C hapter 14

1. Chapter 14 Externalities, Market Failure, and Public Choice

2. Economic Principles • Positive and negative externalities • Property rights • Market failure • Pollution taxation and obligatory controls Gottheil - Principles of Economics, 4e

3. Economic Principles • Pure public goods and near-public goods • Public choice • Government failure Gottheil - Principles of Economics, 4e

4. Economic Externalities Externalities • Unintended costs or benefits that are imposed on unsuspecting people and that result from economic activity initiated by others. Gottheil - Principles of Economics, 4e

5. Economic Externalities Third parties • People upon whom the externalities are imposed. Gottheil - Principles of Economics, 4e

6. Economic Externalities • Persons or companies that initiate activities do so to benefit themselves. • The activity’s effect on others is excluded from the decision about whether to undertake the activity. Gottheil - Principles of Economics, 4e

7. Economic Externalities Negative externalities • Externalities that impose unintended costs. Gottheil - Principles of Economics, 4e

8. Economic Externalities Some examples of negative externalities include: • The impact on your health from someone smoking in an elevator with you. • The decrease in your property value that results from a neighbor dumping garbage in their yard. Gottheil - Principles of Economics, 4e

9. Economic Externalities In modern societies, the most important negative externalities are precisely those that are the most difficult to measure and the most difficult to track to specific offenders. Gottheil - Principles of Economics, 4e

10. Economic Externalities Positive externalities • Externalities that generate unintended benefits. Gottheil - Principles of Economics, 4e

11. Economic Externalities Some examples of positive externalities include: • The pleasure you derive from your neighbor’s beautifully landscaped yard. • Being able to watch baseball games for free from your rooftop because you live near the park. Gottheil - Principles of Economics, 4e

12. Economic Externalities Positive externalities can be as difficult to measure as negative externalities. Gottheil - Principles of Economics, 4e

13. Economic Externalities Free rider • Someone who consumes a good or service without paying for it. Typically, the good or service consumed is in the form of a positive externality. Gottheil - Principles of Economics, 4e

14. Externalities and Property Rights Property rights • The right to own a good or service and the right to receive the benefits that the use of the good or service provides. Gottheil - Principles of Economics, 4e

15. Externalities and Property Rights The property rights associated with the people who either suffer the negative externalities or enjoy the positive externalities are poorly defined. Gottheil - Principles of Economics, 4e

16. Externalities and Property Rights Therefore, we can’t lay claim to the positive externalities we generate, nor place the cost to society that negative externalities generate on the source of the externality. Gottheil - Principles of Economics, 4e

17. Externalities and Property Rights Some forms of property are not easily privatized and title to them is virtually impossible to claim, so no one has an interest in defending or maintaining the property. Gottheil - Principles of Economics, 4e

18. Externalities and Property Rights What are some examples of forms of property that do not have associated clear and exclusive rights? • Air and the atmosphere • The oceans • Viewscapes Gottheil - Principles of Economics, 4e

19. Externalities and Property Rights It is difficult to find incentives that would lead people, companies, and governments to be careful about creating negative externalities when they know their actions affect “only” a form of property that cannot be claimed. Gottheil - Principles of Economics, 4e

20. Why Should Economists Be Interested in Externalities? The presence of positive and negative externalities associated with almost every economic activity undertaken in our economy calls into question the efficacy of our market system. Gottheil - Principles of Economics, 4e

21. Why Should Economists Be Interested in Externalities? • When choosing whether to produce a good, producers must take into consideration the cost of inputs and the dollar value for which the good can be sold on the market. • If the cost of inputs is greater than the potential revenue, then producing the good would be an inefficient use of resources. Value would be reduced. Gottheil - Principles of Economics, 4e

22. Why Should Economists be Interested in Externalities? Is it an efficient use of resources to produce bread if the inputs used to produce the bread are valued at $3 and the bread can be sold on the market for $4? • Yes. Producing the bread would create value. Gottheil - Principles of Economics, 4e

23. Why Should Economists Be Interested in Externalities? Social cost • The cost to society of producing a good. This cost includes both the private costs associated with the good’s production and the external cost generated by its production. Gottheil - Principles of Economics, 4e

24. Why Should Economists Be Interested in Externalities? Market failure • The failure of the market to achieve an optimal allocation of the economy’s resources. The failure results from the market’s inability to take externalities into account. Gottheil - Principles of Economics, 4e

25. Why Should Economists Be Interested in Externalities? Suppose that external costs generated from baking bread is estimated to be $3 per loaf. If the inputs to produce the bread cost $3 and the value of the bread on the market is $4, is this an efficient use of resources? • No. The social cost of producing the bread is $6. Therefore, value is reduced. Gottheil - Principles of Economics, 4e

26. Why Should Economists Be Interested in Externalities? Because the market does not incorporate externalities into its cost calculations, it appears to be signaling an efficient use of resources—creating value—when, in fact, it is anything but efficient. Gottheil - Principles of Economics, 4e

27. EXHIBIT 1 THE EFFECT OF EXTERNALITIES ON THE MARKET FOR CHICKEN Gottheil - Principles of Economics, 4e

28. Exhibit 1: The Effect of Externalities in the Market for Chicken 1. What does the supply (private cost) curve in Exhibit 1 reflect? • The supply curve reflects the marginal cost curves of firms producing chicken. These costs are private, representing only the firms’ cost of production. Gottheil - Principles of Economics, 4e

