Externalities Economics PDF

Welcome Economics Lucerne School of Business Professor Gour Saraff Externalities Page 1  CHAPTER CHAPTER 5 Externalities, Environmental Policy, and Public Goods...

Welcome Economics Lucerne School of Business Professor Gour Saraff Externalities Page 1  CHAPTER CHAPTER 5 Externalities, Environmental Policy, and Public Goods Chapter Outline and Learning Objectives 5.1 Externalities and Economic Efficiency 5.2 Private Solutions to Externalities: The Coase Theorem 5.3 Government Policies to Deal with Externalities 5.4 Four Categories of Goods © 2015 Pearson Education, Inc. 2 What Is the “Best” Level of Pollution? Is there a way to know what is the optimal level of pollution for a society? “No pollution” may be good for the environment, but is probably not good for people—most modern conveniences in some way result in pollution. But unrestrained pollution is probably not optimal either. Economics offers some ideas for how to decide on how much pollution to allow. © 2015 Pearson Education, Inc. 3  Externalities and Economic Efficiency 5.1 LEARNING OBJECTIVE Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency. © 2015 Pearson Education, Inc. 4 Pollution is an Externality No one sets out to create pollution; pollution is an unintended by- product of various activities. Pollution would not be a problem if pollution only affected the person who created it; people would create pollution only until its marginal cost equaled its marginal benefit. But pollution is an example of an externality: a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Think of an externality like a side-effect. © 2015 Pearson Education, Inc. 5 Electricity Production Electricity production is an incredibly important industry for a modern economy. Consider the market for electricity. It consists of: Sellers, who face increasing marginal costs to produce electricity Buyers, who face decreasing marginal benefits of additional electricity The actions of these groups generate market supply and demand curves for electricity. © 2015 Pearson Education, Inc. 6 Cost of Electricity Production When firms produce electricity, they have costs of production: Buildings Equipment Fuel Labor, etc. Those firms make their decisions about how much to produce based on these private costs. But the social cost is higher: the cost to society includes both the private cost and the external cost of the pollution. © 2015 Pearson Education, Inc. 7 Externalities in the Electricity Production Market Supply curve S1 represents just the marginal private cost that the electricity producer has to pay. Supply curve S2 represents the marginal social cost, which includes the costs to those affected by pollution. The optimal level of production for society is QEfficient; at this quantity, the Figure 5.1 The effect of pollution marginal cost to society is just on economic efficiency equal to the marginal benefit. © 2015 Pearson Education, Inc. 8 Inefficiency Due to Negative Externalities However the market equilibrium results from the decisions of producers, who see their cost of production given by S1. Price (PMarket) is “too low” and quantity (QMarket) is “too high”: the cost to society of the additional electricity exceeds its benefit to society. Deadweight loss results. When there is a negative externality in producing a good or service, too much of the good or service will be Figure 5.1 The effect of pollution on economic efficiency produced at market equilibrium. © 2015 Pearson Education, Inc. 9 Externalities Pollution is an example of a negative externality in production. Negative externalities might result from consumption. Example: cigarette smoke Externalities might also be positive, with social benefits exceeding private benefits. Example: college education 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. Positive externalities result in underproduction relative to efficiency. © 2015 Pearson Education, Inc. 10 Externalities in the College Education Market College educations have positive externalities. The marginal social benefit from a college education is greater than the marginal private benefit to 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. Figure 5.2 The effect of a positive When there is a positive externality in externality on economic efficiency consuming a good or service, too little of the good or service will be produced at market equilibrium. © 2015 Pearson Education, Inc. 11 Externalities and Market Failure If there are negative or positive externalities, the market equilibrium will not result in the efficient quantity being produced. There will be deadweight loss. This is an example of market failure: a situation in which the market fails to produce the efficient level of output. The larger the externality, the greater is likely to be the size of the deadweight loss—the extent of the market failure. © 2015 Pearson Education, Inc. 12 What Causes Externalities? Externalities arise because of incomplete property rights, or from the difficulty of enforcing property rights in certain situations. Suppose a farmer and a paper mill share a stream. If no-one owns the stream, the paper mill will discharge waste into the stream, making it unusable for the farmer. If the farmer owns the stream, he can Prevent the mill from discharging into the stream, or Allow the mill to discharge for a fee, if that is beneficial to him. Either way, good property rights avoid the market failure. Property rights: The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. © 2015 Pearson Education, Inc. 13  Private Solutions to Externalities: The Coase Theorem 5.2 LEARNING OBJECTIVE Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality. © 2015 Pearson Education, Inc. 14 An Efficient Amount of Pollution This graph shows pollution reduction, which has both costs and benefits. 10 units of pollution reduction is “too much”; the cost of the last unit exceeds the benefit. 