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CHAPTER

18
Externalities
and
Public Goods

Prepared by:
Fernando & Yvonn Quijano

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e.
CHAPTER 18 OUTLINE

18.1 Externalities
18.2 Ways of Correcting Market Failure
18.3 Stock Externalities
Chapter 18 Externalities and Public Goods

18.4 Externalities and Property Rights


18.5 Common Property Resources
18.6 Public Goods
18.7 Private Preferences for Public Goods

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 2 of 36
18.1 EXTERNALITIES

● externality Action by either a producer or a


consumer which affects other producers or
consumers, but is not accounted for in the market
price.
Negative Externalities and Inefficiency
Chapter 18 Externalities and Public Goods

● marginal external cost Increase in cost imposed


externally as one or more firms increase output by one
unit.

● marginal social cost Sum of the marginal cost of


production and the marginal external cost.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 3 of 36
18.1 EXTERNALITIES

Negative Externalities and Inefficiency


Figure 18.1

External Cost

When there are


negative externalities,
the marginal social cost
Chapter 18 Externalities and Public Goods

MSC is higher than the


marginal cost MC.
The difference is the
marginal external cost
MEC.
In (a), a profit-
maximizing firm
produces at q1, where
price is equal to MC.
The efficient output is
q*, at which price
equals MSC.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 4 of 36
18.1 EXTERNALITIES

Negative Externalities and Inefficiency


Figure 18.1

External Cost (continued)

In (b), the industry’s


competitive output is
Q1, at the intersection of
Chapter 18 Externalities and Public Goods

industry supply MCI and


demand D.
However, the efficient
output Q* is lower, at
the intersection of
demand and marginal
social cost MSCI.
The shaded triangle is
the aggregate social
cost.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 5 of 36
18.1 EXTERNALITIES

Positive Externalities and Inefficiency

● marginal external benefit


Increased benefit that accrues
to other parties as a firm
Chapter 18 Externalities and Public Goods

increases output by one unit.

● marginal social benefit Sum


of the marginal private benefit
plus the marginal external
benefit.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 6 of 36
18.1 EXTERNALITIES

Positive Externalities and Inefficiency

Figure 18.2

External Benefits

When there are positive


externalities, marginal
Chapter 18 Externalities and Public Goods

social benefits MSB are


higher than marginal
benefits D.
The difference is the
marginal external benefit
MEB.
The price P1 results in a
level of repair, q1.
A lower price, P*, is
required to encourage the
efficient level of supply, q*.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 7 of 36
18.1 EXTERNALITIES

Figure 18.3

Sulfur Dioxide Emissions


Reductions

The efficient sulfur


Chapter 18 Externalities and Public Goods

dioxide concentration
equates the marginal
abatement cost to the
marginal external cost.
Here the marginal
abatement cost curve is
a series of steps, each
representing the use of a
different abatement
technology.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 8 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Figure 18.4

The Efficient Level of Emissions

The efficient level of factory


Chapter 18 Externalities and Public Goods

emissions is the level that


equates the marginal
external cost of emissions
MEC to the benefit
associated with lower
abatement costs MCA.
The efficient level of 12
units is E*.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 9 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

An Emissions Standard
● emissions standard Legal limit on the amount of
pollutants that a firm can emit.

Figure 18.5
Standards and Fees

The efficient level of emissions


Chapter 18 Externalities and Public Goods

at E* can be achieved through


either an emissions fee or an
emissions standard.
Facing a fee of $3 per unit of
emissions, a firm reduces
emissions to the point at which
the fee is equal to the marginal
cost of abatement.
The same level of emissions
reduction can be achieved with
a standard that limits emissions
to 12 units.

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18.2 WAYS OF CORRECTING MARKET FAILURE
An Emissions Fee
● emissions fee Charge levied on each unit of a firm's
emissions.
Standards versus Fees
Figure 18.6

The Case for Fees


Chapter 18 Externalities and Public Goods

With limited information, a


policymaker may be faced with
the choice of either a single
emissions fee or a single
emissions standard for all firms.
The fee of $3 achieves a total
emissions level of 14 units
more cheaply than a 7-unit-per-
firm emissions standard.
With the fee, the firm with a
lower abatement cost curve
(Firm 2) reduces emissions
more than the firm with a higher
cost curve (Firm 1).
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 11 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Standards versus Fees


