Microeconomics
Claudia Vogel
EUV
Winter Term 2009/2010
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
1 / 21
Externalities and Public Goods
Lecture Outline
Part IV Information, Market Failure and the Role of Government
14
Externalities and Public Goods
Externalities
Ways of Correcting Market Failure
Common Property Resources
Public Goods
Summary
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Externalities
Externalities
externality: Action by either a producer or a consumer which aects other
producers or consumers, but is not accounted for in the market price.
Negative Externalities and Ineciency
marginal external cost: Increase in cost imposed externally as one or more
rms increase output by one unit.
marginal social cost: Sum of the marginal cost of production and the
marginal external cost.
Positive Externalities and Ineciency
marginal external benet: Increased benet that accrues to other parties as
a rm increases output by one unit.
marginal social benet: Sum of the marginal private benet plus the
marginal external benet.
Claudia Vogel (EUV)
Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
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Externalities
Negative Externalities and Ineciency
When there are negative externalities, the marginal social cost MSC is higher than
the marginal cost MC.
The dierence is the marginal external cost MEC.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Externalities
Positive Externalities and Ineciency
When there are positive externalities,
marginal benets are MSB are higher than
marginal benets D.
The dierence is the marginal external
benet MEB.
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Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
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Externalities
Example: The Costs and Benets of Sulfur Dioxide
Emissions
The ecient sulfur dioxide concentration
equates the marginal abatement cost to
the marginal external cost.
Here the marginal abatement cost curve
is a series of steps, each representing the
use of a dierent abatement technology.
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Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Ways of Correcting Market Failure
The Ecient Level of Emissions
The ecient level of factory emissions is the level that equates the marginal
external cost of emissions MEC to the benet associated with lower abatement
costs MCA.
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Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
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Ways of Correcting Market Failure
Emission Standards and Fees
emissions standard: Legal limit on
the amount of pollutants that a rm
can emit.
emissions fee: Charge levied on
each unit of a rm's emissions.
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Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Ways of Correcting Market Failure
Standards versus Fees
Claudia Vogel (EUV)
Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
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Ways of Correcting Market Failure
Tradeable Emission Permits
tradeable emissions permits: System of marketable permits, allocated
among rms, specifying the maximum level of emissions that can be
generated.
Marketable emissions permits create a market for externalities. This market
approach is appealing because it combines some of the advanategous features of a
system of standards with the cost advantages of a fee system.
Example: Price of Tradeable Emissions Permits for Sulfur Dioxide
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Ways of Correcting Market Failure
Recycling
The ecient amount of recycling of scrap material is the amount that equates the
marginal social cost of scrap disposal, MSC, to the marginal cost of recycling,
MCR.
A refundable fee increases the cost of disposal. With the higher cost of disposal,
the individual will reduce disposal and increase recycling to the optimal social level
m*.
Claudia Vogel (EUV)
Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
11 / 21
Common Property Resources
Common Property Resources
common property resource: Resource to which anyone has free access.
When a common property resource,
such as a shery, is accessible to all,
the resource is used up to the point
FC at which the private cost is equal
to the additional revenue generated.
This usage exceeds the ecient level
F ∗ at which the marginal social cost
of using the resource is equal to the
marginal benet (as given by the demand curve).
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Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Common Property Resources
Example: Crawsh Fishing in Louisiana
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Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
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Public Goods
Public Goods
public good: Nonexclusive and nonrival good.
nonrival good: Good for which the marginal cost of its provision to an
additional consumer is zero.
nonexclusive good: Good that people cannot be excluded from consuming,
so that it is dicult or impossible to charge for its use.
free rider: Consumer or producer who does not pay for a nonexclusive good
in the expectation that others will.
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Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Public Goods
Eciency and Public Goods
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Microeconomics
Externalities and Public Goods
Winter Term 2009/2010
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Public Goods
Public Goods and Market Failure
The three curves describe the willingness to pay for clean air (a reduction in the level of nitrogen oxides)
for each of three dierent households
(low income, middle income, and high
income).
