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Fernando & Yvonn Quijano

Prepared by:

Externalities

and

Public Goods

18

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Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

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2 of 35Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

CHAPTER 18 OUTLINE

18.1 Externalities

18.2 Ways of Correcting Market Failure

18.3 Stock Externalities

18.4 Externalities and Property Rights

18.5 Common Property Resources

18.6 Public Goods

18.7 Private Preferences for Public Goods

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EXTERNALITIES18.1

Negative Externalities and Inefficiency

In (b), the industrys

competitive output is Q1,at the intersection ofindustry supply MCIand

demand D.

However, the efficientoutput Q* is lower, atthe intersection ofdemand and marginalsocial cost MSCI.

External Cost (continued)

Figure 18.1

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EXTERNALITIES18.1

Positive Externalities and Inefficiency

Figure 18.2

External Benefits

When there are positiveexternalities, marginal

social benefits MSB arehigher than marginalbenefits D.The difference is themarginal external benefitMEB.The price P1results in a

level of repair, q1.A lower price, P*, isrequired to encourage theefficient level of supply, q*.

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EXTERNALITIES18.1

Figure 18.3

Sulfur Dioxide Emissions

Reductions

The efficient sulfurdioxide concentrationequates the marginalabatement cost to themarginal external cost.Here the marginalabatement cost curve isa series of steps, each

representing the use of adifferent abatementtechnology.

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WAYS OF CORRECTING MARKET FAILURE18.2

Figure 18.4

The Efficient Level of Emissions

The efficient level of factoryemissions is the level that

equates the marginalexternal cost of emissionsMEC to the benefitassociated with lowerabatement costs MCA.The efficient level of 12units is E*.

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An Emissions Standardemissions standard Legal limit on the amount of

pollutants that a firm can emit.

Figure 18.5

Standards and Fees

The efficient level ofemissions at E* can beachieved through either anemissions fee or anemissions standard.

Facing a fee of $3 per unit ofemissions, a firm reducesemissions to the point atwhich the fee is equal to themarginal cost of abatement.

The same level of emissionsreduction can be achievedwith a standard that limitsemissions to 12 units.

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An Emissions Feeemissions fee Charge levied on each unit of a firm's

emissions.

Standards versus FeesFigure 18.6

The Case for Fees

With limited information, a

policymaker may be faced withthe choice of either a singleemissions fee or a singleemissions standard for all firms.

The fee of $3 achieves a totalemissions level of 14 units

more cheaply than a 7-unit-per-firm emissions standard.

With the fee, the firm with alower abatement cost curve(Firm 2) reduces emissionsmore than the firm with a higher

cost curve (Firm 1).

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Figure 18.7

The Case for Standards

When the government has limitedinformation about the costs andbenefits of pollution abatement,

either a standard or a fee may bepreferable. The standard ispreferable when the marginalexternal cost curve is steep andthe marginal abatement costcurve is relatively flat.

Here a 12.5 percent error insetting the standard leads to extrasocial costs of triangleADE.

The same percentage error insetting a fee would result inexcess costs ofABC.

Standards versus Fees

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Tradeable Emissions Permits

tradeable emissions permits System of marketablepermits, allocated among firms, specifying the maximum level ofemissions that can be generated.

Marketable emissions permits create a market for externalities. Thismarket approach is appealing because it combines some of theadvantageous features of a system of standards with the cost

advantages of a fee system.

Sulfur dioxide emissions produced through the burningof coal for use in electric power generation and the wide

use of coal-based home furnaces have caused a hugeproblem in Beijing as well as other cities in China.

Over the long term, the key to solving Beijings problem

is to replace coal with cleaner fuels, to encourage theuse of public transportation, and to introduce fuel-

efficient hybrid vehicles.

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Price of Tradeable Emissions Permits

The price of tradeable permits for sulfur dioxide emissions fluctuatedbetween $100 and $200 in the period 1993 to 2003, but then increasedsharply during 2005 and 2006 in response to an increased demand forpermits. Since then, the price has fluctuated around $400 to $500 per ton.

Figure 18.8

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Figure 18.9

The Efficient mount of RecyclingAs the amount of scrapdisposal increases, themarginal private cost, MC,increases, but at a much

lower rate than themarginal social cost MSC.

