Chapter Eighteen

Chapter Eighteen Externalities, Open-Access, and Public Goods

Topics • Externalities. • The Inefficiency of Competition with Externalities. • Market Structure and Externalities. • Allocating Property Rights to Reduce Externalities. • Open-Access Common Property. • Public Goods. © 2009 Pearson Addison-Wesley. All rights reserved.

Externalities • externality - the direct effect of the actions of a person or firm on another person’s wellbeing or a firm’s production capability rather than an indirect effect through changes in prices. • negative externality -an externality that harms someone. • positive externality –an externality that benefits other. © 2009 Pearson Addison-Wesley. All rights reserved.

The Inefficiency of Competitionwith Externalities • Firms produce paper and by-products of the production process—such as air and water pollution—that harm people who live near paper mills. • we’ll call the pollution gunk. • each ton of paper that is produced increases the amount of gunk by one unit, • the only way to decrease the volume of gunk is to reduce the amount of paper manufactured. • no less-polluting technologies are available, • it is not possible to locate plants where the gunk bothers no one. © 2009 Pearson Addison-Wesley. All rights reserved.

The Inefficiency of Competitionwith Externalities (cont). • private cost - the cost of production only, not including externalities. • social cost - the private cost plus the cost of the harms from externalities © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 18.1 Welfare Effects of Pollution in a Competitive Market , p , r 450 $ per ton ice of pape r P p MC e p = 240 c c 30 Demand = 0 Q 105 225 c Q , T ons of paper per day © 2009 Pearson Addison-Wesley. All rights reserved.

The Inefficiency of Competitionwith Externalities (cont). • social marginal cost (MCs) - is the cost of manufacturing one more ton of paper to the paper firms plus the additional externality damage to people in the community from producing this last ton of paper. © 2009 Pearson Addison-Wesley. All rights reserved.

s p g = + MC MC MC e s p = 282 s p g MC MC g MC = Q 84 s Figure 18.1 Welfare Effects of Pollution in a Competitive Market , p , r 450 $ per ton ice of pape r P A p MC E B D C e p = 240 c c H 198 G F 84 30 Demand = 0 Q 105 225 c Q , T ons of paper per day © 2009 Pearson Addison-Wesley. All rights reserved.

The Inefficiency of Competitionwith Externalities (cont). A deadweight loss results because the competitive market equates price with private marginal cost instead of with social marginal cost. © 2009 Pearson Addison-Wesley. All rights reserved.

The Inefficiency of Competitionwith Externalities (cont). • A competitive market produces excessive negative externalities. • The optimal amount of pollution is greater than zero. © 2009 Pearson Addison-Wesley. All rights reserved.

Reducing Externalities. • Kyoto agreement. • Reached in Kyoto, Japan, in 1997 • required most industrialized nations to reduce CO2emissions by an average of 5.2% below 1990 levels by 2008–2012. • To achieve this goal, the United States, Europe, and Japan need to curb their CO2 emissions by 31%, 22%, and 35%, respectively, from the levels that would have been attained in the absence of a reduction policy. • The Bush administration rejected this agreement. © 2009 Pearson Addison-Wesley. All rights reserved.

Reducing Externalities (cont). • The government: • might control pollution directly by restricting the amount of pollution that firms may produce • emissions standard • by taxing them for pollution they create. A governmental limit on the amount of air or water pollution • emissions fee – tax on air pollution • effluent charge - tax on discharges into the air © 2009 Pearson Addison-Wesley. All rights reserved.

Emissions Fee. • The government may impose costs on polluters by taxing their output or the amount of pollution produced. • internalize the externality - to bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others) © 2009 Pearson Addison-Wesley. All rights reserved.

s p = + MC MC t ( Q ) e s p = 282 s t = 84 p MC = 198 g MC g MC = 84 = Q 84 s Figure 18.2 Taxes to Control Pollution , $ per ton 450 p , r MCp + t ice of pape p MC r P Demand 0 225 Q , T ons of paper per d a y © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem18.1 • For the market with pollution in Figure 18.1, what constant, specific tax, τ, on output could the government set to maximize welfare? © 2009 Pearson Addison-Wesley. All rights reserved.

Cost-Benefit Analysis • Result from the supply-and-demand analysis: a competitive market produces too much pollution because the price of output equals the marginal private cost rather than the marginal social cost. • Cost-benefit analysis offers another interpretation of the pollution problem in terms of the marginal cost and benefit of the pollution itself. © 2009 Pearson Addison-Wesley. All rights reserved.

Cost-Benefit Analysis (cont). Welfare is maximized by reducing output and pollution until the marginal benefit from less pollution equals the marginal cost of less output. © 2009 Pearson Addison-Wesley. All rights reserved.

