P1246990952mFtcO

1
4 THE ECONOMICS OF THE PUBLIC SECTOR
2
10

• Externalities

3
Market Failure

• Recall from Chapter 7
• Adam Smith had argued that the invisible hand
  of the marketplace leads self-interested buyers
  and sellers to an outcome in which the total
  surplus of society is maximized.
• But markets can fail. Why?

4
EXTERNALITIES AND MARKET INEFFICIENCY

• An externality is the uncompensated impact of
  one persons actions on the well-being of a
  bystander.
• Als action may affect the well-being of Betty, a
  bystander.
• If Al pays no compensation (when his action has a
  negative effect on Betty) nor receives a reward
  (when his action has a positive effect on Betty),
  the effect of Als action on Betty is called an
  externality.

5
EXTERNALITIES AND MARKET INEFFICIENCY

• When the impact on the bystander is harmful, the
  externality is called a negative externality.
• When the impact on the bystander is beneficial,
  the externality is called a positive externality.

6
Negative Externalities

• Automobile exhaust
• Cigarette smoking
• Barking dogs (loud pets)
• Loud stereos in an apartment building
• The Club, an anti-theft device for cars

7
Dealing with negative externalities

• Should we completely ban an activity that has
  negative externalities?
• Should we ban all cars?
• Is it a good idea to ban all smoking in public
  spaces?
• Should we muzzle all dogs?
• Should we ban stereos in apartment buildings?

8
Dealing with negative externalities

• How should we determine the extent to which these
  activities should be tolerated?
• We can evaluate virtually any policy proposal by
  asking how it would affect total surplus.
• Recall from Chapter 7, the concept of total
  surplus.

9
Positive Externalities

• Immunizations
• Education
• Restored historic buildings
• Research into new technologies
• LoJack, an anti-theft device for cars

10
EXTERNALITIES AND MARKET INEFFICIENCY

• Externalities can cause markets to become
  inefficient.
• We saw in chapter 7 that total surplus is
  maximized in a perfectly competitive economy.
• But when there are externalities, that is no
  longer true total surplus might be less than the
  maximum achievable.
• This might provide a justification for government
  intervention.

11
EXTERNALITIES AND MARKET INEFFICIENCY

• Negative externalities cause markets to produce a
  larger quantity than is socially desirable.
• Positive externalities cause markets to produce a
  smaller quantity than is socially desirable.
• If and when markets fail (to produce the socially
  desirable quantity), government intervention may
  be necessary.

12
Figure 1 The Market for Aluminum
When there are no externalities in aluminum
production or consumption, the equilibrium
quantity (QMARKET) maximizes social surplus.
Price of
Aluminum
Quantity of
0
Aluminum
13
Welfare Economics Without Externalities A Recap

• When there are no externalities, the equilibrium
  quantity
• is efficient
• maximizes total surplus (which is the sum of
  producer and consumer surplus)
• is the socially desirable quantity

14
Welfare Economics With Externalities

• If the aluminum factories emit pollution, it is a
  negative externality
• Then the cost to society of producing aluminum is
  larger than the cost to aluminum producers.
• For each unit of aluminum produced, the social
  cost includes the private cost of the producers
  plus the external cost to those bystanders
  adversely affected by the pollution.
• The equilibrium quantity exceeds the socially
  optimal quantity

15
Social, private, and external costs

• When the production of aluminum causes pollution
  
• Social cost of aluminum private cost external
  cost
• Private cost is the cost to aluminum producers of
  the raw materials and labor used in production
• External cost is the cost to bystanders of having
  to deal with the effects of pollution

16
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Quantity of
0
Aluminum
17
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
4. B C, Value of aluminum to buyers
2. A B, Cost of pollution to those affected.
5. Social costs exceed benefits for the units by
which market output exceeds optimum output
3. A B C, Total Cost of aluminum production
to society
1. C, Cost (to producers) of producing aluminum
Quantity of
0
6. Therefore, the market is producing too much
aluminum.
Aluminum
18
Negative Externalities

• The intersection of the demand curve and the
  social-cost curve determines the socially optimal
  output level.
• Note that the socially optimal output level is
  less than the market equilibrium quantity.

