Chapter 13 Notes: Externalities and Public Goods

Externalities & Public Goods

Key Concepts

• Externalities: An action or transaction that affects a third party who is not a party to it.
• Market failure: A market outcome does not provide the socially optimal level of output.
• Shadow price: (Not explicitly defined in the transcript, but generally refers to the implicit cost of a resource).
• Coase theorem: (Not explicitly defined, but refers to the idea that efficient solutions to externalities can be reached through bargaining if property rights are well-defined and transaction costs are low).
• Public goods: Goods that are nonrival and nonexcludable.
• Nonrivalry: Consumption by one person does not reduce the utility of the good to others.
• Nonexcludability: Once the good is provided, it's impossible to prevent others from enjoying it.
• Free rider: Someone who enjoys the benefits of a public good without paying for it.
• “Tragedy of the commons”: Overuse of common property resources leads to depletion.
• Asymmetric information: One party in a transaction has more information than the other.
• Government failure: Government intervention leads to a less efficient allocation of resources.
• Command and control policies: Regulations set by a central agency for emissions.
• Market-based policies: Using market forces (taxes, subsidies, permits) to achieve environmental objectives.
• Pigouvian tax: A tax on pollution to achieve the socially efficient outcome.
• Cost-benefit analysis: Evaluating the costs and benefits of a project or policy.
• Sustainable development: (Not explicitly defined, but generally refers to development that meets the needs of the present without compromising the ability of future generations to meet their own needs).

Market Failure

Market failure occurs when a market outcome does not provide the socially optimal level of output.

Causes of market failure include:

1. Externalities
2. Existence of public goods
3. Common property resources

Externalities

• An action or transaction that affects a third party who is not a direct participant.
• Positive externality: Benefits to others outside the market.
• Negative externality: Costs to others outside the market.
• Externalities can arise from production or consumption.

Examples of Externalities

• Negative Production Externality: Buying a car and gasoline leads to pollution.
• Negative Consumption Externality: Owning a dog that barks at night, disturbing neighbors.
• Positive Consumption Externality: Getting a flu shot protects others by reducing disease transmission.

Social versus Private Costs and Benefits

• Social costs/benefits: Full resource costs/benefits of an economic activity, including externalities.
  • Marginal Social Cost = MSC
  • Marginal Social Benefit = MSB
• Private costs/benefits: Costs/benefits directly borne by the producer or consumer, excluding externalities.
  • Marginal Private Cost = MPC
  • Marginal Private Benefit = MPB

Negative Production Externalities

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

Graph: Supply curve represented as Sp (MPC), shifting to Ss (MSC) to the left. Intersection of Demand curve D with Sp (MPC) at market quantity Q{MKT}. Socially optimal point where D intersects Ss (MSC) is at QS.

Positive Consumption Externalities

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

Graph: Demand curve represented as Dp (MPB), shifting to Ds (MSB) to the right. Intersection of Supply curve S with Dp (MPB) at market quantity Q{MKT}. Socially optimal point where S intersects Ds (MSB) is at QS.

Smoking as an Example of Externalities

• Smoking prevalence statistics:
  • National (median): 18.4%
  • Tennessee: 23.1%
  • Age groups: Varying percentages across different age groups.
  • Education: Varies significantly based on education level.
  • Gender: Male 26.6%, Female 19.9%

Tobacco-Related Costs

• The burden of death, disease, and disability lies beyond the smoker.

• Tobacco-related health care costs (2000-2012): 133 billion.

• Missed opportunities for programs and services: 16.6 billion.

• Society pays and so do you.

• Society: Tobacco-related health care costs and productivity loss in the US: 289 Billion

• You: Health-related costs to you per pack of cigarettes: 35

• Average price per pack of cigarettes in the US: 6.36

Externalities and Market Incentives

• Market incentives shift pollution costs from a single producer to society as a whole.
• In case of consumption, such as smoking, others bear the cost of my decision to smoke due to second-hand smoke, health care costs, and lost productivity.

Public Goods

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

Taxonomy of Goods

A table categorizing goods based on rivalry and excludability:

Examples of Goods

Public Goods Game

• Each player is given 100. They can contribute 100 or nothing to the public good.
• The sum of contributions is multiplied by 1.5 and divided equally across players.
  *Payoff matrix:

• Main issue with public goods is the incentive to ”free-ride” since there is no way to exclude people who do not pay.

Common Property Resources

• Common property resources are nonexcludable but rival.
• Overuse of common property resources can lead to the "tragedy of the commons".

Bluefin Tuna as a Common Property Resource

• Bluefin tuna stocks have declined by 96.4 percent from pre-1950 levels due to sushi preferences.
• 2023 price at Japan’s Toyosu market auction = 273,000 ($58/lb). The record was in 2019 when the first tuna sold for almost 3 million ($5000/lb)!
• Smaller fish are better to eat to promote sustainability (avoids mercury and does not deplete stocks as much).

