Another important cause of market failure in competitive markets arises when the actions taken by market participants create either benefits or costs that spill over to other members of society. When these spillover effects are beneficial to society, economists call them positive externalities. Flu vaccination provides an example of a spillover or external benefit creating a positive externality. When one person at the office chooses to get a flu vaccine, everyone who works with that person benefits from a reduced probability of catching the flu at work. Alterna- tively, when spillover effects are costly to society, economists call them negative externalities. Pollution is a particularly important example of negative externality.
If an upstream business chooses to dump polluted wastewater into a nearby river, parties downstream who use the river for recreational or productive purposes—
swimmers, boaters, and fishing companies, for example—will bear the spillover or external cost of this pollution through reduced enjoyment and productivity of the river.
External or spillover benefits and costs undermine allocative efficiency because market participants, when making consumption and production decisions, ratio- nally choose to ignore the benefits and costs of their actions that spill over to other parties. Consequently, competitive market prices do not include the social benefits or costs that spill over to other members of society. As you learned earlier in this
Now try T echnical Problem 6.
positive (negative) externalities
Occur when the actions of buyers or sellers create spillover or external benefits (costs) that spill over to other members of society.
chapter, equilibrium price must equal both marginal social benefit and marginal social cost to provide buyers and sellers with the correct incentive to make alloca- tively efficient decisions. In competitive markets experiencing either positive or negative externalities, the equilibrium price sends the wrong signal to buyers and sellers, causing them to consume and produce either too much or too little output.
Since the wrong amount of output is produced, both types of externality create a deadweight loss reflecting the lost social surplus of allocative inefficiency. For many businesses, the externality of greatest consequence for their profits is the negative externality created by pollution since government environmental agen- cies usually attempt to impose remedies on business polluters. Thus we focus our analysis here on pollution generated by businesses in the process of making goods and services for society.
As we stated previously, managers rationally ignore spillover or external costs when making their profit-maximizing production decisions. Profit maximization only concerns private costs of production, that is, costs incurred by firm owners to use productive resources. Because external costs do not affect profits, managers will likely ignore these costs that spill over to others in society. External costs, nonetheless, are real costs borne by society for the production of goods and ser- vices. The social cost of production is the sum of the private cost incurred by pro- ducers and any external or spillover cost imposed on other members of society
Social cost 5 Private cost + External cost
Economists sometimes say that a negative externality drives a “wedge” between social and private costs of production
Social cost 2 Private cost 5 External cost
The larger the external costs of a negative externality, the greater the difference between social and private costs of production, and the greater will be the result- ing deadweight loss.
Figure 16.5 shows why the “wedge” of negative externality makes allocative efficiency impossible to achieve in competitive markets. The demand curve for the competitively supplied good correctly measures the marginal social benefit of the good: D 5 MSB. The marginal private costs of production are given by the competitive supply curve: S 5 MPC. Competitive market equilib- rium is established at the intersection of demand and supply (point C), where QC units are produced and consumed at price PC. Production of this good by competitive suppliers creates an external cost that spills over to society. The marginal external cost, shown as MEC in Figure 16.5, increases with the level of output. At every output level, the marginal social cost curve is the vertical sum of the marginal private cost and marginal external cost: MSC 5 MPC + MEC. As you can see, in competitive equilibrium, too much output is pro- duced because MSC exceeds MSB at point C. Allocative efficiency occurs at QE (point E), where MSC equals MSB. By producing the units from QE to QC, the competitive industry creates a deadweight loss on each unit that costs more to produce than it is worth to society. The area of the gray-shaded triangle DWL
is the amount by which social surplus is reduced by overproducing and over- consuming the good.
Perhaps you are now thinking that a “good” manager should consider all ex- ternal costs that spill over to society to “do good for society.” The issue of “doing good for society” often surfaces in class discussions when we analyze the loss of social surplus caused by pollution. As we will examine pollution externality in the next section, perhaps now is a good time to stress how little economists have to say about “doing good.” As you know from your course in business ethics, any debate about how managers should handle spillover costs to society raises com- plicated subjective and ethical issues concerning the appropriate level of social re- sponsibility of business enterprises. Although ethical issues fall outside the realm of objective (positive) economic analysis, we can offer you two objective reasons to ignore external costs in decision making. First, managers who choose not to ignore external costs will produce less output than would maximize profit, which, of course, reduces profits and wealth of the firms’ owners. If your firm operates in a competitive industry, you will be forced to exit in the long run. You can safely predict that other managers in your industry, wishing to survive in the long run, will make profit-maximizing decisions.
