Chapter 11 | Externalities, Carbon Taxes, Free Riders and Public Goods Flashcards
Handcuffing the Invisible Hand: Market Failure with Externalities
When externalities exist, prices don’t reflect all social costs and benefits; markets fail to coordinate private smart choices with social smart choices.
Negative externalities (external costs)
costs to society from your private choice that affect others, but that you do not pay.
Positive externalities (external benefits)
benefits to society from your private choice that affect others, but that others do not pay you for.
Externalities occur when clear property rights are missing.
– Tragedy of the commons — the overuse and depletion of a resource that no one can be excluded from because of missing property rights.
– Free riders — those who consume products or services without paying.
When externalities exist, prices don’t reflect all social costs and benefits, and markets fail to produce efficient outcomes. Instead markets produce:
– too many products and services with negative externalities (second-hand smoke, pollution, traffic jams).
– too few products and services with positive externalities (vaccinations, education).
Why Radical Environmentalists Dislike Economists: Efficient Pollution
For an efficient market outcome when there are negative externalities, choose the quantity of output where marginal social cost equals marginal social benefit.
Efficient pollution” balances the additional environmental benefits of lower pollution with the additional opportunity costs of reduced living standards.
– The socially desirable amount of pollution is not zero; at some point the additional opportunity costs of reducing pollution are greater than the additional benefits of lower pollution.
The market quantity and price are determined at the intersection of the marginal private benefit and marginal private cost curves.
The market quantity and price are determined at the intersection of the marginal private benefit and marginal private cost curves.
For any product or service that generates an externality, the rule for a smart choice is: Choose the quantity of output where marginal social cost equals marginal social benefit.
– Marginal social cost
– Marginal external cost
- Marginal social benefit
– Marginal external benefit
– Marginal social cost
(MSC) = marginal private cost (MC) plus marginal external cost
– Marginal external cost
= price of preventing or cleaning up damage to others external to the original activity
– Marginal social benefit (MSB)
(MSB) = marginal private benefit (MB) plus marginal external benefit
Marginal external benefit
= price of the value or savings to others external to the original activity
Markets overproduce products and services with negative externalities; the price is too low because it does not incorporate external costs.
Markets overproduce products and services with negative externalities; the price is too low because it does not incorporate external costs.
Liberating the Invisible Hand: Policies to Internalize the Externality
If polluters are forced by government to pay the marginal external costs of their pollution, this internalizes the externalities/costs into private choices, creating smart social choices.
Without property rights to the environment, businesses have incentives to save money and improve profits by ignoring external costs like pollution and global warming.
Without property rights to the environment, businesses have incentives to save money and improve profits by ignoring external costs like pollution and global warming.
Governments can remedy market failures from externalities by creating social property rights to the environment, making polluting illegal, and penalizing polluters.
Governments can remedy market failures from externalities by creating social property rights to the environment, making polluting illegal, and penalizing polluters.
Emissions tax
tax to pay for external costs of emissions
- Carbon Tax
- Smart Carbon Tax
Carbon tax
emissions tax on carbon-based fossil fuels
Smart carbon tax
= marginal external cost of damage from emissions
Cap-and-trade system
— limits the quantities of emissions businesses can release into environment.
– Government auctions off pollution permits to the highest bidders.
– Total quantity of emissions allowed by permits = emissions target.
– Businesses buy and sell emissions permits. Permit price becomes a private cost to business reflecting the marginal external cost of pollution.
Internalize the externality
— transform external costs into costs the producer must pay to the government.
Carbon taxes and emissions permits give pollution a price reflecting marginal external cost of damage done, so smart individual and business choices become smart social choices.
Carbon taxes and emissions permits give pollution a price reflecting marginal external cost of damage done, so smart individual and business choices become smart social choices.
Carbon taxes and cap-and-trade systems are smart policies for efficient pollution, but may be inequitable in hurting lower-income consumers most.
Carbon taxes and cap-and-trade systems are smart policies for efficient pollution, but may be inequitable in hurting lower-income consumers most.
With positive externalities, buyers and sellers are not paid for the external benefits their exchange creates. The market-clearing price is too high for buyers to be willing to buy the socially best quantity of output, and too low for sellers to be willing to supply.
With positive externalities, buyers and sellers are not paid for the external benefits their exchange creates. The market-clearing price is too high for buyers to be willing to buy the socially best quantity of output, and too low for sellers to be willing to supply.
Public goods
— provide external benefits consumed simultaneously by everyone; no one can be excluded.
– Public goods like lighthouses and national defence are extreme examples of positive externalities.
Free-rider problem
— markets underproduce products and services with positive externalities.
– Price charged to buyers is too high.
– Price received by sellers is too low.
The smart social quantity of output with positive externalities is at the intersection of the marginal social benefit and marginal social cost curves.
– With positive externalities, no single price can coordinate smart individual choices and smart social choices.
– The market-clearing price is too high for buyers to be willing to buy and too low for sellers to be willing to supply.
Why Your Tuition Is Cheap (Really!): Subsidies for the Public Good
When there are positive externalities, government subsidies can get everyone to voluntarily choose the socially best quantity of output where marginal social benefit equals marginal social cost.
Subsidy
— payment to those who create positive externalities.
– Smart subsidy = marginal external benefit of savings to others associated with an activity.
– Subsidies remove the disconnect between prices for buyers and sellers caused by positive externalities, leading individuals and businesses to voluntarily choose the quantity of output best for society.
– Subsidies to either suppliers or demanders can achieve an efficient social outcome.
Public provision
— government provision of products or services with positive externalities, financed by tax revenue.
