Chapter 17 Copyright (c)2014 John Wiley & Sons, Inc Externalities and Public Goods Chapter Seventeen Overview Motivation Inefficiency of Competition with Externalities Allocation Property Rights to Restore Optimality • • • The Coase Theorem Problems with the Coase Approach Other Methods to Restore Optimality – Standards and Fees • • • Copyright (c)2014 John Wiley & Sons, Inc Public Goods A Taxonomy Demand for Public Goods Free Riders and the Supply of Public Goods Chapter Seventeen Externalities Definition: If one agent's actions imposes costs on another party, the agent exerts a negative externality, while if the agent's actions have benefits for another party, the agent exerts a positive externality Network externalities, snob effects Wind chimes When externalities are present, the competitive market may not attain the Pareto Efficient outcome Chapter Seventeen Copyright (c)2014 John Wiley & Sons, Inc • • Copyright (c)2014 John Wiley & Sons, Inc Inefficiency of Competition with Externalities Chapter Seventeen Inefficiency of Competition with Externalities Private Social Change Optimum Consumers Surplus • Private Producers Surplus E+ F+ R+H+N • Externality Cost -R-H-N-G-K-M • Net Social Benefits A+B+G +K A+B+E+F-M A -B-C-K B+E+F+R+H+G -R-H-G A+B+E+F B+G-N M+N+K M Copyright (c)2014 John Wiley & Sons, Inc • (consumer surplus + private producer surplus - cost of externality) • Deadweight Loss M zero M Chapter Seventeen Copyright (c)2014 John Wiley & Sons, Inc Inefficiency of Competition with Externalities Chapter Seventeen Inefficiency of Competition with Externalities Private Social Change Optimum Private Consumers Surplus • Producers Surplus • Externality Benefit • Government Cost from Subsidy • Net Social Benefits (consumer surplus + private producer B+E +F G+R A+H+J zero A+B+E+F +G+H+J+R B+E+F+G+K+L F+G+R+J+M A+H+J+M+N+T G+K+L F+J+M M+N+T -F-G-J-K-L-M-T -F-G-J-K-L-M-T Copyright (c)2014 John Wiley & Sons, Inc • A+B+E+F+G+H M+N +J+M+N+R surplus - cost of externality) Chapter Seventeen Competitive Market & Social Optimum Competitive market: p = MPC Social optimum: p = MSC Competitive market creates a dead-weight loss (socially excessive negative externalities) This is because the polluter does not have to pay for pollution Copyright (c)2014 John Wiley & Sons, Inc Socially optimal amount of waste is non-zero How can we restore optimality? Chapter Seventeen Competitive Market & Social Optimum Emissions Standards – A governmental limit on the amount of pollution that may be emitted Copyright (c)2014 John Wiley & Sons, Inc Emissions Fee – A tax imposed on pollution that is released into the environment Chapter Seventeen Methods to Restore Optimality Pp ($/ton) MCS = MCP + MCW Emissions Standards (quota) Emissions Standards (quota) MCP Demand for Paper Qp (tons/day) W (units/day) Chapter Seventeen 10 Copyright (c)2014 John Wiley & Sons, Inc MCW The Coase Theorem • Transaction Costs may be high; • Large numbers of injured parties; • Incomplete/Asymmetric Information Copyright (c)2014 John Wiley & Sons, Inc Challenges e.g What are the long run effects of genetic engineering? Chapter Seventeen 18 Public Goods Definition: Definition: Rivalry Rivalryininconsumption consumptionmeans meansthat thatonly onlyone oneperson personcan canconsume consumeaagood: good:the the good goodisisused usedup upininconsumption consumption(it(itcan canbe bedepleted) depleted) Definition: Definition: Exclusion Exclusion inin consumption consumption means means that that others others can can be be prevented prevented from from Copyright (c)2014 John Wiley & Sons, Inc consuming consumingaagood good Chapter Seventeen 19 Public Goods Definition: Private goods have properties of rivalry and exclusion Pure Public goods lack both rivalry and exclusion Club goods lack rivalry but have property of exclusion Common property lacks exclusion but does have the property of rivalry Examples No exclusion Rivalry Pure Private Commons: goods: Apple Fisheries No Rivalry Club goods: concert Chapter Seventeen Pure public good: clean air 20 Copyright (c)2014 John Wiley & Sons, Inc Exclusion Demand for Public Goods Because Becausepublic publicgoods goodslack lackrivalry, rivalry,the theaggregate aggregatedemand demandisisthe the aggregate aggregate willingness willingness toto pay pay curve: curve: the the vertical vertical sum sum ofof the the Copyright (c)2014 John Wiley & Sons, Inc individual individualdemand demandcurves curves Chapter Seventeen 21 Efficient Provision of a Public Good 400 Price ($/unit) 300 100 D1 30 Quantity of Public Good 100 Chapter Seventeen 22 Copyright (c)2014 John Wiley & Sons, Inc 200 Efficient Provision of a Public Good 400 Price ($/unit) 300 100 D2 D1 30 Quantity of Public Good 100 200 Chapter Seventeen 23 Copyright (c)2014 John Wiley & Sons, Inc 200 Efficient Provision of a Public Good 400 Price ($/unit) 300 MC = 240 100 D2 MC = 50 D1 30 Quantity of Public Good 100 200 Chapter Seventeen 24 Copyright (c)2014 John Wiley & Sons, Inc 200 Efficient Provision of a Public Good 400 Price ($/unit) MSB 300 MC = 240 100 D2 MC = 50 D1 30 Quantity of Public Good 100 200 Chapter Seventeen 25 Copyright (c)2014 John Wiley & Sons, Inc 200 Efficient Provision of a Public Good 400 MC = 400 Price ($/unit) MSB 300 MC = 240 100 D2 MC = 50 D1 30 Quantity of Public Good 100 200 Chapter Seventeen 26 Copyright (c)2014 John Wiley & Sons, Inc 200 Efficient Provision of a Public Good Example Consumer 1: P1 = 100 - Q Consumer 2: P2 = 200 - Q How would we determine the efficient level of the public god algebraically assuming the marginal cost of the public good is $240? Copyright (c)2014 John Wiley & Sons, Inc Summing P1 and P2, we obtain MSB = P1 + P2 = 100 - Q + 200 - Q = 300 - 2Q Chapter Seventeen 27 Efficient Provision of a Public Good Setting SettingMSB MSB==MC, MC,we wehave: have: 300 300- -2Q 2Q==240 240 Copyright (c)2014 John Wiley & Sons, Inc Or Or Q* Q*==30 30 Chapter Seventeen 28 Free Rider Definition: a free rider benefits from an action of other (s) without paying for that action Solutions to the free rider problem Social Pressure Copyright (c)2014 John Wiley & Sons, Inc Government Action Transformation to Private Good Chapter Seventeen 29 Summary When one agent's actions affect another agent, the agent exerts an externality When externalities are present the competitive market may not attain the Pareto Efficient outcome We can restore optimality by assigning property rights to the cause of the externality (The Coase Theorem) If we follow this approach, efficiency is achieved regardless of who receives the property rights; however, the property rights affect the income distribution Chapter Seventeen Copyright (c)2014 John Wiley & Sons, Inc 30 Summary When transaction costs are high or there is asymmetric or incomplete information, allocating property rights may not restore optimality Other methods of restoring optimality include standards and fees Private goods have the properties of rivalry and exclusion Other types of goods exist that Copyright (c)2014 John Wiley & Sons, Inc not have these properties Chapter Seventeen 31 Summary Goods that lack rivalry and exclusion are called pure public goods The demand for pure public goods is the vertical sum of the individual willingness to pay for the good Chapter Seventeen Copyright (c)2014 John Wiley & Sons, Inc 10 Pure public goods tend to be undersupplied by the market 32 ... gunk by installing filters and fishermen can reduce emissions by installing a Suppose that paper mill may reduce its emissions of gunk by installing filters and fishermen can reduce emissions by. .. valuable (The party with the property rights is compensated by the other Copyright (c)2014 John Wiley & Sons, Inc party.) Chapter Seventeen 17 The Coase Theorem • Transaction Costs may be high; •... environment Chapter Seventeen Methods to Restore Optimality Pp ($/ton) MCS = MCP + MCW Emissions Standards (quota) Emissions Standards (quota) MCP Demand for Paper Qp (tons/day) W (units/day) Chapter