lecture 11: externalities and public goodslfbrooks/leahweb/teaching/pppa6085/2015/lecture... ·...

Admin Externalities Fix Ext. Public Goods Q∗PG Private PG Public PG

Lecture 11:Externalities and Public Goods

November 10, 2015


Overview

Course Administration

Positive and Negative Externalities

Fixing Externalities

Defining Public Goods

Optimal Provision of Public Goods

Private Provision of Public Goods

Public Provision of Public Goods


Course Administration

1. Bookstore website says reading packet needed for next week isavailable

2. Problem Set 10 is posted, problem set 8 answers posted

3. Elasticity paper: voluntary classmate feedback• Post paper by Nov. 17 8 pm to Blackboard discussion board

called “elasticity paper draft”• Put last name at beginning of file name• You’ll need to return comments on 2 to 3 papers by 8 pm

12/22 (Sunday) – and you could make alternate arrangementswith your group

• I’ll assign groups randomly after papers are posted• Suggestions?

4. Office hours extended: Wednesdays 10 am to 1 pm

5. Last class: probably 1/2 class asymmetric information, 1/2review

6. Questions?


Ripped from the Headlines

Next Week

Afternoon

Finder Presenter

Lily Robin Carly Evans

Evening

Finder Presenter

Amber Ebarb Jenny Lewis


Externality Definition

Externality ≡ cost or benefit accruing to party not involved ineconomic transaction

• Positive externality ≡ benefit accruing to party not involved ineconomic transaction

• Negative externality ≡ cost accruing to party not involved ineconomic transaction

Examples, please.


In a Market Without Externalities

P

D

Q

S

• If private demand = privatemarginal benefit = socialmarginal benefit

• And Private supply =private marginal cost =social marginal cost

• Then market equilibriummaximizes social welfare,which is total surplus

• Provides goods to consumerat lowest possible cost


In a Market With Externalities

Assume a negative externality

• =⇒ Social marginal cost 6= private marginal cost

• =⇒ Social marginal cost = Private marginal cost + externalmarginal cost

Assume a positive externality

• =⇒ Social marginal benefit 6= private marginal benefit

• =⇒ Social marginal benefit = Private marginal benefit +external marginal benefit

What does this mean for the relationship between marketequilibrium PMKT and QMKT and socially optimal PSOC andQSOC?


What Does a Negative Externality Do to Market Supply?Where Are the Private Market P and Q?

P

D

Q

S = MC


What Does a Negative Externality Do to Market Supply?Where is the Social Marginal Cost?

P

D

Q

S = MC

QMKT

PMKT


What Does a Negative Externality Do to Market Supply?What are the Socially Optimal P and Q?

P

D

Q

S = MC + EMC

S = MC

QMKT

PMKT


What Does a Negative Externality Do to Market Supply?What is the Vertical Distance Between the Supply Curves?

P

D

Q

S = MC + EMC

S = MC

QMKTQSOC

PMKT

PSOC


What Does a Negative Externality Do to Market Supply?Where is the Deadweight Loss?

P

D

Q

S = MC + EMC

S = MCEMC

QMKTQSOC

PMKT

PSOC


What Does a Negative Externality Do to Market Supply?Too Much Production, at Too Low a Price

P

D

Q

S = MC + EMC

S = MCEMC

QMKTQSOC

PMKT

PSOC

DWL


Positive ExternalitiesWhere Are Market Equilibrium P and Q?

P

Q

D = PMB

S


Positive ExternalitiesWhere is the Social Marginal Benefit Curve?

P

Q

D = PMB

S

QMKT

PMKT


Positive ExternalitiesWhat are the Socially Optimal P and Q?

P

Q

D = PMB

S

QMKT

PMKT D = PMB + EMB


Positive ExternalitiesWhat is the Vertical Difference Between the Demand Curves?

P

Q

D = PMB

S

QMKT QSOC

PMKT

PSOCD = PMB + EMB


Positive ExternalitiesWhere is the Deadweight Loss?

P

Q

D = PMB

SEMB

QMKT QSOC

PMKT

PSOCD = PMB + EMB


Positive ExternalitiesToo Little Production, at Too High a Price

P

Q

D = PMB

SEMB

QMKT QSOC

PMKT

PSOCD = PMB + EMB

DWL


Try It Yourself: Negative Externalities

Suppose that leather is sold in a perfectly competitive industry.The industry short-run supply curve (marginal cost curve) isP = MC = 3Q, where Q is measured in millions of hides per year.The demand for leather hides is given by Q = 60/7− P/7.

