24-i-PEC-iple-test10-L28-30-merged.pdf

Academic Year 2023-2024 (II term) International Politics and Economics, IPLE degree Public Economics Self-evaluation test (solutions on pp. 3-5) TEST 10. Issues in taxation (Ref. Lectures 28-30; Hindriks and Myles-HM (2013, chapter 15, pp. 505-509, 515-517; chap 16: 537-546-77). MOCK EXAM Answer ALL questions. Time: 90 Minutes ------------------------------------------------------------------------------------------------------------------------------------------------ MULTIPLE-CHOICE test Tick the correct box: Max 5 points 1 point is given for each correct answer, -0.5 point is given for each wrong answer, 0 point is given for no answer The excess burden of a commodity tax is defined as 1a  the difference between the commodity tax revenue and the equivalent variation 1b  the difference between the equivalent variation and the commodity tax revenue 1c  the sum between the equivalent variation and the commodity tax revenue With two commodities, if one commodity is taxed, the excess burden of taxation is 2a  absent if the two goods are perfect substitutes 2b  absent if the two goods are perfect complements 2c  maximised if the two goods are perfect complements The Corlett-Hague rule of commodity taxation states that 3a  goods that are consumed jointly with leisure should be taxed at lower rates 3b  goods that are not consumed with leisure should be taxed at higher rates 3c  goods that are consumed jointly with leisure should be taxed at higher rate An income tax is progressive if, at any level of income, 4a  the average tax rate is lower than the marginal tax rate 4b  the average tax rate is higher than the marginal tax rate 4c  the average tax rate is equal to the marginal tax rate If leisure is a normal good, with a proportional income tax, an increase in the tax rate 5a  increases the labour supply if the substitution effect dominates the income effect 5b  increases the labour supply if the income effect dominates the substitution effect 5c  lowers the labour supply if the income effect dominates the substitution effect ------------------------------------------------------------------------------------------------------------------ Question 1. The inverse elasticity rule of commodity taxation (from HM, problem 15:11, p, 533) (15 points). Consider the utility function U=a log x1 + b log x2 and budget constraint I= q1x1 + q2x2 where a>0 and b>0 are two parameters, x1 and x2 are two consumption goods, q1 and q2 are consumer prices, and I is exogenous income. i) Given that the marginal rate of substitution between the two goods is MRS12 =a x2/ b x1 find the demand for the two goods. ii) Show that the price elasticity of demand for both commodities is equal to -1. iii) Setting producer prices at p1 =p2=1, show that the inverse elasticity rule implies t1/t2= q1/q2. iv) Letting I=100 and a+b=1, calculate the tax rates required to achieve revenue of R=10. ------------------------------------------------------------------------------------------------------------------------ Question 2. Issues on taxation (10 points; from HM, problem 15.21, p. 536) Are the following statements true or false? Answer and discuss a) The theory of optimal commodity taxation argues that equal tax rates should be set across all commodities so as to maximize efficiency by “smoothing taxes”. b) In the United States prescriptions drugs and CDs are taxed at the same rate of 10%. The Ramsey rule suggests that this is the optimal tax policy. End-PEC-2024 copyright 1 ----------------------------------------------------------------------------------------------------------------------- ANSWERS Multiple-choice test 1b, 2b, 3c, 4a, 5b. -------------------------------------------------------------------------------------------------------------------- Answer to Question 1 (15 points; adapted from HM solution to Ex 15.11) i) The consumer demands are derived as follows. Equate the MRS to the slope of the budget constraint: MRS12 =a x2/b x1= q1/q2. This gives a relationship between optimal spending for x1 and x2: q1 x1=(a/b) q2 x2 Substituting into the budget constraint q1 x1+ q2 x2 = I yields: (a/b) q2 x2+q2 x2 = I. Solving this equation yields the demand for good 2: x2=[b/(a+b)] I/ q2. Using this back into q1 x1=(a/b) q2 x2 =(a/b)[b/(a+b)] I. Solving for x1 yields: x1=[a/(a+b)] I/ q1. ii) The price elasticity of demand for good 1 is (dx1/ dq1) q1/x1 = -[ [a/(a+b)] I/ (q1)2] q1/x1= - 1. The same result is found for the price elasticity of demand for good 2: (dx2/ dq2) q2/x2 = -[ [a/(a+b)] I/ (q2)2] q2/x2= - 1. iii) The inverse elasticity rule states that (see Lecture 29, slides 11) ti/(pi+ti) = [(α+λ)/λ] [1/εdi] i=1, 2 here. Where ti is the tax rate and εdi is the consumer price elasticity of demand of good i. From ii) it follows that εdi =-1 for both goods. Therefore, we have: t1/(p1+t1) =[(α+λ)/λ]= t2/(p2+t2) Given that qi =pi+ti, setting producer prices at p1 =p2=1, we have: t1/q1 = t2/q2 Rearranging yields the required result: t1/t2 = q1/q2 iv)Total revenue is defined as R= t1x1+ t2x2. Using the solutions for the demands, and letting a+b=1: R= t1x1+ t2x2= t1aI/ q1+ t2bI/ q2 Since t1= q1t2/q2, we have: R= t2aI/ q2 + t2bI/ q2=(a+b) t2I/ q2= t2I/ q2 Letting I=100, and recalling that q2=1+ t2, the optimal tax rate on good 2 that achieves revenue R=10, is the solution to: 10= t2100/ (1+t2), namely t2=1/9. Hence, t1=1/9. Answer to Question 2 (10 points; answer from HM solution to Ex 15.21) a. False. The inverse elasticity rule makes it very clear that taxes should be generally be differentiated among commodities in order to minimize excess burden. In particular, a commodity with a low elasticity of demand should be taxed at a higher rate than a commodity with high elasticity. b. False. If we interpret prescription drugs as a necessity (low elasticity of demand) and CDs a luxury (high elasticity), the Ramsey rule would most likely place the heavier tax burden on prescription drugs. (Note that all cross effects in demand would have to be considered to completely justify this answer). End-PEC-2024 copyright 2 PUBLIC ECONOMICS Notes by Camilla Massalongo What governments do? Chapters 1, 4, 5 (pp.119-123) What is Public Economics (PEC)? PEC studies the economic role of government/state in modern market economies, mainly focusing on its taxing and spending activities. Two issues: 1. NORMATIVE ANALYSIS: when and how is government intervention desirable in a market economy? What decisions should the government make and when? 2. POSITIVE ANALYSIS: which tools does the government use to make decisions and what are their economic effects? How does the government make decisions? What are the economic effects of these decisions? Intermezzo: what is a market economy? Market economy = economic system in which the allocation of resources among alternative uses is mainly based on the market price mechanism. The market price mechanism coordinates and makes consistent the decentralised decisions to buy and sell made by many individuals (firms, households). The market economy is one of the main features of capitalism. Capitalism (=mostly private ownership of capital goods; legally free hired labour; profit- motivated and decentralised coordination of production ) is the only mode of production in the world today. Despite «globalisation», different «varieties of capitalism» are in place. Hall and Soskice, 2001: e.g. European coordinated market economies vs. Anglo-Saxon liberal market economies. i) different role of alternative-to market-mechanisms for coordinating decisions (market prices vs. non-market institutions: voting, employer-union wage bargaining; cost benefit analysis by technocrats; workers cooperatives and not-for-profit organizations); ii) different market structures (e.g., competition, monopoly, oligopoly); iii) different role for government (e.g. govt size, redistribution, market regulation). Normative analysis; desirability of government intervention. MARKET FAILURES (allocative function of government) Reading in the negative of the two “Fundamental theorems of Welfare Economics (WE)” (Topic 2) First theorem: the laissez- faire market equilibrium (or allocation of resources) is socially optimal (i.e. Pareto efficient) in the absence of public goods (non rivalrous and non excludable goods) (Topic 3), consumption or production externalities (Topic 4), market power (i.e., monopoly power, monopsony power) and/or increasing returns to scale (Topic 5), asymmetric (or imperfect) information (Topic 6). On the contrary, there is a market failure: the unfettered market equilibrium is Pareto inefficient. Market failures open up the possibility of a corrective, Pareto-improving government intervention on purely efficiency grounds: in the presence of market failures, in theory, the government should intervene to correct the sub-optimal allocation of resources made by unregulated markets. Externalities (spillovers) occur when consumption or production decisions of a consumer/firm directly affect the wellbeing/welfare (utility/profits) of other agents, without being reflected in market prices/incomes. Negative consumption externalities: - smoking cigarettes indoors can reduce welfare of non-smokers. - having a noisy house party can reduce the welfare of neighbours. Positive consumption externalities: - wearing face masks during a pandemic or getting a Covid-19 vaccine jab can reduce the probability of infection for others and increase their level of welfare. Positive externalities usually create a positive gap between Social and Private Marginal Benefits of a consumption activity. Suppose that wearing a mask in a pandemic (or vaccinating against infectious diseases) generates positive consumption externalities. Unless people are altruistic and consider the welfare of others, they will tend to do too little of the activity with positive externalities (e.g. not enough people wear a mask or take a vaccine). In this case, the Social Marginal Benefits > Private MB. SMB of mask wearing = PMB+ positive external effects Message: unregulated individual choice may result in too few people wearing