Chapter 16 Externalities and Public Goods 2004 Thomson

Chapter 16 Externalities and Public Goods © 2004 Thomson Learning/South-Western

Defining Externalities l l l 2 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.

Externalities between Firms l l 3 Consider two firms--one producing eyeglasses, and another producing charcoal. The production of charcoal is said to have an external effect on the production of eyeglasses if the output of eyeglasses depends not only on the amount of inputs chosen by the eyeglass firm but also on the level of production of charcoal.

Externalities between Firms l l l 4 Suppose the eyeglass firm is near and downwind from the charcoal company. The amount of eyeglasses may depend upon the amount of charcoal in the air which affects the precision grinding wheels. The level of eyeglass production is partially determined by the amount of charcoal produced, with more charcoal reducing the amount of eyeglasses.

Externalities between Firms l One of the most famous beneficial externalities between firms involves one firm producing honey and the other producing apples. – – 5 Bees feed on apple blossoms, which increases the production of honey, and Bees pollinate apple crops, which increases the production of apples.

Externalities l l l 6 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.

Reciprocal Nature of Externalities l In dealing with externalities it is important to recognize that both parties are needed for an externality to exist. – – 7 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.

APPLICATION 16. 1: Secondhand Smoke l l 8 Secondhand smoke (officially, environmental tobacco smoke, or ETS), refers to the effects of smokers’ consumption of cigarettes and other tobacco products on third-party bystanders. The harm of ETS is controversial, but the Environmental Protection Agency estimates approximately 2, 200 deaths annually.

APPLICATION 16. 1: Reciprocal Nature of the ETS Externality l Smokers potentially harm bystanders, but limiting the “rights” of smokers impose inconveniences as well. – l 9 One study suggests that workplace restrictions on smoking results in a loss of approximately $20 billion per year in consumer surplus. Such estimates, like those of the harms of ETS, are controversial.

APPLICATION 16. 1: Private Action and Public Actions l l l 10 Many private decisions have limited smoking in the workplace and in public areas. The Occupational Safety and Health Administration has proposed banning all workplace smoking. Many question whether governmental action is necessary given the private actions already taken.

Externalities and Allocational Efficiency l The presence of externalities can cause a market to operate inefficiently. – – 11 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.

Social Costs l Social costs are the costs of production that include both input costs and costs of the externalities that production may cause. – – 12 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.

A Graphical Demonstration l Assume the charcoal producer is a price taker so that its demand curve is horizontal, as shown in Figure 16. 1. – – 13 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.

FIGURE 16. 1: An Externality in Charcoal Production Causes an Inefficient Allocation of Resources Price, costs of charcoal MCS MC E P* 14 0 q* Charcoal per week

A Graphical Demonstration – – 15 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’).

FIGURE 16. 1: An Externality in Charcoal Production Causes an Inefficient Allocation of Resources MCS Price, costs of charcoal B A P* MC E C 16 0 q’ q* Charcoal per week

Property Rights l l l 17 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.

Costless Bargaining and Competitive Markets l 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. – l 18 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.

Ownership by the Polluting Firm l If the charcoal firm owns the land, it must add these ownership costs to its total costs. – – 19 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.

Ownership by the Polluting Firm – – 20 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 *.

Ownership by the Injured Firm l If the eyeglass maker owns the air, the charcoal firm will offer a payment to use the air associated with output level q’. – l 21 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.

The Coase Theorem l l 22 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.

Distributional Effects l The assignment of property rights does affect the distribution of the benefits. – – l 23 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.

The Role of Transactions Costs l l l 24 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.

APPLICATION 16. 2: Property Rights in Nature—Bees and Apples l l 25 In many locales contractual bargaining between beekeepers and orchard owners provide for renting bees for the pollination of many crops. Rents appear to accurately reflect the value of honey that is yielded with higher rents for clover growers because apple blossoms yield less honey.

APPLICATION 16. 2: Property Rights in Nature—Shellfish l l Overfishing creates an externality since no single fisher takes into account the fact that his or her catch with reduce others catches. Coastal situations allow property rights so owners can consider harvesting practices. – 26 One study suggests that oyster yields were higher in Virginia because it made it easier to enforce property rights.

