1 / 69

Chapter 12: Externality

Chapter 12: Externality. References: Advanced Level Microeconomics, LAM pun-lee, CH 17 A-Level Microeconomics, CHAN & KWOK, CH 17 HKALE Microeconomics, LEUNG man-por, CH 18. Pareto-optimal Condition. Pareto-optimal condition is a state where:

issac
Download Presentation

Chapter 12: Externality

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 12: Externality • References: • Advanced Level Microeconomics, LAM pun-lee, CH 17 • A-Level Microeconomics, CHAN & KWOK, CH 17 • HKALE Microeconomics, LEUNG man-por, CH 18 CH12-Externality/Ver 2004

  2. Pareto-optimal Condition • Pareto-optimal condition is a state where: • it is no longer possible to reallocate the use of resources so that one individual will gain without loss to another • Product P = MUV = MC CH12-Externality/Ver 2004

  3. Market Failure • If the market is allowed to function without any intervention, market failure means • the Pareto-optimal condition is not reached • non-market institutions would provide a more desirable result CH12-Externality/Ver 2004

  4. Externality • Externality occurs when the decision-maker does not bear all of the costs or reap all of the gains from his action • As a result, in a competitive market too much or too little of the good will be produced from the point of view of society. CH12-Externality/Ver 2004

  5. Externality • Positive/Beneifical externality/Social benefit: • If the world around the person making the decision benefits more than he does, then the good will be underconsumed and underproduced by individual decision makers. CH12-Externality/Ver 2004

  6. Externality • Negative/Harmful externality/Social cost: • if the costs to the world exceed the costs to the individual making the choice (pollution, crime) then the good will be overconsumed and overproduced from society's point of view. CH12-Externality/Ver 2004

  7. Private Cost vs. Social Cost • Private cost measures the value of the highest-valued alternative uses of the resources available to the decision maker • Social cost measures the value of the highest-valued alternative uses of the resources available to the whole society. CH12-Externality/Ver 2004

  8. Private Cost vs. Social Cost • External/Spillover/Third-party cost or harmful externality occurs when one person's action imposes costs on others without bearing the cost. • Social cost = private cost + external cost • The existence of external cost implies that there is a divergence between private and social costs. CH12-Externality/Ver 2004

  9. Private Product vs. Social Product • Private product measures the value of the product to the decision maker. • Social product measures the value of the product to the whole society. CH12-Externality/Ver 2004

  10. Private Product vs. Social Product • Social product or spillover/third-party/external benefit exists when one person's action benefits others without receiving payment. • Beneficial externality = private product + external benefits • The existence of external benefit implies that there is divergence between private and social products. CH12-Externality/Ver 2004

  11. Harmful Externality • With the existence of negative externality, the marginal private cost (MPC) is smaller than the marginal social cost (MSC), resulting in overproduction. CH12-Externality/Ver 2004

  12. P MSC A MPC1 B MUV 0 Qe Q1 Qty Harmful Externality • Remarks: • Assuming MUV=MR • Qe = Pareto-optimal output level • QeQ1 = overproduced amount • AB = divergence between private and social costs CH12-Externality/Ver 2004

  13. Harmful Externality P • Traditional solution: • Government intervention is required • (Pigovian) tax should be imposed to raise the MPC up to the level of MSC and thus eliminating the excess output. MSC=MPC2 MPC1 MUV 0 Qe Q1 Qty CH12-Externality/Ver 2004

  14. P MC A B MSP MPP 0 Q1 Qe Qty Beneficial Externality • Remarks: • Qe = Pareto-optimal output level • Q1Qe = underproduced amount • AB = divergence between private and social products CH12-Externality/Ver 2004

  15. P MC A B MSP=MPP2 MPP 0 Q1 Qe Qty Beneficial Externality • Traditional solution: • Government intervention is required • Subsidy should be granted to raise the MPP up to the level of MSP and thus avoiding the underproduction. CH12-Externality/Ver 2004

  16. B A D C Pigou's Two Roads • Assumptions: • Road ABD: • straight but narrow & with limited capacity • Traveling time: 1 hr • Road ACD: • broad & uncrowded but winding & poorly surfaced • Traveling time: 2 hrs • Average driving time is the only cost of driving from A to D CH12-Externality/Ver 2004

