Externality Essentials P E Q E

Transcription

1 Micro Externality Essentials If it ain t broke, don t fix it consider our standard supply and demand diagram below note the size of the shaded economic surplus generated if we allow the market to O reach its equilibrium level of output, E if we try to improve upon the market s performance by picking some other level of output, we suffer a deadweight loss in other words, economics surplus falls and society is less well off so, if allocative efficiency is your goal, this is a pretty strong argument for leaving markets alone S E E D Why we love markets markets help achieve productive, allocative, and distributive efficiency these are the 3 things needed to ensure that we are best satisfying wants and needs markets transactions are also voluntary, so they allow a great deal of freedom markets are self-correcting, so they adapt to changes in the world around us markets maximize economic surplus, the sum of producer and consumer surplus, which means that markets maximize social welfare all-in-all markets work fabulously most of the time There s the rub there are a variety of situations in which markets might not produce the most efficient outcome for society when production or consumption of a good generates externalities when we have public as opposed to private goods when monopolies exist when imperfect/asymmetric information exists in these instances, there is a potential role for the government externality essentials.doc 1 Revised on: 10/5/2015

2 Take a look at a supply and demand diagram again a supply curve represents the producer s willingness to produce the good at each possible price level the producer s willingness to produce another unit of the good depends on what it costs the producer to produce that unit of the good since the supply always tracks the marginal cost to the supplier of producing each unit of the good, we can also refer to the supply curve as the marginal private cost (MC) curve a demand curve represents the consumer s willingness and ability to consume units of the good at each price level the consumer s willingness to purchase another unit depends on the additional utility/satisfaction/benefit the consumer receives from consuming that unit therefore we can refer to the demand curve as the marginal private benefit (MB) curve markets, left to their own devices, always produce where supply and demand intersect, so markets left to their own devices always produce a level of output where MC=MB for the last unit produced S=MC E D=MB E Is this a good thing? It is, if no one other than the producer or consumer is affected by the production or consumption of this good If the act of producing the good doesn t impose any costs on anyone else, or confer any benefits on anyone else, then society s costs of production are the same as the producer s costs In this case we can say that marginal social cost (MSC) = marginal private cost and our supply curve is works as a MSC curve as well If the act of consuming this good doesn t impose any costs on anyone else, or confer any benefits on anyone else, then society s benefits from consumption are the same as the consumer s benefits In this case we say that marginal social benefit (MSB) =marginal private benefit and our demand curve works as a MSB curve as well externality essentials.doc 2 Revised on: 10/5/2015

3 (Continued) In these cases, when the market chooses a level of output where the supply curve intersects the demand curve, we find that MSC=MSB for that last unit produced and consumed That, essentially is the definition of allocative efficiency, the right amount is being produced Example: consider a good like carrots farmers produce them in a sustainable manner, and consumers buys them and take them home in reusable cloth shopping bags (very environmentally correct) these transactions really only involves only two parties the costs to society are simply the farmers cost of producing the carrots so, the marginal private cost MC curve is also the marginal social cost MSC curve the benefits to society consist solely of the benefits the consumers receive from eating carrots the marginal private benefit MB curve is also the marginal social benefit MSB curve when the market achieves MC=MB it also achieves MSC=MSB therefore, we have achieved allocative efficiency from society's perspective, just the right amount of this good is being produced. S=MC= MSC E D=MB=MSB E Remember: How long do you do something? Up until the point at which the additional benefits are just equal to the additional costs Alas, not all goods are carrots externality essentials.doc 3 Revised on: 10/5/2015

4 Externalities sometimes production and consumption affect individuals other than the buyer and seller these effects are known as externalities they are external to the bargain both negative and positive externalities exist Externalities - an incidental cost or benefit which accrues to, or is imposed on, individuals not directly involved in the transaction Activities producing negative externalities driving your car (when there are others on the road) burning leaves (when you have neighbors) cranking Heavy Metal (when senior citizens are around) Activities producing positive externalities Getting vaccinated Getting and education Landscaping your property What's wrong with externalities? externalities lead to market failure Market failure - a situation in which a free market fails to lead to an efficient level of output, one at which MSC MSB Why does the market fail decisions are still made by individuals on the basis of MC and MB output will occur at E where MC = MB however, the existence of an externality means either MSC > MC, or MSB > MB negative externality MSC > MC result MSC > MSB at E, free market equilibrium too much is being produced positive externality, MSB > MB result MSB > MSC at E, free market equilibrium too little is being produced externality essentials.doc 4 Revised on: 10/5/2015