1. Find the equilibrium market price and quantity.

2. Suppose that the leather tanning releases bad stuff intowaterways. The external marginal cost is $4/hide. Calculatethe socially optimal level of output and price for the tanningindustry.


What is the Right Level of Production with NegativeExternalities?

• Efficient level of production ≡ level of production necessary toproduce the efficient quantity of the good tied to theexternality

• Assume that there is a marginal cost of production (= privatecost + external cost)

• Assume that there is a marginal benefit of production (=marginal cost of abatement)

• What level of production is optimal?


Optimal Provision of a Good with a Negative Externality

Whyis POLL∗ 6= 0?


Getting to the Socially Optimal P and Q

Three methods

1. Change prices

2. Change quantities

3. Tradeable permits


1. Using Taxes and Subsidies to Return to the EfficientPoint

• Suppose we know the external marginal cost

• Charge a tax equal to the external marginal cost

• This returns us to the socially optimal equilibrium outcome

• Called a Pigouvian tax

• Requires that you (the policymaker) know the cost exactly

• Can redistribute tax revenues to those harmed by policy


To Be Clear

Before tax

• private marginal cost = MC

• social marginal cost = MC + EMC

After tax, T = EMC

• private marginal cost = MC + T

• social marginal cost = MC + EMC


1a. Correcting for a Negative ExternalityPrivate and Social Supply Before a Tax

P

D

Q

S = MCEMC

QMKTQSOC

PMKT

PSOC

S = MC + EMC


1a. Correcting for a Negative ExternalityAfter the Tax, Private Supply = Social Supply

P

D

Q

S = MC + EMC = MC + T

S = MCEMC = T

QMKT

PMKT

QSOC

PSOC


1b. Correcting for a Positive ExternalityPrivate and Social Demand Before a Subsidy

P

Q

D = PMB

SEMB

QMKT QSOC

PMKT

PSOCD = PMB + EMB


1b. Correcting for a Positive ExternalityAfter the Subsidy, Private Demand = Social Demand

P

Q

D = PMB

SEMB= Sub

QMKT

PMKT D = PMB + EMB= PMB + Sub

QSOC

PSOC


2. Using a Quota to Get to Efficient PointPrivate and Social Supply Before a Quota

P

D

Q

S = MC + EMC

S = MCEMC

QMKT

PMKT

QSOC

PSOC


2. Using a Quota to Get to Efficient PointWith a Quota

P

D

Q

S = MC + EMC

S = MCEMC

QMKT

PMKT

S = MC w/ quota

QSOC

PSOC


The Trouble with Using Quotas

1. May be hard to know optimal market output level

2. Even if you know the optimal market output, policy mustassign quotas by firm. Ideally, you’d assign quotas by cost ofreduction, but you’d need to know firm-specific costs.

3. All costs and benefits are borne by market participants; no taxrevenues to redistribute


3. Tradeable Permits

• The government decides how much negative activity (orpositive activity) to allow

• It makes permits to allow that much activity

• It distributes permits to anybody (firms, you)• The choice of distribution method determines winners and

losers!

• Permits trade

Why is this superior in terms of getting to the equilibriumoutcome?

• Government doesn’t need to know anything about firms’ coststructures

• Firms with lowest cost of reducing activity will undertake it



Public goods are both non-rival and non-excludable

• Non-rival ≡ goods where your consumption does not impactmy consumption

• Non-excludable ≡ goods from which consumption cannot beexcluded

Pure public goods are rare: national defense, perhaps air forbreathing.Public goods are not necessarily publicly provided goods.






Pure public goods are rare:

national defense, perhaps air forbreathing.Public goods are not necessarily publicly provided goods.






Pure public goods are rare: national defense, perhaps air forbreathing.

Public goods are not necessarily publicly provided goods.






Pure public goods are rare: national defense, perhaps air forbreathing.Public goods are not necessarily publicly provided goods.


Public Good Typology

Rival Non-Rival

Excludable Private good Club goodNon-Excludable Common resource Pure public good

With your neighbors: examples of each type. Can substitute alocal public good for the “pure public good.”


Optimal Provision of Private Goods


Using Algebra To Do This

Suppose we have two demand curves

• QJoe = 5− 0.05P

• QJack = 13− 0.25P

This is a piece-wise linear function. What are the pieces?

• At P > $52, Jack doesn’t want any more

• At P > $100, Joe doesn’t want any more

We write this as

QM =

{18− 0.3P if 0 < P < 52

5− 0.05P if P > 52


Adding Private Good Demand

• For private goods, we add up Q at a given price, P

• How many oranges do people want to buy if the price is $6?

