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8/19/2019 Session 7 -Post
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Managerial EconomicsSisir Debnath
Session 7
Indian School of BusinessMay 18, 2015
1Sisir Debnath, Managerial Economics, Indian School of Business
Deadliest Killer?• Suppose you want to offer a mosquito abatement
program to your community.
• The cost of the program is 5 lack Rs.
• The total benefit of the program is more than 5 lack.
• There are 100,000 households which will benefit.
• Can you charge Rs. 5 to each household and break
even?
Sisir Debnath, Managerial Economics, Indian School of Business 2
Sisir Debnath, Managerial Economics, Indian School of Business 3
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BP Oil Spill• BP drills a well in the depths of the Gulf of
Mexico, hoping that the marginal benefits fromlarge oil deposits exceed the marginal costs of
drilling• The explosion of Deepwater Horizon creates an
oil spill that threatens the livelihoods of Louisianafishermen
• The fishermen were not party to the decision todrill
• Drilling creates a social problem that is notaddressed through unrestricted markets
Sisir Debnath, Managerial Economics, Indian School of Business 4
Public Goods
• Transactions in free markets with price systems
always make market participants better off
• If all participants were not better off, the
transaction would not take place
• But what about non-participants? They might
either benefit or suffer from transactions between
market participants
• The objective of today's class is to analyze the
provision of goods and services that impact both
market participants and non-participants
Sisir Debnath, Managerial Economics, Indian School of Business 5
Today
Public Goods and Externalities
– Public Goods
– Externalities
– Optimal provision of Public goods
– Coasian bargaining
– Pigouvian taxes
– Cap and trade
Sisir Debnath, Managerial Economics, Indian School of Business 6
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Public Goods• Apart from “usual” goods and services, we consume
many public services everyday
• The military protects us even without a conscious
choice to consume their services
• Roads, railways and telecommunications enable us to
access different goods and services
• Health and education services increase our ability to
appreciate different goods and services
• Imagine life without public goods and services
• Libertarian paradise?
Sisir Debnath, Managerial Economics, Indian School of Business 7
Public Goods
• Public goods are goods and services that are non-
rivaled and non-excludable in consumption.
• National defense is a pure public good.
– Non-rivaled : marginal cost of protection given the
level of defence is zero.
– Non-excluded : One person cannot exclude another
from protection.
• Radio broadcasts are a pure public good.
– Non-rivaled : Cost for a marginal listener is negligible.
– Non-excluded : One listener cannot exclude another
tuning in.
Sisir Debnath, Managerial Economics, Indian School of Business 8
Other Types of Public Goods• Marketable public goods are non-rivaled but
excludable – Also called club goods
– Examples?
– Highways with low traffic, satellite television
• Common property goods are rivaled andnonexcludable – Suffer from congestion problems
– Examples?
– Fish stock, Grazing in common area
• Private goods are both rivaled and excludable – Most goods and services
– Examples?
Sisir Debnath, Managerial Economics, Indian School of Business 9
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Voluntary Contributions to Public
Goods• Your group is allocated Rs. 50
•
You can contribute any amount ( x, including 0 and50) towards a public good
• Public good provision is sum of x from all groups
• Your group's earnings
• Actual payment to one randomly chosen group
Sisir Debnath, Managerial Economics, Indian School of Business 10
good publicTotal504 )- x(i
i
i
xgood publicTotal
Features of Public Goods• Even when everyone consumes equal quantities of a
public good, not everyone has same value ofconsumption
• Classification of public good is not absolute
– Depends on market conditions and state oftechnology
– Example: Broadcast, Cable and Satellite TV
• Private sector does not need to supply only privategoods
• Yet difficult for the private sector to provide non-excludable goods and make a profit
• Example: Basic research
• Not necessary that public goods are produced only by
public sector Sisir Debnath, Managerial Economics, Indian School of Business 11
Aggregate Demand for Public Goods• For private goods aggregate demand is obtained by
summing up individual demand at each price
• How to obtain aggregate demand for public good?
• Recall that the same amount of public good many be
consumed by many at the same time.
Sisir Debnath, Managerial Economics, Indian School of Business 12
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Voluntary Contributions to Public
Goods• What is the optimal provision of public good?
•
Under voluntary provision, are public goods under orover supplied?
Sisir Debnath, Managerial Economics, Indian School of Business 13
Externalities• Think about the following examples:
– Introducing a knowledgeable worker to a team of
employees increases the team's productivity
– Vaccination against communicable diseases
protects not only vaccine receivers, but reduces the
probability others around them get the disease
– Literacy not only improves a person's job
prospects, but also allows society to use written
contracts and forms of communication
Sisir Debnath, Managerial Economics, Indian School of Business 14
Externalities• An externality is the effect of a decision by one set of
parties on others who were not participants in that
decision.
• Externalities are not always beneficial
• Air pollution from a factory or a car's tailpipe has a
negative impact on asthma sufferers who live or work
close by
• A business that underfunds the pension fund pushes
the cost of providing retirement income on society
• Corruption by bureaucrats has a negative impact on
users of public services
Sisir Debnath, Managerial Economics, Indian School of Business 15
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Externalities & Managerial DecisionMaking
• In what context do managers deal with externalities?
