Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG

Lecture 11: Externalities and Public Goods

November 10, 2015 Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Overview

Course Administration

Positive and Negative Externalities

Fixing Externalities

Defining Public Goods

Optimal Provision of Public Goods

Private Provision of Public Goods

Public Provision of Public Goods Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Course Administration 1. Bookstore website says reading packet needed for next week is available 2. Problem Set 10 is posted, problem set 8 answers posted 3. Elasticity paper: voluntary classmate feedback • Post paper by Nov. 17 8 pm to Blackboard discussion board called “elasticity paper draft” • Put last name at beginning of file name • You’ll need to return comments on 2 to 3 papers by 8 pm 12/22 (Sunday) – and you could make alternate arrangements with your group • I’ll assign groups randomly after papers are posted • Suggestions? 4. Office hours extended: Wednesdays 10 am to 1 pm 5. Last class: probably 1/2 class asymmetric information, 1/2 review 6. Questions? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Ripped from the Headlines

Next Week

Afternoon Finder Presenter Lily Robin Carly Evans

Evening Finder Presenter Amber Ebarb Jenny Lewis • Positive externality ≡ benefit accruing to party not involved in economic transaction • Negative externality ≡ cost accruing to party not involved in economic transaction Examples, please.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Externality Definition

Externality ≡ cost or benefit accruing to party not involved in economic transaction • Negative externality ≡ cost accruing to party not involved in economic transaction Examples, please.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Externality Definition

Externality ≡ cost or benefit accruing to party not involved in economic transaction • Positive externality ≡ benefit accruing to party not involved in economic transaction Examples, please.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Externality Definition

Externality ≡ cost or benefit accruing to party not involved in economic transaction • Positive externality ≡ benefit accruing to party not involved in economic transaction • Negative externality ≡ cost accruing to party not involved in economic transaction Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Externality Definition

Externality ≡ cost or benefit accruing to party not involved in economic transaction • Positive externality ≡ benefit accruing to party not involved in economic transaction • Negative externality ≡ cost accruing to party not involved in economic transaction Examples, please. Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG In a Market Without Externalities

• If private demand = private marginal benefit = social

P marginal benefit • And Private supply = private marginal cost = S social marginal cost • Then market equilibrium maximizes social welfare, D which is total surplus Q • Provides goods to consumer at lowest possible cost Assume a positive externality • =⇒ Social marginal benefit 6= private marginal benefit • =⇒ Social marginal benefit = Private marginal benefit + external marginal benefit What does this mean for the relationship between market equilibrium PMKT and QMKT and socially optimal PSOC and QSOC ?

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG In a Market With Externalities

Assume a negative externality • =⇒ Social marginal cost 6= private marginal cost • =⇒ Social marginal cost = Private marginal cost + external marginal cost What does this mean for the relationship between market equilibrium PMKT and QMKT and socially optimal PSOC and QSOC ?

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG In a Market With Externalities

Assume a negative externality • =⇒ Social marginal cost 6= private marginal cost • =⇒ Social marginal cost = Private marginal cost + external marginal cost Assume a positive externality • =⇒ Social marginal benefit 6= private marginal benefit • =⇒ Social marginal benefit = Private marginal benefit + external marginal benefit Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG In a Market With Externalities

Assume a negative externality • =⇒ Social marginal cost 6= private marginal cost • =⇒ Social marginal cost = Private marginal cost + external marginal cost Assume a positive externality • =⇒ Social marginal benefit 6= private marginal benefit • =⇒ Social marginal benefit = Private marginal benefit + external marginal benefit What does this mean for the relationship between market equilibrium PMKT and QMKT and socially optimal PSOC and QSOC ? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What Does a Negative Externality Do to Market Supply? Where Are the Private Market P and Q?

P

S = MC

D

Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What Does a Negative Externality Do to Market Supply? Where is the Social Marginal Cost?

P

S = MC PMKT

D

QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What Does a Negative Externality Do to Market Supply? What are the Socially Optimal P and Q?

P

S = MC + EMC

S = MC PMKT

D

QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What Does a Negative Externality Do to Market Supply? What is the Vertical Distance Between the Supply Curves?

P

S = MC + EMC

P SOC S = MC PMKT

D

QSOC QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What Does a Negative Externality Do to Market Supply? Where is the Deadweight Loss?

