Chapter 5

Microeconomics Chapter 5: Externalities, Environmental Policy, and Public Goods

Chapter Outline

  • 5.1 Externalities and Economic Efficiency

  • 5.2 Private Solutions to Externalities: The Coase Theorem

  • 5.3 Government Policies to Deal with Externalities

  • 5.4 Four Categories of Goods

5.1 Externalities and Economic Efficiency

  • Definition of Pollution: Pollution is described as an unintended by-product of various activities.

    • If pollution only affected the person who created it, it would be produced only until the marginal cost equaled the marginal benefit.

    • Externalities Explained: An externality is defined as a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

    • This can be likened to a side-effect.

  • Economic Efficiency and Externalities:

    • Externalities interfere with economic efficiency by causing a disparity between private costs and social costs.

    • Private Cost: The cost borne by the producer of a good or service.

    • Social Cost: Total cost of producing a good or service, including both private cost and any external costs.

    • Most significant externalities in production are negative, which increase social costs, like pollution.

  • Market Dynamics in Energy Production:

    • The market for electricity comprises:

    • Sellers: They face increasing marginal costs.

    • Buyers: They experience decreasing marginal benefits from additional electricity use.

    • Together, these actions generate demand and supply curves for electricity.

  • Costs of Electricity Production:

    • Firms incur production costs including:

    • Buildings

    • Equipment

    • Fuel

    • Labor, etc.

    • Decisions on electricity production are based on private costs, not accounting for higher social costs due to pollution.

  • Economic Efficiency and Pollution:

    • Figure 5.1 illustrates how pollution affects economic efficiency:

    • Supply Curve S1: Represents the marginal private cost to the electricity producer.

    • Supply Curve S2: Represents the marginal social cost, which includes costs to those affected by pollution.

    • Optimal Production Level (Efficient Q): At this quantity, marginal cost to society equals marginal benefit.

    • Market Equilibrium: Achieved at the intersection of demand and supply curves resulting in so-called "too low" prices and "too high" quantities, leading to deadweight loss.

  • Externalities in Consumption:

    • Differentiation between Private and Social Benefits:

    • Private Benefit: Received by the consumer of a good or service.

    • Social Benefit: Total benefit of consuming a good, encompassing both private benefits and external benefits.

    • Typically, consumption externalities are viewed positively (e.g., education), while some are negative (e.g., cigarettes).

  • Positive Externalities in Consumption:

    • Figure 5.2:

    • College education produces positive externalities; marginal social benefit exceeds marginal private benefit.

    • Results in underproduction of college educations at market equilibrium.

  • Market Failure and Externalities:

    • Markets fail to produce efficient quantities due to externalities:

    • Overproduction occurs with negatives; underproduction with positives.

    • Deadweight loss arises due to market failure proportionate to externality size.

  • Causes of Externalities:

    • Occur when property rights are either absent or inadequately enforced.

    • Example: Public property leads to overconsumption of shared resources, resulting in pollution.

5.2 Private Solutions to Externalities: The Coase Theorem

  • Property Rights and Externalities:

    • Externalities stem from incomplete property rights, defined as the exclusive rights to use property and the ability to buy or sell it.

  • Resolving Externalities with Property Rights:

    • Example Scenario: A farmer and a paper mill sharing a stream where:

    • Without ownership, the mill pollutes the stream.

    • If the farmer owns it, they can either prevent pollution or charge for it, ultimately resolving the market failure.

  • Efficiency of Non-Zero Pollution:

    • Sometimes a non-zero pollution level is optimal, achieved where the marginal benefit of pollution equals the marginal cost of pollution reduction.

  • Figures Illustrating Efficiency:

    • Figure 5.3: Displays marginal benefit from pollution reduction equating to marginal cost.

    • Figure 5.4: Illustrates the benefits of pollution reduction, where total benefits exceed total costs.

  • Implications of Legality on Property Rights:

    • If utility firms are liable for pollution, they have incentives to negotiate terms allowing them to pollute up to an efficient level.

  • The Coase Theorem Overview:

    • Ronald Coase proposed that externalities can be addressed through private bargaining if:

    • Property rights are assigned/enforceable.

    • Transaction costs are low.

    • Transaction Costs: Costs incurred in time and resources during exchange agreements.

  • Irrelevance of Property Rights Assignment:

    • Coase highlighted that the assignment of property rights does not affect the solution to the externality issue. Both parties can reach an efficient outcome, regardless of the initial rights.

  • Real-World Application of Coase Theorem:

    • Example of solving seat recline disputes on planes via the Coase theorem, assessing transactions costs.

5.3 Government Policies to Deal With Externalities

  • Taxes and Deadweight Loss Relation:

    • Taxes induce inefficiencies by misaligning production away from efficiency. Conversely, correct taxation can restore efficiency.

  • Applying Taxation for Negative Externalities:

    • Figure 5.5 illustrates utilizing a tax equal to the cost of pollution which shifts the supply curve upwards, leading to a new market equilibrium at an efficient level.

  • Positive Externalities and Alternative Measures:

    • Positive externalities suggest that subsidies are needed as taxes alone won't reduce production efficiently.

  • Subsidy Mechanism:

    • Figures 5.6 showcase how subsidies shift demand curves upwards in markets like education, leading to optimal output levels.

  • Pigovian Taxes and Subsidies:

    • Named after economist Arthur Cecil Pigou, these measures correct externalities while generating revenue for the government and can potentially reduce inefficiencies in other tax areas.

    • Example: British Columbia's carbon tax initiative.

  • Negative Externalities in Health Context:

    • Cigarettes and soda identified as candidates for Pigovian taxes due to their shared negative health implications, creating an excess consumption scenario which necessitates governmental intervention.

  • Alternatives to Taxation:

    • Command-and-control policies; a traditional approach where the government sets quantitative pollution limits, mandating installation of certain pollution control measures.

    • Example scenario: Regulations requiring catalytic converters in cars.

  • Efficiency in Pollution Reduction:

    • Recognizing firms with varying costs for pollution reduction leads to inefficiencies when holding all firms to the same standards.

  • Tradable Emissions Allowances (Cap-and-Trade):

    • System where allowable emissions are established by the government with firms trading allowances; firms with lower reduction costs sell to those with higher costs, achieving cost-effective pollution reduction.

  • Carbon Tax Implementation for Climate Change:

    • Current estimates put the marginal social cost of carbon dioxide emissions at approximately 49 per metric ton, with proposed taxes raising gasoline prices by roughly 0.44 per gallon. However, a global adoption is necessary to avoid disadvantaging U.S. firms, yet political support for such measures remains low.

5.4 Four Categories of Goods

  • Definitions:

    • Rivalry: Consumption by one individual prevents another from consuming the same unit.

    • Excludability: Individuals not paying for a good cannot consume it.

  • Classification of Goods:

    • Private Goods:

    • Rival and Excludable (Example: Big Macs, Running shoes)

    • Common Resources:

    • Rival and Nonexcludable (Examples: Tuna in the ocean, Public pasturelands)

    • Quasi-Public Goods:

    • Nonrival and Excludable (Examples: Cable TV, Toll roads)

    • Public Goods:

    • Nonrival and Nonexcludable (Examples: National Defense, Court System)

  • Market Efficiency by Goods:

    • Markets excel in providing efficient levels of private goods because decisions are based primarily on individual preferences that align with personal benefits.

    • In contrast, markets struggle with public goods due to free-riding issues and inefficiency in conserving common resources due to overconsumption.

Copyright Information: This material is protected under copyright laws and is meant for instructor use only. Any dissemination or resale is prohibited.