It s important to be clear about certain terms and definitions before we can go forward with a more in-depth analysis of externalities.

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1 University of Pacific-Economics 53 Lecture Notes #16 I. Externalities A. Introduction An externality is defined as a cost or benefit related to the production or consumption of some good that is imposed on second or third parties (people not participating in the market transaction). When producers fail to take into account the social costs and benefits the amount of output produced will either be overproduced or underproduced. Likewise, when consumers fail to take into account the costs and benefits of their actions too much or too little output will be consumed vs. what is socially optimal. As societies get more urbanized, the presence of externalities becomes more commonplace. With more people, the likelihood that actions be decision makers will have a greater chance of affecting others increases. Externalities are fairly common in our society. Here are some examples: Air pollution (negative production externality) Second-Hand Smoking (negative consumption externality) Bee Keepers and Pollination (positive production externality) Vaccinations (positive consumption externality) B. Definitions It s important to be clear about certain terms and definitions before we can go forward with a more in-depth analysis of externalities. Private Benefit: The increase in consumer happiness from the consumption of one more unit of a good or service. This is equivalent to our usual demand curve. Private Cost (Marginal Cost): The increase in a firm s costs when it produces one more unit of a good or service. This is equivalent to the usual supply curve. The word private is used to emphasize the fact that there are two main actors in a transaction in the output market: the buyer of a good or service (the households) and sellers of a good or service (the firms). When we talk about private benefits or private cost we are discussing the costs and benefits that apply only to the direct participants in a transaction in the output market. The term social is used to emphasize the fact that in some transactions the entire society (and not just a household or a firm) is affected by a market transaction. Social Benefit: The total benefit gained by society from the consumption of a good. It includes any private benefit and any consumption externality that might exist. Social Cost: The total cost from the production of a good, including both the private cost and any production externality.

2 When there is NO externality on the production side then: Social Cost = Private Cost Where there is NO externality on the consumption side then: Social Benefit = Private Benefit Economic Efficiency will always occur when social costs = social benefits When there is no externalities on either the production or consumption side, then economic efficiency will occur when private costs = private benefits. As we have seen already, private cost is just the marginal cost curve facing a firm. Private costs = MC What about private benefits? What is the benefit to you from consuming one more unit of a good? We ve seen already that the benefit has to be at least the price of the good. If the benefit you would get from consuming one more unit of a good is less than the price you are willing to pay for the good then you would not purchase it. If however, the benefit you would get is greater than the price of the good than you will certainly purchase the good. Thus private benefits = P Since we stated that economic efficiency occurs where private costs= private benefits. Then when there is no externalities a firm will produce here P = MC. This is illustrated in Figure 1 for a perfectly competitive firm. Figure 1: Perfectly Competitive Firm with o Externalities When externalities occur, then society will want to produce at a point where social benefits is equal to social costs. When this statement is saying is that the benefits to society (both private and social) from producing 1 more unit of a good must b equal to the cost to society (both private

3 and social). If social benefits were greater than social costs, then society would be better off if the firm produced one more unit of the good. On the other hand if social costs were greater than the social benefits, the society would be better off if the firm produced less of the good because the social resources needed to produce the good is greater than the social benefits gained from consuming the good. In general, we assume that producers and consumers only take into account their own private costs and benefits. They will ignore the social costs and benefits. As a result, when there is a negative externality, the market will end up producing too much of a good than what is socially optimal. When there is a positive externality, the market will end up producing too little of a good than what is socially optimal. In the next section, we ll look at two examples C. Examples of Externalities 1. egative Production Externality In a negative production externality, the producer does not face the entire cost of production. For example, an oil refinery generates air pollution in its production of oil. The presence of air pollution makes the community around the oil refinery worse off due to diminished health or due to diminished ability to view a clear blue sky, etc Refer to Figure 2. The firm will only take into account their own private costs and thus will produce where private benefits = private costs. Which is equivalent as saying where supply equals demand. The oil refinery would produce at Point A where (Quantity = Q 1 ; Price = P 1 ). However, there are social costs (the air pollution) to the production of oil, which the oil refinery ignores. The social cost curve must be higher (to the left) of the private cost curve. At the original level of production, social costs are higher than social benefits and thus this quantity is not efficient and we have market failure. The reason for market failure is that the market participants do not factor in the full social costs of their harmful economic activities. There is a divergence between social costs and private costs which is the negative externality. Note that there is no externality on the consumption side, so private benefit = social benefit (the demand curve will be the same). We know that when externalities exists, economic efficiency will only occur when social benefit is equal to social cost. In this case, economic efficiency will be at Point B. The shaded area is the area in which social costs exceeded social benefit that results from overproduction. This is the deadweight loss. Society would be better off if the economy was at Point B rather than at Point A. Note that at Point B, the efficient solution is not to reduce the harmful activity to 0. As long as the firm has the ability to compensate the damaged parties fully and still have profits left over, then pollution is worth it to society. It would be inefficient for the oil refinery to stop polluting. Notice that if the quantity produced were below Q 2, the benefits gained from society would have been greater than the social costs. Society would be better off if they produce more of the polluting product.

