chapter 10: externalities chapter 11: public goods and...

Intro Market Failure Categorization Pigouvian Tax

Econ 1023 Introduction to Economics: Micro

Chapter 10: ExternalitiesChapter 11: Public Goods andCommon Resources

Instructor: Hiroki WatanabeSpring 2013

Watanabe Econ 1023 10 Externality & 11 Public Goods 1 / 59


1 Introduction

2 When Market Fails

3 Categorization

4 Pigouvian Tax

5 Summary



1 IntroductionDefinitionInstancesQuestion

2 When Market Fails

3 Categorization

4 Pigouvian Tax

5 Summary


Notes

Notes

Notes


Definition

Definition 1.1 (Externality)

is a cost or a benefit directly imposed upon someoneby actions taken by others.

"Directly"=Bypassing the market transaction.An externally imposed benefit is a positiveexternality.An externally imposed cost is a negativeexternality.



Instances

Examples of negative externalities:Air pollution.Water pollution.Traffic congestion.Second-hand cigarette smoke.Increased insurance premiums due to alcohol ortobacco consumption.Show tunes Tuesday.



Instances

Examples of positive externalities:Beekeepers and orchards.A well-maintained property next door that raisesthe market value of your property.A pleasant cologne or scent worn by the personseated next to you.Improved driving habits that reduce accident risks.Show tunes Tuesday.


Notes

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Instances

Externality impacts a third party;i.e. somebody who is not a participant in theactivity that creates the external cost or benefit.



Question

Question 1.2 (Cap and Trade)

Listen to Marketplace Clip .Why do we use cap and trade scheme in the firstplace?How exactly does China benefit from avoidingcarbon duties?



1 Introduction

2 When Market FailsBlocking SunlightImplicationsFixes: Coase’s TheoremSunlight Permits

3 Categorization

4 Pigouvian Tax

5 Summary


Notes

Notes

Notes

http://www.marketplace.org/topics/dont-provoke-cap-and-trade-war


Blocking Sunlight

Suppose Kenneth’s neighbor Liz plans to build a10-story apartment.Each floor brings in the net profit of $5 ($10 to buildand $15 from the rent payment for example).Kenneth incurs $ for reduced sunlight ( =# offloors).

Watanabe Econ 1023 10 Externality & 11 Public Goods10 / 59


Blocking Sunlight

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Marginal Cost to KennethMarginal Profit to Liz

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Blocking Sunlight

Since there is no sunlight market, Liz builds his10-story apartment as planned.Her total profit is then,

πL( = 10) = 15 · 10− 10 · 10 = 50.

Thanks to Liz’s apartment, reduced sunlight incurstotal cost of

πK( = 10) = 0− (1+ 2+ · · ·+ 10) = −55.

Total surplus isπL( = 10) + πK( = 10) = 50− 55 = −5.


Notes

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Blocking Sunlight

= 10 is not efficient.If Liz chooses = 9 instead, then,

πL( = 9) = 15 · 9− 10 · 9 = 45.πK( = 9) = 0− (1+ 2+ · · ·+ 9) = −45.TS = 45− 45 = 0(> −5).

Since there is no market for sunlight, Liz can reducesunlight without compensating the neighbors.Liz imposes negative externality.



Implications

First Theorem fails to hold because of the presenceof negative externality.Externalities cause efficiency loss; typically

1 too much scarce resource is allocated to an activitywhich causes a negative externality

2 too little resource is allocated to an activity whichcauses a positive externality.

What would be the most ideal result (i.e. the mostefficient outcome)?Not building anything ( = 0) so that we wouldn’tincur any cost to Kenneth?



Fixes: Coase’s Theorem

The answer is = 5 (or 4).

πL( = 5) = 15 · 5− 10 · 5 = 25.πK( = 5) = 0− (1+ 2+ · · ·+ 5) = −15.TS∗ = 25− 15 = 10.

