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An Externality Is an Unintended Consequence of a Choice That Falls on Someone Other Than the Decision-Maker

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An Externality Is an Unintended Consequence of a Choice That Falls on Someone Other Than the Decision-Maker © 2010 Pearson Education Canada An externality is an unintended consequence of a choice that falls on someone other than the decision-maker. Externalities may be positive or negative Externalities may arise in consumption or production © 2010 Pearson Education Canada Production Externalities Production externalities drive a wedge between the marginal private cost (MC) that is borne by the producer, and the marginal social cost (MSC) that is the total cost to society. MSC = MC + marginal external cost The marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer. © 2010 Pearson Education Canada Negative Production Externalities © 2010 Pearson Education Canada Negative Production Externalities: Pollution Production and Pollution: How Much? In the market for a good with an externality that is unregulated, the amount of pollution created depends on the equilibrium quantity of the good produced. © 2010 Pearson Education Canada Negative Externalities: Pollution Figure 16.2 shows the equilibrium in an unregulated market with an external cost. The quantity produced is where marginal private cost equals marginal social benefit. © 2010 Pearson Education Canada Negative Externalities: Pollution At the market equilibrium, MSB is less than MSC, so the market produces an inefficient quantity. At the efficient quantity, marginal social cost equals marginal social benefit. With no regulation, the market overproduces and creates a deadweight loss. © 2010 Pearson Education Canada Consumption Externalities Consumption externalities drive a wedge between the marginal private benefit (MB) that is borne by the producer, and the marginal social benefit (MSB) that is the total cost to society. MSB = MB + marginal external benefit The marginal external benefit is the benefit from consuming one more unit of a good or service that falls on people other than the consumer. © 2010 Pearson Education Canada Positive Consumption Externalities: Knowledge The marginal external benefit is the vertical distance between the MB and MSB curves. © 2010 Pearson Education Canada Positive Externalities: Knowledge A private market will underproduce an item that generates an external benefit and creates a deadweight loss. © 2010 Pearson Education Canada Externalities and property rights Property Rights Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts. One way to look at the market failure that arises in the presence of externalities is that it comes about because of the absence of property rights. © 2010 Pearson Education Canada Externalities and property rights The Coase Theorem The Coase theorem is a proposition that if property rights exist, only a small number of parties are involved, and transactions costs (defined below) are low, then private transactions are efficient. There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights. To see this, take the example of “the barking dog”. © 2010 Pearson Education Canada Barking dog example D owns a dog that barks J is bothered by the dog barking What is the efficient allocation? Depends on value of benefit to D of keeping dog compared to cost to J of barking. © 2010 Pearson Education Canada Benefit to D from owning dog: $500 Cost to J of barking dog: -$800 Total surplus if D keeps dog : -$300 Total surplus if D gets rid of the dog : $ 0 Efficient outcome: J pays D to get rid of the dog Scenario 1 Suppose D owns the “property right” to let the dog bark. J can offer to pay him to get rid of the dog. She will offer P<$800; he will accept P>500. So he gets rid of the dog - outcome is efficient. Scenario 2 Suppose J owns the “property right” to quiet. D can offer to pay her not to complain about the dog. D will offer P<500; J will accept P>500. No deal. She complains, the dog is removed. The outcome is efficient. © 2010 Pearson Education Canada This example illustrates the Coase theorem: (1) if property rights exist, only a small number of parties are involved, and transactions costs (defined below) are low, then private transactions are efficient; and (2) the outcome is independent of who has the property rights. Easy to see (2) in our example. In both scenarios, the dog is not allowed to bark. Does not depend on who has property right. However, the distribution of surplus depends on the property right. When D has the property right, J gets less surplus and D gets more surplus (J pays D to get rid of dog). © 2010 Pearson Education Canada This example illustrates the Coase theorem: (1) if property rights exist, only a small number of parties are involved, and transactions costs (defined below) are low, then private transactions are efficient; and (2) the