19
Public Policies for Negative Externalities

• What can be done to get the market to reduce
  production to the socially optimal level?

20
Market-Based Policy Put a Tax on Negative
Externalities

• Either the producers or the consumers (or both)
  of aluminum can be taxed
• We saw in chapter 6 that a tax reduces the
  equilibrium output, and that is exactly what we
  want.
• A tax solves the problem by forcing the consumers
  and producers of aluminum to internalize the
  externality of aluminum
• Internalizing an externality involves altering
  incentives so that people take account of the
  external effects of their actions.

21
Recall The Effect of a Tax
Price
Quantity
0
22
Tax External Cost is too much
Price of
Aluminum
Desired output reduction
Quantity of
0
The tax is too large and reduces output too much
Aluminum
23
Tax Price of
Aluminum
Desired output reduction
The tax is too small and reduces output too little
Quantity of
0
Aluminum
24
Tax External Cost solves the problem!
Price of
Aluminum
We saw earlier that reducing output from QMARKET
to QOPTIMUM increases total surplus. Now we see
that a tax can do this. (So, unlike what we saw
in Chapter 8, not all taxes reduce total
surplus.) This is a Pigovian tax.
Now the tax is exactly equal to the external
cost. It reduces the quantity by exactly the
ideal amount.
Quantity of
0
Aluminum
25
Positive Externalities

• When an externality benefits bystanders, it is a
  positive externality.
• The social value of the good exceeds the private
  value.

26
Positive Externalities Examples

• A technology spillover is a positive externality
  that is created when a firms innovation not only
  benefits the firm, but enters societys pool of
  technological knowledge and benefits society as a
  whole.
• Education benefits the student and also all
  members of society who are affected by the student

27
Figure 3 Education and the Social Optimum
1. C, Benefits to students of the excess of
optimum education over equilibrium education
2. A B, Benefits of that extra education to
the rest of society
3. A B C, Benefits of that extra education to
society
4. B C, Cost of that extra education
Price of
Education
5. Benefits exceed Costs. This proves that the
equilibrium amount of education is too little.
Quantity of
0
Education
28
Supply-Demand and Positive Externalities

• The intersection of the supply curve and the
  social-value curve determines the optimal output
  level.
• The optimal output level is more than the
  equilibrium quantity.
• The market produces a smaller quantity than is
  socially desirable.
• The social value of the good exceeds the private
  value of the good.

29
Subsidies for positive externalities

• What can be done to get the market to increase
  education to the optimal level?
• A subsidy for either students (buyers of
  education) or educational institutions (sellers)
  will work.
• A subsidy will make students and educational
  institutions internalize the positive externality
  of education

30
Subsidies for Positive Externalities example

• Recall that technology spillovers are positive
  externalities
• Therefore, the equilibrium level of spending on
  research will be less than the socially desirable
  level
• Government intervention may promote
  technology-enhancing industries
• Patent laws are a form of technology policy that
  give the individual (or firm) with patent
  protection a property right over its invention.
• The patent is then said to internalize the
  externality.

31
PRIVATE SOLUTIONS TO EXTERNALITIES

• Government action is not always needed to solve
  the problem of externalities.
• In some cases, the free market ends up maximizing
  total surplus even when there are externalities

32
PRIVATE SOLUTIONS TO EXTERNALITIES

• Moral codes and social sanctions
• Charitable organizations
• Integrating different types of businesses
• Contracting (bargaining, negotiations) between
  those causing the externalities and those
  affected by the externalities

33
The Coase Theorem

• The Coase Theorem is the propositiondue to
  Ronald Coasethat if people can bargain without
  transaction costs over the allocation of
  resources, they can solve the problem of
  externalities on their own.
• Transaction costs are the costs that people incur
  in the process of agreeing to and following
  through on a bargain.

