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Lecture 3 Chapter 3
The Club
Anti Theft Device
Assume you car is parked and has the
club in place.
◦ Does this have an effect on the chance that
other cars are stolen? Why?
Transition to Chapter 3
Class discussion
◦ Class thoughts on Pollution
◦ Where does pollution come from?
◦ Do any class members receive benefits from
the activities that generate pollution?
◦ What would happen if there were a mandate
that would stop all pollution tomorrow?
What would the effects of such a policy be?
Externalities Def: a cost or benefit of market transaction not
reflected in prices.
◦ What happens when benefits and costs are not
accurately reflected in prices?
ANS: Inefficiency
Example:
◦ Sweaty gym clothes
◦ Positive Externality
Purchase of Subway Sandwich
Only You benefit No Externality
Purchase of college education
You AND society benefits
Less Crime, better health, more informed voters etc…
Positive Externalities
Def: Benefits to third parties other than buyers or sellers not reflected in prices Examples: Identify the primary parties and the third
parties
Fire prevention mechanisms for your apartment
Nice Landscaping
Education
Externalities
◦ Negative Externality
Producers of electricity
Pay to get the coal, build the plant, pay the
workers etc
Is that the only cost of electricity consumption
and production?
What other costs are there?
Inflamed asthma, reduced visibility, acid rain etc..
Example: Coal Ash spill in Tennessee
December 27, 2008 – 5.4 million cubic yards
Thought question: Is the optimal level of pollution
zero?
Negative Externality
Def: costs to third parties other than the
buyers and sellers of an item not reflected
in the market price
◦ Examples – Identify the primary parties and
the third parties
Construction on an empty lot next to your house
Commercial aircraft flying over a neighborhood
Driving
Smoking
Auto insurance in California link1 link2
Others?
Effects of Externalities
Markets maximize surplus
◦ Only true in a market without externalities
◦ With externalities, Surplus is reduced
◦ Externalities are a source of Deadweight loss
Private Cost: The cost borne by the producer of the
good or service
◦ Trucks, workers, coal
Social Cost = Private cost + any external costs
◦ Trucks, workers, coal + Asthma, pollution etc..
Private benefit: The benefit received by the consumer
of a good
◦ Higher wage
Social benefit = Private Benefit + any external benefit
◦ Higher wage + lower crime for all of society
Externalities and efficiency
When an externality exists, the MC or
MB that market participants base their
decisions on diverge from MSC and MSB
◦ This implies a loss of efficiency.
Marginal External Cost: The extra cost to
third parties resulting from production
of another unit of a good or service.
◦ MEC is part of the marginal social cost, but is
not part of the price.
How do we see it externalities in a graph?
Let’s start with the case of a negative externality
Externalities and Inefficiency •What will happen to this graph
once we take into account the
extra costs borne by society?
•Ans: Costs go up Supply
curve shifts up
•When we take into account all
MC and all MB, then we are at
the efficient equilibrium •Q2 is efficient because at that point
MB = MC for society as a whole.
•Q1 is inefficient, Why?
•Because at Q1 Extra cost to
society is greater than the extra
benefit
•In other words, society could
save resources by reducing
output.
•Producing at Q1 causes deadweight
loss because marginal costs are
greater than the marginal benefits.
Key Point: In a market with a negative externality,
too much will be produced at the market
equilibrium
Market
Equilibrium
Cheshire
http://www.cheshiretransaction.com/film/f
ilm.html
Seeing the Efficiency Loss of a
Negative Externality Consider paper production
◦ Negative externality – pollution into streams
and rivers
◦ Assume that:
the demand curve for paper is based marginal social
benefits
the supply curve based on marginal costs of
producers (marginal private cost)
Assume the marginal external cost is $10 per ton
Seeing the Efficiency Loss of a Negative Externality
Which point is
the market
equilibrium?
Which point is
the efficient
outcome?
Notice at B MSC = MPC + MEC = MSB Efficiency!
