Lecture Sixxxxxx PDF

Preview

Summary

Lecture 6...

Description

How can governments address issues such as climate change, pollution, problem drinking and rising obesity?

What are externalities and internalities?

This lectur lecture e

What tools can government use to correct for externalities and internalities?

When do mark marke ets wo worrk?

When these conditions hold : • no externalities • perfect competition (i.e. individuals and firms are price takers) • perfect information • agents are rational then the private market equilibrium is Pareto efficient, i.e. nobody can be made better off without somebody else becoming worse off This result is known as the first welfare theorum

then the private market equilibrium will not necessarily be pareto efficient

If these assump assumptio tio tions ns do not hold

Government intervention may be desirable if the assumptions of the first welfare theorem fail, i.e. when there are market failures, and there is a feasible policy that improves welfare Government intervention can potentially improve somebody’s welfare • (or it might improve some people’s and reduce others welfare, which may or may not be desirable depending on the social welfare function)

Externalities

Externalities arise whenever the actions of one economic agent directly affect another economic agent outside the market mechanism • a steel plant that pollutes a river used for recreation is an externality • a steel plant uses more electricity and bids up the price of electricity for other electricity customers is not an externality Externalities are one important case of market failure

Externalities ca can n be positive or neg negaativ ive e

Negative externalities • burning fossil fuels emits green house gases which lead to global warming • playing your stereo loud at night might keep your neighbour awake Positive externalities • a firm invests in research to come up with a new more efficient production process, other firms can see and copy it without having to pay for it • my neighbour plants a nice tree that shades my garden, this benefits me but I didn’t pay for it

In Intternalities

arise when there is a cost to the person them self that they fail to take account of at the point of taking the consumption decision: • e.g. smoking imposes large future costs on smokers (poor health, reduced productivity, higher mortality) • if smokers are forward looking and rational they will take account of all these costs • evidence suggests smokers suffer from self control problems (60% of smokers in UK would like to quit) • some smokers support policies or programmes that restrict the general availability of tobacco

Mark Marke et fa faiilure

Externalities and internalities are examples of market failure A problem that violates one of the assumptions of the first fundamental welfare theorem and causes the market economy to deliver an outcome that is not efficient Negative externalities or internalities will lead individuals to over consume or produce Positive externalities or internalities will lead individual to under consume or produce

Mark Market et fa faiilure fro rom m ex exte te terrnalities In deciding how much to consume individuals will equate their perceived marginal benefit from consumption to the perceived marginal cost

When individuals may not or do not seem to act in their best interests there are two polar views on such situations: Paternalism [Libertarian View] Individual failures do not exist and government wants to impose its own preferences against individuals’ will

In Intternalities

Individual Failures [Behavioral Economics View] Individual Failures exist: Self-control problems, Cognitive Limitations Distinguishing the 2 views: • Under Paternalism, individuals are opposed to government interventions • If individuals understand they have failures, they will support government interventions

Pr Priivate secto torr solutions to ex exte te terrnalities Ronald Coase (Nobel Prize winner): Are externalities really outside the market mechanism? Coase challenged the idea that government intervention was needed to prevent people and companies from behaving in ways that harmed others. He argued that, if certain conditions held, the affected parties could negotiate and settle conflicts privately to their mutual benefit.

Coase Theor Theorem em

Coase Theorem (Part I): When there are welldefined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity Coase Theorem (Part II): The efficient quantity for a good producing an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights

Firms pollute a river enjoyed by individuals. If firms ignore individuals, there is too much pollution

Coase theor theorem em ex exaample

If river is owned by individuals then charge firms for polluting the river • will charge the marginal damage per unit of pollution • why price pollution at marginal damage? If price is above marginal damage, individuals would want to sell an extra unit of pollution, so price must rise. Marginal damage is the equilibrium efficient price in the pollution market If river is owned by firms then firm can charge individuals for polluting less. They will also charge individuals the marginal damage per unit of pollution reduction. Final level of pollution will be the same in both cases

Coase was very clear that this result would only hold under specific assumptions: • Property rights are well defined • Bargaining is costless

