UNIT IV: INFORMATION & WELFARE

UNIT IV: INFORMATION & WELFARE • Decision under Uncertainty • Bargaining Games • Externalities & Public Goods • Review 1/7

Externalities & Public Goods • Externalities • Coase Theorem • Tragedy of the Commons • Remedies • Public Goods • We Play a Game

Externalities Externalities are the effects of consumption and production that are not accounted for in the market (e.g., steel industry creating air pollution). When externalities are present, the price of a good may not reflect its true social cost. As a result, firms may produce too much (or too little) and the market outcome may be inefficient. The practical problem with externalities generally arise when property rights are poorly defined. Remedies include government regulations, taxes, legal recourse, and bargaining among those affected.

Externalities Consider a farmer and a rancher that produce on neighboring land. The rancher’s cattle stray onto the farmer’s land, causing damage to his crops. Number in Herd Annual Crop Loss Crop Loss per Add/l (Steer) (Tons) Steer (Tons) 1 1 1 2 3 2 3 6 3 4 10 4

Externalities Consider a farmer and a rancher that produce on neighboring land. The rancher’s cattle stray onto the farmer’s land, causing damage to his crops. Should the rancher be prohibited from grazing his cows to prevent damage to the farmer’s crops? Coase noted that while this prohibition would remove the cost to the farmer, it would also impose a cost on the rancher (and on society). He called this the reciprocal nature of the externality.

Externalities We know that in a market equilibrium, both consumers (MRS = Px/Py) and firms (MR = MC) are optimizing, and we used these conditions to derive demand and supply curves. that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P P* QS: MR = MC QD: MRS = Px/Py Q* Q

Externalities We know that in a market equilibrium, both consumers (MRS = Px/Py) and firms (MR = MC) are optimizing, and we used these conditions to derive demand and supply curves. that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P P* If there are no externalities, the supply curve depicts the marginal social cost of production; the demand curve depicts the marginal social benefit of production. QS= MSC QD = MSB Q* Q

Externalities In the presence of a negative production externality (e.g. pollution), the marginal social cost (MSC) is higher than the firms’ marginal cost of production (MC). MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P P1 The industry’s competitive output (Q1) is greater than the efficient output (Q*), where MSC = MSB. Price does not reflect the externality. MSC QS = MC QD = MSB Q* Q1 Q

Remedies There are several ways to remedy, or internalize an externality: MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? Impose a tax (emissions fee) on producers equal to the cost of the externality, so that their cost fully reflects the true social cost. MSC = MC + Tax P P1 MSC Tax QD = MSB Q* Q1 Q

Remedies There are several ways to remedy, orinternalize an externality: MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P P1 A tax on consumers would also achieve the efficient level of output, Q*. MSC Tax QS = MC QD = MSB Q* Q1 Q

Remedies There are several ways to remedy, orinternalize an externality: MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P So would a price ceiling … MSC QS = MC QD = MSB Q* Q1 Q

Remedies There are several ways to remedy, orinternalize an externality: MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P Or a maximum output, or emissions standard. MSC QS = MC QD = MSB Q* Q1 Q

Remedies In each case, the efficient level of output is achieved. But producer surplus (profits), consumer surplus, and government revenue may change: MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P A = Consumer surplus B = ??? C = Producer surplus MSC A QS = MC B C QD = MSB Q* Q1 Q

Remedies When the cost of cleaning up pollution (abatement costs) are considered, the efficient outcome will once again be where MSC = MSB: MSC PP = 4 - 1/3QD MSB = (4 - 1/3QD) - 1 Suppose that burning gasoline causes pollution which is harmful to peoples health, and that this harm is measured to be $1 for each gallon gasoline burned. What is the optimal level of gasoline consumption, taking this externality into account? P Q is the quantity of pollution reduction. Q* is the optimal amount of pollution. MSC MSB Q* Q

Remedies Emissions Fees v. Emissions Standards Comparing the costs and benefits of different regulatory schemes can be very difficult, because policy makers need to know the cost each firm faces in reducing its emissions. Fees work best when the goal is to minimize cost per unit of abatement. “Get the biggest bang for the buck.” With incomplete information, there is less certainty about emissions levels but more about abatement costs. The preferable policy, therefore, will depend upon the nature of uncertainty and the shapes of the cost curves.

