Externalities
Kate2310
4748713_88462793_e201ch16.pptxWhat externalities are and why they can lead to inefficiency and government intervention in the market
The difference among negative, positive , and network externalities
The importance of the Coase theorem, which explains how private individuals can sometimes remedy externalities
Why some government policies to deal with externalities, like emissions taxes, tradable emissions permits, or Pigouvian subsidies, are efficient, and others, like environmental standards, are not
What makes network externalities an important feature of high–tech industries
What you will learn in this chapter
1
EXTERNALITIES
Externalities (spillovers): the impact on third parties of a transaction between others.
If fracking pollutes drinking water sources, it is an external cost (“negative externality”).
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Image credit: Associated Press, MCT via Getty Images
The extra safety your neighbor might have because everyone else in the area has purchased burglar alarms is a(n):
private cost.
external cost.
private benefit.
external benefit.
LEARN BY DOING: PRACTICE QUESTION
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EXTERNALITIES
Examples of external costs:
air and water pollution
texting while driving
chemical runoff that affects fish stocks
Examples of external benefits:
education
beehives next to almond orchards
preserved farmland
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
4
FOR INQUIRING MINDS: TEXTING
1 in 4 accidents (250,000 per year) are caused by cell phone use (National Safety Council, 2012)
43 states have banned it… because of the negative (fatal) externalities.
Image: Steve Debenport/Getty Images
5
IS THE MARKET ALWAYS EFFICIENT?
Market failure: free-market equilibrium not providing the socially optimal amount of a good.
Left to itself, a market economy will typically generate too much pollution because polluters have no incentive to take into account the costs they impose on others.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
6
COSTS AND BENEFITS OF POLLUTION
The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution.
Acid rain, smog, contaminated water, etc.
The marginal social benefit of pollution is the additional gain to society as a whole from an additional unit of pollution.
Goods and services, jobs, etc.
The socially optimal quantity of pollution is the quantity society would choose if all costs and benefits were fully accounted for.
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SO HOW DO YOU MEASURE THE MARGINAL SOCIAL COST OF POLLUTION?
It’s the sum of the willingness to pay among all members of society to avoid that unit of pollution.
It may be hard to estimate, so society often underestimates it.
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HOW MUCH DOES YOUR ELECTRICITY REALLY COST?
A 2011 study estimated the cost of 10,000 pollution sources-- and compared the Total External Cost (TEC) to society to its TVC (Total Value Created)
ECONOMICS
IN ACTION
Image Denis Pepin/Shutterstock
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SO HOW DO YOU MEASURE THE MARGINAL SOCIAL BENEFIT OF POLLUTION?
It’s the highest willingness to pay for the right to emit that unit measured across all polluters.
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THE SOCIALLY OPTIMAL QUANTITY OF POLLUTION
Marginal social cost, marginal social benefit
Quantity of pollution
emissions (tons)
QOPT
0
$200
Marginal social cost of pollution
O
Socially optimal quantity of pollution
Socially optimal point
Marginal social benefit of pollution
The socially optimal amount of pollution is not zero.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
WHY A MARKET ECONOMY PRODUCES TOO MUCH POLLUTION
QMKT
QH
QOPT
0
$400
300
200
100
O
Marginal social benefit at QMKT
Market-determined quantity of pollution
Marginal social cost of pollution
The market outcome is inefficient: marginal social cost of pollution exceeds marginal social benefit.
Marginal social cost, marginal social benefit
Quantity of pollution emissions (tons)
Marginal social cost at QMKT
Marginal social benefit of pollution
In a market economy without government intervention, those who benefit from pollution—like the owners of power companies—decide how much pollution occurs.
Socially optimal quantity of pollution
PRIVATE SOLUTIONS TO EXTERNALITY PROBLEMS
In certain situations the private sector can resolve externalities.
Solving problems requires time and effort.
Transaction costs: all of the costs to individuals of making a deal.
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PRIVATE SOLUTIONS TO EXTERNALITIES
In an influential 1960 article, the economist Ronald Coase pointed out that in an ideal world, the private sector could indeed deal with all externalities.