Coase theor theorem em As Coase himself acknowledged, in many cases, these are course, very unrealistic assumptions”. limit limitaations “of • Not always clear how property rights should be assigned (e.g. global warming) • Bargaining is often costly from both a monetary and time perspective

In practice, the Coase theorem is has limited applicability to many real world externalities

Pr Pro oblems with Coasia Coasian n soluti solution on

The assignment problem: when externalities affect many (e.g. global warming), assigning property rights is difficult Coasian solutions are likely to be more effective for small, localized externalities than for larger, more global externalities involving large number of people and firms The holdout problem: Shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution) – this is amplified with an externality involving many parties Transaction Costs and Negotiating Problems: it is hard to negotiate when there are large numbers of individuals on one or both sides of the negotiation – this is amplified for an externality such as global warming, where the potentially divergent interests of billions of parties on one side must be somehow aggregated for a negotiation

The main policies used to tackle negative externalities are: price policy: corrective tax (or subsidy) equal to marginal damage (or benefit) per unit

Pu Pub blic policy re rem medies for ex extternalities

regulation: e.g. government restricts firms to produce the socially efficient quantity In an ideal world price and quantity regulation are equivalent but in practice there are often reasons to favour one over the other for targeting different externalities

Corrective taxes are commonly implemented as “excise taxes”: • e.g. on motor fuels, tobacco, alcohol, soda

Corr Correct ect ectiv iv ive e tax taxe es

• excise taxes comprise 7.2% of total tax receipts Corrective taxation discourages socially harmful consumption by (trying to) aligning perceived private marginal costs with actual social marginal costs

Pig Pigouvian ouvian ttaaxes Pigou showed that the socially efficient outcome could be achieved by setting the tax equal to the marginal externality or internality at the socially efficient quantity.

Corr Corrective ective taxes Unlike other taxes, corrective taxes do not create inefficiency, they restore efficiency!

This looks very simple, BUT, in reality there are complicating factors:

Corr Correct ect ectiv iv ive e tax taxe es

• measuring the externality • variation across consumers in the amount of externality and their responsiveness to tax

Obesity is a world wide problem • about 13% of the world’s population obese in 2016

Po Pollicy to towa wa ward rd rdss obesi obesity ty

Government are getting more involved in telling consumers what they can and can’t eat as they grappling rising obesity • some people believe that the government should mind its own business and let consumers decide for themselves what they eat • others argues that consumers need protection from themselves and from outside temptation

Adult obes obesity ity ra rattes

Source: Public Health England, National Child Measurement Programme

These differences can have long term consequences for health as well as social and economic outcomes

Wh Whyy sho should uld gover govern nment get in invvolv olved? ed?

Policies such as taxes on junk foods, restrictions to the availability and advertising of foods, nutritional labelling and regulation to encourage firms to reformulate products aims to encourage a healthier diet • but these policies have sometimes proved controversial What effects will these policies have? Could we design them better?

When markets function well the best outcome is achieved when people choose for themselves what to consume • people trade off the costs and benefits of their choices

Po Pollicy aims to improve choices

• the market functions better than government because people have better information about their own preferences and the trade offs they would like to make However, there is clear evidence that people are making bad choices leading to poor health, economic and social outcomes • these poor choices affect that person over their lifetime and affect other people • policy might be able to help consumers make better choices

Conseq Consequenc uenc uences es of poor choi choices: ces: externa ernalililiti ti ties es

Consequences of p poor oor choices choices:: int internalit ernalit ernalities ies

We want policies that

We Welll designed policy

• reduce externalities (costs imposed on wider society) and internalities (costs imposed on the person themselves in the future) To design good policy we need to understand • why people are making bad choices • how specific policies, or combinations of policies, will affect different people (i.e. will it lead people with the highest externalities or internalities to change their choices) • what other effects the policies might have (e.g. lead firms to change their behaviour)

Wh Whyy ar are e people making bad choices?

They lack information?

Wh Whyy ar are e peopl people e ma making king bad choic choices? es? Poverty and cognitive overload?

Wh Whyy ar are e peopl people e ma making king bad choic choices? es? Poverty and cognitive overload?