4 Figure 2 2. Positive Consumption Externality Consider the market for flu shots. Flu shots are an example of a positive consumption externality. The more people who get flu shots, the less likely any person who has not received the shot will become ill with the flu. Thus, in this case, there is a clear benefit to society if one gets the flu shot. However, you don t get compensated by society for this benefit (in fact in some cases you have to pay to get a flu shot). Therefore, you will only consider your private benefit in determining whether or not to get a flu shot. This will be a case where the social benefit will differ from the private benefit. The social benefit curve for a positive consumption externality will be to the right of the private benefit curve. This is the case, because at every price, society would benefit more from flu shots. There is no externality on the production side, therefore the social and private costs are the same. Refer to Figure 3. We know that the market equilibrium is where the private costs=private benefits at Point A. However, Point A cannot be efficient since at that quantity the social benefits exceed the social costs. Economic efficiency will only be reached when social costs = social benefits at Point B. The shaded area is the positive externality that is realized as we

5 produced the good. The deadweight loss is the shaded area between Q 1 and Q 2. It is the loss to society by not producing enough of the good. Figure 3 D. Solutions to Externalities There are several ways we can achieve an efficient level of production in the presence of externalities. (1) Taxes and Subsidies: The government can be used to internalize: the externality that will force the market participants to see the full economic consequences of their actions. In the case of a negative externality this can be done using a tax. If the tax is set to the amount of the externality cost, then it will have the effect of shifting the curves in the right direction and the efficient amount will be produced. For example in the case of the negative production externality. The government can charge a tax on production of the good equal to the externality. The tax will shift the S 1 curve to S 2 and the firm will produce at the efficient amount Point B. In the case of a positive externality this can be done using a subsidy (government paying producers to produce or consumers to consume). There is the obvious difficultly of the government s ability to correctly measure the externality. (2) Private Solutions (Bargaining and egotiation): Consider the case of the polluting oil refinery. The victims of the pollution can either bribe the polluters not to pollute, or the polluters could compensate the victims of pollution to allow them to pollute. This is

6 known as Coase Theorem. The theorem states that if basic rights at issue are understood, transaction costs are low, and if few parties are involved, private parties will find an efficient solution to the problem of externalities. Often, however, transaction costs are not low since there are many people involved in the externality. Thus private solutions to an externality are generally not feasible. (3) Legal Rules and Procedures: When externalities generate damage to society, courts and the law can be employed to limit the damage costing action. An injunction is a court order forbidding the continuation of behavior that leads to damages. If the damages have already occurred, the court can issue liability rules which requires the damaging party to compensate for the harm committed. As a result of injunctions and liability rules, the decision makers have an incentive to weigh all the consequences. (4) Selling or Auctioning Pollution Rights: Another method to control pollution is to issue permits to firms to pollute and allow firms to trade these permits in a market setting thereby resulting in an efficient level of pollution. This system is called a cap and trade approach. The Clean Air Act of 1990 is an example of a law that used the cap and trade system. Emissions from each factory was limited to a certain level. Each firm plant was issued permits to emit only that level of production. Permits could be used to emit air pollution or they could be traded to another firm. Firms who had clean technology and were able to produce output at emission levels lower than the federal mandate would sell its unused permits to firms with dirtier technology. The socially desirable level of pollution would thus be generated using this method. Environmental groups could also purchase these permits in the market and choose not to use them, thereby reducing emissions even further. Table 1 shows a hypothetical permit trading scenario Units of Pollution Reduced by Firm A MC of Reducing Pollution for Firm A TC of Reducing Pollution for Firm A Units of Pollution Reduced by Firm B MC of Reducing Pollution for Firm B 1 $5 $5 1 $8 $8 2 $7 $12 2 $14 $22 3 $9 $21 3 $23 $45 4 $12 $33 4 $35 $80 5 $17 $50 5 $50 $130 TC of Reducing Pollution for Firm B Table 1 shows the costs for two firms (Firm A and Firm B) to reduce pollution. For example to reduce 1 unit of pollution will cost Firm A $5. To reduce pollution one more unit will cost Firm A $7 extra. The total cost therefore of reducing pollution by 2 units is $12. As you can see in the table the cost for reducing pollution is cheaper for Firm A than for Firm B. Firm A is using a cleaner technology which makes it cheaper for Firm A to reduce its emissions.

