Paul Krugman and Robin Wells. Microeconomics. Third Edition. Chapter 16 Externalities. Copyright 2013 by Worth Publishers

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1 Paul Krugman and Robin Wells Microeconomics Third Edition Chapter 16 Externalities Copyright 2013 by Worth Publishers

2 1. What s an externality? Costs or benefits of an action that are external to the decision-maker, are paid/enjoyed by others A. positive (beneficial) externalities: flu vaccine negative (harmful) externalities: pollution, barking dogs B. key distinctions: social cost = private cost + negative externality social benefit = private benefit + positive externality C. externalities * cause a divergence between private and social costs and/or benefits of an action * lead to under- or over-production (relative to the efficient, or surplus-maximizing, level of output)

3 D. Example: polluting producer ignores extra social cost, produces too much

4 E. Example: consumers ignore added social benefit of flu vaccines, consume too little

5 F. Thus, there is an optimal amount of pollution (along with the pollution, we get output which we value) BUT, an unregulated market generates too much pollution (see next slide!)

6 Figure 16.2 Why a Market Economy Produces Too Much Pollution Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

7 Panel (a): In absolute terms, the US is one of the biggest polluters. Panel (b): But relative to GDP, we are one of the smallest polluters! Unnumbered Figure 16.1 Economic Growth And Greenhouse Gases In Six Countries Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

8 2. Can the private sector free market economy solve externalities? A. Rely on moral codes? (the Golden Rule, charity, etc.) B. Internalize the externalities? e.g., mergers of bee-keeper (needs apple blossoms) and apple-grower (needs bees) beer company (uses water) and chemical company (pollutes water) C. Coase Theorem: If government assigns property rights, and if private parties can bargain costlessly over resource allocation, then the private market will always solve externalities problems and will allocate resources efficiently, no matter how property rights were assigned (!), without any need for further government intervention.

9 3. The Coase Theorem: An example A s roaming cattle cause $1000 damage to B s land. Building a fence to stop this would cost $X. If A has the right to let cattle roam: If X < $1000, B will build a fence. If X > $1000, the cattle will roam (and B sustains the damage) socially efficient (though maybe not great for B!) If B has property rights: If X < $1000, A will build a fence. If X > $1000, A will pay B for the damage again, socially efficient! 4. Caveats on Coase A. The distribution of rights determines distribution of well-being. B. Transactions costs matter: if bargaining/legal system isn t costless, then the Coase theorem breaks down. (this limitation can be especially important if many people/entities are involved)

10 4. Government and externalities A. Regulation: set quantities: e.g., maximum level of pollution, minimum fuel economy requirement, minimum abatement technology, etc. B. Regulation: set prices (force agents to internalize the externality ) e.g., tax raises cost of an activity with negative externality, forces people to recognize the added (social) cost, encourages people to consume less auction permits for the right to pollute (similar to a tax) subsidy reduces cost of an activity with positive externality, encourages people to consume more

11 (a) Regulate quantities: set maximum emissions levels set level at 300: combined emissions fall by 600 (b) Regulate prices: impose a tax on emissions e.g., set tax (= marginal cost of emissions) at 200: emissions for firm with smaller marginal benefit fall by more Figure 16.3 Environmental Standards versus Emissions Taxes Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

12 5. Example: Taxing a negative externality post-tax equilibrium pre-tax equilibrium surplus pre-tax equilibrium post-tax equilibrium change consumer A+B+G+K A -(B-G-K) producer E+F+R+H+N B+E+F+R+H+G B+G-N cost of externality R+H+N+G+K+M R+H+G -(M+N+K) (= cost savings) net social surplus A+B+E+F-M A+B+E+F M deadweight loss M (zero) -M

13 Why is gasoline taxed so heavily? (Why not tax it even more?) Demand is inelastic, thus low deadweight loss Gasoline generates huge negative externalities: congestion accidents pollution Yet gasoline is taxed much less in the US than in Europe! price per gallon (source: Bloomberg, August 2012) Norway: $10.12 Netherlands: $8.26 Italy: $8.15 UK: $7.87 USA: $3.75 Saudi Arabia: $0.61 Venezuela: $0.09

14 6. Example: subsidies to deal with a positive externality