Chapter 5: Externalities, Enviornmental Policy, and Public Goods

Externality

A n externality is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Pollution for an example. Example of Negative Externality- People with asthma may bear a cost even though they were not involved in the buying. Positive Externality are also possible. Ex) Medical research b/c people who are not directly involved in producing or paying for it can benefit. In a competitive market does a good job of producing the economically efficient amount of a good or service. When there is a negative externality, the market may produce a quantity of the good that is greater than the efficient amount. When there is a positive externality, the market may produce a quantity that is less than the efficient amount. When there are externalities, government intervention can increase economic efficiency and enhance the well being of society. An externality causes a difference between the private cost of production and the social cost or the private benefit from consumption and the social benefit.

If we know the price elasticity of demand for cigarettes- we can calculate how many fewer packs of cigarettes will be demanded at a higher price.

Ex) If governments want to discourage teenage smoking, it can raise the price of cigarettes by increasing the tax on them.

The Economically Efficient Level of Pollution Reduction

Ex) Key point is that the additional benefit that is the marginal benefit received from eliminating another ton of sulfur dioxide declines as sulfur dioxide emissions are reduced. Further reductions in sulfur dioxide will have little additional benefits.

What Causes Externalities?

Example: Lee owns land that includes a lake. A paper company wants to lease some of Lee's land to build a paper mill. The paper mill will discharge pollutants into Lee's lake. Because Lee owns the lake, he can charge the paper company

The Effect Of Exernalities

Externalities interfere with the economic efficiency of a market equilibrium. In Chapter 4: A competitive market achieves economic efficiency by maximizing the sum of consumer surplus and producer surplus. But that result holds only if there are no externalities in production or consumption. An externality causes a difference between the private cost of a production and the social cost, or the private benefit from consumption and the social benefit. Unless there is an externality, the private cost and the social cost are equal. Unless there is an exernality, the social and private benefits are the same.

How a Positive Externality in Consumption Reduces Economic Efficiency

If students receiving a college education could capture all its benefits, the demand curve would be D2, which represents the marginal social benefits. The actual demand curve would be D1 however, which represents only the marginal private benefits received by students. The efficient equilibrium would come at P (Efficient) and quantity (Q Efficient). At this equilibrium, economic surplus is maximized. The market equilibrium at a P(Market) and quantity (Q Market) will not be efficient because the demand curve is above the supply curve for production of the units between Q Market and Q Efficient. That is the marginal benefit including the external benefit for producing these units is greater than the marginal cost. As a result there is a deadwieght loss = to the area of the yellow triange. Because of the positive externality, economic efficiency would be improved if more college educations were produced. Where is a positive externality in consuming a good or service, too little of the good or service will be produced at market equilibrium.

Coase Theorem

If transaction costs are low, private bargaining will result in an efficient solution to the problem of externalities. The argument of economist Ronald Coase that if transaction costs are low, private bargaining will result in an efficient solution to the problem of externalities. Because the benefits from reducing an externality are often greater than the costs, private bargaining can lead to an efficient outcome. Private Bargaining is most likely to reach an efficient outcome if the number of parties bargaining is small.

How a Negative Externality in Production Reduces Economic Efficiency

In chapters 3 and 4 there was the assumption that the producer of a good or service must bear all the costs of production. This is not true, private costs are borne by the utility, but some external cost of pollution are borne by people who are not customers of the utility. (Ex. The social cost of producing electricity is the sum of the private cost plus the external cost) An equilibrium is economically efficient if economic surplus which is the sum of consumer surplus plus producer surplus - at a maximum. When economic surplus is at a maximum, the net benefit to society from the production of the good or service is at a maximum. Economic surplus is reduced by deadweight loss.

How does a competitive market achieve economic efficiency?

It maximizes the sum of consumer surplus and producer surplus. But this holds only if there are no externalities in production or consumption.

The Price Elasticity of Demand and Its Measurement

Law of Demand tells firms only that the demand curves for their products slope downward. More useful is a measure of the responsiveness of the quantity demanded to a change in price. (Price Elasticity of Demand) Percentage Change in the Quantity Demanded of Product/ Percentage Change in Product's Price.

Example:

Lee owns a land that includes a lake. A paper company wants to lease part of Lee's land to build paper mill. The paper mill will discharge pollutants into Lee's lake. Because Lee owns the lake, he can charge the paper company the cost of cleaning up the pollutants. The result is that the cost of the pollution is a private cost to the paper economy and is included in the price of the paper it sells. There is no externality, the efficient level of paper is produced, and there is no market failure. Example 2: Suppose the paper company builds its paper mill on privately owned land on the banks of a lake that is owned by the state. In the absence of any government regulations, the company will be free to discharge pollutant into the lake. The cost of the pollution will be external to the company because they do not have to pay the cost of cleaning it up. More than the economically efficient level of paper will be produced, and a market failure will occur. Example 3: Lee owns the lake, but the pollution is caused by acid rain. Even though someone is damaging Lee's property, the law does not allow him to enforce his property rights in this situation. Once again, there is an externality, and the market failure will result in too much electricity being produced. Example 4: If you buy a house, the governemnt will protect your right to exclusive use of that house. No one else can use the house without your permission. Because of your property rights in the house, your private benefit from the house and the social benefit are the same. When you buy a college education, however, other people are, in effect able to benefit from your college education. You have no property right that will enable you to prevent them from benefiting or to charge them for the benefits they receive. As a a result, there is a positive externality, and the market failure will result in too few college educations being supplied. Conclusion: Externalities and market failures result from incomplete property rights or from the difficult of enforcing property rights in certain situations.

