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17.1 Introduction17.2 Externalities17.3 Public Goods

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First Fundamental Theorem of Welfare Economics:IF

1) All consumers and producers act as perfect competitors (no one has market power)

and2) A market exists for each and every commodity

ThenResource allocation is Pareto Efficient

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An EXTERNALITY occurs when:

1) The activity of one agent directly affects the welfare of another agent

And2) This affect is not transmitted by market

prices

Therefore no perfect competitionTherefore the First Fundamental Theorem of

Welfare Economics doesn’t hold

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A PURE PUBLIC GOOD has two features:

1) Nonrival – once provided, another person can consume it at no additional cost

2) Nonexcludable – once provided, it is impossible or highly expensive to prevent anyone from consuming it

Perfectly competitive markets can’t exist for these goods

Therefore the First Fundamental Theorem of Welfare Economics doesn’t hold

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IF Externalities Exist,THEN

Social marginal cost ≠ private marginal cost,AND

1st Fundamental Theorem of Welfare Economics Fails

THEREFORE

Government could intervene

What is an Externality?Graphical Analysis of ExternalitiesPrivate Responses to ExternalitiesPublic Responses to ExternalitiesImplications for Income DistributionPositive Externalities

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An EXTERNALITY occurs when:

1) The activity of one agent directly affects the welfare of another agent

And2) This affect is not transmitted by market prices

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Externalities:-A firm pollutes the air through production-A dorm student uses up all the bandwidth

downloading So You Think You Can Dance-neighborhood dogs make your house saferNot Externalities:-A store with noisy country music must reduce price

to keep customers-Subway has a sale, forcing Mr. Sub to have a sale also

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Externalities carry a variety of rarely considered features:

1) EXTERNALITIES CAN BE PRODUCED BY CONSUMERS AS WELL AS FIRMS

2) EXTERNALITIES ARE RECIPROCAL IN NATURE3) EXTERNALITIES CAN BE POSITIVE OR NEGATIVE4) PUBLIC GOODS AND EXERNALITIES CAN BE

SIMILAR

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Examples:

-a student using bandwidth -a smoker-a neighborhood watch patrol-a cell phone “loud-talker”

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-all parties using a good affected by externalities affect each other:-the roommate downloading movies and the roommate downloading papers-person using a cell phone beside 2 people talking

-which is “worse” is a biased value judgment

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-As previously stated, externalities can also be positive-negative externalities tend to be overproduced, and positive externalities tend to be underproduced

-ie: shoveling your snow makes winter easier on your neighbors, owning a guard dog protects your neighbors, washing your hands prevents other from getting sick

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-Externalities are unintended costs or benefits to the community, whereas public goods have intended benefits to the community (Mishan 1971)-ie: If you hire security, it has externalities. If your block hires security, it is a public good

-It is still useful to examine them independently in practice

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Q* Q

$

MEC

When an agent consumes a good with a negative externality, he only equates marginal benefit (MB=D) and his Marginal

Private Cost (MPC) and consumes at Q1.

Q1

Society, however, experiences Marginal

External Costs (MEC), and therefore Marginal Social Cost (MSC) is higher than

MPC.

MPC

MSC=MPC+MEC

MB

Efficient consumption therefore occurs where MSC=MB, at point Q*. There is overconsumption.

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-The marginal benefit curve slopes down:1) due to diminishing marginal benefit

or2) As a reflection of the demand curve and market price decreasing with quantity

-Costs tend to increase with output, therefore MPC is upward sloping

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-Typically as output increases, the negative externality also increases, causing the MEC curve to be upward sloping -(2 barking dogs is more annoying than one)

-The distance between the MSC and the MPC is always the MEC.

