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
Ways of Correcting Market Failure l Options for Reducing Emissions to E* 1. Emission Standard Set a legal limit on emissions at E* (12) l Enforced by monetary and criminal penalties l Increases the cost of production and the threshold price to enter the industry l 2. Emissions Fee l Charge levied on each unit of emission Chapter 18 18
Standards and Fees Dollars/ unit of Emissions MSC Standard Fee 3 E* 12 Chapter 18 MCA Level of Emissions 19
Standards and Fees MSC Dollars/ unit of Emissions Fee E* Cost is less than the fee if emissions were not reduced. 3 Total Fee of Abatement Total Abatement Cost 12 Chapter 18 MCA Level of Emissions 20
Ways of Correcting Market Failure l Standards Versus Fees m. Assumptions l Policymakers have asymmetric information l Administrative costs require the same fee or standard for all firms Chapter 18 21
The Case for Fees l Assume two firms m. Same marginal social cost curve m. Different marginal abatement cost curves l MCA 1 and MCA 2 l Emissions fees are preferable to standards in this case m. We want to reduce total emissions by 14 units m. The cheapest way to do that is for firm 1 to reduce by 6 and firm 2 by 8 units Chapter 18 22
The Case for Fees Fee per Unit of Emissions MCA 1 MCA 2 a feeminimizing of $3 was imposed The. Ifcost Firm 1 emissions would fall solution by 6 be to 8. 2 emissions would an. Firm abatement of 6 would fall by 8 to 6. for firm 1 and 8 for firm 2 MCA 1 = MCA 2: efficient and solution. MCA 1= MCA 2 = $3. 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 Chapter 18 9 10 11 12 13 Level of 14 Emissions 23
The Case for Fines l What if the regulatory agency forces each firm to cut emissions by 7 units m MAC for firm 1 increases to $3. 75 m MAC for firm 2 decreases to $2. 50 l This is not cost minimizing because one firm can reduce emissions at a lower cost than the other firm l Marginal cost of abatement must be equal between firms for reductions to occur at minimum cost Chapter 18 24
The Case for Fees Fee per Unit of Emissions The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA 2 < MCA 1 MCA 2 6 5 4 3. 75 Firm 1’s Increased Abatement Costs 3 2. 50 2 Firm 2’s Reduced Abatement Costs 1 0 1 2 3 4 5 6 7 8 Chapter 18 9 10 11 12 13 Level of 14 Emissions 25
Ways of Correcting Market Failure l Advantages of Fees m. When equal standards must be used, fees achieve the same emission abatement at lower cost. m. Fees create an incentive to install equipment that would reduce emissions further. Chapter 18 26
The Case for Standards l Assume we have m. Steep marginal social cost curve m. Flat marginal cost of abatement m. An emissions fee of $8 would be efficient but because of limited information, fee is set at $7 m. Firms emissions increase and with steep MSC, this will lead to significant additional social costs Chapter 18 27
The Case for Standards l What if standard is used instead and has the same percentage mistake m. Standard set at 9 instead of 8 m. Increase in social cost and decrease in abatement costs m. Net increase in social costs is smaller than with fees Chapter 18 28
The Case for Standards C Fee per Unit of 16 Emissions Based on incomplete information fee is $7 (12. 5% decrease). Emission increases to 11. Marginal Social Cost 14 12 ABC is the increase in social cost less the decrease in abatement cost. E 10 A D 8 Based on incomplete information standard is 9 (12. 5% decrease). ADE < ABC B 6 4 Marginal Cost of Abatement 2 0 2 4 6 8 10 Chapter 18 12 14 16 Level of Emissions 29
Ways of Correcting Market Failure l Summary: Fees vs. Standards m. Standards are preferred when MSC is steep and MCA is flat. m. Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement. Chapter 18 30
Ways of Correcting Market Failure l Summary: Fees vs. Standards m. Fees have certainty on cost and uncertainty on emissions. m. Preferred policy depends on the nature of uncertainty and the slopes of the cost curves. Chapter 18 31
Ways of Correcting Market Failure l Transferable Emissions Permits m. Permits help develop a competitive market for externalities. l Agency determines the level of emissions and number of permits l Permits are marketable l High cost firm will purchase permits from low cost firms Chapter 18 32
Ways of Correcting Market Failure l The market for externalities is appealing since it combines the system of standards with the system of fees. l The agency who administers the system determines the total number of permits and therefore the total amount of emissions l Marketability of the permits allows pollution abatement to be achieved at minimum cost. Chapter 18 33
Ways of Correcting Market Failure l Recycling m. Households can dispose of glass and other garbage at very low cost. m. The low cost of disposal creates a divergence between the private and the social cost of disposal. Chapter 18 34
Recycling l Marginal private cost likely constant for fixed amount of garbage l Social cost of disposal includes the harm to environment from littering and injuries caused by litter l Without market intervention, the level of crap will be at m and m 1 > m* l With refundable deposit, MC increases and MC = MSC = MCR Chapter 18 35
The Efficient Amount of Recycling Chapter 18 36
Refundable Deposits l Deposit is paid when bottle is purchased and then refunded when bottle returned. l Can chose the deposit to give household incentive to recycle more l Deposit increases private cost of disposal l Supply of glass comes from new glass and recycled glass m. Increasing deposit increase supply of recycled glass and lowers price of glass Chapter 18 37
Refundable Deposits $ The supply of glass is the sum of the supply of virgin glass (Sr) and the supply of recycled glass (Sr). Sr Without refunds the price of glass is P and Sr is M 1. S’r Sv With refunds Sr increases to S’r and S increases to S’. S S’ Price falls to P’ and the amount of recycled glass increases to M*. P P’ D M 1 M* Chapter 18 Amount of Glass 38
Common Property Resources l Characteristics m. Everyone has free access. m. Likely to be overutilized m. Examples l Air and water l Fish and animal populations l Minerals Chapter 18 39
Common Property Resources l Consider a lake where people fish l Each fisherperson takes fish up to the point where the marginal benefit to them equals the marginal cost l There is no reason that any one fisherperson take into account how their taking fish affects others experience Chapter 18 40
Common Property Resources l Private cost underestimates the true cost to society m. More fishing reduces the stock of fish m. Less is available to others and too low of a stock will completely deplete the fish m. Too many fish are caught Chapter 18 41
Common Property Resources Benefits, Costs ($ per fish) Without control the number of fish/month is FC where PC = MB. Marginal Social Cost Private Cost However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D) Demand (MB) F* FC Fish per Month 42
Common Property Resources l Solution m. Private ownership m. Owner will set fee for sue of resource equal to the marginal cost of depleting the stock m. Fishermen will no longer find it profitable to catch more than the efficient amount of fish m. It is often the case that private ownership is not possible, the government steps in Chapter 18 43
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 44
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 45
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 46
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 47
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 48
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