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Unformatted text preview: 344 CHAPTER 15 EXTERNALITIES Externalities in Our Lives A cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer is called an exter- naiity. Let’s review the range of externalities, classify them, and look at some everyday examples. An externaliry can arise from either production or consumption, and it can be either a negative externality, which imposes an enemal cost, or a posi- tive extemality, which provides an external benefit. 50 there are four types of externalities: I Negative production externalities I Positive production externalities l Negative consumption externalities I Positive consumption externalities Negative Production Externalities The Lincoln Tunnel, which connects New Jersey to Manhattan under the Hudson River, is 1.5 miles long. Yet it can take 2 hours to get through the run— nel in the worst traffic. Each rush—hour user of the Lincoln Tunnel imposes a negative production exter- nality on the other users. When you run your air—conditioning, use hot water, drive a car, or even take a bus or train, your acrion contributes to pollution of the atmosphere. Pollution is another example ofa negative production externality. Positive Production Externalities If a honey farmer locates beehives beside an orange grower’s orchard, two positive production externali— ries arise. The honey farmer gets a positive produc- tion externality from the orange grower because the bees collect pollen and nectar from orange blossoms. And the orange grower gets a positive producrion externaliry because the bees pollinate the blossoms. Negative Consumption Externaiities Negative consumption externalities are a source of irritation for most of us. Smoking tobacco in a con— fined space creates fumes that many people find unpleasant and that pose a health risk. Smoking cre- ates a negative consumption externality. To deal with this externality, in many places and in almost all pub- lic places, smoking is banned. But banning smoking imposes a negative consumption externality on smok- ers! The majority i 'poses a cost on the minority— the smokers who w uld prefer to consume tobacco while dining or takihg a plane trip. Noisy partiesand outdoor rock concerts are other examples of ntgative consumption externalities. They are also examples of the fact that a simple ban on an activity is not a solution. Banning noisy parties avoids the external cost on sleep—seeking neighbors, but it results in the isleepers imposing an external cost on the fun-seeking partygoers. Permitting dandelions to grow in lawns, not picking up leaves in the fall, and allowing a dog to bark loudly or to fopl a neighbor’s lawn are other sources of negative consumption externalities. Positive Consumption Externaiities When you get a flu vaccination, you lower your risk of getting infecred ibis winter. But if you avoid the flu, your neighbor Who didn’t get vaccinated has a better chance of aviiding it too. Flu vaccination generates positive c nSumption externalities. When the owner of a historic building restores it, everyone who sees ihe building gets pleasure from it. Similarly, when so eone erects a spectacular house— such as those builtrliiy Frank Lloyd Wright during the 19203 and 19305—ior another exciting building— such as the Chrysler Building and the Empire State Building in New Y rk or the Wrigley Building in Chicago—an ester 3] consumption benefit flows to everyone who h::E‘oppormnity to view it. Educa— tion, which we ine in this chapter, is another example of this typ of externality. 1 What are the ur types of externality. 2 Try to think 0 an example of each type of ‘ externality, di erent from the ones described above. 3 How are the eiiternalities that you’ve described addressed, eithier by the market or by public policy? i MlCROE’CoMMM t, 3"" mmofi‘ '. \i,, Negative Externalities: Pollution Pollution is not a new problem and is not restricted to rich industrial countries. Preindustrial towns and cities in Europe had sewage disposal problems that created cholera epidemics and plagues that killed millions. London’s air in the Middle Ages was dirtier than that ofLos Angeles today. Some of the worsr pollution today is found in Russia and China. Nor is the desire to find solutions to pollution new. The development in the fourteenth century of garbage and sewage disposal is an example of early attempts to tackle pollution. Popular discussions of pollution usually pay little attention to economics. They focus on physical aspects of the problem, not on the costs and benefits. A common assumption is that if people’s actions cause any pollution, those actions must cease. In con— trast, an economic Study of pollution emphasizes costs and benefits. An economist talks about the effi— cient amount of pollution. This emphasis on costs and benefits does not mean that economists, as citi— zens, do not share the same