Ch18_Pindyck

7/28/2019 Ch18_Pindyck

http://slidepdf.com/reader/full/ch18pindyck 1/80

Chapter 18

Externalities and Public Goods



©2005 Pearson Education, Inc. Chapter 18 2

Topics to be Discussed

Externalities

Ways of Correcting Market Failure

Externalities and Property RightsCommon Property Resources

Public Goods

Private Preferences for Public Goods




Externalities

Externalities arise between producers,between consumers, or betweenproducers and consumers

Externalities are the effects of productionand consumption activities not directlyreflected in the market

They can be negative or positive




Externalities

Negative

Action by one party imposes a cost onanother party

Plant dumps waste in a river, affecting thosedownstream

The firm has no incentive to account for theexternal costs that it imposes on those

downstream




Externalities

Positive

Action by one party benefits another party

Homeowner plants a beautiful garden where allthe neighbors benefit from it

Homeowner did not take their benefits intoaccount when deciding to plant




Negative Externalities andInefficiency

Scenario – plant dumping waste

Marginal External Cost (MEC) is the increasein cost imposed on fishermen downstreamfor each level of production

Marginal Social Cost (MSC) is MC plus MEC

We can show the competitive market firm

decision and the market demand and supplycurves





Assume the firm has a fixed proportionsproduction function and cannot alter itsinput combinations

The only way to reduce waste is to reduceoutput

Price of steel and quantity of steel initially

produced given by the intersection of supply and demand





The MC curve for the firm is the marginal cost of production

Firm maximizes profit by producing where MC

equals price in a competitive firm As firm output increases, external costs on

fishermen also increase, measured by themarginal external cost curve

From a social point of view, the firm producestoo much output




External Costs

MC

S = MCI

P 1

q1

P 1

Q1

MSC

MSCI

Firm output

Price

Industry output

Price

MEC

MECI

q*

P*

Q*

D

Firm will produce q1 at P1. There is MEC of production fromthe waste released. The MSC is

true cost of production.

The profit maximizing firmproduces at q1 while the

efficient output level is q*.




External Costs

Aggregatesocial cost of

negativeexternality

By not producingat the efficientlevel, there is asocial cost on

society.MC

S = MCI

D

P 1 P 1

q1 Q1

MSC

MSCI

Firm output

Price

Industry output

Price

MEC

MECI

q*

P*

Q*




External Cost

Negative externalities encourageinefficient firms to remain in the industryand create excessive production in thelong run




Positive Externalities andInefficiency

Externalities can also result in too littleproduction, as can be shown in anexample of home repair and landscaping

Repairs generate external benefits to theneighbors

Shown by the Marginal External Benefit

curve (MEB)Marginal Social Benefit (MSB) curve adds

MEB +D




MCP 1

External Benefits

Repair Level

Value

D

q 1

MSB

MEB

When there are positiveexternalities (the benefitsof repairs to neighbors),marginal social benefits(MSB) are higher than

marginal benefits (D).

q *

P* A self-interested home owner

invests q 1 in repairs. The

efficient level of repairsq* is higher. The higher price

P 1 discourages repair.




Ways of Correcting MarketFailure

Assumption: The market failure ispollutionOutput decision and emissions decision are

independentFirm has chosen its profit-maximizing output

level

MSC is marginal social cost of emissions

Equivalent to MEC from before Upward sloping because of substantially

increasing harm as pollution increases





MCA is marginal cost of abatingemissions

Additional cost to firm of controlling pollution

Downward sloping because when emissionsare high, there is little cost to controlling them

Large reductions require costly changes inproduction process





If the firm does not consider abatement,their profit maximizing level is 26 units of emissions

Level where MCA is zero

The socially efficient level of emissions is12 where the MSC equals the MCA




The Efficient Level of Emissions

2

4

6

Dollars/ Unitof Emissions

Level of Emissions

0 2 4 6 8 10 12 14 16 18 20 22 24 26

MSC

MCA

E*

The efficient level of

emissions is whereMCA = MSC.

At E o the marginalcost of abating emissions

is greater than themarginal social cost.

E 0

At E 1 the marginalsocial cost is greater

than the marginal benefit.

E 1





Firms can be encouraged to reduceemissions to the efficient level in threeways:

1. Emissions standards

2. Emissions fees

3. Transferable emissions permits





Options for Reducing Emissions to E*

1. Emissions Standard

Set a legal limit on emissions at E* (12)

Enforced by monetary and criminal penalties

Increases the cost of production and thethreshold price to enter the industry

2. Emissions Fee

Charge levied on each unit of emission




Standards and Fees

Level of Emissions

Dollars/ Unitof Emissions MSC

MCA

3

12

E*

Standard

Fee




TotalAbatement Cost

Cost is less than thefee if emissions were

not reduced.

