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EXTERNALITIES ECO 2023 Principles of Microeconomics Dr. McCaleb

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TOPIC OUTLINE Externalities: Basic Concepts Positive Externalities Inefficiency with a Positive Externality Public Policy to Improve Efficiency Negative Externalities Inefficiency with a Negative Externality Public Policy to Improve Efficiency Application: Resource Conservation

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Externalities: Basic Concepts

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EXTERNALITIES: BASIC CONCEPTS Externalities Definition A cost or benefit arising from production that falls on someone other than the producer, or a cost or benefit arising from consumption that falls on someone other than the consumer.

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EXTERNALITIES: BASIC CONCEPTS Externalities Positive externality or external benefit A production or consumption activity that creates an external benefit. Negative externality or external cost A production or consumption activity that creates an external cost.

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Positive Externalities

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POSITIVE EXTERNALITIES Private Benefits and Social Benefits Marginal private benefit The benefit to the consumer of an additional unit of a good or service. Marginal external benefit The benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.

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POSITIVE EXTERNALITIES Private Benefits and Social Benefits Marginal social benefit The marginal benefit enjoyed by the entire society—by the consumers of a good or service and by everyone else who benefits from it. Marginal social benefit is the sum of marginal private benefit and marginal external benefit: MSB = MB + Marginal external benefit

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POSITIVE EXTERNALITIES Private Benefit and Social Benefit with an Externality

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POSITIVE EXTERNALITIES Economic Efficiency with a Positive Externality Market equilibrium is inefficient with a positive externality If an external benefit is uninternalized, consumers choose the quantity at which marginal private benefit equals marginal cost. They ignore or are unaware of the external benefit received by others. Efficiency requires that marginal social benefit be equal to marginal cost. Therefore, with an uninternalized external benefit, the market equilibrium is inefficient because of underproduction. There is too little of the good.

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POSITIVE EXTERNALITIES

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POSITIVE EXTERNALITIES

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POSITIVE EXTERNALITIES Public Policy and External Benefits Internalizing an external benefit Internalizing an external benefit means altering incentives so that consumers take into account the external effects of their actions. When an external benefit is internalized marginal private benefit equals marginal social benefit in equilibrium, marginal social benefit equals marginal cost therefore, the equilibrium is efficient.

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POSITIVE EXTERNALITIES Public Policy and External Benefits Education is an example of a positive externality We use education to illustrate public policy actions for internalizing an external benefit. The external benefits from education can be internalized by Public provision Producer subsidies Vouchers (consumer subsidies)

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POSITIVE EXTERNALITIES

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POSITIVE EXTERNALITIES

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POSITIVE EXTERNALITIES

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Negative Externalities

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NEGATIVE EXTERNALITIES Private Costs and Social Costs Marginal private cost The cost of producing an additional unit of a good or service that is borne by the producer of that good or service. Marginal external cost The cost of producing an additional unit of a good or service that falls on people other than the producer.

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NEGATIVE EXTERNALITIES Private Costs and Social Costs Marginal social cost The marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. Marginal social cost is the sum of marginal private cost and marginal external cost: MSC = MC + Marginal external cost

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NEGATIVE EXTERNALITIES Private Cost and Social Cost with an Externality

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NEGATIVE EXTERNALITIES Economic Efficiency with a Negative Externality Market equilibrium is inefficient with a negative externality If an external cost is uninternalized, producers choose the quantity at which marginal benefit equals marginal private cost. They ignore or are unaware of the external cost imposed on others. Efficiency requires that marginal benefit be equal to marginal social cost. Therefore, with an uninternalized external cost, the market equilibrium is inefficient because of overproduction. Too much of the good is produced.

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NEGATIVE EXTERNALITIES Inefficiency with an External Cost

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NEGATIVE EXTERNALITIES

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NEGATIVE EXTERNALITIES Public Policy and External Costs Internalizing an external cost Internalizing an external cost means altering incentives so that producers take into account the external effects of their actions. When an external cost is internalized marginal private cost equals marginal social cost in equilibrium, marginal social cost equals marginal benefit therefore, the equilibrium is efficient.

