Copyright © 2004 South-Western Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.

Copyright © 2004 South-Western

Policy Conundrum

There are no SOLUTIONS.

There are just TRADE-OFFS.


Market Failure

Recall • Adam Smith’s “invisible hand” leads self-interested buyers

& sellers in a market to maximize the total benefit for society.

But market failures can still happen!

• An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.


EXTERNALITIES AND MARKETS

• When the impact on the bystander is adverse, the externality is called a negative externality.

• When the impact on the bystander is beneficial, the externality is called a positive externality.

• Externalities cause markets to be inefficient.


Negative Externalities

• Automobile exhaust

• Factory pollution

• Cigarette smoking

• Barking dogs (loud pets)

• Airplanes (landing/take-off)

• Landfills

• Chicken litter

• Over-fishing/grazing/driving

• B.O.


Coal-Fired Power Plant

• The owner of the plant bears the costs of the labor, land, concrete, steel, etc. used in production but does NOT pay for the clean air used.

• People also agree to buy electricity (electric bill).

• Social Cost > Private Cost

• Price does not reflect true cost!


A Voluntary Exchange between a willing buyer and seller


But…..

• Although the car owner has paid for the gasoline, he has

NOT paid for the clean air used as he drives.

• Price does not reflect true cost!

. . . . . . COSTS that spill over onto people who don’t receive the benefits.


Property Rights

• The incentives are not correct!

• Auto/factory pollution could be solved…..

• tailpipe

• smokestack


Positive Externalities

• Immunizations

• Landscaping/Home Maintenance

• Research & Development

• Education

• Green space

• Rainforests

• Species


Equilibrium = Balance

• MB = MC = P*• Qs = Qd• Allocative efficiency

Producersurplus

Producersurplus

Consumersurplus

Consumersurplus

Price

Quantity

Equilibriumprice

Equilibriumquantity

Equilibriumprice

Equilibriumprice

Equilibriumquantity

SupplySupply

DemandDemand


EXTERNALITIES AND MARKET INEFFICIENCY

• Negative externalities lead markets to produce and consume a quantity greater than the socially optimal quantity.

• Positive externalities lead markets to produce and consume a quantity less than the socially optimal quantity.


The Market for Aluminum

• The quantity produced & consumed at the market equilibrium is efficient in the sense that it maximizes the benefits to market participants (buyers & sellers).

• If the aluminum factories emit pollution then the cost to society of producing aluminum is larger than the cost to aluminum producers.

• For each unit of aluminum produced, the social cost includes the private costs of the producers plus the damage to those bystanders adversely affected by the pollution.

Figure 2 Pollution and the Social Optimum


Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand(private value)

Supply(private cost)

Socialcost

QOPTIMUM

Optimum

Cost ofpollution

QMARKET


Negative Production Externality

• social cost > private cost

• The intersection of the demand curve and the social-cost curve determines the optimal output level.

• The private market outcome over-produces and consumes aluminum at the market equilibrium quantity.


The Market for Education

• When an externality benefits the bystanders, a positive externality exists…..the social value of the good exceeds the private value.

• Education can be considered a positive externality

• Educated children are more likely to become good citizens (voters, productive workers, less crime).

• Benefits spill over to general public beyond the benefit to individual students.

Figure 3 Education and the Social Optimum


Quantity ofEducation

0

Price ofEducation

Demand(private value)

Socialvalue

Supply(private cost)

QMARKET QOPTIMUM


Positive Consumption Externality

• social benefit > private benefit

• The intersection of the supply curve and the social-value curve determines the optimal output level.

• The private market outcome under produces and consumes education at the market equilibrium quantity.


Solving (addressing) Externalities

• Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

• The government can internalize an externality by imposing a tax/subsidy to reduce/increase the equilibrium quantity to the socially optimal level.

• Patents & Copyrights


Getting an Education Provides Great Benefits

(even for those not in school)

• Social Value > Private Value

• Private market will under-do it.

• Mandate and subsidize!

• What would society look like if we left all education up to the private market?


Immunizations Reduce the Likelihood of Disease

(even for people who don’t get immunized)

• Social Value > Private Value

• Private market will under-do it.

• Mandate and subsidize!

• What would society look like if we left all immunizations up to the private market?


Taxing Activities with Negative Externalities

• Cigarettes

• Alcohol

• Soda/Junk Food

• Gasoline

• Carbon


Government action is not always needed to solve the problem of externalities.

• The Coase Theorem proposes that if property rights are clearly defined and protected private parties can negotiate without cost, then they can solve the problem of externalities on their own.

• Transaction costs are the costs that parties incur in the process of agreeing to and following through on a negotiated settlement.

The Citrus Farmer & The Fisherman


The Coase Theorem

$2,000 $100

$300 $600

citrus farmer fishermanprofits per week profits per week

highoutput

lowoutput


The Coase Theorem

$2,000 $1,000

$300 $6,000

citrus farmer fishermanprofits per week profits per week

highoutput

lowoutput


PUBLIC POLICY TOWARD EXTERNALITIES

• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .

• command-and-control policies.

• market based policies (taxes, pollution permits)


More Examples

• Chickens and chicken litter

• Burning or hauling leaves/brush and debris

• Airport runways

• Over-fishing, over-grazing

• Microwave ovens

• Green space (woods, parks)

• The Brazilian Rainforest


PUBLIC POLICY TOWARD EXTERNALITIES

Policy Conundrum

There are no SOLUTIONS.

There are just TRADE-OFFS.

Copyright © 2004 South-Western Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.

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Transcript of Copyright © 2004 South-Western Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.