The Role of Government in Microeconomics Externalities

ECONOMICS What Does It Mean To Me? Part VI: The Role of Government in Microeconomics/ Externalities Economic functions of Government: 1) Enforce laws and contracts 2) Maintain competition 3) Redistribute income providing an economic safety net 4) Provide public goods -nonexclusion -shared consumption 5) Correct Market Failures -provide market information -correct negative externalities -subsidize goods with positive externalities 6) Stabilize the economy - fight unemployment - encourage price stability - promote economic growth EXTERNALITIES Externality When one person’s actions imposes a cost or benefit on the well-being of a bystander Externalities usually result in market failure Externalities can be: 1) Positive: an external benefit is imposed on someone (examples: gardens, restored historic buildings, research) 2) Negative: an external cost is imposed on someone (examples: exhaust from autos, barking dogs, noise from airplanes) Externalities cause markets to allocate resources inefficiently This happens through: 1) CONSUMPTION: consuming a good results in externality 2) PRODUCTION: producing a good results in externality In general, an external cost means the market overproduces the good (ie, paint) An external benefit means the market underproduces the good (ie, gardens) Are there benefits for other people in the parking lot when someone puts their car alarm on? ANSWER: Yes, because thieves don’t know which cars have alarms What about the club? Are there benefits for other people in the parking lot when someone puts the club on their car? NASH EQUILIBRIUM is a situation where economic actors interacting with each other each choose their best strategy given the strategies that others have chosen GAME THEORY This is also called Game Theory has become a major tool for dealing with pollution problems John Nash 1994 Nobel Prize, Economics Game Theory can be illustrated by what is called THE PRISONER’S DILEMMA The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that each would spend year in jail But they suspect that the two have pulled off some bank robberies but they have no evidence They put Bonnie and Clyde in separate rooms and offer a deal “Right now, we can lock you up for one year But if you testify against your partner, we will set you free and your partner will get 20 years in prison If you both confess to the crime, we can avoid the cost of a trial and you both get years.” Each prisoner has two strategies, confess or remain silent However, the sentence that each gets depends upon the actions of the other Bonnie’s Decision confess confess Clyde’s Decision years each Remain Bonnie goes free silent Clyde - 20 yrs Remain silent Bonnie - 20 yrs Clyde goes free year each OR you can use the PAYOFF MATRIX s s fe n co Bonnie’s Decison Clyde’s Decison ss e f n co Re si mai le n nt B: years C: years B: free C: 20 years Re si mai le n nt s s e nf Clyde’s Decison co Re m si n le nt B: 20 years C: free B: year C: year In the real world, this dilemma is played out by real players Once a negotiation is reached, each country must decide whether they should keep their agreement Iraq’s Decision Iran’s Decision High prod High prod Low prod $40 billion each Iraq - $30 billion Low Iraq - $60 billion prod Iran - $30 billion Iran - $60 billion $50 billion each It can be used in the arms race… U.S.’s Decision Arm Arm USSR’s Decision Disarm Both at risk Disarm US at risk USSR safe US safe USSR at risk Both safe It can be used in the everyday economic decisions……Consider firms which must decide whether to make a new product or not… Yes Yes Firm No Firm No Firm 1: $1.5m Firm 1: Firm 2: $1.5m Firm 2: $2m Firm 1: $2m Firm 1: Firm 2: Firm 2: SAMPLE AP TEST QUESTION The production of Good X creates an externality Is this a negative or positive externality? Price Marginal Social Cost 13 12 Marginal Private Cost D-MSB MR Q1 Q2 Q3 Quantity of Good X Negative Why? MSC > MPC The production of Good X creates an externality Price Identify the socially optimum output Marginal Social Cost 13 12 Q2 Marginal Private Cost D-MSB MR Q1 Q2 Q3 Quantity of Good X Why? MSC=MSB Suppose that good X is produced by a profitmaximizing monopoly Identify the unregulated firm’s output Price Marginal Social Cost 13 12 Why? Marginal Private Cost D-MSB MR Q1 Q1 Q2 Q3 Quantity of Good X At Q1, MPC = MR Suppose that good X is produced by a profitmaximizing monopoly Price To produce socially optimum output, should the government tax or subsidize the firm? Marginal Social Cost 13 12 Marginal Private Cost D-MSB MR Q1 Q2 Q3 Quantity of Good X subsidize How much will it be? $3 Why? Optimum Quantity at Q = MR Suppose that good X is produced in a perfectly competitive industry Price Identify equilibrium output in the absence of regulation Q3 Marginal Social Cost 13 12 Marginal Private Cost D-MSB MR Q1 Q2 Q3 Quantity of Good X Why? D=MPC or MSB=MPC Suppose that good X is produced in a perfectly competitive industry Price To produce at socially optimum output, should the government tax or subsidize? Marginal Social Cost 13 12 Marginal Private Cost D-MSB MR Q1 Q2 Q3 Quantity of Good X Tax How much? $5 The End Created by: Virginia Meachum, Economics Teacher, Coral Springs High School Sources: FTE Economics of Water and the Environment AP MicroEconomics Test Question (2005) [...]