External costs and external benefits (UXL)

Transcription

1 External costs and external benefits (UXL) Competitive markets are effective at encouraging exchanges where both the buyer and the seller benefit. The market will find the equilibrium quantity and equilibrium price for any good available in a free market. The price will rise and fall according to supply and demand, and when the quantity demanded equals the quantity supplied, the quantity and price are said to have reached equilibrium. The transaction of a given good does not occur in a vacuum, but has some effect on the rest of the world. Thus, economics must also concern its study with those people external to the exchange. Externality is the term used in economics for any benefit or cost of a good that is experienced by someone not involved in the production or consumption of the good. A fireworks display is an example of a public good, because the experience of watching it cannot be limited to paying customers and because the enjoyment can be shared equally by all. JEFF KOWALSKY/AFP/GETTY IMAGES If a teenager spends a large sum of money on an expensive new smart phone, for example, she will probably want to use it as often as possible in order to get the maximum value from her purchase. But if that includes taking the smart phone to school and using it during class, this could be a disruption that makes it more difficult for everyone else in class to learn. If others' ability to learn in the class is hampered, they are paying an opportunity cost in wasted time. An

2 opportunity cost is a lost chance to use a resource in another way, and in this case the class has lost the chance to get any value from the class time. If the benefit the smart phone gives its owner is balanced with the combined costs of everyone else's wasted time, the costs could very well outweigh the benefit. Economics calls this hidden cost to her unfortunate classmates a negative externality in the economic value of the smart phone. The cost of the negative externality was not calculated into the price that the buyer paid. Similarly, someone who throws a party late at night and plays loud music will cost all of his neighbors a night's sleep. This is a cost not calculated into the price of the party supplies and music, but paid by people external to the purchases. If, on the other hand, someone keeps her house in excellent shape and works to make her home more beautiful, perhaps by planting a flower garden and installing a deck, this would generate a positive externality for her neighbors, both by the immediate benefit of looking at the beautiful house and by the fact that the value of the neighbors' houses would increase. The market does not take externalities into account when finding the equilibrium of price and quantity, and for this reason it is an example of market failure. Social costs and social benefits Negative externalities can be understood as the difference between the private cost and the social cost of a good. The private cost of a good is the total of what must be given up for an individual to produce something or to purchase something, including all opportunity costs. The social cost of a good is all that must be given up by society. Positive externalities describe the differences between the private benefits and the social benefits of a good. Because the producer and consumer of the good are not calculating the entire social cost but only their own private costs, the market is inefficient and does not provide an accurate price and quantity of the good. When a factory produces something, it pays the private costs of labor and raw materials, but the social cost is paid by anyone who is affected by the pollution, noise, and traffic congestion also created by the factory's operation. It is important to note that society can be described in different ways. With the noisy smart phone in the above example, the society would consist of the user's classmates. In the case of a polluting chemical plant, the society would encompass a larger group that would include those communities located near the plant who are directly exposed to toxins, as well as others farther away that may receive acid rain caused by the air pollution. If people become sick, they may miss work or need to go to the hospital, which creates costs for their employers and insurance companies who pay for their care. The dangers to wildlife and agriculture must also be assessed, as well as any changes that the plant is