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-Private markets will overproduce when negative externalities exist-without a market for externalities, this is a RATIONAL action

-Note that optimal amount of the externality IS NOT ZERO (ie: pollution is a cost, but some level is acceptable for the benefit)

-Overproduction causes a deadweight loss to society:

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Q* Q

$

MEC

Q

MPC

MSC

MB=D

P*

P

ProducerSurplus

ConsumerSurplus

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Q* Q

$

MEC

Q

MPC

MSC

MB=D

P*

P

ExternalityCost

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Q* Q

$

MEC

Q

MPC

MSC

MB=D

P*

P

DeadweightLoss

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Assume a city starts buying dogs that bark at night. Let:

MEC=QMB=350-QMPC=50+QTherefore:MSC=MPC+MECMSC=50+Q+QMSC=50+2Q

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MEC=Q MB=350-QMPC=50+Q MSC=50+2QIndividual:MB=MPC350-Q=50+Q300=2Q150=Q1

P1=350-QP1=350-150P1=200

Society:MB=MSC350-Q=50+2Q300=3Q100=Q*P*=350-QP*=350-100P*=250

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100 Q

$

MEC=Q

150

MPC=50+Q

MSC=50+2Q

MB=350-Q

250

200

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To calculate deadweight loss, we need 2 more points in the graph:

MSC=50+2Q1

MSC=50+2(150)MSC=350

MPC=50+Q*MPC=50+100MPC=150

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100 Q

$

MEC=Q

150

MPC=50+Q

MSC=50+2Q

MB=350-Q

250

200

350

150

Obviously, this graph is not to scale.

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If we were to move from our individual optimum to our social optimum:

1) Society would gain area A+B, (which is equal to area C).

2) The individual would lose profits or utility equal to area B

3) Therefore, assuming everyone is equal in society the net gain is area A

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100 Q

$

MD=Q

150

PMC=50+Q

SMC=50+2Q

MB=350-Q

250

200

350

150

Obviously, this graph is not to scale.

AB

C

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A=(1/2)bhA=(1/2)(350-200)(150-100)A=7,500 Net benefit to society if production is

reducedOR

Deadweight loss of extra production

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B=(1/2)bhB=(1/2)(250-150)(150-100)B=5,000 Loss to individual from lower Q

A+B=12,500 Gain to society from lower Q

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1) Utility and demand are hard to measure, making MB hard to define

2) The Marginal External Cost (MEC) can be hard to identify, quantify, and value:

a) What activities produce pollutants?b) Which pollutants do harm?c) What is the value of the damage done?

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Smog has been linked to many health concerns, and depends on factors such as production causing particulates and gases, temperature, and wind.-But these particulates and gases can travel large distances before causing smog-This makes smog production hard to pin down

-Greenhouse gases have a greater transborder effect

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-Scientists can’t do randomized studies on pollution (take 50 people and expose them to pollution and compare them to 50 kept away from pollution)

-CORRELATION can be found, but CAUSATION is more difficult to prove-It is also possible that an outside variable is increasing both pollution and health problems

-ie: Low income may lead to lower healthcare and lower removal of pollution

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-Assume we have perfect scientific information, and the amount of damage can be accurately assessed-What is the value of that damage?

-One could compare house prices in polluted and non-polluted areas to estimate value-But what if people underestimate (or overestimate) the health impact?-Some effects may also be long-term

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-Although the model is simple, the application is difficult-It requires biologists, engineers, ecologists, and doctors to work with economists

-Long-term and transborder effects make this even more difficult

-The economist’s tool of marginal analysis is essential in any policy, since zero pollution is never a possibility.

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1) Assume a new student moves into dorms and plays loud, bad music (country rap), long into the night. The average GPA of the floor goes from a 3.1 in Fall to a 2.8 in Winter. What are the marginal external costs?

2) A new Styrofoam recycling plant opens up in Podunk (Population 200,000). Cancer rates rise from 10% in 2000 to 15% in 2010. What are the marginal external costs?

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Government regulation isn’t the only method to deal with externalities. Externalities can be dealt with through private individuals through:

1) The Coase Theorem (assigning property rights)2) Mergers3) Social Conventions

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One way to privately deal with externalities is for one party to be given OWNERSHIP or PROPERTY RIGHTS of the market the externality exists in.