goals as others and value a healthy environment. Nor does it mean that econo— mists have the right answers and everyone else has the wrong ones (or vice versa). The starting point for an economic analysis of pollution is the demand For a pollution—free environment. The Demand for a Pollution-Free Environment The demand for a pollution-free environment is greater today than it has ever been. We express this demand by joining organizations that lobby for antipollution regulations and policies. We vote for politicians who support the policies that we Want to see implemented. We buy “green” products, even if we pay a bit more to do so. And we pay higher housing costs and com- muting costs to live in pleasant neighborhoods. The demand for a pollution—free environment has grown for two main reasons. First, as Our incomes increase, we demand a larger range of goods and services, and one of these “goods” is a pollution-free environment. We value clean air, unspoiled natural scenery, and wildlife, and we are willing and able to pay for them. Second, as our knowledge of the eficects of pollu— tion grows, we are able to take measures that reduce those effects. For example, now that we know how sulfur dioxide causes acid rain and how clearing rain forests destroys natural stores of carbon dioxide, we NEGATIVE EXTERNALIT‘zEs: POLLUTION 345 are able, in principle, to design measures that limit ' these problems. Let’s look at the rangghof pollution problems that have been identified and problems. The Sources of Poiiutidn e actions that create those Economic activity pollutes air, water, and land, and these individual areas ofpbllution interact through the ecosystem. Air Pollution Sixty perceri t of our air pollution comes from road transportation tricl induStrial processes. Only 16 percent arises fro tion. A common belief is electric power genera— at air pollution is getting worse. In many developinlglcountties, air pollution is getting worse. But air pol tion in the United States is getting less severe for mbst substances. Figure 15.1 shows the trends in the concentrations of six air pol— lutants. Lead has been almosr eliminated from our air. Sulfur dioxide, carbon monoxide, and suspended particulates have been reduced to around a half of their 1980 levels. And even the more stubborn ozone and nitrogen dioxide hav ‘been reduced to around 70 percent of their 1980 lev 5 These reductions in ldvels of air pollution are even more impressive when they are compared with the level of economic activity. Between 1970 and 2000, total production nil-the United States increased 5 by 158 percent. During t same period, vehicle miles traveled increased by 143 percent, energy conr sumption increased by 45 percent, and the popular tion increased by 36 percent. While all this economic activity was on the increas sources decreased by 29 peggent. While the Facts about , air pollution from all e sources and trends in air pollution are not in doubt. there is disagreement about the affirm of air pollution. The least controversial is acid rain caused by sulfur '0xide and nitrogen oxide emissions from coals and —fired generators of electric utilities. Acid rain begins "th air pollution, and it leads to water pollution an damages vegetation. More controversial ar airborne substances (sus- pended particulates) such lead from leaded gaso- line. Some scientists beli e that in sufficiently large concentrations, these subs ances (189 of which have currently been identified) threatening conditions. use cancer and other life— 546 CHAPTER 15 EXTERNALITIES FIGURE l5.l Trends in Air Pollution git. {its-recounts "‘ 120. § n 0 10C}. to o — 5 BO. 1: a if d' ‘d E 60. So ur onu e a: Suspended g particulates 5 40- U = 3 E 200 .2 .n E < 0..«r,r...-.;.........tt. 1930 1985 1990 1995 2000 Year Lead has almost been eliminated from our air; concentra- tions of carbon monoxide,sulfur dioxide,and suspended particulates have decreased to about 50 percent of their I980 levels;and nitrogen dioxide and ozone have fallen to about 70 percent of their I980 levels. Source of data: US. Environmental Protection Agency, NationaMir Quality‘ and Emissions Trend: Report, i999 and 2000. Even more controversial is glooal worming, which some scientists believe results from the carbon diox- ide emissions. The earth’s average temperature has increased over the past 100 years, but most of the increase occurred 5467': 1940. Determining what causes changes in the earth's temperature and isolat- ing the effect of carbon dioxide from other factors are proving to be difficult. Equally controversial is the problem of ozone layer depletion. There is no doubt that a hole in the ozone layer exists over Antarctim and that the ozone layer protects us from cancer—causing ultraviolet rays from the sun. But how our industrial activity influences the ozone layer is simply not understood at this time. One air pollution problem has almost been