7 Suppose that both firms are currently emitting 5 units of pollution. The government has now mandated that firms in this industry can only emit 2 units of pollution. The result is both firms have to cut their emissions by 3 units. Both Firm A and Firm B get 2 permits each. Each permit allows the firm to emit 1 unit of pollution. Both firms have to reduce its emissions by 3 units. The total cost to Firm A to reduce its emissions by 3 units is $21, while the total cost to Firm B to reduce its emissions by 3 units will be $45. Firm A could go further and reduce its emission by 1 more unit so that it emits only 1 unit of emission. The extra cost for Firm A would be $12. If Firm A spent an additional $12 it would produce only 1 unit of pollution and will have an unused permit. Firm A can then sell that permit to Firm B. Firm B would then have 3 permits allowing it to produce 3 units of pollution. Thus Firm B only has to reduce its emissions by 2 units. Thus it saves $23 in costs from not having to reduce from 2 to 3 units. Note that the cap and trade approach allows the economy to achieve the desired level of emissions at a lower cost than if both firms reduced their emission levels equally. (5) Direct Regulation of Externalities All of the forms of controlling externalities that we have discussed so far are indirect. That is they are designed to encourage firms to internalize the cost and benefits of their actions, but they are not mandatory. Some externalities, however, are too dangerous to society that they require a more direct means of control. Direct regulation involves explicit control over the actions that lead to externalities. Violators of the regulations not only face a monetary cost, but also criminal penalties and sanctions. Direct regulation ensures that firms and households completely weigh the costs of their actions. II. Public Goods A. Characteristics of Public Goods Public goods have the following two characteristics: (1) It must be non-rival in consumption (2) The benefits must be non-excludable There two characteristics make it difficult for private firms to produce the optimal quantity of public goods (or to provide it at all). The provision of public goods often requires the assistance of government. A rival good is a good that once it is consumed, no one else can consume it. A nice juicy steak at Outback Steak House is a good example. Once I finish the steak, no one else can eat it. A good is non-rival if the consumption of the good by one party does not interfere with another party s consumption of that good. For example, if Bill enjoys the police protection of the city that does not prevent Susan from also enjoying police protection.