Coase Theorem Consider a pair of roommates, one a smoker and the other a non-smoker. Smoke is a good for the first and a “bad” for the second. If there are well-established “property rights,” (e.g., smoker’s right to smoke, non-smoker’s right to enjoy clean air), the 2 can bargain over the outcome and both end up better off as a result. The non-smoker, for example, could pay the smoker to smoke less, or the smoker could pay the non-smoker to compensate for her smoking. Coase Theorem: If bargaining costs are zero, the 2 will reach an efficient outcome independent of the structure of property rights.* *and no income effects

Tragedy of the Commons If property rights are well defined, there will be no problem with externalities. Hence, if property rights are not well defined, we can expect economic interactions to give rise to inefficiencies. This is especially so in the case of a common property resource: • Clean air • Clean water • Biodiversity • Antarctica Externalities can arise when resources are used without payment.

Tragedy of the Commons Two fishermen fish from a single lake. Each year, there are a fixed number of fish in the lake and two periods during the year that they can be harvested, spring and fall. Each fisherman consumes all the fish he catches each period, and their identical preferences are described by the following consumption function: Ui = CsCf where Cs = spring catch; Cf = fall catch. Each spring, each fisherman decides how many fish to remove from the lake. In the fall, the remaining fish are equally divided between the two.

Overfishing Consider two fishermen deciding how many fish to remove from a commonly owned lake. There are Y fish in the lake. • Period 1 each fishery chooses to consume: (c1, c2). • Period 2 remaining fish are equally divided: ½[Y – (c1+c2)]. c1 = (Y – c2)/2 U1 = c1(½[Y – (c1+ c2 )]) = ½Yc1 – ½c12 – ½c1c2 FOC: ½Y – c1 – ½c2 = 0 c1 = (Y – c2)/2 c2 Y/3 c2 = (Y – c1)/2 Y/3 c1

Overfishing Consider two fishermen deciding how many fish to remove from a commonly owned lake. There are Y fish in the lake. • Period 1 each fishery chooses to consume: (c1, c2). • Period 2 remaining fish are equally divided: ½[Y – (c1+c2)]. c1 = (Y – c2)/2 NE: c1 = c2 = Y/3 Social Optimum: c1 = c2 = Y/4 c2 Y/3 Y/4 c2 = (Y – c1)/2 Y/4 Y/3 c1

Overfishing Consider two fishermen deciding how many fish to remove from a commonly owned lake. There are Y fish in the lake. • Period 1 each fishery chooses to consume: (c1, c2). • Period 2 remaining fish are equally divided: ½[Y – (c1+c2)]. c1 = (Y – c2)/2 If there are 12 fish in the pond, each will consume (Y/3) 4 in the spring and 2 in the fall in a NE. Both would be better off consuming (Y/4) 3 in the fall, leaving 3 for each in the spring. c2 Y/3 Y/4 c2 = (Y – c1)/2 Y/4 Y/3 c1

Overfishing If there are 12 fish in the lake, each will consume (Y/3) 4 in the spring and 2 in the fall in a NE. Both would be better off consuming (Y/4) 3 in the fall, leaving 3 for each in the spring. C D C9, 9 7.5,10 A Prisoner’s Dilemma C = 3 in the spring D = 4 “ “ What would happen if the game were repeated? D 10,7.5 8, 8

Overfishing Imagine the fisherman make the following deal: Each will Cooperate (consume only 3) in the spring as long as the other does likewise; as soon as one Defects, the other will Defect for ever, i.e., they adopt trigger strategies. This deal will be stable if the threat of future punishment makes both unwilling to Defect, i.e., if the one period gain from Defect is not greater than the discounted future loss due to the punishment: (T – R) < (dR/(1-d) – dP/(1-d))

