Chapter 17 Chapter 17 Externalities and Public Goods

4/14/2014Externalities and Public GoodsExternalities and Public Goods• In some markets have externalities and public goodsare present. These markets are unlikely to allocateresources efficiently.• Externality: The effect that the actions of one decision maker have onthe well‐being of other consumers or producers, beyond the effectstransmitted by changes in prices.• Public Good: A good, such as national defense, that has two definingfeatures: first, one person’s consumption does not reduce the quantitythat can be consumed by any other person (non‐rivalry); second, allconsumers have access to the good or excluding non‐payers fromenjoying the good is extremely expensive(non‐excludability).More about public goodsin a few days. Now:Externalities1

4/14/2014Externalities ‐ ExamplesExample Positive/Negative Consumption/ProductionVaccination Positive ConsumptionBandwagon Effect Positive ConsumptionDevelopment of laser PositiveProductiontechnologyManufacturer Polluting a NegativeProductionRiverHighway congestion Negative ConsumptionComputer Network Negative ConsumptionSnob Effect Negative ConsumptionLet’s consider a negative externality…• A perfectly competitive industry where every firmgenerates one ton of pollutant per ton of chemicalthey produce• The pollutant negatively affects society2

4/14/2014Negative Externality 1)OptimalMarginal Social CostIf the marketis left unregulated:Increase Q untilDem=Supply, entailing Q 1at P 12) But the firm is not considering theMEC it causes.3) Adding MPC + MEC = MSC4) Setting MSC=Dem yields Q * at P *= MPC Marginal PrivateCostUnreg. EquilMarginal External CostOptimalUnreg. EquilNegative Externality• At Q 1 , MSC > Demand implying that too muchpollution is being generated.• Intuitively, pollution at Q 1 is so large that social wellfarewould increase if production is reduced, from Q 1 to Q *3

4/14/2014Is Zero pollution socially efficient? No…• at Q=0 Mg Benefit> Mg Social Cost• Q * is efficient amount of production and pollution• Intuitively, the firm’s increase in profits by emitting thefirst ton of CO 2 are so high, that it would be willing tocompensate consumers for the (small) cost of havingone single ton of CO 2 in the air.• You can extend that argument, until…Q * , whereMg Benefit = Mg Cost of Pollution(Firm) (Consumers)Negative ExternalityUnregulatedEquilibrium(price=p 1 )Social Optimum(price=p * )DifferenceConsumer A+B+G+K A -B-G-KSurplusPrivate Producer E+F+R+H+N B+E+F+R+H+G B+G-NSurplus-Cost of -R-H-N-G-K-M -R-G-H M+N+K (externalExternality= Z + V = Z costs savings) = VNet Social A+B+E+F-M A+B+E+F MBenefitDeadweight LossDeadweight Loss M Zero M4

4/14/2014What do we do with pollution?• So far we showed that too much negative ext. isproduced, i.e., Q 1 > Q *• How can we move the equil. Q 1 towards Q * ?• Two policy instruments:• 1) Emission Standards (quotas)• 2) Emission Fees (taxes)Two Main Ways to Reduce Externalities• 1) Emission standards → Set the maximum amount ofpollution at Q *• A governmental limit on the amount of pollutionthat can be emitted. Since MPC and MSC may bedifficult to calculate for every firm, the governmentmay set an optimal Q * , distributed in permits, andallow firms to decide if they really want to pollute ornot.• Tradable emissions standards: relatively cleanfirms sell them to more polluting firms(e.g., cap and trade systems used in many countries)5

4/14/2014• 2) Emission fees (taxes)• Tax imposed on every unit of pollution that thefirm releases to the environment (e.g., $5 per ton ofCO 2 ).Price paid by Cons.taxtaxPrice ProducersreceiveWelfare Analysis: How does the taxaffect CS, PS,…?Equilibrium (with tax)Consumer SurplusPrivate Producer Surplus-Cost of ExternalityGovernment receipts from emissionstaxNet Social BenefitA (Above P* and below demand)F+R (Below p S and above MPC)-R-H-G=ZB+G+E+HA+B+E+F=(p * -p s ) · Q *tThe emission fee includes firms to producethe socially efficient output level Q*, thusyielding the same net social benefit as in thesocially efficient outcome Q *6