masks/getting vaccinated, which is socially sub- optimal. The analysis can be reframed in terms of opportunity cost. Mask wearing incurs an opportunity cost (the best alternative is no mask wearing, in which case one avoids price of mask, mask fog, loss of personal autonomy…). Individuals wear a mask if private value of self-protection exceeds the private opportunity cost. Usually, the private opportunity cost is higher than the social one (including the value of other people’s lives saved). An individual may choose not to wear a mask when it would be socially desirable to do so. To recap: «Laissez faire» leads to «too little» (in terms of people/ circumstances) mask wearing in a pandemic /vaccination than socially optimal. On efficiency grounds, this calls for government intervention to promote the use of masks/ vaccines. (See also slides 21-24 below): - inform and educate people, - subsidising the price of masks/vaccines; providing them free of charge, - imposing fines if people do not us masks/vaccines, - Making masks/vaccines mandatory (e.g., vaccination as a condition of access to primary education in Italy). Normative analysis; desirability of government intervention. EQUITY (redistributive function of government) 1st approach «Second theorem of welfare economics»: if the conditions supporting the First theorem (see slide 5) hold true, given an appropriate initial distribution of resources among economic agents, the unregulated market can achieve any optimal (or Pareto efficient) final allocation of resources that society prefers (equity criterion). The gov.t only needs to intervene on «initial conditions», by correcting the initial distribution of resources o via appropriate «lump-sum» transfers of resources (lump- sum taxes/subsidies). The unregulated market will then be able to achieve the socially preferred Pareto efficient allocation of resources (Topic2) Implication: No trade–off between equity and efficiency. Intermezzo: What are lump-sum taxes (or subsidies)? Lump-sum taxes (subsidies) affect behaviour, by making people worse off (better off). However, no change in behaviour can affect the amount of lump-sum tax paid (the amount of lump-sum subsidy received). Income effect but not substitution effect, you can’t avoid paying the tax trough changing behaviour. Historical examples of lumpsum taxes: o Poll tax (e.g. Thatcher’s 1990 flat rate per capita tax in the UK) (all inhabitants of UK pay the same tax) o Tax on firms’ «excess profits» (e.g. 1917 WWar profit tax in the US) o Matter-of-fact lump-sum taxes: capital levies announced unexpectedly and with immediate effect (e.g. Amato’s 0.006% tax on bank accounts introduced between July 9 and 10th 1992 in Italy). 2nd approach If I don’t have these instruments, that cannot being avoid, I could have some lost, because the rich’s decisions to avoid the taxes. (possible solution, controlling tax evasion…) Transfers from the rich to the poor are made using Okun’s «leaky bucket»: redistribution is associated with efficiency losses (the «leaks»). In practice, if the conditions of the First theorem hold, redistribution without lumpsum instruments always involves efficiency losses: there is a trade-off between equity and efficiency. The cost for equity is a diminishing in efficiency. Non-lump-sum taxes have distortionary effects («the price of redistribution»). For ex. o a progressive income tax distorts labour supply decisions; o high tax rates on capital discourage investment; o tax collection entails high administrative and compliance costs. 3rd approach With market failures (i.e. if the First theorem does not hold in the status quo lasseiz-faire equilibrium), the efficiency-equity trade-off may disappear: Gov.t redistribution through spending, taxation (and regulation) can improve efficiency, while reducing inequality. Introducing a minimum wage in a monopsony (case in which only one buyer, in this case labours paid less than the marginal product of labour (salary in a competitive labour market) & underemployment) labour market; increasing access to higher education and health care; a land reform taking land from a few landowners and giving it to the tenant farmers. But these efficiency-improving policies are unlikely to be Pareto improving: some agents (the losers) will be made worse off relative to the status quo. Even if the economic reforms increase total income and reduce inequality, there are winners (agents who are made better off) and losers (agents who are made worse off) relative to the status quo. Is the change an improvement? The conventional view is yes, provided that the Hicks-Kaldor compensation test is passed: if side payments are possible, the winners could compensate the losers. If compensation is possible, let’s do those reforms. The problem is not the possibility of compensation but the actual compensation, winners do not compensate the losers. Problem: if there is no compensation, whick kind of improvement is this? For criticisms of the Hicks-Kaldor compensation test, see Sen, A., Deaton, A. and Besley, T. (2020). “Economics with a moral compass? Welfare economics: Past, present and future”. Annual Review of Economics, 12: 1-21. Gini is 1 = perfectly unequal. 1-Gini → Scale of the graph; from perfect inequality to perfect equality Policies that improve both move towards the frontier, policies that changes the trade-off moves along the frontier. First best outcome (points like A on the red frontier in figure above): choice of decision makers is only restricted by production technology and initial endowments/initial resources. Second best outcome (points like B inside the red frontier in figure above): choice is restricted by production technology, initial endowments and by additional constraints (asymmetric information, inability to remove market power, limits to redistribution). Idea that countries on average inside the frontier is consistent from the data. Positive analysis: which tools does the government use to make decisions? 1) Raising revenue from the private sector to finance public spending: «power to tax» with mandatory levies (taxes, duties, fees, social insurance contributions) and expropriation; voluntary levy via public debt; seigniorage (revenues from money creation due to monopoly on high-powered money) 2) Expenditure: direct government production vs. public provision of goods and services. a. The Lombardy regional government provides public health care services to its citizens: i) producing them directly through public hospitals; ii) buying them from accredited private hospitals. b. EU governments provide COVID-19 vaccines for free to their citizens by buying them from private companies (e.g Pzifer) since 2021. 3) Regulation of market activities: a. price regulation (price controls, minimum wage laws), b. quantity regulation (shopping hours, licenses), c. administrative and red-tape costs (administrative burdens on start-ups, legal barriers to entry, compliance costs…), d. ANTITRUST regulation («policing» market competition), industrial policy. Revenue-raising, expenditure and regulation activities can distort the market price mechanism, changing the behaviour of consumers and firms (Topic 7). The Nuffield Council on Bioethics ‘intervention ladder’ (originally developed for promoting positive lifestyle changes) can be used to illustrate the range of government intervention from the least intrusive into people’s lives to the most intrusive (legislation). Typically, to deal with externalities, economists prefer taxes/incentives to mandate. What are the (economic) effects of government decisions? Direct (economic) effects: what the government expects from its policies if the private sector does not react. Indirect (economic) effects: how the private sector reacts to government policies («behavioural responses»). Case study: Mask mandates in 2021 In 2020/21 several European governments introduced mandatory masks to reduce Covid-19 transmission. Some people, feeling safer, responded to the policy by increasing their social activities (or washing their hands less often), thereby increasing their risk of exposure to the virus. Others acted strategically as free riders: as more people around them wore masks, they had less incentive to do the same. With behavioural responses, mandates could backfire and help to spread the disease. Additional public measures (social distancing: limiting visits outside the family; fines for non-compliance) were needed. Case study: the congestion charge zone in Milan, from the Milan Ecopass 2008-2011 to AREA C 2012-now. In 2008, the City of Milan introduced an urban congestion charge (Ecopass) to reduce pollution and congestion. The charge applied to old technology motor vehicles (pre Euro3). Many drivers responded by buying new technology vehicles (being incentivised by a national government subsidy). By 2010 traffic flows had returned to pre-Ecopass levels. AREA C was therefore introduced in 2012. Drivers reacted to AREA C in two ways: 1) shifting trips to the unpriced period (before 7.30AM or after 7:30 pm); 2) driving around the AREA C boundary. Gibson and Carnovale (2015 JUrbEcs) found that vehicle entry was reduced by 14.5% as a result of AREA C. Using marginal willingness-to-pay data, the authors also estimate a $3 billion welfare gain from air pollution reductions. However, these effects have diminished over time: in 2023, the charge increased from €5 to €7.5, but traffic decreased by less than 2% (Dec 22-Dec23). Government failures (see lecture 5) Market failures are necessary but not sufficient for useful government intervention: government intervention «could make things worse». Public Choice and Political Economics present the set of theories of government failures. Government activity can be a source of inefficiency: i. “Government may fail to do (or to do well) things it should do”: good guy a bit stupid and a bit lazy a. due to incompetence, it may implement the wrong policies (higher taxes in a slump); b. due to policy lags/information constraints/ incompetence, it may implement the right policy at the wrong time/of the wrong scale (insufficient number of vaccines shots); c. due to lack of competition, which reduces the incentives to produce services at the lowest technically feasible cost (leading to “X-inefficiencies”). ii. “Government may do things it should not do”: a. e.g. if governments are nonbenevolent and self-interested rent seekers (true for bureaucrats as well). b. Non-benevolent govt? A «Leviathan» that seeks to maximise the revenues that it extracts from the economy. c. This may lead to «excessive government size» and corruption (i.e. private use of public resources). Lecture 2: What governments do? Part 2 2.2 Public sector statistics (and where to find them) 2.3 Justifying the economic role of the government/state: The «three branches» of government intervention (R. Musgrave) 1. Allocative role of government: to address efficiency. 