34
Dick, Spot, and Jane and Ronald Coase
35
Dick, Spot, and Jane and Ronald Coase

• Note that when the free market outcome is not
  optimal, bargaining between Dick and Jane will
  bring about the optimal outcome, irrespective of
  who is favored by the law
• The law is important in other ways, however. For
  example, in one case in which the law favors
  Dick, Jane has to pay a 500 compensation to Dick
  to get him to return Spot

36
Coase Theorem Exercise

• In the case of pollution by an aluminum factory,
  how might production of the socially desirable
  amount be brought about without taxation by the
  government?
• Why might Coases solution fail, as a practical
  matter, in this case?

37
Why Private Solutions Do Not Always Work

• Sometimes the private solution approach fails
  because transaction costs can be so high that
  private agreement is not possible.
• Dick might get greedy and try to haggle with Jane
  for more than 500
• Change the story by substituting three people
  (Jan, Jeanne and Joan) instead of Jane. Jan,
  Jeanne and Joan may find it hard to raise 500
  for Dicks compensation. Each might try to free
  ride on the others.

38
PUBLIC POLICY TOWARD EXTERNALITIES

• When externalities are significant and private
  solutions are not found, government may attempt
  to solve the problem through
• command-and-control policies.
• market-based policies.

39
PUBLIC POLICY Command-and-Control Policies

• Such policies usually take the form of
  regulations
• Forbid certain behaviors.
• Require certain behaviors.
• Examples
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by
  the Environmental Protection Agency (EPA).

40
PUBLIC POLICY MARKET-BASED POLICIES

• Taxes and subsidies can align private incentives
  with social efficiency.
• We have seen this already
• These corrective taxes and subsidies are called
  Pigovian taxes and subsidies.
• They were originally proposed by the British
  economist, A. C. Pigou.

41
PUBLIC POLICY TOWARD POLLUTION
Command-and-Control

• If the EPA decides it wants to reduce the amount
  of pollution coming from a specific plant, it
  could
• tell the firm to reduce its pollution by a
  specific amount (i.e. regulation).
• levy a tax of a given amount for each unit of
  pollution the firm emits (i.e. Pigovian tax).

42
PUBLIC POLICY TOWARD POLLUTION Market-Based

• Pigovian Taxes on the producers or consumers of
  pollution
• Tradable pollution permits that allow the
  voluntary transfer of the right to pollute from
  one firm to another.
• A firm that can reduce pollution at a low cost
  may prefer to sell its permit to a firm that can
  reduce pollution only at a high cost.

43
Figure 4 The Equivalence of Pigovian Taxes and
Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Quantity of
0
Pollution
44
Figure 4 The Equivalence of Pigovian Taxes and
Pollution Permits
(b) Pollution Permits
Price of
Pollution
Quantity of
0
Pollution
45
Policy Exercises

• Should we punish the use of SUVs and promote the
  use of smaller cars?
• Should we force car makers to sell cars with
  higher mileage?
• Should we limit the use of gasoline by each car
  owner?
• Should we tax gasoline?
• Should we tax all fuels based on the damage each
  fuel causes?

46
Any Questions?
47
Summary

• When a transaction between a buyer and a seller
  directly affects a third party, the effect is
  called an externality.
• Negative externalities cause the socially optimal
  quantity in a market to be less than the
  equilibrium quantity.
• Positive externalities cause the socially optimal
  quantity in a market to be greater than the
  equilibrium quantity.

48
Summary

• Those affected by externalities can sometimes
  solve the problem privately.
• The Coase theorem states that if people can
  bargain without a cost, then they can always
  reach an agreement in which resources are
  allocated efficiently.

49
Summary

• When private parties cannot adequately deal with
  externalities, then the government steps in.
• The government can either regulate behavior or
  internalize the externality by using Pigovian
  taxes or by issuing pollution permits.