Price MCI MSC MEC. q1 Firm output. Industry output

Transcription

1 Pindyck and Rubinfeld, Chapter 18 Sections 18.1, 18.2, 18.6 Externalities and Public goods Externalities arise when one agent s production or consumption activities affect another agent s production or consumption activities without the effect being reflected in a market price. With externalities, the price of a good might not equal its marginal cost or marginal benefit to society. Public goods have the property that the marginal cost of providing the good to an additional consumer is zero, and no one can be prevented from consuming it. First discuss externalities, then public goods. An externality can be between producers, between consumers or between consumers and producers. It can be negative or positive. Example of a negative externality between producers: A steel plant dumps waste in a river, which kills the fish. Fishermen downstream depend on the river to catch fish. Without market regulation, the firm doesn t have a reason to take into account the harm caused to the fishermen or the fish in its decision how much to produce. There is no market where these external costs can affect the price of steel. Example of a positive externality between consumers (or between consumers and producers): A homeowner paints her house and plants a nice garden. neighbors, and raises the resale value of their houses. This benefits the Example of a positive externality between producers: for example, Research of one firm leads to some advance in general knowledge which other firms can use to lower their costs of production. Negative externality from consumers to producers: e.g. a consumer-led boycott of a firm. Negative externalities and efficiency Externalities can lead to inefficiency. Negative production externalities result in too much of the good being produced. There are unnecessary costs to society. Consider a steel plant dumping waste into a river. Assume that the firm has a fixed-proportions production function, so that the amount of waste dumped into the river can only reduced by reducing output. This assumption simplifies the analysis because the firm would otherwise be choosing simultaneously how much to produce and how to produce it. 1

2 The first graph below shows how the firm decides how much to produce, assuming the market for steel is competitive. It also shows the marginal social cost curve for this firm s steel production. The second graph below shows market supply, demand and marginal social cost curves for steel. MSC MC Price MSCI MCI MEC P* P1 D q* q1 Firm output Q* Q1 Industry output The price of steel is P 1 at the intersection of the market demand and supply curves. The market supply curve is the horizontal sum of the individual firms supply curves. The demand curve faced by an individual firm is a horizontal line at P 1, since each firm is a price-taker. The firm maximizes profit by producing q 1 at the intersection of the demand curve with its marginal cost curve (assuming that this price is above minimum of average variable cost). This is the firm s profit-maximizing output level. As the firm s output increases, the harm caused by pollution increases. This assumption is reasonable for many types of pollution. At low levels of pollution, adding an additional unit of pollution may not cause much of a difference. But as pollution builds up the incremental damage caused by more pollution increases. This is reflected in an increasing marginal external cost curve. Marginal external cost of the steel firm measures the cost to the fishermen that results from steel production. 2

3 The sum of marginal external cost and marginal cost (of the firm) equals the marginal social cost, MSC = MC + MEC. This is the cost to society of producing an additional unit of steel (starting from some level). Because the marginal external cost is positive at all positive levels of output, the marginal social cost exceeds the marginal (private) cost. Then the intersection of the social marginal cost curve with the firm s demand curve occurs at a lower output than the intersection of the marginal cost curve with the demand curve. Given the price, the optimal point of production by a firm, from society s point of view, is at q, the intersection of social marginal cost with demand. At any output higher than that, the cost to society exceeds consumers valuation of the last unit of steel, so that unit should not be produced. At any output lower than that, consumers valuation of an additional unit exceeds the cost to society, so that unit should be produced. Given the price, the amount of steel produced by an individual firm is higher than the efficient amount. Now consider industry supply, demand and social cost of producing steel. The industry supply curve, MC I, is the horizontal sum of all the firms supply curves. The industry marginal external cost curve, MEC I, is the horizontal sum of all the MEC curves of all the people harmed by the pollution. The industry marginal social cost curve equal the sum of industry marginal external cost and industry marginal cost, MSC I = MC I + MEC I. The efficient total industry output of steel is where the marginal social cost curve intersects the demand curve, MSC I = D. This is where the marginal benefit to society of an additional unit of output equals the marginal cost. The competitive industry output is where the industry supply curve intersects the demand curve. This is the firms profit-maximizing output level. Because the social marginal cost is higher than the industry s marginal cost, this intersection occurs at a higher output level than the efficient output level. The corresponding equilibrium price P 1 is lower than the price corresponding to the efficient amount, P. The cost to society of this inefficiency is shown as the triangle between MSC I and D curves from Q to Q 1. This is the deadweight loss due to overproduction of steel. In the short run, a policy (such as a tax) that moves the output from the equilibrium to the efficient output reduces firms profits and reduces the wellbeing of buyers of steel, but the damage to them is outweighed by the benefit to those that were harmed by the pollution (in the long run with free entry, profits are zero if firms are identical so the long-run profits of those firms that stay in the business are unaffected by the policy. But some firms leave the market). Externalities cause both long-run and short-run inefficiencies. Firms enter a competitive industry when the price of the output exceeds the average cost 3

