Understanding Externalities and Market Inefficiency

1. Chapter 18 Externalities and Public Goods Chapter 18

2. Externalities • Externalities are the effects of production and consumption activities not directly reflected in the market • They can be negative or positive Chapter 18

3. Negative Externalities • Action by one party imposes a cost on another party • Plant dumps waste in a river affecting those downstream • The firm has not incentive to account for the external costs that it imposes on those downstream Chapter 18

4. Positive Externalities • Action by one party benefits another party • Homeowner plants a beautiful garden where all the neighbors benefit from it • Homeowner did not take their benefits into account when deciding to plant Chapter 18

5. Negative Externalities and Inefficiency • Scenario – plant dumping waste • Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production. • Marginal Social Cost (MSC) is MC plus MEC. Chapter 18

6. Negative Externalities and Inefficiency • Assume the firm has a fixed proportions production function and cannot alter its input combinations • The only way to reduce waste is to reduce output • Price of steel and quantity of steel initially produced is at the intersection of supply and demand Chapter 18

7. Negative Externalities and Inefficiency • The MC curve for the firm is the marginal costs of production • Firm maximizes profit by producing where MC equals Price in a competitive firm • As firm output increase, external cost on fishermen increases measured by the marginal external cost curve • From a social point of view, the firm produces too much output Chapter 18

8. MSC MC MSCI S = MCI P* P1 P1 MECI MEC D q* q1 Q* Q1 External Costs The profit maximizing firm produces at q1 while the efficient output level is q*. There is MEC of production from the waste released. The MSC is true cost of production. Firm will produce q1 at P1. Price Price Industry output Firm output Chapter 18

9. Aggregate social cost of negative externality MSC Price Price MSCI MC S = MCI P* P1 P1 MECI MEC D q* q1 Q* Q1 Industry output Firm output External Costs By no producing at the efficient level, there is a social cost on society Chapter 18

10. External Cost • Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run. Chapter 18

11. Positive Externalities and Inefficiency • Externalities can also result in too little production, as can be shown in an example of home repair and landscaping. • Repairs generate external benefits to the neighbors • Show by the Marginal External Benefit curve (MEB) • Marginal Social Benefit (MSB) curve adds MEB +D Chapter 18

12. MSB D P1 MC P* MEB q1 q* External Benefits Value When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair. Repair Level Chapter 18

13. Ways of Correcting Market Failure • Assumption: The market failure due to pollution • Firm has chosen its profit-maximizing output level • MSC is marginal social cost of emissions Chapter 18

14. Ways of Correcting Market Failure • MCA is marginal cost of abating emissions • Additional cost to firm of controlling pollution • Downward sloping because when emissions are high, little cost to controlling them Chapter 18

15. Ways of Correcting Market Failure • If the firm does not consider abatement, their profit maximizing level is 26 units of emissions • Level where MCA is zero • The socially efficient level of emissions is 12 where the MSC equals the MCA Chapter 18

16. MSC MCA E0 E1 E* 0 2 4 6 8 10 12 14 16 18 20 22 24 26 Level of Emissions The Efficient Level of Emissions Dollars/ unit of Emissions 6 At Eo the marginal cost of abating emissions is greater than the marginal social cost. 4 At E1 the marginal social cost is greater than the marginal benefit. The efficient level of emissions is where MCA = MSC. 2 Chapter 18

17. Ways of Correcting Market Failure • Firms can be encouraged to reduce emissions to the efficient level in three ways • Emissions standards • Emissions fees • Transferable emissions permits Chapter 18

18. Ways of Correcting Market Failure • Options for Reducing Emissions to E* • Emission Standard • Set a legal limit on emissions at E* (12) • Enforced by monetary and criminal penalties • Increases the cost of production and the threshold price to enter the industry • Emissions Fee • Charge levied on each unit of emission Chapter 18

19. MSC Standard Fee 3 MCA E* 12 Standards and Fees Dollars/ unit of Emissions Level of Emissions Chapter 18

20. MSC Total Fee of Abatement Fee E* MCA Total Abatement Cost Standards and Fees Dollars/ unit of Emissions Cost is less than the fee if emissions were not reduced. 3 12 Level of Emissions Chapter 18

21. Ways of Correcting Market Failure • Standards Versus Fees • Assumptions • Policymakers have asymmetric information • Administrative costs require the same fee or standard for all firms Chapter 18

22. The Case for Fees • Assume two firms • Same marginal social cost curve • Different marginal abatement cost curves • MCA1 and MCA2 • Emissions fees are preferable to standards in this case • We want to reduce total emissions by 14 units • The cheapest way to do that is for firm 1 to reduce by 6 and firm 2 by 8 units Chapter 18

23. Fee per Unit of Emissions MCA1 MCA2 6 5 4 3 2 1 Level of Emissions 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 The Case for Fees The cost minimizing solution would be an abatement of 6 for firm 1 and 8 for firm 2 and MCA1= MCA2 = $3. If a fee of $3 was imposed Firm 1 emissions would fall by 6 to 8. Firm 2 emissions would fall by 8 to 6. MCA1 = MCA2: efficient solution. Chapter 18

24. The Case for Fines • What if the regulatory agency forces each firm to cut emissions by 7 units • MAC for firm 1 increases to $3.75 • MAC for firm 2 decreases to $2.50 • This is not cost minimizing because one firm can reduce emissions at a lower cost than the other firm • Marginal cost of abatement must be equal between firms for reductions to occur at minimum cost Chapter 18

25. Fee per Unit of Emissions MCA1 MCA2 6 5 4 3.75 Firm 1’s Increased Abatement Costs 3 2.50 Firm 2’s Reduced Abatement Costs 2 1 Level of Emissions 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 The Case for Fees The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA2 < MCA1. Chapter 18

