Microeconomics - Externalities and Public Goods

Externalities and Public Goods

Learning Objectives

  • Explain why competitive markets may not allocate resources efficiently when externalities are present.
  • Discuss the nature and limitations of private negotiation as a remedy for market failures associated with externalities.
  • Evaluate various public policies that are designed to address externalities.
  • Identify the characteristics of a good that can justify public provision.

Overview

  • Externalities: When choices directly affect the well-being of others not involved in the transaction, competitive markets may allocate resources inefficiently.
  • Private parties have strong incentives to identify inefficiencies and negotiate mutually beneficial solutions.
  • When the private sector fails to address externalities, appropriate government policies can potentially improve economic efficiency.
  • The government provision of public goods is sometimes beneficial.

Externalities

  • Externality: When an action affects someone with whom the decision-maker has not engaged in a related market transaction.
    • Negative externality: When such an action harms someone else.
    • Positive externality: When such an action benefits someone else.
  • External cost: The economic harm that a negative externality imposes on others.
  • External benefit: The economic gain that a positive externality provides to others.

Inefficiency in Competitive Markets

  • When an externality is present, the private costs and/or benefits of an activity to the party who performs it differ from the social costs and/or benefits of that activity.
  • When a consumption or production activity creates an externality, competitive markets will usually allocate resources inefficiently.

Competitive Equilibrium with a Negative Externality

  • Example: Paper Mill
  • The Marginal Social Cost (MSC{mill}) is higher than the Marginal Cost (MC{mill}) due to the Marginal External Cost (MEC_{mill}).
  • Graph shows a deadweight loss where the marginal social cost is greater than the market supply (S_{market}).

Competitive Equilibrium with a Positive Externality

  • Marginal Social Benefit (MSB) is higher than the Marginal Benefit (MB).
  • Marginal External Benefit (MEB) exists.
  • Deadweight loss occurs where MSB is greater than the supply (S=MC=MSC).

Remedies for Externalities

  • Private Sector
    • Property rights and negotiation
  • Public sector
    • Policies that support markets
    • Quantity controls
    • Taxes, fees, subsidies
    • Liability rules

Property Rights and Negotiation

  • The outcome of any negotiation depends on the allocation of property rights.
    • The party who holds the relevant property rights is in a stronger bargaining position.
  • Coase Theorem: If bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will remedy the market failures associated with externalities and restore economic efficiency.

Property Rights and Negotiation: Example (Right to Pollute)

  • If the mill has the right to pollute, the profit-maximizing production is q^*.
  • Negotiation may lead to lowering production to q_{eff}.
  • A = Maximum payment that farmers may offer to the mill for lowering output to q_{eff} = external cost reduction.
  • B = Minimum payment from farmers that the mill is willing to accept for lowering output q_{eff} = profit reduction.
  • If A > B, there exist mutual gains from negotiation.

Property Rights and Negotiation: Example (Farmer’s Right to Clean Water)

  • If the farmer has the right to clean water, the output is 0, and the mill has zero profits.
  • A = Maximum payment that the Mill may offer to the farmer as compensation for increasing output to q_{eff} = Mill’s profits increase.
  • B = Minimum payment from the Mill that the farmer is willing to accept for letting the Mill produce q_{eff} = external cost increase.
  • If A > B, there exist mutual gains from negotiation.

Limitations of Bargaining

  • Bargaining can be impractical, requiring substantial time and effort.
  • The assignment of property rights may be ambiguous.
  • Parties may have limited information about each others’ costs and benefits.
  • Efficient contracts may be difficult to monitor and enforce.

Methodological Note: Missing Markets

  • The externality problem can be thought of as a problem of missing markets. Specifically, the market for the externality is missing.
  • Example: Effluents from the mill (Z).
  • Positive one-to-one association between the mill’s output, q, and Z: Z = f(q), where f(.) is a strictly increasing function so that q = f^{-1}(Z).
  • Simplified: q = aZ, where a > 0 is a known parameter.
  • Demand side for Z is represented by the mill. For the mill, Z is an input: 1 extra unit of q can only be produced through \frac{1}{a} extra units of Z.
  • Firm MC(q) can be expressed as MC(aZ), and if the firm is price taking, MB(Z) = p^* - MC(aZ) is the marginal benefit of the firm.
  • MB can be also thought of as the marginal cost of abatement, MCA, that is, the profit lost from abating q by 1 unit or, equivalently, Z by \frac{1}{a} units.
  • The supply side of the market for Z is represented by the farmers, as for them, Z is costly. MEC(aZ) can be thought of as the MSC of effluents, MSC(Z) = MEC(aZ).
  • In the absence of an institutional setup ensuring that the supply of Z follows MSC(Z), that is, ensuring that farmers are paid a price equal to MSC(Z) for any Z, any amount of Z could be permitted at a zero price, and consequently, the mill will demand/generate the highest amount of effluents, Z^: MB(Z^) = 0 (Z^* emerges as the horizontal intercept of the MB curve).
  • The efficient amount of Z, say Z_{eff}, would emerge as the equilibrium quantity in the market for externality if MSC(Z) is enforced as the market supply curve for Z.

The Externality Problem in Terms of a Missing Market

  • Efficient equilibrium if the market is created, that is, if MSC(Z) is enforced as the supply curve for Z.
  • Equilibrium with a missing market.

Remedies for Externalities: The Public Sector

  • Public sector
    • Policies that support markets
    • Quantity controls
    • Taxes, fees, subsidies
    • Liability rules

Policies That Support Markets

  • When private negotiations fail to remedy the market failures associated with externalities, appropriate government policies can potentially improve economic efficiency.
  • In some situations, governments can address externalities by helping the private sector create the necessary markets.
    • Establish clear property rights, pass laws that protect those rights, and enforce contracts.
    • Governments can even create and operate a market.

