Chapter 18
Externalities and
Public Goods
Chapter 18 Slide 2
Topics to be Discussed
Externalities
Ways of Correcting Market Failure
Externalities and Property Rights
Common Property Resources
Chapter 18 Slide 3
Topics to be Discussed
Public Goods
Private Preferences for Public Goods
Chapter 18 Slide 4
Externalities
Negative
Action by one party imposes a cost on
another party
Positive
Action by one party benefits another
party
Chapter 18 Slide 5
External Cost
Scenario
Steel plant dumping waste in a river
The entire steel market effluent can be
reduced by lowering output (fixed
proportions production function)
Chapter 18 Slide 6
External Cost
Scenario
Marginal External Cost (MEC) is the cost
imposed on fishermen downstream for
each level of production.
Marginal Social Cost (MSC) is MC plus
MEC.
MC
S = MCI
D
P1
Aggregate
social cost of
negative
externality
P1
q1 Q1
MSC
MSCI
When there are negative
externalities,the marginal
social cost MSC is higher
than the marginal cost.
External Costs
Firm output
Price
Industry output
Price
MEC
MECI
The differences is
the marginal external
cost MEC.
q*
P*
Q*
The industry competitive
output is Q1 while the efficient
level is Q*.
The profit maximizing firm
produces at q1 while the
efficient output level is q*,
Chapter 18 Slide 8
External Cost
Negative Externalities encourage
inefficient firms to remain in the
industry and create excessive
production in the long run.
Chapter 18 Slide 9
Externalities
Positive Externalities and Inefficiency
Externalities can also result in too little
production,as can be shown in an
example of home repair and
landscaping.
Chapter 18 Slide 10
MCP1
External Benefits
Repair Level
Value
D
Is research and development
discouraged by positive
externalities?
q1
MSB
MEB
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
q*
P*
A self-interested home owner
invests q1 in repairs,The
efficient level of repairs
q* is higher,The higher price
P1 discourages repair.
Chapter 18 Slide 11
Ways of Correcting Market Failure
Assumption,The market failure is
pollution
Fixed-proportion production technology
Must reduce output to reduce
emissions
Use an output tax to reduce output
Input substitution possible by altering
technology
Chapter 18 Slide 12
The Efficient Level of Emissions
Level of Emissions
2
4
6
Dollars
per unit
of Emissions
0 2 4 6 8 10 12 14 16 18 20 22 24 26
MSC
MCA
E*
The efficient level of
emissions is 12 (E*) where
MCA = MSC.
Assume:
1) Competitive market
2) Output and emissions decisions are independent
3) Profit maximizing output chosen
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost.
E0
At E1 the marginal
social cost is greater
than the marginal benefit.
E1
Why is this more efficient
than zero emissions?
Chapter 18 Slide 13
Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emission Standard
Set a legal limit on emissions at E*
(12)
Enforced by monetary and criminal
penalties
Increases the cost of production and
the threshold price to enter the
industry
Chapter 18 Slide 14
Standards and Fees
Level of Emissions
Dollars
per unit
of Emissions MSC
MCA
3
12
E*
Standard
Fee
Chapter 18 Slide 15
Options for Reducing Emissions to E*
Emissions Fee
Charge levied on each unit of
emission
Ways of Correcting Market Failure
Chapter 18 Slide 16
Total
Abatement Cost
Cost is less than the
fee if emissions were
not reduced.
Total Fee
of Abatement
Standards and Fees
Level of Emissions
Dollars
per unit
of Emissions MSC
MCA
3
12
E*
Fee
Chapter 18 Slide 17
Standards Versus Fees
Assumptions
Policymakers have asymmetric
information
Administrative costs require the same
fee or standard for all firms
Ways of Correcting Market Failure
Chapter 18 Slide 18
Firm 2’s Reduced
Abatement
Costs
Firm 1’s Increased
Abatement Costs
MCA1
MCA2
The Case for Fees
Level of
Emissions
2
4
6
Fee per
Unit of
Emissions
0 1 2 3 4 5 6 7 8 9 10 11 12 13
1
3
5
14
The cost minimizing solution
would be an abatement of 6
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
3.75
2.50
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
If a fee of $3 was imposed
Firm 1 emissions would fall
by 6 to 8,Firm 2 emissions
would fall by 8 to 6.
