Externalities, Public Goods, Income Inequality, and Poverty

Externalities and Public Goods

Chapter Objectives

• Describe the impact of negative and positive externalities on society.
• Describe the Coase theorem on social costs and the role transaction costs play in determining an optimal allocation of resources.
• Explain the nature of public goods and why private markets will usually not provide them.
• Explain how common resources can lead to resource degradation.
• Discuss how health care exhibits characteristics of public goods and why it is prone to the free rider problem.
• Demonstrate the importance of the discount rate in assessing the costs and benefits of environmental policies.
• Determine a socially efficient level of pollution using marginal analysis.
• Compare command and control policies with market-based approaches to environmental regulation.
• Explain the economic issues surrounding global climate change.
• Discuss strategies that minimize greenhouse gases and promote sustainable development.

Market Failure

Market failure occurs when a market outcome does not provide a socially optimal level of goods or services. Causes include:

• Externalities
• Existence of public goods
• Common resources

Externality

An externality arises when an action or transaction affects a third party who is not involved.

• A positive externality provides benefits to others (e.g., keeping your yard tidy).
• A negative externality produces costs to others (e.g., hosting a loud house party).

Negative Externalities

An external cost shifts the supply curve up and to the left. The market produces more output than is socially optimal.

• Supply curve shifts from SP (MPC - Marginal Private Cost) to SS (MSC - Marginal Social Cost).
• Market produces quantity Q{MKT} at price P{MKT}, while the socially optimal level is QS at price PS.

The Coase Theorem

• In the presence of an externality, if transaction costs are small, the resulting allocation of resources will be efficient regardless of the initial allocation of property rights.
• The socially optimal level of production will be resolved no matter whether polluters are given the right to pollute or victims are given the right to be free of pollution.
• Ronald Coase (1910–2013) argued that private markets are the most efficient way to solve externality problems as long as property rights are clearly defined.
• This key idea became known as the Coase theorem. He won the Nobel Prize in Economics in 1991 for his work on transaction costs and property rights.

Positive Externalities

An external benefit shifts the demand curve up and to the right. The market produces less output than is socially optimal.

Public Goods

Exhibit nonrivalry and nonexcludability.

• Nonrivalry: Consumption by one does not reduce the utility of that good or service to others.
• Nonexcludability: Once a good or service is provided, it is not possible to exclude others from enjoying it.

Demand for Public Goods

The demand for public goods is the vertical summation of individual demand curves.

Optimal Provision of Public Goods

• Providing public goods involves the political process and uses some form of cost-benefit analysis.
• The demand for a public good represents the benefit to society, and the supply curve represents society’s costs. Therefore, equating marginal benefits and marginal costs yields the optimal outcome.

Common Resources

Such as a public festival, are nonexcludable but rival. Overuse of common resources can lead to the “tragedy of the commons.” Example: the effects of overfishing.

Solutions to Common Resource Problems

1. Establishing private property rights.
2. Using government policy to restrict access to the common resource.
3. Creating informal organizations that restrict each user’s benefits from the resource.
   • Examples include raising the gas tax, subsidizing alternative transportation, and privatizing toll roads.

Health Care

An industry with some public goods characteristics.

• Free ridership occurs when uninsured patients seek emergency medical care but do not pay their bills.
• Asymmetric information poses a challenge for private insurance markets.
• Government provides health care coverage to those age 65 and over (Medicare), those with lower incomes (Medicaid), and most veterans.

Environmental Policy

Deals with the incentives faced by policymakers who wish to align public interests with business interests.

Government Failure

Government failure occurs when:

1. Public policies do not bring about an optimal allocation of resources.
2. The incentives of politicians and government bureaucrats are not in line with the public interest.

Present Value

A higher discount rate reduces the present value, which means that the interests of the current generation will be weighed more heavily than that of future generations. To guide environmental policy, policymakers must balance the interests of different generations.

Marginal Damages and Marginal Abatement Costs

• MD curve shows the change in damages from a change in emissions.
• MAC curve shows how costs rise as emissions are reduced from E_0.
• The socially optimal level of emissions is E_S at a cost to society of CE (point e).

