Externalities and Public Goods
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Externalities Basics
o Definition: An externality is present when the cost of producing a good or the benefits of
consuming a good spill over to those not producing or consuming a good.
o The transaction affects someone not involved in the transaction (so they can’t decide whether or
not is should happen)
o Difference between private and social benefits/costs
ƒ Private: applying to the agents making the transaction
ƒ External: applying to agents other than those making the transaction
ƒ Social: total (all agents) so = private + external
o Why do we care about externalities?
ƒ If private costs or benefits differ from social costs or benefits, then private profit
maximization or utility maximization will no longer be socially optimal or “efficient”
ƒ Pollution example
• If the firm is just maximizing profits, but is ignoring how much their production
process hurts people outside the firm, they will produce too much since they are
ignoring the costs to different members of society.
ƒ So, the First Theorem of Welfare Economics (competitive equilibrium is efficient)
doesn’t hold with externalities
o Examples
ƒ Negative: pollution in power production, construction outside my window
ƒ Positive: education, shoveling your sidewalk, flu shot
Supply / Demand Diagram Treatment
o Used to see deadweight loss and determine policies (taxes or subsidies) that will return us to the
socially optimal equilibrium.
o Positive Externality – draw graph with MSB above MPB P
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ƒ Note competitive equilibrium – private utility max
ƒ Note socially optimal equilibrium
ƒ Note DWL (below social optimum, MSB > MSC so could increase overall surplus)
ƒ Show gain from increasing production by a bit
ƒ Show optimal subsidy that brings us back to social optimum
Negative Externality – draw graph with MSC above MPC P
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Note convention of moving B curve with positive externality and moving C curve with
negative externality (just a convention, but makes things simpler)
ƒ Note competitive equilibrium – private utility max
ƒ Note socially optimal equilibrium
ƒ Note DWL (past social optimum, MSC > MSB so losing overall surplus)
ƒ Show gain from reducing production by a bit
ƒ Show optimal tax that brings us back to social optimum
Ask for questions about Hw7 q1
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Abatement Diagram Treatment
o This graph is Confusing – so pay close attention and make sure makes sense
o Draw graph from Hw7q2a, but put in MPB P
Read the graph from right to left
Define abatement
MCA gets higher as pollution gets lower because it is easy to clean up a little, hard to clean up a
lot
o MBA gets lower as pollution gets lower because it really helps to get rid of a little pollution, but
if there isn’t much pollution, it doesn’t really hurt us and cleaning up one unit doesn’t help as
much
o Show maximum pollution, unregulated level of pollution, socially optimal amt of pollution
o Show cost between different points – Area under MCA curve between two pollution levels is
total cost of making that move.
Property rights and tradable permits
o Assign rights to the activity associated with an externality and allow agents to buy and sell the
rights to the activity
ƒ Example of playing lout music
• I like to listen to loud music at 2am and you are my neighbor who likes to sleep
at 2am
• Could give me the right to listen to loud music – you will pay me to turn off the
music
• Could give you the right to silence – I will pay you to allow me to turn on the
music
• Could issue loud music permits to each of us and we will buy and sell them until
both of us are happy with the outcome
o Coase Theorem
ƒ Reach efficient level of activity regardless of who gets rights (it just changes how money
changes hands).
ƒ The same amount of loud music will be played in all three above cases, the only
difference is how money changes hands
ƒ “Allocation” means how you divide up a given amount of rights between different people
• if the government makes permits for 100 minutes of loud music, it could allocate
them (0,100), (100,0), (50,50), (60, 40) etc.
• note that the total number didn’t change, just the division between people.
o Draw graph like Hw7q2c
ƒ Two firms with different MCA curves
ƒ Start at 300 each firm – at this point MCAv > MCAk so a permit to pollute is worth a lot
to v and less to k, so k sells to v
ƒ Keep doing this until they don’t want to trade any more – when the MCA’s are equal
ƒ Since started at 300 each, we have to have both firms the same distance from 300 and the
final price ends up being 60, with v producing 400 and k producing 200
ƒ What if we allocated them as (100,500) instead of (300,300) --> would get the same
answer by Coase Theorem (this wouldn’t work for (100,400) since the total amount
changed – the Coase Thm only applies for situations where the number of permits is the
same, but the allocation changes).
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Public Goods
o Non-rival goods: increased consumption of the good by one person does not decrease the amount
available for consumption by others
ƒ Note free-rider problem
ƒ National defense
ƒ Clean air
o Non-excludable goods: goods for which people can not be stopped from consuming it
ƒ Lighthouses
ƒ Broadcast radio
o Public goods: goods that are both non-rival and non-excludable, and thus are usually provided by
governments
o Numerical Example:
ƒ Consider a lighthouse protecting a fishing fleet with 10 ships.
ƒ For each ship, the MV of hours of lighthouse light is MV = 8 – Q where Q is the number
of hours (ie. this is each ship’s demand curve).
ƒ The marginal value to society MVS = 10*MV = 80 – 10Q.
