Mod 2.2

Mod 2.1 Cont.

2 Types of Externalities

  • Positive Externality:

  • social benefit of consumption = WTP + value of benefits that accrue to others from private consumption (value of the positive externality)

  • social benefit > private benefit (WTP)

  • market solution is too little product


  • Negative Externality:

  • social cost of production = private cost of production + value of cost that accrue to others from production (value of the negative externality)

  • social cost > private cost

  • market solution is too much product


  • to get the market to recognize an externality, govt. has to internalize it (what the Pigouvian Tax does)


Prime Externality Ex: Air Pollution

  • coal-fired power plants will run if price of electricity is high enough to cover a plant’s operating costs

  • the only costs considered by plant owners are those costs paid by the owners (private costs):

  • labor, coal, materials, energy, etc

  • some costs are borne by other people, they are “external” to the plant

  • CO2 emissions → costs associated w/ global warming

  • fine particulates: SO2 emissions, mercury


Mod 2.2

Social Costs vs. Private Costs / Social Benefits vs. Private Benefits

  • social costs = private costs + value of externality (external costs)

  • social benefits = private benefits + value of externality (external benefits)

  • negative externalities are costs borne by members of society nut not by producers of the externality

  • positive externalities are benefits borne by members of society but not by producers of the externality

  • value of externality = damage suffered (benefit accrued) by those not party to market transaction

  • when some costs or benefits are not accounted for, market outcomes can’t be characterized as being efficient (i.e., wealth maximizing)


Implication of Accounting for Negative Externalities Associated W/ Coal

  • social cost of producing electricity from coal exceeds the private costs when coal companies don’t have to pay for costs caused by air pollution

  • they don’t have to “internalize” the externality/external cost

  • if owners of coal-fired plants had to pay pollution costs, then they would require a higher electricity price to produce

  • if plants have to pay for the external costs, we say they are “internalizing” those costs (now they have to consider them on their profit-maximizing decisions)

  • making owners pay for external costs would give a competitive advantage to clean energy providers

  • coal’s share of electricity market would drop → economic efficiency would go up!


How Markets Fail (Cassidy)

  • starts w/ discussion of 4 polar bears dying by drowing

  • receding ice in northern Arctic → less food for polar bears & less ice to live on

  • climate change → mostly from burning fossil fuels & leads to more CO2 in atmosphere (& other GHGs, e.g., methane)

  • CO2 concentrations:

  • 1750s: 250 ppm

  • 2000: 430 ppm

  • expected rise in global temp: 2.5 → 4 C by end of century

  • largest emitters: China, U.S., India

  • largest emitters/capita: U.S., Russia, South Korea

  • U.S.: largest emitter → transportation

  • next: electricity generation

  • emissions aren’t a goal of production, but they’re an unintended consequence

  • externality: unintended consequence of production & consumption decisions

  • “market” fails in terms of distributing goods & services to society efficiently in presence of externalities

  • private decisions aren’t what’s best for society

  • society can do better

  • ex: power station burns coal to produce electricity but generates pollution (emissions)

  • don’t pay for emissions but pays a lower cost for generating electricity via coal than via wind

  • “human induced climate change is at its most basic level an externality (market failure)” (Stern)

  • people want to maximize utility & firms want to maximize profits

  • nearly all activities generate some spillover effects on others (to varying degrees)

  • so → nearly all activities generate “externalities”—they’re pervasive

  • so laissez-faire often can’t be justifies in these situations

  • require some sort of govt. intervention

  • first economist to really identify these issues: Pigou

  • illustrated difference between the private & public values of economic activity

  • value of activity to individuals often includes costs (or benefits) not borne by individual but by others—for public policy, want to consider all social value (which includes all values)

  • want to balance social costs w/ social benefits (best for society as a whole)

  • not private costs & private benefits

  • Pigou suggested using taxes & subsidies to “internalize” the externality (correct the market failure)

  • ex: carbon tax, congestion pricing (NYC)


Other Examples of Externalities

  • negative externalities:

  • water pollution, noise pollution, congested traffic, second-hand smoke

  • any costs borne by 3rd parties

  • positive externalities:

  • vaccination, mass transit, yard maintenance


Market Failure #3: Too Few Public Goods

  • public goods are generally provided by the public sector

  • but not all goods provided by the public sector are public goods

  • attribute of a pure public good:

  • it’s excludable → only people who pay for a good can “consume” it

  • it’s rivalrous → once I consume the good, then it’s not available for consumption by someone else (or not as much)

  • markets do a good job of supplying pure private goods (opposite of public goods)

  • consumption of goods limited to those who pay for it