  17. Pigou's Two Roads • Drivers originally will use Road ABD only • If traffic increases to the point of congestion on Road ABD, each road user will slow down the speed of others, thus imposing time cost upon one another CH12-Externality/Ver 2004

  18. Pigou's Two Roads • Harmful externality occurs since the driver only consider his or her private time cost and ignores the time cost imposed upon all other drivers, there is a divergence between private and social costs. CH12-Externality/Ver 2004

  19. Time(hrs) Time(hrs) MC AC 2 AC = MC 1 0 Q1 Q2 Q3 Users 0 Users Pigou's Two Roads • At Q1, congestion sets in Road ABD, an extra user imposes external time cost on all other users, thus the average time cost will increase Road ABD Road ACD CH12-Externality/Ver 2004

  20. Time(hrs) Time(hrs) MC AC 2 AC = MC 1 0 Q1 Q2 Q3 Users 0 Users Pigou's Two Roads • With external costs, a road user considers now only the average time cost instead of marginal time cost • Drivers after Q3 would choose Road ACD, resulting in the AC in using both roads is the same, 2 hours. Road ABD Road ACD CH12-Externality/Ver 2004

  21. Pigou's Two Roads • Pigou's argument: • The Road ABD should be taxed to force some drivers to use Road ACD • The diverted users lose nothing as they still spend two hours to travel on the uncongested Road ACD CH12-Externality/Ver 2004

  22. Pigou's Two Roads • Pigou's argument: • For those drivers still using Road ABD (except for the marginal user) will still gain as the time saved from being congestion-free is worth more than the amount they are taxed. • The market fails to achieve the optimal condition as it is still possible to make someone better off without hurting others. CH12-Externality/Ver 2004

  23. Knight's Attack on Pigou • Pigou did not specify the nature of property rights governing the use of the roads • No private property rights to roads • If the road is privately owned, a toll for its use would be charged, which will be equal to the difference between the values of travel times for the two roads. CH12-Externality/Ver 2004

  24. Knight's Attack on Pigou • At the margin, the value of travel time for Road ACD and the value of travel time plus the toll for Road ABD will be equal. CH12-Externality/Ver 2004

  25. $ = rental value W1 MC ARP MRP 0 Q1 Q2 Fishing effort Gordon's Fishery • If the fishing ground is privately owned, the equilibrium fishing effort is Q1 and a rental value will be received as the TRP(=ARPxQ1) >TFC(=MCxQ1, given MC = W1. CH12-Externality/Ver 2004

  26. $ ARP1 W1 MC ARP MRP 0 Q1 Q2 Fishing effort Gordon's Fishery • If the fishing ground is commonly owned, an individual fisherman will enter only if the expected average revenue product (say ARP1) is larger than the marginal cost (in terms of the forgone alternative earning in using his or her labor) CH12-Externality/Ver 2004

  27. Gordon's Fishery • However, the entering of an extra fisherman into the fishing ground will reduce the catch of other fishermen, i.e. they have to bear a spillover cost in fishing. • With external cost, there is a divergence between private and social costs, the MRP is thus less than the ARP. CH12-Externality/Ver 2004

  28. $ Over-fishing ARP1 W1 MC ARP MRP 0 Q1 Q2 Fishing effort Gordon's Fishery • A fisherman will enter the fishing ground until the falling ARP equals W1, TRP equals TVC(=MCxQ2), then the rental value becomes zero, i.e. the rent is dissipated. • Over-fishing(Q1Q2) occurs. CH12-Externality/Ver 2004

  29. Gordon's Fishery • With private property rights, the owner of the fishing ground has an incentive to maximize rental value by restricting fishing up to point at where the MRP equals MC. CH12-Externality/Ver 2004

  30. Gordon's Fishery • Question 1: Why are not all the fishing grounds privatized to eliminate the problem of negative externality in fishing? Must overfishing lead to dissipation of rent? Waste? CH12-Externality/Ver 2004

  31. Gordon's Fishery • A property may be held in common because the value of capturing its potential rent is lower than the cost of enforcing exclusivity or private property. • With prohibitive huge transaction costs, overfishing may be regarded as economically unavoidable and constitutes no wastage. CH12-Externality/Ver 2004

