4
THE ECONOMICS OF THE PUBLIC SECTOR
Market Failure
• Recall from Chapter 7:
– Adam Smith had argued that the “invisible hand”
of the marketplace leads self-interested buyers and
sellers to an outcome in which the total surplus of
society is maximized.
• But that requires properly functioning markets
• In reality, markets can fail
• When markets fail, government intervention
may help
CHAPTER 10 EXTERNALITIES
2
10
Externalities
EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality is the uncompensated impact of
one person’s actions on the well-being of a
bystander.
CHAPTER 10 EXTERNALITIES
4
EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality is the uncompensated impact of
one person’s actions on the well-being of a
bystander.
– Al’s action may affect the well-being of Betty, a
bystander, in a negative or positive way.
– If Al pays no compensation (when his action has a
negative effect on Betty) nor receives a reward
(when his action has a positive effect on Betty), the
effect of Al’s action on Betty is called an
externality.
CHAPTER 10 EXTERNALITIES
5
• In this case, Al will ignore the effects of his
action on Betty when deciding whether or not
to take the action
• Therefore, Al may take this action even if it is
undesirable for society
• And, conversely, Al may refuse to take this
action even if it is desirable for society
• In other words, when actions have external
effects, society’s total surplus might not be
maximized in the free market equilibrium
• Government intervention may be able to
increase total surplus
CHAPTER 10 EXTERNALITIES
6
Externalities, negative and positive
• When the impact of a person’s action on a
bystander is harmful, the externality is called a
negative externality.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.
CHAPTER 10 EXTERNALITIES
7
Negative Externalities
•
•
•
•
•
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
The Club, an anti-theft device for cars
CHAPTER 10 EXTERNALITIES
8
Dealing with negative externalities
• Should we completely ban an activity that has
negative externalities?
–
–
–
–
–
Should we ban all cars?
Should we ban all smoking in public spaces?
Should we muzzle all dogs?
Should we ban stereos in apartment buildings?
Should we ban The Club?
CHAPTER 10 EXTERNALITIES
9
Positive Externalities
•
•
•
•
•
Immunizations
Education
Restored historic buildings
Research into new technologies
LoJack, an anti-theft device for cars
CHAPTER 10 EXTERNALITIES
10
Dealing with positive externalities
• Should we take all activities that have positive
externalities to the max?
–
–
–
–
Should we force everybody to take flu shots?
Should we require everybody to get a PhD?
Should we restore all historic buildings?
Should we pay for every research project
scientists want to do?
– Should we require every car owner to use LoJack?
CHAPTER 10 EXTERNALITIES
11
Dealing with negative externalities
• How should we determine the extent to which
activities that have negative externalities
should be tolerated?
• We can evaluate virtually any policy proposal
by asking how it would affect total surplus.
– Recall from Chapter 7, the concept of total
surplus.
CHAPTER 10 EXTERNALITIES
12
EXTERNALITIES AND MARKET
INEFFICIENCY
• Externalities can cause markets to become
inefficient.
–We saw in chapter 7 that total surplus is
maximized in a perfectly competitive economy.
– But when there are externalities, this is no longer
true:
•total surplus might be less than the maximum
achievable.
• This might provide a justification for
government intervention.
CHAPTER 10 EXTERNALITIES
26
EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative externalities from the production or
consumption of a good can cause markets to
produce more than is socially desirable.
• Positive externalities cause markets to produce
less than is socially desirable.
• If and when markets fail (to produce the
socially desirable quantity), government
intervention may be necessary.
CHAPTER 10 EXTERNALITIES
27
Figure 1 The Market for Aluminum
Price of
Aluminum
Ch. 7 Recap: Assume there are no externalities in
aluminum consumption. Then, the height of the
demand curve at, say, the 11th unit of aluminum
is the benefit obtainable from the 11th unit when
all 11 units are distributed among aluminum
consumers so as to maximize the total benefit.
Supply
(private cost)
$10
Equilibrium
Demand
(private benefit)
0
11
QMARKET
Quantity of
Aluminum
Figure 1 The Market for Aluminum
Price of
Aluminum
Ch. 7 Recap: Assume there are no externalities in
aluminum production. Then, the height of the
supply curve at, the 11th unit of aluminum is the
cost of the 11th unit when all 11 units are
distributed among aluminum producers so as to
minimize the total cost.
Supply
(private cost)
$10
Equilibrium
$3
Demand
(private benefit)
0
11
QMARKET
Quantity of
Aluminum
Figure 1 The Market for Aluminum
Ch. 7 Recap: When there are no
externalities in aluminum production or
consumption, the equilibrium quantity
(QMARKET) maximizes social surplus.
