The main contents of the chapter consist of the following: Annuities: ordinary annuity and annuity due (find future value), present value of an ordinary annuity (find present value), sinking funds (find periodic payments).
Chapter 13 Challenge To Market Effectiveness 3: Externalities And The Environment McGrawưHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.AllRightsReserved Learning Objectives ã What are negative and positive externalities? • What is the pollution problem? • What are the methods of reducing the pollution problem? • What is the challenge of global warming? • What are the methods of reducing traffic jams? • What role does politics play in externalities? • What are the environmental problems caused by the government? • What are technological spillovers? 13-2 The Pollution Problem • Without government assistance, Adam Smith’s invisible hand does little to reduce pollution • As pollution is created by imperfect markets and regulated by imperfect governments, there is no ultimate pollution solution 13-3 Externalities Negative Externalities: • A negative externality is a cost paid by people other than the buyer or seller of a good • Self-interested buyers and sellers don’t take into account negative externalities in their decision-making, e.g pollution and smoking Positive Externalities: • Positive externalities are benefits received by people other than the buyer and seller of a good • Self-interested individuals will buy less than the socially optimal number of positive externality goods, e.g vaccine and perfumes 13-4 Externalities and Anti-Theft Devices • The Club is a metal “club” that locks through a steering wheel, preventing a thief from turning the wheel • One car owner’s use of The Club therefore decreases the chance of his car getting stolen, but increases the chance of another car being pilfered: Negative externality • LoJack is a tiny electronic locator When a car with LoJack is stolen, the locator is activated, signaling the car’s location to the police • Widespread use of LoJack makes it less likely that thieves will steal any car since they don’t know which car has LoJack: Positive externality 13-5 Methods of Reducing the Harm of Pollution Forbidding all pollution: • Many valuable economic activities create pollution If the government banned all types of pollution, it would drastically reduce economic production 13-6 Methods of Reducing the Harm of Pollution • • • Command and control approach: The government tells each firm how much it can pollute and what kind of pollution-reducing technologies it must employ This approach suffers from two problems: Information Deficiencies Markets excel at gathering and organizing information whereas government bureaucrats tend to be informationally challenged Governmental Corruption Self-interested politicians are most often motivated to protect their supporters rather than enacting socially optimal pollution regulation 13-7 Methods of Reducing the Harm of Pollution • • • • • • Pigouvian taxes: According to Arthur Pigou, governments should tax goods that create negative externalities Such “Pigouvian taxes” reduce individual’s incentives to use such goods The advantages of Pigouvian taxes over command and control approach: Taxation allows firms to pick their own level of pollution Firms have an incentive to reduce their pollution since less pollution means lower taxes Taxation gives firms flexibility in deciding how to reduce pollution Pollution taxes create incentives for firms to use the most cost efficient pollution-reducing methods Taxation creates incentives for pollution technological innovation 13-8 Supply, Demand, and Pigouvian Taxes • Externalities, by definition, don’t affect consumers or producers directly • Externalities don’t have any direct effect on supply and demand curves • However, externalities create deadweight loss • The Pigouvian tax reduces amount of pollution $ Pollution externality =$3 Pigouvian tax =$3 Supply with tax $13 Supply $10 Demand 491 870 Quantity 13-9 Externality and Pigouvian Taxes • Pigouvian taxes force people and firms to internalize any externalities they cause • Internalizing Externalities means forcing someone to fully take into account the harm his externalities cause when deciding how much of the product to use • By forcing the creators of externalities to pay a tax equal to the harm caused to others by their activity, Pigouvian taxes cause consumers and firms to engage in externality-causing activities only when the benefit of the activity exceeds the total social cost of the activity • However, the government can’t set limits on the total amount of pollution with Pigouvian taxation Pigouvian taxation works best when the harm of pollution is always proportional to the amount of pollution 10 13-10 Traffic Jams • Each vehicle on a crowded road increases the time it takes other cars to reach their destination • Traffic delay is a negative externality of driving • Very few motorists are altruistic enough to take into account their negative traffic externalities • We need to rely on the government to reduce traffic jams 17 13-17 Methods to Reduce Traffic Jams • • • Gas taxes: Gas taxes raise the cost of driving and so reduce the total amount of driving and traffic jams But they fail to induce motorists to switch to driving at times or on roads where there is little traffic Under some circumstances, gas taxes can even increase traffic congestion 18 13-18 Methods to Reduce Traffic Jams • • • Toll roads: Tolls can force drivers to internalize their negative traffic externalities Governments can impose tolls only on motorists driving over busy roads Unfortunately, most U.S states use toll roads as a source of revenue, not for traffic management 19 13-19 Methods to Reduce Traffic Jams • • • • • Subsidize Mass Transportation: On crowded roads in equilibrium, drivers receive zero economic profit When the government initially subsidizes mass transport, the number of drivers on a busy road decreases But this decline in traffic reduces the opportunity cost of driving and creates a disequilibrium because drivers on this slightly less busy road now receive positive profits These profits attract new drivers and so increase the delay In equilibrium, drivers must again receive zero profit and face the exact same delay they did before the mass transport