Figure 18.7

The Case for Standards

When the government has limited


information about the costs and
benefits of pollution abatement,
Chapter 18 Externalities and Public Goods

either a standard or a fee may be


preferable. The standard is
preferable when the marginal
external cost curve is steep and
the marginal abatement cost
curve is relatively flat.
Here a 12.5 percent error in
setting the standard leads to extra
social costs of triangle ADE.
The same percentage error in
setting a fee would result in
excess costs of ABC.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 12 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE
Tradeable Emissions Permits
● tradeable emissions permits System of marketable
permits, allocated among firms, specifying the maximum
level of emissions that can be generated.
Marketable emissions permits create a market for externalities. This
market approach is appealing because it combines some of the
Chapter 18 Externalities and Public Goods

advantageous features of a system of standards with the cost


advantages of a fee system.

Sulfur dioxide emissions produced through the burning


of coal for use in electric power generation and the wide
use of coal-based home furnaces have caused a huge
problem in Beijing as well as other cities in China.
Over the long term, the key to solving Beijing’s problem
is to replace coal with cleaner fuels, to encourage the
use of public transportation, and to introduce fuel-
efficient hybrid vehicles.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 13 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Figure 18.8
Price of Tradeable Emissions Permits
Chapter 18 Externalities and Public Goods

The price of tradeable permits for sulfur dioxide emissions fluctuated


between $100 and $200 in the period 1993 to 2003, but then increased
sharply during 2005 and 2006 in response to an increased demand for
permits. Since then, the price has fluctuated around $400 to $500 per ton.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 14 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Recycling
Figure 18.9

The Efficient Amount of Recycling

As the amount of scrap


disposal increases, the
Chapter 18 Externalities and Public Goods

marginal private cost,


MC, increases, but at a
much lower rate than the
marginal social cost
MSC.
The marginal cost of
recycling curve, MCR,
shows that as the amount
of disposal decreases,
the amount of recycling
increases; the marginal
cost of recycling
increases.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 15 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Recycling
Figure 18.9

The Efficient Amount of Recycling


(continued)

The efficient amount of


recycling of scrap material is
Chapter 18 Externalities and Public Goods

the amount that equates the


marginal social cost of scrap
disposal, MSC, to the marginal
cost of recycling, MCR.
The efficient amount of scrap
for disposal m* is less than the
amount that will arise in a
private market, m1.
A refundable fee increases the
cost of disposal. With the
higher cost of disposal, the
individual will reduce disposal
and increase recycling to the
optimal social level m*.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 16 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Refundable Deposits

Figure 18.10

Refundable Deposits

The supply of virgin glass


containers is given by Sv and
Chapter 18 Externalities and Public Goods

the supply of recycled glass


by Sr.
The market supply S is the
horizontal sum of these two
curves.
As a result, the market price
of glass is P and the
equilibrium supply of recycled
glass is M1.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 17 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Refundable Deposits

Figure 18.10

Refundable Deposits (continued)

By raising the relative cost of


disposal and encouraging
Chapter 18 Externalities and Public Goods

recycling, the refundable


deposit increases the supply
of recycled glass from Sr to
S’r and the aggregate supply
of glass from S to S’.
The price of glass then falls
to P’, the quantity of recycled
glass increases to M*, and
the amount of disposed
glass decreases.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 18 of 36
18.2 WAYS OF CORRECTING MARKET FAILURE

Many other countries have made greater efforts to


encourage recycling than the United States.
A number of proposals to encourage more recycling in
the United States include a refundable deposit,
Chapter 18 Externalities and Public Goods

curbside charge, and mandatory separation. Mandatory separation is


perhaps the least desirable of the three alternatives.
A recent case in Perkasie, Pennsylvania, shows that recycling programs
can indeed be effective. Prior to implementing a program combining all
three economic incentives just described, the total amount of unseparated
solid waste was 2573 tons per year. When the program was
implemented, this amount fell to 1038 tons—a 59-percent reduction. As a
result, the town saved $90,000 per year in disposal costs.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 19 of 36
18.3 STOCK EXTERNALITIES

● stock externality Accumulated result of action


by a producer or consumer which, though not
Chapter 18 Externalities and Public Goods

accounted for in the market price, affects other


producers or consumers.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 20 of 36
18.3 STOCK EXTERNALITIES
Stock Buildup and Its Impact

How does the stock of a pollutant change over time?