A second important consideration concerns the possible legal consequences for you if your shareholders believe your practice of including social costs in decisions conflicts with your legal responsibilities to protect the value of the firm. The legal standards that apply to this area of executive responsibility are not clear, but we advise you, as we have throughout this book, to make decisions
F I G U R E 16.5
Negative Externality and Allocative Inefficiency
Price, benefits, and costs (dollars)
PE PC
QE Quantity
D = MSB MEC S = MPC DWL
MSC = MPC + MEC
E
C
QC 0
that will increase the value of the firm. Government authorities certainly don’t count on individual firms to sacrifice profits for the good of society. If, for example, you do decide to undertake a costly investment in “green” production technology for your firm, prepare to show owners of the firm that “green”
production methods are indeed economically efficient (i.e., “green” production lies on your firm’s expansion path) or that buyers will substantially increase their demand for your product when they hear about your sensitivity to the environment. In the absence of a clear profit justification for internalizing the costs of negative externalities, you may find yourself in legal trouble—while you search for a new job!
As we have stressed throughout this chapter, government intervention is warranted only when there is market failure that government policy can fix at lower cost to society than the market failure itself. In the case of negative externalities, public policymakers can eliminate allocative inefficiency by devising methods of forcing firms to internalize external costs they would otherwise rationally choose to ignore. Once external costs are internalized, firm owners face the full social cost of producing goods and services, and allocative efficiency is restored. Taxation and assignment of property rights provide two of the most effective methods government can employ for internalizing costs. In the next section, we will show how taxes can be used to restore allocative efficiency in the case of a negative externality caused by pollution. We will also show you how reassigning property rights can restore productive efficiency for common pool resources, which may suffer from negative externality problems. We can now summarize our discussion of negative externality in the following principle.
Principle A producer creates a negative externality by imposing an external cost on other members of society without making a compensating payment for the harm caused. Negative externality drives a wedge between social and private costs of production, which causes producers in competitive equilibrium to overproduce the good or service. The loss of allocative efficiency due to negative externality creates a deadweight loss to society.
Pollution: Market Failure and Regulation
Let’s consider again the example we mentioned previously: An upstream com- petitive industry chooses to dump polluted wastewater into a nearby river.
Parties downstream, who use the river for recreational or productive purposes—
swimmers, boaters, and fishing companies, for example—are burdened by the external cost of this pollution through reduced enjoyment and productivity of the river. First we will analyze the market failure of this competitive industry caused by the pollution it creates. Then we will turn our attention to the role government environmental policymakers can play in solving the externality problem. We will show you how environmental economists identify the optimal level of pollution emissions and demonstrate that a properly set charge or tax on emissions can motivate profit-maximizing firms to reduce their pollution levels to the socially optimal level.
Now try T echnical Problem 7.
Allocative inefficiency and market failure In Figure 16.6, the marginal external cost (MEC) caused by the pollution externality is increasing as industry output rises. MEC for the 6,000th unit of output is $2. The marginal private cost (MPC) in- curred by competitive firms to produce the 6,000th unit is $3. MPC represents the competitive industry supply curve, S, because suppliers ignore the external cost of pollution. Marginal social cost to produce the 6,000th unit is $5 (5 $2 + $3). MSC is constructed by repeating the vertical summation at every output level.
As usual the competitive equilibrium price, $3, is found at the intersection of demand and industry supply (point C in the figure). Competitive suppliers behave inefficiently, because managers in this market increase production up to the point where price equals marginal private cost. Because the marginal social cost of the 6,000th unit is $5, industry output in competitive equilibrium exceeds the level that would maximize social surplus. Allocative efficiency happens when the industry produces 4,800 units at point E in Figure 16.6.
The deadweight loss of social surplus caused by overproduction and over- consumption equals the area of the gray-shaded triangle ECu, which is $1,200 (5 0.5 3 1,200 3 $2).
Regulators can restore allocative efficiency by taxing producers on their pollution emissions, causing them to internalize the external pollution costs.
