10

◘Chaper 10 Externalities

A cost or a benefit that arises from production and that falls on someone other than the producer; or a cost or benefit that arises from consumption and that falls on someone other than the consumer

Natural Monopoly Goods

A good that is nonrival but excludable (bottom left of Figure 11.1) is a good produced by a natural monopoly. We define natural monopoly in Chapter 16, (p. 400). A natural monopoly is a firm that can produce at a lower cost than two or more firms can. Examples are the Internet, cable television, and a bridge or tunnel. One more user doesn't decrease the enjoyment of the other users, and people can be excluded with user codes, scramblers, and tollgates.

◘11.3 Common Resources 317

Overgrazing the pastures of a village in Middle Ages England and overfishing North Atlantic cod during the recent past are tragedies of the commons. The tragedy of the commons is the overuse of a common resource. To study the tragedy of the commons, its cause and its possible remedies, we'll study the overfishing and depletion of the cod stock. ♦ two problems that give rise to the tragedy of the commons: • Unsustainable use of a common resource • Inefficient use of a common resource

11.1 Excludable

• A good, service, or resource is excludable if it is possible to prevent someone from enjoying its benefits. (Security services, Seafood restaurant fish, concerts are examples. you must pay to consume them). • A good, service, or resource is nonexcludable if it is impossible (or extremely costly) to prevent someone from benefiting from it. • The services of the city police department, fish in the Pacific Ocean, and a concert on network television are examples. When a police cruiser slows the traffic on a highway to the speed limit, it lowers the risk of an accident to all the road users. It can't exclude some road users from the lower risk. Anyone with a boat can try to catch the fish in the ocean. Anyone with television can watch a network broadcast.

◘Externalities in our daily lives

•4 types of externalities •Negative production externalities • Positive production externalities • Negative consumption externalities • Positive consumption externalities

◘11.1 CLASSIFYING GOODS AND RESOURCES 305

•Classifying-the extent to which people can be excluded from consuming them and the extent to which one person's consumption rivals the consumption of others.

◘TAX OR CAP AND PRICE POLLUTION

•Governments use two main methods of confronting polluters with the costs of their decisions: • Taxes • Cap-and-trade

◘10.1 NEGATIVE EXTERNALITIES:POLLUTION

•Pollution is a negative externality. Both production and consumption activities create pollution. •Factory dumps waste into river-ppl who live by and use it to fish and boat bear the cost of pollution. Paint factory doesn't consider the cost of pollution when deciding the qty of paint to produce. ♦Supply curve based on own costs-not costs inflicted on others. ☻when external costs are present, we produce more output than the efficient quantity and we get more pollution than the efficient quantity •The development in the fourteenth century of a pure water supply and the hygienic disposal of garbage and sewage are examples of early efforts to improve the quality of the environment.

◘Negative Consumption Externalities

•Source of irritation •Smoking tobacco in a confined space-airplanes or restaurants-creates health risk for others. Ban avoids a negative consumption externalitiy for most-imposes a negative external cost on smokers. •Noisy parties and outdoor rock concerts. •A ban on an activity is not a solution. ♦Banning noisy parties avoids the external cost on sleepseeking neighbors, but it results in the sleepers imposing an external cost on the fun-seeking partygoers.

◘Positive Consumption Externalities

•flu vaccine-lower risk of being infected-your neighbor didn't get vaccinated but has a better chance of remaining healthy •Flu vaccine generate positive consumption externalities. •Historic building restored by owner- everyone benefits and enjoys ♦EDUCATION IS A MAJOR EXAMPLE.

◘Using the Commons Efficiently: Individual Transferable Quotas 323

•used when producers are difficult to monitor or where MC varies across producers. •a production limit assigned to an individual who is then free to transfer (sell) the quota to someone else. A market in ITQs emerges and ITQs are traded at their market price. ♦Mkt price of an ITQ=highest price someone is willing to pay for one. (MSB-MC) The price of an ITQ will rise to this level because fishers who don't have a quota would be willing to pay this amount to get one. ♦A fisher with an ITQ could sell it for the market price, so by not selling the ITQ the fisher incurs an opportunity cost. The marginal cost of fishing, which now includes the opportunity cost of the ITQ, equals the marginal social benefit from the efficient quantity. Figure 11.10 illustrates how ITQs work. Each fisher receives an allocation of ITQs and the total catch permitted by the ITQs is 300,000 tons per year. Fishers trade ITQs: Those with low marginal cost buy ITQs from those with high marginal cost, and the market price of an ITQ settles at $10 per pound of fish. The marginal private cost of fishing now becomes the original marginal private cost, MC, plus the price of the ITQ. The marginal private cost curve shifts upward from MC to MC + price of ITQ and each fisher is confronted with the marginal social cost of fishing. Now no one has an incentive to cheat and exceed the quota because to do so would send marginal cost above the market price and result in a loss on the marginal catch. The outcome is efficient.