P

S = MC + EMC

P EMC SOC S = MC PMKT

D

QSOC QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What Does a Negative Externality Do to Market Supply? Too Much Production, at Too Low a Price

P

S = MC + EMC DWL P EMC SOC S = MC PMKT

D

QSOC QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Positive Externalities Where Are Market Equilibrium P and Q?

P

S

D= PMB Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Positive Externalities Where is the Social Marginal Benefit Curve?

P

S

PMKT

D= PMB

QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Positive Externalities What are the Socially Optimal P and Q?

P

S

PMKT D = PMB + EMB

D= PMB

QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Positive Externalities What is the Vertical Difference Between the Demand Curves?

P

S

PSOC

PMKT D = PMB + EMB

D= PMB

QMKT QSOC Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Positive Externalities Where is the Deadweight Loss?

P

S EMB

PSOC

PMKT D = PMB + EMB

D= PMB

QMKT QSOC Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Positive Externalities Too Little Production, at Too High a Price

P

S EMB DWL

PSOC

PMKT D = PMB + EMB

D= PMB

QMKT QSOC Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Try It Yourself: Negative Externalities

Suppose that leather is sold in a perfectly competitive industry. The industry short-run supply curve (marginal cost curve) is P = MC = 3Q, where Q is measured in millions of hides per year. The demand for leather hides is given by Q = 60/7 − P/7. 1. Find the equilibrium market price and quantity. 2. Suppose that the leather tanning releases bad stuff into waterways. The external marginal cost is $4/hide. Calculate the socially optimal level of output and price for the tanning industry. Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG What is the Right Level of Production with Negative Externalities?

• Efficient level of production ≡ level of production necessary to produce the efficient quantity of the good tied to the externality • Assume that there is a marginal cost of production (= private cost + external cost) • Assume that there is a marginal benefit of production (= marginal cost of abatement) • What level of production is optimal? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Optimal Provision of a Good with a Negative Externality

Why is POLL∗ 6= 0? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Getting to the Socially Optimal P and Q

Three methods 1. Change prices 2. Change quantities 3. Tradeable permits Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 1. Using Taxes and Subsidies to Return to the Efficient Point

• Suppose we know the external marginal cost • Charge a tax equal to the external marginal cost • This returns us to the socially optimal equilibrium outcome • Called a Pigouvian tax • Requires that you (the policymaker) know the cost exactly • Can redistribute tax revenues to those harmed by policy After tax, T = EMC • private marginal cost = MC + T • social marginal cost = MC + EMC

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG To Be Clear

Before tax • private marginal cost = MC • social marginal cost = MC + EMC Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG To Be Clear

Before tax • private marginal cost = MC • social marginal cost = MC + EMC After tax, T = EMC • private marginal cost = MC + T • social marginal cost = MC + EMC Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 1a. Correcting for a Negative Externality Private and Social Supply Before a Tax

P

S = MC + EMC

P EMC SOC S = MC PMKT

D

QSOC QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 1a. Correcting for a Negative Externality After the Tax, Private Supply = Social Supply

P

S = MC + EMC = MC + T

P EMC = T SOC S = MC PMKT

D

QSOC QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 1b. Correcting for a Positive Externality Private and Social Demand Before a Subsidy

P

S EMB

PSOC

PMKT D = PMB + EMB

D= PMB

QMKT QSOC Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 1b. Correcting for a Positive Externality After the Subsidy, Private Demand = Social Demand

P

S EMB = Sub

PSOC

PMKT D = PMB + EMB = PMB + Sub

D= PMB

QMKT QSOC Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 2. Using a Quota to Get to Efficient Point Private and Social Supply Before a Quota

P

S = MC + EMC

P EMC SOC S = MC PMKT

D

QSOC QMKT Q Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 2. Using a Quota to Get to Efficient Point With a Quota

P S = MC w/ quota

S = MC + EMC

P EMC SOC S = MC PMKT

D

QSOC QMKT Q 1. May be hard to know optimal market output level 2. Even if you know the optimal market output, policy must assign quotas by firm. Ideally, you’d assign quotas by cost of reduction, but you’d need to know firm-specific costs. 3. All costs and benefits are borne by market participants; no tax revenues to redistribute

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG The Trouble with Using Quotas Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG The Trouble with Using Quotas

