Chapter 18 Externalities and Public Goods Chapter 18
Chapter 18 Externalities and Public Goods Chapter 18 1
Externalities l Externalities are the effects of production and consumption activities not directly reflected in the market l They can be negative or positive Chapter 18 2
Negative Externalities l Action by one party imposes a cost on another party m. Plant dumps waste in a river affecting those downstream m. The firm has not incentive to account for the external costs that it imposes on those downstream Chapter 18 3
Positive Externalities l Action by one party benefits another party m. Homeowner plants a beautiful garden where all the neighbors benefit from it m. Homeowner did not take their benefits into account when deciding to plant Chapter 18 4
Negative Externalities and Inefficiency l Scenario – plant dumping waste m. Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production. m. Marginal Social Cost (MSC) is MC plus MEC. Chapter 18 5
Negative Externalities and Inefficiency l Assume the firm has a fixed proportions production function and cannot alter its input combinations m. The only way to reduce waste is to reduce output l Price of steel and quantity of steel initially produced is at the intersection of supply and demand Chapter 18 6
Negative Externalities and Inefficiency l The MC curve for the firm is the marginal costs of production l Firm maximizes profit by producing where MC equals Price in a competitive firm l As firm output increase, external cost on fishermen increases measured by the marginal external cost curve l From a social point of view, the firm produces too much output Chapter 18 7
External Costs MSC Price Theis profit maximizing firmfrom There MEC of production Firm will produce q 1 at P 1. at q 1 while theproduces waste released. The the MSC is efficient output level is q*. true cost of production. MC MSCI S = MCI P* P 1 MECI MEC D q* q 1 Firm output Chapter 18 Q* Q 1 Industry output 8
External Costs MSC Price MSCI MC By no producing at the efficient level, there is a social cost on society S = MCI Aggregate social cost of negative externality P* P 1 MECI MEC D q* q 1 Firm output Chapter 18 Q* Q 1 Industry output 9
External Cost l Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run. Chapter 18 10
Positive Externalities and Inefficiency l Externalities can also result in too little production, as can be shown in an example of home repair and landscaping. l Repairs generate external benefits to the neighbors m. Show by the Marginal External Benefit curve (MEB) m. Marginal Social Benefit (MSB) curve adds MEB +D Chapter 18 11
External Benefits Value MSB When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. D P 1 MC P* A self-interested home owner invests q 1 in repairs. The efficient level of repairs q* is higher. The higher price P 1 discourages repair. MEB q 1 Repair Level q* Chapter 18 12
Ways of Correcting Market Failure l Assumption: The market failure due to pollution m. Firm has chosen its profit-maximizing output level m. MSC is marginal social cost of emissions Chapter 18 13
Ways of Correcting Market Failure l MCA is marginal cost of abating emissions m. Additional cost to firm of controlling pollution m. Downward sloping because when emissions are high, little cost to controlling them Chapter 18 14
Ways of Correcting Market Failure l If the firm does not consider abatement, their profit maximizing level is 26 units of emissions m. Level where MCA is zero l The socially efficient level of emissions is 12 where the MSC equals the MCA Chapter 18 15
The Efficient Level of Emissions Dollars/ unit of Emissions MSC 6 At Eo the marginal cost of abating emissions is greater than the marginal social cost. 4 At E 1 the marginal social cost is greater than the marginal benefit. The efficient level of emissions is where MCA = MSC. 2 MCA E 0 0 2 4 6 8 10 E* 12 14 E 1 16 18 20 Chapter 18 22 24 26 Level of Emissions 16
Ways of Correcting Market Failure l Firms can be encouraged to reduce emissions to the efficient level in three ways 1. Emissions standards 2. Emissions fees 3. Transferable emissions permits Chapter 18 17
Public Goods l Characteristics m. Nonrival l For any given level of production the marginal cost of providing it to an additional consumer is zero. m. Nonexclusive l People cannot be excluded from consuming the good. m. Example – use of lighthouse by a ship Chapter 18 18
Public Goods l Nonexclusive goods m. Goods that people cannot be excluded from consuming, so that it is difficult or impossible to charge for their use m. Example: fireworks, national defense Chapter 18 19
Efficiency and Pubic Goods l Efficient level of private good is where marginal benefit equals marginal cost l For a public good, the value of each person must be considered m. Can add demand of all those who value good l Must equate the sum of these marginal benefits to the marginal cost of production Chapter 18 20
Efficient Public Good Provision Benefits (dollars) D 1 is demand for consumer 1 D 2 is demand for consumer 2 D is total demand for all consumers $7. 00 MC $5. 50 D 2 $4. 00 Efficient output occurs where MC = total MB 2 units of output. MB is $1. 50 + $4. 00 or $5. 50. D $1. 50 D 1 0 1 2 3 4 5 6 7 Chapter 18 8 9 10 Output 21
Public Goods and Market Failure l Free Riders m. There is no way to provide some goods and services without benefiting everyone. m. Households do not have the incentive to pay what the item is worth to them. m. Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it. Chapter 18 22
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