The marginal cost ofrecycling curve, MCR,shows that as the amountof disposal decreases,

the amount of recyclingincreases; the marginalcost of recyclingincreases.

Recycling

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The efficient amount ofrecycling of scrap material isthe amount that equates the

marginal social cost of scrapdisposal, MSC, to the marginalcost of recycling, MCR.

The efficient amount of scrapfor disposal m* is less than theamount that will arise in a

private market,m1.

A refundable fee increases thecost of disposal. Theindividual will reduce disposaland increase recycling to theoptimal social level m*.

Recycling

Figure 18.9

The Efficient mount of Recycling(continued)

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Figure 18.10

Refundable Deposits

The supply of virgin glasscontainers is given by Svandthe supply of recycled glassby Sr.The market supply Sis thehorizontal sum of these twocurves.

As a result, the market priceof glass is Pand the

equilibrium supply of recycledglass is M1.

Refundable Deposits

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By raising the relative cost ofdisposal and encouragingrecycling, the refundable

deposit increases the supplyof recycled glass from SrtoSrand the aggregate supplyof glass from Sto S.

The price of glass then fallsto P, the quantity of recycled

glass increases to M*, andthe amount of disposedglass decreases.

Figure 18.10

Refundable Deposits (continued)

Refundable Deposits

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Many other countries have made greater efforts toencourage recycling than the United States.

A number of proposals to encourage more recycling inthe United States include a refundable deposit,

curbside charge, and mandatory separation. Mandatory separation isperhaps the least desirable of the three alternatives.

A recent case in Perkasie, Pennsylvania, shows that recycling programscan indeed be effective. Prior to implementation of a program combiningall three economic incentives just described, the total amount of

unseparated solid waste was 2573 tons per year. When the program wasimplemented, this amount fell to 1038 tonsa 59-percent reduction. As aresult, the town saved $90,000 per year in disposal costs.

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STOCK EXTERNALITIES18.3

stock externality Accumulated result of actionby a producer or consumer which, though notaccounted for in the market price, affects other

producers or consumers.

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Stock Buildup and Its Impact

How does the stock of a pollutant change over time?With ongoing emissions, the stock will accumulate, but some fraction

of the stock, , will dissipate each year. Thus, assuming the stock

starts at zero, in the first year, the stock of pollutant (S) will be just the

amount of that years emissions (E):

In general, the stock in any year t is given by the emissions generated

that year plus the nondissipated stock from the previous year:

If emissions are at a constant annual rate E, then after Nyears, the

stock of pollutant will be

As Nbecomes infinitely large, the stock will approach the long-run

equilibrium level E/.

1 1S E

1(1 )

t t tS E S

2 1[1 (1 ) (1 ) (1 ) ]NN

S E

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Numerical Example Table 18.1 shows how the stock builds upover time. Note that after 100 years, the stock will reach a level of

4,337 units. (If this level of emissions continued forever, the stock will

eventually approach E/ = 100/.02 = 5,000 units.)


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To determine whether a policy of zero emissions makes sense,we must compare the present value of the annual cost of $1.5 billion

with the present value of the annual benefit resulting from a reduced

stock of pollutant.

2 99NPV

( 1.5 .198) ( 1.5 .296) ( 1.5 4.337)( 1.5 .1)

1 (1 ) (1 )R R R

Table 18.2 shows the NPV as a function of the discount rate. It also shows how

the NPV of a zero emissions policy depends on the dissipation rate, . If is

lower, the accumulated stock of pollutant will reach higher levels and cause more

economic damage, so the future benefits of reducing emissions will be greater.

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social rate of discount Opportunity cost tosociety as a whole of receiving an economicbenefit in the future rather than the present.

In principle, the social rate of discount depends on

three factors: (1) the expected rate of real economic

growth; (2) the extent of risk aversion for society as

a whole; and (3) the rate of pure time preference

for society as a whole.

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Emissions of carbon dioxide and other greenhouse

gases have increased dramatically over the past

century, which has in turn led to an increase in

atmospheric concentrations of greenhouse gases,

or GHGs.

The problem is that the costs of reducing GHG emissions would occur

today but the benefits from reduced emissions would be realized only in

some 50 or more years.

