Externalities, Open-Access and Public Goods Chapter 18 PDF

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Tyler Downey

ECON 300

Chapter 18

Externalities, Open-Access, and Public Goods INTRO o Property Right  The exclusive privilege to use an asset  If one is not clearly assigned, a market failure is likely  Many goods have incomplete or unclear property rights  May cause externalities, which occur when someone’s consumption or production activities help or harm someone else outside of a market  If no one holds a property right for a good or a bad, it is unlikely to have a price  A good has an exclusion if its owner has clearly defined property rights and can prevent others from consuming it o Market failures may also occur if a good lacks rivalry, where only one person can consume it o Open-Access Common Property  A resource where exclusion of potential users is impossible o Club Good  A good or service that allows for exclusion but is non-rival  One person’s consumption does not use up the good, and others can also consume it o Public Good  Both nonexclusive and non-rival o Main Topics  Externalities  By-products of consumption and production may benefit or harm other people  The Inefficiency of Competition with Externalities  A competitive market produces too much of a harmful externality  Regulating Externalities  Overproduction of pollution and other externalities can be prevented through taxation or regulation  Market Structure and Externalities  With a harmful externality, a noncompetitive market equilibrium may be closer to the socially optimal level than that of a competitive equilibrium  Allocating Property Rights to Reduce Externalities  Clearly assigning property rights allows exchanges that reduce or eliminate externality problems  Rivalry and Exclusion  If goods lack rivalry or exclusion, competitive markets suffer from a market failure EXTERNALITIES o Externality

Tyler Downey   

ECON 300

Chapter 18

The direct effect of the actions of a person or firm on another person’s well-being or a firm’s production capability rather than an indirect effect through changes in prices May either help or harm others  Negative Externality vs. Positive Externality An action may create both positive and negative externalities at once

THE INEFFICIENCY OF COMPETITION WITH EXTERNALITIES o Competitive firms and consumers do not have to pay for the harms of their negative externalities  So they create excessive amounts o Producers are not compensated for the benefits of a positive externality  So too little of such externalities are produced o Externalities lead to non-optimal production o Private Cost  The cost of production only, not including externalities o Social Cost  The private cost plus the cost of the harms from externalities o A competitive market produces excessive pollution because the firm’s private cost is less than their social cost

Tyler Downey

ECON 300

Chapter 18

o The market supply curve (in Figure 18.1) is the aggregate private marginal cost curve, MCp, which is the horizontal sum of the private marginal cost curves of each firm o The private producer surplus is the producer surplus based on their private marginal cost curve o The competitive equilibrium maximizes the sum of consumer surplus and private producer surplus would equal welfare, so competition would maximize welfare. o Because of pollution, the competitive equilibrium does NOT maximize welfare. This market failure results from competitive forces that equalize the price and private marginal cost rather than social marginal cost, which includes both the private costs of production and the externality damage. o Welfare is the sum of consumer surplus and social producer surplus, which is based on the social marginal cost curve rather than the private marginal cost curve.  Welfare is maximized where price equals social marginal cost  A deadweight loss results because the competitive market equates price with private marginal cost instead of with social marginal cost REGULATING EXTERNALITIES o Government intervention may provide a social gain because of how competitive markets produce too many negative externalities  A government can optimally control pollution by taxing firms for the pollution they create or by limiting how much they can produce  Emissions Standard  A limit on the amount of air or water pollution that may be released  Emissions Fee  Tax on air pollution  Effluent Charge  Tax on discharges into the air or waterways  It is generally better to regulate pollution directly rather than to regulate output  This encourages firms to adopt efficient new technologies to control pollution  Internalize the Externality  To bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others)  A manufacturer is provoked to do this because of an output tax  The after-tax private marginal cost or supply curve is the same as the social marginal cost curve; as a result, the after-tax competitive equilibrium is the social optimum

Tyler Downey



ECON 300

Example Problem #1:

MARKET STRUCTURE AND EXTERNALITIES o Monopoly and Externalities

Chapter 18

Tyler Downey

ECON 300

Chapter 18

The monopoly outcome may be less than the social optimum even with an externality  The monopoly tends to produce too little output because it sets its price above its marginal cost  The monopoly tends to produce too much output because its decisions depend on its private marginal cost instead of the social marginal cost  Which effect dominates depends on the elasticity of demand for the output and on the extent of the marginal damage the pollution causes  If the demand curve is very elastic, the monopoly markup is small. As a result, the monopoly equilibrium is close to the competitive equilibrium and greater than the social optimum  If extra pollution causes little additional harm – marginal cost is close to zero at the equilibrium – the social marginal cost essentially equals the private marginal cost, and the monopoly produces less than the social optimum o Monopoly Versus Competitive Welfare with Externalities  In the absence of externalities, welfare is greater under competition than under an unregulated monopoly  However, with an externality, welfare may be greater with monopoly than with competition 

Tyler Downey   

ECON 300

Chapter 18

If both monopoly and competitive outputs are greater than the social optimum, welfare must be greater under monopoly because the competitive output is larger than the monopoly output If the monopoly produces less than the social optimum, we need to check which distortion is greater: the monopoly’s producing too little or the competitive market’s producing too much Example Problem #2:

o Taxing Externalities in Non-competitive Markets  To achieve a social optimum in a competitive market, the government only has to reduce the externality  In a non-competitive market, the government must eliminate problems arising from both externalities AND the exercise of market power  The government needs more information to regulate a non=competitive market  The failure to regulate a non-competitive market is less harmful than the failure to regulate a competitive market ALLOCATING PROPERTY RIGHTS TO REDUCE EXTERNALITIES o Coase Theorem  A polluter and its victim can achieve the optimal levels of pollution if property rights are clearly defined and they can practically bargain  Not a practical solution to most pollution problems  Demonstrates that a lack of clearly defined property rights is the root of the externality problem  Three Key Results of the Coase Theorem:  If property rights are not clearly assigned, one firm pollutes excessively and joint profit is not maximized  Clearly assigning property rights affects how they split the joint profit. Because the property rights are valuable, the other party compensates the party with the property rights.

Tyler Downey 



ECON 300

Chapter 18

To achieve the socially optimal outcome, the two sides must bargain successful for at least three important reasons:  If transaction costs are very high, it might not pay for the two sides to meet  If firms engage in strategic bargaining behavior, an agreement may not be reached  If either side lacks information about the costs or benefits of reducing pollution, the outcome is likely not to be optimal Coase bargaining is likely to occur in relatively few situations

o Markets for Pollution  If high transaction costs preclude bargaining, society may be able to overcome this problem by using a market, which facilitates exchanges between individuals  Cap-and-trade system  The government distributes a fixed number of permits that allow firms to produce a specified amount of pollution  The permits create a property right to pollute and put a limit or cap on the total amount of pollution  The permits can be traded in a market  Firms who need them less sell them o Markets for Positive Externalities  A market without regulation or government intervention to clearly define property rights cannot solve the harms from negative externalities.  But if the market has property rights that are usually clearly defined, little or no government intervention is needed to solve positive externality problems RIVALRY AND EXCLUSION o Rival Good  A good that is used up as it is consumed o Exclusion  Others can be prevented from consuming a good

Tyler Downey

ECON 300

Chapter 18

o Open-Access Common Property  A resource that is non-exclusive and rival  Everyone has free access and an equal right to exploit this resource o Club Goods  Goods that are non-rival but subject to exclusion  Create a market failure but government intervention is rare o Public Goods  Goods that are non-rival and non-exclusive  A special type of externality  Free Riding  Benefiting from the actions of others without paying  Markets undersupply public goods due to a lack of clearly defined property rights  Free riders want to benefit from a positive externality  It is difficult for a firm to profitably provide a public good because few people want to pay for it no matter how valuable it is to them  The social marginal benefit of a public good is the sum of the marginal benefit to each person who consumes the good  The social demand curve or willingness-to-pay curve for a public good is the vertical sum of the demand curves of each individual

Tyler Downey

ECON 300

Chapter 18

o Example Problem #3:

o Reducing Free Riding  One solution is for the government to provide the good  Or governmental or other collective actions can be done to reduce it  E.g. social pressure, mergers, privatization, mandates, and compulsion o Valuing Public Goods  To ensure a non-exclusive public good is provided, a government usually produces it or compels others to do so  Citizens may be asked to complete a survey or vote about a public good  It is efficient to provide the good if the value of it to society is at least as great as its cost...