Lecture 3 Chapter 3

The Club

Anti Theft Device

Assume you car is parked and has the

club in place.

◦ Does this have an effect on the chance that

other cars are stolen? Why?

Transition to Chapter 3

Class discussion

◦ Class thoughts on Pollution

◦ Where does pollution come from?

◦ Do any class members receive benefits from

the activities that generate pollution?

◦ What would happen if there were a mandate

that would stop all pollution tomorrow?

What would the effects of such a policy be?

Externalities Def: a cost or benefit of market transaction not

reflected in prices.

◦ What happens when benefits and costs are not

accurately reflected in prices?

ANS: Inefficiency

Example:

◦ Sweaty gym clothes

◦ Positive Externality

Purchase of Subway Sandwich

Only You benefit No Externality

Purchase of college education

You AND society benefits

Less Crime, better health, more informed voters etc…

Positive Externalities

Def: Benefits to third parties other than buyers or sellers not reflected in prices Examples: Identify the primary parties and the third

parties

Fire prevention mechanisms for your apartment

Nice Landscaping

Education

Externalities

◦ Negative Externality

Producers of electricity

Pay to get the coal, build the plant, pay the

workers etc

Is that the only cost of electricity consumption

and production?

What other costs are there?

Inflamed asthma, reduced visibility, acid rain etc..

Example: Coal Ash spill in Tennessee

December 27, 2008 – 5.4 million cubic yards

Thought question: Is the optimal level of pollution

zero?

Negative Externality

Def: costs to third parties other than the

buyers and sellers of an item not reflected

in the market price

◦ Examples – Identify the primary parties and

the third parties

Construction on an empty lot next to your house

Commercial aircraft flying over a neighborhood

Driving

Smoking

Auto insurance in California link1 link2

Others?

Effects of Externalities

Markets maximize surplus

◦ Only true in a market without externalities

◦ With externalities, Surplus is reduced

◦ Externalities are a source of Deadweight loss

Private Cost: The cost borne by the producer of the

good or service

◦ Trucks, workers, coal

Social Cost = Private cost + any external costs

◦ Trucks, workers, coal + Asthma, pollution etc..

Private benefit: The benefit received by the consumer

of a good

◦ Higher wage

Social benefit = Private Benefit + any external benefit

◦ Higher wage + lower crime for all of society

Externalities and efficiency

When an externality exists, the MC or

MB that market participants base their

decisions on diverge from MSC and MSB

◦ This implies a loss of efficiency.

Marginal External Cost: The extra cost to

third parties resulting from production

of another unit of a good or service.

◦ MEC is part of the marginal social cost, but is

not part of the price.

How do we see it externalities in a graph?

Let’s start with the case of a negative externality

Externalities and Inefficiency •What will happen to this graph

once we take into account the

extra costs borne by society?

•Ans: Costs go up Supply

curve shifts up

•When we take into account all

MC and all MB, then we are at

the efficient equilibrium •Q2 is efficient because at that point

MB = MC for society as a whole.

•Q1 is inefficient, Why?

•Because at Q1 Extra cost to

society is greater than the extra

benefit

•In other words, society could

save resources by reducing

output.

•Producing at Q1 causes deadweight

loss because marginal costs are

greater than the marginal benefits.

Key Point: In a market with a negative externality,

too much will be produced at the market

equilibrium

Market

Equilibrium

Cheshire

http://www.cheshiretransaction.com/film/f

ilm.html

Seeing the Efficiency Loss of a

Negative Externality Consider paper production

◦ Negative externality – pollution into streams

and rivers

◦ Assume that:

the demand curve for paper is based marginal social

benefits

the supply curve based on marginal costs of

producers (marginal private cost)

Assume the marginal external cost is $10 per ton

Seeing the Efficiency Loss of a Negative Externality

Which point is

the market

equilibrium?

Which point is

the efficient

outcome?

Notice at B MSC = MPC + MEC = MSB Efficiency!