Overfishing Equilibrium Efficient Equilibrium

♦11.7 The market demand curve for fish is the marginal social benefit curve, MSB. The market supply curve is the marginal private cost curve, MC. Market equilibrium occurs at the intersection point of these two curves. The equilibrium quantity is 800,000 tons of fish per year and the equilibrium price is $10 per pound. At the market equilibrium quantity, marginal social cost exceeds marginal social benefit ♦The efficient quantity is where marginal social benefit equals marginal social cost. In Figure 11.7, the efficient quantity of fish is 300,000 tons. At this quantity, the marginal social cost (on the MSC curve) and marginal social benefit (on the MSB curve) are equal.

11.1 Rival

♦A good, service, or resource is rival if its use by one person decreases the quantity available for someone else. ex Brink's security might work for two banks, but one truck can't deliver cash to two banks at the same time. •A fish, whether in the ocean or on a fish farm, can be consumed only once. •One seat at a concert can hold only one person at a time. These items are rival. ♦A good, service, or resource is nonrival if its use by one person does not decrease the quantity available for someone else. •The services of the city police department and a concert on network television are nonrival. •The arrival of one more person in a neighborhood doesn't lower the level of police protection enjoyed by the community

◘Using the Commons Efficiently: Property Rights

A common resource that no one owns and that anyone is free to use contrasts with private property, which is a resource that someone owns and has an incentive to use in the way that maximizes its value. The resource is used efficiently. One way of overcoming the tragedy of the commons is to convert a common resource to private property. With private property rights, the owner of the resource faces the same conditions as society faces. It doesn't matter who owns the resource. The users of the resource that someone owns are confronted with the opportunity cost of using it. ♦If the user is the owner, the opportunity cost of using it is forgone rental income. ♦If the resource is used by someone who leases it from its owner, the opportunity cost of using it is the rent paid to the owner. ♦The private property solution to the tragedy of the commons is available in some cases. It was the solution to the original tragedy of the commons in England's Middle Ages. ♦It is also a solution that has been used to prevent overuse of the airwaves that carry cell-phone services. The right to use this space (called the frequency spectrum) has been auctioned by governments to the highest bidders. The owner of each part of the spectrum is the only one permitted to use it (or to license someone else to use it). ♦assigning private property rights is not always feasible and it isn't a practical solution to the problem of overfishing. The cost of policing millions of square miles of ocean would be far greater than the benefit arising from it. Also, there would be international disputes about which country had the right to enforce property rights. Further, in some cases and the ocean fish stock is one of them, people have an emotional objection to assigning private property rights. Critics of private property rights say it is immoral for someone to own a resource that they regard as public. In the absence of property rights, some form of government intervention is used, one of which is a production quota.

Public Goods

A good or service that is both nonrival and nonexcludable (bottom right of Figure 11.1) is a public good: It can be consumed simultaneously by everyone, and no one can be excluded from enjoying its benefits. A flood-control levee is an example of a public good. Everyone who lives in a protected floodplain enjoys the benefits, and no one can be excluded from receiving those benefits. The system of law and order provided by the courts and the body of laws is another example.

Common Resources

A resource that is rival and nonexcludable (top right of Figure 11.1) is a common resource: A unit of it can be used only once, but no one can be prevented from using what is available. Ocean fish and the Earth's atmosphere are examples of common resources. Ocean fish are rival because a fish taken by one person is not available for anyone else, and they are nonexcludable because it is difficult to prevent people from catching them. The Earth's atmosphere is rival because oxygen used by one person is not available for anyone else, and it is nonexcludable because we can't prevent people from breathing!

◘EYE ON THE US ECONOMY US AIR POLLUTION TRENDS290

Air quality in the United States has improved. The figure shows the trends since 1980 for the atmospheric concentrations of five main air pollutants monitored by the Environmental Protection Agency (EPA) and a sixth pollutant (suspended particulates) monitored since 1990. By using a mix of regulation, pollution limits, economic incentives, and permit trading, the EPA has almost eliminated lead and has substantially decreased sulfur dioxide, carbon monoxide, nitrogen dioxide, and suspended particulates. Ozone is harder to eliminate, but it has nonetheless fallen to 70 percent of its 1980 level.

◘Produce less and Pollute less

An alternative to incurring the cost of using an abatement technology is to use the polluting technology but cut production, reduce pollution, and get a higher income from renting homes by the river. Firms will choose the least-cost alternative method of lowering pollution.

