ECON 2100 Principles of Microeconomics (Fall 2018) Externalities

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1 ECON 21 Principles of Microeconomics (Fall 218) Externalities Relevant readings from the textbook: Mankiw, Ch. 1 Externalities Suggested problems from the textbook: Chapter 1 Quick Quiz Multiple Choice (Pages 26-27): 1, 2, 3, 4, and 6 Chapter 1 Questions for Review (Pages 27-28): 1, 2, 4, and 6 Chapter 1 Problems and Applications (Pages 28-29): 1, 2, 3, 4, 5, 6, 8, and 9 Definitions and Concepts: Market Failure a situation in which the free market outcome is inefficient, in that there is a positive Deadweight-Loss at the resulting free market level of trade. Common sources of Market Failure: (i) Market Power, (ii) Externalities, and (iii) Public Goods External Cost or Negative Externality a cost of an activity borne by someone not engaging in the activity. e.g., air pollution from industrial activity, noise from low-flying aircraft, speeding on a highway External Benefit or Positive Externality a benefit from an activity realized by someone not engaging in the activity. e.g., vaccines, installation of smoke detector in attached apartments, basic scientific research, fireworks display, planting of trees (for erosion control) Main Insight: market provision of a good for which there is either a negative externality or a positive externality will be inefficient: Negative externality => free markets would provide more than the optimal amount of the good. (i.e., positive DWL due to too much trade ) Positive externality => free markets will provide less than the optimal amount of the good. (i.e., positive DWL due to too little trade ) Pigouvian Tax a per unit tax imposed on a good which generates a negative externality, which reduces trade to the efficient level (and therefore eliminates Deadweight-Loss) [in order for the efficient level of trade top result, the magnitude of the tax must be equal to the marginal external cost at the efficient level of trade] Coasian Solution to the problem of externalities: 1. clearly and fully define property rights 2. make individuals pay compensation if they infringe upon property rights of others 3. allow parties to negotiate with one another regarding infringements on property rights caused by the externality Coase Theorem in the presence of an externality, if the following conditions hold: (i) property rights are clearly, completely defined (and can be enforced at low cost) (ii) parties can negotiate with each other at low cost then (regardless of which party is granted the initial property right) negotiation between the affected parties will result in the efficient level of the externality

2 Market Outcome in Presence of a Negative Externality : In general, Social Cost is equal to the sum of Costs over all people in society => The sum of Private Cost and External Cost => MSC=MPC+MEC In the presence of a Negative Externality there is a positive External Cost, making Social Cost greater than Private Cost (that is, since MEC> => MSC>MPC) If this good was traded in a free, unrestricted, unregulated market => rational, selfinterested market participants would base their actions upon Private Costs (and Private Benefits ), not taking into account the External Cost. Efficient amount of Negative Externality Deadweight-Loss Social Costs Private Costs = MPC = Supply Private Benefits = MPB = Demand Efficient Level of Trade Free Market Level of Trade Free Market outcome results in too much of the activity => positive DWL illustrated by gray area Positive DWL is why market provision of a good which generates a negative externality is bad But note that at the efficient level of trade, there is a positive amount of the negative externality being generated (illustrated by the purple area above) Best Level of Pollution for society is NOT ZERO! In order to have zero pollution we would have to have: no cars, no electricity, no fire Clearly the costs of the initial units of pollution are well below the benefits of the initial units of the activities that cause the pollution

3 Market Outcome in Presence of a Positive Externality : In general, Social Benefit is equal to the sum of Benefits over all people in society => The sum of Private Benefit and External Benefit => MSB=MPB+MEB In the presence of a Positive Externality there is a positive External Benefit, making Social Benefit greater than Private Benefit (that is, since MEB> => MSB>MPB) If this good was traded in a free, unrestricted, unregulated market => rational, selfinterested market participants would base their actions upon Private Benefits (and Private Costs ), not taking into account the External Benefit. Deadweight-Loss Private Costs = MPC = Supply Social Benefits Private Benefits = MPB = Demand Free Market Level of Trade Efficient Level of Trade Free Market outcome results in too little trade => positive DWL illustrated by orange area Positive DWL is why market provision of a good which generates a positive externality is bad