Relative to the efficient outcome, when a negative

externality is present, is too much or too little produced? Too much!

Your Turn

In a recent study at a large university, students were

randomly assigned roommates. Researchers found that, on

average, males assigned to roommates who reported

drinking alcohol in the year before entering college had

GPAs .25 lower than those assigned to non-drinking

roommates. For males who drank frequently before college,

being assigned a roommate who also drank frequently

before college reduced their GPAS by .67.

◦ Draw a graph showing the price of alcohol and the

quantity of alcohol consumption on college campuses.

Include in the graph the private and social cost of drinking.

Label any deadweight loss that arises in this market.

An Alternate View of the Club

The club helps professional thieves steal

cars.

The typical driver today is in a car that weighs 4,089 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,500 pounds.

What type of externalities might result for SUVs?

Environmental Externalities:

The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions.

Wear and Tear on Roads:

Each year, federal, state, and local governments spend $33.2 billion repairing our roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight.

Safety Externalities:

One major appeal of SUVs is that they provide a feeling of security because they are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.

The Externality of SUVs

A P P L I C A T I O N

An Example in the News

From the 2008 Financial Crisis

◦ Paulson argues for a government bail out.

Positive Externalities

In a positive externality, prices do not fully

equal the marginal social benefit (MSB) of a

good or service

Marginal external benefit (MEB): Benefit of

additional output accruing to parties other

than buyers and sellers of the good

Consumers base decisions on marginal

private benefit (MPB)

Externalities and Inefficiency •What happens in this graph when we

taken into account the extra benefits

society gets from people getting

educated?

•Ans: Benefits go up Demand

Curve shifts up

•When we take into account all MC

and MB, then we are at the efficient

equilibrium

•Q2 is efficient because at that point

MB = MC for society as a whole.

•Q1 is inefficient, Why?

•Because at Q1 the extra benefit

is greater than the extra cost.

•In other words, society could be

better off by producing more

education.

•Producing at Q1 causes deadweight

loss because marginal benefits are

greater than marginal cost.

•Key Point: When there is a positive

externality, the market equilibrium is

below the efficient equilibrium

•The market produces too little of

the good

= MSC

Seeing the Efficiency Loss of a

Positive Externality Inoculations against disease

◦ Positive externality

◦ Assume that

Supply curves is the MSC Curve

Demand Curve is the Marginal Private benefit curve

Marginal external benefit is $20

Seeing the Efficiency Loss of a

Positive Externality

Internalizing Externalities

Internalization of an externality: Marginal private

benefit or cost of goods and services are

adjusted so that users consider the actual

marginal social benefit or cost of their decisions

◦ Negative externality – MEC is added to MPC

◦ Positive externality – MEB is added to MPB

2 Primary Ways to Internalize and

Externality

1. Corrective taxes and subsidies (these involve

the government)

2. Coase-Type Solutions (“private solutions”)

Internalizing Externalities – The

corrective tax Do Taxes change our behavior?

◦ Which year a baby is born

◦ How much you drive

Corrective tax: Designed to adjust MPC of a good

or service in such a way as to internalize the

externality

◦ Tax = Marginal External cost

What is the difference between a corrective tax

and a regular tax?

◦ Corrective taxes are designed to correct inefficient

outcomes related to externalities. Regular taxes are

designed primarily for revenue.

How to regain Surplus lost from

Externalities: Government Solutions

This is where the market settles

This is where society is best off

S2 Marginal

Social Cost

•What do we know of

that will move us from

S1 to S2?

•A Tax

•A tax forces

producers to take into

account the external

costs

•A tax in the case of

externality eliminates

the dead weight lost.

•That is because the

tax helps to equate

society’s MC to

society’s MB

DWL

Internalizing Externalities – The

Corrective Tax Corrective Tax

Is the efficient level > or < market level in this example?

What is the size of the net gains in well being?