Health Care

• Affordable Care Act (ACA) 2010
• We have many types of insurance (not just health insurance)
• How insurance works:
  • Law of large numbers
  • Premium
  • Deductible

Asymmetric Information in Health Care

• Role of asymmetric information – when one party to a transaction knows more than another party
• The individual typically knows their health status better than the insurance company.
• Those with higher health risks are more likely to purchase health insurance.

Health Insurance Coverage

• Sources of Health Insurance in the United States, 2009: Before ACA a majority of people in the United States live in households that have private health insurance.
• Government programs insure about 29 percent of the population.
• Percentage of People by Type of Health Insurance Coverage and Change From 2018 to 2020:
  • Uninsured: 8.6%
  • With health insurance: 91.4%
  • Any Private Plan: 66.5%
  • Any Public Plan: 34.8%
    *The estimates by type of coverage are not mutually exclusive: people can be covered by more than one type of health insurance during the year.

Health Care Spending

• The U.S. spends more on health care per person than any other nation.
• The U.S. lags behind other wealthy countries in infant mortality rate and life expectancy.
• Despite spending the most money on health care per person, the U.S. has worse outcomes:
  • higher infant mortality
  • lower life expectancy

Infant Mortality and Life Expectancy

• Infant mortality rates by OECD member countries and top- and bottom-ranking U.S. states, 2019 edition
  • United States 5.8 deaths per 1,000 live births
• Life expectancy at birth by OECD member countries and top-and bottom-ranking U.S. states, 2019 edition
  • United States 78.6 years

Environmental Policy

• Deals with the incentives faced by policymakers who wish to align public interests with business interests.
• The economically efficient optimal level of pollution occurs where marginal benefits = marginal costs of pollution.

Marginal Damages and Marginal Abatement Costs

• The marginal damage curve shows the change in damages from a change in emissions.
• The marginal abatement cost curve shows how costs rise as emissions are reduced from E0.
• The socially optimal level of emissions is ES at a cost to society of Ce.

Graph illustrating marginal damage (MD) and marginal abatement cost (MAC) curves intersecting at the socially optimal emission level Es and cost Ce.

Air Pollution

• Damages caused by air pollution in the US: (~7% of deaths)
• Worldwide? (3 million in china)
• Almost 40% of Americans live in a non-attainment region (128 million people)

Air Quality in Knoxville

• In 2016 Knoxville was a nonattainment area for two pollutants
• From “State of the Air: 2013”: Knox county received a grade of “D” in ozone and a “Fail” in annual particle pollution. Knoxville was a non-attainment region for both in 2013.
• As of Oct 2017 Knoxville is no longer a non- attainment area.

Environmental Policy Options

• A producer has an incentive to continue polluting using cheaper technology as long as doing so is more profitable.

• The goal is to discourage production and consumption activities that impose external costs on society.

• We can do this in one of two ways:

  1. Command and control (vehicle emissions standards)
  2. Market-based policies (taxes, subsidies, tradable permits)

• Air quality in the U.S. is cleaner now than it was 50 years ago.

Environmental Policies: Command and Control vs. Market-Based

Emission Taxes

A tax on every unit of pollution produced to achieve the socially efficient outcome.

• Also known as Pigouvian taxes
• Some firms can reduce pollution at less cost than others. Emission taxes produce efficiencies.

Using a Tax to Deal with a Negative Externality

• Tax equals vertical distance between marginal social cost and marginal private cost.

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 certain amount.
• These permits can be bought and sold; hence the common term cap and trade.
• Cap and trade worked for sulfur dioxide.

Carbon Trading

• If sulfur dioxide trading worked to decrease acid rain, why can’t carbon trading work to reduce the effects of climate change?
  • Effects are not local (if coal plant reduces sulfur dioxide, surrounding area benefits – if a country reduces CO2 levels, the country does not benefit any more than the rest of the world)
  • The country who bears the costs to reduce emissions shares those benefits with all other countries – the incentive is to let your neighbors pay the cost so you can enjoy the benefits for free (free riding issue).

Carbon Trading Trends

• What about carbon trading?
• 2021 carbon in Europe traded above 50/ton$$ for the first time
• countries/firms are increasingly accounting for their carbon emissions

Quantifying a Ton of CO2

1. One ton equals ~ 2,000 pounds.
2. The density of CO2 is 0.1234 pounds per cubic foot.
3. So one pound of CO2 fills about 8.1 cubic feet of space. That’s a cube that’s 2 feet on each side.
4. 2,000 pounds of CO2 fill about 16,200 cubic feet.
5. That 16,200 cubic feet is about 25.3 feet on each side.