The economics of the public sector:

Transcription

1 The economics of the public sector: Externalities and market inefficiency Public goods and common resource Dr. Anna Kowalska-Pyzalska Department of Operations Research Presentation is based on:

2 Externality Coase theorem Transaction costs Pigovian tax Excludability Rivalry Private v. public goods Common resource Free rider Tragedy of the commons

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4 Recall: Adam Smith s invisible hand of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. Buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply. But market failures can still happen

5 Market failure: A problem that violates one of the assumptions of the welfare theory and causes the market economy to deliver an outcome that does not maximize efficiency.

6 Firms produce paper and by-products of the production process such as air and water pollution that harm people who live near paper mills. Is a release of dioxin a problem for society? What happens to the social welfare?

7 Externalities cause markets to be inefficient, and thus fail to maximize total surplus. They refer to the uncompensated impact of one person s actions on the well-being of a bystander. Externality : the direct effect of the actions of a person or firm on another person s wellbeing or a firm s production capability rather than an indirect effect through changes in prices.

8 An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. When the impact on the bystander is adverse, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality.

9 Negative Externalities Automobile exhaust Cigarette smoking Barking dogs (loud pets) Loud stereos in an apartment building

10 Positive Externalities Immunizations Restored historic buildings Research into new technologies

11 Price of Aluminum Supply (private cost) Value to consumers, measures by the prices they are willing to pay Equilibrium Reflects the costs of production Demand (private value) 0 Market allocates resources in a way that maximizes the total surplus Q MARKET Quantity of Aluminum Copyright 2004 South-Western

12 The Market for paper The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the paper factories emit pollution (a negative externality), then the cost to society of producing paper is larger than the cost to paper producers.

13 The market for paper For each unit of paper produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

14 private cost - the cost of production only, not including externalities. social cost - the private cost plus the cost of the harms from externalities

15 Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable.

16 Copyright 2004 South-Western Price of paper Cost of pollution Social cost Supply (private cost) Optimum Equilibrium Demand (private value) 0 Q OPTIMUM Q MARKET Quantity of paper

17 In production & consumption

18 The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity.

19 When a firm's production reduces the well-being of others who are not compensated by the firm. Private marginal cost (PMC): The direct cost to producers of producing an additional unit of a good Marginal Damage (MD): Any additional costs associated with the production of the good that are imposed on others but that producers do not pay Social marginal cost (SMC = PMC + MD): The private marginal cost to producers plus marginal damage Example: steel plant pollutes a river but plant does not face any pollution regulation (and hence ignores pollution when deciding how much to produce)

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22 Achieving the Socially Optimal Output: The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

23 to bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others) Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

24 When an externality benefits the bystanders, a positive externality exists. The social value of the good exceeds the private value. A technology spillover is a type of positive externality that exists when a firm s innovation or design not only benefits the firm, but enters society s pool of technological knowledge and benefits society as a whole.

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26 The intersection of the supply curve and the social-value curve determines the optimal output level. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good.

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28 Internalizing Externalities: Subsidies Used as the primary method for attempting to internalize positive externalities. Industrial (Technology) Policy Government intervention in the economy that aims to promote technology-enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality.

29 Negative externalities in production or consumption lead markets to produce a larger quantity than is socially desirable. Positive EX lead markets to produce smaller quantities than is desirable.

30 Government action is not always needed to solve the problem of externalities. Sometimes people can develop private solutions: Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties. Do unto others as you would them do unto you

31 And the property rights

32 The Coase Theorem is a proposition that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. The optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined.

33 Property right: is the exclusive privilege to use an asset

34 Jane and John: Should John be forced to get rid of the dog or should Jane have to suffer sleepless nights because of dog s barking? Who has higher benefits than the costs? Who should pay whom in the final bargain? Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off

35 Lets compare costs and benefits: If cost is higher, than John should get rid of the dog If benefit is higher, than Jane must get used to the barking dog. If John and Jane do not negotiate, John keeps the dog and takes most of the benefits from it, ignoring the effect the barking has on Jane.