29. Exhibit 1: The Effect of Externalities in the Market for Chicken 2. What is the equilibrium price and quantity before social costs? • The equilibrium price is $4.00 per chicken. • The equilibrium quantity is 8 billion chickens. Gottheil - Principles of Economics, 4e

30. Exhibit 1: The Effect of Externalities in the Market for Chicken 3. How does the social cost supply curve differ from the private cost supply curve? • The social cost supply curve includes the pollution cost associated with producing chicken. Gottheil - Principles of Economics, 4e

31. Exhibit 1: The Effect of Externalities in the Market for Chicken 3. How does the social cost supply curve differ from the private cost supply curve? • The social cost supply curve is shifted to the left of the private cost supply curve. Gottheil - Principles of Economics, 4e

32. Exhibit 1: The Effect of Externalities in the Market for Chicken 4. How do equilibrium price and quantity change when the social cost supply curve is used? • Equilibrium price increases to $5.00. • Quantity decreases to 7 billion chickens. Gottheil - Principles of Economics, 4e

33. Exhibit 1: The Effect of Externalities in the Market for Chicken 5. What is the effect of ignoring the cost of the negative externalities? • Market failure occurs. The market is inefficient, pricing chicken too low and producing more chicken than it should. Gottheil - Principles of Economics, 4e

34. Correcting Market Failure While firms can measure their own private costs to the penny, measuring externalities may require a considerable amount of research. Gottheil - Principles of Economics, 4e

35. Correcting Market Failure In general we know too little about environmental impacts to confidently trace out social cost curves for various industries. Gottheil - Principles of Economics, 4e

36. Correcting Market Failure Does this mean that we should not try? • No. We must try. If we can’t correct market failure we can at least try to improve upon it. Gottheil - Principles of Economics, 4e

37. Correcting Market Failure We typically rely on government to attempt to correct market failure for two reasons: • Government has access to more relevant information than any private firm or individual. • Government is probably the most objective. Gottheil - Principles of Economics, 4e

38. Correcting Market Failure There are three policy options government can pursue in an attempt to correct market failure: • Create new property forms to handle externalities. • Levy a pollution tax on the polluting industry. • Enforce an environment-protecting set of standards on the polluting industry. Gottheil - Principles of Economics, 4e

39. Correcting Market Failure: Creating New Property Forms The government can convert public property into private property by auctioning it off to private enterprise. Gottheil - Principles of Economics, 4e

40. Correcting Market Failure: Creating New Property Forms 1. What are some benefits of privatizing property? • When property is privately owned, there is a strong incentive to maintain it. • Anyone damaging the property would be liable. • The government gains revenue from the auction. Gottheil - Principles of Economics, 4e

41. Correcting Market Failure: Creating New Property Forms 2. What is one serious limitation of privatizing property? • Not all property can be easily privatized. For example, how could the government sell the atmosphere? Gottheil - Principles of Economics, 4e

42. Correcting Market Failure: Levying a Pollution Compensation Tax • The government can charge the polluter a tax, based on its estimate of the cost of the negative externality. • The tax money could then be used to clean up the pollution. Gottheil - Principles of Economics, 4e

43. Correcting Market Failure: Levying a Pollution Compensation Tax • The advantage of this policy is that the tax falls on the producers and consumers of the good that created the pollution. • Those who do not consume the good do not pay the tax. • Those who consume less of the good pay less than those who consume more. Gottheil - Principles of Economics, 4e

44. Correcting Market Failure: Creating Obligatory Controls • The government can impose rules and regulations that limit activities that produce negative externalities. • This is the most common policy used by the government to protect the environment. Gottheil - Principles of Economics, 4e

45. Correcting Market Failure: Creating Obligatory Controls What are some examples of obligatory controls used to protect the environment? • Leaf-burning laws to protect the atmosphere. • Sign ordinances to protect scenic beauty. • Mandated use of catalytic converters on cars. Gottheil - Principles of Economics, 4e

46. Correcting Market Failure: The Environmental Protection Agency • The EPA is the environmental regulatory agency of the nation. • Through its directives, the EPA controls the quantity and quality of pollutants that firms discharge into our water, land, and atmosphere. Gottheil - Principles of Economics, 4e

47. Correcting Market Failure: The Environmental Protection Agency What are some of the environmental laws that the EPA administers? • The Clean Air Act, the Water Pollution Control Act, the Safe Drinking Water Act, and the Toxic Substances Control Act. Gottheil - Principles of Economics, 4e

48. Externalities and Public Goods Market failure is not only associated with negative externalities. It can happen as the result of positive externalities. Gottheil - Principles of Economics, 4e

49. EXHIBIT 2 THE EFFECT OF EXTERNALITIES ON THE MARKET FOR TREES Gottheil - Principles of Economics, 4e

50. Exhibit 2: The Effect of Externalities on the Market for Trees 1. What does the private value demand curve reflect? • The private value demand curve reflects the value each tree creates for the person who bought it. Gottheil - Principles of Economics, 4e