Externality Essentials Revised

Transcription

1 Micro Externality Essentials Revised Why we love markets Markets help achieve productive, allocative, and distributive efficiency. o Productive, allocative, and distributive efficiency are required to ensure that we are best satisfying wants and needs. Markets transactions are also voluntary, so they allow a great deal of freedom. Markets are self correcting, so they adapt to changes in the world around us. o There should be no long term shortages or surpluses in free markets. Markets maximize economic surplus, the sum of producer and consumer surplus, which means that markets maximize social welfare. All in all markets work fabulously most of the time. Most of the time is not all of the time There are a variety of situations in which markets might not produce the most efficient outcome for society, specifically, when: Production or consumption of a good generates externalities. We are looking at public as opposed to private goods. Monopolies exist. Imperfect/asymmetric information exists. In all of these cases, the unfettered operation of free markets ends in market failure. In these instances, there is a potential role for the government. Marginal private cost and marginal private benefit A supply curve represents the producer s willingness to produce the good at each possible price level. o That willingness to produce another unit of the good depends on what it costs the producer to produce that unit of the good, its marginal cost. o So, since the supply always tracks the marginal cost to the supplier of producing each unit of the good, we can also refer to the supply curve as the marginal private cost (MPC) curve A demand curve represents the consumer s willingness and ability to consume units of the good at each price level. o That willingness to purchase another unit depends on the additional utility/satisfaction/benefit the consumer receives from consuming that unit, its marginal utility. o Therefore, we can refer to the demand curve as the marginal private benefit (MPB) curve. (MPB and MU are synonyms.) Markets, left to their own devices, always produce where supply and demand intersect. externality essentials - r doc 1 Revised on: 2/25/2018

2 Ergo, free markets always produce a level of output where MPC=MPB for the last unit produced. P S=MPC P E D=MPB Q E Q At Q E, MPC = MPB Is this a good thing? It is, if no one other than the producer or consumer is affected by the production or consumption of this good. If the act of producing the good doesn t impose any costs on anyone else, or confer any benefits on anyone else, then society s costs of production are the same as the producer s costs. o In this case, we can say that marginal social cost (MSC) = marginal private cost and our supply curve is the MSC curve as well. If the act of consuming this good doesn t impose any costs on anyone else, or confer any benefits on anyone else, then society s benefits from consumption are the same as the consumer s benefits. o In this case, we say that marginal social benefit (MSB) =marginal private benefit and our demand curve is the MSB curve as well In these cases, when the market chooses a level of output where the supply curve intersects the demand curve, we find that MSC=MSB for that last unit produced and consumed. That is essentially the definition of allocative efficiency, the right, amount of output for this good. We are allocating the right amount of resources to the production of a good if MSC = MSB for the last unit. externality essentials - r doc 2 Revised on: 2/25/2018

3 Example: consider the carrot Assume that farmers produce them in a sustainable manner, and consumers buy them and take them home in reusable cloth shopping bags. o Thus, these transactions really only involve the producer and consumer. o Therefore, the costs to society are simply the farmers cost of producing the carrots. o Thus, the marginal private cost MPC curve is also the marginal social cost MSC curve. Likewise, the benefits to society consist solely of the benefits the consumers receive from eating carrots. o Therefore, the marginal private benefit MPB curve is also the marginal social benefit MSB curve. So, when the market achieves MPC=MPB it also achieves MSC=MSB Thus, in this case, a free market achieves allocative efficiency. From society's perspective, the right quantity of resources is being allocated to the production of this good. P S=MPC= MSC P E D=MPB=MSB Q E Q Both MPC=MPB and MSC=MSB at Q E Alas, not all goods are carrots externality essentials - r doc 3 Revised on: 2/25/2018

4 Externalities Sometimes production and consumption affect individuals other than the buyer and seller. These effects are known as externalities. They are external to the bargain. Both negative and positive externalities exist. Externality an incidental cost or benefit which accrues to, or is imposed on, individuals not directly involved in the transaction Activities producing negative externalities Driving your car (when there are others on the road) Burning leaves (when you have neighbors) Cranking Heavy Metal (when senior citizens are around) Activities producing positive externalities Getting vaccinated Getting and education Landscaping your property What's wrong with externalities? Externalities lead to market failure. Market failure a situation in which a free market fails to lead to an efficient level of output, one at which MSC MSB Why does the market fail? Decisions are still made by individuals on the basis of MPC and MPB. So, output will occur at Q E where MPC = MPB. However, MSC MSB because either MSC>MPC or MSB>MPB. When a negative externality exists, MSC > MPC. o In this case, MSC > MSB at Q E, the free market equilibrium. o Too much is being produced. When a positive externality exists, MSB > MPB. o In this case, MSB > MSC at Q E, the free market equilibrium. o Too little is being produced. externality essentials - r doc 4 Revised on: 2/25/2018

