WELFARE ECONOMICS AND PUBLIC CHOICE THEORY

City & Metropolitan Economics Week 02 – Market Forces and Externalities, Revisited January 18, 2018

For those attending Metro Solutions

• What are the panelist’s positions (what do they think is going on, and what will happen)?

• Are you convinced by their statements? Why, or why not?

Questions on everybody’s minds… • How do markets determine prices for goods?

• How does government address externalities?

Demand curves • Tells us the quantity of a good that consumers are willing to buy at different prices.

• Law of Demand: holding all other factors that influence demand fixed, there is an inverse relationship to price and quantity.

• As prices fall, demand rises • As prices rise, demand falls

Individual Demand Curve- Opera Tickets

Individual demand curve -- opera tickets

0

50

100

150

200

250

0 1 2 3 4 5 6 7 8 9

quantity

pr ic

e marginal benefit

quantity

Pr ic

e

Demand curves • What about luxury goods? In some cases, consumers purchase more of these goods at higher prices because a high price indicates superior quality.

• Answer: other factors (perceptions of quality) are influencing behavior.

Supply curves • Tells us the total quantity of a good that suppliers are willing to sell at different prices.

• Law of supply: holding all other factors that influence supply fixed, there is positive relationship to price and quantity.

• As prices fall, suppliers produce less for sale • As prices rise, suppliers produce more for sale

market supply of opera tickets

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8 9

quantity (in 00s)

pr ic

e

market supply (marginal cost across producers)

Market supply of Opera Tickets

Quantity (in 00s)

price

Supply curves • Other factors (ex. factors of production) can influence quantity supplied. • Resources, such as labor and raw materials, will affect quantity.

• Prices of other goods sellers produce can influence supply.

Equilibrium • Equilibrium is the point at which demand and supply curves intersect.

• At any other price than equilibrium, pressures exist for price to change.

Market-clearing price = $125; Market-clearing quantity = 4,000

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8 9

quantity of tickets (in 00s)

pr ic

e of

t ic

ke ts

$

market supply market demand

Market-clearing price = $125 Market-clearing quantity = 4,000

Quantity of tickets (in 00s)

Pr ic

e o

f t ic

ke ts

( $)

• If we know that the price of a ticket is $125…

$125 = -25(q) + 225

Q =4

Market-clearing price = $125; Market-clearing quantity = 4,000

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8 9

quantity of tickets (in 00s)

pr ic

e of

t ic

ke ts

$

market supply market demand

Excess Supply: at $150, market will purchase 3,000 tickets Producers will supply 5,000 tickets

Quantity of tickets (in 00s)

Pr ic

e o

f t ic

ke ts

( $)

Pressure for prices to fall with excess supply

Market-clearing price = $125; Market-clearing quantity = 4,000

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8 9

quantity of tickets (in 00s)

pr ic

e of

t ic

ke ts

$

market supply market demand

Excess Demand: at $100, producers supply 3,000 tickets Consumers demand 5,000 at that price (but not available)

Quantity of tickets (in 00s)

Pr ic

e o

f t ic

ke ts

( $)

Pressure for supply to increase, and prices will rise

Externalities, revisited

Ground to be covered today

• Review of the concept of externalities • Approaches to the mitigation of negative externalities

• Public remedies – fines, taxes, regulations • Private solutions – the Coase Theorem

Externality

• Externalities entail economic costs and benefits that are not accounted for in market exchange. When an economic transaction has an effect that goes “unpaid-for” or unaccounted for, there is an externality.

Externalities • When this happens the resource allocation that results is inefficient – either too much or too little is produced/consumed.

A Positive Externality (social benefit > private benefit)

Quantity

Pr ic

e City subsidizes compost bins

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8 9

quantity

p ri

c e

Marginal external benefit

Marginal private cost Marginal private benefit

Market-clearing supply socially optimal supply

Marginal social benefit (private + external)

Marginal Cost (supply)

Market-clearing supply

Socially optimal supply

Marginal private benefit (market demand)

10

20

30

4 5

In contrast… • Goods with negative externality effects are overproduced, because the cost to society is greater than the private costs incurred. From society’s perspective there should be less of these goods than there are in an unregulated market.

