Econ Chapter 10 Notes - Summary Principles of Economics PDF

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Econ 1 Chapter 10—Externalities Intro  

Why markets sometimes fail to allocate resources efficiently, how government policy can improve market’s allocation, and what kind of policies are likely to work best Externality—uncompensated impact of one person’s actions on the well-being of a bystander o Byproduct of producing a product (outside of supply and demand) Influences the well-being of a bystander but neither pays nor receives compensation for that effect  Positive externality—beneficial  Negative externality—Adverse effect With externalities, society’s interest in market outcome is made up of buyers, sellers, and bystanders who are affected Buyers and sellers neglect the external affects of their actions, so the market equilibrium isn’t efficient o Equilibrium fails to maximize the total benefit to society as a whole  Government needs to step in (to influence behavior to protect the interests of bystanders) Ex. Negative—pollution, barking dogs o Positive—historic buildings, research for new technology o

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Externalities and Market Inefficiency  

Welfare Economics: A Recap o Equilibrium =( value to buyers) – (cost to sellers) Negative Externalities o The cost to society is greater than the cost to producers, due to the externality of pollution  Social cost—(private cost of producer) + (cost to bystander)  Social cost curve is above supply curve because it takes into account the external costs imposed on society by producing the good  The difference between social cost curve and supply curve is the cost of pollution emitted o Optimal quantity—where the demand curve crosses social-cost curve  Determines optimal amount from view of society as a whole o How to reach optimal outcome  Tax producers by size of pollutantnew supply curve that coincides with the social-cost curve  Internalizing the externality—altering incentives so that people take account of the external effects of their actions o Gives buyers/sellers incentive to take into account the external effects of their actions

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Ex. Producers take cost of pollution into account because the tax would make them pay the external costs

Positive Externalities o Ex. Education—the benefit is private (productive workers and higher wages) and public with positive externalities…  Educated population means more informed voters (better government for everyone), lower crime rates, and encourages development of technological advances (leading to higher productivity and wages) o Social value is greater than private so social curve is above the demand curve  The socially optimal quantity is greater than the private market on its own o Government Intervention—subsidy Sum Up o Negative externalities lead markets to produce a larger quantity than socially desirable o Positive externalities lead markets to produce a smaller quantity than wanted o Government can internalize the externality by taxing and subsidizing goods Case Study: Technology Spillovers, Industrial Policy, and Patent Protection o Technology Spillovers—impact of one firm’s research and production efforts on other firm’s access to technological advance o Industrial Policy—government intervention that aims to promote technology-enhancing industries o Patent Protection—protect the rights of inventors by giving them exclusive use of their inventions for a period of time

Public Policy toward Externalities  

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Intro o The goal is moving the allocation of resources closer to the social optimum Command-and-Control Policies: Regulation o Government can either require or forbid certain behaviors—Dictates o With pollution, it isn’t sensible for all transportation to be banned, so instead society weighs the costs and benefits to decide the quantities it allows  Environment Protection Agency (EPA) develops and enforces regulations aimed at protecting the environment  They can dictate max levels of pollution a factory may emit OR require a firm to adopt a technology to reduce emissions  The government needs to know details about an industry and it is difficult to obtain that info Market-Based Policy 1: Corrective Taxes and Subsidies o Market based policies are used to align private incentives with social efficiency o Corrective taxes—a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality  Also called Pigovian taxes

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 Gives an economic Incentive  Should ideally equal the external cost or benefit o Economists prefer tax to regulation—tax relates to individual factory whereas regulation is the same amount for everyone (one size fits all) o Corrective taxes alter incentives for the presence of externalities and move the allocation of resources closer to the social optimum—enhance economic efficiency o Case Study—Why is Gasoline Taxes so Heavily (due to 3 externalities)  Congestion—encourages less drivers so less traffic  Accidents—bigger cars are more dangerous to others so it makes those with bigger cars pay more for their gas guzzling cars  Pollution—reduces use of gasoline  There is no deadweight tax because there is a benefit to society Market-Based Policy 2: Tradable Pollution Permits o Social welfare is enhanced by allowing selling of permits  Both companies better off because paying less and pollution is reduced by the same amount—it is all voluntarily o Similar to corrective tax—polluting firms pay the government and it is more costly to the government by internalizing the externality o An auction price of a permit is better at approximating the size of the corrective tax Objections to the Economic Analysis of Pollution o Argument—the environment is so important that should be protected regardless of cost o But—complete clean air/water has high opportunity cost of technology and high standard of living  Law of demand—lower price of environmental protection, the more the public will want (increases demand for clean environment)

Private Solutions to Externalities 

The Types of Private Solutions o Moral codes and social sanctions  There is a moral injunction that tells us to think about how our actions affect other people  In economic terms—internalize externalities o Charities  Nonprofit organizations funded through private donations (ex. Sierra Club whose goal is to protect the environment)  Universities who receive gifts from alumni and foundations because education has a positive externality for society  The government encourages private solutions by allowing income tax deductions for charitable donations o Solves the problem by relying on the self-interest of the relevant parties  The solution takes the form of integrating different types of business

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Ex. If an apple grower and a beekeeper have mutually benefiting operations, internalizing by having one person own both  Both activities would take place within the same firm and that single firm could choose the optimal number required  Internalizing externalities is why firms are involved in multiple types of business o Interested parties enter into a contract  The contract can solve the inefficiency (ex. contract between apple trees and beekeeper) The Coase Theorem o How effective is the private market in dealing with externalities? o Coase theorem—the proposition that if private parties can bargain without cost over the allocation of resources (at no cost), they can solve the problem of externalities on their own  Ex. Dick and Jane and the benefit/cost of the barking dog  By Jane paying Dick to get rid of the dog, the private market o The private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient Why Private Solutions Do Not Always Work o Interested parties have trouble reaching and enforcing an agreement (bargaining doesn’t always work) o Transaction costs—the costs that parties incur in the process of agreeing to and following through on a bargain  Ex. hiring a translator or a lawyer o Bargaining breaks down and they fail to reach an agreement

Conclusion  

When there are external effects, such as pollution, evaluating a market outcome requires taking into account the well-being of third parties When people cannot solve the problem privately, the government intervenes by requiring the decision makers to bear the full costs of their actions...