externalities and public goods

Session VII Externalities and Public Goods Principles of Economics Overview What is an externality? Why do externalities make market outcomes inefficient? What public policies aim to solve the problem of externalities? How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? 1 Overview (cont’d) What are public goods? What are common resources? Give examples of each. Why do markets generally fail to provide the efficient amounts of these goods? How might the government improve market outcomes in the case of public goods or common resources? 2 Learning Objectives By the end of this session, students should understand: – what an externality is. – why externalities can make market outcomes inefficient. – the various government policies aimed at solving the problem of externalities. – how people can sometimes solve the problem of externalities on their own. – why private solutions to externalities sometimes do not work. 3 Learning Objectives (cont’d) By the end of this session, students should understand: –the defining characteristics of public goods and common resources. –why private markets fail to provide public goods. –some of the important public goods in our economy. – why the cost–benefit analysis of public goods is both necessary and difficult. – why people tend to use common resources too much. – some of the important common resources in our economy. 4 Externalities and Public Goods Part I Effects of Externalities 6 Introduction One of the principles from Session 1: Markets are usually a good way to organize economy activity. In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. One type of market failure: externality Externalities can be negative or positive 7 Introduction (cont’d) Self-interested buyers and sellers  market outcome is not efficient. Another principle from Session 1: Governments can sometimes improve market outcomes. In presence of externalities, public policy can improve efficiency. 8 Examples of Negative Externalities Air pollution from a factory Late-night stereo blasting from the dorm room next to yours Health risk to others from second-hand smoke 9 Recap of Welfare Economics 0 1 2 3 4 5 0 10 20 30 Q (gallons) P $ The market for gasoline S: private cost D: private value $2.50 25 Source: Mankiw (2011) [...]... of Externalities: Summary  If negative externality – market quantity larger than socially desirable  If positive externality – market quantity smaller than socially desirable  To remedy the problem, or “internalize the externality,” – tax goods with negative externalities – subsidize goods with positive externalities 18 Externalities and Public Goods Part II Public Policies toward Externalities Public. .. position of this demand curve, – The permits system achieves pollution reduction targets more precisely 30 Externalities and Public Goods Part III Private Solution to Externalities Private Solutions to Externalities Types of private solutions: Moral codes and social sanctions, e.g., the “Golden Rule” Charities, e.g., the Sierra Club Contracts between market participants and the affected bystanders 32 Private... and Public Goods Part II Public Policies toward Externalities Public Policies Toward Externalities Two approaches:  Command -and- control policies regulate behavior directly  Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own – E.g corrective taxes and subsidies – tradable pollution permits 20 Corrective Taxes & Subsidies Corrective... sellers  sellers’ costs = social costs When market participants must pay social costs, market equilibrium = social optimum 13 Examples of Positive Externalities  Being vaccinated against contagious diseases  R&D  Education  And more… 14 Positive Externalities Social value of a good includes – private value – external benefit The socially optimal Q maximizes welfare 15 Exercise VII-1: Analysis... achieved at lower total cost and lower cost to each firm than using regulation! 28 Tradable Pollution Permits A tradable pollution permits system reduces pollution at lower cost than regulation Who sell permits? Who buy permits? Result: Pollution reduction is concentrated among those firms with lowest costs 29 Corrective Taxes vs Tradable Pollution Permits  When firms’ demand for the ability to pollute... permits to each firm Establish market for trading permits  Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons Your task: Compute cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each 26 Exercise VII-2 Answer: Lowering SO2 Emissions by Tradable pollution permits  Goal: reduce emissions... “Golden Rule” Charities, e.g., the Sierra Club Contracts between market participants and the affected bystanders 32 Private Solutions to Externalities The Coase theorem: If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own 33 The Coase Theorem: An Example  Dick owns a dog named Spot  Negative externality: Spot’s barking...Analysis of a Negative Externality P $5 The market for gasoline Social cost = private + external cost 4 external cost Supply (private cost) 3 External cost = value of the negative impact on bystanders 2 1 0 0 Source: Mankiw (2011) 10 20 30 Q (gallons) 10 Analysis of a Negative Externality P $5 The market for gasoline Social The socially optimal quantity is cost 20 gallons S 4 3 2 D 1 0 0 Source:... account of the social costs that arise from a negative externality – Also called Pigouvian taxes after Arthur Pigou (1877-1959) The ideal corrective tax = external cost For activities with positive externalities, ideal corrective subsidy = external benefit 21 Corrective Taxes vs Regulations  Different firms have different costs of pollution abatement  Efficient outcome?  A pollution tax is efficient:... pollution – Firms with high abatement costs  pay tax  In contrast, a regulation requiring all firms to reduce pollution by a specific amount NOT efficient 22 Exercise VII-1: Lowering SO2 Emissions  Acme and US Electric run coal-burning power plants Each emits 40 tons of sulfur dioxide per month, total emissions = 80 tons/month  Goal: Reduce SO2 emissions 25%, to 60 tons/month  Cost of reducing emissions: . students should understand: –the defining characteristics of public goods and common resources. –why private markets fail to provide public goods. –some of the important public goods in our economy “internalize the externality,” – tax goods with negative externalities – subsidize goods with positive externalities Externalities and Public Goods Part II Public Policies toward Externalities. of public goods is both necessary and difficult. – why people tend to use common resources too much. – some of the important common resources in our economy. 4 Externalities and Public