MCA1 = MCA2,efficient solution.
Chapter 18 Slide 19
Advantages of Fees
When equal standards must be used,
fees achieve the same emission
abatement at lower cost.
Fees create an incentive to install
equipment that would reduce emissions
further.
Ways of Correcting Market Failure
Chapter 18 Slide 20
ABC is the increase
in social cost less the
decrease in abatement
cost.
Marginal
Social
Cost
Marginal Cost
of Abatement
The Case for Standards
Level of Emissions
Fee per
Unit of
Emissions
0 2 4 6 8 10 12 14 16
2
4
6
8
10
12
14
16
E
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
DA B
C Based on incompleteinformation fee is $7
(12.5% reduction).
Emission increases to 11.
Chapter 18 Slide 21
Summary,Fees vs,Standards
Standards are preferred when MSC is
steep and MCA is flat.
Standards (incomplete information) yield
more certainty on emission levels and
less certainty on the cost of abatement.
Ways of Correcting Market Failure
Chapter 18 Slide 22
Summary,Fees vs,Standards
Fees have certainty on cost and
uncertainty on emissions.
Preferred policy depends on the nature
of uncertainty and the slopes of the cost
curves.
Ways of Correcting Market Failure
Chapter 18 Slide 23
Transferable Emissions Permits
Permits help develop a competitive
market for externalities.
Agency determines the level of
emissions and number of permits
Permits are marketable
High cost firm will purchase permits
from low cost firms
Ways of Correcting Market Failure
Chapter 18 Slide 24
Question
What factors could limit the efficiency of
this approach?
Ways of Correcting Market Failure
Chapter 18 Slide 25
The Costs and Benefits
of Reduced Sulfur Dioxide Emissions
Cost of Reducing Emissions
Conversion to natural gas from coal and
oil
Emission control equipment
Chapter 18 Slide 26
Benefits of Reducing Emissions
Health
Reduction in corrosion
Aesthetic
The Costs and Benefits
of Reduced Sulfur Dioxide Emissions
Chapter 18 Slide 27
Sulfur Dioxide Emissions Reductions
Sulfur dioxide
concentration (ppm)
20
40
60
0
Dollars
per
unit of
reduction
0.02 0.04 0.06 0.08
Marginal Social Cost
Marginal Abatement Cost
Observations
MAC = MSC @,0275
.0275 is slightly below actual emission level
Economic efficiency improved
Chapter 18 Slide 28
Emissions Trading and Clean Air
Bubbles
Firm can adjust pollution controls for
individual sources of pollutants as long
as a total pollutant limit is not exceeded.
Offsets
New emissions must be offset by
reducing existing emissions
2000 offsets since 1979
Chapter 18 Slide 29
Cost of achieving an 85% reduction in
hydrocarbon emissions for DuPont
Three Options
85% reduction at each source plant
(total cost = $105.7 million)
85% reduction at each plant with internal
trading (total cost = $42.6 million)
85% reduction at all plants with internal and
external trading
(total cost = $14.6 million)
Emissions Trading and Clean Air
Chapter 18 Slide 30
1990 Clean Air Act
Since 1990,the cost of the permits has
fallen from an expected $300 to below
$100.
Causes of the drop in permit prices
More efficient abatement techniques
Price of low sulfur coal has fallen
Emissions Trading and Clean Air
Chapter 18 Slide 31
Recycling
Households can dispose of glass and
other garbage at very low cost.
The low cost of disposal creates a
divergence between the private and the
social cost of disposal.
Ways of Correcting Market Failure
Chapter 18 Slide 32
The Efficient Amount of Recycling
Scrap
Cost
0 4 8 12
MCR
MSC
m*
With a refundable deposit,
MC increases and
MC = MSC = MCR.
MC + per unit refund
MC
m1
Without market intervention
the level of scrap will be at m1
and m1 > m*.
Chapter 18 Slide 33
Refundable Deposits
Amount of Glass
$
D
Price falls to P’ and
the amount of
recycled glass
increases to M*.
Sv
Sr
S
The supply of glass is
the sum of the supply
of virgin glass (Sr) and
the supply of recycled
glass (Sr).
M1
P
Without refunds the
price of glass is P and
Sr is M1.
S’r
S’
P’
M*
With refunds Sr increases
to S’r and S increases to S’.
