Market Failure and the
Role of Government:
Externalities
AP MICROECONOMICS
MR. BORDELON
Pollution

Pollution sucks. However, given the conveniences of modern life, it’s
an inevitability in some form. To have hot water, electricity and
more, we must accept a certain amount of pollution. As such, we
have to find a cost-benefit balance.

Marginal social cost (MSC). Additional cost imposed on society as a
whole by an additional unit of pollution.

Marginal social benefit (MSB). Additional benefit to society from an
additional unit of pollution.

Socially optimal quantity of pollution. Quantity of pollution society
would choose if all the costs and benefits of pollution were fully
accounted for.
Costs and Benefits of Pollution
In a MSC/MSB graph, MSB corresponds to the
demand curve, and MSC corresponds to the
supply curve.
MSC is upward sloping because low levels of
pollution are manageable but more difficult to
manage at higher levels. When pollution is at low
levels, another ton of pollution isn’t that big a deal.
Nature can handle it. When pollution is at high
levels, then another ton of pollution has a much
greater cost, because nature can’t take care of it.
MSB is downward sloping because it becomes
more difficult to achieve more and more reduction
in pollution as the amount declines. At high levels
of pollution, reducing it is fairly easy. The value of
those resources used to reduce pollution
(abatement) is small, so it doesn’t cost us much.
At low levels of pollution, reducing it is costly. All
the easy abatement methods, so the more
expensive and harder methods must be used.
Costs and Benefits of Pollution
It’s easy to reduce the first ton of pollution,
and difficult to reduce the last one. The
benefit of the first ton is very high, and the
benefit of the last ton is very low.
Equilibrium can be found at O, the socially
optimal point. Notice that the socially
optimal quantity of pollution, QOPT, is not
zero. At QOPT, the MSB from an additional
ton of emissions and its MSC meet at $200.
The question is whether a free market
economy will achieve the socially optimal
quantity of pollution.
It’s a good bet that it will not.
What’s the problem?

In a word, incentive. With no government intervention, polluters
decide how much pollution occurs, with no incentive to take into
account the costs of pollution on society.

The benefits are monetary. By emitting an extra ton of pollution, any
given polluter saves the cost of buying expensive pollution control
equipment or more expensive fuels.

The costs of pollution fall on society as a whole, however, as they
have no say in how much pollution occurs.

In economics terms, this means that without government
intervention, polluters will continue to pollute until the MSB = 0.
Costs and Benefits of Pollution
This graph demonstrates the problems
related to a lack of incentive in a market
economy, specifically what we’ll call a
negative externality.
In a market economy, only the benefits of
pollution are taken into account in choosing
the quantity of pollution. As such, pollution
will be produced at QMKT, where MSB of an
extra ton of pollution is zero, but MSC is $400.
Pollution will be higher than what’s socially
optimal. QMKT > QOPT
Polluters don’t have to compensate society.
The marginal cost of pollution to any given
polluter is zero because there is no incentive
to limit the amount of emissions.
External Costs, Benefits
and Externalities

External cost. Uncompensated cost that an individual or firm
imposes on others.


External benefit. Benefit that individuals or firms confer on others
without receiving compensation.


AP Examples: pollution, traffic, second-hand smoking.
AP Examples: vaccinations (3 times)
Externalities. External costs and benefits.

Positive externalities. External benefits.

Negative externalities. External costs.
Inefficiency of Excess
Pollution
Take a look at the graph again. Back in
perfect competition, we saw that
equilibrium represents efficiency. Yes, it
totally does. Nobody can be made better
off without making someone worse off.
Another way to look at it is to say that
equilibrium is where total surplus is
maximized.
MSB is zero at QMKT, reducing the quantity of
pollution by one ton wouldn’t really do all
that much. The benefit to polluters from the
last unit of pollution is low/zero.
MSC is $400 at QMKT, imposed on rest of
society, reducing quantity of pollution by
one ton, total social cost of pollution falls by
$400, but total social benefit falls by virtually
zero.
Inefficiency of Excess
Pollution
Total surplus rises by approximately
$400 if quantity of pollution at QMKT is
reduced by one ton.
With every little bit of abatement,
total surplus would increase. Let’s
say that we did enough abatement,
that pollution reduced to QH. At that
level, MSC is $300 and MSC is $100,
meaning reducing just by one ton at
that level increases total surplus by
$200.
Even reducing it to a lower level, QH,
would still be inefficiently high, but
certainly better than QMKT. The
efficient outcome is at QOPT. Society
gains the area of the shaded
triangles.
Coase Theorem and Private Solutions

Coase theorem. Even in the presence of externalities, an economy
can reach an efficient solution, provided that the legal rights of the
parties are clearly defined and the transaction costs of making a
deal are sufficiently low.


Transactions costs. Costs to individuals of making a deal.

Costs of communication among interested parties.

Costs of making legally binding agreements.

Costly delays involved in bargaining.
In short, Coase suggests that it is possible to achieve a solution
through the free market so long as both parties are on an equal
footing and it doesn’t cost too much.
Bob and Bobbette’s Pigs

Bobbette buys a house worth $200,000. Bob moves in next door and
promptly brings with him some pigs. The stench is…ugh. Bobbette’s
house drops in worth to $150,000. She’s suffering from a negative
externality.

