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Unformatted text preview: PADP 6950: Founda1ons of Policy Analysis Externali*es Angela Fer1g, PhD The Role of Government in a Market Economy Under a system of compe11ve markets, resources will be allocated efficiently without direct government interven1on in the produc1on or distribu1on of goods As long as all market par1cipants take into account the full social costs and benefits of their ac1ons (no externali1es exist) Even without market failure, there is always poten1ally an equity ra1onale for government interven1on However, this role is simply to redistribute resources while crea1ng as few price and quan1ty distor1ons as possible. Also note that for compe11ve markets to func1on properly it is necessary for the government to establish a system of legal ins1tu1ons to protect property rights and facilitate the voluntary exchange of goods and services 1 An efficiency ra1onale for government interven1on In some cases, a market system can fail to allocate resources efficiently in the absence of government interven1on. These cases, where a market failure exists, include: Missing markets Monopoly power Informa1on Asymmetries Externali1es Public goods Market Failure: Market Failures and Policy Responses A missing market is a situa1on where the good in ques1on is not exchanged through market transac1ons. If the relevant market does not exist, we cannot really expect a market system to allocate the good efficiently. The policy response in this case is to try and create the needed market Monopoly power is the failure of too liTle compe11on. The policy response is to promote compe11on and punish firms that abuse monopoly power or try to gain monopoly power through misconduct. Informa1on asymmetries occur when the two sides of a transac1on have different amounts of informa1on. The policy response is to provide incen1ves for the more informed party to reveal the informa1on to the less informed party. 2 Market Failures and Policy Responses An externality is a situa1on where the ac1ons of one agent impose costs or benefits on other agents, but these spillover costs and benefits are not priced in market transac1ons Policy response is to tax or subsidize the ac1vity that creates the externality, in order to get the agent to internalize the spillover costs or benefits A public good is a good that benefits the en1re community, but cannot be withheld from those who do not pay for it Policy response is for the government to provide the good directly, or to enter into a contract with a private firm whose job it is to provide the good The Efficiency Ra1onale In general, the existence of a market failure provides an "efficiency ra1onale" for government interven1on The government's role is to increase efficiency by altering the price signals faced by agents so that they take into account the full social costs and benefits of their ac1ons 3 Externali1es An externality is an example of a market failure The ac1ons of some agent (consumer or producer) impose costs or benefits on other agents that are not priced in market transac1ons When there is an externality, the market does not produce the efficient quan1ty of the good that creates the externality There is an opportunity for government interven1on to increase the efficiency of resource alloca1on Nega1ve externali1es A nega1ve externality occurs when the ac1ons of one agent impose costs on others, but the agent does not have to compensate anyone for these costs Can result from consump1on or produc1on ac1vi1es Examples: Pollu1on Exploita1on / deple1on of natural resources Traffic conges1on Poor property maintenance Criminal behavior With a nega1ve externality, compe11ve market exchanges result in too much of the ac1vity that creates the externality 4 Economic Analysis of Nega1ve Externali1es Consider a nega1ve externality in produc1on (such as pollu1on) Then the marginal social cost of produc1on exceeds the marginal private cost: MSC MEC = marginal external cost P MEC MPC = S Market equilibrium quan1ty (Q*) is greater than socially op1mal quan1ty (Q0) MB = D Q0 Q* Q Policy Solu1on: Pigouvian Taxes Suppose the government puts a tax on produc1on equal to the marginal external cost at the socially op1mal quan1ty: P MSC MPC + t MPC MEC(Qo) Then the market will end up producing the socially op1mal quan1ty MB Qo Q* Q But, government requires a lot of info to choose correct t. 5 Posi1ve Externali1es A posi1ve externality occurs when the ac1ons of one agent create benefits for other agents but the agent is not compensated for producing these benefits Can result from either consump1on or produc1on Examples: Educa1on Bee farms next to orchards Charitable contribu1ons / volunteer work Crea1ng knowledge and informa1on When there is a posi1ve externality, compe11ve market exchanges will result in too liTle of the ac1vity that generates the externality Economic Analysis of Posi1ve Externali1es Consider a posi1ve externality in consump1on (e.g., educa1on) Then the marginal social benefit of consump1on is greater than the marginal private benefit: P MEB = marginal external benefit MEB MC= S Market equilibrium quan1ty (Q*) is less than socially op1mal quan1ty (Q0) MSB MPB = D Q* Qo Q 6 Policy Alterna1ves It is difficult to accurately calculate the Pigouvian tax or subsidy government must have a lot of informa1on Rather than using a Pigouvian tax or subsidy, the government could try to reach the efficient quan1ty by: Regula1ng the firms with quotas or specific rules Requires a lot of knowledge about industry Inflexible (when 1mes change, need new rules) Crea1ng markets for the produc1on of the externality (e.g., auc1oning off or assigning emissions permits) Assigning property rights to one of the par1es to the transac1on and lejng the two sides bargain with each other to determine the appropriate amount of compensa1on for the externality Emission Permits Suppose the government decides to auc1on off pollu1on rights to producers In effect the government creates the missing market for the resource being affected by the externality The pollu1on rights auc1oned off will allow firms to discharge the quan1ty of pollu1on associated with the socially op1mal quan1ty of the pollu1ng good Firms bid for the right to own the pollu1on permits, and the permits go to the firms with the highest bids The price paid for permission to pollute is called an effluent fee 7 Efficient Bargaining: The Coase Theorem The root cause of an externality is the absence of property rights So one op1on for correc1ng the externality is to assign property rights to someone and let the affected par1es bargain with each other For instance, if the polluter receives the property rights, the person harmed by the pollu1on will have to pay the polluter not to pollute. The Coase Theorem says that, as long as transac1ons costs are zero, bargaining among the par1es will result in the efficient quan1ty of the good, regardless of who is ini1ally assigned the property rights! Example Dick owns a dog that barks and disturbs Jane, Dick's neighbor. Dick gets a benefit from owning the dog, but the dog confers a nega1ve externality on Jane. The socially efficient outcome is to compare Dick's benefit to the cost incurred by Jane and if C>B, the dog goes to the pound, and if B>C, then Dick keeps the dog. According to Coase's Theorem, Dick and Jane can always reach the efficient outcome. 8 Example cont. If Dick's benefit=$500, Jane's cost=$800; then Jane pays Dick $600 to get rid of the dog If Dick's benefit=$1000, then Dick keeps the dog. B>C so efficient outcome is reached C>B so efficient outcome is reached What if property rights were reversed? Jane has the right to peace and quiet. Then Dick has to pay Jane to keep the dog and the efficient outcome is s1lled achieved. So, whatever the ini1al distribu1on of rights, the par1es can always reach a bargain that achieves the efficient outcome. The distribu1on of property rights is not irrelevant though: it determines who has to pay whom in the bargain. Why don't we see Coase's Theorem solving more problems? It is rare that the transac1on costs are 0 Par1es can't agree on a payment There are many par1es (not just 2) to organize 9 ...
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This note was uploaded on 01/18/2012 for the course PADP 6950 taught by Professor Fergi during the Spring '11 term at UGA.
- Spring '11