141A Economics Economics of Government Behavior I
Professor Francesca Mazzolari Fall 2007 Lecture 5
Outline for today
Externalities
What are externalities? Private sector solutions to externalities
Coase Theorem
Wednesday Public sector solutions
Taxes/Subsidies Regulation
Externalities (definition)
Externalities arise when the activity of one entity directly affects the welfare of another in a way that is outside the market mechanism
In other words, the actions of one party make the other party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so
Externalities represent a market failure for which government action could be appropriate and improve welfare
Externalities (definition)
Can be negative or positive
Negative externalities Qpvt > Q* Positive externality Qpvt < Q*
Can affect production (S) or consumption (D)
Ex: A negative production externality is when a firm's production reduces the well-being of others who are not compensated by the firm Ex: A negative consumption externality is when an individual's consumption reduces the well-being of others who are not compensated by the individual
Externalities (examples)
The most common examples have to do with the environment
pollution may be the by-product of production the big difference from any other good is that there is typically not a market for pollution you may really dislike breathing the polluted air and may even suffer bad health effects if there were a good "less pollution" or "pollution abatement" you would be willing to buy some of it
so the real problem is one of missing markets
Externalities (examples)
A specific example of negative externality due to pollution is global warming
Many scientists believe this warming trend is caused by human activity, namely the use of fossil fuels These fuels, such as coal, oil, natural gas, and gasoline produce carbon dioxide that in turn traps heat from the sun in the earth's atmosphere
Global average temperature
56.5
57.5
58.5
56
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Figure 1
57
58
Global Average Temperature Over Time
Year
Externalities (examples)
Although this warming trend has negative effects overall on society, the distributional consequences vary In much of the U.S., warmer temperatures will improve agricultural output and quality of life In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea levels If you're wondering why you should care about Bangladesh, then you have identified the market failure that arises from externalities From your private perspective, you shouldn't!
Externalities (examples)
There are other types of behaviors that can have negative effects on others
Smoking Playing music too loud!
An important class of negative externalities is known as common resources pools of scarce resources that are not restricted grazing land for cattle oil wells use of network or dial-in services
Externalities (examples)
There are also externalities that convey benefits on other people
Lojack
Small radio transmitter hidden in your car. If stolen, police turn it on remotely and track and recover car Research shows that for every 3 Lojacks installed in central city, car thefts reduced by one Positive externality means too few Lojacks are purchased
R&D charitable contributions Public goods and externalities are very closely related all of these things directly affect the utility of many others
What does it mean to be outside the market mechanism?
The activity is not reflected in prices
No one pays for it
Pollution example (negative production externality) A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river The fishermen downstream are harmed by this activity, as the fish die and their profits fall Fishermen are adversely affected but are they not compensated for this harm
What does it mean to be outside the market mechanism?
Example of something that is NOT an externality
Property values rise in California because people move here from other states So, it is more expensive for native Californians to buy a house One entity is affecting the welfare of another, but through prices Movers from other states pay for what they're doing While this may have distributive consequences, it is still efficient according to our strict Pareto definition
What do externalities do to the market?
When markets are complete:
Aggregate S curve represents Social Marginal Cost curve Aggregate D curve represents Social Marginal Benefit curve
First Fundamental Theorem of Welfare Economics
Valid when markets are complete The competitive market equilibrium is Pareto efficient (that is, it maximizes the total social surplus) MSB=MSC Pareto optimum
What do externalities do to the market?
In the presence of externalities
Production externalities: MSC MPC Consumption externalities: MSB MPB
Consumers and firms solve MPC=MPB
The equilibrium in the market is not Pareto optimum
Notation: Gruber reverses order in naming all curves (SMB instead of MSB, PMC instead of MPC, etc.)
Market for steel
(negative production externality)
$
DWL
MSC=MPC+MD S=MPC
MD
MD D=MSB=MPB
Q*
Qpvt
Q
Changes in welfare from correcting the externality
$ F G H I A E J B D MPC C MSB=MPB Q MSC
Qpvt PS
Q*
CS
SS
Changes in welfare from correcting the externality
$ F G H I A E J B D MPC C MSB=MPB Q MSC
Qpvt PS ACI
Q* ABEG
CS
SS
Changes in welfare from correcting the externality
$ F G H I A E J B D MPC C MSB=MPB Q MSC
Qpvt PS ACI
Q* ABEG
CS FCIEFGACDH ABEH SS
Changes in welfare from correcting the externality
$ F G H I A E J B D MPC C MSB=MPB Q MSC
Qpvt PS ACI
Q* ABEG
CS FCIEFGACDH ABEH SS HEFCDE HEF
Coase Theorem
Part I: When there are well-defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level
Thus, the role of government intervention may be very limited--that of simply assigning and enforcing property rights private markets will "internalize" externalities and arrive at efficient allocation
Coase Thm, Part II
Efficient solution is independent of who is assigned the property rights, so long ...