242topic6.docx

242topic6.docx

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242topic6

Topic6:

ExternalitiesandPublicGoods

Anexternalityiscreatedwhentheactionsofparticipantsinaprivatemarketaffectthewellbeingofsomeonenotdirectlyassociatedwiththatmarket.

Considerthemarketforpaper.Papercreatesabyproductinitsproductioncalleddioxin.Dioxinaffectsinnocentbystandersbycausingcancerandbirthdefects.Thisisanegativeexternalityinproductionbecausethepaperfirmdoesn’tconsiderthiscosttosocietywhenmakingproductiondecisions.Sincethesenegativeexternalitiesaffectinnocentby-standers,thecosttosocietyisgreaterthanthecosttofirms.

Price,$S（SocialCost）

S（PrivateCost）

D（PrivateValue）

QEQ*QuantityofPaper

Considerthemarketforhistoricbuildingsandhomes.Thesebuildingsandhomescreatepositiveexternalitiesinconsumptionbecausebystandersvaluehistorichomes–theirbeautyandsenseofhistory.Thus,society’svalueofthehomesisgreaterthanthattotheownersofthebuildings.

Price,$

S（PrivateandSocialCost）

D（SocialValue）

D（PrivateValue）

Q*QEHistoricHomesandBuildings

Consideralcohol,whichcreatesanegativeexternalityinconsumptionwherethevaluetosocietyislessthanthevaluetoconsumers（becauseofcarwrecks,injuriestoothers,andviolence）.

Price,$

S（PrivateandSocialCost）

tD（PrivateValue）

D（SocialValue）

QEQ*Alcohol

But,wecanachievetheefficientmarketoutcomebytaxingconsumptionofalcohol.Thisexplainswhyalcoholisoneofthemosthighlytaxedgoods.

Considereducation,whichcreatesapositiveexternalityinconsumption.Thatis,education’svaluetosocietyisgreaterthanthevaluetoprivateconsumers.Moreeducationequateswithabetterinformedpopulace,bettergovernment,betterbehavior,andbettercitizenship.

Price,$

S（PrivateandSocialCost）

SD（SocialValue）

D（PrivateValue）

Q*QEEducation

Wecaninternalizetheexternalitybysubsidizingeducation.Thisexplainswhyeducationisoneofthemosthighlysubsidizedgoods.

Now,gobacktothefirsttwoexamples.Whatcouldthegovernmentdotointernalizetheexternalitycreatedbytheconsumptionofhistorichomesandbuildings?

Whatcouldthegovernmentdotointernalizetheexternalitycreatedbytheproductionofpaper?

Actually,therearethreeoptions:

TheEnvironmentalProtectionAgency（EPA）could:

1.Prohibitpollutionalltogetherbysettingquotas（q=0）.

2.Regulatepaperquantitytobeq=qE.

3.Taxpaperproduction.

Economistspreferthetax.Thisisbecause:

1.Thetaxraisesrevenue.

2.Withregulations,firmshavenoincentivetoreduceQbelowtheregulatedlevel.Withtaxes,factorieshaveincentivestodevelopbetter/cleanertechnologies.

3.Thetaxisjustaseffectivebutmoreefficientthanthequota.Thatis,bothgetequalreductionsinpollution,butthetaxreducespollutionmostefficiently.

Considerthefollowingexample:

InternationalPaper（IP）andLittlePigeonRiverPaperMill（LPRPM）eachdump200tonsofpollutioninrivers.Thecostofreducingaunitofpollutionis$100forIPand$20forLPRPM.Thegovernmentwantstoreducepollutionby200.LetT=50.Then,LPRPMwillreducepollutionby200andIPwillreducepollutionby0.Thetotalcostofpollutionreductionis200（20）=4,000.Ifthegovernmentrequiredeachfirmtoeliminate100unitsofpollution,thenthecostwouldbe100（100）+100（20）=$12,000.

Now,considerpollutionpermits.IPstillproduces200tonsofpollution,andtheircostofclean-uppertonisstill$100.Similarly,LPRPMalsoproduces200tonsofpollution,andthecostofclean-uppertonis$20.Thegovernmentwantstolimitpollutionto200tons.Anequalreductionwouldcost$12,000,asseenabove.WhatifIPwantstoincreasepollutionby100tonsandLPRPMwantstodecreasepollutionby100?

IsthatO.K.?

Itmakesthefirmscollectivelybetteroffandsocialwelfareisenhanced.

Supposethegovernmentissues100pollutionpermits.Itdoesn’tmatterhowthepermitsareallocatedinitially,IPwillbuyall100permitsbecausetheyareworthmoretoIPthantoLPRPM.Thisinternalizespollutionbymakingitcostlytopollute.IPwillpayapriceforthepermitsthatisbetween$100and$20.And,pollutionpermitswillbebetterthanPigoviantaxesifthegovernmentknowshowmuchpollutionitwillallowbutitdoesn’tknowthebesttaxtoset（becausetheydon’tknowwhatthedemandcurvelookslike）.

CoaseTheorem:

ifprivatepartiescanbargainwithoutcostovertheallocationofresources,thentheycansolvetheproblemofexternalitiesontheirown.

ConsiderRichardandJaneandSpot.SpotisRichard’sdog,buthebarksandkeepsJaneupatnights.AnegativeexternalityinconsumptioniscreatedonJane,thebystander.