Overview of Environmental Policies

• Command and Control: A central agency sets rules for emissions, including the levels allowed, usable technologies, and enforcement.
• Market-Based Policies: Charges, taxes, subsidies, deposit-refund systems, or tradable emission permits to achieve a targeted level of emissions.

Optimal Abatement

As abatement approaches A0 (zero pollution), the marginal cost becomes very high, exceeding the marginal benefit. Optimal abatement at Ae still results in some pollution.

Market-Based Policies: Emissions Taxes

Are a tax on every unit of pollution produced to achieve a socially efficient outcome.

• Also known as Pigouvian taxes.
• Some firms can reduce pollution at a lower cost than others. Therefore, emissions taxes create efficiencies in achieving targeted abatement levels.

Market-Based Policies: Marketable or Tradable Permits

A regulatory body sets a maximum allowable quantity allowed, typically called the cap, and issues permits granting the right to pollute a specific amount. These permits can be bought and sold; hence the common term cap and trade.

Tradable Permits Example

There are two firms, X and Y. All 10 permits are issued to firm X, which can use them or sell them to firm Y.

Climate Change

Has reached a sense of urgency as scientists predict catastrophic consequences if greenhouse gases are not contained.

Climate Change Policy

Cost-benefit analysis is a method of decision-making that looks at the discounted value of future costs and benefits of a proposed policy.

Technology to deal with global climate change is a public good. Private firms find it difficult to fund it when others free-ride on their innovations.

Sustainable Development

The ability to meet the needs of the present without compromising the ability of future generations to meet their own needs.

Governmental Social Responsibility

Much of the technology to reduce greenhouse gases is available today, but governments are sometimes reluctant to spend limited money today for benefits received in the future.

Corporate Social Responsibility

Companies must balance their responsibility to their shareholders and their responsibility to society through programs that benefit the environment and local communities.

Individual Social Responsibility

Ways to Increase Conservation:

• Forgo paper financial statements and printed newspapers and books.
• Use LED or compact fluorescent bulbs.
• Install smart temperature controls.
• Plant trees or purchase carbon offsets.
• Drive less or drive fuel-efficient vehicles.
• Insulate walls and modernize windows.
• Install solar panels.

Key Concepts

• Externalities
• Market failure
• Shadow price
• Coase theorem
• Public goods
• Nonrivalry
• Nonexcludability
• Free rider
• “Tragedy of the commons”
• Asymmetric information
• Government failure
• Command and control policies
• Market-based policies
• Pigouvian tax
• Cost-benefit analysis
• Sustainable development

Income Inequality and Poverty

Chapter Objectives

• Differentiate between wealth and income.
• Analyze functional, personal, and family income distributions.
• Measure and describe the distribution of wealth and income using a Lorenz curve and Gini coefficient.
• Explain the impact of income redistribution efforts.
• Explain the causes of income inequality.
• Explain how poverty thresholds are determined.
• Explain the two measures for determining depth of poverty for households.
• Discuss alternative methods of measuring poverty.
• Describe the prevailing theories on how to address the issues of poverty and income inequality.

Income and Wealth

• Income: A flow measure reflecting the funds received by individuals or businesses over a specific period.
• Wealth: A measure of an individual’s or a family’s assets, net of liabilities, at a given time.

Functional Distribution of Income

The functional distribution of income splits income among the factors of production. For 2020 Distribution:

• Wages = 68.4%
• Proprietor’s Income = 9.9%
• Rent = 4.0%
• Corporate Profits = 13.9%
• Net Interest = 3.8%

Personal or Family Distribution of Income

The distribution of income to individuals or household groups (typically by quintiles, or fifths, of the population).

The U.S. distribution of income has grown more unequal over the past three decades. Every income quintile except the highest has declined in percentage of income.

Lorenz Curve

The Lorenz curve is a graph that illustrates the distribution of income or wealth.

• It cumulates households of various income levels on the horizontal axis.
• It cumulates the share of total income on the vertical axis.
• The more bowed the Lorenz curve, the greater the income inequality.

In the United States, wealth is distributed more unevenly than income. The poorest 20% earn 3.0% of total income, and the poorest 40% earn 11.1% of total income. The richest 20% earn 52.3% of total income and own 89.1% of wealth.