elim— inated: lead from gasoline. In part, this happened because the cost of living without leaded gasoline, it turns out, is not high. But sulfur dioxide and the so— called greenhouse gases are a much tougher problem to tackle. Their alternatives are costly or have pollu- tion problems of eir own. The major sources of these pollutants Road vehicles c e road vehicles and electric utilities. be made “greener” in a variety of ways. One is with new fuels, and some alternatives being investigated are alcohol, natural gas, propane and butane, and hydrogen. Another way of making cars and trucks “ of gasoline. Refi reener” is to change the chemistry rs are working on reformulations of gasoline that reduce tailpipe emissions. Similarly, electricity can be generated in cleaner ways by har- nessing wind pm, solar power, tidal power, or geo- thermal power. ile technically possible, these methods are more costly than conventional carbon- fiieled generators This method is god for air pollution but creates a potential long-term problem for land and water pol- lution because thpre is no known entirely safe method of disposing of spent nuclear fuel. . Another alternative is nuclear power. 'n Water Poliution The largest sources of water pollu- tion are the dum ing of industrial waste and treated sewage in lakes izers. A more dr of crude oil into spill in Alaska in cl rivers and the runoff from fertil— atic source is the accidental spilling e oceans such as the Exxon Valdez 1939. There are two main alternatives to polluting the waterways and 0 ing of wasre to r other, in wide us sites for Storage i eans. One is the chemical process- der it inert or biodegradable. The :for nuclear waste, is to use land secure containers. Land Pollution Land pollution arises from dumping toxic waste products. Ordinary household garbage does not pose a gollution problem unless contami— nants from dum ply. This possibil capacity and less eStimated that 8 and other East ed garbage seep into the water sup- ty increases as landfills reach suitable landfill sites are-used. It is percent of existing landfills will be ast states) and some countries full by 2010. Sge regions (New York, New Jersey, (Japan and the etherlands) are seeking less costly alternatives to landfill, such as recycling and incinera— tion. Recycling is an apparently attractive alternative, but it requires investment in new technologies to be eEective. Inciperation is a high—cost alternative to landfill, and it p these alternative cient only when We’ve seen oduces air pollution. Furthermore, are not free, and they become effi— e cost of using landfill is high. at the demand for a pollution—free environment has: grown, and we’ve described the l range of pollution problems. Let’s now look at the economics of these problems. The starting point is the distinction between private costs and social costs. Private Costs and Social Costs A private can of production is a cost that is borne by the producer of a good or service. Marginal cart is the cost of producing an additional unit of a good or service. So marginal private cost (MC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service. You’ve seen that an external cart is a cost of produc- ing a good or service that is not home by the producer but borne by Other people. A marginal external cost is the cost of producing an additional unit of a good or service that falls on people Other than the producer. Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost. That is, MSC = MC + Marginal external cost. We express costs in dollars. But we must always remember that a cost is an opportunity cost—what we give up to get something. A marginal external cost is what someone other than the producer of a good or service must give up when the producer makes one more unit of the good or service. Something real, such as a clean river or clean air, is given up. Valuing an External Cost Economists use market prices to put a dollar value on the cost of pollution. For example, Suppose that there are two similar rivers, one polluted and the other clean. Five hundred iden— tical homes are built along the side of each river. The homes on the clean river rent for $2,500 a month, and those on the polluted river rent for $1,500 a month. If the pollution is the only detectable differ— ence between the two rivers and the two locations, the rent decrease of $1,000 per month is the cost of the pollution. For the 500 homes on the polluted river, the external cost is $500,000 a month. External Cost and Output Figure 15.2 shows an example of the relationship between output and cost in a chemical industry that pollutes. The marginal cost curve, MC, describes the marginal private cost borne by the firms that produce the chemical. Marginal cost increases as the quantity of chemical produced NEGATIVE EXTERNAtITIEs: POLLUTION 347 l increases. If the firms cjump waste into a river, they impose an external cos that