4/14/2014Learn by doing 17.2• Inverse Demand Curve: Pd = 24 – Q• Inverse Supply Curve: MPC = 2 + Q• Industry emits one unit of pollutant for each ton ofchemical it produces. As long as fewer than 2 millionunits of pollutant emitted each year, the external costis zero. But when pollution exceeds 2 million units themarginal external cost is positive.Supply = 2 + QMEC = 0, when Q 22 Q whenQ 2221MEC = Q – 2for Q > 2Learn by doing 17.2 (cont.)• Suppose the government wants to use an emission feeof $T that will induce the market to produce theeconomically efficient amount of the chemical, Q*.• Construct a graph and table comparing the equilibriawith and without the emission fee.7

4/14/2014Learn by doing 17.2 (cont.)• Unregulated equilibrium• Dem = Supply• 24‐Q = 2 + Q• Q = 11 units• Price = 24 – Q = 24 – 11 = $13,• as indicated by point H at the center of the figure.Learn by doing 17.2 (cont.)= (2 + Q) + (-2 + Q) = 2Q for all Q>22+Qtax-2 + Q if Q>20 if Q≤2=24-QSlope=2Slope=1Soc. Opt.Unregulated Equilibrium8

4/14/2014MSC• b) Social OptimumDem = Supply + MEC24‐Q = (2+Q) + (‐2+Q)24‐Q = 2Q → Q = 24/3 = 8P = 24‐8 = $16Point M on the Figure• c) How much must the tax be to move from H to M?• From point M, extend a dotted line downwards until you cross N,that is…Evaluate MPC (supply) at the socially optimal output of Q=8 units:MPC = 2 + 8 = $10Height of Point N in the FigureQ• Therefore the tax is the difference between:• M (what consumers actually pay for the good) = $16• N (what producers actually receive for the good) = $10. Here, theper‐unit tax is…T = $16 ‐ $10 = $69

4/14/2014Learn by doing 17.2 (cont.)UnregulatedSocially OptimalNo Emissions Fee Emissions Fee of $6 aunitConsumer Surplus AJH (60.5 mil) ABM (32 mil)Private ProducerSurplus-Cost of ExternalityFJH (60.5 mil)FEN (32 mil)-VLH=-GUI (-40.5 mil) -VNM=-GKR (-18 mil)Gov’t Earnings from ZerofeeNet Social Benefit AMVF-MLH (80.5mil)ENMB (48 mil)AMVF (94 mil)Learn by doing 17.2 (cont.)• In order to find the values above you have to rememberyour geometric equations.• Triangle: .5Base*Height• Square: Base*Height• Example: consumer surplus in the unregulatedequilibrium is AJH, in particular .5{(24‐13)(11)}=60.5• Repeat for all other regions of the graph above.10

4/14/2014Learn by doing 17.2 (cont.)• What is the DWL from an excessive amount ofpollution in the unregulated equilibrium?• DWL is the area of the triangle MNH,DWL=HeightBaseLearn by doing 17.2 (cont.)Tax Revenues• b) Why is the sum of CS + PPS –MEC+GOVT+DWL thesame with or without the fee?• The figures in the table show that the sum is going to be 94million both ways because the figure represents thepotential net benefit in the market whether or not there is afee.• When there is no fee the market performs inefficientlybecause of the negative externality and there is a DWL>0.• When there is a fee the market performs efficiently and theentire welfare potential is captured but DWL=0.• Indeed, $80.50 + $13.50 = $94Without FeeWith Fee11