◘Cap and Trade

Cap-and-trade places a cap or ceiling on emissions and assigns or sells emission rights to individual producers who are then free to trade permits with each other. It is a tool that seeks to combine the power of government to limit total emissions with the power of the market to minimize cost and maximize benefit. A government that uses this method must first estimate the efficient quantity of pollution and set the overall emissions cap to achieve the efficient outcome. Then the government must somehow allocate shares of the cap to individual firms (and possibly even households). In an efficient allocation of emissions quotas to firms, each firm has the same marginal social cost of production and emissions abatement. So to allocate the cap efficiently across firms, the government would need to know a lot about each firm's production and abatement costs. A Pigovian tax achieves an efficient allocation of pollution across firms because each firm chooses how much to produce and pollute taking the tax into account, and then produces the quantity at which marginal social cost equals price. Because all firms face the same market price, they also incur the same marginal social cost. The government solves the allocation problem by making an initial distribution of the cap across firms and then allowing them to trade in a market for emission permits. Firms that have a low marginal abatement cost sell permits and make big cuts in pollution. Firms that have a high marginal abatement cost buy permits and make smaller cuts or perhaps even no cuts in pollution. The market in permits determines the equilibrium price of emissions and each firm, confronted with that price, maximizes profit by setting its marginal pollution cost or marginal abatement cost, whichever is lower, equal to the market price of a permit. By confronting polluters with a price of pollution, trade in pollution permits can achieve the same efficient outcome as a Pigovian tax.

◘Private Provision : Underproduction

Could a private firm—say, North Pole Protection, Inc.—deliver the efficient quantity of satellites? Most likely it couldn't, because no one would have an incentive to pay his or her share of the cost of the satellites. Everyone would reason as follows: "The number of satellites provided by North Pole Protection, Inc., is not affected by my decision to pay my share or not. My own private consumption will be greater if I free ride. If I do not pay, I enjoy the same level of security and I can buy more private goods. So I will free ride on the public good." Such reasoning is the free-rider problem. If everyone reasons the same way, North Pole Protection, Inc., has no revenue and so provides no satellites.

Deadweight Loss from Overfishing

Deadweight loss measures the cost of overfishing. The gray triangle in Figure 11.7 illustrates this loss. It is the marginal social cost minus the marginal social benefit from all the fish caught in excess of the efficient quantity.

◘10.1 NEGATIVE EXTERNALITIES: Valuing an external cost 284

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, with identical homes along the side of each river. The homes on the clean river rent for $1,000 a month more than those on the polluted river. If pollution is the only detectable difference between the two locations, the $1,000 a month rent difference is the social cost per home of the pollution. The $1,000 multiplied by the number of homes on the polluted river is the total external cost of this pollution.

◘Inefficient Use of a Common Resource 318

Even if the catch is sustainable, it will exceed the efficient catch: overfishing occurs. Why does overfishing occur? The answer is that fishers face only their own private cost and don't face the cost they impose on others—the external cost. In pursuit of self-interest, the fishers ignore this external cost. Let's explore overfishing in more detail, starting with the marginal social cost of catching fish.

Public Provision Versus Private Subsidy

In the two methods we've just studied, the same number of students enroll and tuition is the same. So are these two methods of providing education services equally good? This question is difficult to resolve. The bureaucrats that operate public schools don't have as strong an incentive to minimize costs and maximize quality as those who run private schools. But for elementary and secondary education, charter schools (see p. 259) might be an efficient compromise between traditional public schools and subsidized private schools.

EYE ON YOUR LIFE A STUDENTS FREE-RIDER PROBLEM

MP3 music files are nonrival because they can be duplicated at the click of a mouse. Files can be created at zero opportunity cost. A music file is nonexcludable because it is costly to exclude anyone who wants to make an illegal copy of a file. Because music files are nonrival and effectively nonexcludable, they create a free-rider problem. If everyone obtained their music by copying the files of their friends, you can see that it would not take long for the provision of songs to dry up. Only amateur performers who record for fun would be left in the business. We tackle this free-rider problem by using the copyright laws that restrict the legal right to copy music files. The problem is that making something illegal isn't effective if it is difficult to detect and punish the illegal acts. Another solution might be to put a tax on MP3 players and distribute the revenue to performers and recording companies, but this approach doesn't provide an incentive to limit illegal file sharing. Once the player tax has been paid, it has no effect on how it is used. The best solution currently available is for the courts to enforce property rights and for the recording companies to pursue illegal file sharers and hit them with large penalties. But the cost of enforcing these property rights is high.

The Principle of Minimum Differentiation

This tendency toward identical policies is an example of the principle of minimum differentiation: To appeal to the maximum number of clients or voters, competitors tend to make themselves identical. This principle not only describes the behavior of political parties but also explains why fast-food restaurants cluster in the same block and even why new car models have similar features. If McDonald's opens a restaurant in a new location, it is more likely that Burger King will open next door to McDonald's rather than a mile down the road. If Chrysler designs a new back-up camera or a hands-free phone system, most likely Ford will too.