  32. Story of Cattle-raiser & Farmer • Ronald Coase assumes: • A farmer and a cattle-raiser share an unfenced property line • The raiser's cattle eat or damage the farmer's crops as they stray. CH12-Externality/Ver 2004

  33. Story of Cattle-raiser & Farmer • Question 2: Fill in the table above. CH12-Externality/Ver 2004

  34. Story of Cattle-raiser & Farmer • Question 3: What is the size of herd if the cattle-raiser ignores the crop damage? CH12-Externality/Ver 2004

  35. Story of Cattle-raiser & Farmer • The herd size is determined when MR = MC = $4, i.e. four steers CH12-Externality/Ver 2004

  36. Story of Cattle-raiser & Farmer • Question 4: What is the size of herd if the cattle-raiser taking the external cost (crop loss) into account? CH12-Externality/Ver 2004

  37. Story of Cattle-raiser & Farmer • The herd size is determined when MG = MCL = $2, i.e. two steers CH12-Externality/Ver 2004

  38. Story of Cattle-raiser & Farmer • Question 5: What would possibly be suggested in dealing with the cattle-raising phenomenon? CH12-Externality/Ver 2004

  39. Story of Cattle-raiser & Farmer • With Piguo's analysis: • If the cattle-raiser is not liable for the crop damage, there are too many cattle raised but too few the crop grow • Resources are misallocated • Government should intervene the market by imposing taxes and subsidies, or legal prohibition in order to eliminate the negative externality. CH12-Externality/Ver 2004

  40. Story of Cattle-raiser & Farmer • Case 1: if the farmer has the right to restrain the cattle-raiser from damaging his or her crops, • An exchange of the right allows mutual gains • The cattle-raiser has to compensate the farmer for buying the right to allow his or her steers to eat crops CH12-Externality/Ver 2004

  41. Story of Cattle-raiser & Farmer • Question 6: What is then the optimal size of herd? CH12-Externality/Ver 2004

  42. Story of Cattle-raiser & Farmer • An extra steer should be raised if its expected MG  MCL • The optimal size is 2 steers as MG=MCL CH12-Externality/Ver 2004

  43. Story of Cattle-raiser & Farmer • Case 2: if the cattle-raiser has the right to impose damage on the farmer, • An exchange of the right allows mutual gains • The farmer has to make compensation (equals the forgone MG for not raising a steer) to the cattle-raiser for buying the right to avoid damage by reducing the herd size • By doing so, the farmer's marginal gain equals the saved MCL. CH12-Externality/Ver 2004

  44. Story of Cattle-raiser & Farmer • Question 7: What is then the optimal size of herd? CH12-Externality/Ver 2004

  45. Story of Cattle-raiser & Farmer • Compensation should continue to be made if the saved MCL  MG, • The optimal herd size is 2 steers as the saved MCL = MG CH12-Externality/Ver 2004

  46. Story of Cattle-raiser & Farmer • Question 8: What happen if the farmer and the cattle-raiser jointly own the land for crop-farming and cattle-raising? CH12-Externality/Ver 2004

  47. Story of Cattle-raiser & Farmer • For joint ownership of a property, the incentive to maximize wealth will guarantee that an efficient allocation of resources. • This is simply because the decision of either party will take the external cost into account, i.e. the third party cost now is internalized, eliminating the divergence between private and social costs. CH12-Externality/Ver 2004

  48. Story of Cattle-raiser & Farmer • Question 9: Suppose that the farmer has the right to restrain the cattle-raiser from damaging his or her crops. The raiser may choose to compensate the farmer or erect fences to prevent his or her steers from straying. Will the cattle-raiser always choose to compensate? CH12-Externality/Ver 2004

  49. Story of Cattle-raiser & Farmer • The cattle-raiser will choose to compensate if the value of crop loss is smaller than the cost of erecting fences; vice versa. CH12-Externality/Ver 2004

  50. The Coase Theorem • If property rights are well-defined and transaction costs are zero, then • the allocation of resources will be identical, regardless of the initial assignment of property rights; and • the allocation of resources will be efficient, so there is no problem of externality CH12-Externality/Ver 2004

More Related