Week 12: Externalities Flashcards
Externality
A cost or benefit of an action that falls on someone other than the person or firm choosing the action
Negative externality
An externality that imposes a cost
Positive externality
An externality that provides a benefit
When do negative and positive externalities arise?
Production and consumption activities
Negative production externalities
Billions of tonnes of pollutants in air, oceans, lakes, and rivers; climate change and global warming; CO2 emitted from the burning of fossil fuels to generate electricity and power vehicles
Negative consumption externalities
Plastic waste created when we throw a water bottle, shopping bag, container, or other packages in garbage bins and a source of irritation
Positive production externalities
A source of huge improvements in well-being that arise from a well-educated workforce: new technologies like the iPhone, renewable and green energy sources to counter negative production externalities of carbon fuel
Positive consumption externalities
When one person’s consumption benefits other people like flu vaccinations and education
Infection externalities
All four externality types can arise in a pandemic
Negative infection externalities
Infectious disease spreads through social interaction during production and consumption activities
Positive infection externalities
Limiting the spread through legally enforced public health regulations like a stay-at-home order
Private cost
Cost of producing a good or service that is borne by the producer
Marginal private cost (MC)
Cost of producing an additional unit of a good or service that is borne by its producer
External cost
Cost of producing a good or service that is not borne by the producer but borne by other people
Marginal external cost
Cost of producing an additional unit of a good or service that falls on people other than the producer
Marginal social cost (MSC)
Marginal cost incurred by the producer and by everyone else on whom the cost falls
How do you solve for marginal social cost?
Sum of marginal private cost and marginal external cost
How are external costs valued?
Economists use market prices to put a dollar value on the external costs of pollution
What does the marginal cost curve describe?
The marginal private cost which increases as the output produced increases
What does a point on the marginal social cost curve show?
The sum of the marginal private cost and the marginal external cost at a given level of output
What does the gap between MC curve and MSC curve represent?
Marginal external cost which increases with amount of output produced
S= MC and D=MSB=MPB
The marginal private cost curve is the market supply curve and the market demand curve is the marginal social benefit curve
Where does the inefficient market equilibrium occur due to an external cost?
Where S=D or MC=MSB
Where does the efficient equilibrium occur in a market with negative externality?
Where D or MSB is equal to MSC
Why is there inefficient overproduction at the inefficient market equilibrium in a market with negative externality?
Marginal social cost exceeds marginal social benefit
What is the area of the deadweight loss triangle created by an external cost?
Measures the society’s loss when there’s inefficient overproduction and external cost (pollution) is created
Why does the deadweight loss arise in a market with negative externality?
Firms only take their private cost into account when making their production decision
Three approaches to fixing the inefficiency created by an external cost
Establish property rights, mandate clean technology, and tax or price pollution
Property rights
Legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts; a foundation stone of the market economy but they don’t apply to all property
What can establishing property rights do?
Confront producers with the costs of their actions and provide incentives that allocate resources efficiently
Two possible responses to the cost of producing goods and creating pollution
Use an abatement technology or produce less and pollute less
Abatement technology
A production technology that reduces or prevents pollution from electricity generation and many industrial processes
Produce less and pollute less
An alternative to incurring the cost of abatement technology is to use the polluting technology but cut production, reduce pollution, and get a higher income
How do firms decide whether to use abatement technology or produce less?
Firms will choose the least-cost alternative
What costs do producers face with property rights in place?
Producers face the pollution or abatement costs, whichever is lower, and the cost of production
What is the market supply curve with property rights in place?
MSC curve, labelled S=MC=MSC, includes the cost of producing plus the cost of pollution (external cost) or the cost of abatement, whichever is lower
Where does the efficient market equilibrium occur?
Where MSB=MSC (abatement or pollution costs included)
What does the MC curve that excludes pollution and abatement costs show?
Only part of the producers’ marginal cost
If the pollution cost (forgone income) is less than the abatement cost…
Firms will still create some pollution but it will be the efficient quantity
If the abatement cost is less than the pollution cost (forgone income)…
Firms will stop polluting but they will produce the efficient quantity because marginal cost includes the abatement cost
Coase theorem (Ronald Coase)
The proposition that if property rights exist and the transaction costs of enforcing them are low, then private transactions are efficient and it doesn’t matter who has the property rights (polluter or victim of pollution)
Why does it not matter who owns the resources that might be polluted and has the property rights?
If firms own them, they bear the cost of pollution because they receive a lower income. If they don’t, they still bear the cost of pollution because they must pay a fee to the owners for the right to dump their waste. Either way, they produce the same amount of output and dump the efficient amount of waste.
When does the Coase solution work?
Only when transaction costs are low
Transaction costs
The opportunity costs of conducting a transaction
When does the government mandate clean technology?
