Microeconomics ECON 2302 Spring 2011

1. MicroeconomicsECON 2302Spring 2011 Marilyn Spencer, Ph.D. Professor of Economics Chapter 5

2. 5 CHAPTER Externalities, Environmental Policy, and Public Goods How should government policy deal with the problem of pollution?Can economic analysis help in formulating more efficient pollution policies?

3. 5 CHAPTER Externalities, Environmental Policy & Public Goods Chapter Outline and Learning Objectives

4. Externalities, Environmental Policy, and Public Goods Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

5. 5.1 LEARNING OBJECTIVE Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency. Externalities and Economic Efficiency The Effect of Externalities Private cost The cost borne by the producer of a good or service. Social cost The total cost of producing a good, including both the private cost and any external cost. Private benefit The benefit received by the consumer of a good or service. Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit.

6. The Effect of Externalities: How a Negative Externality in Production Reduces Economic Efficiency Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level. Supply curve S1 represents just the marginal private cost that the utility has to pay. Supply curve S2 represents the marginal social cost, which includes the costs to those affected by acid rain. If the supply curve were S2, rather than S1, market equilibrium would occur at price PEfficient and quantity QEfficient, the economically efficient level of output. The Effect of Pollution on Economic Efficiency FIGURE 5-1 But when the supply curve is S1, the market equilibrium occurs at price PMarket and quantity QMarket, where there is a DWL equal to the area of the yellow triangle. Because of the deadweight loss, this equilibrium is not efficient.

7. The Effect of Externalities: How a Positive Externality in Consumption Reduces Economic Efficiency The Effect of a Positive Externality on Efficiency FIGURE 5-2 People who do not consume college educations can still benefit from them. As a result, the marginal social benefit from a college education is greater than the marginal private benefit seen by college students. Because only the marginal private benefit is represented in the market demand curve D1, the quantity of college educations produced, QMarket, is too low. If the market demand curve were D2 instead of D1, the level of college educations produced would be QEfficient, which is the efficient level. At the market equilibrium of QMarket, there is a DWL equal to the area of the yellow triangle.

8. Externalities and Economic Efficiency Externalities and Market Failure: Market failure A situation in which the market fails to produce the efficient level of output. What Causes Externalities? Property rightsThe rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

9. 5.2 LEARNING OBJECTIVE Discuss the Coase Theorem and explain how private bargaining can lead to economic efficiency in a market with an externality. Private Solutions to Externalities: The Coase Theorem The Problem of Transactions Costs Transactions costsThe costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. The Coase Theorem Coase theoremThe argument of economist Ronald Coase that if (1) transactions costs are low AND (2) all interested parties can be identified, then private bargaining will result in an efficient solution to the problem of externalities.

10. MakingtheConnection The Fable of the Bees If there are positive externalities in both apple growing and bee-keeping, the market may not supply enough apple trees and beehives. Government intervention, however, may not be necessary because beekeepers and apple growers arrive at private agreements. Some apple growers and beekeepers make private arrangements to arrive at an economically efficient outcome.

11. 5.3 LEARNING OBJECTIVE Analyze government policies to achieve economic efficiency in a market with an externality. Government Policies to Deal with Externalities Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level. If the government imposes a tax equal to the cost of acid rain, the utilities will internalize the externality. As a consequence, the supply curve will shift up, from S1 to S2. The market equilibrium quantity changes from QMarket, where an inefficiently high level of electricity is produced, to QEfficient, the economically efficient equilibrium quantity. FIGURE 5-5 When There Is a Negative Externality, a Tax Can Bring about the Efficient Level of Output The price of electricity will rise from PMarket—which does not include the cost of acid rain—to PEfficient—which does include the cost. Consumers pay the price PEfficient, while producers receive a price P, which is equal to PEfficient minus the amount of the tax.

12. Government Policies to Deal with Externalities: The Economically Efficient Level of Pollution Reduction If the reduction of SO2 emissions is at 7.0 M tons/year, the MB of $250 per ton is > the MC of $175/ton. Further reductionsin emissions will increase the net benefit to society. If the reduction of SO2 emissions is at 10.0 M tons, the MC of $225/ton is > the MB of $150/ton. An increase in SO2 emissions will increase the net benefit to society. Only when the reduction is at 8.5 M tons is the MB = MC. This level is the economically efficient level of pollution reduction. FIGURE 5-3

13. Government Policies to Deal with Externalities: The Economically Efficient Level of Pollution Reduction FIGURE 5-4 Increasing the reduction in SO2 emissions from 7.0 M tons to 8.5 M tons results in total benefits equal to the sum of the areas A and B under the MB curve. The TC of this decrease in pollution is equal to the area B under the MC curve. TB > TC by an amount equal to the area of triangle A. Because the TB from reducing pollution are > the TC, it’s possible for those receiving the benefits to arrive at a private agreement with polluters to pay them to reduce pollution. Don’t Let This Happen to YOU!Remember That It’s the Net Benefit That Counts

14. MakingtheConnection The Clean Air Act:How a Government PolicyReduced Infant Mortality The benefit of reducing air pollution in 1970 was much higher than the benefit from a proportional reduction in air pollution would be today, when the level of pollution is much lower. In the two years following passage of the Clean Air Act, there was a sharp reduction in air pollution and also a reduction in infant mortality.

15. Government Policies to Deal with Externalities: Command and Control versus Market-Based Approaches Command-and-control approach An approach that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices. Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.

