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© 2004 Thomson Learning/South-Western

   

  

h An 

  is the effect of one party¶s
economic activities on another party that is not
taken into account by the price system.
h a ternalities can occur between any two
economic actors.
h a ternalities can be beneficial or harmful.

O
   

  
h ÿf social costs are greater than private costs, then a
negative e ternality is present. anvironmental pollution
is an e ample of a social cost that is seldom borne
completely by the polluter thereby creating a negative
e ternality.
h ÿf private costs are greater than social costs, then a
positive e ternality e ists. An e ample is when a
supplier of educational services indirectly benefits
society as a whole but only received payment for the
direct benefit received by the recipient of the
education: the benefit to society of an educated
populace is a positive e ternality.

º
 
 

  

[ Automobile e haust
[ igarette smoking
[
arking dogs (loud pets)
[ oud stereos in an apartment building

˜
   

  

[ ÿmmunizations
[ estored historic buildings
[ esearch into new technologies

‰


   

h onsider two firms--one producing eyeglasses,

and another producing charcoal.
h The production of charcoal is said to have an
e ternal effect on the production of eyeglasses
if the output of eyeglasses depends not only on
the amount of inputs chosen by the eyeglass
firm but also on the level of production of
charcoal.




   

h °uppose the eyeglass firm is near and

downwind from the charcoal company.
h The amount of eyeglasses may depend upon
the amount of charcoal in the air which affects
the precision grinding wheels.
h The level of eyeglass production is partially
determined by the amount of charcoal
produced, with more charcoal reducing the
amount of eyeglasses.
m


   

h 6ne of the most famous beneficial e ternalities

between firms involves one firm producing
honey and the other producing apples.
[
ees feed on apple blossoms, which increases the
production of honey, and
[
ees pollinate apple crops, which increases the
production of apples.




  

h ]irms can generate air, water, and other

types of pollution when producing products.
h Alternatively, auto pollution, graffiti, and noise
are some e ternalities imposed by people on
firms.
h When people do things that harm others, like
playing their radios loudly, or help, like
shoveling their sidewalk, they can impose
e ternalities on other people.
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 ! 



  

h ÿn dealing with e ternalities it is important to

recognize that both parties are needed for an
e ternality to e ist.
[ ÿf the eyeglass producer was not located near the
charcoal factory, there would be no e ternality.
[ ÿf another person was not around, no one would be
bothered when someone plays their radio loudly.


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h °
 
(officially,   


 
 °), refers to the effects of
smokers¶ consumption of cigarettes and other
tobacco products on third-party bystanders.
h The harm of aT° is controversial, but the
anvironmental Protection Agency estimates
appro imately 2,200 deaths annually.


 "#$|"%$& '! 


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h °mokers potentially harm bystanders, but

limiting the ³rights´ of smokers impose
inconveniences as well.
[ 6ne study suggests that workplace restrictions on
smoking results in a loss of appro imately $20
billion per year in consumer surplus.
h °uch estimates, like those of the harms of
aT°, are controversial.

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 "#$|"%$& ' 
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 " 

h Úany private decisions have limited smoking in

the workplace and in public areas.
h The 6ccupational °afety and Health
Administration has proposed banning all
workplace smoking.
h Úany question whether governmental action is
necessary given the private actions already
taken.

º


  
"
 

  

h The presence of e ternalities can cause a

market to operate inefficiently.
[ ÿn the previous e ample an e ternality affected the
production of eyeglasses.
[ The firm producing charcoal did not take into
account the negative effect its production had on the
production of eyeglasses.

˜
 (
|

h (
 are the costs of production that

include both input costs and costs of the
e ternalities that production may cause.
[ ÿn the previous e ample, by not recognizing the
e ternality in its production, the charcoal firm
produced too much.
[ °ociety would be better-off by reallocating
resources away from charcoal production and
toward the production of other goods.

‰
 "
 
 
 

h Assume the charcoal producer is a price taker

so that its demand curve is horizontal, as
shown in ]igure 16.1.
[ The firm ma imizes profits, given the prevailing
market price, by producing q* where price(P*) equals
marginal cost(Ú ).
[ ue to the e ternality, however, the social marginal
cost (Ú °) e ceeds Ú .