increases with the amount of the chemical produced. The marginal social cost curve, MSC is the sum of marginal private cost and marginal exteinal cost. For example, when output is 4,000 tons oil chemical a month, marginal private cost is $100 a ton, marginal external cost is $125 a ton, and marginal social cost is $225 a ton. In Fig. 15.2, when the quantity of chemical produced increases, the amount of pollution increases and the external cost oi pollution increases. Figure 15.2 shows the relationship between the quantity of chemical produced and the cost of the pollution it creates, but it doesn’t tell us how much pollution gets created. That quantity depends on how the market for the chemical operates. First, we’ll see what happens when the industry is free to pollute. l FIGURE I5.2 A External Cost “E .9 300 § MSC % Marginal -_o_ social cost ‘8" U 225 ....fi Marginal ‘ external cost E 150 '5 MC 75 :- _ Marginal” ' private cost. 0 Quonliiy [lhousonds of ions of chemical per monlh] The MC curve shows th marginal private cost borne by the factories that produ e a chemical.The MSC curve shows the sum of marginal pri te cost and marginal external costWhen output is 4, 00 tons of chemical a month, mar- ginal private cost is SI a ton,marginal external cost is $|25 a ton. and margin social cost is $225 a ton. 348 CHAPTER 15 EXTERNALITIES Production and Pollution: How Much? When an industry is unregulated, the amount of pol- lution it creates depends on the market equilibrium price and quantity of the good produced. In Fig. 15.3, the demand curve for a pollution-creating chemical is D. This curve also measures the social bene- fit, M53, of the chemical. The supply curve is .S'. This curve also measures the producers’ marginal private cost, MC. The supply curve is the marginal private cost curve because when firms make their production and supply decisions, they consider only the costs that theywill bear. Market equilibrium occurs at a price of $100 a ton and 4,000 tons of chemical a month. This equilibrium is inefficient. You learned in Chapter 5 that the allocation of resources is efficient when marginal social benefit equals marginal social cost. But we must count all the costs—private and external—when we compare marginal social benefit and marginal social cost. So with an external cost, the allocation is efficient when marginal social benefit equals marginal social cost. This outcome occurs when the quantity of chemical produced is 2,000 tons a month. The unregulated market overproduces by 2,000 tons of chemical a month and creates a deadweight loss shown by the gray triangle. How can the people who live by the polluted river get the chemical factories to decrease their out— put of chemical and create less pollution? If some method can be found to achieve this outcome, every‘ one—the owners of the chemical factories and the residents of the riverside homes—can gain. Let’s explore some solutions. Property Rights Sometimes it is possible to reduce the inefficiency arising from an externalin by establishing a property right where one does not currently exist. Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the cOurts. Suppose that the chemical factories own the river and the 500 homes alongside it. The rent that people are willing to pay depends on the amount of pollution. Using the earlier example, people are willing to pay $2,500 a month to live alongside a pollution—free river but only $1,500 a month to live with the pollution created by 4,000 tons of chemical a month. If the factories produce this quantity, they lose $1,000 a month for each home and a total of $500,000 a month. FIGURE l5.3 Inefficiency with an External Cost social b Inelflcieni‘: ' marker 5 300 iii Marginal E social l =0 c051 ‘ o . 1 l 1 . . . . . . . . . . . . . . . . . . . . .. ‘ . . . . . — . . . . . . . . . . . — . . . — . . . . n. . C , I D II D g . . a: Marsm' Quantity [lhousonds of ions of chemical per man" The supply curve is the marginal private cost curve, S = MC. The demand c we is the marginal social benefit curve”, D = MSB. Market eiuiiibrium at a price of $|00 a ton and I 4,000 tons a month, is inefficient because marginal social cost exceeds margi al social benefit. The efficient quantity is 2,000 tons a mo h.The gray triangle shows the dead weight loss created by the pollution externality. ‘ . The chemical fiictpries are now confronted with the cost of their pollution—forgone rent from the people who live by the ri er. ' Figure 15.4 il ustrates the outcome by using the _ same example as i Fig. 15.3. With property rights in I place, the M C cu . e no longer measures all the costs that the factories co in producing the chemical. It excludes the pollu ion coscs that they must now hear. The MSC curve n w becomes the marginal private fl: cost curve MC. the costs fall on the factories, so the market suppl curve is based on all the marginal . costs and is the c rve labeled S = MC = MSC. Market equili rium now occurs at a price of $150 a ton and LPOO tons of chemical a month. This outcome is efficie t. The factories still produce some pollution, but it ill the efficient quantity. FIGURE I5.4 w i' '."',-,=econiu:;h Property Rights Achieve an Efficient Outcome ’c— 2 300 3 Price equals 5 = MC ' MSC :9 marginal social :3 cost and marginal E social benefit 0 g . . . . I . . I . I I . . v - I . . . . ..