1. May be hard to know optimal market output level 2. Even if you know the optimal market output, policy must assign quotas by firm. Ideally, you’d assign quotas by cost of reduction, but you’d need to know firm-specific costs. 3. All costs and benefits are borne by market participants; no tax revenues to redistribute Why is this superior in terms of getting to the equilibrium outcome? • Government doesn’t need to know anything about firms’ cost structures • Firms with lowest cost of reducing activity will undertake it

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 3. Tradeable Permits

• The government decides how much negative activity (or positive activity) to allow • It makes permits to allow that much activity • It distributes permits to anybody (firms, you) • The choice of distribution method determines winners and losers! • Permits trade • Government doesn’t need to know anything about firms’ cost structures • Firms with lowest cost of reducing activity will undertake it

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 3. Tradeable Permits

• The government decides how much negative activity (or positive activity) to allow • It makes permits to allow that much activity • It distributes permits to anybody (firms, you) • The choice of distribution method determines winners and losers! • Permits trade Why is this superior in terms of getting to the equilibrium outcome? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG 3. Tradeable Permits

• The government decides how much negative activity (or positive activity) to allow • It makes permits to allow that much activity • It distributes permits to anybody (firms, you) • The choice of distribution method determines winners and losers! • Permits trade Why is this superior in terms of getting to the equilibrium outcome? • Government doesn’t need to know anything about firms’ cost structures • Firms with lowest cost of reducing activity will undertake it Pure public goods are rare: national defense, perhaps air for breathing. Public goods are not necessarily publicly provided goods.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Defining Public Goods

Public goods are both non-rival and non-excludable • Non-rival ≡ goods where your consumption does not impact my consumption • Non-excludable ≡ goods from which consumption cannot be excluded national defense, perhaps air for breathing. Public goods are not necessarily publicly provided goods.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Defining Public Goods

Public goods are both non-rival and non-excludable • Non-rival ≡ goods where your consumption does not impact my consumption • Non-excludable ≡ goods from which consumption cannot be excluded Pure public goods are rare: Public goods are not necessarily publicly provided goods.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Defining Public Goods

Public goods are both non-rival and non-excludable • Non-rival ≡ goods where your consumption does not impact my consumption • Non-excludable ≡ goods from which consumption cannot be excluded Pure public goods are rare: national defense, perhaps air for breathing. Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Defining Public Goods

Public goods are both non-rival and non-excludable • Non-rival ≡ goods where your consumption does not impact my consumption • Non-excludable ≡ goods from which consumption cannot be excluded Pure public goods are rare: national defense, perhaps air for breathing. Public goods are not necessarily publicly provided goods. Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Public Good Typology

Rival Non-Rival Excludable Private good Club good Non-Excludable Common resource Pure public good

With your neighbors: examples of each type. Can substitute a local public good for the “pure public good.” Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Optimal Provision of Private Goods Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Using Algebra To Do This

Suppose we have two demand curves

• QJoe = 5 − 0.05P

• QJack = 13 − 0.25P This is a piece-wise linear function. What are the pieces? • At P > $52, Jack doesn’t want any more • At P > $100, Joe doesn’t want any more

We write this as ( 18 − 0.3P if 0 < P < 52 QM = 5 − 0.05P if P > 52 • Mechanically, add Q = f (P) Why doesn’t this work for public goods?

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Adding Private Good Demand

• For private goods, we add up Q at a given price, P • How many oranges do people want to buy if the price is $6? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Adding Private Good Demand

• For private goods, we add up Q at a given price, P • How many oranges do people want to buy if the price is $6? • Mechanically, add Q = f (P) Why doesn’t this work for public goods? Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Optimal Provision of Public Goods?

How Much Are Mr. 1 and Mr. 2 Willing to Pay for Q2 of Fireworks?

P1

P1,2 Q

P2 P2,2 Q

Q Q2 Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Optimal Provision of Public Goods?