If = 5, Liz is willing to pay at most $5 to add 5thfloor.If = 5, Kenneth is willing to allow 5th floor as longas he recieves $5 or more in compensation.If = 0, Liz is willing to pay at most $5 to add 10thfloor.If = 0, Kenneth is willing to allow 1st floor as longas he receives $1 or more in compensation.


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How do we achieve the efficient allocations?This is called internalization of externality.What if we create a market for sunlight?




Ronald Coase’s insight is that most externalityproblems are due to an inadequate specification ofproperty rights and, consequently, an absenceof markets in which trade can be used tointernalize external costs or benefits.Causing a producer of an externality to bear the fullexternal cost or to enjoy the full external benefit iscalled internalizing the externality.




Theorem 2.1 (Coase’s Theorem)When there is no cost associated with negotiations, theefficient level of the externality-generating commodityis produced through negotiation (transaction) nomatter which agent is assigned the property right.


Notes

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Sunlight Permits

Can Liz and Kenneth autonomically achieve = 5?Following Coase’s theorem, create a market forsunlight by issuing sunlight permits.Coase’s theorem implies:

1 Efficient level of production ( = 5) will be achievedwith permits.

2 The outcome does not depend on the issuer.Two scenarios:

1 Kenneth is the issuer.2 Liz is the issuer.



Sunlight Permits

1 Suppose Kenneth owns the permits.

1 1st permit: Kenneth charges $5, Liz buys it( = 0↗ 1).

2 2nd permit: Kenneth charges $5, Liz buys it.3 3rd permit: Kenneth charges $5, Liz buys it.4 4th permit: Kenneth charges $5, Liz buys it.5 5th permit: Kenneth charges $5, Liz buys it.6 6th permit: Kenneth charges $6 or more, Liz

doesn’t buy it.

πL( = 5) = 15 · 5− 10 · 5− 5 · 5 = 0.πK( = 5) = 5 · 5− (1+ 2+ · · ·+ 5) = 10.TS = 0+ 10 = 10(= TS∗).



Sunlight Permits

2 Suppose Liz owns the permits.

1 1st permit: Liz charges $10, Kenneth buys it( = 10↘ 9).

2 2nd permit: Liz charges $9, Kenneth buys it.3 3rd permit: Liz charges $8, Kenneth buys it.4 4th permit: Liz charges $7, Kenneth buys it.5 5th permit: Liz charges $6, Kenneth buys it.6 6th permit: Liz charges $5, Kenneth doesn’t buy it.

πL( = 5) = (10+ 9+ ·6) + 15 · 5− 10 · 5 = 65πK( = 5) = −(1+ 2+ · · ·+ 4+ 5)− (10+ 9+ · · ·+ 6) = −55.TS = 65− 55 = 10(= TS∗).


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Sunlight Permits

Regime Issuer πL πK TS DWL

Laissez-Faire 10 - 50 -55 -5 -15Complete Ban 0 - 0 0 0 -10

Coase 5 Liz 65 -55 10 0Coase 5 Kenneth 0 10 10 0



1 Introduction

2 When Market Fails

3 CategorizationFour Types of GoodsFree-Rider’s Problem

4 Pigouvian Tax

5 Summary



Four Types of Goods

Free goods (goods without market) pose a specialchallenge for economic analysis.Most goods in our economy are allocated inmarkets.And markets usually do a good job:No deadweight loss in equilibrium (c.f. Ch 4):

pE = RP(yE) = MWTP(yE).


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Four Types of Goods

When goods are available free of charge, themarket forces that normally allocate resources inour economy are absent.When a good does not have an associatedprice, private markets cannot ensure that the goodis produced and consumed in the proper amounts.



Four Types of Goods

In such cases, government policy can potentiallyremedy the market failure and raise economicwell-being.It is useful to group goods according to twocharacteristics:

Supply Is the good excludable? (Can I give acheesecake to Liz without giving it toKenneth?) ⇒ Excludability.