4/14/2014Common Property Resources• A resource, such as a public park, a highway, or the internet,that anyone can access.What’s the problem? Congestion!• On the next graph• Before Q 1 = no congestion (MEC = 0 for Q ≤ Q1)• After Q1, there is congestion ( MEC > 0 for Q > Q1)Your car creates a negativeexternality to other users ofthe highway.(You Impose MEC)• Peak: Too much Q 5 ………B‐E is the toll. It makes each driverinternalize the MEC of the congestion he/she causes, moving toQ 4 , where Dem = MSC.• Off Peak: Too much Q 3 …..M‐N is the (smaller) toll in this period ofthe day, moving to Q 2 , where Dem = MSC.Common Property ResourcesMSC = MPC + MEC12

4/14/2014Application:• Congestion pricing in the route:Orange County ↔ L.A. County• There are no toll booths• Drivers buy a “transponder” (electronic device youstick to the windshield of your vehicle) and prepaymoney into the account4:00 to 5:00 PM, wow!• Toll prices range from $1.00 to $9.90• Electronic signs at the entrance of the highway informdrivers about the current toll.This system is now being copied by several countrieswith few highways: Chile, Brazil, etc.(Technological Leapfrogging)Another Application: London Congestion Charge• Drivers must pay around $8 (about $12 US) in order totravel within downtown London (the City and WestEnd) between 7:00 am and 6:30 pm.• Initial fears, but did it work?• YES!• Number of vehicles decreased by 23%• Average speed increased by 21%• Some neighborhoods outside the charging zone nowwant to be included within it.• Similar systems have been implemented in Singapore,Stockholm, Edinburgh and Milan.13

4/14/2014Positive externalities• Activities that create positive benefits for firms orindividuals who didn’t pay for the good or service.• You only take into account your private marginalbenefits (e.g., vaccine), but ignore the marginalexternal benefits that your action causes on otherindividuals.• Examples: education, health care, research anddevelopment (unpatented).Positive Externalities: UnderproductionExample: vaccination,primary/secondary education,…subsidyUnregulatedMPB = MCDemandSupplyOptimal MSB = MCMSB= MPB + MEB14

4/14/20142. What is the socially optimum amount of chocolateproduction?Social Opt. occurs at p d + MEB = p S (we take thepositive externality into account)…(1200‐Q) + (6‐0.05Q) = 440 +Q…Clearly Q equil < Q soc.optimum380 < 400Q* = 400 unitsExercise about Positive Externalities• 3. If the government of Amityville used a subsidy of $S per unitto encourage the optimal amount of chocolate production, whatlevel should that subsidy be?With a subsidy of $S, equilibrium occurs atP d + S = P S(1200‐Q) + S = 440 + QAnd in order to have the socially optimal Q = 400 (found in part bof the exercise),we then need to plug Q = 400 in the above expression,(1200 – 400) + S = 440 + 400Which implies that S must be (i.e. solving for S)S = $40.16

4/14/2014Property rights• So far we have shown that, in the presence ofexternalities, the government might try to restoreefficiency by imposing taxes (emission fees), subsidiesor quotas in the care of negative externalities, orsubsidies in the case of positive externalities.• An alternative, however, is to simply assign propertyrights of the resource to the agents (either firms orindividuals), and allow them to bargain about howmany units of the externality (e.g., pollution) they arewilling to bear.Property Rights• Property Rights: The exclusive control over the use of an asset orresource.• Why don’t we assign property rights over the resource (e.g., lake)and allow firms to bargain?• Coase Theorem: Regardless of how property rights are assigned withan externality, the allocation of resources will be efficient when theparties can costlessly bargain with each other.• Example: Fishery vs. Steel Firm (who owns the river)What if the fishery owns the river?What if the steel firm owns the river?Either way, the socially efficient output Q * is produced!!!17