To See Demand at Q2

P1

P1,2 Q

P2 P2,2 Q

P1+P2

P1,2+P2,2

Q Q2 Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Optimal Provision of Public Goods? Market Demand for Public Goods

P1

P1,2 Q

P2 P2,2 Q

P1+P2

P1,2+P2,2

Q Q2 Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Optimal Provision of Public Goods? Equilibrium Provision of Public Goods

P1

P1,2 Q

P2 P2,2 Q

P1+P2

P1,2+P2,2

Q Q2 Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Adding Market Demand for Public Goods in Math

• For public goods, we add up P at a given quantity, Q • For 300 fireworks, how much is everyone willing to pay? • Mechanically, add P = g(Q) • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods • Don’t blame the producer! Even goods that a whole group wants and is willing to pay for may not be provided.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Level of Private Provision of Public Goods

• Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • Don’t blame the producer! Even goods that a whole group wants and is willing to pay for may not be provided.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Level of Private Provision of Public Goods

• Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods Even goods that a whole group wants and is willing to pay for may not be provided.

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Level of Private Provision of Public Goods

• Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods • Don’t blame the producer! Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Level of Private Provision of Public Goods

• Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods • Don’t blame the producer! Even goods that a whole group wants and is willing to pay for may not be provided. Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Example: Private Provision of Public Goods

• Property owners in a neighborhood agree to levy taxes on themselves • Motivation: owners feel that public services are substandard • Use tax revenues to privately provide services, such as cleaning, marketing and security • Generally regarded as being successful – my research shows lowered crime in City of LA • Overcome the free-rider problem with mandatory contribution Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG When Does Private Market Provide Some Public Goods?

• The smaller the group, the more likely the provision • When one, or a few, members care a lot – we see this in BIDs • Altruism • Warm glow What do you think the problems are with this? • Free-rider problem again: optimal amount of public goods is sum of P given Q • Asking citizens to reveal their true demand is called “Lindahl pricing” • Yields optimal quantity of public goods • Consumers might not know their demand (do you know your demand for missiles?) • And consumers have an incentive to underestimate • Government provision “crowds out” private provision • Before the government firework show, you might have bought some of your own. Now you do not. Other examples? • Costs and benefits hard for government to measure

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Can the Government Do Better?

Due to the failure in the private market, one solution is for government to provide public goods. • Government provision “crowds out” private provision • Before the government firework show, you might have bought some of your own. Now you do not. Other examples? • Costs and benefits hard for government to measure

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Can the Government Do Better?

Due to the failure in the private market, one solution is for government to provide public goods. What do you think the problems are with this? • Free-rider problem again: optimal amount of public goods is sum of P given Q • Asking citizens to reveal their true demand is called “Lindahl pricing” • Yields optimal quantity of public goods • Consumers might not know their demand (do you know your demand for missiles?) • And consumers have an incentive to underestimate Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Can the Government Do Better?

Due to the failure in the private market, one solution is for government to provide public goods. What do you think the problems are with this? • Free-rider problem again: optimal amount of public goods is sum of P given Q • Asking citizens to reveal their true demand is called “Lindahl pricing” • Yields optimal quantity of public goods • Consumers might not know their demand (do you know your demand for missiles?) • And consumers have an incentive to underestimate • Government provision “crowds out” private provision • Before the government firework show, you might have bought some of your own. Now you do not. Other examples? • Costs and benefits hard for government to measure Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Recap of Today

• Externalities • Definitions, positive and negative • Possible corrections • Public goods • Definition • Equilibrium market provision • Adding up demand for public goods Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Next Class

• Turn in Problem Set 10 • Taxes! • Gruber 18 and 19 Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG Problem 1

1. Equilibrium price and quantity. Find equilibrium P and Q by setting QS = QD (or PS = PD ). To set the curves equal, we need to start by finding inverse demand. If Q = 60/7 − P/7, then P = 60 − 7Q. ∗ Set 3Q = 60 − 7Q, or 10Q = 60, which implies Qmarket = 6. Price is ∗ ∗ Pmarket = 3Q = 18. (Check that P = 60 − 7(6) = 60 − 42 = 18.) 2. With external costs The true cost should be MC = 3Q + 4. Solve again. Note before ∗ ∗ ∗ ∗ solving that PSC > Pmarket , and Qmarket > QSC . ∗ Set 3Q + 4 = 60 − 7Q, or 10Q = 56, which implies that QSC = 5.6. ∗ ∗ To find price, PSC = 3Q + 4 = 3(5.6) + 4 = 16.8 + 4 = 20.8. ∗ Check that PSC = 60 − 7(5.6) = 60 − 39.2 = 20.8.