1 Chapter 18 Externalities Main topics 1. externalities 2. inefficiency of competition with externalities 3. market structure and externalities 4. allocating property rights to reduce externalities 5. common property 6. public goods Externalities externality occurs if • someone's consumption or production activities hurt or help others outside a market • well-being of a consumer or production capability of a firm are affected directly by actions of other consumers or firms, rather than indirectly through changes in prices Examples • firm whose production process lets off fumes that harm its neighbors is creating an externality for which there is no market • firm is not causing an externality when it harms a rival by selling extra output that lowers market price Positive and negative externalities • externalities may either help or harm others • externality that harms someone is a negative externality • positive externality benefits others • action may confer positive externalities on some people and negative externalities on others: wind chimes (though it’s hard to imagine the positive ones) Los Angeles air an atmospheric scientist reports that cleaning up LA air over last decade • helped people breathe • caused radiation levels to increase more rapidly than they would have risen if air had remained dirty 2 Michael Jordan: Positive externality • Jordan's presence raised 1991-92 regular season away games • ticket revenues $2.5 million • local TV advertising revenues: $2.4 million • positive externality: extra revenues went to home team rather than to Bulls Additional externalities • Jordan's presence increased national earnings • TV advertising: $6.6 million regular season; $13.9 million playoffs • NBA Properties (clothing and videos) by $15.1 million • shared equally by all teams, so externality • total value of Jordan's positive externalities was $40.3 million Inefficiency of competition with externalities • competitive firms and consumers do not have to pay for harms of their negative externalities • so they produce excessive pollution Assumptions • competitive paper market • firms produce paper and gunk (by-products): air and water pollution that harm people who live near paper mills • each ton of paper produced increases the amount of gunk by 1 unit • only way to decrease volume of gunk is to reduce the amount of paper manufactured • paper firms do not have to pay for harm from pollution they cause Private vs. social costs • private cost: cost to firm of production only, not including externalities: • direct costs of labor, energy, and wood pulp • but not indirect costs of harm from gunk • social cost: private cost plus cost of harms from externalities Supply-and-demand analysis • competitive market produces excessive pollution because firms' private costs < social costs • maximizes welfare: sum of CS and social PS (based on the social marginal cost curve) • social optimum • welfare is maximized where price equals social MC • optimal tradeoff between value of production and pollution harm 3 Figure 18.1 Welfare Effects of Pollution in a Competitive Market Price of paper, p, $ per ton Demand MC p MC g MC g MC s =MC p + MC g 450 p s = 282 p c = 240 30 84 198 Q c = 105Q s = 84 2250 e c e s A B F CD E H G G, Units of gunk per day Q, Tons of paper per day MC p Reducing externalities • competitive markets produce excessive negative externalities • hence government intervention may benefit society Government expenditures • expenditures on environmental protection as a percentage of GDP range between a 0.2 to 1%: • 0.2% Italy • 0.4% Portugal, United Kingdom • 0.6% United States, Spain • 0.7% Sweden • 0.8% Germany, Switzerland • 1.0% Austria, Denmark, and Japan • world's poorest countries spend little if anything on pollution control Emissions relative to economic output • developing countries • China emitted 2,095 metric tons of carbon per million dollars of GDP • Soviet Union, 1,517 • India, 602 • Mexico, 586 • developed countries • United States, 279 • Great Britain, 216 • Japan, 101 Government intervention • direct approach: emissions tax, fee, effluent charge • indirect approach: emissions standard (quantity restrictions on outputs or inputs) • because output and pollution move together, regulating either works Figure 18.2 Taxes to Control Pollution Price of paper, p, $ per ton Demand MC p MC g MC s = MC p +(tQ) MC p + τ τ =84 450 p s = 282 MC p = 198 MC g = 84 Q s = 84 2250 e s G, Units of gunk per day Q, Tons of paper per day 4 Optimal regulation • unfortunately, government usually does not know enough to regulate optimally • government needs to know: • marginal social cost curve • demand for paper curve • how pollution varies with output Enforcement • even if government knows enough to set optimal regulation, it must enforce regulation to achieve social optimum • U.S. Environmental Protection Agency (EPA) smog standards violated in 33 metropolitan areas • including Baltimore, Boston, Chicago, Houston, Los Angeles, Milwaukee, New York, and Philadelphia • http://www.epa.gov/enviro/zipcode.html • http://www.scorecard.org • http://www.formyworld.com Cost-benefit analysis • instead of using the supply-and-demand analysis to show that competitive market produces too much pollution • use a cost-benefit diagram • welfare is maximized by reducing output and pollution until the marginal benefit from less pollution equals the marginal cost of less output Figure 18.3 Cost-Benefit Analysis of Pollution Benefit, Cost, $ Cost: less paper Benefit: les s gu nk Maximum net bene fit 84 63105 0 84105 G, Units of gunk per day Q, Tons of pa per per day G, Units of gunk