1 of 30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 5: Externalities,

1 of 30Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

CHAPTER 5

Externalities, Environmental Policy, and Public Goods

Fernando Quijano

Prepared by:

How should government

policy deal with the problem of

pollution?Can economic

analysis help in formulating more efficient pollution

policies?


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

5.1 Externalities and Economic EfficiencyIdentify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

5.2 Private Solutions to Externalities: The Coase Theorem Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.

5.3 Government Policies to Deal with ExternalitiesAnalyze government policies to achieve economic efficiency in a market with an externality.

5.4 Four Categories of GoodsExplain how goods can be categorized on the basis of whether they are rival or excludable, and use graphs to illustrate the efficient quantities of public goods and common resources.

Chapter Outline andLearning Objectives


CHAPTER 5


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.



Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Private cost The cost borne by the producer of a good or service.

Social cost The total cost of producing a good, including both the private cost and any external cost.

Private benefit The benefit received by the consumer of a good or service.

Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit.

Externalities and Economic Efficiency

The Effect of Externalities

Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

5.1 LEARNING OBJECTIVE


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds



FIGURE 5-1

The Effect of Pollution on Economic Efficiency

How a Negative Externality in Production Reduces Economic Efficiency

Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level. Supply curve S1 represents just the marginal

private cost that the utility has to pay.

Supply curve S2 represents the marginal

social cost, which includes the costs to those affected by acid rain.

If the supply curve were S2, rather than S1,

market equilibrium would occur at price PEfficient and quantity QEfficient, the

economically efficient level of output.

But when the supply curve is S1, the

market equilibrium occurs at price PMarket

and quantity QMarket, where there is a

deadweight loss equal to the area of the yellow triangle. Because of the deadweight loss, this equilibrium is not efficient.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds



How a Positive Externality in Consumption Reduces Economic EfficiencyFIGURE 5-2

The Effect of a Positive Externality on Efficiency

People who do not consume college educations can still benefit from them. As a result, the marginal social benefit from a college education is greater than the marginal private benefit seen by college students.

Because only the marginal private benefit is represented in the market demand curve D1, the quantity of

college educations produced, QMarket,

is too low.

If the market demand curve were D2

instead of D1, the level of college

educations produced would be QEfficient, which is the efficient level. At

the market equilibrium of QMarket, there

is a deadweight loss equal to the area of the yellow triangle.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


Externalities and Market Failure

Market failure A situation in which the market fails to produce the efficient level of output.

What Causes Externalities?

Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Private Solutions to Externalities:The Coase Theorem

The Economically Efficient Level of Pollution Reduction

FIGURE 5-3

The Marginal Benefit from Pollution Reduction Should Equal the Marginal Cost

Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.


If the reduction of sulfur dioxide emissions is at 7.0 million tons per year, the marginal benefit of $250 per ton is greater than the marginal cost of $175 per ton. Further reductions in emissions will increase the net benefit to society.

If the reduction of sulfur dioxide emissions is at 10.0 million tons, the marginal cost of $225 per ton is greater than the marginal benefit of $150 per ton. An increase in sulfur dioxide emissions will increase the net benefit to society.

Only when the reduction is at 8.5 million tons is the marginal benefit equal to the marginal cost. This level is the economically efficient level of pollution reduction.


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Makingthe

Connection

The Clean Air Act:How a Government PolicyReduced Infant Mortality

The benefit of reducing air pollution in 1970 was much higher than the benefit from a proportional reduction in air pollution would be today, when the level of pollution is much lower. In the two years following passage of the Clean Air Act, there was a sharp reduction in air pollution and also a reduction in infant mortality

YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


FIGURE 5-4

The Benefits of Reducing Pollution to the Optimal Level Are Greater Than the Costs

The Basis for Private Solutions to Externalities

Increasing the reduction in sulfur dioxide emissions from 7.0 million tons to 8.5 million tons results in total benefits equal to the sum of the areas A and B under the marginal benefits curve.

The total cost of this decrease in pollution is equal to the area B under the marginal cost curve.

The total benefits are greater than the total costs by an amount equal to the area of triangle A.

Because the total benefits from reducing pollution are greater than the total costs, it’s possible for those receiving the benefits to arrive at a private agreement with polluters to pay them to reduce pollution.



Don’t Let This Happen to YOU!Remember That It’s the Net Benefit That Counts



Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Makingthe

ConnectionThe Fable of the Bees

Some apple growers and beekeepers make private arrangements to arrive at an economically efficient outcome.

If there are positive externalities in both apple growing and bee-keeping, the market may not supply enough apple trees and beehives.

Government intervention, however, may not be necessary because beekeepers and apple growers arrive at private agreements.





Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


The Coase Theorem

Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

The Problem of Transactions Costs

Coase theorem The argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Government Policiesto Deal with Externalities

FIGURE 5-5

When There Is a Negative Externality, a Tax Can Bring about the Efficient Level of Output

Analyze government policies to achieve economic efficiency in a market with an externality.


Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level. If the government imposes a tax equal to the cost of acid rain, the utilities will internalize the externality.

As a consequence, the supply curve will shift up, from S1 to S2.

The market equilibrium quantity changes from QMarket, where an inefficiently high level

of electricity is produced, to QEfficient, the

economically efficient equilibrium quantity.

The price of electricity will rise from PMarket—

which does not include the cost of acid rain—to PEfficient—which does include the cost.

Consumers pay the price PEfficient, while

producers receive a price P, which is equal to PEfficient minus the amount of the tax.


