Market Inefficiencies Externalities and Public Goods Chapter 7
Market Inefficiencies: Externalities and Public Goods Chapter 7
Chapter Objectives Identify what are externalities, and how do they affect markets? Differentiate Explain goods. between private and public goods. the challenges of providing nonexcludable
What have we done so far Consumer surplus is the difference between what a consumer is willing to pay and the price actually paid for the good or service. Produce surplus is the difference between the minimum price a producer is willing to accept and the price he or she actually receives from selling the good. Excise taxes– such as taxes on gasoline, cigarettes, and alcohol– create deadweight loss and reduce overall economic welfare.
Thought Exercise What is the optimal level of pollution? Zero? Why can’t we have zero pollution?
Externalities The costs or benefits of a market activity that affect a third party. Market Failure Occurs when there is an inefficient allocation of resources in a market Externalities are one type of market failure
Externalities Internal Costs The costs of a market activity paid only be an individual participant. External Costs The costs of an activity imposed on people not participating in the market. Social The Costs sum of the internal costs and external costs of a market activity.
Third-Party Problem An externality exists when Internal costs does not equal social costs Internal benefits does not equal social benefits Third-Party Occur Problems when those not directly involved in a market activity experience positive or negative externalities.
Third-Party Problem Negative Externalities Costs experienced by third parties “Too much” of the good is consumed or produced Positive Externalities Benefits “Not experienced by third parties enough” of the good is consumed or produced
Question: Externalities Which of the following activities would most likely create a negative externality? A. Eating a slice of pizza B. Driving intoxicated C. Taking a nap D. Getting a college degree
Question: Externalities Which of the following activities is most likely to create a positive externality? A. Eating a slice of pizza B. Driving intoxicated C. Taking a nap D. Getting a college degree
Correcting for Negative Externalities
Correcting for Externalities Internalizing the externality The individual involved in the activity takes into account the social costs (or benefits) of his or her actions. So he/she/they/xe is aware of how their actions will impact the social welfare of the community, positively or negatively.
Correcting for Externalities For negative externalities: Make firm recognize the external costs Tax the product Regulate production Encourage research and development of alternative substitutes to the product The firm’s costs will equal the social costs The supply curve shifts to the left
Question: Externalities Suppose good X creates a negative externality. Which of the following would NOT be appropriate way to correct the negative externality? A. Subsidize the production of good X B. Tax the production of good X C. Limit how much of good X can be produced D. Require the producers of good X to pay for external costs that arise.
Correcting for Positive Externalities
Correcting for Externalities For positive externalities: Help individuals realize external benefits. Finance and/or subsidize production and consumption of the good Laws requiring consumption Encourage The research and development of similar goods consumer realizes the full (social) benefit The demand curve shifts to the right
Property Rights Externalities often arise because of a lack of clearly defined property rights. Property rights Give the owner the ability to exercise control over a resource Private Property Provides exclusive right of ownership that allows for the use and exchange of property
Property Rights Create Incentives 1. Incentive to maintain 2. Incentive to protect 3. Incentive to conserve 4. Incentive to trade with others
Coase Theorem Two adjacent farmers, no fences One raises cattle One growing wheat Scenario 1: The cattle rancher is liable for damages the cows cause. Options for cattle rancher Put up fence Pay damages to wheat farmer Rancher will consider costs of both to make choices
Coase Theorem Scenario 2: The wheat farmer does not have a legal right to cattle-free fields Options for farmer Put up a fence Accept occasional cattle damage Result? If property rights are fully specified, either the cattle rancher or wheat farmer will build a fence.
Coase Theorem Coase If Theorem there are no barriers to negotiations, and if property rights are fully specified, interested parties will bargain to correct externalities.
Private and Public Goods Economists differentiate private and public goods based on two characteristics: Excludable It is possible to prevent consumers who have not paid for it from having access to it. Rival The good cannot be enjoyed by more than one person at a time.
Private Goods Private Are goods both excludable and rival in consumption Most goods we purchase and consume are private goods
Public Goods Public Can goods be consumed by many Difficult to exclude nonpayers from consumption Free-rider Someone problem has the ability to receive the benefit of a good without paying for it
Public or Private Good? The owner of this booth is asking people to pay to view the sunset. Will this work? Why or why not?
Question: Goods Which of the following is an example of a public good? A. a free outdoor Christmas light display B. a college football game C. a parking spot with a parking meter D. a college education
Club Goods and Common Resources Club goods Nonrival Common Rival and excludable resource goods but nonexcludable
What type of good is this beach?
Four Types of Goods Consumption Yes Excludable Rival Nonrival Private Goods Club Goods hamburgers, watches, automobiles satellite television, country clubs Common Resource Goods No Alaskan king crab, sharing a large popcorn at the movies, congested roads and beaches Public Goods street performers, defense, mosquito abatement
Question: Goods Membership at your local fitness facility is what type of good? A. Private good B. Club good C. Common resource good D. Public good
Cost-Benefit Analysis Cost-benefit analysis Process to determine whether the benefits of providing a public good outweigh the costs. The costs are easier to compute than the benefits are People them might misrepresent the value of the good to
Tragedy of the Commons Occurs when a rival (but nonexcludable) good become depleted or ruined Original Cattle example grazing on a common ground shared by all cattle farmers
Tragedy of the Commons: Example The commons can be sustained indefinitely with a capacity of around 100 cows. Suppose 100 farmers are each allowed to have 1 cow freely graze in the commons. One farmer thinks: what if I bring 2 cows? 100 cows, 101 cows, no difference! But suppose that ALL the farmers are thinking the same thing? Can the commons support 200 cows?
The Tragedy The commons get destroyed, even though this was in nobody’s best interest.
Common Property Incentives Incentive to neglect Incentive to overuse Incentive to ignore others
Possible Solutions Proactive management Taxes Regulations Other ways to internalize the negative externality
Possible Solutions Cap and Trade A system of pollution “permits” that are traded on an open market Firms that can control emissions cheaply will sell their permits Firms who face very high costs to reduce emissions will purchase permits Creates property rights for pollution Internalizes the externality
Conclusion Inefficiencies occur because of poor incentives Externalities Arise from the result of diverging social and private costs (or benefits) Can be corrected by forcing economic agents to internalize them Efficient Must level of pollution? use cost-benefit analysis
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