Chapter 18 Slide 34
Externalities and Property Rights
Property Rights
Legal rules describing what people or
firms may do with their property
For example
If residents downstream owned the
river (clean water) they control
upstream emissions.
Chapter 18 Slide 35
Bargaining and Economic Efficiency
Economic efficiency can be achieved
without government intervention when
the externality affects relatively few
parties and when property rights are well
specified.
Externalities and Property Rights
Chapter 18 Slide 36
Profits Under Alternative
Emissions Choices (Daily)
No filter,not treatment plant 500 100 600
Filter,no treatment plant 300 500 800
No filter,treatment plant 500 200 700
Filter,treatment plant 300 300 600
Factory’s Fishermen’s Total
Profit Profit Profit
Chapter 18 Slide 37
Assumptions
Factory pays for the filter
Fishermen pay for the treatment plant
Efficient Solution
Buy the filter and do not build the plant
Externalities and Property Rights
Chapter 18 Slide 38
Bargaining with
Alternative Property Rights
No Cooperation
Profit of factory $500 $300
Profit of fishermen $200 $500
Cooperation
Profit of factory $550 $300
Profit of fishermen $250 $500
Right to Dump Right to Clean Water
Chapter 18 Slide 39
Conclusion,Coase Theorem
When parties can bargain without cost
and to their mutual advantage,the
resulting outcome will be efficient,
regardless of how the property rights are
specified.
Externalities and Property Rights
Chapter 18 Slide 40
Costly Bargaining --- The Role of
Strategic Behavior
Bargaining requires clearly defined rules
and property rights.
Externalities and Property Rights
Chapter 18 Slide 41
A Legal Solution --- Suing for
Damages
Fishermen have the right to clean water
Factory has two options
No filter,pay damages
Profit = $100 ($500 - $400)
Filter,no damages
Profit = $300 ($500 - $200)
Externalities and Property Rights
Chapter 18 Slide 42
A Legal Solution --- Suing for Damages
Factory has the right to emit effluent
Fishermen have three options
Put in treatment plant
Profit = $200
Filter and pay damages
Profit = $300 ($500 - $200)
No plant,no filter
Profit = $100
Externalities and Property Rights
Chapter 18 Slide 43
Conclusion
A suit for damages results in an efficient
outcome.
Question
How would imperfect information impact
the outcome?
Externalities and Property Rights
Chapter 18 Slide 44
The Coase Theorem at Work
Negotiating an Efficient Solution
1987 --- New York garbage spill (200
tons) littered the New Jersey beaches
The potential cost of litigation resulted
in a solution that was mutually
beneficial to both parties.
Chapter 18 Slide 45
Common Property Resources
Common Property Resource
Everyone has free access.
Likely to be overutilized
Examples
Air and water
Fish and animal populations
Minerals
Chapter 18 Slide 46
Common Property Resources
Fish per Month
Benefits,
Costs
($ per
fish)
Demand
However,private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Marginal Social Cost
F*
Private Cost
FC
Without control the number
of fish/month is FC where
PC = MB.
Chapter 18 Slide 47
Common Property Resources
Solution
Private ownership
Question
When would private ownership be
impractical?
Chapter 18 Slide 48
Crawfish Fishing in Lousiana
Finding the Efficient Crawfish Catch
F = crawfish catch in millions of
pounds/yr
C = cost in dollars/pound
Chapter 18 Slide 49
Crawfish Fishing in Lousiana
Demand
C = 0.401 = 0.0064F
MSC
C = -5.645 + 0.6509F
PC
C = -0.357 + 0.0573F
Chapter 18 Slide 50
Crawfish Fishing in Lousiana
Efficient Catch
9.2 million pounds
D = MSC
Chapter 18 Slide 51
Crawfish Catch
(millions of pounds)
C
Cost
(dollars/pound)
Demand
Marginal Social Cost
Private Cost
Crawfish as a Common
Property Resource
11.9
2.10
9.2
0.325
Chapter 18 Slide 52
Public Goods
Question
When should government replace firms
as the producer of goods and services?
Chapter 18 Slide 53
Public Goods
Public Good Characteristics
Nonrival
For any given level of production the
marginal cost of providing it to an
additional consumer is zero.
Nonexclusive
People cannot be excluded from
consuming the good.