• Mechanically, add Q = f (P)

Why doesn’t this work for public goods?


Optimal Provision of Public Goods?How Much Are Mr. 1 and Mr. 2 Willing to Pay for Q2 of Fireworks?

Q

P1

P2

Q

P1,2

P2,2

QQ2


Optimal Provision of Public Goods?To See Demand at Q2

Q

P1

P2

Q

P1,2

P2,2

P1+P2

P1,2+P2,2

QQ2


Optimal Provision of Public Goods?Market Demand for Public Goods

Q

P1

P2

Q

P1,2

P2,2

P1+P2

P1,2+P2,2

QQ2


Optimal Provision of Public Goods?Equilibrium Provision of Public Goods

Q

P1

P2

Q

P1,2

P2,2

P1+P2

P1,2+P2,2

QQ2


Adding Market Demand for Public Goods in Math

• For public goods, we add up P at a given quantity, Q

• For 300 fireworks, how much is everyone willing to pay?

• Mechanically, add P = g(Q)


Level of Private Provision of Public Goods

• Suppose• Mr. 1 likes 6 units of the public good• Mr. 2 likes 5 units of the public good• Mr. 1 purchases 6 units• What is Mr. 2’s best response?

• This is known as the “free rider problem” ≡ failure tocontribute to public good

• =⇒ in general, private markets underprovide public goods

• Don’t blame the producer!

Even goods that a whole group wants and is willing to pay for maynot be provided.


Example: Private Provision of Public Goods

• Property owners in a neighborhood agree to levy taxes onthemselves

• Motivation: owners feel that public services are substandard

• Use tax revenues to privately provide services, such ascleaning, marketing and security

• Generally regarded as being successful – my research showslowered crime in City of LA

• Overcome the free-rider problem with mandatory contribution


When Does Private Market Provide Some Public Goods?

• The smaller the group, the more likely the provision

• When one, or a few, members care a lot – we see this in BIDs

• Altruism

• Warm glow


Can the Government Do Better?

Due to the failure in the private market, one solution is forgovernment to provide public goods.

What do you think theproblems are with this?

• Free-rider problem again: optimal amount of public goods issum of P given Q

• Asking citizens to reveal their true demand is called “Lindahlpricing”

• Yields optimal quantity of public goods• Consumers might not know their demand (do you know your

demand for missiles?)• And consumers have an incentive to underestimate

• Government provision “crowds out” private provision• Before the government firework show, you might have bought

some of your own. Now you do not. Other examples?

• Costs and benefits hard for government to measure


Can the Government Do Better?

Due to the failure in the private market, one solution is forgovernment to provide public goods. What do you think theproblems are with this?

• Free-rider problem again: optimal amount of public goods issum of P given Q

• Asking citizens to reveal their true demand is called “Lindahlpricing”

• Yields optimal quantity of public goods• Consumers might not know their demand (do you know your

demand for missiles?)• And consumers have an incentive to underestimate

• Government provision “crowds out” private provision• Before the government firework show, you might have bought

some of your own. Now you do not. Other examples?

• Costs and benefits hard for government to measure


Recap of Today

• Externalities• Definitions, positive and negative• Possible corrections

• Public goods• Definition• Equilibrium market provision• Adding up demand for public goods


Next Class

• Turn in Problem Set 10

• Taxes!

• Gruber 18 and 19


Problem 1

1. Equilibrium price and quantity. Find equilibrium P and Q by settingQS = QD (or PS = PD). To set the curves equal, we need to startby finding inverse demand. If Q = 60/7− P/7, then P = 60− 7Q.Set 3Q = 60− 7Q, or 10Q = 60, which implies Q∗

market = 6. Price isP∗market = 3Q∗ = 18. (Check that P = 60− 7(6) = 60− 42 = 18.)

2. With external costs

The true cost should be MC = 3Q + 4. Solve again. Note beforesolving that P∗

SC > P∗market , and Q∗

market > Q∗SC .

Set 3Q + 4 = 60− 7Q, or 10Q = 56, which implies that Q∗SC = 5.6.

To find price, P∗SC = 3Q∗ + 4 = 3(5.6) + 4 = 16.8 + 4 = 20.8.

Check that P∗SC = 60− 7(5.6) = 60− 39.2 = 20.8.

lecture 11: externalities and public goodslfbrooks/leahweb/teaching/pppa6085/2015/lecture... ·...

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