Assume Bob has the legal right to have these pigs. Bobbette’s property
value has dropped $50,000. She’d ultimately be willing to pay up to
$50,000 to get him to knock it off.


Why $50,000? At $50,001, Bobbette would ultimately begin paying Bob for
the loss in value to her property. That’s the value of it.
If Bob is willing to accept $20,000 to not raise the pigs, Bobbette’s only
out $20,000 instead of $50,000. Bob doesn’t get to raise the pigs, but he
now has $20,000 to invest in pork futures.
Bob and Bobbette’s Pigs

Bobbette buys a house worth $200,000. Bob moves in next door and
promptly brings with him some pigs. The stench is…ugh. Bobbette’s
house drops in worth to $150,000. She’s suffering from a negative
externality.

Assume Bobbette has a legal right to a house that does not smell like
pigs. Bob wants to raise pigs in the backyard, and not being able to
raise the pigs is a hardship for him, those tiny tasty little piggies.

If Bob has the pigs, it would harm Bobbette in the amount of $50,000, so
Bob could offer Bobbette $50,000 or more to compensate for the
damages.

Why “or more”? It’s Bobbette in this scenario who needs to be
compensated, so her price could go beyond the value of what she loses.
Coase Theorem and Private Solutions

Key point: Externalities do not need to be inefficient because
individuals have an incentive make mutually beneficial deals, which
lead them to take into account externalities, or internalize the
externalities (yes, I know).


In the pig scenarios, Coase would say that the private solutions
internalize the externality. The party that is imposing the hardship on the
other is required to compensate the victim.
Key point: If externalities are fully internalized, the benefit must be
equal to the external cost imposed. As such the outcome is efficient
even without government intervention.
Coase Theorem and Private Solutions

Criticism. Coase theorem tends to break down when dealing with
individuals not on an equal footing, say Apple Inc. vs. Travis, Wal-Mart
contracting with a union vs. an individual.

When Private Solutions Likely Fail

High communication costs between parties. If everybody’s not thrilled with
you, then the cost of negotiating a settlement between lots of people and
the guy causing the problem get higher.

What if it wasn’t just Bobbette? What if Bob had irritated the entire community?

High legal costs. Negotiations and legally binding agreements might require
lots of attorneys and a huge stack of legal bills.

Costly delays in bargaining. Bob knows Bobbette’s suffering and delays and
postpones every meeting. He may be playing around, assuming you’ll get
tired of the delays and just simply move.
How’s the environment around
Orange City doing?

http://www.epa.gov/myenv/myenview2.html?minx=81.48903&miny=28.87414&maxx=81.10794&maxy=29.02735&ve=11,28.94875,81.29700&pSearch=Orange%20City,%20FL

Take a look at this, then hop on Twitter to explain your outrage (or
lack thereof): @titanecon
Multiple Choice Practice
1.
The socially optimal level of pollution is
A.
less than that created by the market, but not zero.
B.
more than that created by the market.
C.
whatever the market creates.
D.
determined by firms.
E.
zero.
Multiple Choice Practice
1.
The socially optimal level of pollution is
A.
less than that created by the market, but not zero.
B.
more than that created by the market.
C.
whatever the market creates.
D.
determined by firms.
E.
zero.
Multiple Choice Practice
2.
Which of the following is a source of negative externalities?
a.
loud conversations in a library
b.
smokestack scrubbers
c.
a beautiful view
d.
national defense
e.
a decision to purchase dressy but uncomfortable shoes
Multiple Choice Practice
2.
Which of the following is a source of negative externalities?
a.
loud conversations in a library
b.
smokestack scrubbers
c.
a beautiful view
d.
national defense
e.
a decision to purchase dressy but uncomfortable shoes
Multiple Choice Practice
3.
Inefficiencies created by externalities can be dealt with through
a.
government actions only.
b.
private actions only.
c.
market outcomes only.
d.
either private or government actions.
e.
neither private nor government actions.
Multiple Choice Practice
3.
Inefficiencies created by externalities can be dealt with through
a.
government actions only.
b.
private actions only.
c.
market outcomes only.
d.
either private or government actions.
e.
neither private nor government actions.
Multiple Choice Practice
4.
The Coase thoerem asserts that, under the right circumstances,
inefficiencies created by externalities can be dealt with through
a.
lawsuits.
b.
private bargaining.
c.
vigilante actions.
d.
government policies.
e.
mediation.
Multiple Choice Practice
4.
The Coase thoerem asserts that, under the right circumstances,
inefficiencies created by externalities can be dealt with through
a.
lawsuits.
b.
private bargaining.
c.
vigilante actions.
d.
government policies.
e.
mediation.
Multiple Choice Practice
5.
Which of the following makes more likely that private solutions to
externality problems will succeed?
a.
high transaction costs
b.
high prices for legal services
c.
delays in the bargaining process
d.
a small number of affected parties
e.
loosely defined legal rights.