per day Q, Tons of pa per per day (a) Cost and Benefit Margina l be nef it, Marginal cost, $ (b) Marginal Cost and Marginal Benefit 4,000 2,000 105 84 0 MC MB Emission standards for ozone • ozone is a major air pollutant • it is formed in the atmosphere through a chemical reaction between organic gases and nitrogen oxides in sunlight Standards • Clean Air Act of 1990 sets national air- quality standards for major pollutants: > 0.12 parts per million (ppm) • California Air Resources Board (CARB) has an even tighter standard: 0.09 ppm 5 Costs and benefits • cost of reducing ozone: greater expenses of • manufacturing • driving •benefit • better health in urban areas • increased agricultural yields in rural areas • consequently, optimal level differs in urban and rural areas Los Angeles • benefits of reducing ozone level > costs over past several decades • however, CA standards may be too strict even in LA (worst air pollution problem in U.S.) • Krupnick and Portney (1991) est. that reducing ozone to CA standard has an annual • benefit to human health and materials of about $4 billion • annual cost about $13 billion Rural areas • is CA standard too strict for an agricultural area • according to the CARB, crop losses due to high ozone levels range from • 8.4% for alfalfa hay • 32% for oranges • CARB claims production yields fall for ozone- sensitive crops such as beans, cotton, grapes, lemons, and oranges even at ozone levels as low as 0.09 San Joaquin Valley • produces 60% of CA crops and 9% of U.S. crops • has second-worst air quality in CA (after LA) • Kern County in 1990: • ozone went up to 0.17 ppm one day • 0.09 ppm standard was surpassed on 120 days • 0.12 ppm standard was exceeded 37 days Estimated benefits and costs • Kim, Helfand, and Howitt (1998) estimate that meeting the CA’s 0.09 ppm standard • health benefits range from $2.58 million to $51.58 million • consumer surplus ranges from $229 million to $270 million • producer surplus ranges from $297 million to $348 million • welfare is maximized at slightly below 0.14 ppm (conservative estimates) • substantial benefits from reducing pollution Emissions Standards for Ozone 0.12 0.11 0.10 0.090.16 0.15 0.14 0.13 Ozone concentration, ppm Margina l be nef it, Marginal cost, $ millions 400 300 200 100 MC MB 0.12 0.11 0.10 0.090.16 0.15 0.14 0.13 Ozone concentration, ppm State standardFederal standardOptimal Cost Benefit Benefit, Cost, $ mi llions (a) Cost and Benefit 1,000 800 600 400 200 (b) Marginal Cost and Marginal Benefit 6 Monopoly and externalities • monopoly output may be less than social optimum even with an externality • competition is not necessarily better than a monopoly with an externality Figure 18.4 Monopoly, Competition, and Social Optimum with Pollution Price of paper, p, $ per ton Q, Tons of paper per day DemandMR MC p MC g MC s = MC p + MC g 450 330 310 282 240 30 84 105 22570600 e m e c e s e t AB C D Allocating property rights • property right: an exclusive privilege to use an asset • Coase Theorem: optimal levels of pollution and output results from bargaining between polluter and their victims if property rights are clearly defined • parties generally won’t negotiate unless property rights are clearly assigned Right to be free from pollution • boat rental firm has a property right to be free from pollution • rather than shut down, chemical company offers to pay the boat rental firm for the right to dump its waste • boat rental firm insists on making at least $15 (max it can earn if chemical company does not produce) • largest bribe chemical company will pay leaves it with a positive profit • one possibility: chemical company offers boat rental firm $7 per ton for right to dump 7 Right to pollute • chemical company has the property right to dump in the lake • boat rental firm could bribe chemical company to reduce its pollution • for example, boat rental could offer $6 per ton for each ton less than 2 that the chemical company dumps Coase Theorem results • if there are no impediments to bargaining, assigning property rights results in efficient outcome: joint profits are maximized • efficiency is achieved regardless of who is assigned the property rights • who gets the property rights affects the income distribution (property rights are valuable) Problems with Coase approach • Coase approach works only if • property rights clearly defined • parties can bargain successfully • three common causes of bargaining failure • transaction costs are very high • firms engage in strategic bargaining behavior • either side lacks information about costs or benefits Markets • many economists argue in favor of using markets • to do so, government must first assign property rights and let them be traded • important example: U.S. Clean Air Act of 1990 created market for sulfur dioxide (see text) Common property • common property: resources to which everyone has free access • overuse of common property because people don’t have to pay to use it • examples • fisheries • common pools (petroleum, water…) • internet • roads 8 Government response • overuse occurs because individuals do not bear the full social cost • governments apply tax or fee so that individuals internalize the externality • example: bridge toll • some economists estimate that optimal toll on S.F. Bay Bridge is at least $3.60 (current fee is $2) • optimal fee would save commuters 20.6 minutes per day (compared to no toll) Private goods private goods have properties of • rivalry: only one person can consume the good (it is depletable) • exclusion: others can be prevented from consuming the good Public goods • public good: commodity