Monopoly and Externalities (cont). • The reason that a monopoly may produce too little or too much is that it faces two offsetting effects: • The monopoly tends to produce too little output because it sets its price above its marginal cost, but • the monopoly tends to produce too much output because its decisions depend on its private marginal cost instead of the social marginal cost © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem18.2 • In Figure 18.4, what is the effect on output, price, and welfare of taxing the monopoly an amount equal to the marginal harm of the externality? © 2009 Pearson Addison-Wesley. All rights reserved.

Coase Theorem • Coase Theorem - the optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined. © 2009 Pearson Addison-Wesley. All rights reserved.

Coase Theorem - Scenario • Two firms: a chemical plant and a boat rental company, that share a small lake. • The chemical manufacturer dumps its waste by-products, which smell bad but are otherwise harmless, into the lake. The chemical company can reduce pollution only by restricting its output; it has no other outlet for this waste. • The resulting pollution damages the boat rental firm’s business. • There are other lakes nearby where people can rent boats. Therefore, because they dislike the smell of the chemicals, people rent from this firm only if it charges a low enough price to compensate them fully for the smell. © 2009 Pearson Addison-Wesley. All rights reserved.

No Property Rights. • If the firms do not negotiate, the chemical firm produces the output level that maximizes its profit, ignoring the effect on the boat rental firm. © 2009 Pearson Addison-Wesley. All rights reserved.

Property Right to Be Free of Pollution. • If a court or the government grants the boat rental firm the property right to be free of pollution, the firm can prevent the chemical company from dumping at all. © 2009 Pearson Addison-Wesley. All rights reserved.

Property Right to Pollute. • Now suppose that the chemical company has the property right to dump in the lake (for example, by paying a pollution tax). © 2009 Pearson Addison-Wesley. All rights reserved.

Results from Coase Theorem • To summarize the results from the Coase Theorem: • If there are no impediments to bargaining, assigning property rights results in the efficient outcome at which joint profits are maximized. • Efficiency is achieved regardless of who receives the property rights. • Who gets the property rights affects the income distribution. • The property rights are valuable. The party with the property rights may be compensated by the other party. © 2009 Pearson Addison-Wesley. All rights reserved.

Problems with the Coase Approach. • If transaction costs are very high, it might not pay for the two sides to meet. • If firms engage in strategic bargaining behavior, an agreement may not be reached. • If either side lacks information about the costs or benefits of reducing pollution, a nonefficient outcome may occur. © 2009 Pearson Addison-Wesley. All rights reserved.

Markets for Pollution • cap-and-trade system - the government gives firms permits, each of which confers the right to create a certain amount of pollution. Each firm may use its permits or sell them to other firms. © 2009 Pearson Addison-Wesley. All rights reserved.

Markets for Pollution (cont). • Suppose that the cost in terms of forgone output from eliminating each ton of pollution is $200 at one plant and $300 at another. • If the government tells both plants to reduce pollution by 1 ton, • TC = $500. • With tradable permits, the first plant can reduce its pollution by 2 tons and sell its allowance to the second plant, so the total social cost is only $400. © 2009 Pearson Addison-Wesley. All rights reserved.

Public Goods • public good - a commodity or service whose consumption by one person does not preclude others from also consuming it. • rivalry -only one person can consume the good • exclusion -means that others can be prevented from consuming the good. © 2009 Pearson Addison-Wesley. All rights reserved.

Markets for Public Goods • Markets for public goods exist only if nonpurchasers can be excluded from consuming them. • Thus, markets do not exist for nonexclusive public goods. • Usually, if the government does not provide a nonexclusive public good, no one provides it. © 2009 Pearson Addison-Wesley. All rights reserved.

Demand for Public Goods. • Because a public good lacks rivalry, many people can get pleasure from the same unit of output. • As a consequence, the social demand curve or willingness-to-pay curve for a public good is the vertical sum of the demand curves of each individual. © 2009 Pearson Addison-Wesley. All rights reserved.

Demand for Public Goods (cont). • Guards patrolling the mall provide a service without rivalry: • All the stores in the mall are simultaneously protected. • Each store’s demand for guards reflects its marginal benefit from a reduction in thefts due to the guards. © 2009 Pearson Addison-Wesley. All rights reserved.

Free Riding - Example • Two stores in a mall that are deciding whether to hire one guard or none. • The cost of hiring a guard is $10 per hour. • The benefit to each store is $8. • Because the collective benefit, $16, is greater than the cost of hiring a guard, the optimal solution is to hire the guard. © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Eighteen