With ongoing emissions, the stock will accumulate, but some fraction
of the stock, δ, will dissipate each year. Thus, assuming the stock
starts at zero, in the first year, the stock of pollutant (S) will be just the
amount of that year’s emissions (E):
Chapter 18 Externalities and Public Goods

S1  E1
In general, the stock in any year t is given by the emissions generated
that year plus the nondissipated stock from the previous year:
St  Et  (1  )St 1
If emissions are at a constant annual rate E, then after N years, the
stock of pollutant will be
S N  E[1 (1  )  (1  )2  (1  ) N 1]

As N becomes infinitely large, the stock will approach the long-run


equilibrium level E/δ.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 21 of 36
18.3 STOCK EXTERNALITIES
Stock Buildup and Its Impact

Numerical Example Table 18.1 shows how the stock builds up


over time. Note that after 100 years, the stock will reach a level of
4,337 units. (If this level of emissions continued forever, the stock will
eventually approach E/δ = 100/.02 = 5,000 units.)
Chapter 18 Externalities and Public Goods

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18.3 STOCK EXTERNALITIES
Stock Buildup and Its Impact
To determine whether a policy of zero emissions makes sense,
we must compare the present value of the annual cost of $1.5 billion
with the present value of the annual benefit resulting from a reduced
stock of pollutant.
(1.5  .198) (1.5  .296) (1.5  4.337)
NPV  (1.5  .1)   
1R (1  R) 2 (1  R)99
Chapter 18 Externalities and Public Goods

Table 18.2 shows the NPV as a function of the discount rate. It also shows how
the NPV of a “zero emissions” policy depends on the dissipation rate, δ. If δ is
lower, the accumulated stock of pollutant will reach higher levels and cause more
economic damage, so the future benefits of reducing emissions will be greater.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 23 of 36
18.3 STOCK EXTERNALITIES

● social rate of discount Opportunity cost to


society as a whole of receiving an economic
benefit in the future rather than the present.
Chapter 18 Externalities and Public Goods

In principle, the social rate of discount depends on


three factors: (1) the expected rate of real economic
growth; (2) the extent of risk aversion for society as
a whole; and (3) the “rate of pure time preference”
for society as a whole.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 24 of 36
18.3 STOCK EXTERNALITIES

Emissions of carbon dioxide and other greenhouse


gases have increased dramatically over the past
century, which has in turn led to an increase in
atmospheric concentrations of greenhouse gases,
Chapter 18 Externalities and Public Goods

or GHGs.

The problem is that the costs of reducing GHG emissions would occur
today but the benefits from reduced emissions would be realized only in
some 50 or more years.
Does this emissions-reduction policy make sense? To answer that
question, we must calculate the present value of the flow of net benefits,
which depends critically on the discount rate. Economists disagree about
what rate to use, and as a result, they disagree about what should be done
about global warming

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 25 of 36
18.3 STOCK EXTERNALITIES
Chapter 18 Externalities and Public Goods

Table 18.3 shows GHG emissions and average global


temperature change for two scenarios. Also shown is the annual
net benefit from the policy, which equals the damage under the
“business as usual” scenario minus the (smaller) damage when
emissions are reduced minus the cost of reducing emissions.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 26 of 36
18.4 EXTERNALITIES AND PROPERTY RIGHTS
Property Rights
● property rights Legal rules stating what people or
firms may do with their property.

Bargaining and Economic Efficiency


Economic efficiency can be achieved without government intervention
Chapter 18 Externalities and Public Goods

when the externality affects relatively few parties and when property
rights are well specified.

The efficient solution maximizes the joint profit of the factory and the
fishermen. Maximization occurs when the factory installs a filter and
the fishermen do not build a treatment plant.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 27 of 36
18.4 EXTERNALITIES AND PROPERTY RIGHTS

Bargaining and Economic Efficiency


If the factory and the fishermen agree to split this gain equally by
having the fishermen pay the factory $250 to install the filter, this
bargaining solution achieves the efficient outcome.
Chapter 18 Externalities and Public Goods

● Coase theorem Principle that when parties can


bargain without cost and to their mutual advantage,
the resulting outcome will be efficient regardless of
how property rights are specified.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 28 of 36
18.4 EXTERNALITIES AND PROPERTY RIGHTS
Costly Bargaining—The Role of Strategic Behavior
Bargaining can be time-consuming and costly, especially when
property rights are not clearly specified.
Bargaining can break down even when communication and monitoring
are costless if both parties believe they can obtain larger gains.
Chapter 18 Externalities and Public Goods

Another problem arises when many parties are involved.