∙IfBRichard>CJane,thenletRichardkeepthedog.

∙IfBRichard

First,assumeB=$100andC=$150.JanecouldofferRichard$120togetridofthedog.Then,Richardwouldbewillingtogetridofthedogandbothpartieswouldbebetteroff.IfJaneownedthedog,thenshewouldsimplygetridofit.So,theoutcomedoesn’tdependonpropertyrights.

Second,assumeB=$200andC=$150.Then,Janecouldn’tgiveRichardenoughmoneyforhimtobewillingtogetridofthedog.Thatis,Richardshouldkeepthedog,whichistheefficientoutcome.IfJaneownedthedog,thenRichardwouldgiveheranamountbetween200and150tokeepthedog,whichistheefficientoutcome.Again,propertyrightsdon’tmatterwithrespecttoachievingtheoptimaloutcomeforsociety.

WhentheCoaseTheoremdoesn’twork:

1.Whentransactioncostsarehigh.SupposeRichardandJanespeakdifferentlanguagesandatranslatorcosts$1,000.Then,theyshouldn’tbargainbecauseit’stoocostly.Certainlylawyersandcontractsarecostly.

2.Imperfectinformation（bluffing）.LetB=$100andC=$150.ButsupposethatRichardclaimshisbenefitis$140.Also,supposeJaneclaimsthecostisonly$110.Astheyhaggleoverpriceandkeepbluffing,thebarkingpersistsandtheefficientoutcomeisnotattained.

3.（becomesmoredifficult）whenmorepartiesgetinvolved.Supposethereare30neighborsand10otherbarkingdogs.Also,supposeeachneighboreitherhasadifferentvalueforBoradifferentcostofC.

PublicGoodsandCommonResources.

Excludable:

peoplecanbepreventedfromusingthegood.

Rival:

Oneperson’suseofagooddiminishesanother’suse/enjoymentofit.

Rival

Non-Rival

PrivateGoods:

IceCream

NaturalMonopolies:

Utilities

Excludable

Cloths

PhoneService

CongestedTollRoads

UncongestedTollRoads

CommonResources:

fish

PublicGoods:

NationalDefense

Non-Excludable

Environment

Knowledge

CongestedNon-tollRoad

UncongestedNon-tollRoads

PublicGoods

Considerfireworksonthe4thofJuly,whichisapublicgood.ThebenefitperpersonisB=$10.ThecostisC=$1,000.Thereare500people.Shouldtherebeafireworksdisplay?

Whatissociallyoptimal?

Wouldtheprivatemarketresultinafireworksdisplay?

No.Thegovernmentcouldputiton,andincreasetaxesbyt=$2.00.Thefireworksdisplaycreatesapositiveexternalityinconsumption.

Price,$

S（PrivateandSocialCost）

D（SocialValue）

D（PrivateValue）

Q*QEFireworksDisplay

∙Nationaldefenseisanotherpublicgood:

Costis$272billionor$1,035perperson（1995）.

∙Knowledgeisanotherpublicgood.So,theNationalInstitutesofHealthandNationalScienceFoundationsubsidizeknowledgeresearch.

Thegovernmentdecideswhattoprovidewithcost-benefitanalysis.

Consideratrafficlight,whichcosts$10,000.Ifbuilt,engineersestimatethatthechanceofbeingfatallyinjuredinatrafficaccidentwillfallfrom1.6percentto1.1percent.Shouldweputthistrafficlightup?

Ifweplaceinfinitevalueonhumanlives,shouldweputalightoneverycorner?

Whatisthevalueofahumanlife?

CommonResources

Thetragedyofthecommons（medievaltimes）:

atownhadcommonlandonwhicheachmemberofthetowngrazedtheirsheep.But,toomanyseepmadethecommonlandbarrenandthetownlostitslivelihood.Commonresourcescreatenegativeexternalitiesinproduction.

Price,$S（SocialCost）

S（PrivateCost）

T

D

QEQ*Livestock（sheep）

So,thegovernmentcouldsolvethisexternalityby:

∙Taxingland

∙Dividingthelandamongthepheasants,aswasdoneinEngland（privateownershipworksbest）.

Thisexplainsthefailureofcommunism–itisrelatedtothetragedyofthecommons.

Othercommonresources:

1.cleanairandwater

2.commonoilpools

3.fish,whales,buffalo,andelephants（ivorytusks）.

Whyarebuffaloandelephantsonthevergeofbecomingextinctbutcowsarenot?

Considerthemarketforcows:

Price,$

S（PrivateCostandSocialCost）

D

Q*=QECows

Noexternalityherebecausethereisprivateownership.

Price,$S（SocialCost）

S（PrivateCost）

D

QEQ*Buffalo/Elephants

Marketoutputistoohigh–andbuffalo/elephantsarebecomingextinct.

WhatareAfricangovernmentsdoingaboutthis?

∙InKenya,Tanzania,Ugandaitisillegaltokillelephants

∙InBotswana,Malawi,Nambia,andZimbabewe,elephantshavebeenprivatizedbymakingownershipofelephantsaccordingtotheowneroftheland.

ProblemSet6:

ExternalitiesandPublicGoods

1.Depictthesupplyandde