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Principles of Economics, Ninth Edition N. Gregory Mankiw

PowerPoint Slides prepared by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. Gregory Mankiw Principles Of Economics Ninth Edition

Chapter 10

Externalities

Externalities, Part 1

Government action can sometimes improve upon market outcomes

Why markets sometimes fail to allocate resources efficiently

How government policies can potentially improve the market’s allocation

What kinds of policies are likely to work best

Externalities, Part 2

Externality

The uncompensated impact of one person’s actions on the well-being of a bystander

Market failure

Negative externality

Impact on the bystander is adverse

Positive externality

Impact on the bystander is beneficial

Externalities, Part 3

Negative externalities

Exhaust from automobiles

Barking dogs

Positive externalities

Restored historic buildings

Research into new technologies

ASK THE EXPERTS, Part 1

Vaccines

“Declining to be vaccinated against contagious diseases such as measles imposes costs on other people, which is a negative externality.”

Externalities and Market Inefficiency, Part 1

Welfare economics: A recap

Demand curve: value to consumers

Prices they are willing to pay

Supply curve: cost to suppliers

Equilibrium quantity and price

Efficient

Maximizes the sum of producer and consumer surplus

Figure 1 The Market for Steel

Externalities and Market Inefficiency, Part 2

Negative externalities

Cost to society (of producing a good)

Larger than the cost to the good producers

“All I can say is that if being a leading manufacturer means being a leading polluter, so be it.”

Externalities and Market Inefficiency, Part 3

Negative externalities

Social cost

Private costs of the producers (supply)

Plus the costs to those bystanders affected adversely by the negative externality

Social cost curve is above the supply curve

Takes into account the external costs imposed on society

Figure 2 Pollution and the Social Optimum

Externalities and Market Inefficiency, Part 4

Negative externalities

Optimum quantity produced

Maximize total welfare

Smaller than market equilibrium quantity

Government – correct market failure

Internalizing the externality

Altering incentives so that people take account of the external effects of their actions

Externalities and Market Inefficiency, Part 5

Positive externalities

Education

Benefit of education is private

Externalities: better government, lower crime rates, higher productivity and wages

Social value is greater than private value

Social value curve

Above the demand curve

Figure 3 Education and the Social Optimum

Externalities and Market Inefficiency, Part 6

Positive externalities

Socially optimal quantity is greater than market equilibrium quantity

Government – correct market failure

Internalize the externality

Subsidy

Externalities and Market Inefficiency, Part 7

Negative externalities

Markets produce a larger quantity than is socially desirable

Government: tax

Positive externalities

Markets produce a smaller quantity than is socially desirable

Government: subsidy

Technology Spillovers, Industrial Policy, and Patent Protection, Part 1

Technology spillover = Positive externality

Impact of one firm’s research and production efforts on other firms’ access to technological advance

Government: internalize the externality

Subsidy = value of the technology spillover

Technology Spillovers, Industrial Policy, and Patent Protection, Part 2

Industrial policy

Government intervention in the economy that aims to promote technology-enhancing industries

Patent law

Protect the rights of inventors by giving them exclusive use of their inventions for a period of time

ASK THE EXPERTS, Part 2

Vaccines

“Considering the costs of restricting free choice, and the share of people in the US who choose not to vaccinate their children for measles, the social benefit of mandating measles vaccines for all Americans (except those with compelling medical reasons) would exceed the social cost.”

Public Policies toward Externalities, Part 1

Command-and-control policies

Regulate behavior directly

Regulation

Market-based policies

Provide incentives so that private decision makers will choose to solve the problem on their own

Corrective taxes and subsidies

Tradable pollution permits

Public Policies toward Externalities, Part 2

Regulation

Regulate behavior directly: making certain behaviors either required or forbidden

Cannot eradicate pollution

Environmental Protection Agency (EPA)

Develop and enforce regulations

Dictates maximum level of pollution

Requires that firms adopt a particular technology to reduce emissions

Public Policies toward Externalities, Part 3

Corrective taxes and subsidies

Corrective taxes (Pigovian taxes)

Induce private decision makers to take account of the social costs that arise from a negative externality

Places a price on the right to pollute

Reduce pollution at a lower cost to society

Raise revenue for the government

Enhance economic efficiency

Why is Gasoline Taxed so Heavily?, Part 1

Negative externalities associated with driving

Congestion, accidents, pollution

Why is Gasoline Taxed so Heavily?, Part 2

The gas tax = corrective tax

Doesn’t cause deadweight losses

Makes the economy work better

Less traffic congestion

Safer roads

Cleaner environment

Why is Gasoline Taxed so Heavily?, Part 3

How high should the tax on gasoline be?