APPLICATION 16. 2: Property Rights in Nature—Elephants l l l 27 In the past, ivory hunters have lead to a decline of over 50 percent of the population in East African countries. Recently, villages received property rights to elephants and sold limited numbers of elephants for hunting. Elephants populations in these areas are on the rise.

Externalities with High Transactions Costs l l l 28 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 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.

Legal Redress l l l 29 The operation of the law may sometimes provide a way for taking externalities into account. If the charcoal producer in Figure 16. 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.

Taxation l l l 30 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 16. 2 is similar to Figure 16. 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’.

FIGURE 16. 2: Taxation Solution to the Externality Problem Price, costs of charcoal MCS B A P* P* - t 31 0 MC E C q’ q* Charcoal per week

Regulation of Externalities l l l An alternative to taxation is regulation. The horizontal axis in Figure 16. 3 shows percentage reductions in pollution that would exist without regulation. The curve MB shows the marginal benefit by reducing pollution by one unit. – 32 The shape comes from the assumption of diminishing returns.

FIGURE 16. 3: Optimal Pollution Abatement Marginal benefit, cost MC f* MB 0 33 R* 100 Reduction in emission

Regulation of Externalities l The curve MC reflects the marginal costs in reducing environmental emissions including foregone profits and the costs of antipollution equipment. – l 34 The positive slope reflects the assumption of increasing marginal costs. R* is the optimal level of pollution where the marginal benefits equal marginal costs.

Fees, Permits, and Direct Controls l Three general ways to reduce emissions to R* through environmental policy. – – – 35 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.

Fees l An “effluent fee”, f*in Figure 16. 3, is charged for each percent that pollution is not reduced. – – l 36 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.

FIGURE 16. 3: Optimal Pollution Abatement Marginal benefit, cost MC f* MB 37 0 RL R* RH 100 Reduction in emission

Permits l l l 38 Government issued permits would allow firms to “produce” (100 - R*) percent of their unregulated emission levels. As shown in Figure 16. 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.

Direct Controls l 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. – – 39 This is a common approach in the U. S. Specification of the mechanism of reduction may reduce the cost-minimization incentive.

APPLICATION 16. 3: Regulating Power Plant Emissions l l Many electric power plants burn coal for fuel. This generates some byproducts including sulfuric acid which is associated with the creation of “acid rain” which harms lakes and forests. – 40 Acid rain is found in the eastern U. S. and Canada as well as Europe, Russia, and China.

APPLICATION 16. 3: Regulation of Production Technology l l l 41 The U. S. has used a “command-control” (CAC) approach. Air quality standards are defined by law and plants are required to install specific equipment; with most requiring “scrubbers” that clean exhaust fumes in their stacks. Studies suggest that these costs exceed minimum costs by a factor of two.

APPLICATION 16. 3: Emission Charges l A more efficient alternative would be to impose a Pigouvian tax on emissions. – – 42 Firms could choose any technology that gives emission reductions at a marginal cost that is less than or equal to the tax. Studies suggest this is considerable more cost effective, but will decrease the demand for eastern U. S. coal (with employment losses), which is not politically popular.

APPLICATION 16. 3: Emissions Trading l The Clean Air Act amendments of 1990 allow power plants who reduce their pollution levels below specified standards to sell credits to other firms. – – 43 This allows other firms to subsidize the reductions of emissions by those firms who can achieve low pollution with the least cost. This has achieved savings of approximately 50 percent over regular CAC approaches.

An Example: Global Warming l l l 44 Existing models of the earth’s atmosphere are not adequate to explain how carbon emissions may raise global temperatures. Evaluating the costs to restrict carbon emissions involve much uncertainty. Estimates from general equilibrium models range from welfare gains to costs as great as 10 percent of GDP.

Attributes of Public Goods l Nonexclusive goods are goods that provide benefits that no one can be excluded from enjoying. – – 45 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.

Attributes of Public Goods l Nonrival goods are goods that additional consumers may use at zero marginal cost. – 46 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.