Negative externality created by unrestricted access to a scarce common resource

0

50

100

150

200

250

300

350

0 1 2 3 4 5 6 7 8 9

Quantity of fish (in thousands of tons)

P ri

ce o

f fi

sh (

p er

t o

n ) Marginal Social Cost

(= private cost + external cost)

Marginal Private Cost

Coal power generation imposes a social cost in the form of pollution

Marginal social cost

Marginal Private cost

Marginal (private) benefit

Kilowatts of coal-generated power

Pr ic

e p

e r k

ilo w

a tt

Examples • Hog farm

• A 20-story ultra-modern building in a historic neighborhood

OTHERS?

private vs. public claims on common resources

• Resource: Clean air • Producer: manufacturer • By-product of production:(pollution) • Other claimants – all who breathe

private vs. public claims on common resources

• Resource: Fish stocks • Producer: fisherman • By-product of production: ecologically harmful depletion of fish stocks

• Other claimants: other fishing industry actors, eco-systems, future generations

private vs. public claims on common resources

• Resource: Water • Producer: farmer • By-product of production: depletion of water supply

• Other claimants: other water users, eco- systems, future generations

private vs. public claims on common resources

• Resource: Road space • Consumer: driver • By-product of consumption: congestion (also pollution)

• Other claimants: other drivers, pedestrians, the economy at large, beneficiaries of cleaner environment

Policy options (pollution example) • Regulation of production process (input regulations, or the dreaded “command and control”)

• Regulation in the form of a limit on emissions • Tax/fine on emissions

Pigouvian Tax (fine)

Negative externality created by unrestricted access to a scarce common resource

0

50

100

150

200

250

300

350

0 1 2 3 4 5 6 7 8 9

Quantity of fish (in thousands of tons)

P ri

ce o

f fi

sh (

pe r

to n)

Marginal Social Cost (= private cost + external cost)

Marginal Private Cost

tax = $50/ton

Marginal social cost

Marginal private cost

Coal power generation imposes a social cost in the form of pollution

Tax: $50/ thousands of kilowatts

Killowatts of power (in thousands)

Pr ic

e p

e rt

h o

us a

nd k

ilo w

a tt

s

Why a fine/tax is considered more efficient than a regulation • Firms have different cost structures (including different abatement costs), and thus the optimal Q to produce will be different from firm to firm.

• Said differently, if you are trying to achieve an optimal total quantity of pollution it is more efficient to let each firm choose when to stop abating and start paying.

• whether regulation or fining produces efficient level of good w/ negative externality effect depends on 2 things: • Accurate estimate of marginal social cost of externality (true with fine or regulation)

• Accurate estimate of marginal private cost of mitigating externality (true with regulation but not fine)

How much of a fine? Price elasticity of demand

Elasticity of demand = % change in quantity demanded % change in price

If Ed is 1, demand is unit elastic (goes up or down in exact proportion to price chance)

If Ed is between 0 and 1, demand is inelastic (goes up or down but at a lesser proportion than the price change)

If Ed is > 1, demand is elastic (goes up or down at a greater proportion than price change)

Sales tax on coffee

• With tax, coffee increases in price from $1.75 to $2.00

• Survey is conducted at Starbucks outlets – stores that sold 100,000 cups per day prior to tax now sell only 70,000 cups per day.

[(70,000-100,000)/100,000] [($2.00 – $1.75)/$1.75]

Ed = -2.1

price elastic or price inelastic demand?

Price elasticity of demand

• Important to think about when using charges/taxes/fines to mitigate externalities

• Example: goal with a congestion charge is to reduce the number of drivers on the road at peak times • If demand for road space at peak hours is price inelastic, the goal of reducing a congestion externality will be harder to attain

Coase’s basis message

– private resolutions are desirable for many externality dilemmas

“Whenever there are externalities, the parties involved can get together and make some set of arrangements by which the externality is internalized and efficiency ensured” (Stiglitz, paraphrasing Coase)

“Beware that the cure is not worse than the disease” • “The problem which we face in dealing with actions which

have harmful effects is not simply one of restraining those responsible for them. What has to be decided is whether the gain from preventing the harm is greater than the loss which would be suffered elsewhere as a result of stopping the action which produces the harm” – Coase p. 11

Next class: Tuesday, January 30