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Yale ECON 115 - Market Failures II: Externalities and Public Goods

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Market Failures II: Externalities and Public Goods1. Introduction2. The Case of Pollution3. Public policy solutions(a) Standards(b) Fees4. Private solutions and the Coase Theorem5. Public goods6. Summer reading1Introduction• Consider the cost of driving from New Haven to New York City• What are the costs?1. gas and oil2. wear and tear on your car3. tolls4. the value of your time while driving5. adding to the traffic congestion6. increasing the chance of an accident to someone else7. increasing the amount of pollution in the air8. wear and tear on the roads• Costs (1)-(4) are private or internal costs and are taken into accountby potential drivers when deciding whether to make the drive or not.• Costs (5)-(8) are external or social costs. These costs ore typically borneby others and are much less likely to be taken into account by potentialdrivers.2• An externality is an action of a consumer or producer that affect otherconsumer/producers costs and benefits AND are not fully reflected inprices.• Externalities can get in the way of economic efficiency and lead to mar-ket failure. If individuals are unable to take externalities into accountwhen making trades, government intervention in markets may increasewelfare.• Positive externalities infer a benefit to others– Vaccination, education?, basic research, maintaining the exterior ofyour house• Negative externalities impose a cost on others– Noise, pollution, congestion.• So called Pecuniary externalities are effects that are transmittedthrough the price system. These are not externalities.– Example: by supplying labor to the market you tend to lower theprice of labor. This reduces the welfare of others who supply labor.It increases proportionally the welfare of those who buy labor. Botheffects exactly cancel out.3The Case of Pollution• Following the book, let’s consider a steel plant that dumps waste intoa river, killing fish and reducing the value of the river to other (e.g.fisherman, swimmers).• Assumptions: the steel market is competitive and the only way to re-duce pollution is to reduce steel output.• Case I: Only one steel plant pollutes– Figure 18.1(a)– Supply curve is the marginal cost curve– Marginal external cost is the increase in cost imposed externally asone or more firms increase output by one unit.– Marginal social cost is the sum of the marginal cost of productionand the marginal external cost.– Firm is producing too much steel (q1instead of q∗).4• CASE II: Every steel plant pollutes– Figure 18.1(b)– Industry supply curve is MCI.– Marginal external cost is MECI.– Marginal social cost is MCSI.– Firm is producing too much steel (q1instead of q∗).• In both cases too much output is being produced since the market pricedoes not reflect the cost to society of polluting the river.• In this case, markets are not obtaining the efficient outcome.5Public policy solutions to externalities• How much pollution should we allow?• None? – Even the most environmentally conscious societies acceptsome pollution as the cost of producing useful goods and services.• As with almost all of economics, the choice comes down to equatingdecisions on the margin.• The marginal social costs of pollution curve slopes upwards capturingthe idea that small levels of pollutants generate little harm but theharm increases substantially as the level of pollution increases.• The curve MCA is the marginal cost of abatement. It measures theadditional cost to the firm of installing pollution control equipment.This cost curve is downward sloping since the marginal cost of reducingthe first unit of pollution is much cheaper than the cost of eliminatingthe last unit of pollution.• Figure 18.3• With no abatement, the quantity of pollution is 26.• Level of pollution that equates the marginal cost of abatement to themarginal social cost of pollution is 12.• Two ways to obtain this optimal level: fees or standards.6Standards• A standard is a legal limit to how much pollution the firm may release.• Firm must apply to the EPA for the permission to release a certainquantity of pollution.• So for the firm, the cost of releasing pollution up to it’s limit is free;but once it hits the limit, the cost is extremely high.• In our, example of standard of 12 obtains the efficient solution.7Fees• A fee is a tax on pollution.• Firm pays the tax per unit of pollution it produces.• If the cost of abating an unit of pollution is less than the tax, the firmwill abate that unit.• Sets quantity of pollution to the level such that the marginal cost ofabatement is equal to the fee.• Example of this is the gas tax.• Question about whether it is best to regulate through quantities orprices.8A private solution to externalities• Assign explicit property rights.• Consider the case of two room-mates, one is a smoker, one is a non-smoker. Base-line official rule: Smoking is not allowed in the dorm.That is the non-smoker has the right to clean air inside the room.• Non-smoker would prefer if she is not exposed to second hand smoke.The value of this to her is $X annually.• The smoker would like to smoke in her room: The value of this to heris $Y.• Could they make a deal? Yes.– If Y>X, then the smoker could pay the non-smoker $(X+Y)/2(some number between their two valuations) for the right to smokein the room. Both parties will be better off.– If Y<X, then the smoker will not be willing to offer enoughmoney to the non-smoking room-mate for the privilege to smoke inthe room.• If the smoking room-mate values smoking more than the non-smokervalues clean air, smoking will be allowed. Otherwise smoking will notbe allowed.9• What about if smoking was officially allowed? That is the smoker hasthe right to smoke in the room. What would change?– If Y>X, then the non-smoker will not be willing to offer enoughmoney to the smoking room-mate to not smoke in the room.– If Y<X, then the non-smoker could pay the smoker $(X+Y)/2(some number between their two valuations) to not smoke in theroom. Both parties will be better off.• We get the same results: If the smoking room-mate values smokingmore than the non-smoker values clean air, smoking will be allowed.Otherwise smoking will not be allowed.• The Coase Theorem states that with cost-less bargaining, the alloca-tion of resources in the presence of an externality will be efficient. Thisis independent of how property


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Yale ECON 115 - Market Failures II: Externalities and Public Goods

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