Relative to the efficient outcome, when a negative
externality is present, is too much or too little produced? Too much!
Your Turn
In a recent study at a large university, students were
randomly assigned roommates. Researchers found that, on
average, males assigned to roommates who reported
drinking alcohol in the year before entering college had
GPAs .25 lower than those assigned to non-drinking
roommates. For males who drank frequently before college,
being assigned a roommate who also drank frequently
before college reduced their GPAS by .67.
◦ Draw a graph showing the price of alcohol and the
quantity of alcohol consumption on college campuses.
Include in the graph the private and social cost of drinking.
Label any deadweight loss that arises in this market.
An Alternate View of the Club
The club helps professional thieves steal
cars.
The typical driver today is in a car that weighs 4,089 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,500 pounds.
What type of externalities might result for SUVs?
Environmental Externalities:
The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions.
Wear and Tear on Roads:
Each year, federal, state, and local governments spend $33.2 billion repairing our roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight.
Safety Externalities:
One major appeal of SUVs is that they provide a feeling of security because they are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.
The Externality of SUVs
A P P L I C A T I O N
An Example in the News
From the 2008 Financial Crisis
◦ Paulson argues for a government bail out.
Positive Externalities
In a positive externality, prices do not fully
equal the marginal social benefit (MSB) of a
good or service
Marginal external benefit (MEB): Benefit of
additional output accruing to parties other
than buyers and sellers of the good
Consumers base decisions on marginal
private benefit (MPB)
Externalities and Inefficiency •What happens in this graph when we
taken into account the extra benefits
society gets from people getting
educated?
•Ans: Benefits go up Demand
Curve shifts up
•When we take into account all MC
and MB, then we are at the efficient
equilibrium
•Q2 is efficient because at that point
MB = MC for society as a whole.
•Q1 is inefficient, Why?
•Because at Q1 the extra benefit
is greater than the extra cost.
•In other words, society could be
better off by producing more
education.
•Producing at Q1 causes deadweight
loss because marginal benefits are
greater than marginal cost.
•Key Point: When there is a positive
externality, the market equilibrium is
below the efficient equilibrium
•The market produces too little of
the good
= MSC
Seeing the Efficiency Loss of a
Positive Externality Inoculations against disease
◦ Positive externality
◦ Assume that
Supply curves is the MSC Curve
Demand Curve is the Marginal Private benefit curve
Marginal external benefit is $20
Seeing the Efficiency Loss of a
Positive Externality
Internalizing Externalities
Internalization of an externality: Marginal private
benefit or cost of goods and services are
adjusted so that users consider the actual
marginal social benefit or cost of their decisions
◦ Negative externality – MEC is added to MPC
◦ Positive externality – MEB is added to MPB
2 Primary Ways to Internalize and
Externality
1. Corrective taxes and subsidies (these involve
the government)
2. Coase-Type Solutions (“private solutions”)
Internalizing Externalities – The
corrective tax Do Taxes change our behavior?
◦ Which year a baby is born
◦ How much you drive
Corrective tax: Designed to adjust MPC of a good
or service in such a way as to internalize the
externality
◦ Tax = Marginal External cost
What is the difference between a corrective tax
and a regular tax?
◦ Corrective taxes are designed to correct inefficient
outcomes related to externalities. Regular taxes are
designed primarily for revenue.
How to regain Surplus lost from
Externalities: Government Solutions
This is where the market settles
This is where society is best off
S2 Marginal
Social Cost
•What do we know of
that will move us from
S1 to S2?
•A Tax
•A tax forces
producers to take into
account the external
costs
•A tax in the case of
externality eliminates
the dead weight lost.
•That is because the
tax helps to equate
society’s MC to
society’s MB
DWL
Internalizing Externalities – The
Corrective Tax Corrective Tax
Is the efficient level > or < market level in this example?
What is the size of the net gains in well being?
