WEEK 9 - Chapter 10: Externalities

Question 1

What is an externality?

Answer 1

The uncompensated impact of one person’s actions on the wellbeing of a bystander.

If the effect on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality.

Externalities come in many varieties, as do the policy responses that try to deal with the market failure.

Question 2

What is market failure?

Answer 2

Situations where the market fails to achieve an efficient outcome, or where efficient, the outcome is deemed to be socially undesirable.

Question 3

What is government failure?

Answer 3

Situations where the government fails to achieve an efficient outcome or redress a market failure, or where efficient, the outcome is deemed to be socially undesirable.

Question 4

As always, there are trade-offs.

Answer 4

1. Need to consider the costs and benefits of regulation (benefits cost analysis).
2. Not every market failure warrants attention (some are trivial and can be ignored).
3. Sometimes, the best policy may be to do nothing.

Question 5

What happens in the presence of externalities?

Answer 5

In the presence of externalities, society’s interest in a market outcome extends beyond the wellbeing of buyers and sellers in the market; it also includes the wellbeing of bystanders who are affected.

Question 6

Why is the market equilibrium inefficient with externalities?

Answer 6

Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient in the presence of externalities.

That is, the equilibrium fails to maximise the total benefit to society as a whole.

The release of dioxin into the environment, for instance, is a negative externality. Self-interested paper firms will not consider the full cost of the pollution created in their production processes, and consumers of paper will not consider the full cost of the pollution that results from their purchasing decisions. Therefore, the firms will emit too much pollution unless the government prevents or discourages them from doing so.

Question 7

What is a market?

Answer 7

An institution that involves the exchange of goods and
services AND the rights (property rights) to use them.

Individuals with purely selfish motives mutually benefit from exchange.

Question 8

Examples of market failure.

Answer 8

Markets may fail to produce sufficient quantities of certain goods

• eg. Police and fire protection)
• hence government provision/intervention is needed.

Markets may allocate too few resources to certain activities, producing too little of a good or service

• eg. R&D, education
• hence, compulsory primary & secondary schooling and compulsory immunisation.

Markets may allocate too many resources to certain activities, producing too much of a good or service

• eg. Too much pollution is generated, too much environmental devastation generated
• hence, need for interventions to curtail the activities that result in pollution.

Markets can provide many goods/services that are socially regarded as harmful:
- eg. drugs, sale of blood and body parts, slavery
- hence, the production of certain products is made illegal and, the distribution of certain products is restricted

Markets use prices to convey information, but some information is not provided in sufficient quantities or somebody in the market knows more than somebody else
- Drugs, certain foods, entertainment activities and products
- hence the need for health warnings, building codes, prevention of deceptive advertising

Question 9

Negative externalities in production.

Answer 9

The demand curve reflects the value to buyers and the supply curve reflects the costs of sellers. The equilibrium quantity, QMARKET, maximises the total value to buyers minus the total costs of sellers. In the absence of externalities, therefore, the market equilibrium is efficient.

When there is a negative externality to production, the social cost of producing aluminium exceeds the private cost (S curve). The socially desirable quantity of aluminium, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET.

The vertical distance between these two curves reflects the cost of the externality emitted in producing the marginal unit – the difference between the private cost of the producer and the total cost to society for the marginal unit.

Question 10

What is internalising an externality?

Answer 10

Altering incentives so that people take into account the external effects of their actions.

The use of such a tax is said to be internalising an externality because it gives buyers and sellers in the market an incentive to take into account the external effects of their actions.

The social planner achieve the optimal outcome through a tax. The tax would shift the supply curve upwards by the size of the tax. If the tax accurately reflected the social cost the new supply curve would coincide with the social-cost curve.

Question 11

Positive externalities in production.

Answer 11

While some activities impose costs on third parties, others yield benefits. In markets with positive externalities the social cost of production is less than (to the right of) the private cost (S curve).

In the presence of a positive externality to production, the social cost of producing robots is less than the private cost. The socially desirable quantity of a good, QOPTIMUM, is therefore larger than the equilibrium quantity, QMARKET.

How can the government correct this market failure? In this case, the government can internalise the externality by subsidising the production of the good. If the government paid firms for each good produced, the supply curve would shift down by the amount of the subsidy and this shift would increase the equilibrium quantity of the good.

To ensure that the market equilibrium equals the social optimum, the subsidy should equal the value of the technology spillover.

Question 12

Externalities in consumption.

Answer 12

The externalities we have discussed so far are associated with the production of goods. Some externalities, however, are associated with consumption.

The consumption of alcohol, for instance, yields negative externalities if consumers are more likely to drive under its influence, engage in antisocial behaviour and risk the lives of others.

