sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part X

Externalities

ˆ An externality arises when there is an un ompensated impa t of one person's a tions on the well-being of a

bystander.

� If the impa t on the bystander is adverse, it is alled a negative externality

* Examples: Pollution from a paper plant, exhaust from automobiles

� If it is bene� ial, this impa t is alled a positive externality

* Examples: Resear h into new te hnologies, edu ation, restoration of a histori al building

ˆ Sin e buyers and sellers make de entralized, self-interested de isions, the bene�ts or osts of their a tions to

bystanders are not in orporated into the market as a whole.

ˆ We need to a ount for the impa t on bystanders:

Externalities and Market Ine� ien y:

Re all from out analysis of onsumer and produ er surplus that at the equilibrium level, total surplus is max-

imized. In other words, the value to buyers - the ost to sellers is maximized. In the absen e of government

intervention, the market will automati ally move towards the equilibrium level. Let us onsider the market for

aluminum:

ˆ Our market begins in a state of equilibrium

ˆ Aluminum fa tories emit pollution as part of the produ tion pro ess. This � ost to so iety� is not in luded in

the market above.

ˆ We need to introdu e a new supply urve that in orporates this ost � The so ial ost urve in ludes these

osts and is above the private ost urve:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

..

ˆ The equilibrium quantity of aluminum (Qmarket) is higher than the so ially optimal level (Qoptimum)that depends on the so ial ost urve.

ˆ The external ost of the pollution an now be seen in the market. Is there a solution?

ˆ Re all our analysis of taxes. Whether the tax is levied on buyers or sellers, the equilibrium quantity level

de reases. This is the exa t desired out ome in the ase of a negative externality.

ˆ If the tax is equal to the ost of the pollution, the externality is addressed �

� Internalizing the Externality: Altering in entives so that the external a�e ts of a tions are a ounted

for. We an demonstrate with a graph:

Positive Externality:

ˆ A quality edu ation provides bene�ts to so iety beyond the private gains from students

1. More edu ated voters

2. Advan es in te hnology and innovation

3. Lower rime rates

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

ˆ Now the equilibrium quantity of edu ation (Qmarket) is lower than the so ially optimal level (Qoptimum)

ˆ The Government an internalize the externality by subsidizing edu ation. This shift should be equal to the

bene�ts that ome from edu ation and is demonstrated in the following graph:

ˆ The fallout from a subsidy is that the so ially optimal level of quantity is a hieved when a positive externality

is present.

Publi Poli ies towards Externalities:

ˆ Command-and-Control Regulation: In the ase of a negative externality, the government an prohibit or

outlaw ertain a tivities. However, it is not feasible for the government to do this in every situation. The

bene�ts and osts of these de isions need to be addressed � what are the tradeo�s for the government?

ˆ Market-Based Poli y 1: Corre tive taxes and Subsidies �

� Corre tive Tax: A tax designed to indu e private de ision makers to take a ount of the so ial osts that

arise from a negative externality.

� Essentially, a orre tive tax pla es a pri e on the right to pollute. As long as the produ er pays this tax,

they an ontinue to pollute.

� However, the result is still a lower, so ially-optimal level of quantity

* Unlike the other taxes we have analyzed, orre tive taxes more a market loser to the so ial optimum

where the optimal level of quantity is produ ed. Corre tive taxes alter in entives to a ount for the

impa t on 3rd parties.

ˆ Market-Based Poli y 2: Tradeable Pollution Permits �

� The government or other agen y an di tate a ertain �quota� of the goods. Produ ers an trade the

rights among themselves by pur hasing permits that give them the right to ontinue produ tion. We an

analyze the di�eren es between the two poli ies in the market for pollution:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

ˆ In the ase of both orre tive taxes and pollution permits, �rms pay for their pollution

ˆ In either ase, the demand urve is downward sloping. When the pri e of pollution is lower, more �rms will

hoose to pollute.

ˆ When a orre tive tax is utilized, there is a �pri e� of pollution in the market. The urve is perfe tly elasti

be ause the amount of pollution is determined by the demand urve/the quantity of pollution �rms are willing

to pay for.

ˆ In the ase of pollution permits, the supply urve of pollution permits is perfe tly inelasti . This is due to

the �xed amount of pollution permits available. On e again, the position of the demand urve determines the

level of pollution.

� One problem with orre tive taxes is that the government does not know what the demand urves of the

�rms looks like.

� Sin e pollution permits are traded dire tly among the �rms, the appropriate size of pollution will be

negotiated among the �rms.

Private Solutions to Externalities:

ˆ Private solutions eliminate the need for government spending/intervention:

� Parties an sign private ontra ts with spe i� lauses to eliminate or redu e pollution or other negative

externalities

� Coase Theorem: The proposition that if private parties an bargain without ost over the allo ation of

resour es, they an solve the problem of externalities on their own.

� Transa tion Costs: The osts that parties in ur in the pro ess of agreeing to and following through on

the bargain

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part XI

Publi Goods and Common Resour es

Di�erent kinds of goods have di�erent attributes. These attributes have a key impa t on how these goods a t in an

e onomy. Due to the nature of many of these goods, many are available free of harge. Sin e market for es rely on

pri es to e� iently allo ate goods, a unique method of analysis is required.

The Di�erent Kinds of Goods:

ˆ The following de�nitions determine what ategory of good a produ t falls into.