• Externalities that involve the government and the
public – Professional education
– Pollution
– Consumer safety
• Externalities within the firm
– Employees who are particularly helpful or disruptive
– Knowledge sharing
• Externalities between a firm and other firms
– Intellectual property generated through research
Sisir Debnath, Managerial Economics, Indian School of Business 16
A Negative Externality Example
S0 = MarginalPrivate Cost
D = Marginal SocialBenefit
Cost, P
Q
S1 = MarginalSocial Cost
P0
P1
Q0Q1
If there are no externalities,
P0Q0 is the equilibrium
If there are negative
externalities, the marginal
social cost differs from the
marginal private cost, and
P0 is too low and Q0 is too
high to maximize social
welfare
If there are negative
externalities, the marginal
social cost differs from the
marginal private cost, and
P0 is too low and Q0 is too
high to maximize social
welfare
Cost of externality
17Sisir Debnath, Managerial Economics, Indian School of Business
A Positive Externality Example
S = Marginal
Private Cost
D0 = MarginalPrivate Benefit
Cost, P
Q
P0
P1
Q0 Q1
If there are no externalities,
P0Q0 is the equilibrium
If there are positive
externalities, the marginal
social benefit differs from
the marginal private benefit,
and both P0 and Q0 are too
low to maximize social
welfare
If there are positive
externalities, the marginal
social benefit differs from
the marginal private benefit,
and both P0 and Q0 are too
low to maximize social
welfare
Government intervention
may be necessary to
increase consumption
Benefit of
externality
D1 = Marginal SocialBenefit
18Sisir Debnath, Managerial Economics, Indian School of Business
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Externality Solution• Goods and services with negative externalities are
over-supplied by private markets
• Goods and services with positive externalities are
under-supplied by private markets
• If externalities have a significant negative (positive)
impact, how does one mitigate (encourage) their
incidence?
• Internalize the externality
• Alter incentives so that individuals take account of
externality in their own actions
Sisir Debnath, Managerial Economics, Indian School of Business 19
Externality Solutions• Private solutions
– Moral codes
– Private charities
– Bargaining (Coase theorem)
• Public (government) solutions
– Regulation mandating maximum (negativeexternality) or minimum (positive externality)
provision
– Pigouvian taxes (for negative externalities) andsubsidies (for positive externalities)
– Cap and trade
• Privately developed public solutions
–
Social institutionsSisir Debnath, Managerial Economics, Indian School of Business 20
Mandated Maximum Provision
S0
= Marginal
Private Cost
D = Marginal SocialBenefit
Cost, P
Q
S1 = MarginalSocial Cost
P0
P1
Q0Q1
If there are no externalities,
P0Q0 is the equilibrium
If there are externalities, the
marginal social cost differsfrom the marginal private
cost, and P0 is too low and
Q0 is too high to maximize
social welfare
Government intervention
may be necessary to reduce
production
Cost of externality
21Sisir Debnath, Managerial Economics, Indian School of Business
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Coase Bargaining
Example:
– A perfume factory is downstream to a paper mill.
Gunk from the paper mill impose a negative
externality on the operations of the perfume
factory.
– The paper mill could reduce effluents by installing
filters.
– The perfume factory could eliminate the impact of
the gunk by treating water before use.
Sisir Debnath, Managerial Economics, Indian School of Business 22
Coase Bargaining• Definition: A property right is a legal rule that
describes what economic agents can do with an object
or idea.
• Example:
– Deed to parcel of land
– Patent on an idea
Sisir Debnath, Managerial Economics, Indian School of Business 23
Coase Bargaining• Example: Case 1: No explicit rights allocation.
Both the paper mill and the perfume factory cando whatever they wish.
• The paper mill will not install a filter
• The perfume factory will install a treatment plant
• Joint payoff will be 700→ Can they do better?
Sisir Debnath, Managerial Economics, Indian School of Business 24
Perfume Factory
No Treatment Treatment
Paper Mill No Filter (500,100) (500,200)
Filter (300,500) (300,300)
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Coase Bargaining• Example: Case 2: The perfume factory has the right
to clean water and sets a fee of Rs. 500 for receivinggunk.
• The paper mill will install a filter
• The perfume factory will not install a treatment plant
• Joint payoff will be 800→ The best they can do
Sisir Debnath, Managerial Economics, Indian School of Business 25
Perfume Factory
No Treatment Treatment
Paper Mill No Filter (0,600) (0,700)
Filter (300,500) (300,300)
Coase Bargaining• Example: Case 3: The mill has a right to pollute and
sells fresh water for Rs. 250.
• The paper mill will install a filter
• The perfume factory will not install a treatment plant
• Joint payoff will be 800→ The best they can do
Sisir Debnath, Managerial Economics, Indian School of Business 26
Perfume Factory
No Treatment Treatment
Paper Mill No Filter (500,100) (500,200)
Filter (550,250) (550,50)
Coase Bargaining• Summary of the main results
• Ownership of property rights affects incomedistribution
– Party with property rights is compensated by other party
– Property rights are valuable• With no impediments to bargaining, assigning
property rights results in efficient outcome
– Joint profits are maximized at this outcome
• Efficiency is achieved regardless of who receives the property rights!
