Lecture 12-13 Externalities and Public Goods

Externalities and Public Goods

Lecture Overview

• Course: Public Affairs 40 Principles of Microeconomics

• Institution: University of California, Los Angeles

• Instructor: Wesley Yin

• Date: Lectures 12-13

Outline of Topics

• What are externalities?

• Correcting externalities

• Empirical applications

Externalities

Definition

• Externalities are costs or benefits caused by the production and/or consumption of goods that are not reflected in the prices.

• They can be:

  • Positive Externalities: Benefits conferred to others without compensation. Examples include:

    • Receiving a flu shot reduces infections for others.

    • Crop pollination from bees.

    • Scientific research that benefits society.

  • Negative Externalities: Costs imposed on others without compensation. Examples include:

    • Second-hand smoke from cigarettes.

    • Pollution from manufacturing or driving cars.

Market Failure

• Externalities lead to market failure, where free-market equilibrium does not result in a socially optimal quantity of goods/services.

• Common outcomes include:

  • Too much production/consumption of goods with negative externalities (e.g., pollution)

  • Too little production/consumption of goods with positive externalities (e.g., scientific research)

• The distinctions between socially optimal and privately optimal quantities indicate market inefficiencies.

Marginal Benefits and Costs

Concepts

• Marginal Social Cost (MSC): Cost to society from producing an additional unit of a good, incorporating negative externalities such as pollution.

• Marginal Social Benefit (MSB): Benefit to society from consuming an additional unit of a good, incorporating positive externalities like knowledge.

• The socially optimal quantity occurs when all costs and benefits are fully internalized.

Categories of Externalities

Negative Externalities: Production Externality

• The free-market equilibrium occurs at points where:

  • Price (P) = marginal cost of production (MC)

  • Equilibrium price and quantity do not account for the marginal damage (MD) to society due to pollution.

  • Results in deadweight loss (DWL) as production/consumption exceeds the socially optimal level.

Negative Externalities: Consumption Externality

• Free-market equilibrium matches the demand for a good without considering the marginal damages to society.

• The social marginal benefit is lower than the private marginal benefit, leading to overconsumption of harmful goods.

Key Lessons from Externalities

• Private markets often produce inefficient outcomes, failing to account for social costs.

• Zero pollution is not necessarily desired; hence the focus should be on minimizing total social costs.

• Understanding the shapes of MB, marginal private cost (MPC), and MD is crucial for implementing effective Pigouvian taxes.

Coase’s Theorem and Policy Solutions

Coase’s Theorem

• In the absence of transaction costs and with well-defined property rights, voluntary negotiations can lead to an efficient outcome regardless of who holds the rights.

• Examples of property rights include rights to pollute or rights to a clean environment.

Practical Challenges

• Cost of bargaining can be substantial, especially with larger groups.

• Asymmetric information can hinder identifying sources of damage.

• Government may need to intervene in cases of difficult bargaining situations.

Correcting Negative Externalities

Approaches

• Property Rights and Markets for pollution

• Pigouvian Taxes: Imposed to align private costs with social costs.

  • Set equal to the marginal damage at the socially optimal level.

• Regulation: Command-and-control emission standards or tradable permits to control pollution levels.

Pigouvian Tax Mechanics

• Imposes a tax equal to the marginal social cost to reduce the harmful externalities and guide consumption towards socially optimal levels.

• Example: If pollution is priced correctly, quantity consumed falls to the socially optimal level, reflecting true costs.

Measuring Social Costs of Carbon

• The Social Cost of Carbon (SCC) is estimated at around $50 per ton, calculated through a multi-step process that assesses future emissions, climate responses, economic impacts, and discounts future values.

• The SCC is useful in cost-benefit analyses for environmental regulations.

Public Goods

Characteristics of Public Goods

• Excludability: Whether individuals can be prevented from using the good.

  • Non-excludable: Can't easily prevent use (e.g., clean air).

  • Excludable: Can prevent non-payers (e.g., concert tickets).

• Rivalness: Whether one person's use diminishes others' use.

  • Non-rival: Consumption does not decrease availability (e.g., public sanitation).

  • Rival: Consumption reduces availability (e.g., fish in a river).

Challenges and Solutions

• Public goods face the free-rider problem, leading to underfunding and under-consumption due to non-excludability.

• Solutions include government provision, subsidies, or direct taxation to enable sufficient supply of public goods.

Common Resources and Over-Consumption

• Common resources are non-excludable but rival in consumption.

• This leads to overuse as individuals have little incentive to conserve resources like fisheries.

Coase’s Examples and Property Rights

• Coase demonstrates that regardless of property rights assignment (to livestock owners or farmers), efficient outcomes can be negotiated.

• Enforcement of property rights, while effective, may face challenges related to market dynamics and enforcement costs.

Historical Context: Barbed Wire

• The introduction of barbed wire in the 19th century reduced fencing costs, incentivizing property rights assignment and agricultural development.

• Significant changes in land use patterns followed the advent of cheaper fencing.

Conclusion

• Effective correction of externalities and provision of public goods often necessitates a multi-faceted approach, incorporating government intervention, accurate measurement of costs and benefits, and clarity of property rights.