Standards and Fees

Level of Emissions

Dollars/ Unitof Emissions

3

Total Feeof Abatement

12

Fee

MSC

MCA

E*





Standards Versus Fees

Assumptions

Policymakers have asymmetric information

Administrative costs require the same fee or standard for all firms




The Case for Fees

Assume two firmsSame marginal social cost curve

Different marginal abatement cost curvesMCA1 and MCA2

Emissions fees are preferable tostandards in this caseWe want to reduce total emissions by 14

unitsThe cheapest way to do that is for Firm 1 to

reduce by 6 and Firm 2 by 8 units




MCA1

MCA2

The Case for Fees

2

4

6

Fee per Unit of

Emissions

1

3

5

Level of Emissions0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

The cost minimizingsolution would be an

abatement of 6 for Firm1 and 8 for Firm 2 andMCA1= MCA2 = $3.




The Case for Fines

What if the regulatory agency forces each firmto cut emissions by 7 units?

MAC for Firm 1 increases to $3.75

MAC for Firm 2 decreases to $2.50 This is not cost minimizing because one firm

can reduce emissions at a lower cost than theother firm

Marginal cost of abatement must be equal between firms for reductions to occur at

minimum cost




The Case for Fees

2

4

6

Fee per Unit of

Emissions

1

3

5

Level of Emissions0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

MCA1

MCA2

The impact of a standard of abatement of 7 for both firms

is illustrated.Not efficient because

MCA2 < MCA1.

3.75

2.50

Firm 2’s Reduced Abatement

Costs

Firm 1’s Increased Abatement Costs





Advantages of Fees

When equal standards must be used, feesachieve the same emission abatement at a

lower cost

Fees create an incentive to install equipmentthat would reduce emissions further




The Case for Standards

Assume we have

Steep marginal social cost curve

Flat marginal cost of abatement

An emissions fee of $8 would be efficient butbecause of limited information, fee is set at$7

Firms’ emissions increase and with steepMSC, this will lead to significant additionalsocial costs





What if standard is used instead and hasthe same percentage mistake?

Standard set at 9 instead of 8

Increase in social costs and decrease inabatement costs

Net increase in social costs is smaller than

with fees




ABC is the increasein social cost less the

decrease in abatementcost.


Level of Emissions0 2 4 6 8 10 12 14 16

Fee per Unit of

Emissions

2

4

6

8

10

12

14

16

Based on incompleteinformation, standard is 9

(12.5% decrease).ADE < ABC

Based on incompleteinformation, fee is $7

(12.5% decrease).Emission increases to 11.

MarginalSocialCost

Marginal Costof Abatement

B

C

E

D A





Summary: Fees vs. Standards

Standards are preferred when MSC is steepand MCA is flat

Standards (incomplete information) yieldmore certainty on emissions levels and lesscertainty on the cost of abatement





Summary: Fees vs. Standards

Fees have certainty on cost and uncertaintyon emissions

Preferred policy depends on the nature of uncertainty and the slopes of the cost curves





Transferable Emissions Permits

Permits help develop a competitive marketfor externalities

Agency determines the level of emissions andnumber of permits

Permits are marketable

High cost firm will purchase permits from low

cost firms





The market for externalities is appealing since itcombines the system of standards with thesystem of fees

The agency who administers the systemdetermines the total number of permits andtherefore the total amount of emissions

Marketability of the permits allows pollution

abatement to be achieved at minimum cost




The Costs and Benefits of ReducedSulfur Dioxide Emissions

Costs of Reducing Emissions

Conversion to natural gas from coal and oil

Emission control equipment

Benefits of Reducing Emissions

Health

Reduction in corrosion

Aesthetic




The Costs and Benefits of ReducedSulfur Dioxide Emissions

The efficient sulfur dioxide concentrationequates the marginal abatement cost tothe marginal social cost

Can show the marginal abatement costcurve in a series of steps, eachrepresenting a different abatement

technology




Sulfur Dioxide EmissionsReductions

Sulfur dioxideconcentration (ppm)

20

40

60

0

Dollarsper

unit of reduction

0.02 0.04 0.06 0.08

Marginal Social Cost

Marginal Abatement Cost

Observations• MAC = MSC @ .0275• .0275 is slightly below actual emission level• Economic efficiency improved