4 of production and leave the industry when price is below average cost of production. With negative externalities, the average private cost of production is lower than the average social cost. Firms use their average private costs to decide whether to stay in business, but it is inefficient for a firm to stay in business if its average social cost is higher than price. Ways of correcting market failure - Standards - Fees -Tradeable pollution permits Consider a firm that generates pollution that damages the air quality in its area, a negative externality. If the firm has a fixed-proportions production technology, the only way to reduce the pollution is by getting the firm to produce less. This can be done using an output tax. But most firms don t have fixed-proportions technologies. They can substitute among inputs to change the amount of pollution while keeping the output constant. Different input combinations create different amounts of pollution, and also have different costs. The less pollution an input combination generates, the more it costs the firm. 4

5 Dollars Per Unit of emissions standard MEC Per-unit fee 3 MCA 12 emissions 26 In the graph, the horizontal axis shows level of emissions and the vertical axis shows costs per unit of emissions. The marginal external cost (M EC) curve shows the increased harm to society due to an additional unit of emissions. The marginal cost of abatement (MCA) curve shows the additional cost to the firm of an additional unit of pollution reduction. The marginal external cost curve slopes upward because studies have shown that at small amounts of air and water pollution, additional pollution does little incremental damage, whereas the marginal damage of an additional unit of pollution is higher when pollution levels are already high. The marginal cost of abatement curve slopes downward because the marginal cost of slightly reducing emissions tends to be much smaller than the marginal cost when emissions are already low. With no incentives to abate pollution, the firm s profit-maximizing level of emissions is the maximum level, where marginal cost of abatement is zero, which is 26 units of pollution. The efficient level of emissions is where the MEC curve intersects the MCA curve (at 12 units). Here marginal costs and marginal benefits of pollution reduction are equal. If pollution levels were lower than 12, the marginal cost of pollution abatement 5

6 would exceed the marginal benefit, and too little pollution would be emitted relative to the efficient amount. Now consider three possible ways of encouraging the firm to reduce emissions. 1. An emissions standard is an upper limit on how much pollution a firm can emit. The firm or its owners are subject to fines or criminal charges is they exceed this limit. If the government knows what the efficient level of pollution is, it can set that as an upper limit. As long as the penalties are strong enough, the firm will comply with the emissions standard and install pollution abating equipment or produce in a less polluting way. This increases expenditures, causing the firm s average cost curve to rise by the average cost of abatement. Then other firms enter the industry only if the average costs including the average cost of abatement are lower than price. This leads to fewer firms entering the industry. 2. An emissions fee is a tax per unit of emissions. If the fee is set at the marginal cost of abatement where it equals the marginal external cost, the efficient amount of pollution will be emitted. As long as the marginal cost of abatement is lower than the emissions fee, the firm will continue to reduce its pollution. It will stop reducing pollution where the marginal cost of abatement equals the emissions fee. This is where they equal marginal external cost. The total fee paid by the firm is the rectangle with height 3 and base 12. The total abatement cost is the area under the MCA curve from 26 to 12. Comparing fees and standards In the past, the United States has often used emissions standards and other countries like Germany have used fees. Which method is better depends on what knowledge the government has. Suppose that the same fee or the same emissions standard must apply to every firm. Suppose there are two firms, acting competitively, and the marginal social cost of emissions is the same no matter which firm is doing the polluting. But the two firms have different costs of abatement, and different marginal costs of abatement. Let MCA 1 and MCA 2 be the firms marginal costs of emissions. Each firm initially emits 14 units of pollution, at which the marginal cost of abatement is zero. 6

7 Dollars per Unit of emissions MCA1 MCA emissions Suppose the government wants to reduce total emissions by 14 units. The cheapest way to do this is for firm 1 to reduce emissions by 6 and firm 2 by 8. With this reduction, the marginal costs of the two firms are equal. If the marginal costs were not equal, the total cost could be reduced by having the firm with high MCA increase emission by a small amount, and the firm with lower MCA reduce emission by a small amount, keeping total emission the same. If the regulatory agency asks both firms to decrease emissions by 7 units, firm 1 s marginal cost of abatement is higher than firm 2 s. This is not the cheapest to reduce total pollution by 14 units. This shows an advantage of fees over standards. With a $3 fee, both firms will reduce emissions to the point where their marginal costs of abatement equal $3. So firm 1 reduces emissions by 6 units and firm 2 reduces emissions by 8 units. When the same standard must be applied to all firms, fees can reduce emissions at a lower cost than standards. Also, fees give firms an incentive to invest in research that allows them to decrease emissions even more, because they will pay even less of a fee with less emissions. Suppose firm 1 is considering installing devices that will lower its marginal cost of abatement from MCA 1 to MCA 2. A $3 emissions fee gives the firm more of an incentive to install the devices. 7

