Mankiew Chapter 10
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Mankiew Chapter 10

Course Number: HOMEPAGES 201, Fall 2009

College/University: Western Michigan

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10 Externalities PRINCIPLES OF MICROECONOMICS FOURTH EDITION N. G R E G O R Y M A N K I W PowerPoint Slides 2007 Thomson South-Western, all rights reserved In this chapter, look for the answers to these questions: What is an externality? Why do externalities make market outcomes inefficient? How can people sometimes solve the problem of externalities on their own? Why do such private solutions not...

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OF MICROECONOMICS FOURTH 10 Externalities PRINCIPLES EDITION N. G R E G O R Y M A N K I W PowerPoint Slides 2007 Thomson South-Western, all rights reserved In this chapter, look for the answers to these questions: What is an externality? Why do externalities make market outcomes inefficient? How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? What public policies aim to solve the problem of externalities? CHAPTER 10 EXTERNALITIES 2 Introduction Recall one of the Ten Principles from Chap. 1: Markets are usually a good way to organize economic activity. Lesson from Chapter 7: In the absence of market failures, the competitive market outcome is efficient, maximizes total surplus. CHAPTER 10 EXTERNALITIES 3 Introduction One type of market failure: externalities. Externality: the uncompensated impact of one person's actions on the well-being of a bystander Negative externality: the effect on bystanders is adverse Positive externality: the effect on bystanders is beneficial CHAPTER 10 EXTERNALITIES 4 Introduction Self-interested buyers and sellers neglect the external effects of their actions, so the market outcome is not efficient. Another principle from Chapter 1: Governments can sometimes improve market outcomes. CHAPTER 10 EXTERNALITIES 5 Pollution: A Negative Externality Example of negative externality: Air pollution from a factory. The firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity. How govt may improve the market outcome: Impose a tax on the firm equal to the external cost of the pollution it generates CHAPTER 10 EXTERNALITIES 6 Other Examples of Negative Externalities the neighbor's barking dog late-night stereo blasting from the dorm room next to yours noise pollution from construction projects talking on cell phone while driving makes the roads less safe for others health risk to others from second-hand smoke CHAPTER 10 EXTERNALITIES 7 Positive Externalities from Education A more educated population benefits society: lower crime rates: educated people have more opportunities, so less likely to rob and steal educated people make better-informed voters better government: People do not consider these external benefits when deciding how much education to "purchase" Result: market eq'm quantity of education too low How govt may improve the market outcome: subsidize cost of education CHAPTER 10 EXTERNALITIES 8 Other Examples of Positive Externalities Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you. R&D creates knowledge others can use Renovating your house increases neighboring property values CHAPTER 10 EXTERNALITIES Thank you for not contaminating the fruit supply! 9 Recap of Welfare Economics P $5 4 3 $2.50 2 1 0 The market for gasoline The market eq'm maximizes consumer + producer surplus. Supply curve shows private cost, the costs directly incurred by sellers Demand curve shows private value, the value to buyers (the prices they are willing to pay) 0 10 20 25 30 Q (gallons) CHAPTER 10 EXTERNALITIES 10 Analysis of a Negative Externality P $5 4 3 2 1 0 The market for gasoline Social cost = private + external cost external cost Supply (private cost) External cost = value of the negative impact on bystanders = $1 per gallon (value of harm from smog, greenhouse gases) 11 0 10 20 30 Q (gallons) CHAPTER 10 EXTERNALITIES Analysis of a Negative Externality P $5 4 3 2 D 1 0 20 25 30 Q (gallons) The market for gasoline Social cost S The socially optimal quantity is 20 gallons. At any Q < 20, value of additional gas exceeds social cost At any Q > 20, social cost of the last gallon is greater than its value 12 0 10 CHAPTER 10 EXTERNALITIES Analysis of a Negative Externality P $5 4 3 2 D 1 0 20 25 30 Q (gallons) The market for gasoline Social cost S Market eq'm (Q = 25) is greater than social optimum (Q = 20) One solution: tax sellers $1/gallon, would shift supply curve up $1. 13 0 10 CHAPTER 10 EXTERNALITIES "Internalizing the Externality" Internalizing the externality: altering incentives so that people take account of the external effects of their actions In the previous example, the $1/gallon tax on sellers makes sellers' costs equal to social costs. When market participants must pay social costs, the market eq'm matches the social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.) CHAPTER 10 EXTERNALITIES 14 Positive Externalities In the presence of a positive externality, the social value of a good includes private value the direct value to buyers external benefit the value of the positive impact on bystanders The socially optimal Q maximizes welfare: At any lower Q, the social value of additional units exceeds their cost. At any higher Q, the cost of the last unit exceeds its social value. CHAPTER 10 EXTERNALITIES 15 A C T I V E L E A R N I N G 1: P The market for flu shots Analysis of a positive externality $50 40 30 20 10 0 0 10 20 30 D S External benefit = $10/shot Draw the social value curve. Find the socially optimal Q. What policy would internalize this externality? Q 16 A C T I V E L E A R N I N G 1: Answers $50 40 30 20 10 0 0 P The market for flu shots external benefit S Socially optimal Q = 25 shots To internalize the externality, use subsidy = $10/shot. Social value = private value + external benefit D 10 20 25 30 Q 17 Effects of Externalities: Summary If negative externality market produces a larger quantity than is socially desirable If positive externality market produces a smaller quantity than is socially desirable To remedy the problem, "internalize