Session 7 -Post

8/19/2019 Session 7 -Post

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Post Lecture Slides 5/19/20

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



2/13


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


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


Today

Public Goods and Externalities

– Public Goods

– Externalities

– Optimal provision of Public goods

– Coasian bargaining

– Pigouvian taxes

– Cap and trade



3/13


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?


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.


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?



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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


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.



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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?


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


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



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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


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


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


A Positive Externality Example

S = Marginal

Private Cost

D0 = MarginalPrivate Benefit

Cost, P

Q

P0

P1

Q0 Q1



If there are positive


social benefit differs from

the marginal private benefit,

and both P0 and Q0 are too

low to maximize social

welfare

If there are positive


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



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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


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 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



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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.


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


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?


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


Perfume Factory



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


Perfume Factory



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!



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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


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


Pigouvian Taxes and SubsidiesFirm has to either abate pollution or pay a tax


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


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



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


12/13


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.



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


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


13/13


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?


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.


Readings for Next Session• Oligopoly (Course pack page 171-199)


Documents

Session 7 -Post