1Chapter 18ExternalitiesMain topics1. externalities2. inefficiency of competition with externalities3. market structure and externalities4. allocating property rights to reduce externalities5. common property6. public goodsExternalitiesexternality occurs if• someone's consumption or production activities hurt or help others outside a market• well-being of a consumer or production capability of a firm are affected directly by actions of other consumers or firms, rather than indirectly through changes in prices2Examples• firm whose production process lets off fumes that harm its neighbors is creating an externality for which there is no market• firm is not causing an externality when it harms a rival by selling extra output that lowers market pricePositive and negative externalities• externalities may either help or harm others• externality that harms someone is a negative externality• positive externality benefits others• action may confer positive externalities on some people and negative externalities on others: wind chimes (though it’s hard to imagine the positive ones) Los Angeles airan atmospheric scientist reports that cleaning up LA air over last decade• helped people breathe• caused radiation levels to increase more rapidly than they would have risen if air had remained dirty3Michael Jordan: Positive externality• Jordan's presence raised 1991-92 regular season away games• ticket revenues $2.5 million• local TV advertising revenues: $2.4 million• positive externality: extra revenues went to home team rather than to BullsAdditional externalities• Jordan's presence increased national earnings• TV advertising: $6.6 million regular season; $13.9 million playoffs• NBA Properties (clothing and videos) by $15.1 million • shared equally by all teams, so externality• total value of Jordan's positive externalities was $40.3 millionInefficiency of competition with externalities• competitive firms and consumers do not have to pay for harms of their negative externalities• so they produce excessive pollution4Assumptions• competitive paper market• firms produce paper and gunk (by-products): air and water pollution that harm people who live near paper mills• each ton of paper produced increases the amount of gunk by 1 unit• only way to decrease volume of gunk is to reduce the amount of paper manufactured• paper firms do not have to pay for harm from pollution they causePrivate vs. social costs• private cost: cost to firm of production only, not including externalities:• direct costs of labor, energy, and wood pulp • but not indirect costs of harm from gunk• social cost: private cost plus cost of harms from externalitiesSupply-and-demand analysis• competitive market produces excessive pollution because firms' private costs < social costs• maximizes welfare: sum of CS and social PS (based on the social marginal cost curve)• social optimum • welfare is maximized where price equals social MC• optimal tradeoff between value of production and pollution harm5Figure 18.1 Welfare Effects of Pollution in a Competitive MarketPrice of paper, p,$ per tonDemandMCpMCgMCgMCs=MC p+MCg450ps= 282pc= 2403084198Qc=105Qs=84 2250ecesABFCDEHGG, Units of gunk per dayQ, Tons of paper per dayMCpReducing externalities• competitive markets produce excessive negative externalities• hence government intervention may benefit societyGovernment expenditures• expenditures on environmental protection as a percentage of GDP range between a 0.2 to 1%: • 0.2% Italy• 0.4% Portugal, United Kingdom• 0.6% United States, Spain• 0.7% Sweden• 0.8% Germany, Switzerland• 1.0% Austria, Denmark, and Japan• world's poorest countries spend little if anything on pollution control6Emissions relative to economic output• developing countries• China emitted 2,095 metric tons of carbon per million dollars of GDP• Soviet Union, 1,517• India, 602• Mexico, 586• developed countries• United States, 279• Great Britain, 216• Japan, 101Government intervention• direct approach: emissions tax, fee, effluent charge• indirect approach: emissions standard(quantity restrictions on outputs or inputs)• because output and pollution move together, regulating either worksFigure 18.2 Taxes to Control PollutionPrice of paper,p, $ per tonDemandMCpMCgMCs= MCp+(tQ)MCp+ττ=84450ps= 282MCp= 198MCg= 84Qs=84 2250esG, Units of gunk per dayQ, Tons of paper per day7Optimal regulation • unfortunately, government usually does not know enough to regulate optimally• government needs to know:• marginal social cost curve• demand for paper curve• how pollution varies with outputEnforcement• even if government knows enough to set optimal regulation, it must enforce regulation to achieve social optimum• U.S. Environmental Protection Agency (EPA) federal smog standards violated in 33 metropolitan areas• including Baltimore, Boston, Chicago, Houston, Los Angeles, Milwaukee, New York, and Philadelphia• http://www.epa.gov/enviro/zipcode.html• http://www.scorecard.org• http://www.formyworld.comCost-benefit analysis• instead of using the supply-and-demand analysis to show that competitive market produces too much pollution• use a cost-benefit diagram• welfare is maximized by reducing output and pollution until the marginal benefit from less pollution equals the marginal cost of less output8Figure 18.3Cost-Benefit Analysis of PollutionBenefit, Cost, $Cost: less paperBenefit: less gunkMaximumnetbene fit84 63105084105G, Units of gunk per dayQ, Tons of pa per per dayG, Units of gunk per dayQ, Tons of pa per per day(a) Cost and BenefitMargina l be nef it,Marginal cost, $(b) Marginal Cost and Marginal Benefit4,0002,000105840MCMBEmission standards for ozone• ozone is a major air pollutant • it is formed in the atmosphere through a chemical reaction between organic gases and nitrogen oxides in sunlightStandards• Clean Air Act of 1990 sets national air-quality standards for major pollutants: > 0.12 parts per million (ppm)• California Air Resources Board (CARB) has an even tighter standard: 0.09 ppm9Costs and benefits • cost of reducing ozone: greater expenses of• manufacturing• driving•benefit• better health in urban areas• increased agricultural yields in rural areas• consequently, optimal level differs in urban and rural areasLos Angeles• benefits of reducing ozone level > costs over past several decades•
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