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[ The cost of the e ternality is shown by the vertical

distance between Ú° and Ú .
[ At q* the social marginal cost e ceeds what people
are willing to pay for the charcoal, P*.
[ esources are misallocated and production should
be reduced to q¶ where Ú° equals P*.
[ The reduced total social costs (area A
q*q¶) e ceed
the reduced total spending (area Aaq*q¶).


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h    are the legal specification of

who owns a good and the trades the owner is
allowed to make with it.
h | is property that may be
used by anyone without cost.
h  
 is property that is owned by
specific people who may prevent others from
using it.

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 |.

 

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h onsidering the charcoal-eyeglass e ternality,

suppose property rights were defined so as to
give sole rights to use the air to one of the
firms.
[ The firms were then free to bargain over how the air
might be used.
h ÿ  
  the two parties might
arrive at q¶ on their own.

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 &    

h ÿf the charcoal firm owns the land, it must add

these ownership costs to its total costs.
[ The costs of polluting the air are what someone else
is willing to pay for this resource (clean air) in its
best alternative use.
[ The eyeglass company would be willing to pay the
an amount equal to the e ternal cost the charcoal
company is imposing.

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 &    

[ The charcoal company¶s marginal cost will be Ú° ,

and it will produce q¶.
[ The charcoal company will sell the remaining air use
rights to the eyeglass maker for a fee of some
amount between Aa (the lost profits of producing
q¶ rather than q*) and A
a (the ma imum amount
the eyeglass maker would be willing to pay to avoid
having the charcoal producer increase production to
q*.

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 &  $0 

h ÿf the eyeglass maker owns the air, the

charcoal firm will offer a payment to use the
air associated with output level q¶.
[ The eyeglass owner will not sell rights to pollute
beyond this because the price that the charcoal
maker would be willing to pay (P* - Ú ) falls short
of the cost of this additional pollution (Ú ° - Ú ).
h The socially optimal charcoal output, q¶, is
produced in this case as well.
O˜
 % |
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h The |
  (first proposed by onal

oase) states that, if bargaining is costless,
the social cost of an e ternality will be taken
into account by the parties, and the allocation
of resources will be the same no matter how
property rights are assigned.
h ÿn the previous e ample, q¶ was produced
regardless of who owned the air.

O‰
   
 

h The assignment of property rights does affect

the distribution of the benefits.
[ ÿf the charcoal maker receives the property rights,
the fees from the eyeglass producer will make it at
least as well off as if it produced q*.
[ ÿf the eyeglass producer receives the property
rights, the fees from the charcoal producer will at
least cover the pollution damage.
h ]actors, such as equity may be important.
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 % !%

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h The oase theorem relies heavily on the

assumption of zero transactions costs.
h ÿf bargaining costs are high, the voluntary
e change may break down so the efficient
outcome may not be realized.
h This may be particularly true concerning
environmental e ternalities.

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h ÿn many locales contractual bargaining

between beekeepers and orchard owners
provide for renting bees for the pollination of
many crops.
h ents appear to accurately reflect the value of
honey that is yielded with higher rents for
clover growers because apple blossoms yield
less honey.

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h 6verfishing creates an e ternality since no

single fisher takes into account the fact that his
or her catch with reduce others catches.
h oastal situations allow property rights so
owners can consider harvesting practices.
[ 6ne study suggests that oyster yields were higher in
Virginia because it made it easier to enforce
property rights.

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 "#$|"%$& O'!   

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h ÿn the past, ivory hunters have lead to a decline

of over 50 percent of the population in aast
African countries.
h ecently, villages received property rights to
elephants and sold limited numbers of
elephants for hunting.
h alephants populations in these areas are on
the rise.