Sisir Debnath, Managerial Economics, Indian School of Business 27
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Challenges to Coase Bargaining• Why doesn't Coase bargaining solve every
negative externality?
• High transaction costs
– Ex: In Bhopal Gas case, defendants are far away
• Large numbers of injured parties
– Ex: In Erin Brockovich's suit, 1 defendant but 634 plaintiffs
• Incomplete or asymmetric information
– Ex: In carbon emission case, exact marginalabatement costs for each emitter are not known
Sisir Debnath, Managerial Economics, Indian School of Business 28
Pigouvian Taxes and Subsidies• Definition: A Pigouvian tax or subsidy is a tax
(subsidy) levied on a market activity that generatesnegative (positive) externalities.
– A Pigouvian tax is not intended to raise funds, orto tax sinful activities.
• Examples of Pigouvian Subsidies and Taxes
– Subsidies for higher education
– Free vaccines
– Taxes on high sugar sodas and snacks to combatobesity (fat tax)
– Carbon taxes to combat global warming
Sisir Debnath, Managerial Economics, Indian School of Business 29
Pigouvian Taxes and SubsidiesFirm has to either abate pollution or pay a tax
Sisir Debnath, Managerial Economics, Indian School of Business 30
Marginal
Abatement
Costs (MAC)
MAC < Tax
Firm prefers to abate emissions
MAC > Tax
Firm prefers to pay tax
Pigouvian
Tax
Abatement
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Pigouvian Taxes and SubsidiesShift in supply curve when firm internalizes costs
Sisir Debnath, Managerial Economics, Indian School of Business 31
Social Cost
Demand
Supply
Quantity of AluminiumQMQO
PC
PS
Pigouvian Tax
Rs./ton
Cap and Trade• How does cap and trade work?
• Cap or limit on total quantity of production (across
the industry)
• Producers need a permit for every unit of production
• Cap is equal to total number of permits in market
• Permits are tradable => Market price for permits
• Leads to known quantity, unknown price
Sisir Debnath, Managerial Economics, Indian School of Business 32
Sisir Debnath, Managerial Economics, Indian School of Business 33
Firm 1
Firm 2
0 5 10
10 5 0
Rs./tonRs./ton
MAC2
MAC1
Trade 1 unit
of right to
pollute
Cap and TradeSame production but different abatement cost
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Cap and Trade• Each firm must either abate pollution, or pollute with a
permit.
• Initially, each firm is allocated five permits (to pollute 5units).
•
Total pollution is 10 units (the cap).• Both Firm 1 and Firm 2 can pollute first 5 units and must
buy the permit to pollute beyond 5 units.
• But Firm 1 can sell its permit to Firm 2 (the trade).
• Firm 2 will be happy to buy, since using the permit lowersTAC2 (Total Abatement Cost).
• Increase in TAC1 is less than reduction in TAC2 for Firm 2.
• Price of permits is net cost savings for Firm 2.
• Keep trading till MAC1 = MAC2.
• No additional gains from trading for either firm.
Sisir Debnath, Managerial Economics, Indian School of Business 34
Sisir Debnath, Managerial Economics, Indian School of Business 35
Firm 1
Firm 2
0 5 10
105
0
Rs./tonRs./ton
MAC2
MAC1
Net Cost
Savings
Cap and TradeEach firm can do better if Firm 1 sells its permits to Firm 2
Sisir Debnath, Managerial Economics, Indian School of Business 36
Firm 1
Firm 2
0 5 10
10 5 0
Rs./tonRs./ton
MAC2
MAC1
Keep trading till
MACs are
equalized
Net Cost
Savings
Cap and TradeKeep trading till there are no more gains from trade
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Carbon tax vs. Cap-and-Trade• Revenue
– Direct tax revenues from carbon taxes
– Government can redistribute carbon tax revenues as
transfers to individuals or firms – Revenues from cap-and-trade only if permits are
auctioned
– Free permits are a hidden transfer to emitters
• Allocation
– Who should receive permits initially?
– Distribution to current emitters?
– Distribution by auction?
– Distribution to affected parties?
Sisir Debnath, Managerial Economics, Indian School of Business 37
Takeaways from Today's Class• Public goods are non-rivaled and non-excludable in
consumption
– Voluntary provision tends to undersupply public goodsand oversupply public bads
– Remedy through government action
• Externalities are impact of market transactions on non- participants
– Public policy should encourage positive externalitiesand discourage negative ones
– If property rights are well-designed and transactioncosts are low, bargaining will remedy externalities(Coase Theorem)
– But bargaining cannot fix every situation, so role forgovernment through mandates, pigouvian taxes and
subsidies, cap and trade etc.
Sisir Debnath, Managerial Economics, Indian School of Business 38
Readings for Next Session• Oligopoly (Course pack page 171-199)
Sisir Debnath, Managerial Economics, Indian School of Business 39
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