<

.5 * 500k * 10 = 2.5 million

Important things to note

◦ Tax does not reduce pollutants to zero. It

merely raises the cost of production reflect

MEC

◦ Corrective tax will result in some groups

receiving benefits at the expense of other

groups

Why might corrective taxes be politically difficult?

Note: This is a resurfacing of the efficiency vs.

equity tradeoff

Internalizing Externalities – The corrective tax

Corrective subsidy: Payment made by government

to either buyers or sellers so that the price paid

by consumers is reduced

◦ Note again that the difference for the corrective

subsidy Used to internalize a positive externality

Grant a subsidy to internalize a positive

externality

◦ Subsidy should be equal to the MEB

◦ Subsidy shifts the Demand Curve up by the

amount of the MEB

Internalizing Externalities – The corrective subsidy

How to Regain Surplus Lost from

Externalities

This is where the market settles

This is where society is best off

D2 Marginal

Social

benefit

•What Do we know

of that will move us

from D1 to D2?

•A Subsidy

•A subsidy helps us

to take into account

the external benefits

of our actions

•A subsidy in this

case eliminates the

deadweight loss

•That is because the

subsidy helps to

equate society’s MB

to society’s MC

DWL

Internalizing Externalities – The corrective subsidy

What area represents the

efficiency gain? ANS: ZUV

Coase-Type Solutions to

Externalities Example - Smoking

Coase Theorem (Part I) When

there are well-defined property

rights and costless bargaining, then

negotiations between the party

creating the externality and the

party affected by the externality can

bring about the socially optimal

market quantity.

Coase Theorem (Part II) The

efficient solution to an externality

does not depend on which party is

assigned the property rights, as long

as someone is assigned those rights.

Cheshire

http://www.cheshiretransaction.com/film/f

ilm.html

Power produce received payment for

electricity.

Homeowners paid the power company

the price for the electricity

Problem: The price did not reflect the full

cost of electricity generation

Coase-Type Solutions to

Externalities

Rancher vs. Farmer (cattle

vs. wheat)

◦ No Fence separating

◦ Assume that farmer has

right to cattle free land

This causes rancher to take into

account the MEC of his cattle

trampling wheat. Internalizing

the externality

Key For the Coase Theorem

Part 2 is that it does not matter

who receives the property

rights, the farmer or the

rancher. With bargaining, the

efficient quantity will result.

Key Point: Allocation of

resources is the same in either

case. However, it does effect

the distribution of income in the

system.

Applying the Coase Theorem

Consider Air, How could we apply the

Coase theorem to clean air and pollution?

◦ ANS: Assign a property right – Permits to

Pollute

Note: In the market for

pollution, firms are the ones

who benefit from being able

to pollute.

What are some of the

advantages of a market for

permits? Disadvantages?

Environmental Policy

Emission Standards: Dictates the

maximum amount of pollution you can

emit ◦ Do you think a common Emission standard across

firms would result in an efficient outcome? Why?

ANS: No, marginal benefits of pollution varies across firms.

If marginal benefits of emissions vary among firms, emission

standards do not achieve an efficient outcome.

Take Home Point: Flexible standards more likely to

achieve an efficient outcome than uniform standards

Environmental Policy – Standards vs.

a Tax Note: Firms are

benefiting from the

emissions.

Note: Society is

bearing the cost

Does firm A emit more or less

than the efficient level?

Does firm B produce more or less

than the efficient level?

ANS: ______

Note: The efficiency loss is the area

between the MSB and MSC curve between

efficient and inefficient level

Note: The efficiency los is the area

between the MSB and MSC curve between

efficient and inefficient level

ANS: _______

Consider the government imposing

a strict emissions standard at QR

Key Point: Standards can cause a

DWL by not allowing firms an

room to adjust to firm level

factors

Command and Control vs. Coase

Def: Government sets the emission standards and requires specific pollution control technology ◦ What are the incentives for individual firms to

innovate better or cheaper technology for pollution control?

Tradable permits – Coase Solution

(Market Solution)

◦ What are the incentives for individual firms to

innovate better or cheaper technology for

pollution control?