ˆ Ex ludability: The property of a good whereby a person an be an be prevented from using it.

ˆ Rivalry in Consumption: The property of a good whereby one person's use diminishes other people's use.

Types of Goods:

1. Private Goods: Goods that are ex ludable and rival in onsumption.

ˆ Most goods in an e onomy are private goods. It is straightforward to prevent others from using/enjoying

the good and use/enjoyment of the good de reases the amount available to others. The individual who

pays for the good is the only one who bene�ts from it.

ˆ Examples: i e- ream ones, ars, books, pizza, ats, et .

2. Publi Goods: Goods that are neither ex ludable nor rival in onsumption.

ˆ People an not be prevented from using a publi good, and one person's use of a publi good does not

redu e another person's ability to use it.

ˆ Examples: publi park, national defense, tornado siren in a small town, et .

3. Common Resour es: Goods that are rival in onsumption but not ex ludable.

ˆ When people use a ommon resour e, there is less available for others. However, it is not possible to

prevent any use of a ommon resour e. Its use is shared among the entire population.

ˆ Examples: O ean �sh, the environment, et .

4. Club Goods: Goods that are ex ludable but not rival in onsumption.

ˆ Individuals are easily ex luded from the use of a lub good due to the nature of the allo ation of the

good. However, due to this nature there is not less available for others to use when ertain individuals

enjoy the good.

ˆ Examples: Cable TV, internet, �re prote tion, et .

The Following Chart Demonstrates How the Goods are Organized:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

In our analysis, fo us will be pla ed on publi goods and ommon resour es. There are positive externalities

asso iated with publi goods. In the ase of a tornado siren, the general publi bene�ts from the early warning

system. This represents a positive externality. Heavy o ean �shing leaves the environment in poor shape and results

in fewer �sh available to others. This represents a negative externality.

Publi Goods:

ˆ The Free-Rider Problem

� Free Rider: A person who re eives the bene�t of a good but avoids paying for it.

� The fundamental aspe t of a publi good is it is impossible to ex lude its use from anyone. There are

in entives to bene�t from the good without paying for it (a �reworks show in a small town).

� There are external, positive bene�ts from providing a publi good. However, when these bene�ts are not

taken into a ount, the private value is too low to justify the allo ation of the good. Private markets do

not supply the adequate level of the good.

� Thus, the government or another third party often steps in to assure the good is distributed.

Some Important Publi Goods:

1. National Defense

(a) It is impossible to prevent anyone from bene�ting from a military system of national defense. There

is also no bene�t loss to others. The United States has a robust national defense system and most

e onomists agree that national defense is a publi good the government should provide.

2. Basi Resear h

(a) Knowledge reated through resear h and prote ted by patents is ex ludable. However, general knowledge

(su h as formulas in mathemati s) are not ex ludable. Due to the free rider problem, many �rms

would not spend an adequate level of resour es on gaining knowledge through resear h. Thus, government

agen ies subsidize resear h in many di�erent settings.

3. Fighting Poverty

(a) The �good� in question is living in a so iety without poverty. It is di� ult to implement this system

as many individuals would be able to free ride in a so iety and bene�t from the bene�ts of poverty

elimination without ontributing to the ause

(b) A more attra tive option is to tax the ri h and distribute wealth more evenly. The poor will bene�t from

a lower poverty rate and the ri h will bene�t from living in a poverty free so iety.

-The Di� ult Job of Cost-Bene�t Analysis: A study that ompares the osts and bene�ts to so iety of providing a

publi good

ˆ Government intervention assures the appropriate quantity of the publi good is provided

ˆ However, it is very di� ult to determine what the bene�ts of the publi goods are. There are no pri es or

on rete numbers to ompare.

� Additionally, those would bene�t from the publi good (A new suspension bridge) are likely to exaggerate

the value. This in reases the likelihood the publi good will be provided.

ˆ The osts are more straightforward to determine as the government expli itly knows the ost of providing the

publi good.

Common Resour es

ˆ Tragedy of the Commons: A parable that illustrates why ommon resour es are used more than is desirable

from the standpoint of a so iety as a whole.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

ˆ This parable involves a small medieval town with land available for sheep grazing

� The town ommons are olle tively used by the members of the town and are not over-grazed when the

population of the town is low.

� However, when the population rea hes a ertain size, the ommons be ame over-grazed and destroyed.

� The private in entives of the sheep herders were in opposition of the so ial value of over-grazing.

� Essentially, there is a negative externality that stems from the over-grazing of the ommons.

Some Important Common Resour es:

1. Clean Air and Water

(a) Markets do not prote t the environment adequately. This is due to the di�eren e between private

in entives and so ial value. Environmental degradation is a modern �Tragedy of the Commons�

2. Congested Roads

(a) When tra� is parti ularly bad, use of roads shifts to a ommon good. Now, the use of the road is �rival

in onsumption�. A tari� on roads an alleviate this ongestion.

3. Fish, Whales, and Other Wildlife

(a) O eans represent some of the last regulated ommon resour e. Unfortunately, prote ting o ean �sh and

other resour es is in redibly di� ult. Thus, this type of wildlife seriously su�ers from the �Tragedy of

the Commons�.

Property rights give individuals the ex lusive right/ ontrol of a good. This gives in entive to prote t

the good and avoid the tragedy of the ommons.

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