- . . y . . . . . 4 r n I . u . - - - - - - . I I I a a . a I u .- a‘ g Ethcient i' ' pollution 3 market . borne by E equilibrium polluter 150 MC excluding pollution cost mo 75 0 2 4 6 Quantity {thousands of tons of chemical per month) With property rights, the marginal cost curve that excludes pollution costs shows only part of the producers' marginal cost. The marginal private cost curve includes the cost of pollution. so the supply curve is S = MC = MSC. Market equilibrium is at a price of $150 a ton anti 2.000 tons of chemical a month and is efficient because marginal social cost equals marginal social benefit. The efficient quantity of pollution is not zero. The Coase Theorem Does it matter how property rights are assigned? Does it matter whether the polluter or the victim of the pol- lution owns the resource that might be polluted? Until 1960, everyone thought that it did matter. But in 1960, Ronald Coase (see p. 380) had a remarkable insight, now called the Coase theorem. The Cease theorem is the proposition that if property rights exist, if only a small number of par— ties are involved, and if transactions costs are low, then private transactions are efficient. There are no externalities because the transacting parties take all the costs and benefits into account. Furthermore, it doesn’t matter who has the property rights. NEGATIVE Exrrilmtrrrrs: POLLUTION 349 Application of the tease Theorem In the example that we’ve just stu 'ed, the factories own the river and the homes. Su pose that instead, the residents own their homes :1 the river. Now the factories must pay a fee to e homeowners for the right to dump their waste. The greater the quantity of waste dumped into the river, the more the factories must pay. So again, the ctories face the opportunity cost of the pollution th create. The quantity of chemical produced and the iamount ofwasre dumped are the same whoever ow s the homes and the river. If the factories own thetil, they bear the cost of pollution because they rccei e a lower income from home rents. And if the r sidents own the homes and the river, the factories ear the cost of pollution because they must pay a f to the homeowners. In borh cases, the factories bear it cost of their pollution and dump the efficient amo t of waste into the river. The Coase so tion works only when transactions costs are low. Tran actions costs are the opportunity costs of conductin a transaction. For example, when you buy a house, ou incur a series of transactions costs. You might best place and a la that the seller 0 s the property and that after you’ve paid for it, the ow ership has been properly trans— ferred to you. In the example of the homes alongside a river, the transactions costs that are incurred by a small number of chemital factories and a few homeowners might be low eno gh to enable them to negotiate the deals that producfifan efficient outcome. But in many situations, transa ions costs are so high that it would be inefficient to i cut them. In these situations, the Coase solution is not available. Suppose, for examplesthat everyone owns the airspace above their homes up to, say, 10 miles. If someone pollutes your airspace, you can charge a fee. But to collect the fee, you must identify who is pol- luting your airsp e and persuade them to pay you. Imagine the costs of negotiating and enforcing agree- ments with the 5' million people who live in your part of the Unite States (and perhaps in Canada or Mexico) and the everal thousand factories that emit sulfur dioxide an create acid rain that falls on your property! In this iruation, we use public choices to cope with extern ities. But the transactions costs that block a marker 5 lution are real costs, so attempts by the government deal with cxtetnalities offer no easy solution. Lets look at some of these attempts. 