Most European countries

Higher gasoline tax than in the U.S.

2007, Journal of Economic Literature

Optimal corrective tax on gasoline

$2.28 per gallon in 2005 dollars

$2.00 per gallon in 2018 dollars

Actual tax in the U.S. in 2018:

50 cents per gallon

Why is Gasoline Taxed so Heavily?, Part 4

Tax revenue from a gasoline tax

Used to lower taxes that distort incentives and cause deadweight losses

Some government regulations

Production of fuel-efficient cars – unnecessary

ASK THE EXPERTS, Part 3

Carbon Taxes

“The Brookings Institution recently described a U.S. carbon tax of $20 per ton, increasing at 4 percent per year, which would raise an estimated $150 billion per year in federal revenues over the next decade. Given the negative externalities created by carbon dioxide emissions, a federal carbon tax at this rate would involve fewer harmful net distortions to the U.S. economy than a tax increase that generated the same revenue by raising marginal tax rates on labor income across the board.”

ASK THE EXPERTS, Part 4

Carbon Taxes

“A tax on the carbon content of fuels would be a less expensive way to reduce carbon-dioxide emissions than would a collection of policies such as ‘corporate average fuel economy’ requirements for automobiles.”

Public Policies toward Externalities, Part 4

Tradable pollution permits

Voluntary transfer of the right to pollute from one firm to another

New scarce resource: pollution permits

Market to trade permits

Firm’s willingness to pay

Depend on its cost of reducing pollution

Public Policies toward Externalities, Part 5

Advantage of free market for pollution permits

Initial allocation of pollution permits doesn't matter

If firms can reduce pollution at a low cost:

Sell whatever permits they get

If firms can reduce pollution only at a high cost: buy whatever permits they need

Efficient final allocation

Public Policies toward Externalities, Part 6

Reducing pollution using pollution permits or corrective taxes

Firms pay for their pollution

Corrective taxes: pay to the government

Pollution permits: pay to buy permits

Internalize the externality of pollution

Figure 4 The Equivalence of Corrective Taxes and Pollution Permits

Public Policies toward Externalities, Part 7

Objections to the economic analysis of pollution

“We cannot give anyone the option of polluting for a fee.” – late Senator Edmund Muskie

People face trade-offs

Eliminating all pollution is impossible

Clean water and clean air — opportunity cost: lower standard of living

Public Policies toward Externalities, Part 8

Clean environment is a normal good

Positive income elasticity

Rich countries can afford a cleaner environment

More rigorous environmental protection

Clean air and clean water – law of demand

The lower the price of environmental protection

The more the public will want it

Private Solutions to Externalities, Part 1

The types of private solutions

Moral codes and social sanctions

Charities

Self-interest of the relevant parties

Integrating different types of businesses

Interested parties can enter into a contract

Private Solutions to Externalities, Part 2

The Coase theorem

If private parties can bargain without cost over the allocation of resources

They can solve the problem of externalities on their own

Whatever the initial distribution of rights

Interested parties can reach a bargain:

Everyone is better off

Outcome is efficient

Private Solutions to Externalities, Part 3

1. Emily has the legal right to keep a barking dog.

Emily gets a $500 benefit from the dog

Horace bears an $800 cost from the barking

Efficient outcome:

Horace can offer Emily $600 to get rid of the dog

Emily will gladly accept

Private Solutions to Externalities, Part 4

2. Emily has the legal right to keep a barking dog.

Emily gets a $1,000 benefit from the dog

Horace bears an $800 cost from the barking

Efficient outcome:

Emily turns down any offer below $1,000

Horace will not offer any amount above $800

Emily keeps the dog

Private Solutions to Externalities, Part 5

3. Horace can legally compel Emily to get rid of the dog.

Emily can offer to pay Horace to allow him to keep the dog

If the benefit of the dog to Emily exceeds the cost of the barking to Horace

Then Emily and Horace will strike a bargain in which Emily keeps the dog

Private Solutions to Externalities, Part 6

Why private solutions do not always work

High transaction costs

Costs that parties incur in the process of agreeing to and following through on a bargain

Bargaining simply breaks down

Large number of interested parties

Coordinating everyone is costly