Similarly, vaccination against a contagious disease such as measles or influenza yields positive externalities because it lowers the risk of catching the disease for everyone in the population, even those who are not vaccinated.

The analysis of consumption externalities is similar to the analysis of production externalities.

The demand curve no longer reflects the social value from the good.

Question 13

Graphing the effect of negative externalities in consumption.

Answer 13

In this case, the social value is less than (to left of) the private value (D curve), and the socially optimal quantity is smaller than the quantity determined by the private market.

Question 14

Graphing the effect of positive externalities in consumption.

Answer 14

In this case, the social value is greater than (to right of) the private value (D curve), and the socially optimal quantity is greater than the quantity determined by the private market.

Question 15

How to fix externalities in consumption?

Answer 15

Once again, the government can correct the market failure by internalising the externality. To move the market equilibrium closer to the social optimum, a negative externality requires a tax and a positive externality requires a subsidy.

In fact, that is exactly the policy the government follows; alcoholic beverages are among the most highly taxed goods in our economy and vaccination is heavily subsidised through preschool programs and the medical system.

Question 16

Private solutions to externalities.

Answer 16

We have discussed why externalities lead markets to allocate resources inefficiently, but have mentioned only briefly how this inefficiency can be remedied.

In practice, both private individuals and public policymakers respond to externalities in various ways.

All of the remedies share the goal of moving the allocation of resources closer to the social optimum.

Question 17

The types of private solutions.

Answer 17

Moral codes and social sanctions.

• Consider, for instance, why most people do not litter.
• Although there are laws against littering, these laws are not vigorously enforced.
• Most people choose not to litter simply because it is the wrong thing to do.

Charities
- eg. Greenpeace, whose goal is to protect the environment, is a not-for-profit organisation funded by private donations.
- As another example, private individuals and corporations sometimes sponsor scholarships and prizes for university students, in part because education has positive externalities for society.

Integrating different types of business
- eg. consider an apple grower and a beekeeper located next to each other.
- each business confers a positive externality on the other – by pollinating the flowers on the trees, the bees help the orchard produce apples. At the same time, the bees use the nectar they get from the apple trees to produce honey.

Interested parties enter into a contract
- in the example above, a contract between the apple grower and the beekeeper can solve the problem of too few trees and too few bees.
- The contract can specify the number of trees, the number of bees and perhaps a payment from one party to the other.
- By setting the right number of trees and bees, the contract can solve the inefficiency that normally arises from these externalities and make both parties better off.

Question 18

What is coase theorem?

Answer 18

The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

Question 19

Why private solutions do not always work.

Answer 19

Despite the appealing logic of the Coase theorem, private individuals on their own often fail to resolve the problems caused by externalities.

The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement.

In the real world, however, bargaining does not always work, even when a mutually beneficial agreement is possible.

Sometimes the interested parties fail to solve an externality problem because of transaction costs.

Question 20

What are transaction costs?

Answer 20

The costs that parties incur in the process of agreeing to, and following through on, a bargain.

If the benefit of solving a problem is less than the cost of the solving it, the parties might choose to leave the problem unsolved.

Question 21

Public polices on externalities.

Answer 21

When an externality causes a market to reach an inefficient allocation of resources, the government can respond in one of two ways.

Command-and-control policies regulate behaviour directly.
Market-based policies provide incentives so that private decision makers will choose to solve the problem on their own.

Question 22

Explain the following way the government can respond to externalities: Command-and-control policies (regulation)

Answer 22

The government can remedy an externality by either requiring or forbidding certain activities.

Eg. it is a crime to dump poisonous chemicals into the water supply. In this case, the external costs to society far exceed the benefits to the polluter.

The government therefore institutes a command-and-control policy that prohibits this act altogether. In most cases of pollution, however, the situation is not this simple. Despite the stated goals of some environmentalists, it would be impossible to prohibit all polluting activity.

Question 23

Market-based policy 1: corrective taxes and subsidies.

Answer 23

Instead of regulating behaviour in response to an externality, the government can use market- based policies to align private incentives with social efficiency.

For instance, as we saw earlier, the government can internalise the externality by taxing activities (corrective tax) that have negative externalities and subsidising activities that have positive externalities.

Economists usually prefer corrective taxes over regulations as a way to deal with pollution because they can reduce pollution at a lower cost to society.

Question 24

What is a corrective tax?

Answer 24

Taxes enacted to correct the effects of negative externalities are called corrective taxes.

An ideal corrective tax would equal the external cost from an activity with externalities and an ideal corrective subsidy would equal the external benefit from an activity with positive externalities.

Corrective taxes are unlike most other taxes. Most taxes distort incentives and move the allocation of resources away from the social optimum. The reduction in economic wellbeing – that is, in consumer and producer surplus – exceeds the amount of revenue the government raises, resulting in a deadweight loss.