According to the Coase theorem, even in the presence of externalities an economy can always reach an efficient solution provided that the transaction costs are sufficiently low.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
14
PRIVATE SOLUTIONS TO EXTERNALITIES
Coase’s analysis argues that individuals have an incentive to find a way to make mutually beneficial deals that lead them to “internalize the externality”: take externalities into account when making decisions.
Example: a family agrees to stop playing loud music during their next-door neighbor child’s naptime in exchange for use of the lawnmower.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
15
Nobel prize–winner James Meade argued that the production of honey by beekeepers produced a positive externality for farmers in the form of pollination, and thus pollination would be underprovided in a free market. It turns out, however, that pollination is a $15 billion industry in the United States and beekeepers regularly truck their colonies around the country to sell pollination services to farmers. Click here to watch. (5:55 minutes)
http:// www.youtube.com/watch?v=YZCoX9tsT1E
LEARN BY DOING: APPLICATION VIDEO
http://www.youtube.com/watch?v=YZCoX9tsT1E
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In reality, the Coase theorem is unlikely to work because:
most people don’t care if they are affected by an external cost.
externalities are rare and difficult to identify.
transaction costs are often high, making negotiations difficult.
prices will increase as a result of ending the externality.
LEARN BY DOING: PRACTICE QUESTION
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POLICIES FOR POLLUTION
Environmental standards: rules that protect
the environment by
specifying actions
by producers and
consumers.
If the market won’t solve its own externality problems, then what?
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
18
POLICIES FOR POLLUTION
An emissions tax: cost depends on the amount of pollution a firm produces.
Pigouvian taxes: taxes designed to reduce external costs. Example: an emissions tax designed to reduce coal production.
Tradable emissions permits: licenses to emit limited quantities of pollutants; the licenses can be bought and sold by polluters.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
19
POLICIES FOR POLLUTION
Which is the best?
Environmental standards?
Inflexible and don’t allow reductions in pollution to be achieved at minimum cost.
Emissions tax?
Emissions tax ensures that the marginal benefit of pollution is equal for all sources of pollution (unlike environmental standards).
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EMISSIONS TAXES CAN SOLVE EXTERNALITY PROBLEMS
QMKT
QH
QOPT
0
$400
300
200
100
O
Marginal social cost of pollution
Marginal social cost, marginal social benefit
Quantity of pollution emissions (tons)
Socially optimal quantity of pollution
Optimal Pigouvian tax on pollution
Marginal social benefit of pollution
ENVIRONMENTAL STANDARDS VS. EMISSIONS TAXES
(b) Emissions tax
(a) Environmental standard
0
600
400
200
$600
200
0
600
300
$600
150
300
MBB
MBB
MBA
MBA
TA
SA
S B
TB
Emissions
tax
Environmental standards force both plants to cut emission by half.
Without government action, each plant emits 600 tons.
Marginal benefit to individual polluter
Marginal benefit to individual polluter
Quantity of emissions (tons)
Quantity of emissions (tons)
Plant A has a lower marginal benefit so reduces emissions by 400 tons.
Plant B has a higher marginal benefit so reduces emissions by only 200 tons.
ECONOMIC GROWTH AND GREENHOUSE GASES IN SIX COUNTRIES
Canada and the U.S. pollute more absolutely… bot not compared to their GDP
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TRADABLE EMISSIONS PERMITS
Since 1994, the United States has had an SO2 cap-and-trade system, and acid rain has been reduced by 50%— relatively cheaply.
The EU has a mandatory, comprehensive CO2 cap-and-trade scheme on track for 21% reduction in greenhouse gases by 2020.
Image © 2014 TerraPass, Inc.
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CAP AND TRADE
The US caps (and then allows trade in) Sulfur Dioxide (responsible for acid rain) emissions
The EU caps and trades Carbon Dioxide (responsible for greenhouse gases)
The good:
Major pollution reduction at low cost
The bad:
Politicians often bow to industry pressure and create too many permits (eliminating the cap)
Doesn’t work for localized pollutants like mercury
ECONOMICS
IN ACTION
Photo credit: AP Photo/Kin Cheung
25
Suppose a government decides to issue a limited number of tradable pollution permits.