350 CHAPTER 15 EXTERNALITIES Government Actions in the Face of External Costs The three main methods that governments use to cope with externalities are I Taxes I Emission charges I Marketable permits Taxes The government can use taxes as an incentive for producers to cut back on pollution. Taxes used in this way are called Pigovian taxes, in honor of Arthur Cecil Pigou, the British economist who first worked out this method of dealing with mernalities during the 19203. By setting the tax equal to the marginal external cosr, firms can be made to behave in the same way as they would if they bore the cost of the externality directly. To see how government actions can change market outcomes in the face of externalities, let’s return to the example of the chemical factories and the river. ' Assume that the government has assessed the marginal exrernal cost accurately and imposes a tax on the factories that exactly equals this cost. Figure 15.5 illustrates the effects of this tax. The demand curve and marginal social benefit curve, D = M53, and the firms’ marginal cost curve, MC, are the same as in Fig. 15.3. The pollution tax equals the marginal external cost of the pollution. We add this tax to the marginal private cost to find the market supply curve. This curve is the one labeled 5 = MC + tax = MSC. This curve is the market supply curve because it tells us the quantity supplied at each price given the firms’ marginal cost and the tax they must pay. This curve is also the marginal social cosr curve because the pollution tax has been set equal to the marginal external cost. Demand and supply now determine the market equilibrium price at $150 a ton and a quantity at 2,000 tons of chemical a month. At this quantity of chemical production, the marginal social cost is $150 and the marginal social benefit is $150, so the out— come is ePficient. The firms incur a marginal cost of $88 a ton and pay a tax of $62 a ton. The govern- ment collects tax revenue of $124,000 a month. Emission Charges Emission charges are an alternative to a tax for confronting a polluter with the external cost of pollution. The government sets a price per unit of pollution. The more pollution a firm creates, the more it A Pollution Tax to Achieve an Efficient Outcome FIGURE 15.5 w -i| iii-econlnb E 300 at s = MC + tax = Msc :5 Marginal 'soci - -8 cost and ‘morg 7;: social beneiil o .3 225 c U .3 o: I: Pollution " icix 2 4 6 eronlity [lhousands of tons 01" chemical per month] A pollution tax is im osed equal to the marginal external cost of poliution.Tl1 supply curve becomes the marginal private cost curve. C, plus the tax—S = MC + tax. Market equilibrium is at a pliice of $|50 a ton and 2,000 tons of chemical a month arid is efficient because marginal social cost equals marginal social benefit. The government col- lects-a tax revenue Town by the purple rem-angle. pays in emission ch es. This method of dealing with pollution externali has been used only modestly in the United States b t is common in Europe where, for example, France, G many, and the Netherlands make water polluters pay waste disposal charge. To work out tjfe emission charge that achieves efficiency, the gov rnment needs a lot of information about the polluting industry that, in practice, is rarely available. Marketable Permits Instead of taxing or imposing emission charges on polluters, each potential polluter might be assigned a permitted pollution limit. Each firm knows its owri costs and benefits of pollution, and making pollut on limits marketable is a clever way of using this ivate information that is unknown to the governmentT The government issues each firm a ,, 7,4, . . . i.r_fi_,,.ww.—~-- permit to emit a certain amount of pollution, and firms can buy and sell these permits. Firms that have a low marginal cost of reducing pollution sell their pet— mits, and firms that have a high marginal cost of reducing pollution buy permits. The market in per- mits determines the price at which firms trade per- mits. Each firm buys or sells permits until its marginal cost of pollution equals the market price of a permit. This method of dealing with pollution provides an even stronger incentive than do emission charges to find technologia that pollute less because the price of a per— mit to pollute rises as the demand for permits increases. The Market for Emission Permits in the United States Trading in lead pollution permits became common during the 19805, and this marketable per- mit program has been rated a success. It enabled lead to be virtually eliminated from the atmosphere of the United States (see Fig. 15.1). But this success might nor easily translate to other situations because lead pollution has some special features. First, most lead pollution came from a single source: leaded gasoline. Second, lead in gasoline is easily monir rored. Third, the objective of the program was clear: to eliminate lead in gasoline. The Environmental Protection Agency is now considering using marketable permits to promote efficiency in the control of chlorofluorocatbons, the gases that are believed to damage the ozone layer. 1 What is the distinction between private cost ' and social cost? 5 2 How does a negative externality prevent a com- 5 : petitive market from allocating resources efii— ‘ ciently? E 3 How can a negative externality be eliminated by assigning property rights? How does this 3 method of coping with an externality work? 5 4 How do taxes help us to cope with negative externalities? At what level must a pollution tax 1', be set if it is to induce firms to produce the efi‘i— cient quantity of pollution? ' 5 How do emission charges and marketable ' pollution permits work? Study Plan 15.2 xii, it'rr-‘econ‘nb Posrrws EXTERNALirits: KNOWLEDGE 351 _______.