5 Negative production externality the market for coal-produced electricity roducing electricity from coal generates (ha-ha) negative externalities in the form of pollution graph below shows that MSC is greater than MC Result is that MSC>MSB at E, too many miles are driven Socially optimal level of output occurs at * where MSC=MSB MSC S=MC Market for Electricity roduced from Coal E D=MB=MSB * E ositive consumption externality getting vaccinated Getting (consuming) a vaccine generates a positive externality, it reduces the chance of others getting sick as well graph below shows that MSB is greater than MB Result is that MSB>MSC at E, too few vaccinations occur Socially optimal level of output occurs at * where MSC=MSB S=MC= MSC E MSB Market for Vaccines D=MB E * externality essentials.doc 5 Revised on: 10/5/2015

6 Correcting market failures the goal is to internalizing the externality, make the parties account for the external cost or benefit in their calculations of what is best for them Approaches to correcting externalities 1) command and control 2) corrective taxes/subsidies 3) better defining property rights 4) cap and trade 5) doing nothing Command and control refers to the implementation of regulations to control behavior by firms and individuals o could refer to requirements that power generating plants install scrubbers o could refer to mandates that children be vaccinated before starting school government weighs size of the benefit against the costs of implementation sometimes this is the only approach that works potential drawbacks o sometimes relatively expensive o once firms meet the pollution standard or have installed the required technology, they have no further incentive to reduce pollution Corrective tax estimate the difference between MSC and MC at each level of output apply a tax on producer of the externality equivalent to that marginal external cost essentially shifts the supply curve back to where the MSC is located E with the tax in place now occurs where MSC = MSB alternatively, applying that tax to consumers achieves the same result potential issues o one need to be able to measure the damage from the externality in order to set an appropriate tax level o you need to be able to measure the amount of pollutant emitted to apply the tax Corrective subsidy estimate the difference between MSB and MB at each level of output provide a subsidy to consumers equal to that difference this essentially shifts the demand curve out to where the MSB curve is locates E with the tax in place now occurs where MSC = MSB equilibrium now occurs where MSC = MSB alternatively, providing that subsidy to producers achieves the same result potential issues o one need to be able to measure the benefit from the externality in order to set an appropriate subsidy level externality essentials.doc 6 Revised on: 10/5/2015

7 Cap and trade programs government sets a permissible level of pollution permits for a fixed quantity of emissions are created these permits are auctioned off (in the best case) permits are traded among firms if emission reductions are expensive for a firm, they will buy permits instead of reducing their own emissions if emission reductions are cheap for a firm, they will sell permits to other firms and reduce their own emissions cap and trade programs can achieve emission reductions at a lower cost than many other approaches drawbacks o must be able to accurately measure emissions o significant penalties for emitting without a permit must exist o runs counter to some normative judgments regarding burden of pollution Defining property rights people dump waste into the atmosphere, oceans, and rivers not because they are evil, but simply because it is the cheapest way to dispose of waste it s cheap because no one owns the atmosphere, ocean, or river therefore no one charges for the damage being done by this waste disposal this can sometimes be corrected by defining property rights once ownership is determined, each party has to recognize the costs and benefits associated with using that resource Coase Theorem assigning tradable property rights to resources can lead to a socially efficient allocation of resources assumes that property rights can be clearly defined and that transaction costs are minimal with respect to allocative efficiency, it doesn't matter which party receives the property rights with respect to who benefits, it certainly does matter What is the right level of pollution if by right we mean efficient then the answer is usually not zero marginal cost or reducing emissions usually rises as reduce emissions farther marginal benefit of emissions usually falls as we reduce emissions farther an efficient level of emission reduction occurs where the MSC of reduction equals the MSB of reduction, * technology that reduces the marginal cost of emission reduction moves us towards a greater optimal level of reduction externality essentials.doc 7 Revised on: 10/5/2015

8 new information that says the marginal benefit of pollution reduction is higher than we previously thought also moves us towards a greater optimal level of reduction $ MSC MSB * 100% Emission reduction Caveat lease keep in mind that all of the above discussions of externalities and pollution reduction have focused on allocative efficiency as a goal. That is not the only potential goal a society has. Results that are allocatively efficient may have disturbing distributive consequences. externality essentials.doc 8 Revised on: 10/5/2015