Demand If Liz ate a cheesecake, can Kennethstill have the same one? ⇒ Rivalry.



Four Types of Goods

Definition 3.1 (Four Types of Goods)

Rivalry Sharedin consumption consumption

Excludable Private Goods: Club Goods:in supply Cheesecakes Fire Protection

TV set Cable TVCongested toll roads Uncongested toll roads

Universal Common Resources: Pure Public Goods:in supply Fish in the ocean Tornado siren

Congested nontoll roads Uncongested nontoll roadsNational defence

Smoke concentration


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Free-Rider’s Problem

A perfectly competitive market is a market wherethe following conditions are met:

1 product homogeneity (product differentiation)2 small agents (industrial organization)3 free mobility (urban economics)4 perfect knowledge (information economics)5 exclusion (public finance)6 rivalry (public finance)7 free entry (industrial organization)

The First Theorem applies.



Free-Rider’s Problem

Market does not allocate non-excludable goodswell.

Definition 3.2 (Free Rider)is a person who receives the benefit of a good butavoids paying for it.

If the private firm is to supply fish in the ocean ortornado siren, it will go bankrupt.Fishermen or residents can receive the servicewithout paying for it.And they don’t pay for it (free-riders’ problem).



1 Introduction

2 When Market Fails

3 Categorization

4 Pigouvian TaxLandscapeDetecting Externality on I-35Why Shouldn’t Liz Be on I-35?Tragedy of CommonsFixesExample

5 SummaryWatanabe Econ 1023 10 Externality & 11 Public Goods30 / 59

Notes

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Landscape

Consider commuters from Superior to Duluth thismorning. 1

There are cars on the highway.-th driver’s marginal willingness to pay for the tripis MWTP().MWTP is the opportunity cost of driving.

Alternatives: commuter rail, bus etc.

1C.f. Brueckner [?] Chpt 5.Watanabe Econ 1023 10 Externality & 11 Public Goods31 / 59


Landscape

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MWTP(x)Trip Cost t(x)

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Landscape

Definition 4.1 (Trip Cost Function)

Trip cost function t() measures Liz’s cost of makinga trip when there are cars on the road (orequivalently, when she is -th car on the road).

It is not flat all the way through.


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Landscape

Flat at the beginningIncreasing in the end



Detecting Externality on I-35

How does Liz make her decision?1 MWTP() > t()⇒ commute.2 MWTP() < t()⇒

use alternative modes of transportation.

How many cars will there be then?




Is E (equilibrium traffic volume) efficient?E-th commuter’s (private) surplus is

CSP(E) = MWTP(E)− t(E).


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CSMWTP(x)Trip Cost t(x)SMC(x)

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Let’s say Liz is the E-th car on the road.Her MWTP(8) = 6 and the cost of trip is t(8) = 6 aswell.Does Liz consider that her entrance dragseverybody else’s speed down?Her entrance effect over the existing cars are notpriced.Externality at work.



Why Shouldn’t Liz Be on I-35?

What is the Pareto optimal number of cars then?Need to take the externality into consideration.

Definition 4.2 (Social Total Cost)The social total cost of having cars on I-55 (thetotal cost on the society as a whole) is

STC() =


Notes

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Adding Liz costs the society on the whole by:

ΔSTC()

Δ= t()︸︷︷︸

her own cost

+Δt()

Δ︸︷︷︸

everyone has to slow down

︸︷︷︸

# of cars

.

2

2Recall the product rule: (STC())′ = t() + t′().Watanabe Econ 1023 10 Externality & 11 Public Goods40 / 59



Additional increase in social total cost (which is notjust t()) is called social marginal cost.SMC() is larger than trip cost t().

t() just returns the trip cost for each level and does not count additional burden that -th carimposes on the society.

∗-th commuter’s social surplus is

CSS(∗) = MWTP(∗)− SMC(∗).




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What does efficient outcome satisfy?1 MWTP() > SMC(): A gain from additional car

(MWTP) is still larger than the additional burdenimposed on the society.