Which of the following statements is true?
Firms that can easily and at low cost reduce their level of pollution will find it beneficial to purchase these tradable pollution permits.
When the government issues these tradable pollution permits, it effectively creates a market for the right to pollute.
Firms that sell their tradable pollution permits do not fully understand the costs they will incur when they try to reduce the level of pollution they create.
None of the statements is true.
LEARN BY DOING: PRACTICE QUESTION
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POSITIVE EXTERNALITIES
The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to consumers plus its marginal external benefit.
Education creates benefits for students—and the society they live in.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
27
THE IMPECCABLE ECONOMIC LOGIC OF EARLY-CHILDHOOD INTERVENTION PROGRAMS
Breaking the cycle of poverty? Separate studies by The RAND Corporation, University of Pittsburgh and others find $4-17 benefit for each dollar spent.
ECONOMICS
IN ACTION
Image fatihhoca/istockphoto/Getty Images
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EXTERNAL BENEFITS AND EFFICIENCY
Sometimes a market includes benefits that bystanders receive.
External benefit: a benefit received by people other than the consumers or producers trading in the market.
Do motorcycle riders provide an external benefit to those waiting for an organ transplant?
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
29
When the consumption of a good generates positive external benefits, the market tends to produce:
too much of the good, since there are positive external benefits from the consumption of the good.
too little of the good, since the market does not take into account the positive external benefits from the consumption of the good.
LEARN BY DOING: PRACTICE QUESTION
30
THE SOCIALLY OPTIMAL AMOUNT OF FARMLAND
Marginal social cost, marginal social benefit
Quantity of preserved farmland
QOPT
0
10,000
Marginal social cost of preserved farmland
O
Socially optimal quantity of preserved farmland
Socially optimal point
Marginal social benefit of preserved farmland
The market will preserve less than the socially optimal amount of farmland.
The market outcome (no preserved farmland) is inefficient: marginal social benefit of farmland preservation exceeds marginal social cost.
$20,000
All photo credits unless otherwise noted from Freeimages.com (Formerly Stockxchange) or Morguefile.com
PIGOUVIAN SUBSIDY
A Pigouvian subsidy: a payment designed to encourage activities that yield external benefits.
The socially optimal quantity can be achieved by a Pigouvian subsidy equal to the marginal social benefit at the optimal quantity.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
32
With a partner, decide: Do car alarms do any good?
Since they frequently go off for no apparent reason, do they create any negative externalities? What are they?
Police argue that they can “shatter the sense of civility that makes a community safe.” As one of the “signs that no one cares,” car alarms “invite both further disorder and serious crime.”-Police Strategy No. 5, New York Police Department, 1994
Click here for a See blog post on the subject.
LEARN BY DOING: DISCUSS
See the following article for more details and discussion: http://www.nytimes.com/2003/12/11/opinion/11FRED.html
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
33
TECHNOLOGY SPILLOVERS
A technology spillover is an external benefit that results when knowledge spreads among individuals and firms.
Silicon valley: a giant technology spillover
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
34
NETWORK EXTERNALITIES
A good is subject to a network externality when the value of the good to an individual is greater when a large number of other people also use the good.
Examples include:
communication systems, e.g., telephones, telegraphs, fax machines.
railway systems.
hub-and-spoke air travel.
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NETWORK EXTERNALITIES
A good is subject to positive feedback when success breeds greater success and failure breeds failure.
The more popular Windows is, the more software is made for it and the more popular it becomes.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
36
For most pollutants, the socially efficient level of pollution is zero.
True
False
LEARN BY DOING: PRACTICE QUESTION
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ARE WE STILL FRIENDS? A TALE OF FACEBOOK, MYSPACE, AND FRIENDSTER
“When do you focus on growth, and when do you focus on money? We focused on money and Facebook focused on growing the user base and user experience.” Chris Wolfe, MySpace
Technical issues and clunky ads pushed users to Facebook… now some are moving to Snapchat, Instagram, Tumblr, Reddit and Twitter.
What’s your prediction?
