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Externalities and Public Goods: Mcgraw-Hill/Irwin
Externalities and Public Goods: Mcgraw-Hill/Irwin
Externalities and Public Goods: Mcgraw-Hill/Irwin
McGraw-Hill/Irwin
Main Topics
Externalities and inefficiency Remedies for externalities: the private sector Remedies for externalities: the public sector Common property resources Public goods
20-2
Externalities
Competitive markets may not allocate resources efficiently when the assumptions of the model are violated Example: assumed that each consumers well-being depends only on her own consumption An action creates an externality if it affects someone with whom the decision-maker has not engaged in a related market transaction
Negative externality if it harms someone else
Polluting causes health problems in a community, neglecting a garden reduces neighbors home values
Therefore the firms equilibrium production level is socially excessive and inefficient
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Assignment of property rights does not affect the level of pollution but does affect profits Coase theorem: regardless of how property rights are assigned, voluntary agreements will remedy externalities
If bargaining is frictionless
Limitations of Bargaining
Every externality can be traced to missing markets Private negotiations lead to transactions that the parties would have made if the required markets werent missing Many factors that cause externalities also hinder bargaining
Bargaining can be impractical
Difficult logistics, substantial time and effort
Property rights may be ambiguous Limited information can lead to an impasse Contracts may be difficult to enforce
20-11
Quantity Controls
Government can attempt to address an externality by regulating the activity that produces it An emissions standard is a legal limit on the amount of pollution that a person or company can produce
When engaged in a particular activity
Example: Aircraft noise abatement Setting a socially efficient abatement standard requires information about abatement costs and benefits Private parties may have an incentive to exaggerate their costs (or benefits)
Government may have trouble learning the truth Can lead to an inefficient standard and deadweight loss
20-12
Ideal Pigouvian tax reproduces the price that the good in question would command in an efficient competitive equilibrium
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Liability Rules
Another mechanism for addressing negative externalities Under a liability rule a party who takes an action that harms others must compensate the affected parties for their losses Liability rules induce decision-makers to internalize all external costs
Lead to efficient choices
In some cases, the government needs less information to effectively use a liability rule than an emissions standard or Pigouvian tax Liability rules raise other difficulties because of their legal nature
20-15
Ideal rule would force all parties contributing to the externality to bear a portion of the social costs
20-16
Standard is superior when the MCA curve is relatively flat and the MSC curve is relatively steep Tax is superior when the MCA curve is relatively steep and the MSC curve is relatively flat
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Each firm will pollute up to the point at which the marginal cost of abatement equals the tax rate Firms produce different amounts of pollution but will share the same marginal cost of abatement Any change in firms emissions that leaves total pollution unchanged will increase overall abatement costs
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Total emissions are limited by the number of permits the government issues
Enables the government to reduce the level of pollution to any desired target
Can achieve any given reduction in total emissions at the lowest possible abatement cost Competitive market for permits may emerge Each firm will generate pollution up to the point at which marginal cost of abatement equals the market price of a permit Note that the market does not set the level of pollution
20-21
Generally, each persons use of a common property resource reduces its value to others
Creates a negative externality
Consider a large lake, the only source of fish for nearby towns, where anyone can become a fisherman free of charge The marginal social cost of fishing exceeds the marginal private cost
Each fisherman fails to account for the fact that his decision to catch fish reduces the fish population and raises the cost of fishing for future fishermen Competitive level of fishing is socially excessive
Remedies for market failures associated with common property resources are the same as for negative externalities
20-22
MSC
1500
1000 MEC
500
Qefficient
Qequilib
Fish (pounds)
20-23
A good is nonexcludable if there is no way to prevent a person from consuming it Examples of public goods: national defense, construction of lighthouses Governments often provide public goods
Not all goods provided by a government are public goods
20-24
To determine the marginal social benefit of a public good, add up the gains to all affected individuals
Important difference from process for private good Sum individual curves vertically for a public good
20-26
Competitive markets produce too little output when positive externalities are present If provision of a public good is left entirely to the independent actions of private parties, the level of production will be inefficiently low Market failure associated with public goods is due to free riding A free rider contributes little or nothing to a public good while benefiting from others contributions
20-27
Subsidization often takes the form of tax deductibility for contributions to charitable causes that support public goods These are variants of the methods used to address externalities Efficient public provision of a public good need not entail public production
Market failure of public goods related to demand, not production Governments often rely on the private sector to produce public goods Example: U.S. obtains military equipment from private defense contractors
20-28
A Groves mechanism is a way to set the level of a public good that induces everyone to report their preferences correctly
Produces a socially efficient outcome
Ask each citizen to report the total benefit he would receive from the public good
Calculate teach individuals marginal benefit as though he told the truth
Each consumers contribution toward the public good is based on the quantity of public good that would be optimal with and without his reported benefits Consumer will be worse off if he exaggerates or understates his benefits than if he tells the truth Groves mechanism gives consumers a strong incentive to tell the truth
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Public Decision-Making
The field of political economy examines the economic consequences of public sector decision-making Example: determine whether public intervention is justified
Weigh the consequences of a market failure against the likely consequences of a government failure
When markets fail, the public sector may be able to improve the allocation of resources, in principle Do democratic mechanisms promote socially efficient government decision-making?
Assume a policy is overturned if more than 50% of voters prefer an alternative
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Median voter is the voter who has the median ideal policy among all voters Majority rule leads to the selection of the median ideal policy
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