Chapter 5. Externalities, Environmental Policy, and Public Goods

Chapter 5. Externalities, Environmental Policy, and Public Goods Instructor: JINKOOK LEE Department of Economics / Texas A&M University ECON 202 504 Principles of Microeconomics

Externalities Externality: A benefit or cost that affects someone who is not directly involved in the production or consumption of a good. both positive and negative externality are possible. When there is an externality, competitive market does not work well. with negative (positive) externalities, market may produce more (less) quantity than the efficient amount. Government intervention can resolve problems from externalities, and may increase economic efficiency.

Positive Externality or Negative Externality

Effect of Externalities An externality causes a difference between the private cost of production and the social cost. Private cost: The cost borne by the producer of a good or service. Social cost: The total cost of producing a good or service (private cost + external cost). An externality also causes a difference between the private benefit of consumption and the social benefit. Private benefit: The benefit received by the consumer of a good or service. Social benefit: The total benefit from consuming a good or service (private benefit + external benefit).

Effect of Negative Externalities When a firm produce electricity, it only consider private costs. private costs: cost of generating electricity. social cost: private cost + external costs of pollution.

Effect of Negative Externalities Summary of effects with market equilibrium, supply curve is above the demand curve. marginal social cost is greater than the marginal benefit to consumers (Q Market, P Market ) is not efficient economic surplus is reduced by deadweight loss. too much of the good will be produced.

Effect of Positive Externalities When students receive a college education, they can not capture all its benefits. private benefit: benefit from learning knowledge. social benefit: private benefit + external benefit from less crime.

Effect of Positive Externalities Summary of effects with market equilibrium, demand curve is above the supply curve. marginal social benefit is greater than the marginal cost. (Q Market, P Market ) is not efficient economic surplus is reduced by deadweight loss. too little of the good will be produced.

Market Failure and Property Rights Market failure: A situation in which the market fails to produce the efficient level of output due to externalities. Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations. Property rights: The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. example: paper company

Economically Efficient Level of Pollution Reduction Sulfur dioxide emissions contribute to smog and acid rain. Then what is the economically efficient level of the pollutant? Zero? At the economically efficient level, MB from pollutant reduction should equal MC.

Private Solutions to Externalities When the reduction in the pollutant increase from 7.0(mt) to 8.5(mt), Benefit and Cost Total Benefit = $375 (A+B) Total Cost = $255 (B) Net Benefit = $120 (A) Private Solution 1 People offer to pay the electric company $255 (B) Private Solution 2 Electric company pay people $255 (B) for the right to pollute.

Coase Theorem Coase theorem: Private bargaining will result in an efficient solution to the problem of externalities, if transactions costs are low, if all parties to the agreement have full information about the costs and benefits associated with the externality, if all parties must be willing to accept a reasonable agreement. Transactions costs: The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

Government Policies on Negative Externalities Pigouvian tax When there is a negative externality, government impose a tax. the tax should be equal to the cost of externality.

Subsidy Government Policies on Positive Externalities When there is a positive externality in consumption, government give consumers a subsidy, or payment. the subsidy should be equal to the value of the externality.

Rivalry / Excludability Rival: one person s consuming a unit of a good means no one else can consume it. Non-rival: one person s consumption does not interfere with another person s consumption. Excludable: anyone who does not pay for a good cannot consume it. Non-excludable: it is impossible to exclude others from consuming the good, whether they have paid for it or not.

Category of This Good?

Free Riding A public good (e.g. national defence) is.. nonrival: your consuming national defense does not interfere with your neighbor s consuming it. nonexcludable: you cannot be excluded from consuming it, whether you pay for it or not. Free riding: Benefiting from a (public) good without paying for it. Q. How can an economy prevent free riding?

The Tragedy of the Commons Common resources (e.g. pasture) is.. rival: the grass one family s cow ate is not available for another family s cow. nonexcludable: every family in the village has the right to use the pasture. The Tragedy of the Commons: The tendency for a common resource to be overused. Q. How can an economy prevent the tragedy of the commons?