8 A good is considered excludable if anyone who doesn t pay for the good cannot consume it. If I want a nice juicy steak at Outback Steakhouse, I ll need to pay for it. If I don t have the money, I won t be able to get the steak. Most public goods are non-excludable. Once the good is produced, it is difficult if not impossible to prevent people from consuming the good or enjoying the service. It s not feasible to deny people fire or police services even if they don t pay taxes to pay for the service. Other types of goods: Private Goods are goods that are excludable and rival Quasi Public Goods are goods that are excludable and non-rival Common Resources are goods that are non-excludable and rival. These two characteristics of non-rivalry and non-excludability make it very difficult for private firms to produce public goods. As an example, suppose during George Bush s administration he tried to privatize national security and wanted to hire the firm Blackwater to provide national security. Blackwater would run into immediate problems in providing national security. First, would be the fact that payment would be voluntary. Blackwater cannot withhold its services for people who don t pay. Everyone would benefit if they invaded a foreign country for national security whether or not they had paid. People have a clear incentive not to contribute if they know they will enjoy the benefits even if they don t contribute. This is known as the free-rider problem. Another example, would be if you really enjoyed a program on PBS. Public television such as PBS have frequent fundraisers to pay for programming. This is a clear example of a free-rider problem. Whether you pick up the phone and make a pledge to PBS will not affect your ability to enjoy your favorite show on PBS. You might contribute because it ll make you feel better about yourself, but there is no economic incentive to make you want to contribute. Another issue Blackwater would face in providing national security is the drop-in-the bucket problem. The budget for the Defense Department last year was $400 billion dollars. Thus it would cost Blackwater $400 billion to provide national security. Suppose that Blackwater could raise this money if each individual in America voluntarily contributed $150. However, the problem is that each individual contribution is so small relative to total cost of providing the service, that if one individual withholds their contribution it will not affect the level of service. The amount of public good provided would not depend on whether an individual paid or not, thus there is no incentive for an individual to pay. Both the free-rider problem and drop in the bucket problem explain why government has to get involved to provide the optimal level of public goods. B. Public Provision of Public Goods (Optimal Level) One of the big problems facing governments is deciding what is the optimal level of public good that should be provided. For example with national defense, an individual such as Dick Cheney would probably want a lot of soldiers, airplanes and missiles, while a anti-war hippie from Berkeley would probably want very little national defense. Given these varying preferences among individuals, how does the government choose the efficient level of public goods?

9 One theory put forth by Paul Samuelson (hence the name Samuelson s Theory) argues that the optimal production of a pubic good depends on society s willingness to pay for the public good. To illustrate this point, let us go back to Chapter 3 and recall how a market demand curve for a private good was derived. Figure 4 shows how market demand curves are determined Figure 4: Market Demand Curves Suppose there was a simple economy with only 2 individuals: A and B. A s demand curve is shown in the far left hand graph in Figure 4, while B s demand curve is shown in the middle graph. We can see from the figure if the price of the good was $1 then A will demand 9 units of the good, while B would demand 13 units of the good. The total market demand when the price is $1 will be 22 units of good (A s demand + B s demand). If the price of the good increased to $3 then A will demand only 2 units of output, while B will demand 9 units of output. The total market demand at $3 will be 11 units of output. With private goods, there exists a price mechanism that reveals what people are willing to pay for goods. Thus the firms are willing to produce only those goods that people want at a certain price. To determine market demand for a private good we add the quantity demanded by each individual at each price level. The difference between a public good and a private good is that there can only be one level of output that can be produced for a public good. The job of the government is to determine what that level should be. Samuelson s Theory argues that the government can produce the efficient level of output if they could ask each individual what they would be willing to pay at each level of output produced. In essence, the government is trying to find the market demand curve for the public good. Figure 5 illustrates how the market demand curve is derived for a public good.

10 Figure 5: Market Demand Curve for Public Goods To simplify things let us assume a simple economy with only 2 individuals. Figure 5 shows the demand curve for individuals A and B for a certain public good. The government has sent out a survey to A and B and asked each what they would be willing to pay if the amount of public good produced was X 1 units. We can see from the graphs that Individual A would be willing to pay $6 for that level of output, while Individual B would be willing to pay $3 for that level. Thus if the government could collect the donations from A and B they know that they could get $9 if they produced X 1 units. They next asked A and B what they would be willing to pay for X 2 units. We see that both A and B would both be willing to pay $2 each. So if the government produced X 2 units, then they could possibly get $4. We thus see how the market demand curve is derived in the case of a public good. We add the amounts that each individual is willing to pay at each potential level of output.

