externalities and public goods lecture 7 – academic year 2013/14 introduction to economics fabio...
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Externalities and Public Goods
Lecture 7 – academic year 2013/14Introduction to Economics
Fabio Landini
Where we are…
• Lecture 1 : Demand and supply model• Lecture 2: Elasticity and its application• Lecture 4: Demand, Supply and economic
policy• Lecture 5: Demand, Supply and economic
efficiency• Lecture 5: Surplus of consumers and producer
What do we do today?
• The “external” effects of economic activities
• How do we internalize externalities?• The different typologies of economic
goods: private goods, public goods, common resources and natural monopolies
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The KYOTO Protocol – since 1997
• The Kyoto Protocol, signed in December 1997 at the UNFCCC COP3 (Conference Of Parties), represents the executive instruments of the Framework Convention
• The countries that are subject to the emission constraint are 39 and they include the European countries (including the East countries), Japan, Russia, United States, Canada, Australia and New Zealand
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The European Directive 2003/87/CE “Emissions Trading” regulate the exchange of quotas for the emission of greenhouse gas. The final aim is to establish an European market for the emission quotas.
During the first three years (2005-2007), the emissions of large combustion plants, such as oil refineries, plants for the production of ferrous metal, mineral goods (concrete, lime, etc.) and the plants for the production of paper and cartboard
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The KYOTO Protocol – since 1997
Market efficiency: A brief recap
In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus.
“The invisible hand” (of the market) maximize the total benefit of society
Markets are usually good instruments to organize the economic activity
Sometimes, however: “markets fail”
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Externalities: definition and effects
When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality.
Whenever they do not take into account the “third party”, the equilibrium prices and quantities are not efficient.
Therefore the externalities cause an inefficient allocation of resources, i.e. market failure.
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The effects of externalities on society
In the presence of externalities:•Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market).•The externalities can be negative or positive•However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged ≠ optimal quantity.
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Negative externalities
Costs on other individuals (consumers or producers) that are not directly involved in the market exchange.
Example: smoke of cigarettes, cars’ exhaust gas
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Positive externalities
Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange.
Example: Vaccines, restoration of a piece of Art, investment in new technologies.
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Externalities and market inefficiency
• Negative externalities in productionQmarket > Qoptimum (socially desirable quantity)
social costs > private costs
• Positive externalities in productionQmarket < Qoptimum
social costs < private costs
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• Negative externalities in consumptionQmarket > Qoptimum (socially desirable quantity)
Social benefit < private benefit
• Positive externalities in consumption
Qmarket < Qoptimum
Social benefit > private benefit
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Externalities and market inefficiency
Negative externalities in production
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EquilibriumEquilibrium
00
Price of Price of aluminiumaluminium
QQMARKETMARKET
DemandDemand(private value)(private value)
SupplySupply(private cost)(private cost)
Social costSocial costCost of Cost of pollutionpollution
QQOPTIMUMOPTIMUM
OptimumOptimum
Quantity of Quantity of aluminiumaluminium
Positive externalities in production
14QuantityQuantity
of Robotof Robot00
Price of Price of RobotRobot
QQOPTIMUMOPTIMUM
DemandDemand(private value)(private value)
Supply (private cost)Supply (private cost)
QQMARKETMARKET
Value of Value of technological technological
diffusiondiffusion
EquilibriumEquilibrium
Social costSocial cost
OptimumOptimum
Negative externalities in consumption
15Quantity of Quantity of alcoholic drinksalcoholic drinks
00
Price of Price of alcoholic alcoholic
drinksdrinks
DemandDemand(private value)(private value)
Supply (private cost)Supply (private cost)
QQMARKETMARKET
EquilibriumEquilibrium
QQOPTIMUMOPTIMUM
OptimumOptimum
Social valueSocial value
Positive externalities in consumption
16Quantity ofQuantity ofeducationeducation
00
Price of Price of educationeducation
DemandDemand(private value)(private value)
Supply (private cost)Supply (private cost)
QQMARKETMARKET
EquilibriumEquilibrium
QQOPTIMUMOPTIMUM
OptimumOptimum
Social valueSocial value
How to obtain Qoptimum?1. Government intervention
Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities.
“To internalize an externality” means to alter market incentive with subsidies and taxes, so as to induce individuals to take adequately into account the external effects of their actions.
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Obtaining optimal production
If the externality is negative: internalization through a tax – the tax reduces the quantity that is exchanged in equilibrium until the social optimum obtains
If the externality is positive: internalization through a subsidy – the subsidy increase the quantity that is exchanged in equilibrium until the social optimum obtains
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Public intervention is not always either necessary or efficacious to deal with externalities.
Example of private solutions:•Ethical codes and social sanctions.•NGOs (in the “no-profit” sector).•Integration of different types of activities.•System of contracts (Coase’s theorem).
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How to obtain Qoptimum?2. Private solution
Externalities and public goods
A case in which externalities are of particular relevance is when we deal with specific types of economic goods, called public goods and common resources
Example: knowledge (technological spillover), environment (pollution)
What are public goods and common resources?