Overfishing Imagine the fisherman make the following deal: Each will Cooperate (consume only 3) in the spring as long as the other does likewise; as soon as one Defects, the other will Defect for ever, i.e., they adopt trigger strategies. This deal will be stable if the threat of future punishment makes both unwilling to Defect, i.e., if the one period gain from Defect is not greater than the discounted future loss due to the punishment: (T – R)/(T – P) <d

Externalities: Summary The practical problem with externalities generally arise when property rights are poorly defined. In the presence of an externality, there is a unique efficient level of production, but there is no unique efficient price. As a practical matter, measuring the effect of an externality is difficult, and scientific evidence is not always clear cut. An alternative, with lower informational requirements, would be to allow those affected to bargain over the outcome (e.g., tradable property rights).

Public Goods Public goods are extreme cases of externalities, where all consumers can enjoy the good even if they don’t pay for it. A pure public good, such as national defense, exhibits both Public goods are often undersupplied (or not supplied) by the market, and the government must step in. nonrivalry: the consumption of the good by one individual does not inhibit another’s enjoyment of the good; and nonexcludability: it is impossible to prevent an individual from enjoying the benefits of the good even if she has contributed nothing to its provision.

Public Goods Public goods are extreme cases of externalities, where all consumers can enjoy the good even if they don’t pay for it. qme = qyou = QS Because public goods are nonrival in consumption, it is always efficient to increase the number of people who consume a public good. Any pricing scheme that excludes some individuals from the consumption of a public goods is necessarily inefficient. nonrivalry: the consumption of the good by one Market Failure

Public Goods Public goods are extreme cases of externalities, where all consumers can enjoy the good even if they don’t pay for it. q1 = q2 = QS When we looked at efficiency of competitive markets, we assumed only private goods: Private goods: MRS1 = MRS2 = MCPRIVATE Public goods: MRS1 + MRS2 = MCPUBLIC Marginal Rate of Transformation (MRT): amount of one good that must be given up to produce one additional unit of another. = MRT

Public Goods Demand for a private good is the horizontal sum of individual demand curves. q1 = q2 = QS $ Demand of two consumers for a private good: d1, d2. d1 d2 D = d1+ d2 Q

Public Goods Demand for a public good is the vertical sum of individual demand curves. $ D = d1+ d2 = MRS1+ MRS2 Demand of two consumers for a public good: d1, d2. d2 d1 Q

Public Goods Demand for a public good is the vertical sum of individual demand $ D = MSB The efficient provision of a public good occurs where: MSB = MSC. S = MSC d2 d1 Q* Q

Public Good Game At each round of the game, you will have the chance to contribute to a public good (e.g., clean air; national defense). The game is repeated for several rounds, and payoffs are calculated as follows: 1 pt. for each contribution made + 4 pts. for each round you don’t contribute. See Holt and Laury, JEP 1997: 209-215.

Public Good Game Payoffs 1 pt. for each contribution made. + 4 pts. for each round you don’t contribute. You play: Contribution Rate (n-1) 0% 25 … 50 … 75 100% Contribute 1 7 13 19 25 Don’t 4 10 16 22 28 Assume n = 25 N-person Prisoner’s Dilemma: Don’t Contribute is a dominant strategy. But if none contribute, the outcome is inefficient. The Free-rider Problem

Public Good Game Typically, contribution rates: • 40-60% in one-shot games & first round of repeated games • <30% on announced final round • Decease with group size • Increase with “learning”

Public Goods: Summary • Public goods are extreme cases of externalities, where all consumers can enjoy the good even if they don’t pay for it. A pure public good, such as national defense, exhibits both nonrivalry and nonexcludability. • Public goods are subject to free-riding and thus often undersupplied (or not supplied) by the market; and the government may be needed to step in. • Experiments show that people do contribute to the provision of public goods, even when “rationally” they should not.

Next Time 1/14 Review 1/21 FINAL EXAM

UNIT IV: INFORMATION & WELFARE