11 The optimal production of a public good occurs where the society s wiliness to pay (represented by the market demand curve) is equal to the marginal cost of providing the public good (represented by the supply curve). Figure 6 illustrates this. Market demand curve is D A+B while the supply curve is the marginal cost. The efficient level of output is going to be at X 1 and the price charged will be $9. The obvious problem with this method is that it requires the government being able to determine the preferences for every individual and their willingness to pay. If people knew that their responses would somehow determined how much they would be taxed to provide for the public good they would simply lie about their willingness to pay. The solution depends on the type of political system set up in the economy. In dictatorships, the optimal amount of public good is determined by one individual, the dictator. In representative democracies, the decision for provision of public goods can be determined by representatives, while in true democracies the voters can decide the level of public goods. C. Tiebout Hypothesis One theory proposed by Charles Tiebout (Tiebout hypothesis) states that efficient amount of public goods can be produced at the local level. The idea is that people who prefer a higher level of public good will reveal that preference by paying higher housing price and/or taxes. Suppose that a community spends a lot of money on law enforcement with the result of very low crime rates. Those households that

12 value safety and are willing to pay for it, will want to move to this community. Those who don t value the police service will not move to the community. Does the town is able to provide the efficient level of output of public goods. D. Mixed Goods Some goods have characteristics consistent with both private and public goods. A good example is college education. College education has aspects that are consistent with private goods. College education is certainly excludable. If you don t pay your student fees you will be prevented from enrolling in classes. However, college education does provide benefits that are nonexcludable. All members of society benefit when people go to college. A college educated society will have a lower crime rate, higher productivity and higher wages. Some mixed goods such as education produces a positive externality. III. Social Choice As we have seen one of the problems with public goods is determining what society wants. Public officials and elected representatives cannot know the preferences of everyone concerning public goods such as roads, national defense and clean air and water. Thus we have to rely on imperfect social choice mechanisms to determine public good allocation. Social choice is the problem of deciding what society wants. It is done by adding up individual preferences to make a choice for society as a whole. A. Majority Voting and the Voting Paradox The most common form of social choice in democratic societies is majority voting, where societies wants are determined by the majority of voters. However, even in this simple public choice mechanism problems arise. Consider the following example: Suppose that the Brady Family-Mike (the Dad), Carol (the Mom) and Greg (the sole surviving son of a horrific car accident that killed 5 other siblings) are deciding where to take their family vacation. The choices are: London, Orlando and New York. Given the choices each of the family members have certain preferences: Mike s 1 st choice would be New York, his 2 nd choice would be London and his 3 rd Orlando. Carol s 1 st choice would be London, her 2 nd choice would be Orlando and her 3 rd New York. Greg s 1 st choice would be Orlando, his 2 nd New York and his 3 rd choice would be London. If the choice was between New York and London, the Brady family would go to New York, since Mike and Greg would outvote Carol. If the choice was between London and Orlando, the Brady family would go to London, since Mike and Carol would choose London over Orlando. Thus we would expect that since the Brady Family prefers New York to London, and prefers London to Orlando it must be the case that the Brady family will prefer New York to Orlando. Is this true?

13 Well looking at the family preferences, we see if the choice was between Orlando and New York, Orlando would win out! Greg and Carol would both choose Orlando over New York and thus the Bradys would go to Orlando. This contradiction is called the voting paradox. The paradox shows that majority rule voting can lead to contradictory and inconsistent results. Majority voting has other problems as well. Logrolling In Congress, bills must be passed by a majority vote. However if a piece of legislation would only benefit the West Coast, it might have difficultly gaining the votes necessary to pass. One solution is to engage in logrolling where Congressional people agree to help get each other by trading votes to get legislation passed. In our example, suppose there was another bill pending in Congress that only would benefit the South. The Western congressmen would offer their support for the Southern bill so it can pass the House. In exchange the southern congressmen would support the western bill. Logrolling can lead to inefficient pork-barrel legislation. Incentive for Voters to ot Be Well Informed Another problem for voting to determine social choice is that voters have little incentive to be well informed. There is little chance that your vote will matter (unless you were in Florida in 2000), but aside from that is the fact that costs or benefits from your vote will be spread out among the entire voting population. If you voted for a bond measure that ended up costing the state billions of dollars, it will end up costing you only a small fraction of that amount personally. Even if social choice decisions are not made directly by voters but by public officials there will be problems with that mechanism as well. Public sector agencies have little incentive to be efficient. Unlike private business firms who will go out of business if they are not efficient, public agencies will still be around even if they are inefficient. It is hard to punish or fire a public official, thus there is little incentive for the public official to make the best decision possible. Some on the right side of the political spectrum have argued that private firms might be able to provide the same service at a lower cost.