4/14/2014Criticisms of Coase Theorem:• For the Coase Theorem to hold, we need that allparties involved in the negotiation must be perfectlyinformed about each other’s benefits and costs fromthe externality, e.g., pollution.• In addition, we need negotiation costs to be fare.• However, negotiation costs can be substantial if manyfirms and consumers are involved … why not set a quotaor a tax instead?IMPORTANT CLASS ANNOUNCMENT• If you like these topics:• SPECIAL CLASS ON ENVIRONMENTAL ECONOMICSNEXT FALL• Econ S 33018

4/14/2014Public Goods• National Defense• Clean AirExamplesPublic goods must satisfy two properties:1. Non‐Rival: When consumption of a good by one persondoes not reduce the quantity that can be consumed byothers.• National Defense (yes)• Highway (not so much: if I use it the quality of the serviceyou receive can decrease)• Clothing or an apple (not at all: if I eat the apple, youcannot eat it)Public GoodsIn addition, public goods must satisfy the property ofnon‐exclusivity2. Non‐Exclusive: A good that, once produced, isaccessible to all consumers; no one can be excludedfrom consuming such a good after it is produced.(or his exclusion is extremely expensive)• National Defense (yes)• Clean air (yes)• Highway (not so much)Easy to exclude if you didn’t paythe toll19

4/14/2014Public Goods, putting the twoproperties together…RivalNon-RivalExcludable Clothing/Food Pay-TV Channels(Private Goods) (Club Goods)Non-Excludable Hunting National Defense/Clean(Common Pool AirResources)(Public Goods)Learning‐by‐Doing 17.4 – Public Goods• Demand of individual 1 P 1 =100‐Q• Demand of individual 2 P 2 =200‐Q• a) If MC =240, what is the efficient amount of Q?• Start by adding the equations vertically:• MSB= P 1 +P 2 = (100‐Q) + (200‐Q) = 300‐2Q300 2QforQ100MSB 200 Q for 2000 Q1000 Q 200 This gives usMSBLet’s see its figure…20

4/14/2014Finding MSBAdding the two consumers’ demand for thepublic good vertically we obtain the MarginalSocial Benefit (MSB) of the public goodMSB300 – 2Q for Q≤ 100From point E to G200 – Q for Q Є (100,200]From point G to H0 for Q > 200For all units beyond point HIntuitively, for a given value of Q (e.g. Q=30 units), the MSB curve informs us about the totalbenefit that all consumers benefitting from the public good obtain.After finding MSB, we are now ready to find the optimalproduction of the public good by setting MSB = MC• Set MSB=MC300‐2Q=24060=2QQ=30(Point F in the Figure three slides ahead)21

4/14/2014• b) What if MC=50?MSB=MC200‐Q=50150=QQ=150 (Point K in the figure two slides ahead)c) And what if MC=400?300‐2Q=4002Q=‐100Q=‐50?• That is, when MC=400, the marginal social benefit of thispublic good is not high enough for any of it to beprovided so the optimal amount is Q=0.22

4/14/2014Learning by doing 17.4Question (c)Question (a)Question (b)Free Rider• Definition: A consumer who doesn’t pay for a non‐excludablegood, expecting that others pay.• Examples: PBS (100 Million viewers but only 4 millioncontributors)• National Public Radio (22 million listeners but only 3 millioncontributors)23

4/14/2014• Additional Examples about public goods andexternalities that can be worked out:• Exercises from the textbook 17.1, 17.6, 17,16 (seealso handout of the review session for answers tosimilar exercises)We are done this semester!• Slacker: “I am so glad we are done! I won’t be usingmicroeconomics again!”• My response: “I will miss you, but I know you will beusing microeconomics in literally all your remainingclasses, one way or another. The good news is thatyour foundations are now solid, and you will only applywhat we learned to specific settings.”24

4/14/2014Future courses where you will beusing Intermediate Micro…• If you like the models about firm competition…• Take the course on Industrial Organization (EconS 425)• If you like strategy and games, especially in uncertaincontexts…• Take the course on Strategy and Game Theory (EconS424)• If you like externalities and environmental policy...• Take Environmental Economics (EconS 330)25