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NEGATIVE EXTERNALITIES Public Policy and External Costs Pollution is an example of a negative externality We use pollution to illustrate public policy actions for improving economic efficiency when there are external costs. Zero pollution is not an option. Pollution imposes costs on society, but the production activities that generate pollution also confer benefits. The objective is to balance the costs of pollution against the benefits from the goods and services whose production generates pollution—in other words, to find the optimal or efficient amount of pollution.

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NEGATIVE EXTERNALITIES

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NEGATIVE EXTERNALITIES Public Policy and External Costs Quasi-market policies to achieve optimal pollution Economists favor quasi-market approaches that rely on incentives to improve efficiency when there is pollution. Quasi-market approaches to reducing pollution include Marketable permits (or tradable emission rights) Emission charges Pollution taxes

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NEGATIVE EXTERNALITIES Public Policy and External Costs Marketable permits The optimal amount of pollution in a geographic area is determined based on marginal benefits and marginal costs. Each polluter is assigned a pro rata share of the total allowed pollution. Polluters are allowed to buy and sell their pollution permits. In this way, a market is created in pollution rights and the market establishes prices for the right to pollute. Polluters who can reduce pollution at relatively low cost sell their permits to polluters for whom pollution reduction would be relatively more costly.

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NEGATIVE EXTERNALITIES Public Policy and External Costs Emission charges A price charged to polluters per unit of pollution. Emission charges have effects similar effects to pollution taxes. Pollution taxes A tax imposed on polluters equal to the marginal external cost of the polluting activity.

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NEGATIVE EXTERNALITIES

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NEGATIVE EXTERNALITIES Public Policy and External Costs Advantages of quasi-market policies Quasi-market policies are more efficient than regulation in promoting economic efficiency and achieving optimal pollution. The desired amount of pollution reduction is achieved at the lowest possible cost. Because pollution rights have a price, polluters have incentives to substitute less-polluting technologies for existing technologies or to develop new less-polluting technologies.

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NEGATIVE EXTERNALITIES Public Policy and External Costs Regulation is costly and often inefficient because it Shifts decision-making from consumers and producers who have better information about benefits and costs to bureaucrats and politicians who have less information about benefits and costs. Is inflexible and slow to respond to changes in benefits and costs. Is often politically motivated and promotes special interests rather than promoting economic efficiency and the public interest. Imposes high administrative costs.

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NEGATIVE EXTERNALITIES Private Action to Internalize an Externality Private action is an alternative to public policy Many externalities are internalized by private action—by private negotiation among the affected individuals, by adjustment of market prices, and by rearrangement of property rights. No public policy action is necessary to internalize these externalities. If only a small number of individuals are involved and transaction costs are low, then private negotiation among the affected individuals can internalize an externality. With complete and efficient markets, market prices may internalize externalities, increasing to reflect the value of an external benefit or decreasing to reflect an external cost.

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NEGATIVE EXTERNALITIES Final Observation Not every externality problem is worth solving An uninternalized externality imposes an opportunity cost on society. The opportunity cost is the deadweight loss that arises from overproduction with a negative externality or underproduction with a positive externality. But, there are also costs to internalizing an externality. Sometimes the costs of internalizing the externality are greater than the cost of the externality. In that case, the optimal action is no action—do nothing. Internalizing the externality costs more than it is worth.

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Application: Resource Conservation

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APPLICATION: RESOURCE CONSERVATION Property Rights and Conservation Private property encourages optimal conservation Many people mistakenly believe that resources are more likely to be conserved for the future and less likely to be depleted if they are owned in common than if they are private property. In fact, quite the opposite is true. Unlike common property rights, private property rights provide incentives for optimal conservation of a resource and ensure against too rapid depletion of a resource.

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APPLICATION: RESOURCE CONSERVATION Common Property Resources Definition A resource for which rights are held in common by a group of individuals none of whom has exclusive ownership. With common property resources, property rights are absent or incomplete. Typically, the only right to a common property resource that an individual possesses is the right to current use of the resource. In particular, an individual has no guaranteed future interest in the resource.

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APPLICATION: RESOURCE CONSERVATION Common Property Resources Common property rights create uninternalized externalities An individual who refrains from consuming a resource now and conserves it for the future incurs a cost. The cost is the loss in value the individual would obtain from current consumption. But the individual also creates a benefit by increasing the amount of the resource available for future consumption.