Chapter 18 Slide 54
Public Goods
Not all government produced goods
are public goods
Some are rival and nonexclusive
Education
Parks
Chapter 18 Slide 55
D1
D2
D
When a good is nonrival,the social marginal
benefit of consumption (D),is determined by
vertically summing the individual demand
curves for the good.
Efficient Public Good Provision
Output0
Benefits
(dollars)
1 2 3 4 5 6 7 8 109
$4.00
$5.50
$7.00
Marginal Cost
$1.50
Efficient output occurs
where MC = MB at 2
units of output,MB is
$1.50 + $4.00 or $5.50.
Chapter 18 Slide 56
Public Goods
Public Goods and Market Failure
How much national defense did you
consume last week?
Chapter 18 Slide 57
Public Goods
Free Riders
There is no way to provide some goods
and services without benefiting
everyone.
Households do not have the incentive to
pay what the item is worth to them.
Free riders understate the value of a
good or service so that they can enjoy its
benefit without paying for it.
Chapter 18 Slide 58
Public Goods
Establishing a mosquito abatement
company
How do you measure output?
Who do you charge?
A mosquito meter?
Chapter 18 Slide 59
The Demand for Clean Air
Clean Air is a public good
Nonexclusive and nonrival
What is the price of clean air?
Chapter 18 Slide 60
The Demand for Clean Air
Choosing where to live
Study in Boston correlates housing
prices with the quality of air and other
characteristics of the houses and their
neighborhoods.
Chapter 18 Slide 61
The Demand for Clean Air
Nitrogen Oxides
(pphm)0
Dollars
1 2 3 4 5 6 7 8 109
2000
2500
3000
500
1500
1000
Low Income
Middle Income
High Income
Chapter 18 Slide 62
The Demand for Clean Air
Findings
Amount people are willing to pay for clean air
increases substantially as pollution increases.
Higher income earners are willing to pay more
(the gap between the demand curves widen)
National Academy of Sciences found that a
10% reduction in auto emissions yielded a
benefit of $2 billion---somewhat greater than
the cost.
Chapter 18 Slide 63
Private Preferences for Public Goods
Government production of a public
good is advantageous because the
government can assess taxes or fees
to pay for it.
Determining how much of a public
good to provide when free riders exist
is difficult.
Chapter 18 Slide 64
Determining the Level
of Educational Spending
Educational spending
per pupil$0
Willingness
to pay
$
$1200$600 $1800 $2400
W1 W2 W3
AW
The efficient level of educational
spending is determined by summing the
willingness to pay for education for each
of three citizens.
Chapter 18 Slide 65
Determining the Level
of Educational Spending
Educational spending
per pupil$0
Willingness
to pay
$
$1200$600 $1800 $2400
W1 W2 W3
AW
Will majority rule yield an efficient outcome?
W1 will vote for $600
W2 and W3 will vote for $1200
The median vote will always win in a majority
rule election.
Chapter 18 Slide 66
Question
Will the median voter selection always
be efficient?
Answer
If two of the three preferred $1200 there
would be overinvestment.
If two of the three preferred $600 there
would be underinvestment.
Private Preferences for Public Goods
Chapter 18 Slide 67
Majority rule is inefficient because it
weighs each citizen’s preference
equally---the efficient outcome weighs
each citizen’s vote by his or her
strength of preference.
Private Preferences for Public Goods
Chapter 18 Slide 68
Summary
There is an externality when a producer or
a consumer affects the production or
consumption activities of others in a
manner that is not directly reflected in the
market.
Pollution can be corrected by emission
standards,emissions fees,marketable
emissions permits,or by encouraging
recycling.
Chapter 18 Slide 69
Summary
Inefficiencies due to market failure
may be eliminated through private
bargaining among the affected
parties.
Common property resources are not
controlled by a single person and can
be used without a price being paid.
Chapter 18 Slide 70
Summary
Goods that private markets are not
likely to produce efficiently are either
nonrival or nonexclusive,Public
goods are both.
A public good is provided efficiently
when the vertical sum of the individual
demands for the public good is equal
to the marginal cost of producing it.
Chapter 18 Slide 71
Summary
Under majority rule voting,the level of
spending provided will be that
preferred by the median voter---this
need not be the efficient outcome.