7 units of pollution reduction is “too little”; the benefit of the next unit exceeds the cost. 8.5 units is efficient; the marginal cost just equals Figure 5.3 The marginal benefit from pollution reduction should the marginal benefit. equal the marginal cost © 2015 Pearson Education, Inc. 15 The Coase Theorem Nobel laureate Ronald Coase argued that private parties could solve the externality problem through private bargaining, provided Property rights are assigned and enforceable, and Transaction costs are low. Transaction costs: The 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 also requires that parties have full information about the costs and benefits involved. © 2015 Pearson Education, Inc. 16 The Coase Theorem and Property Rights Perhaps Coase’s most important observation was that it did not matter to whom property rights were assigned. In the example of the paper mill and the farmer, we said that if the farmer had enforceable property rights over the stream, the externality problem could be resolved. But the same is true if the paper mill owns the stream! Can you explain why? © 2015 Pearson Education, Inc. 17  Making the The Birds Apples and the Bees Connection There are mutual positive externalities in apple- growing and beekeeping. This suggests both will be underprovided. But apple-growers and beekeepers have developed private solutions to this: Beekeepers along the West Coast rent their hives out to orchardists in “pollination contracts,” moving them to where they are needed at different times of the year. © 2015 Pearson Education, Inc. 18  Government Policies to Deal with Externalities 5.3 LEARNING OBJECTIVE Analyze government policies to achieve economic efficiency in a market with an externality. © 2015 Pearson Education, Inc. 19 When Can Two Wrongs Make a Right? In chapter 4, we learned that taxes caused inefficiency (deadweight loss) by moving the level of production away from the efficient level. In this chapter, externalities cause inefficiency for the same reason. A tax of just the right size could cause these two effects to cancel out, returning us to the efficient level of production. © 2015 Pearson Education, Inc. 20 Corrective Taxes for Negative Externalities Utilities do not bear the cost of pollution, so they produce too much. If the government imposes a tax equal to the cost of the pollution, the utilities will internalize the externality. The supply curve will shift up, from S1 to S2. The market equilibrium Figure 5.5 When there is a negative quantity falls to the externality, a tax can lead to economically efficient level. the efficient level of output © 2015 Pearson Education, Inc. 21 Effect of the Corrective Taxes 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. Figure 5.5 When there is a negative externality, a tax can lead to the efficient level of output © 2015 Pearson Education, Inc. 22 Can Taxes “Solve” Positive Externalities Too? Taxes worked to solve the problem of negative externalities because: Negative externalities caused too much to be produced, while Taxes reduced the amount of output. When there are positive externalities, too little will be produced. Taxes won’t work; but subsidies might. Subsidy: An amount paid to producers or consumers to encourage the production or consumption of a good. © 2015 Pearson Education, Inc. 23 Corrective Subsidies for Positive Externalities Individuals make decisions about whether or not to “consume” a college education, with a resulting market price and quantity. But what if there are positive externalities to a college education? It is good for us all if other people are smart and make good decisions. This is an argument for a Figure 5.6 When there is a positive externality, a subsidy can bring subsidy in the market for about the efficient level of output college education. © 2015 Pearson Education, Inc. 24 Effect of the Corrective Subsidies The subsidy will cause the demand curve to shift up, from D1 to D2. The market equilibrium quantity will shift from QMarket to QEfficient, the economically efficient equilibrium quantity. Producers receive the price PEfficient, while consumers pay a price P, Figure 5.6 When there is a positive which is equal to PEfficient externality, a subsidy can bring minus the amount of the about the efficient level of output subsidy. © 2015 Pearson Education, Inc. 25 Corrective Taxes and Subsidies The taxes and subsidies seen in the last few slides “correct” the externality problem. They are known as Pigovian taxes and subsidies, after the English economist Arthur Cecil Pigou, who first demonstrated the use of government taxes and subsidies in bringing about an efficient level of output in the presence of externalities. Pigovian taxes are especially popular with economists, because they increase efficiency while bringing in tax revenue; then (in theory) this allows inefficiency-causing taxes in other markets to be reduced, a double dividend of taxation. © 2015 Pearson Education, Inc. 26  Making the Should We Tax Cigarettes and Soda? Connection The consumption of cigarettes and soda are thought to have negative externalities. Why? Both cigarettes and soda have negative health consequences. This by itself is not sufficient to be a negative externality But people’s medical expenses are shared with others, either via public or private health insurance. Therefore we expect there to be too much consumption of cigarettes and soda, and they are candidates for Pigovian taxes. In general, cigarettes are taxed much more heavily than soda. Is this appropriate? © 2015 Pearson Education, Inc. 27  Making the Should We Tax Cigarettes and Soda?