2. Redistributive role of govt to address equity. 3. Stabilisation role of govt to address macroeconomic objectives (economic growth, full employment, price stability). 2.4 Conclusion Economic role of government varies across countries and over time. Several summary statistics may help to measure it. 1) Size of government (controlling for price inflation and country size). - Total consolidated government spending as a percentage of gross domestic product (GDP) in a given year. - Total consolidated government revenues as a % of GDP in a given year. 2) Composition of government - Composition of expenditure by function - Tax revenue by categories 3) Other summary statistics - Total gross government debt as a % of GDP - Seigniorage/GDP - Market regulation indexes. - Measures of inequality: Gini index; Top 1% vs. bottom 50% share of GD General government revenues as % of GDP: 2000 vs 2019 Way to evaluate fiscal pressure, as well as the public provision of social goods and services. GDP share of spending varies across countries, but it is significant even in liberal market economies. - Public provision of private goods: despite differences in the expenditure shares of GDP, the composition of expenditure is quite similar across Europe: o Limited share of spending on core govt functions (defence plus public order) o Largest share of spending on private goods (education, health care, insurance) Why education, health care, pensions… are publicly provided? Efficiency and equity reasons - These goods are also supplied by markets: 1. parents/students can borrow to pay for education. 2. workers can save for retirement and buy insurance products for healthcare or other risks. But there are market failures related to asymmetric information in insurance markets (see Topic 6); capital markets may not be competitive (imperfect competition) or «too complex» for individuals, people may be bad in planning or myopic. Govts provide education and health care because they have strong positive externalities (e.g. they contribute to economic growth). Basic education is compulsory and funded by taxes, because not all parents can afford to educate their children. In most of Europe, health care is universal and mostly financed by taxes, as low incomes cannot pay. Public pension schemes are compulsory and funded by social security contributions because capital markets are not perfect and not all workers would save sufficiently. General revenues = sum of direct taxes (on income and wealth), indirect taxes (on goods and services) other taxes, plus net social security contributions. Valuating the social spending, public, private and total you can see the difference in who spend the money. Fiscal pressure is caused by public services, indeed in US there are a lot of private spending… Low taxes may signal high private provision of social spending (cash benefits, like pensions, in-kind provision of goods and services, like health care and education tax-breaks for social purposes), while high taxes may signal high public provision. Which service is more efficient? Govts can raise revenue not only through taxation, but also through borrowing and seigniorage. These tools are studied in Macroeconomics. PUBLIC DEBT: Govt can raise revenue by issuing public debt. Investors lend money to the govt at an interest rate, expecting the capital to be paid back at maturity. If the real interest rate exceeds the real GDP growth rate, the only way the govt can honour its debt obligations is by In this case, public debt is «deferred taxation». Issuing debt may be desirable to «smooth taxation» over time (to minimise welfare losses from distortionary taxes), especially when financing exceptionally high expenditure for a limited period (e.g. war, green transition of the economy). But a high or rising debt/GDP ratio can raise «sustainability» concerns, fears of default and destabilise financial markets. Stock of debt is the accumulation of past budget deficits (i.e. excess of expenditures over revenues), as long as deficits are financed issuing new debt. Gross Debt/GDP: «rough» index of government solvency (if interest rate> growth rate) Gross Debt/GDP ratio increased in general after the 2007 Great Financial Crisis. Why? i) GDP falls in a recession; ii) increasing deficits to offset recession Rule of thumb for assessing debt sustainability: the debt/GDP ratio should not explode over time, but should stabilise or decline over the medium term. Govts can raise revenue not only through taxation, but also through borrowing and seigniorage. SEIGNIORAGE: fiscal revenues from money creation. - In modern economies, national Central Banks (which are part of the government) have the monopoly power to create high powered money. They make profits from these monopoly activities. - The share of profits that CB remits to the Treasury is called seigniorage. For ex., a CB creates accounts for commercial banks (where banks deposit their reserves). - If the CB pays interest on these accounts at a lower rate than it receives on the assets it acquires, the CB makes a profit. - Seigniorage was high in the 2010s, when interests on commercial bank reserves was close to zero. - In 2014, the FED remitted $96.9 bln to the US government (equivalent to about 1/3 of federal corporate income tax and 6.4% of total tax receipts) However, governments that rely on seigniorage as a regular and systematic source of revenue (e.g. by forcing CBs to buy government bonds) sooner or later end up with hyperinflation (monthly inflation above 50%). Market regulation Standard public sectors stats overlook the economy role of the government. Government regulation affects market economies without generating measurable expenditure or revenue. OECD Product Market Regulation (PMR) (de jure indicator) - barriers to firm entry and competition (e.g., licences, regulatory protection of incumbents) - distortions induced by State intervention (e.g., price regulation - Higher levels of PMR imply weaker competition (hence, higher profit rates, higher prices, lower entry rates). - Until the 2000s, the US had lower PMR than the EU. - But, over the last 20 years, PMR declined in the EU, while remaining stable in the US. Regulatory policies matter: since the establishment of the European single market in 1922 EU markets have become more competitive than US markets. - “Until the 1990’s, US markets were more competitive than European markets. Today, European markets have lower concentration, lower excess profits, and lower regulatory barriers to entry.” - According to Gutierrez and Philippon (2023, JEEA), there is a two-fold explanation for these facts: 1. EU countries agreed to set up an anti-trust regulator that is tougher and more independent than their old national regulators (and the US regulator); 2. US companies spend more on lobbying US politicians and regulators than EU companies. Net wealth inequality of households in Italy (financial and non-financial asset distribution net of debt) -Median wealth Mean MRS of all voters Under provision if: Median voter’s MRS< Mean MRS of all voters Hence, majority voting can lead both to under provision and to over provision of the public good. Unanimity voting and personalised prices/taxes: Lindahl equilibrium Majority voting leads to inefficiency in providing G because all voters consume the same quantity AND pay the same price/tax, but have different preferences. Efficiency is achieved, if voters wish to purchase the same given quantity of G. With different preferences, voters wish to purchase the same quantity of G if and only if they face different prices/taxes: - voters with a low marginal willingness to pay for an extra unit of the public good should face low prices/taxes; - voters with a high marginal willingness to pay should face high prices/taxes. Wicksell (1896): unanimity voting on G plus personalised prices /taxes reflecting the individual marginal willingness to pay leads to efficient public good provision. A method to implement Wicksell’s principle is given by Lindahl’s equilibrium. This can be shown in a stylised model. Lindahl (1919) model: unanimity voting with personalised prices-taxes leads to efficient provision of a pure public good A community with two voters h=1, 2, must choose i) whether to provide a pure public good (eg. Lamp posts) and at which level; ii) how to share the costs. Assumptions 1) Direct democracy: voters vote directly on policies. 2) Each policy specifies: i) quantity of G to be provided ii) share of the cost of producing each unit of the good paid by each voter t h (personalised price/tax) 3) The government produces G under competitive conditions: the price of one unit of G is equal to the constant Marginal Cost of producing it, with MC=1. 4) Policies are self-financing. The sum of taxes covers MC: t1+ t 2 =1. 5) Each t h reflects the private individual benefit from consuming G (i.e. the individual marginal willingness to pay for one extra unit of the public good). 