3 making to the global climate, regardless of how small they may be for any one plant. When people take good care of their health, they benefit not just themselves but everyone in their homes and schools and perhaps the nation in general. The social costs and benefits of a good are usually not obvious, and often need to be discovered by investigation. For this reason, it can be very difficult to assess social costs and benefits and to know when externalities require intervention. Remedies for externalities Private remedies One theory about how externalities are caused was described by British economist Ronald Coase ( ) in his 1960 article The Problem of Social Cost. In what is now known as the Coase theorem, Coase explains that externalities are generated because of a failure to establish complete property rights. In a competitive, free market economy, individuals have the right to make use of their own property, as long as that use does not infringe on anyone else's property. According to Coase's model, any externality can be solved if property rights are complete and enforceable. This approach makes sense because all markets rely on some property rights to work. A seller cannot sell a product unless she counts that product as her property, and a buyer will only buy a product that will then be considered his property. To deal with the above-mentioned problem of the classmate with the loud phone, one could establish that the other students have a right of property to their undisturbed class time. Someone whose neighbor is playing loud music could claim his right as a homeowner to a quiet night, and the music-playing neighbor could pay for the right to play his music, or the music-playing neighbor could claim his right as a music system owner to play his music, and the quiet-seeking neighbor could pay for a night's peace. Either property claim would solve the inefficiency, as long as the expense of negotiating the two property claims does not grow so cumbersome that it costs more than the original externality. The cost and difficulty of negotiating and enforcing complicated property rights like the above examples make this remedy unsuccessful for externalities that affect large numbers of people, especially people who do not know each other. Class-action lawsuits attempt to claim money for wrong done to large numbers of people, but they are complicated and expensive. They often take many years to process and the rewards are often minimal.

4 Command and control It is often necessary for a government to intervene when confronted with an externality. The simplest way for a government to step in and change the amount of a good produced is to pass a law either prohibiting the production altogether or regulating it, perhaps, for example, by limiting the amount of pollution that can be produced by each factory. This is referred to as the command and control method. It is effective for negative externalities that are so dangerous that they must be absolutely prohibited, but in other circumstances it is necessary to weigh the cost of the externality against the cost of missed benefit from producing less of the product. There are more efficient ways to do this using market solutions. Another drawback with this approach is that there is only incentive to follow the letter of the law by reducing the externality to just below the legal limit, which may not solve the problem. Command and control regulation also introduces the problem of regulatory capture, or the corruption of the regulators by the regulated. In order to enforce the regulations, a government must assign a team of regulators to monitor and report on whether industries are following the law. Regulators must have sufficient knowledge of the industry they are watching, which can lead them to become sympathetic to those they are supposed to be regulating. They often become friendly with the people they meet in the industry and may even accept jobs at those very industries after leaving their regulatory positions, or they might even secretly receive benefits from the company in return for overlooking violations. This affects how effectively they are able to provide a social benefit through regulation. Governments can also assign taxes with the intent to limit certain activities. Such taxes are known as Pigovian taxes after British economist Arthur Pigou ( ). This process takes an external cost and internalizes it so that the private producer must pay for it as another cost of production. The value of a Pigovian tax is that it incentivizes companies to find the most efficient way of reducing externalities. A Pigovian tax will result in an increase of price and a reduction of quantity of a good, but since this is a political process, it is not precise and can potentially cause more harm by pushing the amount of production too low. Cap and trade Issuing tradable allowances, commonly known as cap and trade, is a solution to externalities that makes use of the market. Under a cap and trade proposal, the government permits companies to create externalities by issuing allowances to do so. These allowances are then traded between countries. In the case of emissions that cause environmental damage, the government issues permits to companies that will allow them to pollute to a certain extent. Over time, the