º


    2  
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 |

h When transactions costs are high, e ternalities

may cause real losses in economic welfare.
h The fundamental problem is that, with high
transactions costs, economic actors face no
pressure to recognize the third-party effects
they have.
h All solutions to e ternality problems in these
cases must therefore find some way to get the
actors to ³internalize´ the third-party effects
they cause.
º
 #
!

h The operation of the law may sometimes provide

a way for taking e ternalities into account.
h ÿf the charcoal producer in ]igure 16.1 can be
sued for the harm it does to eyeglass makers,
payment of damages will increase the costs
associated with charcoal production.
h Hence, the charcoal Ú curve will shift upward
to Ú ° and an efficient allocation of resources
will be achieved.
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h A  


(first proposed by A. .
Pigou) is a ta or subsidy on an e ternality
that brings about an equality of private and
social marginal costs.
h ]igure 16.2 is similar to ]igure 16.1, e cept
that an e cise ta of amount t is shown that
reduces the net price to P* - t.
h This causes the firm to produce the socially
optimal level of output, q¶.
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h An alternative to ta ation is regulation.

h The horizontal a is in ]igure 16.3 shows
percentage reductions in pollution that would
e ist without regulation.
h The curve Ú
shows the marginal benefit by
reducing pollution by one unit.
[ The shape comes from the assumption of
diminishing returns.

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h The curve Ú reflects the marginal costs in

reducing environmental emissions including
foregone profits and the costs of antipollution
equipment.
[ The positive slope reflects the assumption of
increasing marginal costs.
h * is the optimal level of pollution where the
marginal benefits equal marginal costs.

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h Three general ways to reduce emissions to *

through environmental policy.
[ A Pigovian-type effluent fee for each percent of
pollution not reduced.
[ overnmental regulators could issue permits to
produce emission levels.
[ irect controls of the amount of pollution allowed.

º
 

h An ³effluent fee´,f*in ]igure 16.3, is charged

for each percent that pollution is not reduced.
[ ]or reductions less than *, the fee e ceeds
marginal cost, so firms will choose abatement.
[ eductions greater than * would not be
profitable.
h The firm is free to choose its method to
reduce pollution.

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h overnment issued permits would allow firms

to ³produce´ (100 - *) percent of their
unregulated emission levels.
h As shown in ]igure 16.3, freely traded permits
would sell for a price of f*.
h A competitive market will ensure that the
optimal level of emissions reductions will be
attained at minimal social cost.

˜
 |

h overnments can tell firms the level of

emissions they would be allowed, and, in many
cases, are accompanied by specification of the
precise mechanism by which * is to be
achieved.
[ This is a common approach in the U.°.
[ °pecification of the mechanism of reduction may
reduce the cost-minimization incentive.

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h Úany electric power plants burn coal for fuel.

h This generates some byproducts including
sulfuric acid which is associated with the
creation of ³acid rain´ which harms lakes and
forests.
[ Acid rain is found in the eastern U.°. and anada
as well as aurope, ussia, and hina.

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h The U.°. has used a ³command-and-control´

( A ) approach.
h Air quality standards are defined by law and
plants are required to install specific
equipment; with most requiring ³scrubbers´ that
clean e haust fumes in their stacks.
h °tudies suggest that these costs e ceed
minimum costs by a factor of two.

˜˜
 "#$|"%$& º'   |


h A more efficient alternative would be to impose

a Pigouvian ta on emissions.
[ ]irms could choose any technology that gives
emission reductions at a marginal cost that is less
than or equal to the ta .
[ °tudies suggest this is considerable more cost
effective, but will decrease the demand for eastern
U.°. coal (with employment losses), which is not
politically popular.

˜‰
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h The lean Air Act amendments of 1990 allow

power plants who reduce their pollution levels
below specified standards to sell credits to
other firms.
[ This allows other firms to subsidize the reductions
of emissions by those firms who can achieve low
pollution with the least cost.
[ This has achieved savings of appro imately 50
percent over regular A approaches.

˜
 "

'
4
 

h a isting models of the earth¶s atmosphere are

not adequate to e plain how carbon emissions
may raise global temperatures.
h avaluating the costs to restrict carbon
emissions involve much uncertainty.
h astimates from general equilibrium models
range from welfare gains to costs as great as
10 percent of P.

˜m
 "  

h 
  are goods that provide
benefits that no one can be e cluded from
enjoying.
[ ational defense is an e ample since, once an
army or navy is set up, everyone in the country
receives protection whether they pay or not.
[ Alternatively, a hamburger is e clusive since,
someone can be e cluded from consuming if they
do not pay for it.
˜
 "  

h  
 are goods that additional

consumers may use at zero marginal cost.
[ ]or e ample, one more person crossing an already
e isting bridge during an off-peak period requires no
additional resources and does not reduce
consumption of anything else.