system was built 20 13-20 Methods to Reduce Traffic Jams • • • Building more roads: Building additional roads attracts new drivers Road construction therefore often doesn’t reduce traffic congestion When a government builds new roads, it initially reduces the commute time and so subsidizes people living farther from their city jobs As workers move farther from their jobs they drive more miles, creating more negative traffic externalities 21 13-21 Politics and Externalities • Governments play a huge role in regulating externalities Accidents and car weight: • Since heavy cars create significant negative externalities, many economists would prefer that governments discourage consumers from buying SUVs through either tax on SUVs or subsidies for small cars • But for a period the U.S government provided massive subsidies for SUVs Driving while elderly: • Impaired elderly drivers create greater negative externalities as they are more likely to get into accident • However, the elderly have tremendous political power in the U.S., so politicians fear restricting the driving rights of the elderly 22 13-22 Politics and Externalities Driving while drunk: • The group Mothers Against Drunk Driving (MADD) has led a successful long-term U.S political campaign to increase penalties for drunk drivers • MADD shows that to get the government to take action against negative externalities one must organize politically so that it becomes in the self-interest of politicians to regulate the externality Driving while cell-phoning: • Several studies have concluded that talking on a cell phone while driving is at least as dangerous as driving while drunk • However, there is no regulation against it because there has been no organized political campaign against cell phone driving 23 13-23 Government-Caused Environmental Problems Subsidizing Pollution: • Governments spend hundreds of billions of dollars each year subsidizing activities such as logging, fishing, and mining that create negative environmental externalities Banning DDT: • In the 1970s, the U.S and the Western European nations not only banned DDT in their own borders but also used their foreign aid budgets to bully poor nations into banning the mosquito-killing insecticide DDT Mosquito-born diseases are one of the greatest killers of humans Banning supposed Frankenfoods 24 13-24 Government-Caused Environmental Problems Drying the Aral Sea: • Among the environmental disasters caused by the former Soviet Union was the drying out of the Aral Sea to obtain water to grow cotton Killing Sparrows: • Former Chinese dictator Mao Zedong decided to kill all of China’s sparrows Destroying Trees to Make Useless Steel: • Mao Zedong forced Chinese peasants to set up small steel furnaces all over China To feed these furnaces peasants cut down all the trees on many mountains and hillsides 25 13-25 Technological Spillovers • Innovation is the primary cause of economic growth • On an average, around 80% of the gain from innovations goes to people other than the innovators • Most of the wealth that people in rich countries have is due to these technological spillovers • Even when firms succeed in profiting greatly from their innovations, they still create enormous spillovers • Because innovation creates such enormous positive externalities, firms engage in less than the socially optimal level of innovation 26 13-26 Do You Know? • Why are products with negative externalities overused? A negative externality is a cost paid by people other than the buyer or seller of a good Self-interested buyers and sellers don’t take into account negative externalities in their decision-making and hence overuse the those products • What are Pigouvian taxes? Pigouvian taxes are taxes on creating negative externalities These taxes such as pollution taxes force people and firms to internalize any externalities they cause 27 13-27 Do You Know? • What are tradable pollution permits? Tradable pollution permits are permits that allow firms to pollute only up to the amount covered by the permits A firm can use its permit, buy permits from other firms or sell its permits to other firms They give tremendous flexibility to firms in deciding how to combat pollution • What are technological spillovers? Technological spillovers are the gains from innovations that go to people other than the innovators Technological spillovers create positive externalities 28 13-28 Summary • As pollution is created by imperfect markets and regulated by imperfect governments, there is no ultimate pollution solution • A negative externality is a cost paid by people other than the buyer or seller of a good • Positive externalities are benefits received by people other than the buyer and seller of a good • Pigouvian taxes and tradable permits are the better methods of reducing the harm of pollution among others • Pigouvian taxes force people and firms to internalize any externalities they cause • Tradable permits allow the government to set the total amount of pollution that will be generated 29 13-29 Summary • Poor countries are under polluted • The best long-term environmental strategy to protect us from global warming is to keep increasing the wealth of humanity while taxes or tradable permits for greenhouse gas emission can work in the short run • We need to rely on the government to reduce the negative externality of traffic jams • Toll roads are one of the best methods of reducing traffic jams • Politics influences governments’ role in regulating externalities • Governments themselves have caused many environmental problems • Most of the wealth that people in rich countries have is due to these technological spillovers 30 13-30 Coming Up What are property rights? 31 13-31 ... nations into banning the mosquito-killing insecticide DDT Mosquito-born diseases are one of the greatest killers of humans Banning supposed Frankenfoods 24 1 3- 24 Government-Caused Environmental Problems... taxation Pigouvian taxation works best when the harm of pollution is always proportional to the amount of pollution 10 1 3- 10 Methods of Reducing the Harm of Pollution • • • • • Tradable permits: Under... Corruption Self-interested politicians are most often motivated to protect their supporters rather than enacting socially optimal pollution regulation 1 3- 7 Methods of Reducing the Harm of Pollution