Emissions Trading and CleanAir

Bubbles

Firm can adjust pollution controls for individual sources of pollutants as long as a

total pollutant limit is not exceeded

Offsets

New emissions must be offset by reducing

existing emissions 2000 offsets since 1979





Cost of achieving an 85% reduction inhydrocarbon emissions for DuPont

Three Options

85% reduction at each source plant(total cost = $105.7 million)

85% reduction at each plant with internal trading(total cost = $42.6 million)

85% reduction at all plants with internal andexternal trading(total cost = $14.6 million)





1990 Clean Air Act

Since 1990, the cost of the permits has fallenfrom an expected $300 to below $100

Causes of the drop in permit prices

More efficient abatement techniques

Price of low sulfur coal has fallen




Price of Tradable EmissionsPermits





Recycling

Households can dispose of glass and other garbage at very low cost

The low cost of disposal creates adivergence between the private and thesocial cost of disposal




Recycling

Marginal private cost likely constant for fixed amount of garbage

Social cost of disposal includes the harm

to environment from littering and injuriescaused by litter

Without market intervention, the level of scrap will be at m and m1 > m*

With refundable deposit, MC increasesand MC = MSC = MCR




The Efficient Amount of Recycling




Refundable Deposits

Deposit is paid when bottle is purchasedand then refunded when bottle returned

Can choose the deposit to give

household incentive to recycle moreDeposit increases private cost of disposal

Supply of glass comes from new glass

and recycled glassIncreasing deposit increases supply of recycled glass and lowers price of glass




Refundable Deposits

Amount of Glass

$

D

Price falls to P’ andthe amount of recycled glassincreases to M*.

S v

S r

S

The supply of glass isthe sum of the supply

of virgin glass (S V ) andthe supply of recycled

glass (S r ).

M 1

P

Without refunds theprice of glass is P and

S r is M 1 .S’ r

S’

P’

M*

With refunds S r increasesto S’ r and S increases to S’.




Externalities and PropertyRights

Property Rights

Legal rules describing what people or firmsmay do with their property

For example:

If residents downstream owned the river (cleanwater) they would control upstream emissions





Bargaining and Economic Efficiency

Economic efficiency can be achieved withoutgovernment intervention when the externality

affects relatively few parties and whenproperty rights are well specified




Profits Under AlternativeEmissions Choices (Daily)





Assumptions

Factory pays for the filter

Fishermen pay for the treatment plant

Efficient Solution

Buy the filter and do not build the plant

B i i i h Al i




Bargaining with AlternativeProperty Rights

E t liti d P t





Conclusion: Coase Theorem

When parties can bargain without cost and totheir mutual advantage, the resulting

outcome will be efficient, regardless of howthe property rights are specified

C tl B i i Th R l f




Costly Bargaining – The Role of Strategic Behavior

Bargaining requires clearly defined rulesand property rightsIf property rights were not clear, the other

party might not be willing to pay as much andthe bargaining process would break down

One party might incorrectly assume the other party will eventually break down and acceptless

Problems also arise when there are manyparties affected

A L l S l ti S i f




A Legal Solution – Suing for Damages

In many situations involving externalities,one party is harmed (victim)

They can recover monetary damagesequal to harm suffered

A suit for damages is different thaneffluent fee since the victim, not the

government, is paid

A L l S l ti S i f




A Legal Solution – Suing for Damages – Example

Fishermen have the right to clean water

Factory has two options:

No filter, pay damages

Profit = $100 ($500 - $400)

Filter, no damages

Profit = $300 ($500 - $200)

A L l S l ti S i f




A Legal Solution – Suing for Damages – Example

Factory has the right to emit effluent

Fishermen have three options:

Put in treatment plant

Profit = $200Filter and pay damages

Profit = $300 ($500 - $200)

No plant, no filter

Profit = $100 A suit for damages results in an efficient

outcome




The Coase Theorem at Work

Negotiating an Efficient Solution

1987 – New York garbage spill (200 tons)littered New Jersey beaches

The potential cost of litigation resulted in asolution that was mutually beneficial to bothparties




Common Property Resources

Characteristics

Everyone has free access

Likely to be overutilized

Examples

Air and water

Fish and animal populations

Minerals





Consider a lake where people fish

Each fisherperson takes fish up to thepoint where the marginal benefit to themequals the marginal cost

There is no reason that any onefisherperson take into account how their

taking fish affects others’ experience





Private cost underestimates the true costto society

More fishing reduces the stock of fish

Less is available to others and too low of astock will completely deplete the fish

Too many fish are caught





Fish per Month

Benefits,Costs($ per

fish)

Demand (MB)

However, private costs

underestimate true cost.The efficient level of

fish/month is F* whereMSC = MB (D).