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APPLICATION: RESOURCE CONSERVATION Common Property Resources With common property rights, the benefits from future consumption may be enjoyed by all of society. Thus, conservation generates external benefits so there is too little conservation and too much current consumption. Because of the absence of private property rights, especially the lack of a guaranteed future interest, common property resources tend to be overused, poorly maintained, and depleted too rapidly.

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APPLICATION: RESOURCE CONSERVATION Externalities and Property Rights Externalities arise when private property rights are absent or unenforced Private property rights provide incentives for individuals to use resources efficiently and prevent individuals from imposing costs on others without compensation. Externalities arise when private property rights are either absent or unenforced. By establishing private property rights and enforcing existing rights, some externalities can be internalized.

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APPLICATION: RESOURCE CONSERVATION Externalities and Property Rights Example: Property rights and pollution Suppose polluting factories own a river and the homes along it. The more the factories pollute, the less rent are people willing to pay to live in the homes. Suppose the residents own the river and the homes. Then, the factories must pay the homeowners for polluting the river. The more the factories pollute, the more they pay.

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APPLICATION: RESOURCE CONSERVATION Externalities and Property Rights Either way, regardless of who owns the river, so long as someone owns it, the factories bear the cost of polluting the river, the quantity of the goods produced is efficient, and the amount of pollution is optimal. But if there are no enforced property rights, if neither the factories nor the residents own the river, the factory can pollute the river without bearing any cost. The costs of the pollution fall on the residents, and there is overproduction and too much pollution.

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APPLICATION: RESOURCE CONSERVATION Efficiency with Private Property Rights

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APPLICATION: RESOURCE CONSERVATION Efficiency with Private Property Rights

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APPLICATION: RESOURCE CONSERVATION Private Property and Optimal Conservation Prices determine the timing of resource consumption The expected future price, PF, of a resource reflects the expected value of consuming one more unit of the resource in the future. The current price, PC, reflects the value of consuming one more unit of the resource today. If the resource is privately owned, the owner has an incentive to conserve the resource for future consumption if PF>PC and to consume the resource today if PF

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APPLICATION: RESOURCE CONSERVATION Private Property and Optimal Conservation Prices reflect marginal benefits and marginal costs The value of consuming one more unit of a resource in the future is the marginal benefit from conservation. But this means PF=MB of conservation. The value of consuming one more unit of a resource today is the marginal benefit of consumption today, or alternatively, it is the marginal cost of conservation. So, PC=MB of current consumption=MC of conservation.

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APPLICATION: RESOURCE CONSERVATION Private Property and Optimal Conservation Prices provide incentives for optimal conservation Resource owners will conserve more and consume less today if PF>PC. But this means MB of conservation>MC of conservation. Resource owners will conserve less and consume more today if PF

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APPLICATION: RESOURCE CONSERVATION Private Property and Optimal Conservation Competitive markets and efficient conservation In competitive markets with private property rights, the quantity of the resource that is conserved for future use is the quantity at which the expected future price equals the current price. But that is also the quantity at which the marginal benefit from conservation of the resource equals the marginal cost. And that is the rule for optimal conservation. With private property rights, competitive market prices guide resource owners toward optimal conservation of a resource.

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APPLICATION: RESOURCE CONSERVATION Private Property and Resource Depletion Private property rights prevent too rapid depletion of a resource Contrary to popular belief, resource depletion is less likely to occur with private property rights in resources, competitive markets, and unregulated prices than with common property rights and regulation. Markets and prices provide a self-limiting mechanism that prevents rapid depletion of a valuable resource. As a resource becomes scarcer, its price increases and consumption decreases so that depletion is avoided.

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APPLICATION: RESOURCE CONSERVATION Markets, Prices, and Resource Depletion

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APPLICATION: RESOURCE CONSERVATION Markets, Prices, and Resource Depletion

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APPLICATION: RESOURCE CONSERVATION Markets, Prices, and Resource Depletion

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APPLICATION: RESOURCE CONSERVATION Summary Private property rights and economic efficiency With a complete set of private property rights in resources there are no uninternalized externalities. competitive market prices guide resource owners toward optimal conservation of a resource. resources are efficiently used, efficiently maintained, and efficiently conserved so as to maximize the net social benefit of the resources.

Теги Externalities

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