<
.5 * 500k * 10 = 2.5 million
Important things to note
◦ Tax does not reduce pollutants to zero. It
merely raises the cost of production reflect
MEC
◦ Corrective tax will result in some groups
receiving benefits at the expense of other
groups
Why might corrective taxes be politically difficult?
Note: This is a resurfacing of the efficiency vs.
equity tradeoff
Internalizing Externalities – The corrective tax
Corrective subsidy: Payment made by government
to either buyers or sellers so that the price paid
by consumers is reduced
◦ Note again that the difference for the corrective
subsidy Used to internalize a positive externality
Grant a subsidy to internalize a positive
externality
◦ Subsidy should be equal to the MEB
◦ Subsidy shifts the Demand Curve up by the
amount of the MEB
Internalizing Externalities – The corrective subsidy
How to Regain Surplus Lost from
Externalities
This is where the market settles
This is where society is best off
D2 Marginal
Social
benefit
•What Do we know
of that will move us
from D1 to D2?
•A Subsidy
•A subsidy helps us
to take into account
the external benefits
of our actions
•A subsidy in this
case eliminates the
deadweight loss
•That is because the
subsidy helps to
equate society’s MB
to society’s MC
DWL
Internalizing Externalities – The corrective subsidy
What area represents the
efficiency gain? ANS: ZUV
Coase-Type Solutions to
Externalities Example - Smoking
Coase Theorem (Part I) When
there are well-defined property
rights and costless bargaining, then
negotiations between the party
creating the externality and the
party affected by the externality can
bring about the socially optimal
market quantity.
Coase Theorem (Part II) The
efficient solution to an externality
does not depend on which party is
assigned the property rights, as long
as someone is assigned those rights.
Cheshire
http://www.cheshiretransaction.com/film/f
ilm.html
Power produce received payment for
electricity.
Homeowners paid the power company
the price for the electricity
Problem: The price did not reflect the full
cost of electricity generation
Coase-Type Solutions to
Externalities
Rancher vs. Farmer (cattle
vs. wheat)
◦ No Fence separating
◦ Assume that farmer has
right to cattle free land
This causes rancher to take into
account the MEC of his cattle
trampling wheat. Internalizing
the externality
Key For the Coase Theorem
Part 2 is that it does not matter
who receives the property
rights, the farmer or the
rancher. With bargaining, the
efficient quantity will result.
Key Point: Allocation of
resources is the same in either
case. However, it does effect
the distribution of income in the
system.
Applying the Coase Theorem
Consider Air, How could we apply the
Coase theorem to clean air and pollution?
◦ ANS: Assign a property right – Permits to
Pollute
Note: In the market for
pollution, firms are the ones
who benefit from being able
to pollute.
What are some of the
advantages of a market for
permits? Disadvantages?
Environmental Policy
Emission Standards: Dictates the
maximum amount of pollution you can
emit ◦ Do you think a common Emission standard across
firms would result in an efficient outcome? Why?
ANS: No, marginal benefits of pollution varies across firms.
If marginal benefits of emissions vary among firms, emission
standards do not achieve an efficient outcome.
Take Home Point: Flexible standards more likely to
achieve an efficient outcome than uniform standards
Environmental Policy – Standards vs.
a Tax Note: Firms are
benefiting from the
emissions.
Note: Society is
bearing the cost
Does firm A emit more or less
than the efficient level?
Does firm B produce more or less
than the efficient level?
ANS: ______
Note: The efficiency loss is the area
between the MSB and MSC curve between
efficient and inefficient level
Note: The efficiency los is the area
between the MSB and MSC curve between
efficient and inefficient level
ANS: _______
Consider the government imposing
a strict emissions standard at QR
Key Point: Standards can cause a
DWL by not allowing firms an
room to adjust to firm level
factors
Command and Control vs. Coase
Def: Government sets the emission standards and requires specific pollution control technology ◦ What are the incentives for individual firms to
innovate better or cheaper technology for pollution control?
Tradable permits – Coase Solution
(Market Solution)
◦ What are the incentives for individual firms to
innovate better or cheaper technology for
pollution control?