Public Goods l l 47 Public goods provide nonexclusive benefits to everyone in a group and that can be provided to one more user at zero marginal cost. Table 16. 1 presents a cross-classification of goods by their possibilities for exclusion and rivalry.

TABLE 16. 1: Types of Public and Private Goods 48

Public Goods and Market Failure l l 49 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.

Public Goods and Market Failure l l l 50 However, the buyer will not take societies benefits into consideration. As a result, private markets will tend to underallocate resources to public goods. Figure 16. 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.

FIGURE 16. 4: Derivation of the Demand for a Public Good Willingness to pay Total demand Demand by person 2 Demand by person 1 51 [ , ] Denotes equal distances Quantity of public good per week

Public Goods and Market Failure l l 52 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.

Voluntary Solutions for Public Goods l Since public goods cannot be traded efficiently in competitive markets, one approach deals with whether an efficient allocation might come out voluntarily. – l 53 Would people agree to be taxed in exchange for the benefits the public good provides? One solution was proposed by Erik Lindahl in 1919.

The Lindahl Equilibrium l In Figure 16. 5, the curve labeled SS shows one person’s (Smith) demand for a particular public good. – – 54 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.

FIGURE 16. 5: Lindahl Equilibrium in the Demand for a Public Good Share of cost 100 paid by Smith S S 0 55 Quantity of public good

The Lindahl Equilibrium l The second individual’s (Jones) public good demand curve is derived similarly, but the proportion paid by Jones is shown on the right axis. – – 56 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.

FIGURE 16. 5: Lindahl Equilibrium in the Demand for a Public Good Share of cost paid by Smith 100 0 J S 0 57 100 Quantity of public good Share of cost paid by Jones

The Lindahl Equilibrium l The two demand curves intersect at C with an output level OE of the public good. – – 58 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.

FIGURE 16. 5: Lindahl Equilibrium in the Demand for a Public Good Share of cost paid by Smith 100 Share of cost 0 paid by Jones J S C 60 40 J S 0 59 100 E Quantity of public good

The Lindahl Equilibrium – l 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. – 60 For output levels greater than OE, people are not willing to pay the total cost of the good. The tax shares are “pseudo prices, ” and the outcome can be shown to be efficient.

Revealing the Demand for Public Goods: The Free Rider Problem l l 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. – 61 It is likely that this poll would prove to be extremely inaccurate because of free riders.

The Free Rider Problem l l 62 People may feel that they should understate their true preferences to reduce their tax liability with the hope that others will be willing to bear the burden of paying the taxes for the public good. A free rider is a consumer of a nonexclusive good who does not pay for it in the hope that other consumers will.

APPLICATION 16. 4: Why is There So Much Fund-Raising Public Broadcasting? l l 63 The public radio and television broadcasting corporations in the U. S. were intended to be supported primarily by listeners and viewers through voluntary contributions. Since users can not be excluded from using what is “on the air” and costs do not increase if another user tunes in, broad-casting appears to be a pure public good.

APPLICATION 16. 4: Why is There So Much Fund-Raising Public Broadcasting? l l 64 However, thriving commercial markets suggest that broadcasting may not be underproduced. Viewed as a mechanism for delivering advertising messages, broadcasting is both exclusive (advertisers must pay) and rival (only one advertiser can use a time slot).

APPLICATION 16. 4: Why is There So Much Fund-Raising Public Broadcasting? l l An alternative justification is that certain types of broadcasting will be unattractive to advertisers (for example, cultural) and will be underprovided in private markets. However, the free rider problem tends to undermine voluntary support. – 65 Fewer than 10 percent of the viewers of public television make voluntary contributions.

APPLICATION 16. 4: Why is There So Much Fund-Raising Public Broadcasting? l l l 66 Public broadcasting has had to turn to advertising. Cable television stations, such as The Learning Channel, today provide programming that is indistinguishable from public broadcasting. Voluntary support of public is declining and its long-run viability is in doubt.