Does this emissions-reduction policy make sense? To answer that

question, we must calculate the present value of the flow of net benefits,which depends critically on the discount rate. Economists disagree aboutwhat rate to use, and as a result, they disagree about what should be done

about global warming

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Table 18.3 shows GHG emissions and average global

temperature change for two scenarios. Also shown is the annual

net benefit from the policy, which equals the damage under the

business as usual scenario minus the (smaller) damage when

emissions are reduced minus the cost of reducing emissions.

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EXTERNALITIES AND PROPERTY RIGHTS18.4

Property Rights

property rights Legal rules stating what people orfirms may do with their property.

Bargaining and Economic Efficiency

Economic efficiency can be achieved without government intervention

when the externality affects relatively few parties and when property

rights are well specified.

The efficient solution maximizes the joint profit of the factory and the

fishermen. Maximization occurs when the factory installs a filter and

the fishermen do not build a treatment plant.

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Bargaining and Economic Efficiency

If the factory and the fishermen agree to split this gain equally byhaving the fishermen pay the factory $250 to install the filter, this

bargaining solution achieves the efficient outcome.

Coase theorem Principle that when parties can bargain withoutcost and to their mutual advantage, the resulting outcome will beefficient regardless of how property rights are specified.

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Costly BargainingThe Role of Strategic Behavior

A Legal SolutionSuing for Damages

Bargaining can be time-consuming and costly, especially whenproperty rights are not clearly specified.

Bargaining can break down even when communication and monitoring

are costless if both parties believe they can obtain larger gains.

Another problem arises when many parties are involved.

A suit for damages eliminates the need for bargaining because it

specifies the consequences of the parties choices. Giving the party

that is harmed the right to recover damages from the injuring partyensures an efficient outcome. (When information is imperfect,however, suing for damages may lead to inefficient outcomes.)

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COMMON PROPERTY RESOURCES18.5

common property resource Resource to which anyonehas free access.

Figure 18.11

Common Property Resources

When a common propertyresource, such as a fishery,is accessible to all, the

resource is used up to thepoint Fcat which the privatecost is equal to the additionalrevenue generated.

This usage exceeds theefficient level F* at which the

marginal social cost of usingthe resource is equal to themarginal benefit (as given bythe demand curve).

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COMMON PROPERTY RESOURCES18.5

Figure 18.12

Crawfish as a Common Property Resource

Because crawfish are bred inponds to which fishermen haveunlimited access, they are acommon property resource.

The efficient level of fishingoccurs when the marginal benefitis equal to the marginal socialcost.However, the actual level offishing occurs at the point atwhich the price for crawfish is

equal to the private cost offishing.The shaded area represents thesocial cost of the commonproperty resource.

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PUBLIC GOODS18.6

public good Nonexclusive and nonrival good:the marginal cost of provision to an additionalconsumer is zero and people cannot be excludedfrom consuming it.

nonrival good Good for which the marginal

cost of its provision to an additional consumer iszero.

nonexclusive good Good that people cannotbe excluded from consuming, so that it is difficultor impossible to charge for its use.

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PUBLIC GOODS18.6

Figure 18.13

Efficient Public Good Provision

When a good is nonrival,the social marginalbenefit of consumption,

given by the demandcurve D, is determined byvertically summing theindividual demand curvesfor the good, D1and D2.

At the efficient level of

output, the demand andthe marginal cost curvesintersect.

Efficiency and Public Goods

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PUBLIC GOODS18.6

Public Goods and Market Failure

free rider Consumer or producer who does not pay for anonexclusive good in the expectation that others will.

Figure 18.14

The Demand for Clean Air

The three curves describe thewillingness to pay for clean air (areduction in the level of nitrogenoxides) for each of three differenthouseholds (low income, middleincome, and high income).In general, higher-income

households have greaterdemands for clean air than lower-income households. Moreover,each household is less willing topay for clean air as the level ofair quality increases.

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PRIVATE PREFERENCES FOR PUBLIC GOODS18.7

Figure 18.15

Determining the Level of

Educational Spending

The efficient level of educationalspending is determined bysumming the willingness to payfor education (net of tax payments)of each of three citizens.

Curves W1, W2, and W3representtheir willingness to pay, and curve

AWrepresents the aggregatewillingness to pay.

The efficient level of spending is$1200 per pupil. The level of

spending actually provided is thelevel demanded by the medianvoter. In this particular case, themedian voter's preference (givenby the peak of the W2curve) isalso the efficient level.

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