◘Government actions in the face of external benefits

To get closer to producing the efficient quantity of a good or service that generates an external benefit, we make public choices through governments and modify the market outcome. To achieve a more efficient allocation of resources in the presence of external benefits, such as those that arise from education, governments can use three devices: • Public provision • Private subsidies • Vouchers

◘Public Provision: Efficient Production

p 312 wtf graph 11.4 The political process might be efficient or inefficient. We look first at an efficient outcome. There are two political parties, the Hawks and the Doves, which agree on all issues except for the quantity of defense satellites. The Hawks want 300 satellites, and the Doves want 100 satellites. Both parties want to get elected, so they run a voter survey and discover the MSB curve of Figure 11.4. They also consult with satellite producers to establish the marginal cost schedule. The parties then do a "what-if" analysis. If the Hawks propose 300 satellites and the Doves propose 100 satellites, the voters will be equally unhappy with both parties. Compared to the efficient quantity, the Doves want an underprovision of 100 satellites and the Hawks want an overprovision of 100 satellites. The deadweight losses are equal, and the election would be too close to call. Contemplating this outcome, the Hawks realize that they are too hawkish to get elected. They figure that if they scale back to 250 satellites, they will win the election if the Doves propose 100 satellites. The Doves reason in a similar way and figure that if they increase the number of satellites to 150, they can win the election if the Hawks propose 300 satellites. Each party knows how the other is reasoning, and they realize that their party must provide 200 satellites, or it will lose the election. So both parties propose 200 satellites. The voters are indifferent between the parties, and each party receives 50 percent of the vote.

Public Provision: Overproduction: Objective of Bureaucrats 313

•A bureau head seeks to maximize her or his department's budget because a bigger budget brings greater status and power. For the Pentagon, the objective is to maximize the defense budget. Figure 11.5 shows the outcome if the Pentagon is successful in the pursuit of its goal. The Pentagon might try to persuade the politicians that 200 satellites cost more than the originally budgeted amount; or the Pentagon might press its position more strongly and argue for more than 200 satellites. •In Figure 11.5, the Pentagon persuades the politicians to go for 300 satellites. Why don't the politicians block the Pentagon? Won't overpaying or overproducing satellites cost future votes? It will if voters are well informed and know what is best for them. Voters might not be well informed, and well-informed interest groups might enable the Pentagon to achieve its objective and overcome the objections of the politicians.

EYE ON THE PAST: IS A LIGHTHOUSE A PUBLIC GOOD?

•A lighthouse looks like a public good: nonexcludable and nonrival. But in the eighteenth century, lighthouses in England were built and operated by private companies that earned profits by charging tolls on ships docking at nearby ports. A ship that refused to pay the lighthouse toll was excluded from using the port. So even the services of a lighthouse, when it is near a port, are excludable! Such a lighthouse is an example of a natural monopoly good and not a public good.

◘Private subsidies.

•A payment by the government to a producer to cover part of the costs of production. •In the absence of a subsidy, the marginal cost curve is the market supply curve of private college education, S = MC. The marginal benefit is the demand curve, D = MB

◘10.1 NEGATIVE EXTERNALITIES :Use an Abatement technology 286

•A technology that reduces or prevents pollution. •catalytic converter in cars combined w lead-free gas, has dramatically reduced pollution •Abatement technologies are available to reduce carbon emissions from electricity generation and pollution from industrial processes and paint manufacture.

◘Vouchers

•A token that the government provides to households, which they can use to buy specified goods or services. •food stamps that the USDEPT of Agri provides under a fed food stamp program is an ex. •The government would provide each student with a voucher. Students would choose the school to attend and pay the tuition with dollars plus a voucher. Schools would exchange the vouchers they receive for dollars from the government. If the government set the value of a voucher equal to the marginal external benefit of a year of college at the efficient quantity, the outcome would be efficient. Figure 10.9 illustrates an efficient voucher scheme in action. The government issues vouchers worth $15,000 per student per year. Each student pays $10,000 tuition and the government pays $15,000 per voucher, so the school collects $25,000 per student. The voucher scheme results in 15 million students attending college, the marginal cost of a student equals the marginal social benefit, and the outcome is efficient.

◘Negative Production Externalities

•Burning coal to generate electricity emits carbon dioxide that warms the planet and other chemicals that pollute the atmosphere. •Logging and the clearing of forests destroy the habitat of wildlife and also influence the amount of carbon dioxide in the atmosphere. •Noise

◘EYE ON THE US ECONOMY: EDUCATION QUALITY: CHARTER SCHOOL AND VOUCHERS 298

•Charter Schools A charter school is a public school but one that is free to make its own education policy. Around 4,000 charter schools in 40 states are operating today and they teach more than 1 million students. When the demand for places in a charter school exceeds the supply, students are chosen by lottery. How efficient are the charter schools? School efficiency has two dimensions: cost per student and educational standard attained. Charter schools perform well on both criteria. They cost less than public schools and they achieve more. Cost per student in New York charter schools is 18 percent less than regular public schools. And charter school students perform higher in math and reading than equivalent students who apply to but (randomly) don't get into a charter school. Vouchers School vouchers are much less used than charter schools and more controversial. But an increasing number of states, among them Wisconsin, Louisiana, Ohio, the District of Columbia, and New York, operate a school voucher program. Studies of the effects of vouchers have generated more controversies than firm conclusions, but some economists are convinced that they offer the best solution.