Wh Whyy ar are e peopl people e ma making king bad choic choices? es? Poverty and cognitive overload?

Wh Whyy ar are e people making bad choices?

They lack self-control?

Wh Whyy ar are e people making bad choices?

Advertising?

Ther There e ar are e man manyy polici policies, es, wha whatt ar are e the theyy aiming to achieve eve??

Wha Whatt do these p policies olicies aim tto o co corrrec rectt?

provide information

Wha Whatt do these p policies olicies aim tto o co corrrec rectt?

self control

Wha Whatt do these p policies olicies aim tto o co corrrec rectt?

self control

Wha Whatt do these p policies olicies aim tto o co corrrec rectt?

self control

UK Soft Drinks Industry Levy

Soda taxes have been implemented in 50 jurisdictions • 27 studies of taxes in 11 jurisdictions

In Interna terna ternation tion tional al evi evid dence on eff effe ect of soda tax taxe es

All studies find that taxes lead to increased prices • pass-through is lower in smaller jurisdictions; in settings like the UK taxes are fully passed through to prices Most studies find that taxes • led to substantial reductions in purchases of soda

Dif Difffer erence ence betw between een ec econo ono onomic mic and public health appr approaches oaches

Economics: how does the policy change individual’s trade off of the benefits against the costs of consumption • where costs include prices, future health, social and economic costs to the individual, and any externalities they have on others Public health: how does the policy affect population outcomes • does it reduce risk factors for diseases • this does not value the benefits individuals get from consumption • and often does not pay attention to impact on individuals, and eg. inequalities

• how do individual consumers respond? do the policies change behaviour of the target group of consumers? • how do firms respond?

How ef efffective are these polici policies? es?

• ex post analysis • use data to compare outcomes before and after a policy reform in a ``treatment'' and a ``control'' group • ex ante or ``structural'' analysis • use data and economic theory to figure out both what will happen if the policy is implemented (the ``treatment'') and what will happen in the absence of the policy (the ``control'') • importantly, helps us to understand the mechanisms through which policies works

Massive over consumption of sugar

• Who is the target population? • people with largest internalities; young and heavy consumers?

Ar Are e ssoda oda tax taxe es ef efffective ve??

• Are these groups responsive to taxes • if they are then tax reduces welfare, because they can’t buy a product they like, but they gain in the long run due to reduced internalities • if they aren’t then tax reduces welfare, because they have to pay higher prices, and they still experience internalities in the long run • evidence suggests that the young are, but not heavy consumers • What is the scope for further use of taxes?

Long term decline in food prices in the UK 110%

100%

90%

80%

70%

1975 1980 1985 1990 1995 2000 2005 2010 2015

Lower food prices have led to important welfare gains for poor households • Poorest households (lowest 10% income) • food is 15% of expenditure • Richest households (highest 10% income) • food is 7% of expenditure

Wha Whatt effects do advertising re rest st strrictions have ave??

Advertising of junk foods

The impact of ban banning ning junk ffoods oods adv adverts erts

• Adverts of junk food • are persuasive, distract people from other characteristics of the product (price, bad health consequences) • lead people to choose to buy more junk food (than in the absence of adverts) • Firms compete in advertising and in prices • Banning advertising means • consumers pay more attention to price and other characteristics • firms can’t compete in advertising, so they compete more in prices • both of these mean that price competition increases and prices fall • A reduction in prices leads to increased purchases

There is compelling evidence that people are making suboptimal choices regarding food consumption

Summary

Policy can potentially make people better off by protecting them from themselves and from outside temptation • however, there are many reasons that individual and firm behaviours might undermine the ability of policy to achieve this aim • to be effective policies must address market failures and be well targeted • policies can make things worse and might even reduce welfare of the people they are aiming to help - be wary of unintended consequences • doesn't mean we shouldn't implement policies, but do so intelligently • substantive policy reforms such as education and lifting households out of poverty are likely to have bigger long term impact, but they are much more costly and how can we fund them?

What's next? Policy brief due by 2pm Wed Nov 13 penalties for late submission are automatic and harsh Lecture 7 How do we know when policies work and why they work?...