Market Failure and the Role of Government: ExternalitiesAP MICROECONOMICS

MR. BORDELON

Pollution sucks. However, given the conveniences of modern life, it’s an inevitability in some form. To have hot water, electricity and more, we must accept a certain amount of pollution. As such, we have to find a cost-benefit balance.

Marginal social cost (MSC). Additional cost imposed on society as a whole by an additional unit of pollution.

Marginal social benefit (MSB). Additional benefit to society from an additional unit of pollution.

Socially optimal quantity of pollution. Quantity of pollution society would choose if all the costs and benefits of pollution were fully accounted for.

Pollution

Costs and Benefits of PollutionIn a MSC/MSB graph, MSB corresponds to the demand curve, and MSC corresponds to the supply curve.

MSC is upward sloping because low levels of pollution are manageable but more difficult to manage at higher levels. When pollution is at low levels, another ton of pollution isn’t that big a deal. Nature can handle it. When pollution is at high levels, then another ton of pollution has a much greater cost, because nature can’t take care of it.

MSB is downward sloping because it becomes more difficult to achieve more and more reduction in pollution as the amount declines. At high levels of pollution, reducing it is fairly easy. The value of those resources used to reduce pollution (abatement) is small, so it doesn’t cost us much. At low levels of pollution, reducing it is costly. All the easy abatement methods, so the more expensive and harder methods must be used.

Costs and Benefits of PollutionIt’s easy to reduce the first ton of pollution, and difficult to reduce the last one. The benefit of the first ton is very high, and the benefit of the last ton is very low.

Equilibrium can be found at O, the socially optimal point. Notice that the socially optimal quantity of pollution, QOPT, is not zero. At QOPT, the MSB from an additional ton of emissions and its MSC meet at $200.

The question is whether a free market economy will achieve the socially optimal quantity of pollution.

It’s a good bet that it will not.

In a word, incentive. With no government intervention, polluters decide how much pollution occurs, with no incentive to take into account the costs of pollution on society.

The benefits are monetary. By emitting an extra ton of pollution, any given polluter saves the cost of buying expensive pollution control equipment or more expensive fuels.

The costs of pollution fall on society as a whole, however, as they have no say in how much pollution occurs.

In economics terms, this means that without government intervention, polluters will continue to pollute until the MSB = 0.

What’s the problem?

Costs and Benefits of PollutionThis graph demonstrates the problems related to a lack of incentive in a market economy, specifically what we’ll call a negative externality.

In a market economy, only the benefits of pollution are taken into account in choosing the quantity of pollution. As such, pollution will be produced at QMKT, where MSB of an extra ton of pollution is zero, but MSC is $400. Pollution will be higher than what’s socially optimal. QMKT > QOPT

Polluters don’t have to compensate society. The marginal cost of pollution to any given polluter is zero because there is no incentive to limit the amount of emissions.

External cost. Uncompensated cost that an individual or firm imposes on others. AP Examples: pollution, traffic, second-hand smoking.

External benefit. Benefit that individuals or firms confer on others without receiving compensation. AP Examples: vaccinations (3 times)

Externalities. External costs and benefits. Positive externalities. External benefits.

Negative externalities. External costs.

External Costs, Benefitsand Externalities

Inefficiency of Excess PollutionTake a look at the graph again. Back in perfect competition, we saw that equilibrium represents efficiency. Yes, it totally does. Nobody can be made better off without making someone worse off. Another way to look at it is to say that equilibrium is where total surplus is maximized.

MSB is zero at QMKT, reducing the quantity of pollution by one ton wouldn’t really do all that much. The benefit to polluters from the last unit of pollution is low/zero.

MSC is $400 at QMKT, imposed on rest of society, reducing quantity of pollution by one ton, total social cost of pollution falls by $400, but total social benefit falls by virtually zero.

Inefficiency of Excess PollutionTotal surplus rises by approximately $400 if quantity of pollution at QMKT is reduced by one ton.

With every little bit of abatement, total surplus would increase. Let’s say that we did enough abatement, that pollution reduced to QH. At that level, MSC is $300 and MSC is $100, meaning reducing just by one ton at that level increases total surplus by $200.

Even reducing it to a lower level, QH, would still be inefficiently high, but certainly better than QMKT. The efficient outcome is at QOPT. Society gains the area of the shaded triangles.

Coase theorem. Even in the presence of externalities, an economy can reach an efficient solution, provided that the legal rights of the parties are clearly defined and the transaction costs of making a deal are sufficiently low. Transactions costs. Costs to individuals of making a deal.

Costs of communication among interested parties.

Costs of making legally binding agreements.

Costly delays involved in bargaining.

In short, Coase suggests that it is possible to achieve a solution through the free market so long as both parties are on an equal footing and it doesn’t cost too much.

