17.1 Introduction
17.2 Externalities
17.3 Public Goods
1
First Fundamental Theorem of Welfare Economics:
IF
1) All consumers and producers act as perfect
competitors (no one has market power)
and
2) A market exists for each and every commodity
Then
Resource allocation is Pareto Efficient
2
An EXTERNALITY occurs when:
1) The activity of one agent directly affects the
welfare of another agent
And
2) This affect is not transmitted by market prices
Therefore no perfect competition
Therefore the First Fundamental Theorem of
Welfare Economics doesn’t hold
3
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
4
IF Externalities Exist,
THEN
Social marginal cost ≠ private marginal cost,
AND
1st Fundamental Theorem of Welfare Economics
Fails
THEREFORE
Government could intervene
5
What is an Externality?
Graphical Analysis of Externalities
Private Responses to Externalities
Public Responses to Externalities
Implications for Income Distribution
Positive Externalities
An EXTERNALITY occurs when:
1) The activity of one agent directly affects the
welfare of another agent
And
2) This affect is not transmitted by market prices
7
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 safer
Not 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
8
Externalities carry a variety of rarely considered
features:
1) EXTERNALITIES CAN BE PRODUCED BY
CONSUMERS AS WELL AS FIRMS
2) EXTERNALITIES ARE RECIPROCAL IN NATURE
3) EXTERNALITIES CAN BE POSITIVE OR NEGATIVE
4) PUBLIC GOODS AND EXERNALITIES CAN BE
SIMILAR
9
Examples:
-a student using bandwidth
-a smoker
-a neighborhood watch patrol
-a cell phone “loud-talker”
10
-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
11
-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
12
-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
13
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.
MSC=MPC+MEC
$
MPC
MEC
MB
Q* Q1
Society, however, experiences
Marginal External Costs
(MEC), and therefore
Marginal Social Cost (MSC)
is higher than MPC.
Q
Efficient consumption therefore occurs where MSC=MB, at
point Q*. There is overconsumption.
14
-The marginal benefit curve slopes down:
1) due to diminishing marginal benefit
or
2) As a reflection of the demand curve and
market price decreasing with quantity
-Costs tend to increase with output, therefore
MPC is upward sloping
15
-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.
16
-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:
17
$
MSC
MPC
P*
P
Producer
Surplus
MEC
Consumer
Surplus
MB=D
Q*
Q
Q
18
$
Externality
Cost
MSC
MPC
P*
P
MEC
MB=D
Q*
Q
Q
19
$
Deadweight
Loss
MSC
MPC
P*
P
MEC
MB=D
Q*
Q
Q
20
Assume a city starts buying dogs that bark at
night. Let:
MEC=Q
MB=350-Q
MPC=50+Q
Therefore:
MSC=MPC+MEC
MSC=50+Q+Q
MSC=50+2Q
21
MEC=Q
MPC=50+Q
Individual:
MB=MPC
350-Q=50+Q
300=2Q
150=Q1
P1=350-Q
P1=350-150
P1=200
MB=350-Q
MSC=50+2Q
Society:
MB=MSC
350-Q=50+2Q
300=3Q
100=Q*
P*=350-Q
P*=350-100
P*=250
22
$
MSC=50+2Q
MPC=50+Q
250
200
MEC=Q
MB=350-Q
100
150
Q
23
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+100
MPC=150
24
$
MSC=50+2Q
MPC=50+Q
350
250
200
150
MEC=Q
MB=350-Q
100
150
Q
Obviously, this graph is not to scale.
25
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
26
$
SMC=50+2Q
PMC=50+Q
350
250
200
150
A
B
MD=Q
C
100
MB=350-Q
150
Q
Obviously, this graph is not to scale.
27
A=(1/2)bh
A=(1/2)(350-200)(150-100)
A=7,500
 Net benefit to society if production is
reduced
OR
 Deadweight loss of extra production
28
B=(1/2)bh
B=(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
29
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?
30
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
31
-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
32
-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
33
-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.
34
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?
35
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) Mergers
3) Social Conventions
36
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:
37
$
MSC
MPC
MEC
MB
Q*
Q1
Movie Downloads
38
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:
39
$
MSC
MPC
MEC
Payment
MB
Movie Downloads
q
The maximum payment Evan is willing to give Mark to give
up consumption point q is greater than MB-MPC
40
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:
41
$
MSC
MPC
MEC
Payment
Payment
MB
Movie Downloads
q
The minimum payment Evan is willing to accept to allow
consumption point q is less than MB-MPC
42
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=MPC
11-Q=1
Q=10
43
Evan’s internet slows down because Mark
downloads so much. His MEC=Q, therefore,
the social optimum is:
MB=MSC=MPC+MEC
11-Q=1+Q
2Q=10
Q=5
44
MSC=1+Q
$
1
MEC=Q
MB=11-Q
5
10
MPC=1
Downloads (10’s Gigs)
45
MSC=1+Q
$
MEC=Q
Note: if Q=10,
MEC(10)=1+5=10
10
Note: if Q=5,
MEC(5)=5
5
Max
Payment
MB=11-Q
1
5
10
MPC=1
Downloads (10’s Gigs)
46
Evan’s would pay up to his extra cost to reduce
the overuse of the internet:
Evan’s Max Cost=Big triangle-Small triangle
Max Pay=(1/2)bh-(1/2)bh
Max Pay=(1/2)(10)(10)-(1/2)(5)(5)
Max Pay=50-12.5
Max Pay=37.5
47
MSC=1+Q
$
MEC=Q
Note: if Q=5,
MSC(5)=1+5=6
6
Min
Fee
1
MB=11-Q
5
10
MPC=1
Downloads (10’s Gigs)
48
Mark would accept anything above his excess
benefit to reduce his overuse:
Mark’s Minimum Fee =(1/2)bh
Min 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.
49
For the above analysis to work:
1) Bargaining costs must be low
2) 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.
50
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)
51
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
52
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
53
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
54
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
55