Local Public Goods l Since individuals are relatively free to move from one locality to another, the public goods problem may be more tractable on the local level. – – 67 “Voting with one’s fee” provides a mechanism for revealing demand for public goods. People who want high-quality schools or strong police protection can choose to live in high tax areas.

Direct Voting and Resource Allocation l l In some situations, people vote directly on policy questions. While majority rule is a common criteria, many cases require even greater amounts (even 100 percent in Quaker meetings) to win in a voting situation. – 68 However, for what follows, majority rule is assumed.

TABLE 16. 3: Preferences That Produce the Paradox of Voting 69

The Paradox of Voting l l Majority-rule voting systems may not arrive at an equilibrium but instead may cycle among alternative options. This paradox is illustrated in Table 16. 3. – 70 Suppose there are three voters (Smith, Jones, and Fudd) choosing among three policy options regarding spending on a particular public good (A = low, B = medium, and C = high).

The Paradox of Voting – Preferences of the three voters are indicated by the order listed in the table. l – – – 71 For example, Smith prefers A to B and B to C. In a vote between A and B option A would win. Similarly, a vote between A and C would result in option C winning. But, a vote between C and B would find B (which lost to A above, and A lost to C) winning.

Single-Peaked Preferences and the Median Voter Theorem l l 72 Equilibrium voting outcomes can always occur in cases where the issue being voted upon is one-dimensional and where voters’ preferences are “single-peaked. ” In Figure 16. 6, the preferences that give rise to the paradox of voting are shown by assigning hypothetical utility levels to A, B, and C.

Single-Peaked Preferences and the Median Voter Theorem l l The preferences of Smith and Jones are singlepeaked--as levels of public goods’ expenditures rise, there is only one local utility maximizing choice (A for Smith, B for Jones. Fudd has two local peaks (A and C). – 73 If Fudd’s preferences were represented by the dashed line, option B would defeat both A and C.

FIGURE 16. 6: Single-Peaked Preferences and the Median Voter Theorem Utility Fudd (alternate) Jones Smith A 74 B C Quantity of public good

Single-Peaked Preferences and the Median Voter Theorem l B wins because it is the choice of the median voter whose preferences for a public good represent the middle point of all voters’ preferences for the good. – – 75 The median voter result applies to any number of voters. If choices are one-dimensional and preferences are single-peaked, majority rule will select the median voter’s choice.

APPLICATION 16. 5: Referenda on Public Spending l California’s Proposition 13, passed in 1977, required that property in California be taxed at a maximum rate of 1 percent of the 1975 fair market value. – – 76 It also imposed sharp limits on tax increases in future years. Local property tax revenues declined by nearly 60 percent between fiscal 1978 and 1979.

APPLICATION 16. 5: Referenda on Public Spending l One explanation for the passage of this law was a demand for changing the sources of local tax revenues. – 77 Citizens were largely content with existing levels of local services but wanted state tax sources (income and sales, primarily) to take over a larger share of the burden.

APPLICATION 16. 5: Referenda on Public Spending--California’s Proposition 13 l l Alternatively, voters may have wished for a decline in local government size. Both hypotheses have empirical support. – 78 California voters did raise other state taxes, but spending is significantly lower than before the initiative.

APPLICATION 16. 5: Referenda on Public Spending--Massachusetts and Michigan l l 79 In Massachusetts, the 1980 passage of Proposition 2½, similar to Proposition 13, was fueled by a preference for “greater efficiency” in government. The Michigan “Headler Amendment, ” which proposed to limit state taxes, also appeared to stem from preferences for more efficiency.

APPLICATION 16. 5: Referenda on Public Spending --Home Rule in Illinois l “Home Rule, ” which eliminates state-level restrictions on spending, was adopted by communities in Illinois. – – – 80 More heterogeneous groups appeared to want to limit local spending. More homogeneous groups wanted to forsake the spending restrictions. The homogeneous groups have similar interests with respect to government size and functions.

Representative Government and Bureaucracies l l 81 In a representative government, individuals vote for directly for candidates, not policies. This raises the issue of whether or not representatives will actually vote the way their constituents want and present the possibility for rent-seeking behavior where firms or individuals influence government policy to increase their own welfare.