6) Voters reveal their preferences sincerely: G h demand of h=1, 2 for G. 7) Individual demands G h are decreasing in the personalised price-ta x t h: the higher the personalised tax, the smaller the demand for lamp posts. U1C yields higher utility than U1B U1B yields higher utility than U1A U2C yields higher utility than U2B U2B yields higher utility than U2A This is because the same level of public good consumption can be achieved by paying a lower personalised price-tax. Each individual indifference curve Is backward bending, as long as below the tax corrisponding to the turning point, each voter is willing to pay a higher share for more public good, and the other way round above it. Note t* can be any number between 0 and 1 (both excluded), it is NOT necessarily ½. Lindahl equilibrium: crossing point of the two voters’ demand for G. Public good provision: G*, t1=t*, t2=1-t -Lindahl equilibrium prices are t 1=t* and t2=1-t*. At these preannounced individual prices-taxes, there is unanimity agreement on G*. - G* is a Pareto efficient level (ie Samuelson’s rule holds). Intuition: each voter pays a share of the marginal cost of G. This lowers the perceived private marginal cost. Hence, each voter increases her demand relatively to the case of private provision (when they face a common price). These shares t* and 1-t* are equal to the individual marginal willingness to pay for one additional unit of G. Hence G* is optimal for both voters. At a Lindahl equilibrium there is Pareto efficient provision of the public good Proof. Assume that the private good x and the public good G are produced under competitive conditions; the price of each good is equal to 1, thus: MRTG,x=1. Voter h’s demand for the public good yields by maximising U h(x h, G) s.t. M h=x h+t hG. Thus, it satisfies MRS h G, x = t h , h=1,2. In Lindahl equilibrium: t1=t*, t 2=1-t * It follows that MRS1G, x + MRS 2 G, x = t*+1-t* =1 =MRTG,x Namely, Samuelson’s condition for Pareto efficient public good provision holds in Lindahl equilibrium. How do we get to the Lindahl equilibrium if we start away from it? A tatonnement process (also in Appendix) Start with the government announcing to voters a pair of individual prices-taxes t h , such that t1+ t 2 =1. Having heard the announcement, each voter states how much of the public good G h (ie. the number of lampposts) she wishes to have supplied at the pre-announced t h. If both voters wish the same level, there is unanimity: the government provides the chosen G1=G 2= G and each voter pays a tax t h for each unit of the public good. If there is no unanimity agreement on G, the share are adjusted and the process is repeated. The government announces now a different pair of taxes: increasing the tax for the voter asking a higher level, and reducing the tax for the voter asking a lower level in the previous voting round. Then, voters declare their preferred quantity: if there is unanimity agreement on G at the new preannounced individual prices- taxes, the Lindahl equilibrium is achieved. Otherwise, the process is repeated until the Lindahl equilibrium is reached. A Lindahl equilibrium may not exist if preferences for G are largely heterogeneous Problems with implementing a Lindhal equilibrium Even if a Lindahl (i.e. voluntary exchange) equilibrium does exist, it might not be achieved in practice. Two possible reasons: 1) Transaction costs associated with unanimity voting in large communities. 2) Strategic behaviour in small communities: each individual gains by false announcement on her true marginal willingness to pay for the public good (i.e. by declaring a lower demand), as long as her personalised price-tax increases if she declares a higher demand for the public good. Consider the example in the next diagram. Voter 2 falsely claims a lower demand (the dotted line). At point e M voter 2 can maximise her true utility, given the demand for the public good by 1 (see the tangency point between voter 2’s highest indifference curve and voter 1’s demand) Conclusions Majority voting does not lead (but in a very special case) to a Pareto efficient level of public good provision. Unanimity voting leads to a Pareto efficient level of public good provision if there exists Lindahl prices, namely personalised prices taxes reflecting each voter’s marginal willingness to pay. But there are many difficulties in implementing the Lindahl equilibrium: e.g. 1) transaction costs in large communities. 2) incentives to manipulate the mechanism by underestimating one own’s true public good demand in small communities. Lecture 13 Externalities: definitions Externalities and market failures - externalities in consumption - externalities in production Externalities occur whatever the action of one economic agent (ie consumer, firm) has a direct effect on the welfare (ie utility or profits) of another agent in the economy, without affecting market prices and incomes. Externalities are an example of market failure: - In market economy economic agents make decisions based on prices. But as long as market prices do not reflect the economic effects of externalities, unregulated competitive markets will determine a level of economic activity (consumption, production) that is usually distorted relative to the Pareto efficient level. In unregulated markets, relative to the Pareto efficient level: - activities generating negative externalities are “too large”; - activities generating positive externalities are “too small”. In the presence of externalities, competition does not lead to the optimal allocation of resources. Externalities open up the possibility of corrective action by government, through taxation or regulation, on purely efficiency grounds. «Pecuniary externalities» do not create inefficiencies Externalities should be distinguished from «pecuniary externalities». «Pecuniary externalities» occur when the effects of the action of one economic agent on the welfare of other agents lead to changes in market prices or incomes. Pecuniary externalities generate no inefficiency. Therefore, unregulated competitive markets will achieve efficient outcomes in this case. Only (non-pecuniary) externalities justify government intervention. Example of pecuniary extenality: a large high-tech IT multinational firm- MNE establishes a new activity in Milan. This affects the labour market for IT engineers in Lombardy. Short-run effect: competition for skilled IT engineers bids up wages: engineers living in Lombardy are better off, incumbent IT firms in Milan are worse off. Employee benefits equal to employer costs. Medium-run effect: highly qualified IT engineers from all over the world move to Milan to work for the MNE; competition for jobs in the Lombardy engineering labour market bids down wages: engineers already living in Lombardy are worse off, incumbent IT firms in Milan are better off. Employer’ benefits equal employee costs. In both cases, the net welfare effect is zero. No inefficiency of unregulated markets. Unregulated competitive markets do not usually achieve Pareto efficient outcomes in the presence of externalities: the case of consumption externalities Model (from HM: 225-228) Demand side: two households h=1, 2, consuming two private (i.e. rival and excludable) goods: i= x, z. The consumption of z may provoke consumption externalities. The consumption externality is positive if ∂vh/∂zk>0 , where h≠k: an increase in the consumption of z by consumer k increases the utility of h. Eg: good z is the number of face masks consumed during the Covid-19 pandemic. The consumption externality is negative if ∂vh/∂zk, where h≠k: an increase in the consumption of z by consumer k reduces the utility of h. Eg: good z is the number of cigarettes smoked while waiting at the bus stop (assuming that people like active smoking, but don’t like passive smoking). Supply side: Consumers have an endowment of time equal to ωh. Time can be consumed as leisure x (so, x is a non-produced good) or supplied as labour. A competitive industry uses labour as its only input to produce good z under constant returns. The wage rate is set equal to 1: the producer price of z is equal to 1. From the previous assumptions, the budget constraint of consumer h in terms of her «full income» is: This means that the market value of consumer h’s time endowment (her «full income») can be spent on leisure x and consumption good z. The competitive equilibrium is described by three equations: i) The demand for good z by consumer h=1,2 ii) the budget constraint of consumer h=1, 2; iii) Walras’ law: (x1+z1- ω1)+(x2+z2- ω2)=0. (“The sum of the values of excess demands is identically zero at any prices”. This means that the sum of the household’s budget constraints is equal to zero. Therefore, if the market for good z clears, the market for good x will also clear.) Note: Although the external effect does not appear directly in the FOC, its existence leads to the inefficiency of the unregulated competitive market equilibrium, as shown below. The pareto efficient allocation is found by maximising the sum of the utilities of the two households 1 and 2, with respect to xh and zh, h=1,2, subject to the resource constraint. Substituting the consumer budget constraints into W to eliminate xh, the problem becomes one of choosing z1 and z2 to maximize: This effect is ignored by the market outcome: the market solution cannot be Pareto efficient. Consumption externalities: insights The level of consumption is unregulated markets is Pareto inefficient in the presence of externalities: there is a market failure. If externality is negative, too much of the good z is consumed in competitive equilibrium, as long as SMBPMB. If the externality is positive, too little of the good z is consumed. In competitive eqm, as long as SMB>PMB. Production externalities Production externalities often imply a divergence between SMC (Social Marginal Costs) and PMC (Private Marginal Costs). For negative production externalities this divergence is called Marginal Damage= SMCPMC>0. With a negative externality, «too much» output is produced in an unregulated market. E.g., pollution. (With a positive externality, e.g., basic research from a private university benefitting a private firm, «too little» output is produced in an unregulated market). Negative production externalities with a single polluter and a single polluttee A standard example of a negative production externality is pollution