Let’s examine the case of internet bandwidth. We have 2 people sharing the internet, one for downloading movies (Mark), another for everyday use (Evan). As we see on the following graph, Mark’s downloading causes Marginal Damage to Evan:

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Q* Movie Downloads

$

MEC

Q1

MSC

MB

MPC

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Assume that Mark is given property rights over bandwidth. -Mark consumes up to Q1 because his MB>MPC up to that point-He’d be willing to give up marginal consumption if Payment>(MB-MPC)-Evan is willing to pay up to his MEC-Since between Q1 and Q*, MEC>MB-MPC, room for negotiating exists:

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Movie Downloads

$

MEC

MSC

MB

MPC

Payment

The maximum payment Evan is willing to give Mark to give up consumption point q is greater than MB-MPC

q

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Assume that Evan is given property rights over bandwidth:-Consumption starts at zero-Evan is willing to allow downloading if the payment he receives is greater than MEC (which starts at zero)-Mark is willing to pay to download if the payment is less than his MB-MPC-To the left of Q1, this is the case:

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Movie Downloads

$

MEC

MSC

MB

MPC

Payment

The minimum payment Evan is willing to accept to allow consumption point q is less than MB-MPC

q

Payment

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Assume Mark and Evan’s problem is as follows:Mark and Evan pay $1 per 10 Gig (Q)

downloaded for internet. Mark’s monthly marginal internet benefit is 11-Q. Mark’s private optimum is expressed as:

MB=MPC11-Q=1Q=10

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Evan’s internet slows down because Mark downloads so much. His MEC=Q, therefore, the social optimum is:

MB=MSC=MPC+MEC11-Q=1+Q2Q=10Q=5

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5 Downloads (10’s Gigs)

$ MEC=Q

10

MSC=1+Q

MB=11-Q MPC=11

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5 Downloads (10’s Gigs)

$ MEC=Q

10

MSC=1+Q

MB=11-Q MPC=1

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Note: if Q=10,MEC(10)=1+5=1010

Note: if Q=5,MEC(5)=5

MaxPayment

5

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Evan’s would pay up to his extra cost to reduce the overuse of the internet:

Evan’s Max Cost=Big triangle-Small triangleMax Pay=(1/2)bh-(1/2)bhMax Pay=(1/2)(10)(10)-(1/2)(5)(5)Max Pay=50-12.5Max Pay=37.5

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5 Downloads (10’s Gigs)

$ MEC=Q

10

MSC=1+Q

MB=11-Q MPC=11

Note: if Q=5,MSC(5)=1+5=6

Min Fee

6

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Mark would accept anything above his excess benefit to reduce his overuse:

Mark’s Minimum Fee =(1/2)bhMin Pay=(1/2)(5)(6-1)Min Pay=12.5

Conclusion: Evan will pay Mark between $12.50 and $37.50 to reduce his internet use to the social optimum, 50 Gigs/month.

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For the above analysis to work:1) Bargaining costs must be low2) Resource owners must be able to identify

damages to their property and legally prevent them (ie: Evan cutting off Mark’s internet)

Note that since for most production points the willingness to pay > willingness to accept, the actual payments are a function of bargaining ability.

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WHO receives property rights affects income distribution, but not outcome – production moves to Q*, where MB=MSC

THE COASE THEOREM implies that once property rights are established, no government intervention is required to deal with externalities. (Coase 1960)

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The Coase Theorem works best in cases where few parties are involved and the sources of externalities are well-defined.

-Often many people are involved (ie: air polution)-Often the externalities are poorly defined (ie: air

pollution, noise pollution, etc)

-Coasian assignment of property rights has been successful both in waterways of England and Scotland and elephant herds of Zimbabwe

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One way to “internalize” an externality is to combine involved parties. For example, if one firm’s actions caused an externality to another, the two firms could merge (through buyout or a 3rd party)

-IE: Bookstore buys out the Discotheque next door (externality = noise)-The new, superfirm would then take their externality into account and move to Q*

-Since everything happens within one firm, one could argue it is no longer an externality

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Social conventions and moral precepts encourage people to take Marginal External Cost into account:

-you should recycle, if you don’t you’re a horrible person

-you should respect others, and not litter or be noisy-you shouldn’t bud in line, as it is rude and affects

everyone else behind you

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The Golden Rule:

“Do unto others as you would have them do unto you”

can be turned into economic terms as:

“Always consider the external marginal benefits and marginal costs of an

action”-social conventions and moral precepts work to move

MPC closer to MSC