Price of
Aluminum
Supply
(private cost)
Equilibrium
Demand
(private benefit)
0
QMARKET
Quantity of
Aluminum
Welfare Economics Without Externalities: A Recap
• When there are no externalities, the
equilibrium quantity:
– is efficient
– maximizes total surplus
• Total surplus = total benefits – total costs
– is the socially desirable quantity
CHAPTER 10 EXTERNALITIES
31
Social, private, and external costs
• When the production of aluminum causes
pollution …
• Social cost of aluminum = private cost +
external cost
• Private cost is the cost to aluminum producers
of the raw materials and labor used in
production
• External cost is the cost to bystanders of
having to deal with the effects of pollution
CHAPTER 10 EXTERNALITIES
33
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Public Policies toward Negative
Externalities
• We just saw that when there are negative
externalities, the equilibrium quantity is larger
than the optimum quantity
– In other words, we have market failure
• Can public policy fix the market failure?
– Command-and-Control Policy: Regulation
– Market-Based Policy: Corrective Taxes
– Market-Based Policy: Tradable Pollution Permits
CHAPTER 10 EXTERNALITIES
37
PUBLIC POLICY: Command-and-Control
Policies
– Such policies usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
– Examples:
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
CHAPTER 10 EXTERNALITIES
38
PUBLIC POLICY TOWARD POLLUTION:
Command-and-Control
• If the EPA decides it wants to reduce the
amount of pollution coming from a specific
plant, it could…
– tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
– levy a tax of a given amount for each unit of
pollution the firm emits (i.e. Pigovian tax).
CHAPTER 10 EXTERNALITIES
39
Public Policies for Negative Externalities:
Market-Based Policy: Corrective Taxes
Price
Price buyers pay
Supply
Tax
Price without tax
Ch. 6 Recap
Price sellers
receive
Demand
0
Quantity after tax
Quantity before tax
Quantity
Public Policies for Negative Externalities:
Market-Based Policy: Corrective Taxes
We saw in Ch. 6 that a tax (on either buyers or sellers of aluminum) will reduce the
quantity bought and sold in the aluminum market. If the per-unit tax is set equal to the
per unit external cost, the quantity bought and sold will be reduced to exactly the
optimum amount. Problem solved!
Price of
Aluminum
Social
cost
Per-unit
External Cost
Price
Supply
(private cost)
Supply
Optimum
Corrective
Tax
Equilibrium
Equilibrium
Demand
(private value)
0
QOPTIMUMQMARKET
Quantity of
Aluminum
0
Demand
QOPTIMUMQMARKET
Quantity of
Aluminum
Market-Based Policy: Put a Tax on Negative
Externalities
• A corrective tax solves the problem caused by
negative externalities by forcing the consumers and
producers of aluminum to internalize the pollution
externality of aluminum production
– Internalizing an externality involves altering incentives so
that people take account of the external effects of their
actions.
• Corrective taxes are also called Pigovian taxes.
– They were originally proposed by the British
economist, A. C. Pigou.
CHAPTER 10 EXTERNALITIES
42
Public Policies for Negative Externalities:
Market-Based Policy: Tradable Pollution Permits
• The government can do the following:
– require permits for aluminum production
– issue QOPTIMUM permits by auctioning them off
• Each permit will sell for a price equal to the
unit cost of pollution
• The effect will be identical to a corrective tax
equal to the unit cost of pollution
CHAPTER 10 EXTERNALITIES
48
Tradable Pollution Permits
• The price of each tradable pollution permit
will be equal to the unit cost of pollution
• Why?
CHAPTER 10 EXTERNALITIES
49
PUBLIC POLICY TOWARD POLLUTION:
Market-Based
• Pigovian Taxes on the producers or consumers
of pollution
• Tradable pollution permits that allow the
voluntary transfer of the right to pollute from
one firm to another.
– A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
CHAPTER 10 EXTERNALITIES
50
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigovian
tax sets the
price of
pollution . . .
Demand for
pollution rights
0
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(b) Pollution Permits
Price of
Pollution
Supply of
pollution permits
P
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Q
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
Public Policies toward Positive Externalities
• A technology spillover is a positive externality
that is created when a firm’s innovation not
only benefits the firm, but enters society’s pool
of technological knowledge and benefits
society as a whole.
• Education benefits the student and also all
members of society who are affected by the
student
CHAPTER 10 EXTERNALITIES
54
Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QMARKET
QOPTIMUM
Social
value
Quantity of
Education
Public Policies toward Positive Externalities
• When an activity—such as education—has
positive externalities:
– The social value of the good exceeds the private
value of the good.
– The optimal output level is more than the
equilibrium quantity.
– The market produces a smaller quantity than is
socially desirable.
CHAPTER 10 EXTERNALITIES
57
Public Policies toward Positive
Externalities: Corrective Subsidies
• What can be done to get the market to
increase education to the optimal level?