5 Negative externality example the market for automobiles Driving a car produces pollution and endangers other drivers. Therefore, driving produces negative externalities. So, to get the MSC of cars, you have to add these costs to the MPC of producing cars. This means that the MSC of cars is greater than the MPC of cars. The MSC curve sits above MPC. The result is that MSC>MSB at Q E. Too many resources are devoted to auto production. Socially optimal level of output occurs at Q* where MSC=MSB P MSC S=MPC P E Vertical distance between MSC and MPC represents the size of the externality. D=MPB=MSB Q* Q E Q MSC=MSB MSC>MSB Positive externality example the market for vaccines Getting vaccinated generates a positive externality, a benefit for people who come into contact with the vaccinated individual. It reduces their chances of getting sick, being miserable, and missing work. To get the MSB of a vaccine, you have to add these benefits to the MPB. So, MSB>MPB. The MSB curve sits above the MPB curve. The result is that MSB>MSC at Q E. Too few vaccinations occur. Socially optimal level of output occurs at Q* where MSC=MSB externality essentials - r doc 5 Revised on: 2/25/2018

6 P S=MPC= MSC P E Q E Q* MSB D=MPB Q Vertical distance between MSB and MPB represents the size of the positive externality. MSB>MSC MSC=MSB Correcting market failures the goal is to internalizing the externality, make the parties account for the external cost or benefit in their calculations of what is best for them Approaches to correcting externalities 1) Command and control 2) Corrective taxes/subsidies 3) Better defining property rights 4) Cap and trade 5) Doing nothing Command and control refers to the implementation of regulations to control behavior by firms and individuals o could refer to requirements that power generating plants install scrubbers o could refer to mandates that children be vaccinated before starting school government weighs size of the benefit against the costs of implementation sometimes this is the only approach that works potential drawbacks o sometimes relatively expensive o once firms meet the pollution standard or have installed the required technology, they have no further incentive to reduce pollution externality essentials - r doc 6 Revised on: 2/25/2018

7 Corrective tax estimate the difference between MSC and MPC at each level of output apply a tax on producer of the externality equivalent to that marginal external cost essentially shifts the supply curve back to where the MSC is located Q E with the tax in place now occurs where MSC = MSB alternatively, applying that tax to consumers achieves the same result potential issues o one need to be able to measure the damage from the externality in order to set an appropriate tax level o you need to be able to measure the amount of pollutant emitted to apply the tax Corrective subsidy estimate the difference between MSB and MPB at each level of output provide a subsidy to consumers equal to that difference this essentially shifts the demand curve out to where the MSB curve is locates Q E with the tax in place now occurs where MSC = MSB equilibrium now occurs where MSC = MSB alternatively, providing that subsidy to producers achieves the same result potential issues o one need to be able to measure the benefit from the externality in order to set an appropriate subsidy level Cap and trade programs government sets a permissible level of pollution permits for a fixed quantity of emissions are created these permits are auctioned off (in the best case) permits are traded among firms if emission reductions are expensive for a firm, they will buy permits instead of reducing their own emissions if emission reductions are cheap for a firm, they will sell permits to other firms and reduce their own emissions cap and trade programs can achieve emission reductions at a lower cost than many other approaches drawbacks o must be able to accurately measure emissions o significant penalties for emitting without a permit must exist o runs counter to some normative judgments regarding burden of pollution externality essentials - r doc 7 Revised on: 2/25/2018

8 Defining property rights people dump waste into the atmosphere, oceans, and rivers not because they are evil, but simply because it is the cheapest way to dispose of waste it s cheap because no one owns the atmosphere, ocean, or river therefore no one charges for the damage being done by this waste disposal this can sometimes be corrected by defining property rights once ownership is determined, each party has to recognize the costs and benefits associated with using that resource Coase Theorem assigning tradable property rights to resources can lead to a socially efficient allocation of resources assumes that property rights can be clearly defined and that transaction costs are minimal with respect to allocative efficiency, it doesn't matter which party receives the property rights with respect to who benefits, it certainly does matter What is the right level of pollution if by right we mean efficient then the answer is usually not zero marginal cost or reducing emissions usually rises as reduce emissions farther marginal benefit of emissions usually falls as we reduce emissions farther an efficient level of emission reduction occurs where the MSC of reduction equals the MSB of reduction, Q* technology that reduces the marginal cost of emission reduction moves us towards a greater optimal level of reduction new information that says the marginal benefit of pollution reduction is higher than we previously thought also moves us towards a greater optimal level of reduction $ MSC MSB Q* 100% Emission reduction externality essentials - r doc 8 Revised on: 2/25/2018

9 Caveat Please keep in mind that all of the above discussions of externalities and pollution reduction have focused on allocative efficiency as a goal. That is not the only potential goal a society has. Results that are allocatively efficient may have disturbing distributive consequences. externality essentials - r doc 9 Revised on: 2/25/2018