... who pollutes the stream, we punish the offender because we are not sure who owns the stream, but we DO know who pollutes it We get into trouble when we use this criteria regarding the air QuickTim e™ and a TIFF (Uncom pressed) decom pressor are needed to see this picture The tendency for a society to overuse and therefore abuse common resources is called: TRAGEDY OF THE COMMONS What is the difference... recreation or fishing Public Interest - Water rights especially the right to transfer are limited by the “public interest>” Laws and courts define “public interest” as things like protecting an economic area or environment or public health and safety Even though water is essential for life and diamonds are not, water is cheap and diamonds are expensive? Why? It has to do with the elasticity of the supply... (non-rival good) What defines property rights? Property rights are established by formal and informal rules about the privileges and limitations on the ownership, use, and transfer of goods and resources These rights are specified in various municipal ordinances, other legislation, court decisions (common law), tradition and custom Property rights need to be: 1) clearly defined 2) exclusive 3) enforceable...ANSWER: No because the thief can SEE the club Your neighbor puts in a nice garden Are you receiving a benefit? When you admit you are receiving a positive benefit, your neighbor asks you to pay him $100 a month for the benefit When you say no, he puts up a fence What if you lived next door to this? Do you receive a benefit? PROPERTY RIGHTS is the issue? Who owns the air? The rivers? The parks? If we... defense Street lights An Overview of U.S Water Law Riparian Common Law - people who own land along streams, lakes and springs have a right to “reasonable use” of the water First -in- time, First -in- right - the first person to divert water and use it has the first right People who come later can take what is left Use-it or Lose-it - If a person with water rights doesn’t use all the water he claims a right... supply curve and the amount of consumer/producer surplus With DIAMONDS, supply is very inelastic Price P Consumer Surplus Producer Surplus Price S With WATER, supply is very elastic S P D Q Quantity D Q Quantity Why would a farmer in the desert of Southern California grow rice a crop that requires a great deal of water? How much water do you NEED to live per day? Answer: 1 1/2 liters What is the average... average per capita consumption of water per day in the State of Florida? Answer: 169 gallons Compare this to 130 gal/day in Massachusetts and Rhode Island And 325 gal/day in Nevada When is a basketball an alternative to water? When is coal an alternative to a waterfall? What are some other ways to conserve water? Xeriscape Drip irrigation Rocks Compost Massage Night watering Broom Safflower oil Denim... permanently loses his right to the portion he doesn’t use An Overview of U.S Water Law (cont.) Salvaged water rule - If a person is able to save water (I.e by better irrigation system), he cannot sell the extra water or even keep his right to it Beneficial use - People may not establish water rights unless they are using the water for “beneficial use” (I.e.) Agriculture is recognized in all states, but only... enforceable 4) transferable Consider each of the items below: Are they ? Clearly Defined? Exclusive? skateboard gun library book hamburger Garden view Bottled water Lake water Stream water Transferable? Enforceable? What is a free-rider? Someone who uses the good but doesn’t pay for it Free riders occur when there are nonexclusion and shared consumption Spraying for mosquitoes Police & fire protection... or threaten (fine, tax) 3) You can PAY me to stop (what is it worth to you?) People’s use responds to incentives Consider the following taxing methods to control water usage: Mayor asks bill = $.002/gal Flat fee = $10/month MC = 0 Flat fee = $30/month Billed at $.01/gal Billed at $.05/gal MC >MB The government has dealt effectively with most water issues BUT .what about GARDENS???