EYE ON THE GLOBAL ECONOMY: ITQ'S WORK

•Economists agree ITQ's effective for achieving efficient use of the stock of ocean fish. •Iceland, Netherlands and Canada firrst to adopt ITQ's in late 70's New Zealand first to make it national policy in 1986 Marine biologists and economists agree that ITQs prevent fish stocks from collapsing and restore fisheries in critical decline. Studies based on large data sets of more than 10,000 fisheries and over more than half a century have shown that without ITQs, there would be a major collapse of the global fish stock, but that with ITQs, a fish crisis has been averted. One study found that ITQs even reverse a trend decline and turn it around to a trend recovery. Fisheries that are managed with ITQs are half as likely to collapse as those that are not. ITQs help maintain fish stocks, but they also reduce the size of the fishing industry. This consequence of adopting ITQs to restore fish stocks pits the use of ITQs against the self-interest of fishers. In all countries, the fishing industry opposes restrictions on its activities, but in the countries that pioneered ITQs, the opposition was not strong enough to block them. In the United States the opposition to ITQs was so strong that the fishing industry persuaded Congress to outlaw them. In 1996, Congress passed the Sustainable Fishing Act that put a moratorium on ITQs that lasted until 2004. Since then, many U.S. fisheries have been managed by ITQs and have begun to see their benefits. ITQs are a success story

◘10.1 NEGATIVE EXTERNALITIES :Establish Property Rights

•Legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts. •establishing property rights where they do not currently exist can confront prdcrs with the costs of their actions and provide them incentive to allocate resources efficiently. ♥Porperty rights and paint producers.-paint producers own river and homes alone river. Rental income earned depends on amount of pollution they create. If people willing to pay $1,000/mo more to live alongside a pollution-free river, the paint prdrs can earn that amount for each of the homes they own by not polluting the river. ♦The forgone rental income from homes alongside a polluted river is an opportunity cost of producing paint. It is part of the paint producers' marginal private cost and the paint producers must now decide how to respond to this cost. -Use an abatement technology -produce less and pollute less

◘The Marginal Benefit from a Public Good 309

•Lisa and Max share a common parking area that has no security lights. Both of them would like some lights, but how many? What is the value or benefit from just one light, from adding a second, and perhaps from adding a third light? To answer this question, we must somehow combine the value of lights to both Lisa and Max and find the marginal benefit from different quantities of lights—the marginal benefit curve of lights. ♦PVT GOOD, MB CURVE =Market demand curve •Everyone pays the same market price for a private good, and each person chooses the quantity to buy at that price. ♦we find the marginal benefit from a public good by summing the marginal benefits of all individuals at each quantity, we find the MSB curve by summing the individual marginal benefit curves vertically. In contrast, to obtain the MB curve for a private good—which is also the market demand curve—we sum the quantities demanded by all individuals at each price—we sum the individual demand curves horizontally. ♦everyone shares in the benefits of a public good, the marginal private benefits of everyone in the society are added together to get the public good's marginal benefit. So the marginal benefit from a public good is a marginal social benefit, and its marginal benefit curve is a marginal social benefit curve, MSB.

◘10.1 NEGATIVE EXTERNALITIES : External Cost and Output

•Marginal Cost curve-MC-, describes the private marginal cost borne by the firms that produce the paint. Marginal cost increases as the quantity of the paint produced increases. •If the firms dump waste into a river, they impose an external cost that increases with the amount of the paint produced. ♦The marginal social cost curve, MSC, is the sum of marginal private cost and marginal external cost. •For example, when firms produce 4 million gallons of paint a month, marginal private cost is $1.00 a gallon, marginal external cost is $1.25 a gallon, and marginal social cost is $2.25 a gallon.

◘10.1 NEGATIVE EXTERNALITIES :Private Costs and Social Costs 283

•Marginal Private cost of production (MC)-born by producer of a good/service. •Marginal Cost-cost of producing one addtl unit that is borne by the producer of that good/service •Marginal External Cost-the cost of producing an addtl unit of a good/svc that falls on people other than the producer. •Marginal Social Cost (MSC)-marginal cost incurred by entire society by the producer and by everyone else whom the cost falls. ♦MSC=MC+ Marginal External Cost. ♦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 item. Something real that people value, such as a clean river or clean air, is given up.

◘10.2 POSITIVE EXTERNALITIES: EDUCATIOn

•Marginal private benefit The benefit from an additional unit of a good or service that the consumer of that good or service receives. •Marginal external benefit The benefit from an additional unit of a good or service that people other than the consumer of that good or service enjoy. •Marginal social benefit The marginal benefit enjoyed by society—by the consumer of a good or service and by everyone else who benefits from it. It is the sum of marginal private benefit and marginal external benefit. •MSB= MB + Marginal External Benefit •Marginal pvt benefit-expanded job opportunities and higher incomes. ♦MPB decreases as the qty of education increases. •college graduates generate external benefits. On the average, college graduates communicate more effectively w others and tend to be better citizens. Their crime rates are lower, and they are more tolerant of the views of others. •A society with a large number of college graduates can support activities such as high-quality music, theater, and other organized social activities.