End of Chapter 18
Externalities and
Public Goods
Externalities and
Public Goods
Chapter 18 Slide 2
Topics to be Discussed
Externalities
Ways of Correcting Market Failure
Externalities and Property Rights
Common Property Resources
Chapter 18 Slide 3
Topics to be Discussed
Public Goods
Private Preferences for Public Goods
Chapter 18 Slide 4
Externalities
Negative
Action by one party imposes a cost on
another party
Positive
Action by one party benefits another
party
Chapter 18 Slide 5
External Cost
Scenario
Steel plant dumping waste in a river
The entire steel market effluent can be
reduced by lowering output (fixed
proportions production function)
Chapter 18 Slide 6
External Cost
Scenario
Marginal External Cost (MEC) is the cost
imposed on fishermen downstream for
each level of production.
Marginal Social Cost (MSC) is MC plus
MEC.
MC
S = MCI
D
P1
Aggregate
social cost of
negative
externality
P1
q1 Q1
MSC
MSCI
When there are negative
externalities,the marginal
social cost MSC is higher
than the marginal cost.
External Costs
Firm output
Price
Industry output
Price
MEC
MECI
The differences is
the marginal external
cost MEC.
q*
P*
Q*
The industry competitive
output is Q1 while the efficient
level is Q*.
The profit maximizing firm
produces at q1 while the
efficient output level is q*,
Chapter 18 Slide 8
External Cost
Negative Externalities encourage
inefficient firms to remain in the
industry and create excessive
production in the long run.
Chapter 18 Slide 9
Externalities
Positive Externalities and Inefficiency
Externalities can also result in too little
production,as can be shown in an
example of home repair and
landscaping.
Chapter 18 Slide 10
MCP1
External Benefits
Repair Level
Value
D
Is research and development
discouraged by positive
externalities?
q1
MSB
MEB
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
q*
P*
A self-interested home owner
invests q1 in repairs,The
efficient level of repairs
q* is higher,The higher price
P1 discourages repair.
Chapter 18 Slide 11
Ways of Correcting Market Failure
Assumption,The market failure is
pollution
Fixed-proportion production technology
Must reduce output to reduce
emissions
Use an output tax to reduce output
Input substitution possible by altering
technology
Chapter 18 Slide 12
The Efficient Level of Emissions
Level of Emissions
2
4
6
Dollars
per unit
of Emissions
0 2 4 6 8 10 12 14 16 18 20 22 24 26
MSC
MCA
E*
The efficient level of
emissions is 12 (E*) where
MCA = MSC.
Assume:
1) Competitive market
2) Output and emissions decisions are independent
3) Profit maximizing output chosen
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost.
E0
At E1 the marginal
social cost is greater
than the marginal benefit.
E1
Why is this more efficient
than zero emissions?
Chapter 18 Slide 13
Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emission Standard
Set a legal limit on emissions at E*
(12)
Enforced by monetary and criminal
penalties
Increases the cost of production and
the threshold price to enter the
industry
Chapter 18 Slide 14
Standards and Fees
Level of Emissions
Dollars
per unit
of Emissions MSC
MCA
3
12
E*
Standard
Fee
Chapter 18 Slide 15
Options for Reducing Emissions to E*
Emissions Fee
Charge levied on each unit of
emission
Ways of Correcting Market Failure
Chapter 18 Slide 16
Total
Abatement Cost
Cost is less than the
fee if emissions were
not reduced.
Total Fee
of Abatement
Standards and Fees
Level of Emissions
Dollars
per unit
of Emissions MSC
MCA
3
12
E*
Fee
Chapter 18 Slide 17
Standards Versus Fees
Assumptions
Policymakers have asymmetric
information
Administrative costs require the same
fee or standard for all firms
Ways of Correcting Market Failure
Chapter 18 Slide 18
Firm 2’s Reduced
Abatement
Costs
Firm 1’s Increased
Abatement Costs
MCA1
MCA2
The Case for Fees
Level of
Emissions
2
4
6
Fee per
Unit of
Emissions
0 1 2 3 4 5 6 7 8 9 10 11 12 13
1
3
5
14
The cost minimizing solution
would be an abatement of 6
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
3.75
2.50
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
If a fee of $3 was imposed
Firm 1 emissions would fall
by 6 to 8,Firm 2 emissions
would fall by 8 to 6.