4 Possible policies to address DWL from an externality: Consider a market in which production/consumption generates a negative externality 1. Entirely ban the production of the good (e.g., illegal to emit any pollution ) DWL from entirely banning production DWL at free market outcome (i.e., DWL from doing nothing ) Social Costs = MPC = Supply Private Costs Private Benefits = MPB = Demand In many instances, entirely banning the activity which generates the negative externality would likely result in lower Total Social Welfare (i.e., a larger DWL) than simply doing nothing 2. Establish minimum compliance standards for manufacturers (i.e., can only pollute up to a certain level ), and then allow producers to choose the most effective way to reduce their pollution 3. Offer subsidy payments to manufacturers for each unit of pollution they don t emit (e.g., set a ceiling on the acceptable amount of pollution, and then pay the firm to reduce their emissions below this level ) 4. Clearly and completely define property rights, and then allow affected parties to negotiate Nobel Laureate Ronald Coase (191-; Noble Prize in 1991) argued that the problem with externalities was simply a problem of property rights not being defined For example: Does the factory have the right to pollute the air? or Do households have the right to clean air? => start by addressing this issue Coase s solution was to internalize the externality => clearly and completely define property rights, and then allow parties to negotiate. Coase Theorem in the presence of an externality, if the following two conditions are met: (iii)property rights are defined clearly and completely (and can be enforced at low cost) (iv) parties can negotiate with each other at low cost then (regardless of which party is granted the initial property right) negotiation between the affected parties will result in the efficient level of the externality

5 5. Impose a tax on the good We know that imposing a tax on a good will lead to less trade taking place, which is exactly what we want (from an efficiency standpoint) in this case How large should the tax be? To get the efficient level of trade, set the per unit tax equal to the (marginal) value of the negative externality on the last unit which should be traded from the standpoint of efficiency i.e., set the tax equal to the MEC at the efficient level of trade Pigouvian Tax a per unit tax imposed on a good which generates a negative externality, which reduces trade to the efficient level (and therefore eliminates Deadweight-Loss) In order for the efficient level of trade top result, the magnitude of the tax must be equal to the marginal external cost at the efficient level of trade Named for economist Arthur C. Pigou ( ) Social Cost at Efficient Level of Trade Magnitude of Pigouvian Tax Social Costs Supply with Tax Private Costs = Supply without Tax Efficient Level of Trade Private Benefits = MPB = Demand Free Market Level of Trade

6 Problem: 1. The production of phosphate fertilizers results in substantial pollution. The graph below illustrates Private Benefits, Private Costs, and Social Costs for different levels of trade in this market. Answer the questions below based upon the information conveyed in this graph Social Costs = ( Private Costs) + ( External Costs) Supply = ( Private Costs) Demand = ( Private Benefits) 1A. What is the efficient level of production/consumption of this good? Explain. 1B. Suppose that a Per Unit Tax of 11 per unit was imposed in this market. Would the resulting level of trade be more than or less than the efficient level of trade? Explain. 1C. Suppose that the production of phosphate fertilizers was completely banned. Does it appear as if this policy would be better than or worse than doing nothing? Explain. Multiple Choice Questions: 3,8 8,4 1,2 1. Market Failure refers to A. a situation in which the free market outcome results in either more than or less than the efficient amount of trade. B. a situation in which a firm is unable (due to technological constraints) to develop a product which consumers would value. C. the practice of charging different consumers different prices for different units of a good (which the price difference not resulting from differences in production costs). D. the argument that the best way to deal with problems related to externalities is to clearly and completely define property rights, and then allow affected parties to negotiate with one another.