◘Taxes

•Pigovian taxes-government uses taxes as an incentive for producers to reduce the pollution they create. •By setting the tax equal to the marginal external cost (or marginal abatement cost if it is lower), firms can be made to behave in the same way as they would if they bore the cost of the externality directly. •Assume that the government has assessed the marginal external cost of pollution accurately and imposes a tax on the factories that exactly equals this cost. The producers are now confronted with the social cost of their actions. The market equilibrium is one in which price equals marginal social cost—an efficient outcome. Figure 10.4 illustrates the effects of a Pigovian tax on pollution from paint factories. The curve D = MB is the market demand for paint and the marginal benefit curve. The curve MC is the marginal private cost of producing paint. The tax equals the marginal external cost of the pollution. We add this tax to the marginal private cost to find the market supply curve, the curve labeled S = MC + tax. This curve is the market supply curve because it tells us the quantity of paint supplied at each price, given the factories' marginal cost and the tax they must pay. This curve is also the marginal social cost curve MSC because the pollution tax has been set equal to the marginal external cost at the quantity produced. Demand and supply now determine the market equilibrium price at $1.50 per gallon and a quantity of 2 million gallons of paint a month. At this quantity of paint produced, the marginal social cost is $1.50 and the marginal benefit is $1.50, so the market outcome is efficient. The factories incur a marginal private cost of 90¢ per gallon and pay a pollution tax of 60¢ per gallon. The government collects tax revenue of $1.2 million per month.

◘The Marginal Cost of a Public Good

•Principle of increasing marginal cost applies to MC of a public good •MC curve of a public good slopes upward. •public good does not create an externality so MC is also MSC graph

◘ A Fourfold Classification: Private Goods

•Private goods A good or service that is both rival and excludable ♦It can be consumed by only one person at a time and only by the person who has bought it or owns it. •Ex The fish on East Point's farm are an example of a private good. One person's consumption of a fish rivals others, and everyone except the person who bought a fish is excluded from consuming it.

Rational Ignorance

•Rational choice balances marginal benefit and marginal cost. •An implication of rational choice is that it is rational for a voter to be ignorant about an issue unless that issue has a perceptible effect on the voter's well-being and the voter can influence the political outcome. •Rational ignorance is the decision not to acquire information because the marginal cost of doing so exceeds the marginal benefit. ♦For example, each voter in the United States knows that he or she can make virtually no difference to the defense policy of the U.S. government. Each voter also knows that it would take an enormous amount of time and effort to become even moderately well informed about alternative defense technologies. So voters remain relatively uninformed about the technicalities of defense issues. (Although we are using defense policy as an example, the same principle applies to all aspects of government economic activity.) •All voters benefit from national defense, but not all voters produce national defense—only a small number work in the defense industry. Voters who own or work for firms that produce satellites have a direct personal interest in defense because it affects their incomes. These voters have an incentive to become well informed about defense issues and to lobby politicians to further their own interests. In collaboration with the defense bureaucracy, these voters exert a larger influence on public policy than do the relatively uninformed voters who only benefit from this public good.

◘Unsustainable Use of a Common Resource

•Renewable common resources such as fish and trees replenish themselves by the birth and growth of new members of the population. ♦cod in north america. At any given time, there is a stock of cod, a rate of renewal, and rate of use-catch rate. •if rate of renewal > catch rate then stock grows and cod is being caught sustainably. •if rate of catch = renewal rate then stock=constant ♦if catch rate > renewal rate the stock decreases and is being used unsustainably. The sustainable catch depends on the stock. With a small stock, few fish are born, so only a small quantity can be sustainably caught. With a large stock, many fish are born but they must compete with each other for food, so only a few survive to reproduce and to grow large enough to be caught. So again, the sustainable catch is small. Between a small and a large stock is a stock at which, given the availability of food, the rate of renewal is at its maximum. At this stock, the sustainable catch rate is also at its maximum. The sustainable catch curve, SCC, shows the sustainable catch rate at each stock size. As the stock increases, the sustainable catch increases to a maximum and then decreases. If the catch rate is less than the sustainable catch rate, at a point such as A, the cod stock grows. If the quantity caught equals the sustainable catch, at any point on the SCC, the fish stock remains constant and is available for future generations of fishers in the same quantity that is available today. But if the quantity caught exceeds the sustainable catch, at a point such as B, the fish stock shrinks and, unchecked, eventually falls to zero.

