Course: Public Affairs 40 Principles of Microeconomics
Institution: University of California, Los Angeles
Instructor: Wesley Yin
Date: Lectures 12-13
What are externalities?
Correcting externalities
Empirical applications
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.
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 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.
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.
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.
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.
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.
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.
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.
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.
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.
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).
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 are non-excludable but rival in consumption.
This leads to overuse as individuals have little incentive to conserve resources like fisheries.
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.
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.
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.