Corrective taxes alter the incentives that the market participants face to account for the presence of externalities and thereby move the allocation of resources closer to the social optimum. Thus, while corrective taxes raise revenue for the government, they enhance economic efficiency.

Question 25

Market-based policy 2: Tradeable pollution permits.

Answer 25

If the government allows firms to make these deals, it will, in essence, have created a new scarce resource – pollution permits.

A market to trade these permits will eventually develop and that market will be governed by the forces of supply and demand. The invisible hand will ensure that this new market efficiently allocates the right to pollute.

That is, the permits will end up in the hands of those firms that value them most highly, as judged by their willingness to pay.

A firm’s willingness to pay for the right to pollute, in turn, will depend on its cost of reducing pollution: The more costly it is for a firm to cut back on pollution, the more it will be willing to pay for a permit.

As long as there is a free market for the pollution rights, the final allocation will be efficient whatever the initial allocation.

Question 26

Graphing a corrective (pigovian) tax and pollution permits.

Answer 26

Correct tax:
. This sets the price of pollution (horizontal line)
. With the Demand curve this determines the quantity of pollution (intersection)

Pollution permit:
. This sets the quantity of pollution (vertical line)
. With the Demand curve this determines the price of pollution (intersection)

Question 27

Objections to the economic analysis of pollution.

Answer 27

Some environmentalists argue that clean air and clean water are fundamental human rights that should not be debased by considering them in economic terms.

Economists have little sympathy with this type of argument. To economists, good environmental policy begins by acknowledging the first of the Ten Lessons from Economics in chapter 1 – people face trade-offs.

Certainly, clean air and clean water have value. But their value must be compared with their opportunity cost – that is, with what one must give up to obtain them.

Eliminating all pollution is impossible. Trying to eliminate all pollution would reverse many of the technological advances that allow us to enjoy a high standard of living.

Few people would be willing to accept poor nutrition, inadequate medical care or shoddy housing in order to make the environment as clean as possible.

Question 28

What do economists argue regarding environment activists?

Answer 28

Economists argue that some environmental activists hurt their own cause by not thinking in economic terms.

A clean environment can be viewed as simply another good.

Like all normal goods it has a positive income elasticity: Rich countries can afford a cleaner environment than poor ones and, therefore, usually have more rigorous environmental protection.

Further, like most other goods, clean air and clean water obey the law of demand: The lower the price of environmental protection, the more the public will want.

The economic approach of using pollution permits and corrective taxes reduces the cost of environmental protection. It should, therefore, increase the public’s demand for a clean environment.

Question 29

Causes of market failure - externalities.

Answer 29

. Economic transactions generate costs and benefits
. Often, these costs and benefits fall on third
parties.
. These costs and benefits are not considered by those undertaking the transaction.
. Third parties are not compensated for the cost or benefit falling upon them.
. Also known as spillovers
. If parties to a transaction do consider all the costs & benefits of their actions and compensate third parties, then there is no externality.
. Note that welfare effects that arise solely from movements in market prices are NOT externalities.
- e.g. if the price of wine rises because more people want wine, this is not an externality.

Question 30

What is a negative externality?

Answer 30

An uncompensated cost born by a third party.

Lead to oversupply of good/service.

Question 31

What is a positive externality?

Answer 31

An uncompensated benefit born by a third party.

Lead to undersupply of good/service.

Question 32

Types of externalities.

Answer 32

Producer on producer:
. Chemical plant polluting a lake used for fishing
. Bee-keeper located next to apple grower

Producer on consumer:
. Impact of noise from factory on residential areas
. Factory builds a sealed road
. Contamination of ground water from fertilizers

Consumer on consumer:
. Congestion of roads, automobile emissions
. Neighbour renovates their house
. Knowledge passed on to others
. Smoking in restaurant

Consumer on producer:
. Campers burn tree plantation

Government on producer:
. Knowledge from government research centres spilling over to industry
. US government stabilisation policies on Australian producers

Government on consumer:
. Government owned coal-fired electric utility plant
causing air pollution

Producer on government:

Consumer on government:

Question 33

Impact of externalities on a market: eg. Alcohol.

Answer 33

Normal Demand curve - labelled MPB
MSB is below this (acute angle from vertical axis)
Normal supply curve - labelled MC

OR

Normal supply curve - labelled MPC
MSC is above this (acute angle from vertical axis)
Normal Demand curve - MB

Question 34

Acronyms.

Answer 34

MPB = Marginal Private Benefit (MR)
MPC = Marginal Private Cost (MC) 
MSB = Marginal Social Benefit 
MSC = Marginal Social Cost