economic efficiency iii
TRANSCRIPT
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Externalities
When a private action has side effects thataffect other people in important ways, wehave the problem of externalities
By-product of a good or activity that affectssomeone not immediately involved intransaction
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The Private Solution to a NegativeExternality
Under certain conditions, inefficiency thatwould be caused by a negative externalitywill automatically be resolved by the parties
themselves
The outcome is the efficient outcome
Achieves maximization of total net benefits possible
in the situation
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The Coase Theorem
What if building a theater would create$100,000 of benefits for some but $70,000worth of harm for others?
Whether the theater will or will not be builtdepends entirely on whether it is theefficient or inefficient outcome
Regardless of who holds the legal rights Negative externality is solved by market
No government intervention is required, otherthan the initial assignment of legal rights
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The Coase Theorem
The Coase Theoremnamed aftereconomist Ronald Coase
States that private market will solve externalityproblem on its own, always arriving at theefficient outcome
When side payments can be negotiated andarranged without cost
While initial distribution of legal rights willdetermine allocation of gains and losses amongthe parties, it will not affect action taken
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The Coase Theorem
Requires that side payments can be arranged without costor, inpractice, that cost is so low relative to gains or losses at stake that itdoesnt matter This requirement is most likely to be satisfied when all of the following
conditions are present
Legal rights are clearly established Legal rights can be easily transferred
The number of people involved is very small
Unfortunately, many real world situations do not satisfy theseconditions
Biggest problem is applying Coase theorem to many real-worldexternalities is the third condition Often, a large number of people are involved
When many people are involved, achieving efficiency with sidepayments is plagued by an often insoluble problem Free rider problem
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The Free Rider Problem
Occurs when efficient outcome requires a sidepayment but individual gainerseach obligated topay a small share of the side paymentwill notcontribute
If extensive enoughcan shrink the side paymentuntil it isnt large enough to compensate losersand still leave gainers better off
Stands in the way of many Pareto improvements One of the main reasons why we typically turn togovernment to deal with important externalities thataffect many people
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Market Externalities andGovernment Solutions
A competitive market has many buyers and sellers When a negative externality affects a market, the private solution is
unlikely to work
A market with a negative externality associated with
producing or consuming a good will produce more than theefficient quantity Creating a welfare loss
Unfortunately, with so many people involved, it would taketoo much time and trouble for individual producers and
consumers to arrange appropriate side payments andproduction cutbacks In any case, free rider problem would effectively destroy the
arrangement
Efficient outcome requires government intervention in the market
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Figure 11a: A Tax on Producers toCorrect a Negative Externality
100 125
D
S
$1.00A
MSC
C $0.50B
(a)
Millions of Gallonsper Period
Dollars
2. The efficient quantity is here . . .
3. but the equilibriumquantity is here.
4. In equilibrium, the welfareloss is triangle ABC.
1. This market has a negativeexternality of $0.50 per unit.
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Figure 11b: A Tax on Producers toCorrect a Negative Externality
100 125
D
$1.00
$0.50B
(b)
Millions of Gallonsper Period
Dollars
$1.30
$0.80
SBefore Tax
SAfter Tax
6. shifts the supply curve upward . . .
7. and moves theequilibrium to theefficient quantity.
5. A tax per unit on producers, equalto the negative externality per unit,
A
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Taxing a Negative Externality
Government could use a tax on producers to move gasoline market to point B
Payment of the externality tax is shared between consumers and producers,as is the payment of any tax, and will depend on elasticities of supply anddemand A tax on each unit of a good, equal to the external harm it causes, can correct a
negative externality and bring market to an efficient output level
Consider the logic of this result Tax cures the inefficiency because it forces market to internalize the externality
To take account of the harm caused by gasoline
Suggests that a tax on consumers of gasoline would work just as well as a taxon producers
Taxes to correct negative externalities have been used in countries around theworld In United States, however, taxes designed to correct negative externalities are less
common
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Regulation and Tradable Permits
A tax is not only way to correct a negative externality Government can also use regulation to move a market closer to
the efficient point
In last two decades, U.S. government has relied
increasingly on an innovative technique to reduce severaltypes of pollution Tradable permits
License that allows a company to release a unit of pollution into theenvironment over some period of time
Firms can trade their permits in an organized market Left to itself, a market with a negative externality will
produce too much output Taxes, regulation, and tradable permits are examples of
government intervention to decrease output toward efficient level
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Dealing with a Positive Externality
What about the case of a positive externality? By-product of an activity or a service benefits other
parties, rather than harms them
A market with a positive externality associatedwith producing or consuming a good will produceless than the efficient quantity, creating a welfareloss
A subsidy on each unit of a good, equal to theexternal benefits it creates, can correct a positiveexternality and bring the market to an efficientoutput level
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Figure 12a: A Subsidy for Consumers toCorrect a Positive Externality
800,000 1,000,000
D
S
$100,000MSB
C
A
$30,000
2. The equilibrium quantity is here . . .
3. but the efficientquantity is here.