the externality" tax goods with negative externalities subsidize goods with positive externalities CHAPTER 10 EXTERNALITIES 18 Private Solutions to Externalities Types of private solutions: moral codes and social sanctions, e.g., the "Golden Rule" charities, e.g., the Sierra Club contracts between market participants and the affected bystanders CHAPTER 10 EXTERNALITIES 19 Private Solutions to Externalities The Coase theorem: If private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own. CHAPTER 10 EXTERNALITIES 20 The Coase Theorem: An Example Dick owns a dog named Spot. Negative externality: Spot's barking disturbs Jane, Dick's neighbor. The socially efficient outcome maximizes Dick's + Jane's well-being. If Dick values having Spot more than Jane values peace & quiet, the dog should stay. See Spot bark. Coase theorem: The private market will reach the efficient outcome on its own... CHAPTER 10 EXTERNALITIES 21 The Coase Theorem: An Example CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500 Cost to Jane of Spot's barking = $800 Socially efficient outcome: Spot goes bye-bye. Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off. Private outcome = efficient outcome. CHAPTER 10 EXTERNALITIES 22 The Coase Theorem: An Example CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000 Cost to Jane of Spot's barking = $800 Socially efficient outcome: See Spot stay. Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays. Private outcome = efficient outcome. CHAPTER 10 EXTERNALITIES 23 The Coase Theorem: An Example CASE 3: Benefit to Dick of having Spot = $500 Cost to Jane of Spot's barking = $800 But Jane has the legal right to peace & quiet. Socially efficient outcome: Dick keeps Spot. Private outcome: Dick pays Jane $600 to put up with Spot's barking. outcome Private = efficient outcome. The private market achieves the efficient outcome regardless of the initial distribution of rights. CHAPTER 10 EXTERNALITIES 24 A C T I V E L E A R N I N G 2: Brainstorming Collectively, the 1000 residents of Green Valley value swimming in Blue Lake at $100,000. A nearby factory pollutes the lake water, and would have to pay $50,000 for non-polluting equipment. A. Describe a Coase-like private solution. B. Can you think of any reasons why this solution might not work in the real world? 25 Why Private Solutions Do Not Always Work Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargain Sometimes when a beneficial agreement is possible, each party may hold out for a better deal. Coordination problems & costs when the number of parties is very large. CHAPTER 10 EXTERNALITIES 26 Public Policies Toward Externalities Two approaches Command-and-control policies regulate behavior directly. Examples: limits on quantity of pollution emitted requirements that firms adopt a particular technology to reduce emissions Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own. CHAPTER 10 EXTERNALITIES 27 MarketBased Policy #1: Corrective Taxes & Subsidies Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality Also called Pigouvian taxes after Arthur Pigou (1877-1959). The ideal corrective tax = external cost For activities with positive externalities, ideal corrective subsidy = external benefit CHAPTER 10 EXTERNALITIES 28 MarketBased Policy #1: Corrective Taxes & Subsidies Example: Acme, US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO2 causes acid rain & other health issues. Policy goal: reducing SO2 emissions 25% Policy options regulation: require each plant to cut emissions by 25% corrective tax: Make each plant pay a tax on each ton of SO2 emissions. Set tax at level that achieves goal. CHAPTER 10 EXTERNALITIES 29 MarketBased Policy #1: Corrective Taxes & Subsidies Suppose cost of reducing emissions is lower for Acme than for US Electric. Socially efficient outcome: Acme reduces emissions more than US Electric. The corrective tax is a price on the right to pollute. Like other prices, the tax allocates this "good" to the firms who value it most highly (US Electric). CHAPTER 10 EXTERNALITIES 30 MarketBased Policy #1: Corrective Taxes & Subsidies Under regulation, firms have no incentive to reduce emissions beyond the 25% target. A tax on emissions gives firms incentive to continue reducing emissions as long as the cost of doing so is less than the tax. If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. CHAPTER 10 EXTERNALITIES 31 MarketBased Policy #1: Corrective Taxes & Subsidies Other taxes distort incentives and move economy away from the social optimum. But corrective taxes enhance efficiency by aligning private with social incentives. CHAPTER 10 EXTERNALITIES 32 Example of a Corrective Tax: The Gas Tax The gas tax targets three negative externalities: congestion the more you drive, the more you contribute to congestion accidents larger vehicles cause more damage in an accident pollution burning fossil fuels produces greenhouse gases CHAPTER 10 EXTERNALITIES 33 A C T I V E L E A R N I N G 3: Discussion question Policy goal: Reducing gasoline consumption Two approaches: A. Enact regulations requiring automakers to produce more fuel-efficient vehicles B. Significantly raise the gas tax Discuss the merits of each approach. Which do you think would achieve the goal at lower cost? Who do you think would support or oppose each approach? 34 MarketBased Policy #2: Tradable Pollution Permits Recall: Acme, US Electric each emit 40 tons SO2, total of 80 tons. Goal: reduce emissions 25% (to 60 tons/month) Suppose cost of reducing emissions is $100/ton for Acme, $200/ton for US Electric. If regulation requires each firm to reduce 10 tons, cost to Acme: (10 tons) x ($100/ton) = $1,000 cost to USE: (10 tons) x ($200/ton) = $2,000 total cost of achieving goal = $3,000 CHAPTER 10 EXTERNALITIES 35 MarketBased Policy #2: Tradable Pollution Permits Alternative: issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons) give 30 permits to each firm establish market for trading permits Each firm can choose among these options: emit 30 tons of SO2, using all its permits emit < 30 tons, sell unused permits buy addi...
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