Coase Theorem and Private Solutions

Bob and Bobbette’s Pigs

Bobbette buys a house worth $200,000. Bob moves in next door and promptly brings with him some pigs. The stench is…ugh. Bobbette’s house drops in worth to $150,000. She’s suffering from a negative externality. Assume Bob has the legal right to have these pigs. Bobbette’s

property value has dropped $50,000. She’d ultimately be willing to pay up to $50,000 to get him to knock it off.

Why $50,000? At $50,001, Bobbette would ultimately begin paying Bob for the loss in value to her property. That’s the value of it.

If Bob is willing to accept $20,000 to not raise the pigs, Bobbette’s only out $20,000 instead of $50,000. Bob doesn’t get to raise the pigs, but he now has $20,000 to invest in pork futures.

Bob and Bobbette’s Pigs

Bobbette buys a house worth $200,000. Bob moves in next door and promptly brings with him some pigs. The stench is…ugh. Bobbette’s house drops in worth to $150,000. She’s suffering from a negative externality. Assume Bobbette has a legal right to a house that does not smell like

pigs. Bob wants to raise pigs in the backyard, and not being able to raise the pigs is a hardship for him, those tiny tasty little piggies.

If Bob has the pigs, it would harm Bobbette in the amount of $50,000, so Bob could offer Bobbette $50,000 or more to compensate for the damages.

Why “or more”? It’s Bobbette in this scenario who needs to be compensated, so her price could go beyond the value of what she loses.

Key point: Externalities do not need to be inefficient because individuals have an incentive make mutually beneficial deals, which lead them to take into account externalities, or internalize the externalities (yes, I know). In the pig scenarios, Coase would say that the private solutions

internalize the externality. The party that is imposing the hardship on the other is required to compensate the victim.

Key point: If externalities are fully internalized, the benefit must be equal to the external cost imposed. As such the outcome is efficient even without government intervention.

Coase Theorem and Private Solutions

Criticism. Coase theorem tends to break down when dealing with individuals not on an equal footing, say Apple Inc. vs. Travis, Wal-Mart contracting with a union vs. an individual.

When Private Solutions Likely Fail High communication costs between parties. If everybody’s not

thrilled with you, then the cost of negotiating a settlement between lots of people and the guy causing the problem get higher.

What if it wasn’t just Bobbette? What if Bob had irritated the entire community?

High legal costs. Negotiations and legally binding agreements might require lots of attorneys and a huge stack of legal bills.

Costly delays in bargaining. Bob knows Bobbette’s suffering and delays and postpones every meeting. He may be playing around, assuming you’ll get tired of the delays and just simply move.

Coase Theorem and Private Solutions

How’s the environment around Orange City doing?

http://www.epa.gov/myenv/myenview2.html?minx=-81.48903&miny=28.87414&maxx=-81.10794&maxy=29.02735&ve=11,28.94875,-81.29700&pSearch=Orange%20City,%20FL

Take a look at this, then hop on Twitter to explain your outrage (or lack thereof): @titanecon

Multiple Choice Practice

1. The socially optimal level of pollution is

A. less than that created by the market, but not zero.

B. more than that created by the market.

C. whatever the market creates.

D. determined by firms.

E. zero.

Multiple Choice Practice

1. The socially optimal level of pollution is

A. less than that created by the market, but not zero.

B. more than that created by the market.

C. whatever the market creates.

D. determined by firms.

E. zero.

Multiple Choice Practice

2. Which of the following is a source of negative externalities?

a. loud conversations in a library

b. smokestack scrubbers

c. a beautiful view

d. national defense

e. a decision to purchase dressy but uncomfortable shoes

Multiple Choice Practice

2. Which of the following is a source of negative externalities?

a. loud conversations in a library

b. smokestack scrubbers

c. a beautiful view

d. national defense

e. a decision to purchase dressy but uncomfortable shoes

Multiple Choice Practice

3. Inefficiencies created by externalities can be dealt with through

a. government actions only.

b. private actions only.

c. market outcomes only.

d. either private or government actions.

e. neither private nor government actions.

Multiple Choice Practice

3. Inefficiencies created by externalities can be dealt with through

a. government actions only.

b. private actions only.

c. market outcomes only.

d. either private or government actions.

e. neither private nor government actions.

Multiple Choice Practice

4. The Coase thoerem asserts that, under the right circumstances, inefficiencies created by externalities can be dealt with through

a. lawsuits.

b. private bargaining.

c. vigilante actions.

d. government policies.

e. mediation.

Multiple Choice Practice

4. The Coase thoerem asserts that, under the right circumstances, inefficiencies created by externalities can be dealt with through

a. lawsuits.

b. private bargaining.

c. vigilante actions.

d. government policies.

e. mediation.

Multiple Choice Practice

5. Which of the following makes more likely that private solutions to externality problems will succeed?

a. high transaction costs

b. high prices for legal services

c. delays in the bargaining process

d. a small number of affected parties

e. loosely defined legal rights.