Gini Coefficient

The Gini coefficient is the ratio of area A to area A + B. The more unequal the income distribution, the greater is area A and the greater the Gini coefficient.

Impact of Redistribution

Income distribution becomes more equal when progressive taxation and transfer payments are taken into account.

Comparing Gini Coefficients

Denmark and Sweden have the most equal distribution of income. South Africa and Brazil have the most unequal distribution of income.

Causes of Income Inequality

• Differences in human capital, as high-paying jobs require much more education and skills than before.
• Discrimination that keeps wages low for certain groups of workers.
• The rise of two-earner households, which has increased overall household income significantly.
• Government policies that impact the distribution of income.

Differences in human capital are important: college graduates earn much more income on average than high school graduates.

Poverty

Is a problem affecting about 12% of U.S. households.

Poverty Thresholds

Developed in the 1960s based on the USDA’s food plan and are updated each year by the Census Bureau to account for inflation.

Poverty Guidelines

A slightly modified measure issued by the Department of Health and Human Services is the poverty guidelines and is used to determine eligibility for federal programs.

Poverty Guidelines (2023)

• One person: \$14,580
• Two persons: \$19,720
• Three persons: \$24,860
• Four persons: \$30,000
• Five persons: \$35,140
• Six persons: \$45,420
• Seven persons: \$41,910

U.S. poverty rates declined from 1959 to 1975 and have remained roughly steady since. Poverty rates for Blacks and Hispanics have decreased but remain above the poverty rate for Whites.

Depth of Poverty Measures

• One measure of poverty depth is the income deficit, the difference between the poverty threshold and a household’s income.

  • If a household of four has income of \$19,000 and the poverty threshold is \$27,750, the income deficit would be: \$27,750 – \$19,000 = \$8,750

• A second measure of poverty depth is the ratio of income to poverty, which measures a household’s income as a percentage of the poverty threshold.

  • Households with ratios below 0.5 are “severely or desperately poor.”
  • Households with ratios between 0.5 and 1.0 are “poor.”
  • Households with ratios between 1.0 and 1.25 are “near poor.”

Alternative Measures of Poverty

• Concerns with traditional measures of poverty:
  • They count gross income, including taxes paid.
  • They do not take into account varying family circumstances.
• The U.S. Census Bureau’s new measurements:
  • Use after-tax income.
  • Count antipoverty program benefits such as food stamps and housing subsidies.
  • Use revised expenditure estimates.

Traditional Causes of Poverty

1. Lack of human capital
2. Mental or physical disability
3. Drug addiction
4. Unwillingness to work or apathy toward work
5. Refusal to relocate for work

New Factors Causing Poverty

1. Wages have not kept up with rising costs.
2. Technological changes and globalization have changed employment opportunities.
3. Rising health care costs.
4. Changing family structures.

Poverty can be a relative or an absolute measure.

According to the World Bank, “poor” is defined as living on less than \$3.20 per day.

Policies to Reduce Income Inequality and Poverty

Are politically controversial.

Political Theories on Poverty

• Political Left: Focus on equity: The goal should be to make income and wealth more equitable through policies such as expanding public education, housing subsidies, and health care (i.e., making the pie slices more equal).
• Political Right: Focus on growth: The goal should be to provide incentives to work and reduce government welfare programs. The best way to cure poverty is to increase growth and make the overall pie bigger.

The Rawls vs. Nozick Argument

• Rawls Maximin Principle: A society should maximize the welfare of the least well-off individual. Suggests that some people are born unlucky into poor households, and therefore income redistribution would make society more equitable.
• Nozick’s Argument: It would be unjust to redistribute wealth when it is earned through hard work and innovation. Justice requires protecting property rights to ensure people are rewarded for their hard work.

People move in and out of poverty, but policies can be used to keep the overall rates of poverty low.

Key Concepts

• Income
• Wealth
• Functional distribution of income
• Personal or family distribution of income
• Lorenz curve
• Gini coefficient
• Poverty thresholds
• Poverty rate
• Income deficit
• Ratio of income to poverty