generated as a by-product of a firm’s economic activity. In this case, the externality determines a divergence between SMC and PMC, with SMC>PMC Consider a typical competitive profit maximising textile firm A producing fabrics. Fabrics are sold to the fashion industry at a fixed unit price MB=p. The firm A is located on a river’s banks. When producing fabrics, firm A throws dirty water into the river. Water pollution damages firm B, a profit maximising fishery operating downstream. Assume marginal damage MD for the fishery rises with the textile firm output. Cumulative effect of pollution → the first unit have a high marginal cost, and the last one the same. As long as the textile firm A does not consider the externality (damage) it imposes on the fishery firm B, fabrics production will be inefficiently high. This is a market failure. Findings R1. Qc>Q* A’s maximises its profits at Qc. This level of Q is inefficiently high: A’s does not consider the damage provoked on B. R2 B’s privately optimal level of A’s output Q is zero: B’s damage is zero when Q=0 R3. The socially optimal level of Q is Q*0 destroys the natural resource, i.e. dead river?) R4 At the socially optimal level of output Q*, there is a positive level of pollution: zero pollution is not socially desirable. R4 is found because MD rises linearly with output (what would happen if pollution from Q>0 destroys the natural resource, i.e. dead river?) Negative production externalities with a single polluter and a single pollutee: an example A numerical example (using the numbers of the self-evaluation test n.5, Q3). Assume that firm A faces the following MB and PMC curves MB=2 PMC=1+Q Assume that firm B faces the following MD curve MD=Q/2 i) Find A’s profit maximising level of output: MB=PMC → Qc=1. ii) Find B’s marginal damage at A’s profit maximising level of output MD=Qc/2=1/4. iii) Find the socially optimal level of Q. MB=SMC, but SMC=PMC+MD 2=1+Q+Q/2 1=3Q/2 Q*=2/3 If there are externalities in production, there is a market failure. With a negative externality, inefficiency takes the form of overproduction. This can be measured in welfare terms as deadweight loss». How to eliminate the deadweight loss? In the example, one problem is that A and B use the river as an input in production, but this is free. One way to reduce deadweight loss is to set a user price for the river. Several solutions are possible: for example, government intervention (e.g. through taxes set as the price of pollution) or market solutions (e.g. where the government gives B ownership of the river and make A pay for the right to pollute it). These and other solutions will be considered in lectures 15-16. Conclusion: Externalities occur when the action of one agent (firm, consumer) directly affects the welfare of another agent, without any change in market prices or incomes. In the presence of consumption externalities, the competitive equilibrium is Pareto inefficient, with either overconsumption (for negative externalities) or underconsumption (for positive externalities). In the presence of production externalities, the competitive equilibrium is Pareto inefficient, with either overproduction (for negative externalities) or underproduction (for positive externalities). There is a market failure. Deadweight loss is a welfare measure of inefficiency. Lecture 14 – Market failures: externalities, market solutions. - Solving externality-driven market failures - Market solutions o Internalising the externalities o Civic mindedness o Coase’s property-right approach Market solutions to the externalities: internalisation by merger - Although externalities cause market failure, market-based solutions can help to eliminate the inefficiency. - Internalisation is a market-based method of controlling an externality, Internalisation by merger requires the parties concerned to form a single entity. - Using the example from Lecture 13, if firm A’s activity pollutes the enviroment and causes a loss of profit for firm B, merging means forming a single multi-product firm. - The merged firm maximises the sum of the profits of A and B. - Thus, when choosing the level of output for A, the merged firm takes into account the pollution externality on B. In this way, private and social costs become equal. - Merger internalisation also works for consumption externalities. o Eg two flatmates (one of whom smokes) form a single household. When deciding whether to light a cigarette, each member of the household will consider the utility of the other member. - Problems: i) Merging can lead to monopoly positions: we need to trade off the two distortions (externality and monopoly). ii) One of the parties involved may not want to be merged into a single unit. Market solutions to externalities: rules of civic coexistence - Corporate social responsibility towards the enviroment may induce firms to self-regulate themselves by considering the externalities they provoke. o If a firm is responsible for the environment. When maximising its profits, it considers as a cost factor the environmental damage it may cause. o This should lead to lower production or to the adoption of cleaner technologies («environmentally friendly» production, recycling). - Cultural change and social norms: activities that generate positive externalities or reduce negative externalities can become «social norms». (ex. Not using plastic bottles) o People may come to understand that they can save lives, by slowing down the spread of viruses during a pandemic, by wearing masks indoors, washing their hands more frequently, taking vaccines. Wearing masks, washing hands more frequently, taking a vaccine may therefore become a «social norm». o Economic incentives (eg. subsidising masks, paying people to wear masks) can crowd out social norms (if you expect money to behave, you will not behave without a reward). o When caring for the environment becomes a social norm, consumers change their consumption patterns (e.g., using stainless steel water bottles instead of plastic ones, buying locally produced or organic food, using paper bags …). Market solutions: Coase’s (1960) property-right approach Governments can «delegate» to markets the solution of the externality problem. Idea: inefficiency depends on the lack of private ownership on the use of «free» resources. Problem is solved if property rights are clearly defined. Property rights allow to create a market for the externality. If the government assigns property rights on the free resource, markets will automatically reach an inefficient solution. The Coase «theorem»: «In a competitive economy with complete information and zero transaction costs (negotiations among the parties are costless), the allocation of resources will be efficient and invariant with respect to legal rules of entitlement (i.e., property rights of resources)”. Coase’s theorem is a “benchmark”. Ex. If the river would be of someone (property right of the river to a third party) you will resolve the problem. (Medema (December 2020, Journal of Economic Literature): It shows the conditions under which voluntary bargaining through markets can achieve efficiency. The Coase “theorem” Property rights determine: i) the ownership of assets/resources; ii) who is legally entitled to receive compensation payments if the right is violated. Coase’s theorem: if property rights are clearly defined, agents affected by an externality will enter into private agreements (through bargaining) with those who cause it. If there are no income effects, the outcome is invariant to the party (eg. the polluter or pollutee) to whom the rights are assigned. Compensations are “personalised prices” paid to the property right holder as the “price of the externality”. i) either the “price of pollution” (when the owner is the pollutee) ii) or the “price for not being polluted” (when the owner is the polluter). Ex. Market of the resource → The use of the river has got a price. Gov has to decide who own the river. An upstream textile firm A pollutes a river as a result of its production activities. The pollution damages a downstream firm B, which catches fish in the river. Assume that utility is transferable (i.e. utility is measured in euro and can be transferred from one firm to the other via compensation payments). Suppose the government assigns property rights over the river either to 1) the polluter: so textile firm A has a «right to pollute»; firm B must pay A to avoid being polluted. 2) the pollute: therefore, firm B has a «right not to be polluted» ad A must pay B to pollute. Using graphical analysis (as in Lecture 13), we can show that in both cases Coasean bargaining (voluntary negotiations) leads to a Pareto efficient outcome. Case 1: the polluter (here the textile firm) has the property right on the river Textile production by firm A pollutes the river, damaging the fishery firm B. Textile firm A has the property right over the river. Chooses Q to maximise profits. If MB=p and PMC=1+Q, profit maximisation occurs at p=1+Q, with output Q1. Let MD=Q/2 marginal damage (cost) of textile production for the fishery. Social Marginal Cost at each level of output is equal to Private Marginal Cost plus Marginal Damage: SMC=PMC+MD=(1+Q)+Q/2. -Market eqm: MB=PMC : Q1 Pareto efficiency: MB=SMC : Q* < Q* Form B asks firm to reduce output by 1 unit from Q* to Q2. The profit loos for 1 is the area between MB and PMC (gg’g’’). The reduction in total damage for B is the area below the MD curve between Q2 and Q1. (Q2Q1ff’). Profit loss is more and for the firm, the fishery will pay the firm of the small triangle and it still benefit. MD > MB-PMC ➔ this negotiation proceeds up to the point where MD =MB – PMC. ➔ Socially optimal level. Compensation from the fishery to the textile will proceed up to the point where the fishery is indifferent between paying the compensation or suffering the damage. This occurs at the level of Q whereby MD=MB- PMC. And the problem is solved. ➔ MB = PMC-MD → level of output Q*. Case 2: the pollute has the property right on the river, Coasean bargaining. The fishery firm B has the property right to the