A Legal Solution—Suing for Damages

A suit for damages eliminates the need for bargaining because it


specifies the consequences of the parties’ choices. Giving the party
that is harmed the right to recover damages from the injuring party
ensures an efficient outcome. (When information is imperfect,
however, suing for damages may lead to inefficient outcomes.)

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 29 of 36
18.4 EXTERNALITIES AND PROPERTY RIGHTS

As a September 1987 cooperative agreement between New York City


and New Jersey illustrates, the Coase theorem applies to
governments as well as to people and organizations.
Chapter 18 Externalities and Public Goods

For many years, garbage spilling from waterfront trash facilities along
New York harbor had adversely affected the quality of water along the
New Jersey shore and occasionally littered the beaches. New Jersey
wanted cleaner beaches, not simply the recovery of damages. And
New York wanted to be able to operate its trash facility.
Consequently, there was room for mutually beneficial exchange. After
two weeks of negotiations, New York and New Jersey reached a
settlement.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 30 of 36
18.5 COMMON PROPERTY RESOURCES
● common property resource Resource to which anyone
has free access.
Figure 18.11
Common Property Resources

When a common property


resource, such as a fishery,
Chapter 18 Externalities and Public Goods

is accessible to all, the


resource is used up to the
point Fc at which the private
cost is equal to the additional
revenue generated.
This usage exceeds the
efficient level F* at which the
marginal social cost of using
the resource is equal to the
marginal benefit (as given by
the demand curve).

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 31 of 36
18.5 COMMON PROPERTY RESOURCES

Figure 18.12
Crawfish as a Common Property Resource

Because crawfish are bred in ponds to


which fishermen have unlimited access,
they are a common property resource.
The efficient level of fishing occurs when
Chapter 18 Externalities and Public Goods

the marginal benefit is equal to the


marginal social cost.
However, the actual level of fishing occurs
at the point at which the price for crawfish
is equal to the private cost of fishing.
The shaded area represents the social
cost of the common property resource.
In the region where the various curves
intersect, the three curves in the graph are as
follows:
Demand: C = 0.401 − 0.0064F
Marginal social cost: C = −5.645 + 0.6509F
Private cost: C = −0.357 + 0.0573F

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 32 of 36
18.6 PUBLIC GOODS

● public good Nonexclusive and nonrival good:


the marginal cost of provision to an additional
consumer is zero and people cannot be excluded
from consuming it.
Chapter 18 Externalities and Public Goods

● nonrival good Good for which the marginal


cost of its provision to an additional consumer is
zero.
● nonexclusive good Good that people cannot
be excluded from consuming, so that it is difficult
or impossible to charge for its use.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 33 of 36
18.6 PUBLIC GOODS
Efficiency and Public Goods

Figure 18.13

Efficient Public Good Provision

When a good is nonrival,


the social marginal
Chapter 18 Externalities and Public Goods

benefit of consumption,
given by the demand
curve D, is determined by
vertically summing the
individual demand curves
for the good, D1 and D2.
At the efficient level of
output, the demand and
the marginal cost curves
intersect.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 34 of 36
18.6 PUBLIC GOODS
Public Goods and Market Failure
● free rider Consumer or producer who does not pay for a
nonexclusive good in the expectation that others will.

Figure 18.14
Chapter 18 Externalities and Public Goods

The Demand for Clean Air

The three curves describe the


willingness to pay for clean air (a
reduction in the level of nitrogen
oxides) for each of three different
households (low income, middle
income, and high income).
In general, higher-income
households have greater
demands for clean air than lower-
income households. Moreover,
each household is less willing to
pay for clean air as the level of
air quality increases.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 35 of 36
18.7 PRIVATE PREFERENCES FOR PUBLIC GOODS
Figure 18.15
Determining the Level of
Educational Spending

The efficient level of educational


spending is determined by
summing the willingness to pay
for education (net of tax
payments) of each of three
Chapter 18 Externalities and Public Goods

citizens.
Curves W1, W2, and W3 represent
their willingness to pay, and curve
AW represents the aggregate
willingness to pay.
The efficient level of spending is
$1200 per pupil. The level of
spending actually provided is the
level demanded by the median
voter. In this particular case, the
median voter's preference (given
by the peak of the W2 curve) is
also the efficient level.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 36 of 36

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