MCA1 = MCA2,efficient solution.
Chapter 18 Slide 19
Advantages of Fees
When equal standards must be used,
fees achieve the same emission
abatement at lower cost.
Fees create an incentive to install
equipment that would reduce emissions
further.
Ways of Correcting Market Failure
Chapter 18 Slide 20
ABC is the increase
in social cost less the
decrease in abatement
cost.
Marginal
Social
Cost
Marginal Cost
of Abatement
The Case for Standards
Level of Emissions
Fee per
Unit of
Emissions
0 2 4 6 8 10 12 14 16
2
4
6
8
10
12
14
16
E
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
DA B
C Based on incompleteinformation fee is $7
(12.5% reduction).
Emission increases to 11.
Chapter 18 Slide 21
Summary,Fees vs,Standards
Standards are preferred when MSC is
steep and MCA is flat.
Standards (incomplete information) yield
more certainty on emission levels and
less certainty on the cost of abatement.
Ways of Correcting Market Failure
Chapter 18 Slide 22
Summary,Fees vs,Standards
Fees have certainty on cost and
uncertainty on emissions.
Preferred policy depends on the nature
of uncertainty and the slopes of the cost
curves.
Ways of Correcting Market Failure
Chapter 18 Slide 23
Transferable Emissions Permits
Permits help develop a competitive
market for externalities.
Agency determines the level of
emissions and number of permits
Permits are marketable
High cost firm will purchase permits
from low cost firms
Ways of Correcting Market Failure
Chapter 18 Slide 24
Question
What factors could limit the efficiency of
this approach?
Ways of Correcting Market Failure
Chapter 18 Slide 25
The Costs and Benefits
of Reduced Sulfur Dioxide Emissions
Cost of Reducing Emissions
Conversion to natural gas from coal and
oil
Emission control equipment
Chapter 18 Slide 26
Benefits of Reducing Emissions
Health
Reduction in corrosion
Aesthetic
The Costs and Benefits
of Reduced Sulfur Dioxide Emissions
Chapter 18 Slide 27
Sulfur Dioxide Emissions Reductions
Sulfur dioxide
concentration (ppm)
20
40
60
0
Dollars
per
unit of
reduction
0.02 0.04 0.06 0.08
Marginal Social Cost
Marginal Abatement Cost
Observations
MAC = MSC @,0275
.0275 is slightly below actual emission level
Economic efficiency improved
Chapter 18 Slide 28
Emissions Trading and Clean Air
Bubbles
Firm can adjust pollution controls for
individual sources of pollutants as long
as a total pollutant limit is not exceeded.
Offsets
New emissions must be offset by
reducing existing emissions
2000 offsets since 1979
Chapter 18 Slide 29
Cost of achieving an 85% reduction in
hydrocarbon emissions for DuPont
Three Options
85% reduction at each source plant
(total cost = $105.7 million)
85% reduction at each plant with internal
trading (total cost = $42.6 million)
85% reduction at all plants with internal and
external trading
(total cost = $14.6 million)
Emissions Trading and Clean Air
Chapter 18 Slide 30
1990 Clean Air Act
Since 1990,the cost of the permits has
fallen from an expected $300 to below
$100.
Causes of the drop in permit prices
More efficient abatement techniques
Price of low sulfur coal has fallen
Emissions Trading and Clean Air
Chapter 18 Slide 31
Recycling
Households can dispose of glass and
other garbage at very low cost.
The low cost of disposal creates a
divergence between the private and the
social cost of disposal.
Ways of Correcting Market Failure
Chapter 18 Slide 32
The Efficient Amount of Recycling
Scrap
Cost
0 4 8 12
MCR
MSC
m*
With a refundable deposit,
MC increases and
MC = MSC = MCR.
MC + per unit refund
MC
m1
Without market intervention
the level of scrap will be at m1
and m1 > m*.
Chapter 18 Slide 33
Refundable Deposits
Amount of Glass
$
D
Price falls to P’ and
the amount of
recycled glass
increases to M*.
Sv
Sr
S
The supply of glass is
the sum of the supply
of virgin glass (Sr) and
the supply of recycled
glass (Sr).
M1
P
Without refunds the
price of glass is P and
Sr is M1.
S’r
S’
P’
M*
With refunds Sr increases
to S’r and S increases to S’.