outcome is independent of who has the property rights. What about the first proposition? © 2010 Pearson Education Canada The Coase solution works only if transaction costs are low. Transactions costs are the cost of conducting a transaction. In our example, the transactions cost would involve negotiating a price between J and D. When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality. © 2010 Pearson Education Canada Negative Externalities: Pollution Government Actions in the Face of External Costs There are three main methods that the government uses to cope with external costs: Taxes Emission charges Marketable permits © 2010 Pearson Education Canada Negative Externalities: Pollution Taxes The government can set a tax equal to marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost, MC + tax = MSC. This tax is called Pigovian tax, in honor of the British economist Arthur Pigou, who first proposed dealing with externalities in this fashion. © 2010 Pearson Education Canada Negative Externalities: Pollution A pollution tax equal to the marginal external cost can achieve an efficient outcome because MSC = MSB. The government collects a tax revenue. © 2010 Pearson Education Canada Negative Externalities: Pollution Marketable Permits Each firm is assigned a permitted amount of pollution per period and firms trade permits. The market price of a permit confronts polluters with the marginal social cost of their actions and leads to an efficient outcome. © 2010 Pearson Education Canada Positive Externalities: Knowledge Government Action in the Face of External Benefits Four devices that the government can use to achieve a more efficient allocation of resources in the presence of external benefits are Public provision Private subsidies Vouchers Patents and copyrights © 2010 Pearson Education Canada Positive Externalities: Knowledge Public Provision Under public provision, a public authority that receives payment from the government produces the good or service. Figure 16.7(a) shows how public provision can achieve an efficient outcome. © 2010 Pearson Education Canada Positive Externalities: Knowledge Private Subsidies A subsidy is a payment by the government to private producers. If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced is efficient. © 2010 Pearson Education Canada Positive Externalities: Knowledge Figure 16.7(b) shows how a subsidy can achieve an efficient outcome. © 2010 Pearson Education Canada Positive Externalities: Knowledge Vouchers A voucher is a token that the government provides to households, which they can use to buy specified goods or services. Figure 16.8 shows how vouchers can achieve a more efficient outcome. © 2010 Pearson Education Canada Positive Externalities: Knowledge Patents and Copyrights Intellectual property rights give the creator of knowledge the property right to the use of that knowledge. The legal device for establishing an intellectual property right is the patent or a copyright. A patent or copyright is a government-sanctioned exclusive right given to an inventor of a good, service or productive process to use to produce, use and sell the invention for a given number of years. © 2010 Pearson Education Canada © 2010 Pearson Education Canada Classifying Goods and Resources What is the essential difference between: A city police department and Brinks security Fish in the Atlantic Ocean and fish in a fish farm A live concert and a concert on television These and all goods and services can be classified according to whether they are excludable or nonexcludable and rival or nonrival. © 2010 Pearson Education Canada Classifying Goods and Resources Excludable A good is excludable if only the people who pay for it are able to enjoy its benefits. Brinks’s security services, Cooke Aquaculture’s fish, and a U2 concert are examples. Nonexcludable A good is nonexcludable if everyone can benefit from it regardless of whether they pay for it. The services of the Calgary police, fish in the Atlantic Ocean, and a concert on network television are examples. © 2010 Pearson Education Canada Classifying Goods and Resources Rival A good is rival if one person’s use of it decreases the quantity available for someone else. A Brinks’s truck can’t deliver cash to two banks at the same time. A fish can be consumed only once. Nonrival A good is nonrival if one person’s use of it does not decrease the quantity available for someone else. The services of the Calgary police and a concert on network television are nonrival. © 2010 Pearson Education Canada Classifying Goods and Resources A Four-Fold Classification Private Goods A private good is both rival and excludable. A can of Coke and a fish on Cooke’s Aquaculture farm are examples of private goods. Public goods A public good is both nonrival and nonexcludable. A public good can be consumed simultaneously by everyone, and no one can be excluded from its benefits.
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