Environmental policymakers and enforcement authorities have employed nu- merous taxation methods with varying degrees of success. We will present one
F I G U R E 16.6 Pollution as a Negative Externality
Price, benefits, and costs (dollars)
0 4,800 6,000
Quantity 5
4
3
2
D = MSB S = MPC u
E
C
MSC = MPC + MEC DWL = $1,200
MEC
I L L U S T R AT I O N 1 6 . 1 Taming Negative Externality with
Congestion Pricing
Traffic congestion represents a market failure caused by negative externalities generated by automobiles driving on crowded roadways. Even without con- gestion, driving a car creates exhaust emissions that pollute the air that everyone must breathe. This nega- tive externality occurs regardless of traffic conditions.
However, when congestion arises, each car stuck in traffic creates even more pollution (car engines are running longer) than when traffic flows freely. During periods of the day when traffic is light and no conges- tion occurs, the only negative externality created is the pollution cost imposed on society. However, once roadways become congested, not only the social cost of pollution rises but the time cost to each driver stuck in traffic rises as well. On a congested highway, each additional driver adds a small additional time cost to every other driver. This external cost on other motor- ists drives a wedge between private and social costs of using a roadway.
As we explained in our discussion of negative externalities, this spillover cost leads to allocative inefficiency in road use because all drivers ignore the external cost their cars impose on everyone else.
Thus, motorists make road use decisions based on pri- vate costs that understate the true or full social cost of using a particular roadway at a particular time of day.
If motorists incurred the full social cost of road use, they might choose to drive at a less congested time of day or even give up driving private cars and use pub- lic transportation. And, of course, if they also had to bear the full social cost of their auto emissions, they might well choose to drive a cleaner car or use public transportation.
Market failure created by traffic congestion pro- vides an opportunity for government intervention to improve resource usage and social well-being. One way to improve traffic congestion is to build more public roadways and expand the number of lanes on
existing roads. The cost of building new roads and expanding old ones can be exceedingly high in urban areas where land is scarce and expensive. (Of course, urban areas are typically the locations where conges- tion is a problem!) Furthermore, adding concrete to reduce congestion may worsen the problem of auto- mobile emissions as more people will decide to drive when adding new roads or widening old ones reduces congestion.
Another way for government to improve matters is to charge a fee or toll for the privilege of driving on roads, and then to raise this toll to a level that will re- duce congestion. Nobel laureate economist William Vickrey developed this approach, commonly called
“congestion pricing,” in the 1950s. Vickrey believed that charging drivers higher tolls during peak hours and lower tolls at off-peak hours would close the gap between the private and social costs of driving. By rais- ing the toll at rush hour to reflect the higher marginal congestion costs, transportation officials seek to flatten out the “peaks” in demand each day by giving drivers an incentive to switch their time of travel from peak to off-peak periods.a This is precisely the technique that urban planners are experimenting with in Stockholm, Sweden.
According to a recent article in The Wall Street Jour- nal, automobile traffic in Stockholm is such a night- mare, especially during morning and evening rush hours, that the city has undertaken an experimental test of “the world’s most sophisticated traffic-manage- ment system.” Traffic engineers and urban planners face a particularly difficult problem in Stockholm, be- cause the metropolitan business district spans a num- ber of small islands that are linked by several bridges.
The drive into the city at the peak morning rush hour usually takes three times as long as it does during off- peak hours. The traffic control system charges drivers tolls that vary according to the time of day. To imple- ment this complex pricing scheme, the Swedish gov- ernment contracted with IBM Corporation to install transponder boxes that attach to windshields for the
purpose of deducting tolls from bank accounts. IBM also installed laser detectors to read license tags, and a video camera network capable of tracking every car in Stockholm. During a six-month test period, the dynamic toll system successfully reduced peak-period travel time by one-third—without building or expand- ing a single new bridge or road. The figure below shows the structure of the congestion-pricing plan em- ployed in Stockholm. The Wall Street Journal article also reported that during the trial period of the congestion- pricing system, exhaust emissions and carbon dioxide fell by 14 percent in the inner-city area of Stockholm.
And “some of the biggest beneficiaries weren’t the drivers, but cyclists and bus riders.” Bus ridership rose by 9 percent during the trial period.
