KRUGMAN'SMICROECONOMICS for AP*

Externalities and Public Policy

Margaret Ray and David Anderson

Micro:

Econ:

39

75

Module

What you will learnin this Module:• How external benefits and costs

cause inefficiency in markets.

• Why some government policies to deal with externalities, such as emissions taxes, tradable emissions permits, and Pigouvian subsidies, are efficient, although others, including environmental standards, are not.

Arthur Cecil Arthur Cecil PigouPigou

Policies Toward Pollution

• Environmental Standards (emissions testing; sewage treatment)

• Emissions Taxes

• Tradable Emissions Permits

Production, Consumption, and Externalities

• Private versus social benefits

• Private versus social costs

Externalities

A Pigouvian tax is a tax levied on a market A Pigouvian tax is a tax levied on a market activity that generates negative activity that generates negative externalities (or a subsidy for a positive externalities (or a subsidy for a positive externality. The tax or subsidy is intended externality. The tax or subsidy is intended to correct the market outcome. In the to correct the market outcome. In the presence of negative externalities, the presence of negative externalities, the social cost of a market activity is not social cost of a market activity is not covered by the private cost of the activity. covered by the private cost of the activity. In the presence of positive externalities, In the presence of positive externalities, the social benefit of a market activity is the social benefit of a market activity is not covered by the private benefit of the not covered by the private benefit of the activity.activity.

Positive Externalities

When the production and consumption of a good provides benefits to third parties, that good is said to provide positive externalities to society. Qty home

improvements

Price, MSB

MPB MSB

S

Popt

QoptQmkt

Pmkt SubsidyPcons

Positive Externalities

• We can see that the market We can see that the market under-produces goods that under-produces goods that generate positive generate positive externalities. In other words, externalities. In other words, we don’t get enough of a good we don’t get enough of a good thing. thing.

• This is inefficient and produces This is inefficient and produces deadweight loss just like price deadweight loss just like price controls and monopoly. This controls and monopoly. This represents benefits that would represents benefits that would be enjoyed by society if the be enjoyed by society if the socially optimal, not the socially optimal, not the market, output was produced.market, output was produced.

• The area of the deadweight The area of the deadweight triangle is above the supply triangle is above the supply curve, with base of (Qcurve, with base of (Qoptopt - Q - Qmktmkt), ), and height of (Pand height of (Pmsbmsb – P – Pmktmkt),),

Qty home improvements

Price, MSB

MPB MSB

S

Popt

QoptQmkt

Pmkt SubsidyPcons

Positive Externalities

• How could policy How could policy eliminate the eliminate the deadweight loss?deadweight loss?

• We could provide We could provide a subsidy (called a subsidy (called a Pigouvian a Pigouvian subsidy) on each subsidy) on each unit of home unit of home improvement improvement goods demandedgoods demanded Qty home

improvements

Price, MSB

MPB MSB

S

Popt

QoptQmkt

Pmkt SubsidyPcons

Negative Externalities

When the production and consumption of a good creates costs to third parties, that good is said to create negative externalities to society. Qty electricity

Price, MSC

MPC

D

MSC

Popt

Qopt Qmkt

Pmkt

Tax

Pfirm

Negative Externalities

• We can see that the market We can see that the market over-produces goods that over-produces goods that generate negative generate negative externalities. In other externalities. In other words, we get too much of words, we get too much of a bad thing. a bad thing.

• This is inefficient and This is inefficient and produces deadweight loss produces deadweight loss just like price controls and just like price controls and monopoly. This represents monopoly. This represents additional costs that would additional costs that would not be incurred by society not be incurred by society if the socially optimal, not if the socially optimal, not the market, output was the market, output was produced.produced.

Qty electricity

Price, MSC

MPC

D

MSC

Popt

Qopt Qmkt

Pmkt

Tax

Pfirm

Negative Externalities - Examples• Smokers ignore the unintended but harmful Smokers ignore the unintended but harmful

impact of impact of toxic ‘passive smoking’ on non-smokers

• Acid rain from power stations in the UK can Acid rain from power stations in the UK can damage the forests of Norwaydamage the forests of Norway

• Air pollutionAir pollution from road use and traffic congestion from road use and traffic congestion

• The social costs of drug  and alcohol abuseThe social costs of drug  and alcohol abuse

• External costs of scraping the seabed External costs of scraping the seabed for for supplies of gravelsupplies of gravel

Negative Externalities - Examples

• External costs of traveling by taxiExternal costs of traveling by taxi

• The The environment damageenvironment damage caused by the  caused by the intensive use of fertilizers in agricultureintensive use of fertilizers in agriculture

• The external costs of The external costs of cleaning up from cleaning up from litterlitter and the  and the dropping of chewing gumdropping of chewing gum

• The external costs of the The external costs of the miles that food miles that food travels from producer to the final travels from producer to the final consumerconsumer

Network Externalities

•When more people use When more people use Facebook or Twitter, it Facebook or Twitter, it becomes more valuable to becomes more valuable to you. you.

A network externality exists when the value to an individual of a good or service depends on how many other people use the same good or service.

Figure 75.1 In Pursuit of the Efficient Quantity of PollutionRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 75.2 Environmental Standards versus Emissions TaxesRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 75.3 Positive Externalities and ConsumptionRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 75.4 Negative Externalities and ProductionRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers