C hapter 14 Externalities, Market Failure, and Public Choice © 2002 South-Western

CChapter 14hapter 14

Externalities, Market Failure, and Public Choice

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Positive and negative externalities

• Property rights

• Market failure

• Pollution taxation and obligatory controls

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Economic PrinciplesEconomic Principles

• Pure public goods and near-public goods

• Public choice

• Government failure

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Economic Economic ExternalitiesExternalities

Externalities

Unintended costs or benefits that are imposed on unsuspecting people and that result from economic activity initiated by others.

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Third parties

People upon whom the externalities are imposed.

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• Persons or companies that initiate activities do so to benefit themselves.

• The activity’s effect on others is excluded from the decision about whether to undertake the activity.

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Negative externalities

Externalities that impose unintended costs.

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Some examples of negative externalities include:

• The impact on your health from someone smoking in an elevator with you.

• The decrease in your property value that results from a neighbor dumping garbage in their yard.

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In modern societies, the most important negative externalities are precisely those that are the most difficult to measure and the most difficult to track to specific offenders.

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Positive externalities

Externalities that generate unintended benefits.

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Some examples of positive externalities include:

• The pleasure you derive from your neighbor’s beautifully landscaped yard.

• Being able to watch baseball games for free from your rooftop because you live near the park.

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Positive externalities can be as difficult to measure as negative externalities.

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Free rider

Someone who consumes a good or service without paying for it. Typically, the good or service consumed is in the form of a positive externality.

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Externalities and Externalities and Property RightsProperty Rights

Property rights

The right to own a good or service and the right to receive the benefits that the use of the good or service provides.

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The property rights associated with the people who either suffer the negative externalities or enjoy the positive externalities are poorly defined.

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Therefore, we can’t lay claim to the positive externalities we generate, nor place the cost to society that negative externalities generate on the source of the externality.

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Some forms of property are not easily privatized and title to them is virtually impossible to claim, so no one has an interest in defending or maintaining the property.

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What are some examples of forms of property that do not have associated clear and exclusive rights? • Air and the atmosphere.

• The oceans.

• Viewscapes.

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It is difficult to find incentives that would lead people, companies, and governments to be careful about creating negative externalities when they know their actions affect “only” a form of property that cannot be claimed.

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Why Should Economists Why Should Economists be Interested in be Interested in Externalities?Externalities?

The presence of positive and negative externalities associated with almost every economic activity undertaken in our economy calls into question the efficacy of our market system.

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• When choosing whether to produce a good, producers must take into consideration the cost of inputs and the dollar value for which the good can be sold on the market.

• If the cost of inputs is greater than the potential revenue, then producing the good would be an inefficient use of resources. Value would be reduced.

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Is it an efficient use of resources to produce bread if the inputs used to produce the bread are valued at $3 and the bread can be sold on the market for $4?

• Yes. Producing the bread would create value.

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Social cost

The cost to society of producing a good. This cost includes both the private costs associated with the good’s production and the external cost generated by its production.

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Market failure

The failure of the market to achieve an optimal allocation of the economy’s resources. The failure results from the market’s inability to take externalities into account.

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Suppose that external costs generated from baking bread is estimated to be $3 per loaf. If the inputs to produce the bread cost $3 and the value of the bread on the market is $4, is this an efficient use of resources? • No. The social cost of producing the bread is $6. Therefore, value is reduced.

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Because the market does not incorporate externalities into its cost calculations, it appears to be signaling an efficient use of resources -- creating value -- when, in fact, it is anything but efficient.

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EXHIBIT 1 THE EFFECT OF EXTERNALITIES ON THE MARKET FOR CHICKEN

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Exhibit 1: The Effect of Exhibit 1: The Effect of Externalities in the Externalities in the Market for ChickenMarket for Chicken

1. What does the supply (private cost) curve in Exhibit 1 reflect?

• The supply curve reflects the marginal cost curves of firms producing chicken. These costs are private, representing only the firms’ cost of production.

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2. What is the equilibrium price and quantity before social costs?

• The equilibrium price is $4.00 per chicken.

• The equilibrium quantity is 8 billion chickens.

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3. How does the social cost supply curve differ from the private cost supply curve?

• The social cost supply curve includes the pollution cost associated with producing chicken.

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3. How does the social cost supply curve differ from the private cost supply curve?

• The social cost supply curve is shifted to the left of the private cost supply curve.

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4. How do equilibrium price and quantity change when the social cost supply curve is used?

• Equilibrium price increases to $5.00.

• Quantity decreases to 7 billion chickens.

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5. What is the effect of ignoring the cost of the negative externalities?

• Market failure occurs. The market is inefficient, pricing chicken too low and producing more chicken than it should.

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Correcting Market Correcting Market FailureFailure

While firms can measure their own private costs to the penny, measuring externalities may require a considerable amount of research.

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In general we know too little about environmental impacts to confidently trace out social cost curves for various industries.

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Does this mean that we should not try?

• No. We must try. If we can’t correct market failure we can at least try to improve upon it.

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We typically rely on government to attempt to correct market failure for two reasons:

• Government has access to more relevant information than any private firm or individual.

• Government is probably the most objective.

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There are three policy options government can pursue in an attempt to correct market failure:

• Create new property forms to handle externalities.

• Levy a pollution tax on the polluting industry.

• Enforce an environment-protecting set of standards on the polluting industry.

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Correcting Market Correcting Market Failure: Creating New Failure: Creating New

Property FormsProperty FormsThe government can convert public property into private property by auctioning it off to private enterprise.

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Property FormsProperty Forms1. What are some benefits of privatizing property?

• When property is privately owned, there is a strong incentive to maintain it.

• Anyone damaging the property would be liable.

• The government gains revenue from the auction.

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Property FormsProperty Forms2. What is one serious limitation of privatizing property?

• Not all property can be easily privatized. For example, how could the government sell the atmosphere?

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Correcting Market Correcting Market Failure: Levying a Failure: Levying a

Pollution Compensation Pollution Compensation TaxTax

• The government can charge the polluter a tax, based on its estimate of the cost of the negative externality.

• The tax money could then be used to clean up the pollution.

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Correcting Market Correcting Market Failure: Levying a Failure: Levying a

Pollution Compensation Pollution Compensation TaxTax

• The advantage of this policy is that the tax falls directly on the producers and consumers of the good which created the pollution.

• Those who do not consume the good do not pay the tax.

• Those who consume less of the good pay less than those who consume more.

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Correcting Market Correcting Market Failure: Creating Failure: Creating

Obligatory ControlsObligatory Controls• The government can impose rules and regulations that limit activities that produce negative externalities.

• This is the most common policy used by the government to protect the environment.

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Correcting Market Correcting Market Failure: Creating Failure: Creating

Obligatory ControlsObligatory ControlsWhat are some examples of obligatory controls used to protect the environment? • Leaf-burning laws to protect the atmosphere.

• Sign ordinances to protect scenic beauty.

• Mandated use of catalytic converters on cars.

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Correcting Market Correcting Market Failure: The Failure: The

Environmental Environmental Protection Agency Protection Agency

(EPA)(EPA)• The EPA is the environmental regulatory agency of the nation.

• Through its directives, the EPA controls the quantity and quality of pollutants that firms discharge into our water, land, and atmosphere.

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Correcting Market Correcting Market Failure: The Failure: The

Environmental Environmental Protection Agency Protection Agency

(EPA)(EPA)What are some of the environmental laws that the EPA administers?

• The Clean Air Act, the Water Pollution Control Act, the Safe Drinking Water Act, and the Toxic Substances Control Act.

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Externalities and Externalities and Public GoodsPublic Goods

Market failure is not only associated with negative externalities. It can happen as the result of positive externalities.

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EXHIBIT 2 THE EFFECT OF EXTERNALITIES ON THE MARKET FOR TREES

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Exhibit 2: The Effect of Exhibit 2: The Effect of Externalities on the Externalities on the

Market for TreesMarket for Trees

1. What does the private value demand curve reflect?

• The private value demand curve reflects the value each tree creates for the person who bought it.

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2. What is the equilibrium price and quantity when the private value demand curve is used?

• The equilibrium price is $100 and the quantity is 500 trees.

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3. What is not accounted for when only private value is considered?

• The positive externality created by the trees is not accounted for. There is value placed on the trees by individuals who did not buy them.

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4. What happens when the social value of the trees is added to the private value?

• The equilibrium price increases to $110 and the output increases to 600.

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5. If the social value of a tree is $110, but the private value of the tree is only $90, how do we get people to invest in the 600 trees?

• The government can provide a subsidy of $20 for each purchase of a tree in order to make up the difference.

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Public goods

A good whose benefits are not diminished even when additional people consume it and whose benefits cannot be withheld from anyone.

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• Typically these goods will not be produced without government intervention.

• Not producing these goods can be quite detrimental to the community’s well-being.

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What is an example of a public good? • A lighthouse. No one thinks to build a lighthouse for their own personal use and once its built anyone can use it as much as the wish without diminishing other people’s use of it. The government must intervene to build the lighthouse and tax the community accordingly.

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Near-public goods are goods that are similar to pure public goods, but have some limitations.

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• Some near-public goods may only be used up to a certain point before the use begins to reduce the enjoyment of others.

• For example, everyone can consume as much as they want of a freeway at 2 A.M., but not during rush hour traffic at 5 P.M.

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• Additionally, people can be excluded from consuming some near-public goods.

• For example, a high admission price to a national park will exclude some people from using it.

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Public Goods and Public Goods and Public ChoicePublic Choice

• Most people agree that public goods and near-public goods belong in the government’s domain.

• They think that the government can best decide the quantity and quality of public goods that society should consume.

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Public Goods and Public Goods and Public ChoicePublic Choice

Government failure

The failure of government to buy the quantity of public goods that generate maximum efficiency.

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EXHIBIT 3 THE DERIVATION OF GOVERNMENT FAILURE

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Exhibit 3: The Exhibit 3: The Derivation of Derivation of

Government Failure Government Failure 1. If the cost of extending a library’s hour is $300, and the cost is equally shared by all members of a 3-person community, will the community vote for the Sunday extension in Exhibit 3?

• Yes. The cost to each person for the extension is $100. The value each person receives from extending the hours on Sunday is greater than $100.

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Government Failure Government Failure 2. Will the community vote to extend the hours on Wednesday? • No. Only one person receives a value greater than $100 for extending the hours on Wednesday. The other two receive a value less than $100. They will not vote to extend the hours.

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Government Failure Government Failure 3. Will the community buy the most efficient amount of library hours? • No. The community will only buy two extensions -- Sunday and Saturday. The most efficient quantity, however, is reached when the total positive externality equals the tax of $300. This occurs with the third extension.

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Public Goods and Public Goods and Public Choice Public Choice

• The problem of government failure may be worsened when elected representatives must make decisions for the public.

• Representatives cannot determine their constituents’ specific costs and benefits.

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• Economists hold different views about how government functions.

• Some believe that representatives make an honest effort to represent the public interest.

• Other believe that representatives are guided by their own self-interest.

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Public choice

The view that the behavior of government concerning the production and allocation of public goods is dictated mainly by the needs of members of government to keep their jobs.

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Special-interest lobbying

A group organized to influence people in government concerning the costs and benefits of particular public goods.

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• Some government failure is inevitable.

• How responsive representatives are to their constituents and how willing individuals are to educate themselves on the costs and benefits of buying public goods will affect the dimensions of government failure.

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C hapter 14 Externalities, Market Failure, and Public Choice © 2002 South-Western