfere with anothersconsumption of it.

nonexcludable A characteristic of most public

goods: Once a good is produced, no one can beexcluded from enjoying its benefits.


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The Characteristics of Public Goods

free-rider problem A problem intrinsic to publicgoods: Because people can enjoy the benefits ofpublic goods whether or not they pay for them,they are usually unwilling to pay for them.

drop-in-the-bucket problem A problem intrinsic topublic goods: The good or service is usually socostly that its provision generally does not dependon whether any single person pays.


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Income Distribution as a Public Good?

Note that some economists have argued forredistribution of income on grounds that itgenerates public benefits.

If we accept the idea that redistributing income

generates a public good, private endeavors mayfail to do what we want them to do, andgovernment involvement may be called for.


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Public Provision of Public Goods

All societies, past and present, have had to facethe problem of providing public goods. Whenmembers of society get together to form agovernment, they do so to provide themselves withgoods and services that will not be provided if they

act separately.


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Which of the following is the best example of a mixed good?

a. A Big Mac.

b. The Golden Gate bridge.

c. The Statue of Liberty.

d. Elementary education.

e. All of the above are good examples of mixed goods.


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Which of the following is the best example of a mixed good?

a. A Big Mac.

b. The Golden Gate bridge.

c. The Statue of Liberty.

d.d. Elementary education.Elementary education.

e. All of the above are good examples of mixed goods.


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Optimal Provision of Public Goods

Samuelsons Theory

Economist Paul Samuelson demonstrated thatthere exists an optimal, or a most efficient, level ofoutput for every public good.

An efficient economy produces what people want.Private producers, whether perfect competitors ormonopolists, are constrained by the marketdemand for their products. If they cannot sell theirproducts for more than it costs to produce them,they will be out of business. Because private

goods permit exclusion, firms can withhold theirproducts until households pay. Buying a product ata posted price reveals that it is worth at least thatamount to you and to everyone who buys it.


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Samuelsons Theory

FIGURE 16.4 With Private Goods, Consumers Decide What Quantity to Buy; Market Demand Isthe Sum of Those Quantities at Each Price

At a price of $3, A buys 2 units and B buys 9 for a total of 11.

At a price of $1, A buys 9 units and B buys 13 for a total of 22.

We all buy the quantity of each private good that we want. Market demand is the horizontal sum of all individual

demand curves.


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Samuelsons Theory

FIGURE 16.5 With PublicGoods, There Is Only OneLevel of Output and ConsumersAre Willing to Pay DifferentAmounts for Each Level

A is willing to pay $6 per unit for

X1 units of the public good. B is

willing to pay only $3 forX1 units.

Societyin this case A and Bis

willing to pay a total of $9 forX1

units of the good.

Because only one level of output

can be chosen for a public good,we must add As contribution to

Bs to determine market demand.

This means adding demand

curves vertically.


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Which of the following is/are true?

a. Only one level of output can be chosen for a public good.

b. The demand for a public good is the horizontal summation of

individual demand curves for that good.c. Government must decide how much of a public good to produce.

d. The satisfaction we derive from the quantity consumed of publicgoods is just as great as the satisfaction derived fromconsumption of private goods.

e. All of the above.


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Which of the following is/are true?

a.a. Only one level of output can be chosen for a public good.Only one level of output can be chosen for a public good.

b. The demand for a public good is the horizontal summation of

individual demand curves for that good.c. Government must decide how much of a public good to produce.

d. The satisfaction we derive from the quantity consumed of publicgoods is just as great as the satisfaction derived fromconsumption of private goods.

e. All of the above.


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Samuelsons Theory

FIGURE 16.6 OptimalProduction of a Public Good

Optimal production of a public

good means producing as long as

societys total willingness to pay

per unit (DA+B) is greater than themarginal cost of producing the

good.


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Samuelsons Theory

optimal level of provision for public goods Thelevel at which societys total willingness to pay perunit is equal to the marginal cost of producing thegood.

The Problems of Optimal Provision

One major problem exists. To produce the optimalamount of each public good, the government must

know something that it cannot possibly knoweveryones preferences.


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Local Provision of Public Goods: Tiebout Hypothesis

Tiebout hypothesis An efficient mix of public goodsis produced when local land/housing prices andtaxes come to reflect consumer preferences just asthey do in the market for private goods.

Mixed Goods

mixed goods Goods that are part public goods andpart private goods. Education is a key example.


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Social Choice

The Voting Paradox

Impossibility theorem A proposition demonstratedby Kenneth Arrow showing that no system ofaggregating individual preferences into socialdecisions will always yield consistent, nonarbitraryresults.

social choice The problem of deciding what society

wants. The process of adding up individualpreferences to make a choice for society as awhole.


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Social Choice

The Voting Paradox

FIGURE 16.7 Preferences of Three Top University Officials

VP1 prefers A to B and B to C. VP2 prefers B to C and C to A. The dean prefers C to A and A to B.

TABLE 16.2 Results of Voting on Universitys Plans: The Voting Paradox

Votes of:Vote VP1 VP2 Dean Resulta

A versus B A B A A wins: A > B

B versus C B B C B wins: B > C

C versus A A C C C wins: C > A

aA > B is read A is preferred to B.


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Social Choice

The Voting Paradox

voting paradox A simple demonstration of howmajority-rule voting can lead to seeminglycontradictory and inconsistent results. Acommonly cited illustration of the kind ofinconsistency described in the impossibilitytheorem.

logrolling Occurs when congressionalrepresentatives trade votes, agreeing to help eachother get certain pieces of legislation passed.


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Social Choice

Government Inefficiency: Theory of Public Choice

Looking at the public sector from the standpoint ofthe behavior of public officials and the potential forinefficient choices and bureaucratic waste ratherthan in terms of its potential for improving theallocation of resources has become quite popular.This is the viewpoint of what is called thepublicchoice field in economics that builds heavily on thework of Nobel laureate James Buchanan.


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Social Choice

Rent-Seeking Revisited

A monopolist would be willing to pay to preventcompetition from eroding its economic profits.Manyif not allindustries lobby for favorabletreatment, softer regulation, or antitrust exemption.This, as you recall, is rent-seeking.

Theory may suggest that unregulated markets failto produce an efficient allocation of resources. Thisshould not lead you to the conclusion thatgovernment involvement necessarily leads toefficiency. There are reasons to believe thatgovernment attempts to produce the right goodsand services in the right quantities efficiently mayfail.


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Government and the Market

There is no question that government must beinvolved in both the provision of public goods andthe control of externalities.

The question is not whetherwe need governmentinvolvement. The question is how much and what

kindof government involvement we should have.

REVIEW TERMS AND CONCEPTS


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Coase theorem

drop-in-the-bucket problem

externality

free-rider problem

impossibility theorem

injunction

liability rules

logrolling

marginal damage cost (MDC)marginal private cost (MPC)

marginal social cost (MSC)

market failure

mixed goods

nonexcludable

nonrival in consumption

optimal level of provision forpublic goods

public goods (social orcollectivegoods)

social choice

Tiebout hypothesis

voting paradox

ppt prs econ ch16 9e

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