river. The fishery initially forbids the textile firm to pollute the river. This implies Q=0 so that MD=0. If the textile firm A is allowed to increase its production by one unit, from 0 to Q3 say (diagram to be drawn in class), the effects are as follows: the textile firm A’s gains are equal to the area between MB and PMC for the level of production between 0 and 1: the increase in profits is big. The fishery firm B makes a loss equal to the area below the MD curve for the level of production between 0 and Q3: this loss is small. The textile firm A pays a compensation to the fishery firm B equal to the increase in the total damage caused to fishing by the increase in textile production. Firm A increases its profits, while firm B remains indifferent with respect to the status quo. This process ends when, on the last unit of output produced, firm A experiences an increase in profits equal to the difference between MB and PMC at that output level, which is just enough to compensate firm B for its welfare loss due the marginal damage MD at that output level, namely the compensation process stops at Q* where MB-PMC=MD. Namely, the process stops when MB=P004DC+MD holds, and the efficient output level Q* is produced. The fishery initially bans production of textile from A. Firm A asks permission to B to produce Q1. For B the damage is the small triangle. For A the increase in profits is the area above. MB-PMC>MD The process proceeds up to the point to the profit where: MB-PMC >MD Recap: Coase’s theorem The inefficiency associated with externalities (e.g. a textile firm polluting a river and damaging a fishery) depends on the absence of property rights over the resources subject to the externality (here the river). If property rights (to the river) are assigned by the government to either the polluter (here the textile firm) or the polluttee (here the fishery), negotiation between the parties will lead to the socially optimal level of production. If the owner is the polluter (i.e. the textile firm), the polluter will receive compensation from the pollutee (i.e. the fishery) for not polluting. If the owner is the pollutee (i.e. the fishery), the pollutee will receive compensation from the polluter for allowing pollution. The socially optimal Pareto outcome Q* will be the one obtained regardless of which side has property rights. Policy implication and limits of Coase’s theorem Policy implications: the government should assign property rights on the «free» good, allowing the private sector to «set up a market» for the externality, and then let the market reach the socially optimal solution via negotiation. Coase’s theory. works in practice iff i) There are low transaction costs: - low costs for setting up the market and for negotiation: time and effort to set up the negotiation, information costs… - Problem: transaction costs rise the higher the number of interested parties; ii) the more difficult excludability (when reducing externalities is a public good). ii) It is easy to detect the polluter and the pollute: -hence, who owns the property rights can identify the damage and prevent it legally. -Property rights must be assigned easily: problematic with large-scale externalities (eg air pollution). iii) There is complete information on damages and benefits, compensations need to be computed correctly. iv) Markets are competitive -the externality is the only market failure) On the contrary, Coase’s market mechanism does not work. Coase’s contribution to the analysis of social cost problems (Coase’s definition of externalities) Medema (2020, JEcLit): Coase’s contribution to the analysis of social cost problems (i.e., the divergence between private and social costs/benefits or externality) was three-fold. 1) Externalities are reciprocal in nature. a. if A’s smoking harms B, B could mitigate it by moving away. In a sense, B is as much as A the «cause» of the harm. b. If A harms B by smoking, restraining A’s smoking in favour of B is imposing harm on A. 2) Voluntary exchange/markets achieve efficiency if property rights can be assigned (no matter the side of the exchange) and if pricing system is costless (no transaction costs). 3) In the real world of positive transaction costs, both markets and government intervention are unlikely to achieve first-best efficient outcomes. A case-by-case approach is needed to deal with externalities (depending on institutions), and the best option may be doing nothing. Conclusion: Coase’s theorem suggests that the source of the externality problem is the lack of private ownership on a free resource. If government assigns private ownership to the use of the free resource, there is a market for the externality and the unregulated economy can achieve Pareto efficiency in principle. The Coasian approach may not work universally. Lecture 15 Market failures II: Externalities The tragedy of the commons Externalities: recap Externalities occur whenever the action of some economic agent (ie consumer, firm) has a direct effect on welfare (ie utility or profits) of another agent in the economy, without any effect on market prices and incomes. Externalities are an example of market failures. In unregulated markets, relatively to the Pareto efficient level: activities generating negative externalities are “too large” activities generating positive externalities are “too small”. With externalities, competition does not lead to optimal resource allocation. Externalities open up the possibility of government corrective action, through taxation or regulation, on purely efficiency grounds. The tragedy of the commons The tragedy of the commons: an example of negative externality. Solutions: Is it really a tragedy? Can communities voluntarily regulate themselves to avoid the externality? Commons: goods that are rival, but not excludable (or difficult to exclude). Commons are typically natural resources: - a lake/sea/ocean used for fishing (e.g. the Mediterranean); - a forest used for timber wood (e.g. the Amazon forest); - a pasture open to all shepherds. The history of the tragedy of the commons Garrett Hardin (1968). «Tragedy of the commons», Science. Tragedy: users are likely to overuse the natural resource, leading to its premature depletion in the absence of government regulation or privatization. This view was challenged by Elinor Ostrom (2009 Nobel Prize in Economics), who showed that communities can selfregulate by cooperating to avoid depleting the commons (e.g. by creating reserves). See Frischmann et al. (2019). «Tragedy of the commons after 50 years», Journal of Economic Perspectives for an history-of- economic-thought account. An example: overfishing According to FAO, the United Nation’s authority on fisheries, 34.2% of fisheries are overfished. Overfishing has increased over time. A model Tragedy of the commons: excessive use of a common resource that is rival, but nonexcludable for users. - Overuse is likely to lead to the common resource being completely destroyed in the long run («the tragedy»). - Overuse results from the divergence between private and social incentives, signalling the presence of an externality. Consider a lake used by fishermen from a village located on its banks. The fishermen rent boats at a daily cost c>0. The number of boats hired each day is B. The number of fish F caught by each boat is F(B). Because fish is a rival good, one has F’(B) ≡ ∂F/∂B: the higher the number of boats rented each day, the lower the fish catch for each boat. The price of fish is normalised to one: p=1. Hence, F(B) is both daily total revenue and fish catch per boat. Fishing is a competitive activity with no entry barriers. In equilibrium with free entry and exit in fishing, the profit that the marginal fisherman makes is equal to the opportunity cost of fishing. The opportunity cost of fishing is assumed as the foregone daily wage w from an alternative job in the village. The market equilibrium number of boats, B*, under free entry and exit is given by the following arbitrage condition: Π ≡ F(B*)-c= w, The arbitrage condition describe the condition making the marginal villager indifferent between becoming a fisherman, earning F(B*)-c, or working at the alternative wage w. - namely B* satisfies: F(B*)-c-w=0 How does the competitive solution B* compare with the social optimum? The socially optimal number of boats, Bo, is the one that maximises the total profit for the village, net of the social opportunity cost of fishing. This is found by solving: Choose B to max B[F(B)-c-w] The FOC is: [F(Bo)-c-w]+BO F’(BO)=0. As long as BO F’(BO)0. This leads to the market operating at BOPMC firm prefers paying the abatement cost; c. for PMC>t* firm prefers paying the tax and polluting. Govt Revenue= t*e* 2) Licences (permits to pollute): gvt fixes optimal level of pollution at max e-z*, thus imposing a level of abatement z* (same result with output quota) Carbon taxes or emission licenses? The case of uncertainty on PMC curves Ex ante uncertainty on PMC of abatement (e.g. PMC depends on the wheater). Optimal govt policies are set ex ante, based on the expected PMC curve. For simplicity, only 2 possible ex post (i.e. realised or observed) PMC curves: High and Low, with same probability of occurence (say). The expected PMC curve (i.e. the ex ante PMC curve) is the mean of the two ex post PMC curves.: PC mean. The ex ante optimal policy of government solves SMB=PMC mean. Optimal ex ante tax t* and quota z*. Should the government set taxes or quotas ex ante? If PCM high is observed: i) ex ante optimal quota causes too much abatement : z*> z*H. ii) ex ante optimal tax causes too little abatement: zTAX H< z*H. In this case, the government should choose the ex ante optimal policy that minimises the ex post welfare loss. If PCM low is observed: i) ex ante optimal quota causes too little abatement : z*< z*L. ii) ex ante optimal tax leads to too much abatement zTAX L> z*L In this case too, the government should choose the ex ante optimal policy that minimises the ex post welfare loss. Govt choices depend on the slope of SMB, given PMC mean, at z*. Carbon taxes or emission