—cont. Connection © 2015 Pearson Education, Inc. 28 Alternatives to Taxation for Solving Externalities The traditional solution to the externality problem is command-and- control: 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. Example: Requiring car manufacturers to equip cars with catalytic converters. Problem: What if firms have very different costs of reducing pollution? It may not be efficient for them to reduce pollution by the same amount. © 2015 Pearson Education, Inc. 29 Tradable Emissions Permits This is the concept behind tradable emissions permits, also known as cap-and-trade: The government establishes an allowable amount of emissions. Emissions permits are distributed. Firms can trade emissions permits. Firms with high costs of reducing pollution will buy permits form firms with low costs of reducing pollution, ensuring that pollution is reduced at the lowest possible cost. Hence the market is used to achieve efficient pollution reduction. © 2015 Pearson Education, Inc. 30 The Sulfur Dioxide Cap-and-Trade System In 1990, Congress enacted a cap-and-trade system for sulfur dioxide emissions. Improvements in pollution reduction technology resulted, with the cost of compliance ending up almost 90% less than firm initially estimated. This program was very effective, with benefits at least 25 times the cost of implementing the program. However by 2013, the program had effectively ended. Why? Further emissions reductions were needed; President Bush attempted to lower the cap, but Congress resisted. As a result, the EPA decided to return to a command-and-control approach in order to achieve the reductions. While cap-and-trade appears to be very effective, any policy needs political backing to have a chance at success. © 2015 Pearson Education, Inc. 31 Criticisms of Cap-and-Trade Environmentalists object to cap-and-trade as it gives firms “licenses to pollute.” But pollution has a benefit: it allows cheap production. Every production decision uses up some scarce resource: time, natural resources, clean air, etc. In this sense, paying for the resource of using the clean air seems appropriate. © 2015 Pearson Education, Inc. 32 Why has Cap-and-Trade Lost Its Popularity? Cap-and-trade has lost some of its popularity recently. Why? Cap-and-trade alters who pays for pollution: When pollution is unregulated, all consumers bear the consequences of pollution. When cap-and-trade is enacted, the cost of pollution is borne directly by firms. Polluting firms tend to be able to organize better lobbying efforts, because consumers feel the cost of pollution diffusely. This illustrates the classic special-interest problem in politics: small groups are better able to organize than large groups, even when the large groups might benefit a lot from organizing. © 2015 Pearson Education, Inc. 33  Four Categories of Goods 5.4 LEARNING OBJECTIVE Explain how goods can be categorized on the basis of whether they are rival or excludable and use graphs to illustrate the efficient quantities of public goods and common resources. © 2015 Pearson Education, Inc. 34 Attributes of Goods and Services We have seen that markets are better at providing the efficient level of some goods and services than others. This is related to some important attributes of the goods and services: whether their consumption is rival and/or excludable. 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. © 2015 Pearson Education, Inc. 35 The Four Categories of Goods Figure 5.7 Four categories of goods © 2015 Pearson Education, Inc. 36 Efficient Provision of the Categories of Goods Markets tend to be good at providing efficient levels of private goods. Why? The person making decisions about how much to purchase tends to be the only one benefiting from the good, so only their preferences matter. Markets are not so good at providing efficient levels of the other types of goods. Why? People can free-ride on public goods, enjoying the benefits from them without paying for them. People have little incentive to conserve common resources, leading them to be over-consumed. Profit-maximization tends to lead too many people to be excluded from quasi-public goods. © 2015 Pearson Education, Inc. 37 Efficient Consumption of a Public Resource Common resources tend to be over-consumed. Why? While people cannot be excluded from the resource, their consumption is rival, depleting the resource for other people. This can be thought of as a negative externality. Ideally, we would make people pay for their consumption, as with Pigovian taxes. When this is not possible, the situation is referred to as the Tragedy of the commons, with the common resource being overused. © 2015 Pearson Education, Inc. 38 Common Resources: Efficient Level of Consumption For a common resource such as wood from a forest, the efficient level of use, QEfficient, is determined by the intersection of the demand curve—which represents the marginal benefit received by consumers—and S2, which represents the marginal social cost of cutting the Figure 5.11 Overuse of a common wood. resource But each individual tree-cutter ignores the external cost, resulting in QActual wood being cut. As the quantity is not optimal, there is deadweight loss as a result. © 2015 Pearson Education, Inc. 39 A Way Out of the Tragedy of the Commons The source of the tragedy of the commons is the same as the source of negative externalities: lack of clearly defined and enforced property rights. When enforcing property rights is not feasible, though, two types of solutions to the tragedy of the commons are possible: 1. If the geographic area involved is limited and the number of people involved is small, access to the commons can be restricted through community norms and laws. 2. If the geographic area or the number of people involved is large, legal restrictions through taxes, quotas, and tradable permits on access to the commons are required. © 2015 Pearson Education, Inc. 40  Making the Preserving African Wildlife Connection Traditionally, property rights over wildlife in Africa have not been defined. This has resulted in declining wildlife populations, as poachers have every incentive to hunt large game as quickly as possible. Zimbabwe, Namibia, and South Africa transformed wildlife from a common resource to a private good, giving private landowners control over the wildlife. The result: wildlife populations, which were long in decline, are now rising, because private landowners have the incentive to maintain their own herds. © 2015 Pearson Education, Inc. 41 31.10.2024 Seite 42