externalities and public goods

externalities

an action affects bystanders but those effects aren’t priced

• negative externality → too much activity

• positive externality → too little activity

• goal: make private optimal equal social optimal

negative externality - costs

• marginal private cost (MPC): my cost (supply)

• marginal external cost (MEC): harm to others

• marginal social cost (MSC) = MPC + MEC

• marginal private benefit (MPB) = my benefit (demand)

• market picks MPB = MPC → quantity too high if MEC > 0

negative externality graph

goal is to get from current equilibrium (which is producing too much) to Q*

positive externality - benefits

• marginal private benefit (MPB): my benefit

• marginal external benefit (MEB): benefit to others

• marginal social benefit (MSB) = MPB + MEB

• market picks MPB = MPC → quantity too low if MEB > 0

positive externality graph

goal is to get from current equilibrium (which is producing too little) to Q*

the Coase theorem

if property rights are clearly assigned and bargaining is costless, private negotiation between affected parties can lead to the socially efficient outcome, regardless of who holds the initial rights

• implications:

  • with zero transaction costs, parties bargain to Q* → the allocation is efficient either way; the distribution (who pays/gets paid) depends on initial rights

• when does bargaining work?

  • clear property rights, few parties, easy to find each other, low transaction & legal costs

• common failures:

  • many parties = holdout/free-riding, high bargaining or enforcement costs, harms across borders or generations

Pigouvian taxes & subsidies

• tax for negative externality to drop production

  • ex. carbon tax, trying to price up the item until it hits Q*

• subsidy for positive externality to increase production

  • aligns private with social margin in order to hit Q*

negative externality tax graph

tax per unit = MEC at Q*

positive externality subsidy graph

subsidy per unit = MEB at Q*

how to pick between Coase & policy (ex. tax/sub)

• Coase: few parties, clear rights, low frictions

• policy (tax/sub, standards, cap): many/anonymous parties or high frictions

• distribution vs efficiency: rights affect who pays; well-designed policy targets Q*

cap-and-trade definition

• set total permits = Q* (the optimal quantity in the market)

  • firms can trade permits → establishes market + price

  • achieves Q* at the least cost, aka setting a quota for the good

• cap = hard limit on total emissions/output → issue exactly Q* permits

• each permit = legal right to emit 1 unit; firms must hold permits for emissions

• trade = firms buy/sell permits; the permit price emerges in the market

cap-and-trade results

hit the target quantity Q*, with lowest-cost reducers cutting the most (cost-effective)

• aka firms with low cutting costs have a financial incentive to invest in clean technologies and efficient practices to reduce emissions below their allocated cap → every extra ton of emissions they reduce can be converted into an allowance to sell for profit

cap-and-trade revenue allocation

depends on allocation of system:

• auctions → government gets revenue by auctioning off permits to businesses, bid up prices

• free allocation → no revenue, but permits get traded around

how to pick between tax & c&t

• price certainty (tax): firms know t; quantity adjusts

  • good when damage per unit is stable

• quantity certainty (cap): society fixes total Q; permit price adjusts

  • good when total quantity is critical

• administration (aka $$): tax raises revenue automatically; cap can auction(revenue) or freely allocate (no revenue)

classifying goods:

• excludable: feasible to prevent nonpayers from using it (e.g., paywall, turnstile)

• nonexcludable: can’t feasibly keep nonpayers out (e.g., street lighting)

• rival: one person’s use reduces what’s left for others (e.g., a sandwich)

• nonrival: my use doesn’t diminish yours (e.g., a lecture recording)

kinds of goods

goods - private

rival, excludable

• basically most goods we’ve talked about so far

goods - club

nonrival, excludable

• ex. tennis membership where courts are always available

goods - common resource

rival, nonexcludable

• leads to overuse! tragedy of the commons

• ex. nonrenewable resources (fisheries)

• fixes: quotas, access fees, tradable rights, property rights

  • basically, assign rights to fix this issue → incentivize people to conserve for future profits, make someone the residual claimant for the stock, etc.

  • ex. congestion/toll pricing, private owned fisheries, etc.

tragedy of the commons

overuse and depletion of resources without rules as common resources are private gains with shared costs

goods - public goods

nonrival, nonexcludable

• leads to underproviding! due to free-riding

• ex. national defense

• fixes to underproviding issue: two part-tariffs, donations with matching, norms

calculating marginal benefit (MB) of public goods

calculate the vertical sum of benefits across all users

• works since person A using does not affect person B using

• = marginal benefit of society as a whole