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Typologies of economic goods
The goods available in our economy can be distinguished along two dimensions:
Excludabilityand
Rivalry
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ExcludabilityAn individual can be prevented from using a good (e.g. laws usually recognize the private property of a good)
Typologies of economic goods
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RivalryThe consumption of a good by an individual prevents the simultaneous consumption of the same good by other individuals
Typologies of economic goods
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A bridge connects two shores of a river
Given a certain dimension of the bridge, if the n. of people using the bridge increases (congestion): consumption rivalry
If there is a fee for the bridge (those who don’t pay cannot use it): consumption excludability
Example of a public good: A bridge
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Rivalrous
Non-rivalrous
N. people
Many
Few
Free accessExample of the bridge
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ExcludableNon-
excludable
Fee
yes No
Given number of people
Example of the bridge
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Excludable
Rivalrous
Non-excludable
Rivalrous
Excludable
Non-rivalrous
Non-excludable
Non-rivalrous
Yes No
N. people
Many
Few
Example of the bridge: two-ways table
Fee
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Excludable
Rivalrous
(PRIVATE GOODS)
Non-excludable
Rivalrous
(COMMONS)
Excludabe
Non-rivalrous
(NATURAL MONOPOLY)
Non-excludable
Non-rivalrous
(PUBLIC GOODS)
Yes No
N. people
Many
Few
Example of the bridge: two-ways table
Fee
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Four types of economic goods (1)
Private goods•Both excludable and rivalrousExample: ice-cream, CDs, etc.
Public goods•Neither excludable nor rivalrousExample: national defence, scientific knowledge
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Commons•Rivalrous, but non-excludableExample: sea fishes
Natural monopoly•Excludable, but non-rivalrousExample: drinkable water
Four types of economic goods (1)
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Public goods and externalities
Non-excludable goods all can benefit without paying the price, p = 0
Access to the good cannot be limited; private value = 0, social value > 0
But: production costs > 0 (scarce resources)
Who is it going to produce the good, if not paid?
Therefore: positive externalities of a public good (autonomously, market produces too few).
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The problem of free riding
A free rider is a person who can enjoy the benefit of a good without paying the price
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The bridge is built
The bridge is not built
I contribute(I pay 10) 90 - 10
I do not contribute(I don’t pay) 100 0
In order to build the bridge, a voluntary In order to build the bridge, a voluntary contribution equal to 10 is requested…..contribution equal to 10 is requested…..
It is convenient for me It is convenient for me NOTNOT to pay!!! to pay!!!
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The problem of free riding
Since public goods are non-excludable, each individual can refuse to pay the good, hoping that other people will pay in his/her place.
If everybody reasons the same, the good is not produced.
IMPORTANT: the presence of free riding makes it impossible to rely on the market to supply public goods.
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Solution of the free riding problemIf the benefits > costs (social value > 0), public authorities can produce the good by relying on taxes.
Example: fireworks by Moena’s Municipality – 500 inhabitants; value for each inhabitant =10 €; cost of
fireworks = 1000 €.
– Fireworks tax for each inhabitant = 2€, it covers the costs.
– Consumer surplus = 8€ (= 10€ - 2€).
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The need for a State to produces public goods, whose cost is financed via taxes, represents the main economic justification for the existence of taxation (and thus for the fight against tax evasion): that is the “minimum State”.
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Common resources
Common resources are non-excludable
They are freely available for anybody to exploit
But they are rival: the consumption of the good by one individual reduces the possibility for other individual to consume
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Examples of common resources
• Air and clean water• Congested streets • Fishes, whale and other wild species
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The tragedy of the commons
When an individual, by using a resource, diminishes the availability of the resource for others we encounter the tragedy of the commons.
Common resources tend to be over-exploited
This generates a negative externality.
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The public administration can:• Impose a tax on usage;• Regulate the use of the resource; • Transform the common resource in a private
good (by defining and enforcing individual property rights on the resource.
The tragedy of the commons
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The importance of property rights
When the absence of property rights is the cause of market failures, public intervention can potentially
solve the problem in 3 ways
1) By defining property rights, which enable the market to operate efficiently;
2) By regulating individual behaviour;3) By producing a good that the market does not
supply.
Conclusion
When the transaction between consumer and producer has effects on a third party, there is an externality.
Negative (positive) externalities imply that the quantity exchanged in the market equilibrium is superior (inferior) to the social optimum.
The solution to the problem of externalities can be pursued both by private parties and public intervention
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Economic goods differ in terms of excludability and rivalry.
The market can function when goods are private i.e. both excludable and rivalrous.
Public goods are neither excludable nor rivalrous, hence the market does not function well.
In because of free riding, it is the public sector who is responsible to supply public goods.
Conclusion
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Conclusion
Collective resources are rivalrous but not excludable.
Since individuals do not pay for the use of the resource, there is a tendency toward over-exploitation.
Public administration may limit the use of common resources via access regulation and taxes