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Solved Problem 5-3Using a Tax to Deal witha Negative Externality

YOUR TURN: For more practice do related problem 3.7 at the end of this chapter.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


FIGURE 5-6

When There Is a Positive Externality, a Subsidy Can Bring about the Efficient Level of Output

People who do not consume college educations can benefit from them. As a result, the social benefit from a college education is greater than the private benefit seen by college students. If the government pays a subsidy equal to the external benefit, students will internalize the externality.

The subsidy will cause the demand curve to shift up, from D1 to D2. The result will be

that market equilibrium quantity shifts from QMarket, where an inefficiently low

level of college educations is supplied, to QEfficient, the economically efficient

equilibrium quantity.

Producers receive the price PEfficient, while

consumers pay a price P, which is equal to PEfficient minus the amount of the

subsidy.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.

Command and Control versus Market-Based Approaches

Command-and-control approach An approach that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices.





Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Makingthe

Connection

Can a Cap-and-Trade System

Reduce Global Warming?

Policymakers and economists have debated the mechanism by which reductions in CO2 emissions should occur. The United States has favored a global system of tradable emission permits for CO2 that would be similar to the system for sulfur dioxide discussed earlier in this chapter.





Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Four Categories of Goods

Rivalry The situation that occurs when one person’s consuming a unit of a good means no one else can consume it.

Excludability The situation in which anyone who does not pay for a good cannot consume it.

Explain how goods can be categorized on the basis of whether they are rival or excludable, and use graphs to illustrate the efficient quantities of public goods and common resources.



Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

FIGURE 5-7



Goods and services can be divided into four categories on the basis of whether people can be excluded from consuming them and whether they are rival in consumption.

A good or service is rival in consumption if one person consuming a unit of a good means that another person cannot consume that unit.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


1. Private good. A good that is both rival and excludable.

2. Public good. A good that is both nonrivalrous and nonexcludable.

Free riding Benefiting from a good without paying for it.

3. Quasi-public goods. Goods that are excludable but not rival.

4. Common resource. A good that is rival but not excludable.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Makingthe

Connection

Should the GovernmentRun the Health Care System?

Because health care is so important to consumers and because health care spending looms so large in the U.S. economy, the role of the government in the health care system is likely to be the subject of intense debate for some time to come.





Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


The Demand for a Public Good

FIGURE 5-9

Constructing the Market Demand Curve for a Private Good

The market demand curve for private goods is determined by adding horizontally the quantity of the good demanded at each price by each consumer.

For instance, in panel (a), Jill demands 2 hamburgers when the price is $4.00, and in panel (b), Joe demands 4 hamburgers when the price is $4.00. So, a quantity of 6 hamburgers and a price of $4.00 is a point on the market demand curve in panel (c).




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

FIGURE 5-10

Constructing the Market Demand Curve for a Public Good


The Demand fora Public Good

To find the demand curve for a public good, we add up the price at which each consumer is willing to purchase each quantity of the good.

In panel (a), Jill is willing to pay $8 per hour for a security guard to provide 10 hours of protection. In panel (b), Joe is willing to pay $10 for that level of protection. Therefore, in panel (c), the price of $18 per hour and the quantity of 10 hours will be a point on the market demand curve for security guard services.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


FIGURE 5-10

The Optimal Quantity of a Public Good

The Optimal Quantity of a Public Good

The optimal quantity of a public good is produced where the sum of consumer surplus and producer surplus is maximized, which occurs where the demand curve intersects the supply curve.

In this case, the optimal quantity of security guard services is 15 hours, at a price of $9 per hour.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Solved Problem 5-4Determining the OptimalLevel of Public Goods

DEMAND OR MARGINAL SOCIAL BENEFIT

PRICE (DOLLARS PER HOUR)

QUANTITY (HOURSOF PROTECTION)

$38 134 230 326 422 518 614 710 8

6 9

JILL


QUANITY (HOURS OF PROTECTION)

$20 1

18 216 314 4

12 5

10 6

8 7

6 84 9

2 10

JOE



$20 0

18 1

16 2

14 3

12 4

10 5

8 6

6 7

4 8

2 9

To calculate the marginal social benefit of guard services, weneed to add the prices that Jill and Joe are willing to pay at each quantity




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

Solved Problem 5-4Determining the OptimalLevel of Public Goods (continued)

DEMAND OR MARGINAL SOCIAL BENEFIT



$38 1

34 230 326 422 518 614 710 8

6 9

SUPPLY



$8 1

10 2

12 3

14 4

16 5

18 6

20 7

22 8

24 9

YOUR TURN: For more practice, do related problem 4.4 at the end of this chapter.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds


Common Resources

Tragedy of the commons The tendency for a common resource to be overused.

FIGURE 5-11

Overuse of a Common Resource

For a common resource such as wood from a forest, the efficient level of use, QEfficient, is determined

by the intersection of the demand curve—which represents the marginal benefit received by consumers—and S2, which

represents the marginal social cost of cutting the wood.

Because each individual tree cutter ignores the external cost, the equilibrium quantity of wood cut is QActual, which is greater than

the efficient quantity. At the equilibrium level of output, there is a deadweight loss, as shown by the yellow triangle.




Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

The Carbon Cap DilemmaAN INSIDE LOOK

>>

Using a carbon tax to reduce CO2 emissions.


Cha

pter

5:

Ext

erna

litie

s, E

nviro

nmen

tal P

olic

y, a

nd P

ublic

Goo

ds

KEY TERMS

Coase theorem

Command-and-control approach

Common resource

Excludability

Externality

Free riding

Market failure

Pigovian taxes and subsidies

Private benefit

Private cost

Private good

Property rights

Public good

Rivalry

Social benefit

Social cost

Tragedy of the commons

Transactions costs

Documents

1 of 30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 5: Externalities,