• Add up the marginal values of each ship because they all consume the light
• Vertical summation as opposed to horizontal summation for rivalrous goods).
ƒ Imagine that the marginal cost of an hour of light is 10.
• No ship is willing to pay for the light so Q=0. However, the efficient amount of
light is MC = MVS or Q* = 7. Obviously a bad outcome.
ƒ Now imagine that MC = 5.
• Now society wants Q* = 7.5.
• However, Q still equals 0. While every ship would pay for 3 hours, they would
all prefer that someone else pays for those hours since they still get to consume it.
This is the free rider problem.
ƒ Solutions
• If MC = 10, Government charges everyone a fee and then provides the good
itself. So government should provide the optimal quantity of 7 at a total cost of
$70, so charge each of the 10 ships $7.
• If MC = 5, Government just supplies the good. Total cost of supplying the here
is $75 so the government should charge everyone a fee of $7.5
o Note that public goods can be seen as a good that exhibits a positive externality – without some
government externality it will be underprovided.
Asymmetric Information
• Definition: situations in which some market participants know more about the value of a good than others
• Results in inefficient market outcomes or eve \n market breakdown
• Lemons Problem
o Setup
ƒ 100 buyers of used cars
ƒ 100 sellers of used cars
ƒ Everyone knows: ¾ of the cars are good, ¼ of the cars are bad
ƒ Seller knows: whether the car being sold is good or bad
ƒ Buyer can’t tell whether a potential car is good or bad
Value
Seller
Buyer
Bad
$1000
$1200
Good
$2000
$2400
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Since sellers don’t know which cars are good or bad, they value an unknown car at the “expected
value”
ƒ Expected value = (probability good) * value good + (probability bad) * value bad
ƒ Average value of a randomly chosen car
ƒ EV = ¾ * $2400 + ¼ * $1200 = $2100
This market functions: all cars are sold, since sellers get more than their valuation for good and
bad cars
Revised Setup
ƒ Everyone knows: 1/4 of the cars are good, 3/4 of the cars are bad
Buyers’ EV = ¼ * $2400 + ¾ * $1200 = $1800
This market breaks down:
ƒ Good cars no longer sell since buyers aren’t willing to pay enough for sellers to be
willing to sell
ƒ Only bad cars remain on the market, so everyone eventually realizes this and the price
falls to $1200, since all cars are bad
Cartels and Antitrust
• Sherman Anti-trust Act 1890
o Rule of reason: not illegal to be monopoly per se, but also that it intends to use market power
against other firms
o Example: price setting
ƒ Treble damages: injured firms get three times the actual damages
o Example: predatory pricing
ƒ Charge price below shutdown price
ƒ Problem is that it is nearly impossible to prove because it could just be that firm is more
efficient (ie. lower costs)
o Solutions: fines and breaking up firms
ƒ Rarely has jailtime
ƒ Breaking up only works if they actually compete (long-distance)
• Clayton Act of 1914
o Designed to prevent the formation of monopolies
o Example: merger policy
ƒ Mergers may capture returns to scale but will be blocked by Federal Trade Commission if
it restricts competition
ƒ Herfindal-Hirschman Index
• Sum of squares of market shares
• Will be lower with more firms and when shares are more equal
ƒ If HHI is above 1800, then merger will be opposed if HHI increases by more than 50
ƒ If HHI is between 1000-1800, then merger will be opposed if HHI increases by 100
ƒ If HHI is less than 1000, then merger will be unopposed
ƒ Problem: definition of market
• Also sometimes use price-cost margin
o (P-MC)/MC
o if competition then this is 0, so the higher the number the less competition
Labor Demand
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Labor Supply
o Labor vs. leisure decision
ƒ Leisure is anything other than paid work (includes keeping house, caring for children,
having fun, etc.)
ƒ MB of working is the wage
ƒ MC of working is the value of the leisure you are foregoing by working
o The effects of wage changes
ƒ Consider both substitution and income effects
ƒ Substitution effect: if wage increases, work becomes more attractive relative to leisure Æ
encourages increased working
ƒ Income effect: if wage increases, get more money for less work Æ encourages less work
o Shape of labor supply curves
ƒ Substitution effect dominates (upward sloping) P
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Income effect dominates (downward sloping) P
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Income and substitution effects just cancel each other out (vertical) P
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Backward bending supply curve P
Labor Demand
o Alternate view of firm’s maximization problem
o Can maximize outputs or inputs – labor demand is the amount of labor input that maximizes firm
profits.
o MPL = ΔQ / ΔL
o MRPL = ΔTR / ΔL = Δ(PQ) / ΔL = P (ΔQ / ΔL) = P MPL
o Marginal Analysis
ƒ MB to firm of hiring a worker is MRPL
ƒ MC to firm of hiring a worker is W
ƒ (if can hire fractional units) Optimal hiring chooses L so that MRPL = W
ƒ (if can not hire fractional units) Will continue to increase L as long as MRPL >= W and
will stop if MRPL < W
o Yields a labor demand curve – relationship between W and L
Labor Market Equilibrium
o Intersection between labor supply and labor demand curve