7 2. Last night around 11:3pm, Titus lit-off some fireworks in his front yard, which he had left over from the 4 th of July. Mary and Rob live near Titus. Mary enjoyed watching the fireworks from her front porch. The fireworks woke Rob up, who was trying to sleep because he had an important presentation at work this morning. From this information, it would appear as if Titus fireworks display A. lead to a decrease in Total Social Welfare. B. generated a positive externality, but no negative externality. C. generated both a positive externality and a negative externality. D. More than one of the above answers is correct. 3. In the presence of a positive externality, the free market would typically A. provide the efficient amount of the good. B. provide less than the efficient amount of the good. C. provide more than the efficient amount of the good. D. lead to trade taking place on all units for which any consumer has a positive reservation price. 4. is a per unit tax imposed on a good that generates a negative externality, which reduces trade to the efficient level (and therefore eliminates Deadweight-Loss). A. A Nash Tax B. The Coasian Solution C. A Pigouvian Tax D. A Regressive Tax 5. For which of the following activities would there likely be an external effect (i.e., either a benefit or a cost to someone not directly engaged in the activity)? A. Last week Janet took her son Patrick to the doctor to get a Chicken Pox vaccine. B. Due to an increase in crime in his neighborhood, John hired a security guard to stand watch on his front porch overnight. C. Larry was running late for work this afternoon, so he drove 85 miles per hour on the freeway and ran four red lights during his commute. D. All of the above answers are correct. 6. The reintroduction of the gray wolf into the wilderness of the Western United States during the last several decades A. proves that the proposed Coasian Solution to the problem of externalities does not work. B. led to ranchers in the region realizing an external cost as a result of an increase in the number of their livestock being killed by wild animals. C. was done by a firm with market power and was therefore inefficient. D. More than one of the above answers is correct.

8 For questions 7 through 1, consider the market illustrated below: 11.2 Private Costs = Social Costs a b g e c Social Benefits 1.45 h f Private Benefits 3,25 5,2 7. It would appear as if A. this good is clearly being produced by a monopolist. B. production/consumption of this good generates a positive externality. C. production/consumption of this good generates a negative externality. D. the efficient level of trade of this good is zero units. d 8. The efficient level of trade in this market is, while the free market level of trade is. A. (3,25); (5,2) B. (5,2); (3,25) C. (5,2); () D. (); (5,2) 9. At the free market outcome, there is A. zero Deadweight-Loss B. a Deadweight-Loss equal to area (c). C. a Deadweight-Loss equal to area (d). D. a Deadweight-Loss equal to area (e). 1. If the efficient amount of trade took place, there would be A. external costs equal to areas (d)+(e)+(f)+(g)+(h). B. external costs equal to areas (g)+(h). C. external benefits equal to areas (a)+(b). D. external benefits equal to areas (a)+(b)+(c)+(d).

9 Answer to Problem: 1A. To maximize Total Social Welfare, we need to trade all units (and only those units) for which Social Benefits are greater than or equal to Social Costs. Since there are no external benefits, Social Benefits are simply equal to Private Benefits. Thus, the efficient level of production/consumption occurs at the intersection of the blue curve and the green curve. This intersection occurs at a of 8,4 units. 1B. The market of trade in the absence of any tax is at the intersection of Private Benefits and Private Costs (i.e., the intersection of the blue curve and the red curve ). Applying the insights from our previous discussion of per unit taxes, if a per unit tax of 11 is imposed in this market, the level of trade will be the unique level at which the blue demand curve is exactly 11 (the exact magnitude of the tax) above the red supply curve. Since the vertical gap between these curves at a of 8,4 is only (2) (11) = (9), it follows that in the presence of an 11 per unit tax, fewer than 8,4 units would be traded. Since the efficient level of trade is 8,4 units, the proposed tax would ultimately lead to less than the efficient amount of trade. 1C. As already noted, the efficient level of trade ion this market is 8,4 units. Thus, completely banning the production/trade of this good would result in a positive Deadweight-Loss due to too little trade. More precisely, the Deadweight-Loss from this policy would be equal to the pink shaded area in the graph below. If instead society does nothing, then the free market outcome would result. At the free market outcome there is a Deadweight-Loss from too much trade, illustrated by the yellow shaded area below. Based upon the graph it appears as if the pink shaded area is larger than the yellow shaded area, suggesting that the proposed policy is worse (i.e., leads to a larger Deadweight-Loss) than doing nothing. Social Costs = ( Private Costs) + ( External Costs) Supply = ( Private Costs) Demand = ( Private Benefits) 8,4 1,2

10 Answers to Multiple Choice Questions: 1. A 2. C 3. B 4. C 5. D 6. B 7. B 8. B 9. B 1. D