4. In equilibrium, the welfare loss is triangle ABC.
(a)
Number ofDegrees per Year
Dollars
1.This market has a positive externalityof $30,000 per college degree.
B
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Figure 12b: A Subsidy for Consumers toCorrect a Positive Externality
S
800,000 1,000,000
$100,000
B
A
$30,000
Number ofDegrees per Year
Dollars
(b)
$114,000
$84,000
DBefore Subsidy
DAfter Subsidy
6. shifts the demand curve upward . . .
5. A subsidy per unit for consumers equalto the positive externality per unit . . .
7. and moves the
market to theefficient quantity
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Public Goods
Pure private good One that is both rivalrous and excludable
In absence of any significant market failure, private firms will provide thesegoods at close to efficient levels
When a good is nonexcludable, people have an incentive to become
free riders To let others pay for the good, so they can enjoy it without paying When a good is nonexcludable, private sector will generally be unable
to provide it In most cases, if we want such a good, government must provide it
When a good or service is nonrivalrous, market cannot provide it
efficiently Rather, to achieve economic efficiency, good or service would have to be
provided free of charge
Pure public good One that is both nonrivalrous and nonexcludable
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Figure 13: Pure Private, Pure Publicand Mixed Goods
MoreNonexcludable
More Excludable
More Rival More Nonrival
Mixed Good
Pure Private Good Mixed Good
Pure Public Good
food, clothing,housing
sold-out movie
crowdedhighway
newspaper
software
movie with emptyseats
uncrowded highway downloaded
music file cable
television
urban park
national defense,legal system
police and fire
protection crowdedcity streets fish in international
waters
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Mixed Goods
Goods that appear in upper right and lowerleft corners of Figure 13 can be calledmixed goods
Share features of both public and private goods
These goods are becoming increasinglyimportant in our society
Are responsible for some growing tension andcontroversy
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Excludable But Nonrivalrous Goods
Goods near lower left hand corner are excludable butnonrivalrous Includes most information products
Software is an essentially nonrivalrous good, but an excludable
one Neither pure public nor pure private
Digital music files are another example of this type of mixed good Currently, music remains somewhat excludable
It is against the law to make copyrighted music available online
Many peopleeither because of respect for the law, fear of getting caught,
lack of technical expertise, or scarce timestill prefer to buy their musicfrom a store or online shipping service
Music industry is desperately looking for ways to achieve greaterexcludability
Has not yet found a good solution
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Nonexcludable But Rivalrous Goods
Tragedy of commons occurs when rivalrous but nonexcludable goodsare overuse to detriment of all
An economy with well-functioning, perfectly competitive markets tendsto be economically efficient
Many types of government involvement are needed to ensure that marketsfunction well and to deal with market failures
Cases of government involvement are not without controversy
Debates about public education, Social Security, international trade, andimmigration center on questions of proper role for government
Some of the disagreement is over governments role in bringing abouta more fair economy
Also debate about the governments role in bringing about economic
efficiency
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Nonexcludable But Rivalrous Goods
Information problems While government may be able to move us closer to efficiency, it can also fall short
or overshoot based on inaccurate information
Incentive problems for government Government officials are agents of the general public, and are supposed to serve
public interest
However, they can be influenced by lobbies for special interest groups
In order for government to have the funds it needs to support markets and doother things, it must raise revenue through taxes
Inherent problem with provision of public goods that almost guaranteesdissatisfaction about them
Other important roles for government besides fostering efficiency Equity, fairness, justice, and more
Anyone studying role of government in the economies is struck by one glaringfact Most economic activity is carried out among private individuals
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Using the Theory: Traffic as aMarket Failure
Almost everyone in United States has been caught in atraffic jam in some large town or city at some point in theirlives
Problem in most cities is getting worse Consider London, for example
Traffic congestion has worsened dramatically in recent decades,especially in the historic inner city
Traffic is an externality problem When you decide to take your car onto a city street, your decision
is based on the costs and benefits to you
Traffic can be viewed as a mixed good Can the government solve the problem?
Some cities, such as New York, do charge tolls for cars that enter viabridges or tunnels
But entry tolls are problematic, and are rarely set high enough to solve theproblem
U i h Th T ffi
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Using the Theory: Traffic as aMarket Failure
A bigger problem Political damage to any elected representative who would propose
a fee high enough to be efficient for a good that has traditionallybeen free
All of this conventional political wisdom may have changedin early 2003 In early 2003, Ken Livingstone, the Mayor of London, decided to
take a chance His administration established a 5 (about $8) per day user fee on any
automobile that appeared in the 8 square mile boundary of Londonsinner city
On the first day the fee applied, traffic dropped about 25% 60,000 fewer cars entered the area than on a normal day
Officials in New York, Paris, Los Angeles, and other large citiesaround the world have been studying Londons success