Chapter 18 Slide 34
Externalities and Property Rights
Property Rights
Legal rules describing what people or
firms may do with their property
For example
If residents downstream owned the
river (clean water) they control
upstream emissions.
Chapter 18 Slide 35
Bargaining and Economic Efficiency
Economic efficiency can be achieved
without government intervention when
the externality affects relatively few
parties and when property rights are well
specified.
Externalities and Property Rights
Chapter 18 Slide 36
Profits Under Alternative
Emissions Choices (Daily)
No filter,not treatment plant 500 100 600
Filter,no treatment plant 300 500 800
No filter,treatment plant 500 200 700
Filter,treatment plant 300 300 600
Factory’s Fishermen’s Total
Profit Profit Profit
Chapter 18 Slide 37
Assumptions
Factory pays for the filter
Fishermen pay for the treatment plant
Efficient Solution
Buy the filter and do not build the plant
Externalities and Property Rights
Chapter 18 Slide 38
Bargaining with
Alternative Property Rights
No Cooperation
Profit of factory $500 $300
Profit of fishermen $200 $500
Cooperation
Profit of factory $550 $300
Profit of fishermen $250 $500
Right to Dump Right to Clean Water
Chapter 18 Slide 39
Conclusion,Coase Theorem
When parties can bargain without cost
and to their mutual advantage,the
resulting outcome will be efficient,
regardless of how the property rights are
specified.
Externalities and Property Rights
Chapter 18 Slide 40
Costly Bargaining --- The Role of
Strategic Behavior
Bargaining requires clearly defined rules
and property rights.
Externalities and Property Rights
Chapter 18 Slide 41
A Legal Solution --- Suing for
Damages
Fishermen have the right to clean water
Factory has two options
No filter,pay damages
Profit = $100 ($500 - $400)
Filter,no damages
Profit = $300 ($500 - $200)
Externalities and Property Rights
Chapter 18 Slide 42
A Legal Solution --- Suing for Damages
Factory has the right to emit effluent
Fishermen have three options
Put in treatment plant
Profit = $200
Filter and pay damages
Profit = $300 ($500 - $200)
No plant,no filter
Profit = $100
Externalities and Property Rights
Chapter 18 Slide 43
Conclusion
A suit for damages results in an efficient
outcome.
Question
How would imperfect information impact
the outcome?
Externalities and Property Rights
Chapter 18 Slide 44
The Coase Theorem at Work
Negotiating an Efficient Solution
1987 --- New York garbage spill (200
tons) littered the New Jersey beaches
The potential cost of litigation resulted
in a solution that was mutually
beneficial to both parties.
Chapter 18 Slide 45
Common Property Resources
Common Property Resource
Everyone has free access.
Likely to be overutilized
Examples
Air and water
Fish and animal populations
Minerals
Chapter 18 Slide 46
Common Property Resources
Fish per Month
Benefits,
Costs
($ per
fish)
Demand
However,private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Marginal Social Cost
F*
Private Cost
FC
Without control the number
of fish/month is FC where
PC = MB.
Chapter 18 Slide 47
Common Property Resources
Solution
Private ownership
Question
When would private ownership be
impractical?
Chapter 18 Slide 48
Crawfish Fishing in Lousiana
Finding the Efficient Crawfish Catch
F = crawfish catch in millions of
pounds/yr
C = cost in dollars/pound
Chapter 18 Slide 49
Crawfish Fishing in Lousiana
Demand
C = 0.401 = 0.0064F
MSC
C = -5.645 + 0.6509F
PC
C = -0.357 + 0.0573F
Chapter 18 Slide 50
Crawfish Fishing in Lousiana
Efficient Catch
9.2 million pounds
D = MSC
Chapter 18 Slide 51
Crawfish Catch
(millions of pounds)
C
Cost
(dollars/pound)
Demand
Marginal Social Cost
Private Cost
Crawfish as a Common
Property Resource
11.9
2.10
9.2
0.325
Chapter 18 Slide 52
Public Goods
Question
When should government replace firms
as the producer of goods and services?
Chapter 18 Slide 53
Public Goods
Public Good Characteristics
Nonrival
For any given level of production the
marginal cost of providing it to an
additional consumer is zero.
Nonexclusive
People cannot be excluded from
consuming the good.