or service whose consumption by one person doesn’t preclude others from also consuming it • example: national defense • public good lacks rivalry • some public goods lack exclusion • produce positive externality • excluding anyone from consuming them is inefficient Club good • public good with exclusion (e.g., tennis club) • similarly, concert: • security guards prevent people who don’t have tickets from entering a concert hall • marginal cost of adding one more person is zero as long as hall is not filled Club good • public good with exclusion (e.g., tennis club) • similarly, concert: • security guards prevent people who don’t have tickets from entering a concert hall • marginal cost of adding one more person is zero as long as hall is not filled 9 Markets for public goods • exist only if nonpurchasers can be excluded from consuming them • thus markets do not exist for nonexclusive public goods • if government doesn’t provide a nonexclusive public good one, usually no one will Exclusive public goods markets tend to produce too little of an exclusive public good because of lack of rivalry • Microsoft’s marginal cost for one more unit is virtually zero • it’s price is much higher Demand for public goods • market demand curve is social marginal benefit curve • private good • social marginal benefit = private marginal benefit • market demand is horizontal sum of the demand curve of individuals • public good • social marginal benefit is sum of marginal benefit to each consumer • market demand (willingness-to-pay) curve is vertical sum of individuals’ demand curves Figure 18.5 Inadequate Provision of a Public Good Price of guard service, $ per hour Guards per hour Supply, MC 25 18 13 10 8 7 3 2 57 940 e p e s D 1 D D 2 Free riding • benefit from actions of others without paying • people are often unwilling to pay for their share of a public good Two stores share a guard • cost is $10 per hour • benefit to each store is $8 • social optimum: hire guard because social benefit, $16 per hour, exceeds marginal cost • stores acting independently won’t hire •vote: • if both vote for guard, they split cost • if only one votes for guard, bears full cost 10 Free riding on water • Perth, Australia • water is a private good for most households • pay the price of each unit • most households are individually metered • 10% share meters (duplexes, apartments) - on average 11 of these households share a mete Extra consumption from shared meters compared to households with private meters • consume 17% more water on average • 2-family duplexes consume only 0.05 kiloliters more • 10 housing units in a block average 1.3 kiloliters more • 222 member housing unit in a block average 640 extra kiloliters Providing public goods • to ensure that nonexclusive public good is provided, government usually • produces it • compels others to do so • government has difficulty learning cost and benefits • government learns benefit (value of public good) by • survey • citizens vote Voting • whether majority votes for a public good depends on preferences of • median voter: • person with respect to whom half the populace values the project more and half less • efficient to provide public good if value F cost • majority voting may not lead to efficiency Example • traffic signal costs $300 to install • 3 voters • thus, each votes for signal only if person thinks signal is worth at least $100 (tax person will pay) • 3 cases (corners) in table • in each case, Hayley is median voter, so her views signal outcome • vote doesn’t always lead to efficiency [...]... competitive market may exacerbate monopoly externality problem 5 Common property • common property is a resource to which everyone has free access • they are overexploited because people ignore externalities • example: delays due to congestion on a bridge 11 6 Public goods • public goods lack rivalry • once public good is provided to anyone, it can be provided to others at no extra cost • excluding...1 Externalities • externality occurs when a consumer’s wellbeing or a firm’s production capabilities are directly affected by actions of others rather than indirectly affected through changes in price • pollution is a negative externality 2 Inefficiency of competition with externalities • because producers don’t pay for harm... pay for harm from their negative externalities, their private costs < social costs • thus, competition leads to excessive production of externalities • if government action leads to firms internalizing externality, problem is avoided 4 Allocating property rights to reduce externalities • externalities arise because property rights are not clearly defined • Coase Theorem: allocating property rights to... Public goods • public goods lack rivalry • once public good is provided to anyone, it can be provided to others at no extra cost • excluding anyone from consuming a public good is inefficient • markets provide too little of a nonexclusive public good • government has difficulty learning how much public good is valued 12 . externalities • externalities may either help or harm others • externality that harms someone is a negative externality • positive externality benefits others • action may confer positive externalities. roads 8 Government response • overuse occurs because individuals do not bear the full social cost • governments apply tax or fee so that individuals internalize the externality • example: bridge toll • some. rivalry • once public good is provided to anyone, it can be provided to others at no extra cost • excluding anyone from consuming a public good is inefficient • markets provide too little of a nonexclusive