licences? SMB curve «flat». Tax preferred Area A: welfare loss if set Ex ante optimal quota Area B: welfare loss if set Ex ante Pigouvian tax Choosing the tax to control the externality minimises welfare losses. Assume PMCH is observed: optimal ex post abatement is zH*. The quota/licence policy delivers the mandated abatement level z*: this implies a welfare loss given by the area of triangle A. Under ex ante optimal Pigouvian tax t*, the firm sets PMCH=t* yielding abatement level zTAX H: this implies a welfare loss equal to the area of triangle B. The ex-post welfare loss is minimised with the tax, i.e. the area of triangle B is smaller than the area of triangle A. Carbon taxes or emission licenses? SMB curve is steep. Licence preferred Area A: welfare loss if set ex ante optimal quota Area B: welfare loss if set ex ante Pigouvian tax Choosing licence (output quota) to control the externality minimises welfare losses. Assume PMCH is observed. Ex post optimal z is zH * Emission licence leads to z* Carbon tax leads to zTAX H Emission licence is to be preferred: welfare losses from quotas, given by the area of triangle A are lower than for the tax, whose losses are given by the area of triangle B. Similar analysis can be made for the case ex-post PMC low. TRY Weitzman’s second best rule for choosing tax prices vs. quotas. How to implement Weitzman’s rule in practice? R Cooter - Prices and sanctions Colum. L. Rev., 1984 «Pollution taxes should be used when authorities know the external cost of pollution, but not the optimal quantity of pollution. Quantitative restrictions should be used when authorities know the optimal quantity of pollution, but do not know the tax price which would achieve it; this would be the case when pollution reaches an emergency level». This rule favours quantity regulation “under urgency”. Conclusion Government quantity-based regulation of externalities can take the form of mandates, lockdowns, quotas. With certainty, quantity-based regulation and price-based one (Pigouvian taxes) have the same effect on equilibrium. With uncertainty, quantity-based regulation (eg emission licences) is preferred to price-based regulation (e.g. carbon taxes) if the SMB=MD curve is «steeper» than the SMC curve, as this minimises the welfare ex post welfare loss. Lecture 18 Market failures (II): Public economics of climate change Climate change as the biggest market failure ever seen (short sketch) Scientific consensus on climate change: earth is warming due to human activities Scientific “consensus” “based on well-established evidence, about 97% of climate scientists have oncluded that human caused change is happening.” Scientific evidenced-based consensus: i) Earth’s climate is warming ii) Global warming is earth’s response to increasing concentrations of greenhouse gases (GHGs, maingly CO2) and particulate matter in the atmosphere, largely as the results of human activity. iii) If global temperature increases by 2 centigrade above pre-industrial levels, catastrophic events may occur (extreme weather, loss of biodiversity, loss of lives…) Economic effect of climate change. Many uncertainties on how the economy affects climate change and vice versa. Urgency of action To stop global warming, 1) We need to stabilize temperature increases (temperature target) 2) To stabilize concentration (stock) of GHGs in the atmosphere, hence control of GhG flows(CO2 target) The Paris Agreement at COP21 in December 2015 has established the target of holding temperature increases «well below 2 grades C» with best efforts to 1.5 grades C (see also Sustainable DevelopmentGoals). To achieve this temperature target world emissions must start turning down and continue to drop sharply from the current level of about 60 billions tons of CO2 a year down to net zero emissions by2050. This urgency explains many current policy decisions taken to achieve the CO2 target, such as the ban on internal combustion engines by 2035 in the EU (a command-and—control regulatorypolicy). Climate change is “themost critical threat that the world economyhas ever faced» (HM: 895). Public economists interpret human generated GHG emissions as externalities. → biggest market failure! GHGs externalities differ from the standard ones (lecture 13), as they are large and have global, long-term and potentially irreversible effects (if leading to climate change). Fighting climate change is interpreted as a Global Public Good. National governments have large incentives not to contribute to its provisions (to free ride): i) Unilateral government policy (but by the US and China; to a lesser extent India and the EU) has negligible effects on the GHG stock; ii) No country gets but a fraction of the impacts and benefit of their policies; the majority of benefits (75%) are spillovers. To fight climate change we need international cooperation: a coordinated action of national governments to cut emissions simultaneously (I will if you will strategy) Fighting climate change is a Global Public Good (see lecture6). This means that all countries share the benefits of reducing the GHG stock (non rivalry) and that no country can be excluded from them (non excludability). Hence, each national government has an incentive to free-ride on the others, which leads to an inefficiently low provision of the global public good. Fighting climate change may be interpreted as a Prisoner’sDilemma: it is individually rational for each country not to take unilateral action to lower GHGs: gains are negligible, whereas losses may be large (e.g., introducing a local carbon tax on firms may give incentives to firm relocation in other countries, with job losses); it is socially rational that all countries take action collectively and simultaneously (e.g., by introducing a carbon tax in every country, which does not give any firm relocation incentives); however, it is always individually rational to renege ex-post from the agreement. The PD features of the fight against climate change help to explain why: 1) we observe legally binding international treaties to enforce cooperation: -Kyoto Protocol, 2005: reduce GHGs emissions by 5.2% from 1990 level, see HM: 935; -Paris Agreement, 2016: limit temperature rise this century well below 2 grade Celsius above average pre-industrial levels [year 1750], -EU “Green new deal” wants set by law a bloc-wide goal of net-zero GHGs by2050. 2) some countries may find it optimal not to ratify these treaties, deviating from the cooperative agreement, and “playing Nash” (e.g. the USA in2005) which economic tools to reduce the GHGs externality? All economists agree on the use of carbon pricing policy. This can take the form of: i) carbon taxes per ton of C02 emitted (hence emissions are determined by the market); ii) cap-and-trade programs (ETS in the EU: fix number of CO2 emission permits; sell them via auctions, hence prices are determined by markets). How to “get the carbon tax right”? In the absence of other market failures, set a Pigouvian tax, paid by polluters, equal to the marginal social cost of carbon/ SCC (= the marginal damage of the externality). In this case, SCC is today’s money cost to society (and the planet) of the damage (including discounted future damage) provoked by one extra ton of CO2 into the atmosphere. SCC measures how much society is willing to pay today to improve the environment by reducing emissions by one ton of CO2. Estimates of SCC vary widely: for the USA, Nordhaus sets it at $50 per CO2 ton; Stern and Stiglitzat $100 perCO2 ton. SCC set by different US administrations: $43 under Obama, $3-5 under Trump, $51 under Biden (Italy has no carbon tax). Carbon taxes/pricing are very useful: but are they enough? NO: «Second best view»(climate change is not the only market failure). Stern, Stiglitz, Taylor (2022, see Appendix) Need multiple tools. 1. Need to act urgently: feasible carbon taxes/prices are “are unlikely to deliver the change required on the necessary time scale”. 2. Production activities and the design of cities respond weakly or slowly to feasible marginal carbon price changes. Need public spending on clean infrastructure to accelerate the green transition process. 3. Fossil-fuel related pollution kills already millions of people in the world (about 9 mill in 2015). Regulations a more effective policy (e.g., antismog bans in Lombardy from 20 to 22/2/24). 4. The cost of new clean technologies (solar, wind, batteries, energy storage) has fallen: -80% since 2010 for solar, -60% since 2015 for wind. Regulations and standards can spur further innovation and induce producers to accelerate technological transition. Blanchard, Gollier, Tirole(2023): need a portfolio of economic policies. i) Carbon pricing. ii) Public subsidies favouring R&D in green technology innovation. iii) Standards, bans, and targeted subsidies, but carefully implemented. iv) Domestic and international compensation for losers (eg workers) is key to the acceptability of efficient policies. v) International inspiriting: e.g., the EU “may have a minor direct impact on climate mitigation, but can have a substantial indirect impact: leading by example and showing that things can be done, putting pressure on free-riding countries through border tax adjustments, promoting technological and policy innovation that can be used by poor countries, and playing an intellectual leadership role in the building of international agreements”. Conclusions Human-generated GHGs emission are externalities. Climate change resulting from GHGs emissions can be interpreted as a market failure. Dealing with GHGs requires urgent government action under uncertainty at the international level Fighting climate change is a global public good Governments should use a portfolio of economic policies (including carbon pricing, subsidies to R&D in green innovation, standard and bans) to mitigate climate change Lecture 19 Market failures III: Imperfect competition and the social cost of monopoly - Monopoly o Monopoly equilibrium o Social cost of monopoly o Monopoly regulation (sketch): price caps Imperfect competition (IC) IC arises when an economic