8 But with limited knowledge about the costs of abatement, a standard can be better than a fee. Consider the graph with a steep marginal external cost curve and a less steep marginal cost of abatement curve. The efficient emissions fee is $8. Suppose the government makes a mistake and charges a fee of $7 per unit emissions (a 12.5 percent reduction). The firms emissions will be 11 units, higher than the efficient amount of 8 units. But because the MEC curve is steep, the added social costs will be large. C Dollars Per unit emissions E MEC A D B MCA emissions If a similar error is made using a standard, the increase in social costs will be smaller. The efficient standard is 8 units of emissions. Suppose this standard is increased by 12.5 percent to 9 units. It can be seen on the graph that the increase in social costs is smaller than with the fee. When the MEC curve is steep and the MCA curve is flat, the social cost of having emissions higher than the efficient amount is high. Then a standard can be better because standards give certainty about emissions levels. The total cost to firms may be higher. With a fee, the marginal cost of abatement is known (it will equal the fee), but actual emissions levels will be uncertain. 3. Tradeable emissions permits are another option. They allow the efficient emissions level to be reached at the lowest possible cost if the market for permits 8

9 is competitive. The government either auctions off or gives a certain number of pollution permits to firms. Each pollution permit is traded in to the government in exchange for emitting a certain amount of pollution. The government chooses the number of pollution permits so that the total amount of pollution is the efficient amount. The firms that have a high marginal cost of abatement will buy permits from those that have a low marginal cost of abatement, until all firms are polluting the amount that makes their MCAs equal. The price of a permit in competitive equilibrium will be the MCA of all firms. Emissions trading and clean air. The EPA (Environmental Protection Agency) has used bubble and offset programs since the 1970 s to try to lower pollution reduction costs for firms. A bubble lets a firm increase their emissions of one pollutant in exchange for decreasing its emissions of another pollutant. The offset program allows firms to put plants in places where they do not meet the air-quality standards, in exchange for reducing emissions in existing plants. Recycling Since throwing away waste products imposes almost no cost on producers or consumers, but the environment is harmed by waste products, too much waste material is thrown away relative to an efficient amount. The private cost of waste disposal is lower than the social cost, which includes health problems due to hazardous waste. Consider the disposal of glass containers in a community that has a fixed annual fee for garbage collection. The marginal private cost of disposal is constant at low levels since a household does not need to pay more for additional units, but increases at very high levels, for which there are additional charges. The marginal social cost of disposal is increasing though. The marginal cost of recycling increases as less is thrown away and more is recycled. Assume the marginal social cost of recycling equals the marginal private cost of recycling. The efficient amount of recycling is where the marginal social cost of recycling equals the marginal social cost of disposal. But the equilibrium amount of recycling is where the marginal cost of disposal equals the marginal cost of recycling (assuming that any waste gets either recycled or thrown away). 9

10 cost MCR MSC MC+ per-unit refund MC m* m1 scrap For waste disposal it is difficult to implement disposal fees, disposal standards or transferable disposal permits. Instead, refundable deposits are used. The refund is an additional marginal cost of not recycling. This raises the marginal cost of throwing the container away. Public goods Two properties define a public good: Nonrival and nonexclusive. A good is nonrival if at any level of production, the marginal cost of providing it to an additional agent is zero. Examples: An uncongested highway. The additional cost of another person driving on it is essentially zero. Similarly, the internet at uncongested times is nonrival. TV and radio broadcasts, an uncrowded park. Electricity provided by a network. A good is nonexclusive if no one can be excluded from consuming it. For example, national defense, the eradication of an agricultural pest or of a disease, fish in the open ocean. Some goods are nonrival, but exclusive: People can be prevented from using an uncongested bridge, but the cost of an additional person using the bridge is essentially zero. Television or radio signals are also nonrival but exclusive the 10

11 signal can be scrambled to prevent some people from using it. Some goods are nonexclusive but rival: Fish in the open ocean, open grazing land. Public goods are nonexclusive and nonrival: National defense, a lighthouse, knowledge in some cases (cost of communicating it to an additional may be positive, but much smaller than the cost of producing it), There are many goods provided by governments that are not public goods. For example, education (provided because it gives positive externalities), national parks (people can be excluded). Efficiency The efficient amount of provision of a public good is where social marginal benefit equals social marginal cost. To determine marginal benefit, we have to find how much each person values an additional unit of output, then add these valuations over all people. Graphically, take each person s marginal valuation curve for the good, and add them vertically, as the graph below shows. Benefit, cost D MC D1 D2 Q* output Market failure with public goods 11

12 Suppose a business is considering offering a mosquito abatement program to a community. The program will cost $50,000, but is worth more to the community (the sums of the valuations of all consumers exceed $50,000. By charging a $5 fee for each of the 10,000 households in the community, you will break even. But there is no way for a private business to make a household pay this money. As long as the program is implemented, no one in the community can be excluded from its benefits. This makes it unlikely that a private company will offer a service that is nonexclusive. A way to implement the mosquito abatement program is by charging taxes to finance it. If the benefit of the program to each household exceeds the additional cost in taxes, the households will most likely approve of the program. For government financing of a project lie this through taxes to result in an efficient allocation, the government must know that the benefit of the project exceeds the cost. Cost-benefit analysis studies this problem. 12