Now that the experiment is over, Stockholm government officials have scheduled a voter referendum to decide whether to continue using the congestion-pricing system. A poll of voters at this time finds 52 percent of the voters back the pricing plan. Because the purpose of government interven- tion is to remedy market failures for the public good, it must be encouraging to Stockholm officials to see
their plan winning broad voter support. Indeed, urban and transportation p lanners in Bangkok, New York, Dublin, Prague, Copenhagen, and San Francisco are all considering the same sort of congestion-pricing plan for their inner-city roadways.
aOfficials know that some commuters are neither willing nor able to change their drive times or to substitute public transportation for private cars, while others have much greater flexibility in making their commuting plans. Based on our discussion of price discrimination in Chapter 14, you can see that congestion pricing is a form of second- degree price discrimination—even though capturing con- sumer surplus is not the primary purpose of time-varying prices. Transportation officials, who set the congestion prices, know that commuters vary in their responsive- ness to congestion tolls. Commuters will self-select the toll they pay: commuters who place a high value on peak-time travel will pay the higher congestion price and those who place a low value on peak-time travel will pay the lower, off-peak tolls.
Source: Adapted from Leila Abboud and Jenny
Clevstrom, “Stockholm’s Syndrome: Hostages to Traffic, Swedes Will Vote on High-Tech Plan to Untangle Snarls with Tolls,” The Wall Street Journal, August 29, 2006, p. B1.
Toll for travel in Stockholm (in U.S. dollars)
0 0.50
6 A.M. 7 8 9 10 11 Noon 1 2 3 4 5 6 7
1.38 2.07 2.76
Time of travel
of the more widely used taxation methods here: emissions taxes (or charges).
This method employs market incentives to encourage firms to choose the optimal level of emissions and control activity (called “pollution abatement”).
To set the proper tax rate on pollution emissions, environmental authorities must first determine the socially optimal rate of emissions, which typically ap- plies to a specific geographic area that regularly experiences “excessive” levels of pollution.
The optimal level of pollution (and abatement) Throughout this text, we have applied the reasoning of marginal analysis to solve a variety of optimization problems. Finding the socially optimal level of pollution provides one more opportunity to demonstrate the power of marginal analysis. To find the optimal pollution level, policymakers must be able to measure with a reasonable degree of accuracy the benefits and costs to society for different levels of pol- lution emissions. As you will see, finding the optimal level of emissions also determines the optimal level of effort for firms to expend reducing, preventing, or controlling pollution emissions from their production facilities. Such activity is called pollution control or pollution abatement.
The benefit accruing to society from reducing pollution is equal to the dollar value of damages from pollution avoided by pollution reduction or abatement.
The measure of pollution damages to society includes all costs attributable to pol- lution, such as costs of illness to humans, value of lost productive and recreational use of environmental resources, cost to society of lost biological habitat, and so on. Measuring damages is a controversial “science” involving multidisciplinary analytical methods. You can learn more about this important area of research and methodology by taking a course in environmental economics or reading the text- book for that course. While the scientific and environmental cost data required to estimate accurately pollution damages are generally substantial and costly to obtain, the task must nonetheless be undertaken by government environmental agencies if they wish to make optimal policy decisions.
To find the optimal level of pollution, marginal damage caused by pollution must be estimated, that is, the addition to total damages attributable to discharging one more unit of pollution into the environment must be known. In Figure 16.7, the curve labeled “MD” shows marginal damage for various rates of pollution emission. As you can see by looking at MD, emissions cause no damage below a threshold level of 400 tons per year, after which each additional ton causes ever-greater marginal damage to society. The damage caused by the 600th ton discharged is $20. We can add marginal damages for all units discharged and obtain the total damage caused by any specific level of pollution emission. In this case, total damage caused by 600 tons of emissions is the area under MD from 400 units to 600 units, which is $2,000 (5 0.5 3 200 3 $20). From this com- putation, it follows that the benefit to society of abating these 200 tons of pol- lution—reducing emissions from 600 to 400 tons—is the avoided damages of
$2,000 per year. For this reason, the MD curve measures the marginal benefit of pollution control.
pollution control (or abatement)
Costly efforts undertaken by firms to reduce or prevent emission of pollution from their production facilities.
marginal damage (MD) Additional damage incurred by society by discharging one more unit of pollution into the environment.
total damage Dollar measure of all damages to society caused by pollution emissions.