Externalities and public goods Flashcards
Broadly define an externality. Give an example.
The costs or benefits felt by individual’s not directly involved in the production or consumption of a good or service.
An example of a negative externality comes from the unpleasantness others feel when near a smoker. There is no market for this cost, so consideration of this cost is not thought of when lighting up another cigarette.
Externalities exist as there is no market for them. Consider smoking; how could assigning “property rights” to the situation make everyone better off?
If the smoker “owned” the smoke they emitted smoking then one could “purchase” the smoke in order to get them to stop.
Alternatively, if non-smokers owned clean air, the smoker could pay enough to let them smoke freely.
Oddly enough, the efficient level of pollution in an economy may not be zero. Consider smokers (again), what argument is there for allowing them to smoke?
How does the implementation of state-funded healthcare complicate matters?
Smoking privately (in one’s home) would not impact anyone else, thus there is no need for state intervention. All costs of smoking are borne by the smoker.
State-funded healthcare introduces an externality in the form of everyone’s tax money picking up the bill for the smoker’s ill health. However, as smokers still derive utility from the act, an efficient level of smoking is not zero.
As others bear the burden of the smoker’s actions, they must be traded off against the increased health costs of their habit that are shared by others. Therefore, economic arguments for reducing smoking exist, but not banning it outright.
Consider the negative externalities of producing steel. What can we say about the demand and supply curve of this market?
Imagine a graph where demand equates to marginal benefit and supply marginal cost. Here, as producing steel leads to negative externalities (pollution), the marginal social cost of producing steel exceeds the marginal private cost.
This means steel is over-produced as the social costs of it’s production are not considered. Hence, there is a DWL triangle produced by tracing up from q (private production) to the MSC curve.
Consider the market for steel production and the mechanisms of marginal social cost and benefit.
Under what conditions could a Pareto improvement be made and what would be socially optimal?
Pareto improvements can be made in scenarios where one person can be made better off without making another worse off.
If MSB > MSC, then everyone who benefits from a bit more steel production can compensate everyone who loses and still be made better off. So increasing steel can still lead to a Pareto improvement. Conversely, if MSC > MSB, then those who are harmed by steel production could pay those who benefit to limit production.
Only when MSB equals MSC, can a social optimum be achieved. No Pareto improvements can be achieved here, hence, Pareto optimal.
What is the core idea behind accounting for negative externalities?
They attempt to align the incentives of decision-makers so that the effects of externalities on third parties are somehow accounted for.
There are two main ways in which externalities can be accounted for; government intervention, and internalising the externality. Describe these ideas.
Government intervention: Tax activities with negative externalities or subsidise those with positive externalities. Or, set quotas that impose the socially-optimal levels of output on the relevant market.
Internalising the externality: Change the institution in order to bring affected third parties inside transactions so that they can represent their interests. This might involve creating the missing market or encouraging the mergers between otherwise separate entities.
Considering a negative externality, how may government impose a tax on a good in order to reach a socially-optimal level of consumption?
A negative externality means MSC lies above MPC.
However, a per-unit tax of t* could be imposed to shift the supply curve - the MPC - up, so that the MPC now intercepts the MSB (demand) curve at the point of MSC.
Considering a positive externality, how may government impose a subsidy on a good in order to reach a socially-optimal level of consumption?
A positive externality means MSB exceed MPB.
A per-unit subsidy s* could reduce MPC - the supply curve - out to the point where the socially-optimal amount of the good is traded. This will be where the vertical line tracks down from the original MPC = MSC curve to the MPB curve.
Why might solving externalities with tax or subsidy be difficult in practice as opposed to theory?
The tax (subsidy) must be set equal to the marginal external cost (benefit), the socially optimal level, to achieve the efficient outcome.
In practice, it’s hard to know what the socially optimal level of tax or subsidy should be without already knowing what the socially optimum level of output is. Also, there may be information failures present which prevent the government effectively allocating the correct level of intervention.
Other than general social efficiency, what goods may receive government tax or subsidy?
Demerit goods (smoking, alcohol, etc.) face heavy taxation as the government deems their consumption to be harmful due to negative externalities of consumption (healthcare support, antisocial behaviour, etc.)
Merit goods, on the other hand, can be subsidised by government as their consumption is deemed beneficial.
Positive externalities o f consumption lead them to be under-consumed so subsidy aims to push MPC down to a socially optimal level (where the vertical line down from the MPC = MSC curve intersecting the MSB curve traces down to the MSB curve).
Quotas on the production of a good is another way to manage negative externalities. What is the key trap you shouldn’t fall for when discussing quotas to manage externalities?
The quota should target the externality itself, not the good producing said externality.
Rather than say “You cannot produce more than X tonnes of steel per-month”, you should say “You cannot produce more than Y tonnes of CO2 per-month”. This allows producers to innovate, coming up of ways to limit externalities without impacting production.
Also, targeting the good itself leaves other goods producing the same externality to go unpunished.
Limiting negative externalities in a market with multiple producers can be difficult.
Consider a simple market of A and B, each producing CO2. What needs to be taken into account when looking to reduce market emissions?
The individual firms’ “marginal cost of abatement”. The per-unit cost of reducing CO2 emissions.
Suppose A and B each produce 100 units of CO2 but A can reduce emissions at a cheaper rate than B. A quote of 100 CO2 units split across the firms would not be efficient, as A would more easily be able to reduce emissions to 50, providing an unfair advantage.
Accounting for A’s lower marginal cost of abatement could look like A:B emissions being 30:70 but at a lower combined cost to the two firms.
A more realistic alternative to negative externality quotas are “cap and trade” policies. These policies allow producers of negative externalities, such as emissions, to trade “permits” to produce the externality, such as the EU Emission Trading System.
Describe the logic of these systems.
As permits are traded, a market price per-permit emerges.
This gives firms’ incentive to sell permits when the market price of a permit exceeds the the cost of not being allowed to produce as much - the marginal cost of abatement.
Similarly, firms purchase permits when the market price is less than their marginal cost of abatement.
In equilibrium, all firms trade permits such that their marginal cost of abatement (isoquant curve) equals the market price of permits (isocost curve). Therefore, as all permits are equally-priced, all firms have equal marginal cost of abatement, and there is efficiency.
What concepts may interfere with the efficiency of a cap and trade system such as the EU Emissions Trading System?
The initial allocation of permits: If these are inefficiently assigned, then some firms may be better off without ever planning to pollute as they can sell off all permits for pure profit.
Rent-seeking activity: Potential participants in these schemes may spend resources lobbying to change them in their favour or get rid of them. As these resources do not actively add value, they are considered wasted in economic terms, and lead to inefficiency.