agent is able to influence market prices. This requires that the agent is large relative to the size of the market in which it operates. IC may occur: i) in the inputs market (e.g., in the labour market) or in the goods market; ii) on the seller’s side (monopoly power) or on the buyer’s side (monopsony power: see lecture 21). IC violates the assumption of «price taking» behaviour by firms and consumers on which the Two Fundamental Theorems of Welfare Economics rely upon. IC (usually) provokes a market failure (exception: fully discriminating monopoly). With IC unregulated markets lead to a Pareto inefficient allocation of resources. IC opens up the possibility of efficiency-enhancing government intervention relative to the unregulated market outcome. We analyze: - monopoly; - quantity-setting (Cournot) oligopoly. Common theme: imperfectly competitive firms set prices as a mark-up over marginal costs. Monopoly Monopoly: a single firm produces and sells a good that has no (close) substitutes. The firm can influence prices and exclude competition. Source of monopoly power? i) barriers to entry: due to legal barries (operating licences, patent protection, state concessions;  technology features (scale and scope economies). ii) barriers to exit: nonrecoverable sunk costs (e.g., rail tracks) if the firm exits the market. This makes the market noncontestable for potential competitors («no free entry and exit»). iii) exploitation of unregulated markets to establish a monopoly position, preventing others from entering that market, or undercutting rivals to boot them out of the market («Smithian» view) Examples of monopolies: -US multinational Gilead was granted Italian patent in 2014 for a lifesaving new medicine for hepatitis C (sofosbuvir; a therapy cycle through the Italian NHS cost €40,000). The price was bargained with the Ministry of Health. Gilead was not granted a patent for the same medicine in India. -Ferrovie dello Stato Italiane (FSI): legal monopoly for passenger railway service not occurring on high-speed trains. -Amazon’s «platform monopoly/privilege» for private-label products, -Meta (Facebook) and Google dominance in digital advertising. (Non-discriminatory/ND) monopoly Monopoly perceives a downward- sloping market demand curve for the good it produces and sells (a competitive firm perceives a perfectly elastic product demand); Monopoly chooses a unique point on its demand curve (selecting either the price or the quantity/sales) such that marginal revenue MR equals marginal cost MC (i.e., a monopolist has NO supply curve, but a supply rule: MR=MC); ND monopoly sets a unique price: no price discrimination across consumers; 5 ND monopoly market equilibrium is Pareto inefficient: i. the equilibrium price exceeds marginal cost, p>MC; ii. production and sales fall short of their competitive market level → this generates an efficiency loss: Deadweight Loss (DWL). See Appendix for perfect (i.e. first- degree) price discrimination by the monopolist leading to a Pareto efficient outcome. Monopoly’s profit maximising choice Monopoly’s profit maximising choice Oligopoly markups: Cournot competition with homogeneous product Markups in practice: EU vs. US (note: higher markups, less competition) Between 1978-2015, in the EU the average markup for the economy has remained stable at around 12% (i.e. prices are on average 12% above MC), with a downward trend since the Single Market in 1993 and the EMU in 1999, especially in manufacturing. In the US, on the contrary, the mark up has trended upwards. Monopoly: linear demand When the demand curve is linear, the price elasticity of demand changes along the curve. «Rule of thumb» to compute the elasticity: for a given price, if there is more line below the price than above the price, the demand curve is elastic, ε>1. At mid-point on the curve (where the two lengths are equal) ε=1. A monopoly will always operate on the elastic part of the demand curve (where MR>0). Monopoly: a computable example with linear demand and costs curves Social welfare cost of monopoly: deadweight loss The monopoly equilibrium is Pareto efficient; output and consumption are inefficiently low. A pareto improvement would be possible provided production and consumption levels rise in equilibrium. The difference between the loss of consumer surplus (relative to competition) and monopoly profits gives the “deadweight loss” of monopoly DWL. Proof (see diagram below) Competitive equilibrium (p=Average Cost=Marginal Cost here): zero profits; consumer’s surplus is the area of the triangle ADc. Monopoly equilibrium: profits are the area pm BEc; consumer’s surplus is the area of the triangle ABpm. If consumers could convince the monopoly to increase its sales up to the competitive level yc>ym, the consumer’s surplus would increase by the area pmBDc. In contrast, the monopoly would lose profits equal to the area pmBEc. The consumers could pay full compensation to the monopoly equal to the profit loss and still be better off by the increase in consumption for area BDE=area pmBDc-area pmBEc. Hence, it follows that the monopoly market equilibrium is NOT Pareto efficient: there is a net welfare loss to society equal to the area of the triangle BDE. Monopoly equilibrium with a linear demand curve and constant MC Social welfare costs of monopoly: the role of monopoly rents Monopoly welfare loss Open issues Is the sum of profits and consumer surplus a good metric for «social welfare»? According to some economists, the appropriate metric is the «consumer surplus» (a «Posnerian view»). Hence, the largest the consumer surplus, the more desirable the market outcome. How is the division of social welfare between consumer surplus and profits related to equity? According to some economists, the increase in income inequality observed within Western countries in the last 30 years is related to the increase in market power of firms, leading to more profits in the goods markets (i.e. higher markups) and lower wages in the labour market (due to firms’ monopsony power to set wages, see Lecture 21). As shareholders are concentrated at the top of the income and wealth distributions, higher market power increases measured inequality (i.e., Gini coefficients are higher). A policy to reduce inequalities should focus on i) tackling firm’s market power in goods and labour markets (see Lectures 1-2, slide 56, column predistribution policies at the production stage). ii) favouring «capitalism of the people», meaning widespread diffusion of firm shares among the population. (see e.g. Milanovic, Capitalism, alone, 2019, or Zingales (2016), A capitalism for the people). Regulation of monopoly Imperfect competition (eg monopoly) is associated with a market failure: output and consumption are inefficiently low. Which policies can governments implement to tackle market power-related inefficiencies? Preliminary problem: to assess whether a firm has market power (see Appendix 5, optional). If there is market power, is this situation associated with welfare losses? If this is the case, which policies to lessen or eliminate the inefficiency? Provided monopoly power is associated with welfare losses, there is a potential role for government intervention on efficiency grounds. Which policies? 1) enhancing competition with antitrust legislation: breaking up monopolies into separate competing firms, avoiding mergers or acquisitions that reduce competition E,g., US govt. broke up Bell System telephone company in 1984; E.g., the European Commission rejected Germany’s Siemens and France’s Alstom (railways) merging in 2019. 2) lowering entry barriers: the policy depends on the nature of the barrier: - technological barriers: lowering patent length (trade-off with innovation incentives?) - legal barriers: liberalizing markets (eg. increasing licenses, lowering trade barriers); - corporate strategies to deter entry (e.g. regulating advertisement). 3) «price caps» - public regulators unilaterally fix a maximum market price: e.g., temporary natural gas price cap in the EU since December 2022 and until 2023; - public regulators bargain the market price with the monopoly: e.g., as for the case of the drugs listed in the Italian NHS codex; see also US Medicare 2024. Is negotiating prices between monopolies and public regulators welfare improving? Joe Biden @JoeBiden Dec 19 2023 We're not only working to slow price hikes, we're also working to bring down drug prices. The Inflation Reduction Act finally gives Medicare the power to negotiate to lower drug prices. With this law, we finally beat Big Pharma. Not a single Republican voted for it. As implicitly suggested by this tweet, a well-designed «price cap» can indeed increase social welfare (big welfare gains, small profit losses). Assume a firm is a monopoly thanks to a patent (legal barrier). The government granted the patent to the firm because it developed a new product that is valuable to society (eg. a new drug). The unregulated monopoly sets prices above marginal costs pm>c (see next slide) - profits = area pmBEc, - consumer surplus = area ABpm, - deadweight loss = area BDE Assume a public regulatory agency (e.g., Medicare) negotiates with/forces the monopoly to set a lower price pR. This «price cap» raises consumer surplus and lowers profits (price pm maximises profits: any other price yields lower profits), but total welfare (sum of consumer surplus and profits) increases. Monopoly equilibrium with price cap control Does the price cap lower incentives to innovate? - One drawback of a «static» price cap policy: anticipating this policy, the firm may find it unprofitable to create the new product in the first place. - But if the price reduction due to the cap is small, by the envelope theorem(i.e., «profit functions are flat at the top»), the monopoly firm’s profits would not fall by much. - If new product development generates «sufficient» profits, the firm’s incentive to innovate is unaffected by the price cut: the small price cut(due to the price cap)generates a large, first-order increase in society’s w

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