Externalities and Market Failure

Market Failure: A situation in which the market fails to produce the efficient level of output.

Private Solutions to Externalities: The Coase Theorem

Possible for people to find private solutions to the problem of externalites. Important to recognize that removing an externality usually is not economically efficient. Ex) Pollution, there is an economically efficient level of pollution reduction

Transaction Costs

The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. Transaction costs would include the time and other costs of negotiating an agreement, drawing up a binding contract, purchasing power, and monitoring the agreement. When many people are involved, the transactions costs are often higher than the net benefits from reducing the externality. The cost of transacting ends up exceeding the gain from the transaction, and private solution to an externality problem is not feasible

Why does deadweight loss occur in Figure 5.1?

The deadweight loss occurs because the supply curve is above the demand curve for the production of the units of electricity between Q (Efficient) and Q (Market). The additional cost including the external cost of producing these units is greater than the marginal benefit to consumers, as represented by the demand curve. - In conclusion; the additional cost, including the external cost of producing these units is greater than the marginal benefit to consumers, as represented by the demand curve. Because of the cost of pollution, economic efficiency would be improved if less electricity were produced. Therefore, when there is a negative externality in producing a good or service, too much of the good or service will be produced at market equilibrium.

Net Benefit

The net benefit to society from reducing pollution is equal to the difference between the benefit of reducing pollution and the cost. To maximize the net benefit to society, sulfur dioxide emissions- or any type of pollution- should be reduced up to the point where the marginal benefit from another ton of reduction is equal to the marginal cost.

Price Elasticity of Supply

The responsivness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product's price. Price Elasticity of Supply= % Change in Quantity Supplied/ Percentage Change in Pride.

Property Rights

The rights individuals or businesses have to exclusive use of their property , including the right to sell it. (Includes tangible and intangible)

What about the marginal cost to electric utilities of reducing pollution?

To reduce sulfur dioxide emissions, utilities have to switch from burning high-sulfur coal to burning more costly fuel, or they have to install pollution control devices such as scrubbers. As the level of pollution falls, further reductions become increasingly costly. Example: The marginal cost of removing 97% of pollutants from municipal wastewater is more than twice as high as the marginal cost of removing 95%.

Measuring the Price Elasticity of Demand

We use the slope of the demand curve because the slope of the demand curve tells us how much quantity changes as price changes. The measurement of slope is sensitive to the units chosen for quantity and price.

The Clean Air Act: How a Government Policy Reduced Infant Morality

When levels of pollution are high, the marginal benefit of reducing pollution is also high?

If demand is elastic then an increase in price reduces revenue

because the decrease in quantity demanded is proportionally greater than the increase in price

Private Benefit

benefit received by the consumer of a good or service

Private Cost

cost borne by the producer of a good or service

Elasticity-

measures how one economic variable-such as the quantity demanded responds to changes in another economic variable- such as the price.

If demand is inelastic then an increase in price increases revenue

the decrease in quantity demanded is proportionally smaller than the increase in price.

If demand is unit elastic than an increase in price does not affect revenue

the decrease in quantity demanded is proportionally the same as the increase in price

If demand is elastic then a decrease in price increases revenue

the increase in quantity demanded is proportionally greater than the decrease in price

If demand is unit elastic than an increase in price does not affect revenue

the increase in quantity demanded is proportionally the same as the decrease in price.

If demand is inelastic then a decrease in price reduces revenue

the increase in quantity demanded is propotionally smaller than the decrease in price.

Price Elasticity of Demand

the responsiveness of the quantity demanded of a good to changes in its price (Knowing the price elasticity of demand allows you to compute the effect of a price change on the quantity demanded)

Price Elasticity of Supply

the responsiveness of the quantity supplied of a good to changes in its price

If products are unrelated

then the cross price elasticity of demand will be zero Ex) Tablet computers and peanut butter

If the products are complements

then the cross-price elasticity of demand will be negative. Ex) Tablet computers and applications downloaded from online stores

If the products are substitutes

then the cross-price elasticity of demand will be positive. Ex) Two brands of tablet computers

Social Benefit

total benefit from consuming a good or service, and it is equal to the private benefit plus any external benefit, such as the benefit to others resulting from your college education.

Social Cost

total cost of producing a good or service is equal to the private cost plus any external cost, such as the cost of pollution.