Example: CO2 Permits

  • Governments can create a market for “greenhouse-free air” by auctioning a fixed number of transferable permits for carbon emissions.
  • The equilibrium price can be considered an emission tax rate.
  • The resulting supply curve is vertical, corresponding to the total quantity of carbon emissions permitted, possibly fixed at the efficient volume.

Quantity Controls

  • Emissions standard: Legal limit on the amount of pollution that a person or company can produce when engaged in a particular activity

Taxes, Fees, and Subsidies

  • Pigouvian taxation: The use of taxes or fees to remedy negative externalities.
  • Pigouvian subsidization: The use of subsidies to remedy positive externalities.

Pigouvian Taxation in Terms of Product Market

  • Government taxes the production generating the negative externality with a tax rate t:
    t = MEC(Q{eff}), where Q{eff} is the sales amount equalizing market demand and MSC: D(Q{eff}) = MSC(Q{eff}).
  • St(Q) = MC(Q) + t, let’s evaluate St(Q) at Q{eff}: St(Q{eff}) = MC(Q{eff}) + t = MC(Q{eff}) + MEC(Q{eff}) = MSC(Q_{eff})
  • St(Q{eff}) = D(Q{eff}) implies that Q{eff} is sustained as the market equilibrium quantity.

Liability Rules

  • Liability rule: A legal principle requiring a party who takes an action that harms others to compensate the affected parties for some or all of their losses.

Example: Market Demand and External Costs

  • Market demand: P = 13 - 2Q
  • Private cost: C = 4Q + 0.5Q^2
  • External cost: EC = 2Q + 0.25Q^2
  • Marginal Cost: MC = 4 + Q
  • Marginal External Cost: MEC = 2 + 0.5Q
  • Marginal Social Cost: MSC = 6 + 1.5Q
  • Efficient Quantity: Q{eff}, where MSC = P: 6 + 1.5Q = 13 - 2Q \Rightarrow Q{eff} = 2
  • Pigouvian tax rate: MEC(Q{eff}) = 2 + 0.5 ymes 2 = 3 St = MC + t = 7 + Q \Rightarrow 13 - 2Q = 7 + Q \Rightarrow Q = 2
  • Alternatively, quantity control = 2.
  • Or liability rule: MC = 6 + 1.5Q

Example

  • Given, P = 13 - 2Q, MC = 4 + Q and MEC = 2 + 0.5Q, if Z = 2Q,
  • MB(Z) = P - 4 - Q = 13 - Z - 4 - 0.5Z = 9 - 1.5Z
  • MSC(Z) = 2 + (1/4)Z
  • 2 + (1/4)Z = 9 - 1.5Z \Rightarrow Z{eff} = 4 (NB: consistent with Q{eff} = 2)

Public Good

  • A good is nonrival if more than one person can consume it simultaneously without affecting its value to others.
  • A good is nonexcludable if there is no way to prevent a person from consuming it.
  • Public good: A good that is nonrival and nonexcludable.
  • Private good: A good for which consumption involves perfect rivalry and that is completely excludable.

Public Goods and Market Failure

  • If the provision of a public good is left entirely to the independent actions of private parties, the level of production will usually be inefficiently low.
  • A free rider contributes little or nothing to a public good while benefitting from others’ contributions.

Public Policy toward Public Goods

  • Provide some public goods
    • Examples: national defense, national anti-pandemic plans
  • Contribute to nonprofit organizations that provide other public goods
    • Example: public radio
  • Subsidize private contributions to many public goods
    • Example: research on and production of vaccines, environmental protection

Groves Mechanism

  • Groves mechanism: a procedure for setting the level of the public good that induces everyone to report their preferences correctly, producing a socially efficient outcome.

Example: Public Good

  • 100 individuals in the market, each with MB = 1 - 0.1Q
  • Production cost for the public good, C = 20Q
  • Marginal Social Benefit: MSB = 100 - 10Q
  • Marginal Cost: MC = 20
  • Efficient Quantity: Q{eff}, where MSB = MC 100 - 10Q = 20 \Rightarrow Q{eff} = 8

Exercise 1: Generic Drug Production and Pollution

  • Firm sells generic drug (q) at price P^* = 12. Marginal cost is MC(q) = q. Production causes air pollution with marginal external cost MEC = 2.
    • Calculate the supplied amount of Gprod’s drug at the equilibrium price. q=12
    • Derive the marginal social cost function MSC(q). MSC=q+2
    • Calculate the efficient quantity for the Gprod’s drug. q+2=12 => q=10
    • Calculate the deadweight loss caused by Gprod at the equilibrium price. DWL=(12-10)*2/2=2
    • The local opposition party advocates a specific tax on the supplied amount of Gprod’s drug. t=MEC(q=10): t=2
      What is the name of the tax? Pigou tax

Exercise 2: Market Equilibrium and External Costs

  • Product Q is traded in a perfectly competitive market. Producing Q brings about an external cost. What is true?
    • Q** is the perfectly-competitive market equilibrium quantity
    • Which one? the quantity of product that can be guaranteed by the market in the absence of state intervention is lower than the socially efficient one

Review

  • When an activity creates an externality, competitive markets will allocate resources inefficiently.
  • Externalities result from missing markets. Negotiations can substitute for those markets.
  • If bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will lead to an efficient outcome.
  • Governments can remedy some externalities through policies that help the private sector create the necessary markets, or by creating and operating those markets, or by regulating the level of activities, or by correcting private incentives through taxes, fees, subsidies, or liability rules.
  • The private provision of public goods is affected by a free-rider problem.
  • The efficient provision of public goods requires government interventions.

Looking Forward

  • Next, we will study risk and how people make decisions under uncertainty.
  • This is important to understand the role of information for market equilibria.