In general, higher-income households
have greater demands for clean air
than lower-income households. Moreover, each household is less willing to
pay for clean air as the level of air
quality increases.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Externalities and Public Goods
Summary
Summary
An externality occurs when a producer or a consumer aects the production or
consumption activities of others in a manner that is not directly reected in the
market. Externalities cause market ineciencies because they inhibit the ability of
market prices to convey accurate information about how much to produce and how
much to buy.
Pollution is a common example of an externality that leads to market failure. It can
be corrected by emissions standards, emissions fees, marketable emissions permits,
or by encouraging recycling. When there is uncertainty about costs and benets,
any one of these mechanisms can be preferable, depending on the shapes of the
marginal social costs and marginal benet curves.
Common property resources are not controlled by a single person and can be used
without a price being paid. As a result of free usage, an externality is created in
which the current overuse of the resources harms those who might use it in the
future.
Goods that private markets are not likely to produce eciently are either nonrival or
nonexclusive. Public goods are both. A good is nonrival if for any given level of
production, the marginal cost of providing it to an additional consumer is zero. A
good is nonexclusive if it is expensive or impossible to exclude people from
consuming it.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Exercises 12
Problem 1
1
2
3
4
5
Compare and contrast the following three mechanisms for treating pollution
externalities when the costs and benets of abatement are uncertain: (a) an
emissions fee, (b) an emissions standard, and (c) a system of transferable
emissions permits.
When do externalities require government intervention? When is such
intervention unlikely to be necessary?
Consider a market in which a rm has monopoly power. Suppose in addition
that the rm produces under the presence of either a positive or a negative
externality. Does the externality necessarily lead to a greater misallocation of
resources?
Externalities arise solely because individuals are unaware of the consequences
of their actions. Do you agree or disagree? Explain.
Public goods are both nonrival and nonexclusive. Explain each of these and
show clearly how they dier from each other.
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Microeconomics
Winter Term 2009/2010
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Exercises 12
Problem 2
The market for paper in a particular region in the United States is characterized
by the following demand and supply curves:
QD = 160000 − 2000P and QS
= 40000 + 2000P ,
where QD is the quantity demanded in 100-pound lots, QS is the quantity supplied
in 100-pound lots, and P is the price per 100-pound lot. Currently there is no
attempt to regulate the dumping of euent into streams and rivers by the paper
mills. As a result, dumping is widespread. The marginal external cost (MEC)
associated with the production of paper is given by the curve MEC = 0.0006QS .
1
2
3
Calculate the output and price of paper if it is produced under competitive
conditions and no attempt is made to monitor or regulate the dumping of
euent.
Determine the socially ecient price and output of paper.
Explain why the answers you calculated in parts (1) and (2) dier.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Exercises 12
Problem 3
In a market for dry cleaning, the inverse market demand function is given by
P = 100 − Q and the (private) marginal cost of production for the aggregation of
all dry-cleaning rms is given by MC = 10 + Q . Finally, the pollution generated
by the dry-cleaning process creates external cost curve MEC = Q .
1
Calculate the output and price of dry cleaning if it is produced under
competitive conditions without regulation.
2
Determine the socially ecient price and output of dry cleaning.
3
Determine the tax that would result in a competitive market producing the
socially ecient output.
4
Calculate the output and price of dry cleaning if it is produced under
monopolistic conditions without regulation.
5
Determine the tax that would result in a monopolistic market producing the
socially ecient output.
6
Assuming that no attempt is made to monitor or regulate the pollution,
which market structure yields higher social welfare?
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Exercises 12
Problem 4
A beekeeper lives adjacent to an apple orchard. The orchard owner benets from
the bees because each hive pollinates about one acre of apple trees. The orchard
owner pays nothing for this service, however, because the bees come to the
orchard without his having to do anything. Because there are not enough bees to
pollinate the entire orchard, the orchard owner must complete the pollination by
articial means, at a cost of $10 per acre of trees.
Beekeeping has a marginal cost MC = 10 + 5Q , where Q is the number of
beehives. Each hive yields $40 worth of honey.
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2
3
How many beehives will the beekeeper maintain?
Is this economically ecient number of hives?
What changes would lead to a more ecient operation?
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
21 / 21