◘Application of the Coase Theorem

•Suppose that the residents own their homes and the river. Now the factories must pay a fee to the homeowners for the right to dump waste into the river. The greater the quantity of waste dumped, the more the factories must pay. So again, the factories face the opportunity cost of the pollution they create as part of their marginal private cost. The quantity of paint produced and the amount of waste dumped are the same whoever owns the homes and the river. If the factories own them, they bear the cost of pollution because they receive a lower income from home rents. If the residents own the homes and the river, the factories bear the cost of pollution because they must pay a fee to the homeowners. In both cases, the factories bear the cost of their pollution and dump the efficient amount of waste into the river.

Marginal Social Benefit and Demand

•The MSB from fish is the price that consumers are willing to pay for an additional pound of fish. •MSB decreases as the quantity of fish consumed increases, so the market demand curve, which is also the marginal social benefit curve, slopes downward.

◘EYE ON CLIMATE CHANGE; HOW CAN WE LIMIT CLIMATE CHANGE 291

•The average temp of the Earth is rising and so is the atmospheric concentration of CO2. •Most scientist believe humans are the source. •Economists agree that lowering GHG emissions requires incentives to change •One idea is to cap emissions and issue tradeable emissions permits, a system called cap-and-trade. Carbon emission permits are already priced on a global carbon trading market. ♦Why don't we have more aggressive caps and stronger incentives to encourage a larger reduction in GHG emissions? There are three reasons. First, some people don't accept the scientific evidence that emissions produce global warming; second, the costs are certain and would be borne now, while the benefits would come many years in the future; and third, if current trends persist, by 2050, three quarters of carbon emissions will come not from the United States but from the developing economies.

Marginal Social Cost

•The marginal social cost of catching fish is the marginal private cost plus the marginal external cost. •The marginal private cost of catching fish is the fishers' cost of keeping a boat and crew at sea for long enough to increase the catch by one ton. •The principle of increasing marginal cost applies to catching fish just as it applies to other production activities. Crew fatigue, overfull refrigerators, and a lower speed to conserve fuel decrease the catch per hour, so the marginal private cost of catching fish increases as the quantity caught increases. The marginal external cost of catching fish is the cost per additional ton that one fisher's production imposes on all other fishers. This additional cost arises because one fisher's catch decreases the remaining stock, which in turn decreases the renewal rate of the stock and makes it harder for others to find and catch fish. Marginal external cost also increases as the quantity of fish caught increases. ♦Because both components of marginal social cost increase as the quantity caught increases, marginal social cost increases with the quantity of fish caught.

◘MANDATE CLEAN TECHNOLOGY 288

•The most comprehensive environmental regulation is performed under the provisions of the Clean Air Act of 1970 and its later amendments, which gives the Environmental Protection Agency (EPA) the authority to issue regulations that limit emissions and achieve defined air quality standards. But a major source of greenhouse gas emissions in the United States is electric power utilities that use coal and a deep controversy surrounds the question of whether the Clean Air Act extends to regulating these utilities. The legal battle turns on the question of whether carbon dioxide is a pollutant. The Supreme Court ruled in 2007 that carbon emissions are a pollutant, a ruling that requires the EPA to regulate these utilities, but because this issue is so deeply devisive, the EPA has stood on the sidelines. Although direct regulation can and has reduced emissions and improved air quality, economists are generally skeptical about this approach. Abatement is not always the least-cost solution. Also, government agencies are not well placed to find the cost-minimizing solution to a pollution problem. Individual firms seeking to minimize cost and maximize profit and responding to price signals are more likely to achieve an efficient outcome. We'll now examine these other approaches to pollution.

◘Efficient Market Equilibrium w Property Rights

•The paint producers face the pollution costs or the abatement costs, whichever is lower. The MSC curve includes the cost of producing paint plus either the cost of abatement or the cost of pollution (forgone rent), whichever is lower. This curve, labeled S = MC = MSC, is now the market supply curve. •If forgone rent is less than the abatement cost, factories still create some pollution, but will be the efficient quantity. If the abatement cost is lower than forgone rent, the factories will stop polluting, but they will produce less paint because marginal cost includes the abatement cost. •Coase property rights solution only works when the cost of reaching an agreement betwen prop owners is low. In many situations, these negotiation costs are high, so this solution is not available and government action is needed. One such action is to mandate the use of a clean abatement technology

Publi provision

•The production of a good or service by a public authority that receives most of its revenue from the government. •Education services produced by the pub universities, colleges and schools is an example. •Figure 10.7 shows how public provision might overcome the underproduction that arises in Figure 10.6. Public provision cannot lower the cost of production, so marginal cost is the same as before. •Marginal private benefit, marginal external benefit, and marginal social benefit are also the same as before. The efficient quantity occurs where marginal social benefit equals marginal cost. • In Figure 10.7, this quantity is 15 million students per year. Tuition is set to ensure that the efficient number of students enroll. That is, tuition is set at the level that equals the marginal private benefit at the efficient quantity. In Figure 10.7, 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.

