Chapter 18Chapter 18

© 2006 Thomson Learning/South-Western

Externalities and Public Goods

2

Defining Externalities

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.

3

Externalities between Firms

One of the most famous beneficial externalities between firms involves one firm producing honey and the other producing apples. Bees feed on apple blossoms, which

increases the production of honey, and Bees pollinate apple crops, which increases

the production of apples.

4

Externalities

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.

5

Reciprocal Nature of Externalities

In dealing with externalities it is important to recognize that both parties are needed for an externality to exist. 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.

6

Externalities and Allocational Efficiency

The presence of externalities can cause a market to operate inefficiently. 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.

7

Social Costs

Social costs are the costs of production that include both input costs and costs of the externalities that production may cause. 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.

8

A Graphical Demonstration

Assume the charcoal producer is a price taker so that its demand curve is horizontal, as shown in Figure 18-1. 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.

9

A Graphical Demonstration

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’).

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MCS

MC

E

B

A

C

P*

Charcoalper week0 q’ q*

Price,costs of

charcoal

FIGURE 18-1: An Externality in Charcoal Production Causes an Inefficient Allocation of Resources

11

Property Rights

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.

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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. 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.

13

Ownership by the Polluting Firm

If the charcoal firm owns the land, it must add these ownership costs to its total costs. 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.

14

Ownership by the Polluting Firm

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*.

15

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’. 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.

16

The Coase Theorem

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.

17

Distributional Effects

The assignment of property rights does affect the distribution of the benefits. 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.

18

The Role of Transactions Costs

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.

19

Externalities with High Transactions Costs

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.

20

Legal Redress

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.

21

Taxation

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’.

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MCS

MC

E

B

A

C

P*

Charcoalper week0 q’ q*

Price,costs of

charcoal

FIGURE 18-2: Taxation Solution to the Externality Problem

P* - t

23

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. The shape comes from the assumption of

diminishing returns.

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MB

MC

f*

Reductionin emission0 100R*

Marginalbenefit,

cost

FIGURE 18-3: Optimal Pollution Abatement

25

Regulation of Externalities

The curve MC reflects the marginal costs in reducing environmental emissions including foregone profits and the costs of antipollution equipment. The positive slope reflects the assumption of

increasing marginal costs. R* is the optimal level of pollution where

the marginal benefits equal marginal costs.

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Fees, Permits, and Direct Controls

Three general ways to reduce emissions to R* through environmental policy. 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.

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Fees

An “effluent fee”,f*in Figure 18-3, is charged for each percent that pollution is not reduced. 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.

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MB

MC

f*

Reductionin emission0 RL RH 100R*

Marginalbenefit,

cost

FIGURE 18-3: Optimal Pollution Abatement

29

Permits

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.

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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. This is a common approach in the U.S. Specification of the mechanism of reduction

may reduce the cost-minimization incentive.

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京都議定書

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

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：

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Attributes of Public Goods

Nonexclusive goods are goods that provide benefits that no one can be excluded from enjoying. 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.

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Attributes of Public Goods

Nonrival goods are goods that additional consumers may use at zero marginal cost. 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.

34

Public Goods

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.

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TABLE 18-1: Types of Public and Private Goods

Exclusive Yes No

Yes Hot dogs, automobiles, houses

Fishing grounds, public grazing land, clean air

Rival No

Bridges, swimming pools, scrambled satellite television signals

National defense, mosquito control, justice

36

Public Goods and Market Failure

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.

37

Public Goods and Market Failure

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.

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Total demand

Demand byperson 2

Demand byperson 1

Quantity ofpublic goodper week

[ , ] Denotes equal distances

Willingnessto pay

FIGURE 18-4: Derivation of the Demand for a Public Good

39

Public Goods and Market Failure

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.

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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. Would people agree to be taxed in exchange

for the benefits the public good provides? One solution was proposed by Erik

Lindahl in 1919.

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The Lindahl Equilibrium

In Figure 18-5, the curve labeled SS shows one person’s (Smith) demand for a particular public good. 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.

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S

S

Quantity ofpublic good

Share of costpaid by Smith

100

0

FIGURE 18-5: Lindahl Equilibrium in the Demand for a Public Good

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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. 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.

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SJ

S

J

Quantity ofpublic good

Share of costpaid by Smith100

0 100

Share of costpaid by Jones0

FIGURE 18-5: Lindahl Equilibrium in the Demand for a Public Good

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The Lindahl Equilibrium

The two demand curves intersect at C with an output level OE of the public good. 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.

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C

SJ

S

J

60

Quantity ofpublic good

E

Share of costpaid by Smith100

40

0 100

Share of costpaid by Jones0

FIGURE 18-5: Lindahl Equilibrium in the Demand for a Public Good

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The Lindahl Equilibrium

For output levels greater than OE, people are not willing to pay the total cost of the good.

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. The tax shares are “pseudo prices,” and the

outcome can be shown to be efficient.

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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. It is likely that this poll would prove to be

extremely inaccurate because of free riders.