˜M
  

h   provide none clusive benefits to

everyone in a group and that can be provided
to one more user at zero marginal cost.
h Table 16.1 presents a cross-classification of
goods by their possibilities for e clusion and
rivalry.

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a

†
 

ot dogs, automobiles, Fishing grounds, public
†

houses grazing land, clean air
rridges, swimming National defense,
·  pools, scrambled mosquito control, justice

satellite television
signals

‰
  

)


h ÿn buying a public good, any one person will

not be able to appropriate all the benefits the
good offers.
h °ince others can not be e cluded they can use
the good at zero marginal cost, society¶s
benefits from the public good e ceed the
benefits to the single buyer.

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h However, the buyer will not take societies

benefits into consideration.
h As a result, private markets will tend to
underallocate resources to public goods.
h ]igure 16.4 shows a situation two people
have a demand for a public good. The total
demand for the public good is the ^

sum of each persons demand curve.

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h aach point on the total demand curve shows

what persons 1 and 2, together, are willing to
pay for a particular level of the public good.
h
ecause each individual¶s demand curve is
below the total demand curve, no single buyer
is willing to pay what the good is worth to
society.

‰‰
 8
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h °ince public goods cannot be traded efficiently

in competitive markets, one approach deals
with whether an efficient allocation might come
out voluntarily.
[ Would people agree to be ta ed in e change for the
benefits the public good provides?
h 6ne solution was proposed by arik indahl in
1919.

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 % # 
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h ÿn ]igure 16.5, the curve labeled °° shows

one person¶s (°mith) demand for a particular
public good.
[ The vertical a is measures the share of the public
good¶s cost that °mith must pay.
[ The negative slope of °° indicates that, at a higher
ta ³price´ for the public good, °mith¶s quantity
demanded is smaller.

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h The second individual¶s (Jones) public good

demand curve is derived similarly, but the
proportion paid by Jones is shown on the right
a is.
[ The right a is is reverse scale so that moving up the
a is results in a lower ta paid by Jones.
[ iven this convention, Jones¶s demand curve (JJ)
has a positive slope.

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h The two demand curves intersect at with an

output level 6a of the public good.
[ At this output level °mith is willing to pay 60 percent
of the good¶s cost whereas Jones willingly pays 40
percent.
[ At outputs below 6a, the two people combines are
willing to pay more than 100 percent of the cost of
the public good.


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[ ]or output levels greater than 6a, people are not

willing to pay the total cost of the good.
h 6utput level 6a is a # 
+   
which is a balance between people¶s demand
for public goods and the ta shares that each
must pay for them.
[ The ta shares are ³pseudo prices,´ and the
outcome can be shown to be efficient.

º
 !
   
 
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h The voting patterns of people generally do not

provide enough information to permit indahl¶s
ta share to be computed.
h Alternatively, governments might ask people
how much they are willing to pay for a
particular package of public goods.
[ ÿt is likely that this poll would prove to be e tremely
inaccurate because of free riders.

˜
 % ! 

h People may feel that they should understate

their true preferences to reduce their ta
liability with the hope that others will be willing
to bear the burden of paying the ta es for the
public good.
h A   is a consumer of a none clusive
good who does not pay for it in the hope that
other consumers will.

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h The public radio and television broadcasting

corporations in the U.°. were intended to be
supported primarily by listeners and viewers
through voluntary contributions.
h °ince users can not be e cluded from using
what is ³on the air´ and costs do not increase if
another user tunes in, broad-casting appears
to be a pure public good.


 "#$|"%$& ˜'4  % (
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h However, thriving commercial markets suggest

that broadcasting may not be underproduced.
h Viewed as a mechanism for delivering
advertising messages, broadcasting is both
e clusive (advertisers must pay) and rival (only
one advertiser can use a time slot).

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h An alternative justification is that certain types

of broadcasting will be unattractive to
advertisers (for e ample, cultural) and will be
underprovided in private markets.
h However, the free rider problem tends to
undermine voluntary support.
[ ]ewer than 10 percent of the viewers of public
television make voluntary contributions.