◘The Coase Theorem 286

•The proposition that if property rights exist and the costs of enforcing them are low, then the market outcome is efficient and it doesn't matter who has the property rights.

◘Using the Commons Efficiently

•The three main methods that might be used to achieve the efficient use of a common resource are • Property rights • Production quotas • Individual transferable quotas (ITQs)

◘Positive Production Externalities 282

•To produce orange blossom honey, Honey Run Honey of Chico, California, locates beehives next to an orange orchard. The honeybees collect pollen and nectar from the orange blossoms to make the honey. At the same time, they transfer pollen between the blossoms, which helps to fertilize the blossoms. Two positive production externalities are present in this example. Honey Run Honey gets a positive production externality from the owner of the orange orchard; and the orange grower gets a positive production externality from Honey Run.

◘Why Govt is Large and Growing 314

•Voter preferences for public goods drive the growth of the government. •The demand for national and personal security and the demand for other public services are income elastic. As incomes increase, the demand for these services increases by a larger percentage than the increase in income. ♦Inefficient bureaucratic overprovision of public goods and services might make government too big and too costly. There is no easy fix for this problem. Our ever-growing demand for education and health-care services contribute to the large and growing scale of government.

◘10.1 NEGATIVE EXTERNALITIES : Production and Pollution: How Much?

•When polluting industry is unregulated. market outcome is inefficient overproduction •in pursuit of self interest-firms produce too much, they pollute too much ♦Demand curve=MB curve for paint. •supply curve is the •Marginal pvt cost curve •EQUILIBRIUM OCCURS WHERE MB=MpvtC ♦EFFICIENT outcome is when MB=MSC ☻What can be done to fix inefficiency? •Establish property rights •Mandate Clean technology •Tax/price pollution

◘11.2 PUBLIC GOODS AND THE FREE-RIDER PROBLEM 308

•Why does the U.S. government provide our national defense and district court system? Why do the state governments provide flood-control levees? Why do our city governments provide fire and police services? Why don't we buy our national defense from North Pole Protection, Inc., a private firm that competes for our dollars in the marketplace in the same way that McDonald's does? Why don't private engineering firms provide levees? Why don't we buy our policing and fire services from Brink's and other private firms? The answer is that all of these goods are public goods—goods that are nonexcludable and nonrival—and such goods create a free-rider problem.

◘Free-Rider Problem

•a person who enjoys the benefits from a good or service without paying for it. •public good-everyone consumes same qty-no one can be excluded-no one has incentive to pay for it. •the free-rider problem-the private market, left on its own, would provide too small a qty of a public good. •govt action is required. ♦MB from a public good is diff from a private good.

◘Using the Commons Efficiently: Production Quotas

•an upper limit to the quantity of a good that may be produced in a specified period. The quota is allocated to individual producers, so each producer has its own quota. •Efficient qty is MSB=MSC If everyone catches their own quote, the outcome is efficient. •Implementing a production quota has 2 problems: 1.it is in every fisher's self-interest to catch more fish than the quantity permitted under the quota. The reason is that the market price exceeds marginal private cost, so by catching more fish, a fisher gets a higher income. If enough fishers break the quota, overfishing occurs and the tragedy of the commons remains 2.marginal cost is not, in general, the same for all producers—as we're assuming here. Some producers have a comparative advantage in using a resource. Efficiency requires that the quota be allocated to the producers with the lowest marginal cost. But the government department that allocates quotas does not have information about the marginal cost of individual producers. Even if the government tried to get this information, producers would have an incentive to lie about their costs so as to get a bigger quota. ♦A production quota can work, but only if the activities of every producer can be monitored and all producers have the same marginal cost. Where producers are difficult or very costly to monitor or where marginal cost varies across producers, a production quota cannot achieve an efficient outcome.

EYE ON THE GLOBAL ECONOMY: The North Atlantic Cod Tragedy of the Commons

•before 1970, Atlantic cod was abundant. •in 1812 more than 1600 fishing boas off New England and Newfoundland, Canada. •Fish caught using lines and productivity was low.-low productivity allowed cod to be caught sustainably over hundreds of years. •1960's high efficiency nets (trawls, seines and gill nets), sonar technology, and large ships w efficient processing facilities. •In the last decade, cod landings increased from less than 300,000 tons a year to 800,000 tibs, •this volume of cod could not be taken without a serious collapse in the stock and in 1992 a total ban on cod fishing in the North Atlantic stabilized the pop but at a very low level.

The Efficient Quantity of a Public Good

•efficiency is achieved where MSB=MSC •If marginal social benefit exceeds marginal social cost, resources can be used more efficiently by increasing the quantity of the public good. ♦If marginal social cost exceeds marginal social benefit, resources can be used more efficiently by decreasing the quantity of the public good. ♦If marginal social benefit equals marginal social cost, resources are being used efficiently—in this example, 200 satellites.