—.__..l.__.—-———-——-— Positive Externalities: Knowledge Knowledge comes fro education and research. To study the economics (I)? knowledge, we must distin— guish between private benefits and social benefits. Private Benefits and Social Benefits Aprimte benefit is a bdnefit that the consumer of a good or service receives. Marginal emefit is the bene- fit from an additional m't of a good or service. So a marginal private benefiE (MB) is the benefit from an additional unit of a go d or service that the con- sumer of that good or service receives. The external 5m 1: from a good or service is the benefit that someeiiee other than the consumer receives. A marginal rnal benefit is the benefit from an additional unit of a good or service that people other than the consumer enjoy. Marginal social behefit (M53) is the marginal benefit enjoyed by society—by the consumer of a good or service (marginal private benefit) plus the marginal benefit enjoyed by others (the marginal external benefit). That is, MSB = MB + iMarginal external benefit. Figure 15.6 shows an example of the relationship between marginal priiiate benefit, marginal external benefit, and marginal lsocial benefit. The marginal benefit curve, MB, d cribes the marginal private benefit—such as exp ded job opportunities and higher incomes—enj yed by college graduates. Marginal private ben fit decreases as the quantity of education increas . I But college grad tes generate external benefits. On the average, they end to be better citizens. Their crime rates are lower, d they are more tolerant of the views of others. society with a large number of college graduates can upport activities such as high— quality newspapers (1 television channels, music, theater, and other or anized social activities. In the example i Fig. 15.6, the marginal eater— nal benefit is $15,00 per student per year when 15 million students cut 1 in college. The marginal social benefit curve, MSB, ' the sum of marginal private benefit and marginal external benefit. For example, when 15 million stu ents a year enroll in college, the marginal private benpfit is $10,000 per student and 352 CHAPTER 15 EXTERNALJTIES FIGURE l5.6 An External Benefit Marginal social benefit L.) O h) LII Marginal external benefit: M O Price {thousands oF dollars per student per year) M53 0 Marg inal private benefit 0 5 10 15 20 25 Quantity (millions of students per year) The MB curve shows the marginal private benefit enjoyed by the people who receive a college education. The MSB curve shows the sum of marginal private benefit and mar- ginal external benefit.When l5 million students attend col- lege. marginal private benefit is $|0,000 per student, mar- ginal external benefit is $|5.000 per student, and marginal social benefit is $25,000 per student. the marginal external benefit is $15,000 per student, so the marginal social benefit is $25,000 per student. When people make schooling decisions, they ignore its external benefits and consider only its pri— vate benefits. So if education were provided by pri~ vate schools that charged full-cost tuition, we would produce too few college graduates. Figure 15.7 illustrates the underproduction if the government left education to the private market. The supply curve is the marginal social cost curve, .9 = MSC. The demand curve is the marginal private benefit curve, D = MB. Market equilibrium occurs at a tuition of $15,000 per student per year and 7.5 million students per year. At this equilibrium, mar— ginal social benefit is $38,000 per student, which exceeds marginal social cost by $15,000. There are too few students in college. The efficient number is 15 million per year, where marginal social benefit FIGURE l5.7 Inefficiencywith an ' External Benefit b) m3 Deadweight s = Msc loss El'licient equilibrium Marginal" 7 social benefit Ln) 0 M 0 U1 MSB "a O Price and cost llhausands of dollars per student per year] Ni U1 Inefficient _ market 3 equilibrium Marginal . - D sacral cos! MB O 5 75 10 15 20 25 Quantity [millions of students per year] The market demand curve is due marginal private benefit curve,D = MB.The supply curve is the marginal social cost curveS = MSC. Market equilibrium at a tuition of $6,000 a year and 7.5 miliiori students is inefficient because marginal social benefit exceeds marginal social cost The efficient quantity is l5 milli students.A deadweight lass arises (gray triangle) beca so too few studenu enroll in college. equals marginal sicial cost. The gray triangle shows the deadweightl s. Underprodu ion similar to that in Fig. 15.7 would occur in g de school and high school if an unregulated marker produced it. When children learn basic reading, writing, and number skills, they receive the private benefit; of