2 MWTP() < SMC(): Adding one car does moreharm (SMC) than does good (MWTP).

3 Once you deviate from MWTP() = SMC(),somebody can be better off.

Efficient outcome ∗ satisfies:

MWTP(x) = SMC(x).

∗ = 6(< E = 8).




Liz: drives as long as

MWTP() ≥ t(x).

Society: drive as long as

MWTP() ≥ SMC(x).

∗ = 6(< E = 8).




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DWLOffsetMWTP(x)Trip Cost t(x)SMC(x)

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Tragedy of Commons

Laissez-faire scheme fails to achieve the optimalnumber of cars.A discrepancy between trip cost t() (the cost anindividual driver perceives) and the socialmarginal cost SMC() (the additional cost thesociety as a whole faces).Individual drivers take no account of the costinflicted upon the rest of the drivers.Called tragedy of commons.


Notes

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Tragedy of Commons

Note E actually creates deadweight loss,whereas ∗ maximizes the total surplus.



Fixes

To realize ∗ = 6, you can impose tax (toll) ondrivers.By how much?Pigouvian tax δ := SMC(6)− t(6) = 6.



Fixes

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MWTP(x)Trip Cost t(x)SMC(x)t(x)+6

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Fixes

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CSTax RevenueMWTP(x)Trip Cost t(x)SMC(x)t(x)+6

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Example

Exercise 4.3 (Pigouvian Tax)

The following represents the highway use pattern onI-35.

1 What is the current traffic volume?2 What is the optimal traffic volume?3 What is the deadweight loss?4 How much should the Pigouvian tax be?

0 1035/3 15 20 250

1012.5

20

27.5

32.535

50

Traffic Volume x (in 1000)

Trip

Cos

t, M

WT

P, S

MC

t(x)SMC(x)MWTP(x)

0 1035/3 15 20 250

1012.5

20

27.5

32.535

50


Trip

Cos

t, M

WT

P, S

MC



Example

0 1035/3 15 20 250

1012.5

20

27.5

32.535

50


Trip

Cos

t, M

WT

P, S

MC

t(x)SMC(x)MWTP(x)

0 1035/3 15 20 250

1012.5

20

27.5

32.535

50


Trip

Cos

t, M

WT

P, S

MC


Notes

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Notes


Example

0 1035/3 15 20 250

1012.5

20

27.5

32.535

50


Trip

Cos

t, M

WT

P, S

MC

t(x)SMC(x)MWTP(x)

0 1035/3 15 20 250

1012.5

20

27.5

32.535

50


Trip

Cos

t, M

WT

P, S

MC



1 Introduction

2 When Market Fails

3 Categorization

4 Pigouvian Tax

5 Summary



ExternalityCoase’s theorem4 categoriesPigouvian tax


Notes

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Airline du Jour

Today’s color theme is provided by courtesy of S7



Index

cap and trade, 8club goods, 27Coase’s theorem, 18common resources, 27commuter’s privatesurplus, 36commuter’s social surplus,41CSP(), see commuter’sprivate surplusCSS(), see commuter’ssocial surplusdeadweight loss, 49δ, see Pigouvian taxequilibrium traffic volume,36excludability, 26, 27externality, 4, 38negative, 4, 5positive, 4, 6

free rider, 29free-riders’ problem, 29internalization, 16

marginal willingness topay, 31MWTP(), see marginalwillingness to payopportunity cost, 31Pareto optimal, 39Pigouvian tax, 50private goods, 27property rights, 17pure public goods, 27rivalry, 26, 27SMC(), see socialmarginal costsocial marginal cost, 41social total cost, 39STC(), see social totalcostt(), see trip cost functiontragedy of commons, 48trip cost function, 33E, see equilibrium trafficvolume


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http://www.jetphotos.net/viewphoto_pa.php?id=7298147&pa_photo=87268

chapter 10: externalities chapter 11: public goods and...

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