 "#$|"%$& ˜'4  % (
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h Public broadcasting has had to turn to

advertising.
h able television stations, such as The earning
hannel, today provide programming that is
indistinguishable from public broadcasting.
h Voluntary support of public is declining and its
long-run viability is in doubt.

M
 #
 

h °ince individuals are relatively free to move

from one locality to another, the public goods
problem may be more tractable on the local
level.
[ ³Voting with one¶s fee´ provides a mechanism for
revealing demand for public goods.
[ People who want high-quality schools or strong
police protection can choose to live in high ta
areas.
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h ÿn some situations, people vote directly on

policy questions.
h While majority rule is a common criteria, many
cases require even greater amounts (even 100
percent in Quaker meetings) to win in a voting
situation.
[ However, for what follows, majority rule is assumed.

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°mith A r

ones r A
Fudd A r

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h Úajority-rule voting systems may not arrive at

an equilibrium but instead may cycle among
alternative options.
h This parado is illustrated in Table 16.3.
[ °uppose there are three voters (°mith, Jones, and
]udd) choosing among three policy options
regarding spending on a particular public good (A =
low,
= medium, and = high).

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8 

[ Preferences of the three voters are indicated by the

order listed in the table.
h ]or e ample, °mith prefers A to
and
to .
[ ÿn a vote between A and
option A would win.
[ °imilarly, a vote between A and would result in
option winning.
[
ut, a vote between and
would find
(which
lost to A above, and A lost to ) winning.

m˜
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h aquilibrium voting outcomes can always occur

in cases where the issue being voted upon is
one-dimensional and where voters¶
preferences are ³single-peaked.´
h ÿn ]igure 16.6, the preferences that give rise to
the parado of voting are shown by assigning
hypothetical utility levels to A,
, and .

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h The preferences of °mith and Jones are

single-peaked--as levels of public goods¶
e penditures rise, there is only one local utility
ma imizing choice (A for °mith,
for Jones.
h ]udd has two local peaks (A and ).
[ ÿf ]udd¶s preferences were represented by the
dashed line, option
would defeat both A and .

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wins because it is the choice of the 


 whose preferences for a public good
represent the middle point of all voters¶
preferences for the good.
[ The median voter result applies to any number of
voters.
[ ÿf choices are one-dimensional and preferences are
single-peaked, majority rule will select the median
voter¶s choice.

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h alifornia¶s Proposition 13, passed in 1977,

required that property in alifornia be ta ed at
a ma imum rate of 1 percent of the 1975 fair
market value.
[ ÿt also imposed sharp limits on ta increases in
future years.
[ ocal property ta revenues declined by nearly 60
percent between fiscal 1978 and 1979.

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h 6ne e planation for the passage of this law

was a demand for changing the sources of
local ta revenues.
[ itizens were largely content with e isting levels
of local services but wanted state ta sources
(income and sales, primarily) to take over a larger
share of the burden.


 "#$|"%$& ‰'!
 
( 33|
 
/  º

h Alternatively, voters may have wished for a

decline in local government size.
h
oth hypotheses have empirical support.
[ alifornia voters did raise other state ta es, but
spending is significantly lower than before the
initiative.


 "#$|"%$& ‰'!
 
( 33

 
  


h ÿn Úassachusetts, the 1980 passage of

Proposition 2½, similar to Proposition 13, was
fueled by a preference for ³greater efficiency´
in government.
h The Úichigan ³Headler Amendment,´ which
proposed to limit state ta es, also appeared to
stem from preferences for more efficiency.

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h ³Home ule,´ which eliminates state-level

restrictions on spending, was adopted by
communities in ÿllinois.
[ Úore heterogeneous groups appeared to want to
limit local spending.
[ Úore homogeneous groups wanted to forsake the
spending restrictions.
[ The homogeneous groups have similar interests
with respect to government size and functions.

º
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h ÿn a representative government, individuals

vote for directly for candidates, not policies.
h This raises the issue of whether or not
representatives will actually vote the way their
constituents want and present the possibility
for 3) 
  where firms or
individuals influence government policy to
increase their own welfare.

˜