36 If a court or the government grants Jane the property right to live in peace, Jane can persuade John to get rid of the dog. But John can pay Jane to allow him to keep the dog. Again, if the benefit of the dog to John exceeds the cost of the barking to Jane, then both will strike a bargain and John will keep the dog.

37 Now suppose that John has the property right to have pets, even if they are disturbing the neighbours (e.g. by paying a tax to the local government).

38 Transactions Costs Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain. Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everone is better off and the outcome is effiecient.

39 If transaction costs are very high, it might not pay for the two sides to meet. If firms engage in strategic bargaining behavior, an agreement may not be reached. If either side lacks information about the costs or benefits of getting rid of the dog, a non efficient outcome may occur Pearson Addison-Wesley. All rights reserved.

40 To summarize the results from the Coase Theorem: If there are no impediments to bargaining, assigning property rights results in the efficient outcome at which joint profits are maximized. Efficiency is achieved regardless of who receives the property rights. Who gets the property rights affects the income distribution. The property rights are valuable. The party with the property rights may be compensated by the other party Pearson Addison-Wesley. All rights reserved.

41 Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

42 Sometimes government policies are needed to improve market s allocation

43 When externalities are significant and private solutions are not found, government may attempt to solve the problem through: command-and-control policies. market-based policies.

44 Command-and-Control Policies Usually take the form of regulations: Forbid certain behaviors. Require certain behaviors. Examples: Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

45 Market-Based Policies Government uses taxes and subsidies to align private incentives with social efficiency. Pigovian taxes are taxes enacted to correct the effects of a negative externality.

46 Examples of Regulation versus Pigovian Tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could tell the firm to reduce its pollution by a specific amount (i.e. regulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). A Pigovian tax allocates pollution to those factories that face the highest cost of reducing it.

47 Market-Based Policies Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another: Example: emission trading. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

48 Paper mill and steel mill dump each 500 tons of glop into a river each year. The EPA considers two solutions: Regulation: factories must reduce pollutuin to 300 tons of glop per year Pigovian tax: levy a tax on each factory of $ for each ton of glop it emits. The regulation would dictate a level of pollution Tax would give factory owners an economic incentive to reduce pollutions.

49 Copyright 2004 South-Western (a) Pigovian Tax Price of Pollution 1. A Pigovian tax sets the price of pollution... P 0 Q which, together with the demand curve, determines the quantity of pollution. Pigovian tax Demand for pollution rights Quantity of Pollution

50 Copyright 2004 South-Western (b) Pollution Permits Price of Pollution Supply of pollution permits P which, together with the demand curve, determines the price of pollution. Q Demand for pollution rights 1. Pollution permits set the quantity of pollution... Quantity of Pollution

51 When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

52 Those affected by externalities can sometimes solve the problem privately. The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently.

53 When private parties cannot adequately deal with externalities, then the government steps in. The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

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55 Free goods provide a special challenge for economic analysis. Most goods in our economy are allocated in markets When goods are available free of charge, the market forces that normally allocate resources in our economy are absent.

56 When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts. In such cases, government policy can potentially remedy the market failure that results, and raise economic well-being.

57 When thinking about the various goods in the economy, it is useful to group them according to two characteristics: Is the good excludable? Is the good rival?

58 Excludability Excludability refers to the property of a good whereby a person can be prevented from using it. Rivalry Rivalry refers to the property of a good whereby one person s use diminishes other people s use. rivalry - only one person can consume the good exclusion - means that others can be prevented from consuming the good.

59 Private Goods Are both excludable and rival. Public Goods Are neither excludable nor rival. Common Resources Are rival but not excludable. Natural Monopolies Are excludable but not rival.