F*

Private Cost

F C

Without control, the number of fish/month is F C where

PC = MB.





Solution

Private ownership

Owner will set fee for use of resource equal

to the marginal cost of depleting the stock

Fishermen will no longer find it profitable tocatch more than the efficient amount of fish

It is often the case that when privateownership is not possible, the governmentsteps in




Crawfish Fishing in Louisiana

Crawfish has become very popular inrestaurants

As a common property resource, too

many crawfish have been trapped,causing the population to fall belowefficient level

Finding the Efficient Crawfish CatchF = crawfish catch in millions of pounds/yr

C = cost in dollars/pound




Crawfish Fishing in Louisiana

DemandC = 0.401 = 0.0064F

MSC

C = -5.645 + 0.6509F

PCC = -0.357 + 0.0573F

Efficient CatchD = MSC

9.2 million pounds

Crawfish as a Common




Crawfish Catch(millions of pounds)

Cost($/pound)

Demand


Private Cost

Crawfish as a CommonProperty Resource

11.9

2.10

9.2

0.325




Public Goods

Characteristics

Nonrival

For any given level of production, the marginal

cost of providing it to an additional consumer iszero

Nonexclusive

People cannot be excluded from consuming the

goodExample – use of lighthouse by a ship






Efficiency and Public Goods

Efficient level of private good is wheremarginal benefit equals marginal cost

For a public good, the value of eachperson must be considered

Can add demand of all those who value good

Must equate the sum of these marginal

benefits to the marginal cost of production




D 1

D 2

D

D1 is demand for consumer 1.

D2 is demand for consumer 2.

D is total demand for all consumers.

Efficient Public Good Provision

Output0

Benefits(dollars)

1 2 3 4 5 6 7 8 109

$4.00

$5.50

$7.00

MC

$1.50

Efficient output occurswhere MC = total MB

2 units of output.

MB is $1.50 + $4.00 or $5.50.




Public Goods and Market Failure

Free Riders

There is no way to provide some goods andservices without benefiting everyone

Households do not have the incentive to paywhat the item is worth to them

Free riders understate the value of a good or service so that they can enjoy its benefit

without paying for it




Public Goods and Market Failure

Establishing a mosquito abatementcompany

How do you measure output?

Who do you charge?

A mosquito meter?




The Demand for Clean Air

Clean Air is a public good

Nonexclusive and nonrival

No market and no observable price at which

people are willing to trade clean air for other goods





Choosing where to live

Study in Boston correlates housing priceswith the quality of air and other

characteristics of the houses and their neighborhoods





Nitrogen Oxides(pphm)0

Dollars

1 2 3 4 5 6 7 8 109

2000

2500

3000

500

1500

1000

Low Income

Middle Income

High Income





FindingsThe amount of people who are willing to pay

for clean air increases substantially as

pollution increasesHigher income earners are willing to pay

more (the gap between the demand curveswiden)

National Academy of Sciences found that a10% reduction in auto emissions yielded abenefit of $2 billion---somewhat greater thanthe cost

Private Preferences for Public




Private Preferences for PublicGoods

Government production of a public goodis advantageous because thegovernment can assess taxes or fees to

pay for itDetermining how much of a public good

to provide when free riders exist is

difficult






Can represent different citizens’

willingness to pay for education minusany required tax payments

In general, benefit from increasedspending on education increases asspending increases

Tax payments to provide more educationincrease as well

Determining the Level




Determining the Levelof Educational Spending

Educational spendingper pupil$0

Willingnessto pay

$

$1200$600 $1800 $2400

AW

The efficient level of educationalspending is determined by summing thewillingness to pay for education for each

of three citizens.

Will majority rule yield an efficient outcome?•W 1 will vote for $600•W 2 and W 3 will vote for $1200The median vote will always win in a majorityrule election.

W 2 W 3W 1






Question

Will the median voter selection always beefficient?

Answer If two of the three preferred $1200, there

would be over-investment

If two of the three preferred $600, therewould be under-investment





Majority rule is inefficient because itweighs each citizen’s preference equally

The efficient outcome weighs each citizen’s

vote by his or her strength of preference

Documents

Ch18_Pindyck