increased earning power. But even these basic sllills bring the external benefit of developing better itizcns. External ben new knowledge. retailing, everyone was free to copy the idea, and malls spread like mushrooms. Once someone has discovered a basic idea others can copy it. They do have to work to copy an idea, so they face an opportunity cost. But they do not usu- ally have to pay a fee to use it. When people make decisions, they ignore the external benefits and con- sider only the private benefits. When people make decisions about the amount of education or research to undertake, they balance the marginal private cost against the marginal pri- vate benefit. They ignore the external benefit. As a result, if we left education and research to unregu- lated market forces, we would get too little of these activities. To get closer to producing the efficient quantity of a good or service that generates an external benefit, we make public choices, through governments, to modify the market outcome. is o Eiiicieni ‘5 = MSC market ' equiiibrium Marginal social benefit equals marginal social cue (A O M O C) Price and casi (lhousands oi dollars per siudeni per year} M U! 0 5 10 15 20 25 Quantity [millions of sludenl's per year] (a) Public provision in part (a). marginal social benefit equals marginal social cost with IS million students per year. the efficient quantity. Tuition is set at $ | 0,000 per- student equal to marginal private benefit. Taxpayers cover the other $ I 5,000 of cost per student. 1:. 0 Ed D M LII M O _. 0 Price and cost llhousands of dollars per sludenl per year] POSITIVE EXTERNAtITIEs: KNOWLEDGE 353 Government Actions in the Face of External Benefits Four devices that governments can use to achieve a more efficient allocatipn of resources in the presence of external benefits are I Public provision I Private subsidies l Vouchers l Patents and copyrights Public Provision Under public provision, a public authority that receives its revenue from the govern— ment produces the gobd or service. The education services produced by e public universities, colleges, and schools are exam ies of public provision. Figure 15.8(a) sh ws how public provision might overcome the underpr duetion that arises in Fig. 15.7. l FIGURE I5.8 Public Provision or Private Subsidy to Achieve an Effici¥nt Outcome . coniob 5.;J = MSC Marginal social beneFil equals - marginal social cost Subsidy of 51 5.000 per sludeni SI = MSC — subsidy MSB Efficient marital equilibrium 0 5 10 15 20 25 Quantity [millions of students per year]I (b) Private subsidy In part (b), with a subsidylof $ | 5.000 per student, the supply curve is s. = MSC — subsidy. The equilibrium price is $10,000. and the market equilibriu is efficient with IS million students per year. Marginal social b nefit equals marginal social cost 354 CHAPTER 15 EXTERNALITIES Public provision cannor lower the cost of production, so marginal social cost is the same as before. Marginal private benefit and marginal external benefit are also the same as before. The efficient quantity occurs Where marginal social benefit equals marginal social cost. In Fig. 15.8(a), this quantity is 15 million students. Tuition is set to ensure that the eEicient number of students enrolls. That is, tuition is set equal to the marginal pri— vate benefit at the efficient quantiEY- In Fig. 15.8(a), tuition is $10,000 a year. The rest of the cost of the public university is borne by the taxpayers and, in this example, is $15,000 per Student per year. Private Subsidies A subsidy is a payment that the government makes to private producers. By making the subsidy depend on the level of output, the gov- ernment can induce private decision makers to con- sider external benefits when they make their choices. Figure 15.8(b) shows how a subsidy to private colleges works. In the absence of a subsidy, the mar— ket supply curve is So = M5 C. The demand curve is the marginal private benefit curve, D = MB. If the government provides a subsidy to colleges of $15,000 per student per year, we must subtracr the subsidy from the college’s marginal cost to find the new market supply curve. That curve is S; = M5 C - subsidy. The market equilibrium is tuition of $10,000 a year and 15 milliou students a year. The marginal social cost of educating 15 million students is $25,000 and the marginal social benefit is $25,000. 50 with marginal social cost equal to marginal social benefit, the sub- sidy has achieved an efficient outcome. The tuition and the subsidy just cover the colleges’ marginal cost. ...
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This note was uploaded on 06/09/2011 for the course ECON 330 taught by Professor Marble during the Spring '11 term at University of Texas at Austin.

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externalities_parkin - 344 CHAPTER 15 EXTERNALITIES...

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