Chapter 18 Slide 54
Public Goods
Not all government produced goods
are public goods
Some are rival and nonexclusive
Education
Parks
Chapter 18 Slide 55
D1
D2
D
When a good is nonrival,the social marginal
benefit of consumption (D),is determined by
vertically summing the individual demand
curves for the good.
Efficient Public Good Provision
Output0
Benefits
(dollars)
1 2 3 4 5 6 7 8 109
$4.00
$5.50
$7.00
Marginal Cost
$1.50
Efficient output occurs
where MC = MB at 2
units of output,MB is
$1.50 + $4.00 or $5.50.
Chapter 18 Slide 56
Public Goods
Public Goods and Market Failure
How much national defense did you
consume last week?
Chapter 18 Slide 57
Public Goods
Free Riders
There is no way to provide some goods
and services without benefiting
everyone.
Households do not have the incentive to
pay what the item is worth to them.
Free riders understate the value of a
good or service so that they can enjoy its
benefit without paying for it.
Chapter 18 Slide 58
Public Goods
Establishing a mosquito abatement
company
How do you measure output?
Who do you charge?
A mosquito meter?
Chapter 18 Slide 59
The Demand for Clean Air
Clean Air is a public good
Nonexclusive and nonrival
What is the price of clean air?
Chapter 18 Slide 60
The Demand for Clean Air
Choosing where to live
Study in Boston correlates housing
prices with the quality of air and other
characteristics of the houses and their
neighborhoods.
Chapter 18 Slide 61
The Demand for Clean Air
Nitrogen Oxides
(pphm)0
Dollars
1 2 3 4 5 6 7 8 109
2000
2500
3000
500
1500
1000
Low Income
Middle Income
High Income
Chapter 18 Slide 62
The Demand for Clean Air
Findings
Amount people are willing to pay for clean air
increases substantially as pollution increases.
Higher income earners are willing to pay more
(the gap between the demand curves widen)
National Academy of Sciences found that a
10% reduction in auto emissions yielded a
benefit of $2 billion---somewhat greater than
the cost.
Chapter 18 Slide 63
Private Preferences for Public Goods
Government production of a public
good is advantageous because the
government can assess taxes or fees
to pay for it.
Determining how much of a public
good to provide when free riders exist
is difficult.
Chapter 18 Slide 64
Determining the Level
of Educational Spending
Educational spending
per pupil$0
Willingness
to pay
$
$1200$600 $1800 $2400
W1 W2 W3
AW
The efficient level of educational
spending is determined by summing the
willingness to pay for education for each
of three citizens.
Chapter 18 Slide 65
Determining the Level
of Educational Spending
Educational spending
per pupil$0
Willingness
to pay
$
$1200$600 $1800 $2400
W1 W2 W3
AW
Will majority rule yield an efficient outcome?
W1 will vote for $600
W2 and W3 will vote for $1200
The median vote will always win in a majority
rule election.
Chapter 18 Slide 66
Question
Will the median voter selection always
be efficient?
Answer
If two of the three preferred $1200 there
would be overinvestment.
If two of the three preferred $600 there
would be underinvestment.
Private Preferences for Public Goods
Chapter 18 Slide 67
Majority rule is inefficient because it
weighs each citizen’s preference
equally---the efficient outcome weighs
each citizen’s vote by his or her
strength of preference.
Private Preferences for Public Goods
Chapter 18 Slide 68
Summary
There is an externality when a producer or
a consumer affects the production or
consumption activities of others in a
manner that is not directly reflected in the
market.
Pollution can be corrected by emission
standards,emissions fees,marketable
emissions permits,or by encouraging
recycling.
Chapter 18 Slide 69
Summary
Inefficiencies due to market failure
may be eliminated through private
bargaining among the affected
parties.
Common property resources are not
controlled by a single person and can
be used without a price being paid.
Chapter 18 Slide 70
Summary
Goods that private markets are not
likely to produce efficiently are either
nonrival or nonexclusive,Public
goods are both.
A public good is provided efficiently
when the vertical sum of the individual
demands for the public good is equal
to the marginal cost of producing it.
Chapter 18 Slide 71
Summary
Under majority rule voting,the level of
spending provided will be that
preferred by the median voter---this
need not be the efficient outcome.
End of Chapter 18
Externalities and
Public Goods