5 government will issue fewer of these permits. Cap and trade is efficient because it takes into account the comparative advantage that different companies have in reducing their emissions. A newer firm may be able to reduce its emissions more quickly and easily than an older firm that is dependent on older equipment, and the newer firm could sell some of its permits to the older firm. According to the law of supply and demand, they would find a market price for the permits that enables them both to benefit. The overall cost of reducing the same amount of pollution would be smaller. There are also potential problems with this method. It is possible that the firms that buy the most permits may all be in one geographical area, which would negatively affect one group of people more than another. The use of tradable permits within a market invites speculation, where parties outside the industry buy the permits cheap and then sell them later at a profit. Speculation distorts the value of an asset, in this case a government permit. Encouraging positive externalities There are also ways to increase positive externalities and to produce more goods that have a social benefit. People who enjoy the positive externalities of a good are not paying for the good, but the government can subsidize firms or offer other incentives to produce more of some goods. The government can also offer subsidies to firms who produce goods in a manner that generates positive externalities. An important positive externality from production is the general increase of knowledge that technology brings. Each new technology builds on a previous one developed for a different good. The market, however, offers little reason for producers to spend money specifically researching and developing new technologies. Unsuccessful development will result in a sunk cost, while successful development will likely be imitated by rival firms, affording little gain to the developer. The market encourages producers to create products only slightly more efficiently than their competitors. Providing a system of patents promotes the positive externality of new research and development, and copyright law promotes the positive externality of new creative works, both of which enhance the well-being of society. Sidebar: Hide Super-sized Soda Ban In the 1930s, a nickel bought a bottle of Coca-Cola, which was only six ounces (0.18 liters). Bottle sizes have been growing ever since then. Soda has been available in glass 10- and 12-ounce bottles (0.30 and 0.35 liters, respectively), and soda is now regularly sold in 20-ounce bottles (0.59 liters), more than three

6 times as large as the original size. A large soda may now be 32 ounces (1 liter), which has almost four hundred calories. Large sizes of soda like this have been under attack recently, as they are blamed for contributing to obesity in the United States. Obesity is becoming one of the most serious health issues in the country. Obesity rates have been rising since the 1960s, and now one-third of Americans are obese. Obesity can lead to or worsen diabetes, heart disease, increased chances of stroke, and some kinds of cancer, as well as reducing the quality of life for those afflicted. Obesity is now responsible for more health care costs than either smoking or alcohol use. While the obesity problem has many possible causes, many have pointed to the increase in serving sizes of food and drink. This is especially true for food and drink items made exclusively of empty calories, such as soda, which consists mainly of colored water and high-fructose corn syrup. In September 2012, the New York Metropolitan Board of Health announced that a prohibition on the sale of sodas or any sweetened soft drinks in sizes larger than 16 ounces (0.47 liters) would be going into effect in six months. This ban would only be for restaurants, food carts, movie theaters, and stadiums, and would not affect grocery stores or convenience stores, as those are not under the control of the board. Any of these businesses caught selling sodas larger than allowed would be subject to a $200 fine. The prohibition would not affect the sale of diet sodas, drinks with at least 70 percent juice content, or drinks with alcoholic content. The ban was a relatively unpopular action among New Yorkers and was opposed by softdrink makers and civil rights groups like the National Association for the Advancement of Colored People and the Hispanic Federation. Some of the criticism was that the ban would disproportionately affect small businesses like food cart operators who depend on soda sales for much of their earnings. The ban also had some obvious loopholes; for instance, a soda buyer could simply buy two sodas instead of one large one. Furthermore, the ban would not affect grocery stores or convenience stores, such as 7-Eleven, whose 32-ounce (1-liter) Big Gulp soda became one of the symbols of the debate. In March 2013, immediately before the prohibition was set to take effect, it was invalidated by a judge of the New York Supreme Court (not that state's highest court despite its name), which declared that it was arbitrary and capricious because it did not originate from the city council but rather the board of health, which only has the power to regulate some businesses and not others. Mayor Michael Bloomberg (1942 ) appealed the ruling, but it was sustained by an appeals court in July New York City's next mayor, Bill Deblasio (1961 ), also expressed support for the ban, but as of early 2015, super-sized sodas were still available legally throughout the city.

7 A McDonald's customer in New York City fills a 21-ounce cup with soda. Under Mayor Bloomberg's plan, soda sales would be limited to 16-ounce cups. MARIO TAMA/GETTY IMAGES "Market Failures and Government Intervention." UXL Money: Making Sense of Economics and Personal Finance. Julia Garbus. Ed. Shawn Corridor. Vol. 1: Microeconomics and Domestic Trade. Farmington Hills, MI: UXL, Web. 13 Aug URL 62&it=r&p=GVRL&sw=w&asid=82cd3d35ecd d0bb6e7c938a7d