26. Ways of Correcting Market Failure • Advantages of Fees • When equal standards must be used, fees achieve the same emission abatement at lower cost. • Fees create an incentive to install equipment that would reduce emissions further. Chapter 18

27. The Case for Standards • Assume we have • Steep marginal social cost curve • Flat marginal cost of abatement • An emissions fee of $8 would be efficient but because of limited information, fee is set at $7 • Firms emissions increase and with steep MSC, this will lead to significant additional social costs Chapter 18

28. The Case for Standards • What if standard is used instead and has the same percentage mistake • Standard set at 9 instead of 8 • Increase in social cost and decrease in abatement costs • Net increase in social costs is smaller than with fees Chapter 18

29. C Fee per Unit of Emissions 16 Marginal Social Cost 14 12 E A 10 D B 8 6 4 Marginal Cost of Abatement 2 0 2 4 6 8 10 12 14 16 Level of Emissions The Case for Standards Based on incomplete information fee is $7 (12.5% decrease). Emission increases to 11. ABC is the increase in social cost less the decrease in abatement cost. Based on incomplete information standard is 9 (12.5% decrease). ADE < ABC Chapter 18

30. Ways of Correcting Market Failure • Summary: Fees vs. Standards • Standards are preferred when MSC is steep and MCA is flat. • Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement. Chapter 18

31. Ways of Correcting Market Failure • Summary: Fees vs. Standards • Fees have certainty on cost and uncertainty on emissions. • Preferred policy depends on the nature of uncertainty and the slopes of the cost curves. Chapter 18

32. Ways of Correcting Market Failure • Transferable Emissions Permits • Permits help develop a competitive market for externalities. • Agency determines the level of emissions and number of permits • Permits are marketable • High cost firm will purchase permits from low cost firms Chapter 18

33. Ways of Correcting Market Failure • The market for externalities is appealing since it combines the system of standards with the system of fees. • The agency who administers the system determines the total number of permits and therefore the total amount of emissions • Marketability of the permits allows pollution abatement to be achieved at minimum cost. Chapter 18

34. Ways of Correcting Market Failure • Recycling • Households can dispose of glass and other garbage at very low cost. • The low cost of disposal creates a divergence between the private and the social cost of disposal. Chapter 18

35. Recycling • Marginal private cost likely constant for fixed amount of garbage • Social cost of disposal includes the harm to environment from littering and injuries caused by litter • Without market intervention, the level of crap will be at m and m1 > m* • With refundable deposit, MC increases and MC = MSC = MCR Chapter 18

36. The Efficient Amount of Recycling Chapter 18

37. Refundable Deposits • Deposit is paid when bottle is purchased and then refunded when bottle returned. • Can chose the deposit to give household incentive to recycle more • Deposit increases private cost of disposal • Supply of glass comes from new glass and recycled glass • Increasing deposit increase supply of recycled glass and lowers price of glass Chapter 18

38. D Refundable Deposits Sr The supply of glass is the sum of the supply of virgin glass (Sr) and the supply of recycled glass (Sr). Without refunds the price of glass is P and Sr is M1. $ S’r Sv With refunds Sr increases to S’r and S increases to S’. Price falls to P’ and the amount of recycled glass increases to M*. S S’ P P’ Chapter 18 Amount of Glass M1 M*

39. Common Property Resources • Characteristics • Everyone has free access. • Likely to be overutilized • Examples • Air and water • Fish and animal populations • Minerals Chapter 18

40. Common Property Resources • Consider a lake where people fish • Each fisherperson takes fish up to the point where the marginal benefit to them equals the marginal cost • There is no reason that any one fisherperson take into account how their taking fish affects others experience Chapter 18

41. Common Property Resources • Private cost underestimates the true cost to society • More fishing reduces the stock of fish • Less is available to others and too low of a stock will completely deplete the fish • Too many fish are caught Chapter 18

42. Marginal Social Cost Private Cost Demand (MB) F* FC Common Property Resources Without control the number of fish/month is FC where PC = MB. Benefits, Costs ($ per fish) However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D) Fish per Month

43. Common Property Resources • Solution • Private ownership • Owner will set fee for sue of resource equal to the marginal cost of depleting the stock • Fishermen will no longer find it profitable to catch more than the efficient amount of fish • It is often the case that private ownership is not possible, the government steps in Chapter 18

44. Public Goods • Characteristics • Nonrival • For any given level of production the marginal cost of providing it to an additional consumer is zero. • Nonexclusive • People cannot be excluded from consuming the good. • Example – use of lighthouse by a ship Chapter 18

45. Public Goods • Nonexclusive goods • Goods that people cannot be excluded from consuming, so that it is difficult or impossible to charge for their use • Example: fireworks, national defense Chapter 18

46. Efficiency and Pubic Goods • Efficient level of private good is where marginal benefit equals marginal cost • For a public good, the value of each person must be considered • Can add demand of all those who value good • Must equate the sum of these marginal benefits to the marginal cost of production Chapter 18

47. MC D2 D D1 Efficient Public Good Provision Benefits (dollars) D1 is demand for consumer 1 D2 is demand for consumer 2 D is total demand for all consumers $7.00 $5.50 $4.00 Efficient output occurs where MC = total MB 2 units of output. MB is $1.50 + $4.00 or $5.50. $1.50 Output 0 1 2 3 4 5 6 7 8 9 10 Chapter 18

48. Public Goods and Market Failure • Free Riders • There is no way to provide some goods and services without benefiting everyone. • Households do not have the incentive to pay what the item is worth to them. • Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it. Chapter 18