16. 5-3 Solved Problem Using a Tax to Deal with a Negative Externality

17. Government Policies to Deal with Externalities: Using a Subsidy to Reach the Economically Efficient Level of Higher Education People who do not consume college educations can benefit from them. As a result, the social benefit from a college education is > the private benefit seen by college students. If the government pays a subsidy equal to the external benefit, students will internalize the externality. The subsidy will cause the demand curve to shift up, from D1 to D2. The result will be that market equilibrium quantity shifts from QMarket, where an inefficiently low level of college educations is supplied, to QEfficient, the economically efficient equilibrium quantity. FIGURE 5-6 When There Is a Positive Externality, a Subsidy Can Bring about the Efficient Level of Output Producers receive the price PEfficient, while consumers pay a price P, which is equal to PEfficient minus the amount of the subsidy.

18. MakingtheConnection Can a Cap-and-Trade System Reduce Global Warming? Policymakers and economists have debated the mechanism by which reductions in CO2 emissions should occur. The United States has favored a global system of tradable emission permits for CO2 that would be similar to the system for SO2 discussed earlier in this chapter.

19. Explain how goods can be categorized on the basis of whether they are rival or excludable, & use graphs to illustrate the efficient quantities of public goods & common resources. 5.4 LEARNING OBJECTIVE Four Categories of Goods Rivalry The situation that occurs when one person’s consuming a unit of a good means no one else can consume it. Excludability The situation in which anyone who does not pay for a good cannot consume it.

20. Four Categories of Goods Goods and services can be divided into four categories on the basis of whether people can be excluded from consuming them and whether they are rival in consumption. A good or service is rival in consumption if one person consuming a unit of a good means that another person cannot consume that unit. FIGURE 5-7 Four Categories of Goods

21. Four Categories of Goods • Private good A good that is both rival and excludable. • Public goodA good that is both nonrivalrous and nonexcludable. • Free ridingBenefiting from a good without paying for it. • Quasi-public goodsGoods that are excludable but not rival. • Common resourceA good that is rival but not excludable.

22. MakingtheConnection Should the GovernmentRun the Health Care System? Because health care is so important to consumers and because health care spending looms so large in the U.S. economy, the role of the government in the health care system is likely to be the subject of intense debate for some time to come.

23. Four Categories of Goods:The Demand for a Public Good FIGURE 5-9 Constructing the Market Demand Curve for a Private Good The market demand curve for private goods is determined by adding horizontally the quantity of the good demanded at each price by each consumer. For instance, in panel (a), Jill demands 2 hamburgers when the price is $4.00; and in panel (b), Joe demands 4 hamburgers when the price is $4.00. So, a quantity of 6 hamburgers and a price of $4.00 is a point on the market demand curve in panel (c).

24. FIGURE 5-10 In panel (a), Jill is willing to pay $8/hr for a security guard to provide 10 hrs of protection. Constructing the Market Demand Curve for a Public Good In panel (b), Joe is willing to pay $10 for that level of protection. To find the D curve for a public good, we add up the pricesfor all consumers, for their willing to purchase each Q of the good. Therefore, in panel (c), the price of $18 per hour and the quantity of 10 hours will be a point on the market demand curve for security guard services.

25. Four Categories of Goods:The Optimal Quantity of a Public Good The optimal quantity of a public good is produced where the sum of consumer surplus and producer surplus is maximized, which occurs where the D curve intersects the S curve. The Optimal Quantity of a Public Good FIGURE 5-10 In this case, the optimal quantity of security guard services is 15 hours, at a price of $9 per hour.

26. 5-4 Solved Problem Determining the OptimalLevel of Public Goods To calculate the marginal social benefit of guard services, we need to add the prices that Jill and Joe are willing to pay at each quantity.

27. 5-4 Solved Problem Determining the OptimalLevel of Public Goods (continued)

28. Common Resources For a common resource, such as wood from a forest, the efficient level of use, QEfficient, is determined by the intersection of the D curve - which represents the MB received by consumers - and S2, which represents the MSCof cutting the wood. Because each individual tree cutter ignores the external cost, the equilibrium quantity of wood cut is QActual, which is greater than the efficient quantity. At the equilibrium level of output, there is a deadweight loss, as shown by the yellow triangle. Tragedy of the commons The tendency for a common resource to be overused FIGURE 5-11 Overuse of a Common Resource

29. AN INSIDELOOK >> The Carbon Cap Dilemma Using a carbon tax to reduce CO2 emissions.

30. KEY TERMS Coase theorem Command-and-control approach Common resource Excludability Externality Free riding Market failure Pigovian taxes & subsidies Private benefit Private cost Private good Property rights Public good Rivalry Social benefit Social cost Tragedy of the commons Transactions costs

31. Before we begin Ch. 6 in class, pre-read Ch. 6, including: • Review Questions: 3rd ed., p.194, 1.1-1.4; p 196 2.1, 2.2; p 198, 4.1, 4.2; p 200, 5.1; p 201, 6.1 and “If demand for orange juice (OJ) is inelastic, will a rise in the price of OJ increase or decrease the revenue received by orange juice sellers?” (2nd ed., p. 200, 1.1-1.4; p. 202, 2.1 & 2.2; p. 204, 4.1 & 4.2; pp. 205-6, 5.1; p. 206, 6.1; 1st edition: 1-10, p. 193); • Problems and Applications: 3rd ed., p196, 2.5; p 197, 3.3; p 200, 5.2; p 201, 6.6 and “During 2001 in Afghanistan, the Taliban outlawed growing poppies, from which opium is made. Opium output fell by 95%, and the price of opium rose from 2,000 rupees/kg to 40,000 rupees/kg. What was the price elasticity of demand for opium in Afghanistan?” (2nd ed., p. 202, 3.3; p. 206, 5.2; p. 202, 2.4; p. 207, 6.6; and 1st edition: 2, 3, 5, 6 & 18, pp. 193-195).