60 Copyright 2004 South-Western Yes Rival? No Excludable? Yes No Private Goods Ice-cream cones Clothing Congested toll roads Common Resources Fish in the ocean The environment Congested nontoll roads Natural Monopolies Fire protection Cable TV Uncongested toll roads Public Goods Sunshine, air National defense Uncongested nontoll roads

61 2009 Pearson Addison-Wesley. All rights reserved.

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63 A public good produces a positive externality, and excluding anyone from consuming a public good is inefficient. public good - a commodity or service whose consumption by one person does not preclude others from also consuming it.

64 Markets for public goods exist only if nonpurchasers can be excluded from consuming them. Thus, markets do not exist for nonexclusive public goods. Usually, if the government does not provide a nonexclusive public good, no one provides it Pearson Addison-Wesley. All rights reserved.

65 Because a public good lacks rivalry, many people can get pleasure from the same unit of output. As a consequence, the social demand curve or willingness-to-pay curve for a public good is the vertical sum of the demand curves of each individual Pearson Addison-Wesley. All rights reserved.

66 Guards patrolling the mall provide a service without rivalry: All the stores in the mall are simultaneously protected. Each store s demand for guards reflects its marginal benefit from a reduction in thefts due to the guards Pearson Addison-Wesley. All rights reserved.

67 A free-rider is a person who receives the benefit of a good but avoids paying for it

68 Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. The free-rider problem prevents private markets from supplying public goods.

69 Solving the Free-Rider Problem The government can decide to provide the public good if the total benefits exceed the costs. The government can make everyone better off by providing the public good and paying for it with tax revenue.

70 Methods that may be used include: social pressure, mergers, compulsion, privatization Pearson Addison-Wesley. All rights reserved.

71 A fireworks display is a public good if performed in a town with many residents. But, if performed at a private amusement park, such as Walt Disney World, a fireworks display is more like a private good because visitors to the park pay for admission.

72 Lighthouses are used to mark specific locations so that passing ships can avoid treacherous waters. The benefit that the lighthouse provides to the ship captain is neither excludable nor rival, so each captain has an incentive to free ride by using the lighthouse to navigate without paying for the service. Because of this free-rider problem, private markets usually fail to provide the lighthouses that ship captains need. As a result, most lighthouses today are operated by the government.

73 In deciding whether something is a public good, one must determine the number of beneficiaries and whether these beneficiaries can be excluded from enjoying the good. A free-rider problem arises when the number of beneficiaries is large and exclusion of any one of them is impossible. If a lighthouse benefits many ship captains, it is a public good. Yet if it primarily benefits a single port owner, it is more like a private good.

74 In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good. Cost -benefit analysis refers to a study that compares the costs and benefits to society of providing a public good.

75 A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole. It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. The value of life, the consumer s time, and aesthetics are difficult to assess.

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77 Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them. Common resources are rival goods because one person s use of the common resource reduces other people s use.

78 The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. Common resources tend to be used excessively when individuals are not charged for their usage. This is similar to a negative externality.

79 Clean air and water (clean environment) Congested roads Fish, whales, and other wildlife

80 Will the market protect them? Private Ownership and the Profit Motive! Why is the commercial value of ivory a threat to the elephant, while the commercial value of beef is a guardian of the cow?

81 The market fails to allocate resources efficiently when property rights are not wellestablished (i.e. some item of value does not have an owner with the legal authority to control it). When the absence of property rights causes a market failure, the government can potentially solve the problem.

82 Goods differ in whether they are excludable and whether they are rival. A good is excludable if it is possible to prevent someone from using it. A good is rival if one person s enjoyment of the good prevents other people from enjoying the same unit of the good.

83 Public goods are neither rival nor excludable. Because people are not charged for their use of public goods, they have an incentive to free ride when the good is provided privately. Governments provide public goods, making quantity decisions based upon cost-benefit analysis.

84 Common resources are rival but not excludable. Because people are not charged for their use of common resources, they tend to use them excessively. Governments tend to try to limit the use of common resources.