•KRUGMAN'S•MICROECONOMICS for AP*

Introduction to Externalities

Margaret Ray and David Anderson

Econ: 74

Module

What you will learnin this Module:• What externalities are and why they can

lead to inefficiency in a market economy.• Why externalities often require government

intervention.• The difference between negative and

positive externalities.• The importance of the Coase theorem,

which explains how private individuals can sometimes

I. The Economics of Pollution

A.Marginal social cost (MSC): the additional costs imposed on society as a result of one more unit of pollution.

B.Marginal social benefit (MSB): the additional benefits received by society as a result of one more unit of pollution.

II. The External Cost of Pollution

A. External Cost – an uncompensated cost that an individual or firm imposes on others

B. Also called a negative externality

The Inefficiency of Excess Pollution

Qopt

MSC and MSBof pollution

MSB

MSC

MSC=MSB

Qmkt

$1000

Qty of Pollution Emitted (tons)

At Qmkt, suppose we could reduce pollution by one ton.What would we lose? Since MSB is zero, one less ton of pollution would come at almost $0 of sacrifice to society.What would we gain? Since MSC is $1000, if we reduced pollution by one ton we would avoid nearly $1000 of harmful costs.

III. Private Solutions to Externalities

A. The Coase Theorem - so long as property rights are clearly defined, and transaction costs are minimal, a private solution can be found to a situation such as this.

B. These private solutions internalize the externality. The party that is imposing the hardships on the other is required to compensate the victim.

C. Many times transaction costs are too high to make a private solution easy to negotiate. (legal costs)

•KRUGMAN'S•MICROECONOMICS for AP*

Externalities and Public Policy

Margaret Ray and David Anderson

Econ: 75

Module

What you will learnin this Module:• How external benefits and costs cause

inefficiency in markets.• Why some government policies to deal with

externalities, such as emissions taxes, tradable emissions permits, and Pigouvian subsidies, are efficient, although others, including environmental standards, are not.

I. Policies Toward PollutionA. Environmental

StandardsB. Emissions TaxesC. Tradable Emissions

Permits

Production, Consumption, and Externalities

• Private versus social benefits

• Private versus social costs

II. Negative Externalities

A. When the production and consumption of a good creates costs to third parties, that good is said to create negative externalities to society.

B. Pigouvian Tax Qty electricity

Price, MSC

MPC

D

MSC

Popt

Qopt Qmkt

Pmkt

Tax

Pfirm

III. Positive Externalities

A. When the production and consumption of a good provides benefits to third parties, that good is said to provide positive externalities to society.

B. Pigouvian SubsidyQty home improvements

Price, MSB

MPB MSB

S

Popt

QoptQmkt

Pmkt SubsidyPcons

IV. Network Externalities

A. A network externality exists when the value to an individual of a good or service depends on how many other people use the same good or service.

B. Example: When more people use Facebook or Twitter, it becomes more valuable to you

•KRUGMAN'S•MICROECONOMICS for AP*

Public Goods

Margaret Ray and David Anderson

Econ: 76

Module

What you will learnin this Module:

• How public goods are characterized and why markets fail to supply efficient quantities of public goods.

• What common resources are and why they are overused.

• What artificially scarce goods are and why they are under-consumed.

• How government intervention in the production and consumption of these types of goods can make society better off.

• Why finding the right level of government intervention is often difficult.

I. Private Goods

A. Private goods are what we have studied thus far

B. Private goods have two characteristics. They are;

1. Excludable- You can prevent people who don’t pay from consuming it

2. Rival- the unit of the good cannot be consumed by more than one person at the same time

II. Public Goods

A. Public goods are;

1. Non-excludable- Can’t exclude anyone on basis of payment

2. Non-rival- more than one person can consume it at the same time without the benefit going down

III. Common Resources

A. Common resources are;

1. Non-excludable

2. Rival

IV. Artificially Scarce Goods

A. Artificially scarce goods are;

1. Excludable

2. Non-rival

V. Markets Only Provide Private Goods EfficientlyA. Markets will not

provide the efficient level of public goods

B. The efficient level of public goods is the quantity where MSC = MSB

VI. Providing Common ResourcesA. The problem of overuse

and the “Tragedy of the Commons”

B. Maintaining a common resource

C. Examples of common resources?

iphoto

VII. The Efficient Level of Artificially Scarce Goods

A. MC of providing the good is zero

B. Firms can’t set price equal to zero

C. Example of artificially scarce good?

•KRUGMAN'S•MICROECONOMICS for AP*

Public Policy to Promote Competition

Margaret Ray and David Anderson

Econ: 77

Module

What you will learnin this Module:• The three major antitrust laws and how they

are used to promote competition.• How government regulation is used to

prevent inefficiency in the case of natural monopoly.

• The pros and cons of using marginal cost pricing and average cost pricing to regulate prices in natural monopolies.

I. Promoting Competition and Efficiency

A. Antitrust laws1. Protect competition2. Ensure lower prices3. Promote development of

better products

B. Price regulation1. When economies of scale

make it efficient to have one firm in a market, that natural monopoly can be taken over by the government or regulated

II. Antitrust Laws

A. Sherman Act

B. Clayton Act

C. FTC Act

III. Price Regulation

A. Marginal-cost pricing- the firm must operate at the point where P=MC. Government would subsidize any losses at taxpayer expense.

B. Average-cost pricing- the firm must operate at the point where P=ATC. This insures that the firm will earn normal economic profit, but some dead weight loss will occur.

•KRUGMAN'S•MICROECONOMICS for AP*

Income Distribution and Income Inequality

Margaret Ray and David Anderson

Econ: 78

Module

What you will learnin this Module:• What defines poverty, what causes poverty,

and the consequences of poverty.• How income inequality in America has

changed over time.• How programs like Social Security affect

poverty and income inequality.

I. Poverty

• Trends in poverty• Who is poor?• Causes of poverty• Consequences of

poverty

II. Lorenz CurveLorenz curve: A Lorenz curve shows the

degree of inequality that exists in the distributions of two variables, and is often used to illustrate the extent that income or wealth are distributed unequally in a particular society.

Gini coefficient: A Gini coefficient is a summary numerical measure of how unequally one variable is related to another. The Gini coefficient is a number between 0 and 1, where perfect equality has a Gini coefficint of zero, and absolute inequality yields a Gini coefficint of 1

III. Income Inequality

• Using quintiles to analyze income distribution

• The Gini coefficient

Income group

Average 2008 income

% of total income if distributed equally

2008 % of total income

Bottom quintile

$11,656 20% 3.4%

Second quintile

$29,517 20% 8.6%

Third quintile $50,132 20% 14.7%

Fourth quintile

$79,760 20% 23.3%

Top quintile $171,057 20% 50%

IV. Economic Insecurity

A. In addition to the problem of poverty, we are concerned with the possibility that people or families can fall into poverty due to unanticipated events.

B. Because these uncertain events can cause any family to have economic insecurity, we have a welfare state to provide temporary assistance.

V. U.S. Antipoverty Programs

A. Means-tested1. Criteria is established to qualify2. An example would be level of income and

size of familyB. Social Security and unemployment insurance

– Social Security funded by tax on wages– Unemployment funded by tax on employers

C. The effects of programs on poverty– Research says yes, but…

VI. The Debate Over Income Redistribution• Problems with income

redistribution• The politics of income

redistribution• Barstool Economics

The Laffer CurveThe curve suggests that, as taxes

increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because everything they earned would go to the government.