• A subsidy for either students (buyers of
education) or educational institutions (sellers)
will work.
• A subsidy will make students and educational
institutions internalize the positive externality
of education
CHAPTER 10 EXTERNALITIES
58
Public Policies toward Positive
Externalities: Corrective Subsidies
• Recall that technology spillovers are positive
externalities
• Therefore, the equilibrium level of spending on
research will be less than the socially desirable
level
• Government intervention may promote
technology-enhancing industries
– Patent laws are a form of technology policy that give
the individual (or firm) with patent protection a
property right over its invention.
– The patent is then said to internalize the externality.
CHAPTER 10 EXTERNALITIES
59
PRIVATE SOLUTIONS TO EXTERNALITIES
• Government action is not always needed to
solve the problem of externalities.
• In some cases, the free market ends up
maximizing total surplus even when there are
externalities
CHAPTER 10 EXTERNALITIES
60
PRIVATE SOLUTIONS TO EXTERNALITIES
•
•
•
•
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting (bargaining, negotiations) between
those causing the externalities and those
affected by the externalities
CHAPTER 10 EXTERNALITIES
61
The Coase Theorem
• The Coase Theorem is the proposition—
due to Ronald Coase—that if people
can bargain without transaction costs
over the allocation of resources, they
can solve the problem of externalities
on their own.
– Transaction costs are the costs that people
incur in the process of agreeing to and
following through on a bargain.
CHAPTER 10 EXTERNALITIES
62
Bob, Spot, and Jane and Ronald Coase
Bob and Jane are room mates. Bob gets Spot, a noisy dog, as a birthday gift.
Benefit = $500; Cost =
$800
Benefit = $1000; Cost =
$800
Social optimum
Bob returns Spot
Bob keeps Spot
Government solution
Bob forced to pay $800 tax. No action required. Bob
Bob returns Spot
keeps Spot
Private solution: Jane has
right to quiet
Jane sues to enforce her
right. Bob can’t afford to
pay Jane a big enough
bribe. Bob returns Spot
Bob pays Jane $800. Bob
keeps Spot
Private solution: Bob has
right to keep Spot
Jane pays Bob $500. Bob
returns Spot
Jane can’t afford to pay
Bob a big enough bribe.
Bob keeps Spot
Coase Theorem: Private solutions to externalities can work
63
Bob, Spot, and Jane and Ronald Coase
• Note that when the free market outcome is
not optimal, bargaining between Bob and Jane
will bring about the optimal outcome,
irrespective of who is favored by the law
– The law is important in other ways, however. For
example, in one case in which the law favors Bob ,
Jane has to pay a $500 compensation to Bob to
get him to return Spot
CHAPTER 10 EXTERNALITIES
64
Coase Theorem: Exercise
• In the case of pollution by an aluminum
factory, how might production of the socially
desirable amount be brought about without
taxation by the government?
• Why might Coase’s solution fail, as a practical
matter, in this case?
CHAPTER 10 EXTERNALITIES
65
Why Private Solutions Do Not Always Work
• Sometimes the private solution fails because
transaction costs are so high that private
agreement is not possible.
– Bob might get greedy and try to haggle with Jane
for more than $500
– Change the story by substituting three people (Jan,
Jeanne and Joan) instead of Jane. Jan, Jeanne and
Joan may find it hard to raise $500 for Bob’s
compensation. Each might try to free ride on the
others.
CHAPTER 10 EXTERNALITIES
66
PUBLIC POLICY TOWARD EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through…
– command-and-control policies.
– market-based policies.
CHAPTER 10 EXTERNALITIES
67
Policy Exercises
• Should we punish the use of SUV’s and
promote the use of smaller cars?
• Should we force car makers to sell cars with
higher mileage?
• Should we limit the use of gasoline by each
car owner?
• Should we tax gasoline?
• Should we tax all fuels based on the damage
each fuel causes?
CHAPTER 10 EXTERNALITIES
68
Any Questions?
CHAPTER 10 EXTERNALITIES
69
Summary
• When a transaction between a buyer and a
seller directly affects a third party, the effect is
called an externality.
• Negative externalities cause the socially
optimal quantity in a market to be less than
the equilibrium quantity.
• Positive externalities cause the socially optimal
quantity in a market to be greater than the
equilibrium quantity.
CHAPTER 10 EXTERNALITIES
70
Summary
• Those affected by externalities can sometimes
solve the problem privately.
• The Coase theorem states that if people can
bargain without a cost, then they can always
reach an agreement in which resources are
allocated efficiently.
CHAPTER 10 EXTERNALITIES
71
Summary
• When private parties cannot adequately deal
with externalities, then the government steps
in.
• The government can either regulate behavior
or internalize the externality by using Pigovian
taxes or by issuing pollution permits.
CHAPTER 10 EXTERNALITIES
72