When property rights are too difficult to define and enforce, public choices are made and regulation is the likely response
Examples of Environment Canada’s regulations to monitor air pollution
Regulations that require chemical plants and power utilities to adopt best-practice pollution abatement technologies and limit their emissions and that govern road vehicle emission limits which must be met by the manufacturers
Two main methods governments use to confront polluters with the costs of their decisions
Taxes and cap-and-trade
Pigovian taxes (Arthur Cecil Pigou)
When taxes are used as an incentive for producers to cut back the pollution they create
By setting the tax equal to the marginal external cost or marginal abatement cost if it’s lower…
Firms can be made to behave in the same way as they would if they bore the cost of the externality directly
Cap
An upper limit, a pollution quota
What must a government that uses cap-and-trade do?
Estimate the efficient quantity of pollution and set the overall cap at that level, allocate the pollution cap or quota to individual firms (and possibly even households)
In an efficient allocation of pollution quotas…
Each firm has the same marginal social cost. The government would need to know each firm’s marginal production cost and marginal abatement cost.
How does cap-and-trade avoid the need to know each firm’s costs?
Allowing them to trade in a market for pollution permits
How does trading take place in a market for pollution permits?
Firms that have a low marginal abatement sell permits and make big cuts in pollution. Firms that have a high marginal abatement cost buy permits and make smaller cuts or even no cuts in pollution.
What does a market in permits determine?
Equilibrium price of pollution and each firm, confronted with that price, maximizes its profit by setting its marginal pollution or abatement cost equal to the market price of a permit
By confronting polluters with a price of a pollution permit…
Trade in pollution permits can achieve the same efficient outcome as a Pigovian tax
Private benefit
A benefit that the consumer of a good or service receives
Marginal private benefit (MB)
The benefit that the consumer of a good or service receives from an additional unit of it
External benefit
The benefit that someone other than the consumer of the good or service receives
Marginal external benefit
The benefit of an additional unit of a good or service that people other than its consumer enjoy
Marginal social benefit (MSB)
The marginal benefit enjoyed by society – by the consumer of a good or service and by others
How do you solve for marginal social benefit?
MSB= MB + Marginal external benefit
What is the relationship between MB curve and output?
Marginal private benefit decreases as output increases
Marginal social benefit curve
Sum of marginal private benefit and marginal external benefit at each given level of output
What does the gap between MB curve and MSB curve represent?
Marginal external benefit at each given level of output
D=MB and S=MSC=MPC
Market demand curve is the marginal private benefit curve and supply curve is the marginal social cost curve
Where does inefficient market equilibrium occur in a market with positive externality?
Where MSC=MB or S=D
Where does the efficient equilibrium occur in a market with positive externality?
Where MSB=MSC or S
What causes inefficiency with an external benefit?
Marginal social benefit exceeds marginal social cost, deadweight loss arises because of underproduction (e.g. too few students enroll in university)
What happens when people make decisions about the amount of research or education to undertake?
They balance the marginal private cost against the marginal private benefit, ignore the external benefit and consider only the private benefit
What happens if education and research were left to unregulated market forces?
Underproduction or too little of these activities
Four devices governments use to achieve a more efficient allocation of resources in the presence of external benefits
Public production, private subsidies, vouchers, patents, and copyrights
Public production
A good or service produced by a public authority that receives its revenue from the government e.g. public school education
Does public provision affect MSC, MB, and marginal external benefit?
No, it cannot lower the cost of production so MSC stays the same. MB and marginal external benefit also stay the same.
Where is the tuition fee set when there is public production? The rest of the cost?
Set equal to the marginal private benefit at the efficient quantity to ensure that the efficient number of students enroll. The rest of the cost is borne by the taxpayers.
Private subsidies
Payment by the government to private producers
By making the private subsidy depend on the level of output…
Government can induce private decision makers to consider external benefits when they make their choices
What is the new market supply curve when the government provides a private subsidy?
MSC-Subsidy, subtract the subsidy from the school’s marginal cost
Where is the tuition fee set when provided a private subsidy?
At the efficient market equilibrium or the marginal private benefit at the efficient quantity
Why does a private subsidy achieve an efficient outcome?
Marginal social benefit is equal to marginal social cost at the efficient quantity of students
What is the school’s marginal cost at the efficient market equilibrium?
The tuition plus the subsidy
Vouchers
A token that the government provides to households, which they can use to buy specified goods and services
A school voucher would allow parents and the school to…
Parents can choose the school their children will attend and use the voucher to pay part of the cost. The school cashes the voucher to pay its bills.
What is the value of the school voucher?
Equal to marginal external benefit
Where does the efficient market equilibrium occur given a school voucher?
Where MSC=MSB (MSB curve becomes the demand for education, D=MSB). Each student pays the tuition (MB at efficient quantity) and the school collects the value of the voucher per student.
Why is the outcome of the voucher scheme efficient?
If the government estimates the value of the external benefit correctly and makes the value of the voucher equal to the marginal external benefit, MSC equals MSB and the deadweight loss is eliminated.
The main way of providing incentives to those who develop new ideas
Uses the central idea of the Coase theorem and assigns intellectual property rights to creators
The legal device for establishing intellectual property rights
A patent or copyright
Patent or copyright
A government-sanctioned granted to the inventor of a good, service, or productive process to produce, use, and sell the invention, and prevent others from freely benefitting from it for a given number of years
What is the efficient outcome when granted a patent?
A compromise that balances the benefits of more inventions against the cost of temporary monopoly in new inventions
