Externalities

Major debate to consider whether to regulate pollution or not Government can directly or indirectly control these externalities

Markets sometimes fail (to bring about socially optimal outcomes) Externalities Property rights Public goods Externalities: Actions of a consumer or firm directly affect another persons well-being or another firms production capability. o Unintended side effects, outside of that market. Do not include indirect effects through prices. May be positive or negative. o Pollution vs beautiful scenery can be positive for some & negative for others. The inefficiency of competition with externalities Competitive firms & consumers dont have to pay for the negative externalities therefore continue producing. Firms are not compensated for positive externalities therefore no incentive to produce positive externalities. Eg. Competitive market of firms producing paper; air & water pollution (gunk) harms people living near. Each ton paper produced another unit of gunk; Reduce emissions only by reducing production. Private cost = the cost of production only excluding externalities Social cost = the private cost plus cost of harm from externalities Competitive market produces excess pollution, because firms private cost < social cost. MCp < MCs Ignore the harms of externalities Due to externalities do no maximise welfare W = social producer surplus + consumer surplus Welfare maximised where price = social marginal cost DWL is due to equating with private & social marginal cost

Sum up: Competitive markets produce excessive negative externalities. Optimal amount of pollution is > 0.

Reducing externalities Govt intervention can improve W (reduce exties). (e.g. CO2 emissions; global warming) Govt can intervene if has info about pollution damage, DD curve, costs, & technology. 2 approaches: 1. Emission standards restrict amount firms may emit, i.e. set emissions standards (command & control); 2. Emission fees/Effluent charge tax pollution: emissions fees / effluent charges (economic incentives). Lack of info may make it hard to control / tax pollution directly; govts use quantity restrictions or taxes on outputs or inputs instead. Better to regulate pollution directly (incentive to improve pollution-control technology).

Emissions standards Govt forces paper mill to produce no more than 84 tons paper / day = force it to social optimum (IF ignore posss of cleaner technology.) Problems: high info requirements: social MC, DD, & relationship between gunk & output; enforcing compliance penalties, policing

Emissions charges Taxing output or pollution levels If firm can affect r/ship between output & pollution, then tax pollution itself. If govt knows MC of gunk, set tax t(Q) = MCg, so firms private MC same as social MC, & after-tax equilibrium is at social optimum. Internalise the externality = to bear the cost of charge of damage it inflicts on others Alternatively if government knows the MCg @ social optimum level, set a specific tax of =$84 to shift MCp up to MCp + = MCs

Cost-benefit analysis Costs & benefits of gunk reduction Max W by output & pollution until MB of less pollution = MC of less output Monopoly & externalities

MR & MCp, em (Q < es here) Monopoly Q may be >, < or = soc optimum 2 offsetting effects: Tends to produce too little because p>MC Tends to produce too much because considers private, not social, MC. Net effect depends on: Elastic demand (more lower price too much) MCgunk (pollution damage; steeper too much) Welfare effects DWL from externality in competitive market is D; DWL from monopoly producing too little output is C. Taxing externalities in non-competitive markets May end up reducing welfare if already producing at lower than optimum level. May increase welfare if producing > optimum level o Therefore need more information. Failure to regulate non-competitive market is less harmful than the failure to regulate a competitive market. Property rights to reduce externalities Exclusive privilege to use an asset Legal entitlement to the benefit stream from an asset. Lack of prop rts bads & goods are unpriced (so people only consider MCpvt) Coase Therom Lack of prop rts causes externalities. If parties can negotiate, assigning property rights results in efficiency regardless of who gets the property rights. (Income distribution is affected by who gets the rights.) E.g. polluting firm & other lake users; neighbours sharing a park Problems: High transaction costs may preclude negotiation (esp with many victims). Incomplete info non-efficient outcome. *Property rights Markets for pollution: Govt determines overall level of pollution & issues tradable permits to firms for that level. Firms who can cut pollution at lower cost will do so, & sell permits to firms with higher costs Reduction in pollution at lowest total cost.

Open access property: Resources to which everyone has free access Another cause of externalities: open access, & no one pays to use. Because people arent paying, tend to overuse & overall satisfaction Common pools: e.g. of petrol, water, gas fluid pressure & availability Internet: flat fee in most countries, MC = 0 (congestion) Roads: no property right to the open road - congestion Fisheries: incentives to overfish for now - future population of fish Solutions Internalise externality o User charges, regulate, restrict access Assign property rights o Make private o Common property can be efficiently managed problem is open access, not communal ownership in itself. Public Goods Commodity or service whose consumption by one person does not preclude others from also consuming it. Positive externalities and to little production may occur when produces cannot restrict access to a public good. Private Goods Rivalry depletable Exclusion others can be prevented from consuming it.

Markets for public goods Markets for non-excludable public goods do not exist because government usually provides. With no rivalry, no point producing because people can just reuse and pass on goods. Private goods: DD is the horizontal sum of the individual DD curves. Demand for public goods Vertical sum of the individual demand curves. o Quantity does not change, but value attached to it does.

DD for guard is non-rival, non-excludable Total D = D1 + D2 : MB of society of an extra guard Competitive market - TV shop hires 4 guards o Inefficient because MB > MC Ice-cream shop gets a positive externality Free-riding Benefitting from actions of others without paying (benefit from positive externalities). Many people unwilling to pay for their share of a public good, because They benefit anyway If they do pay, others may free-ride on them o Non-optimal outcome to little provision Undersupply = prisoners dilemma o Dont do whats best for the collectively by acting independently. Reducing free-riding Social pressure small no.: community policing risk. Merge internalise positive externality and work together to get to socially optimal level. Compulsion government or other authority force firms to pay. Privatisation make excludable: individual water meters.

Valuing public goods Government has to work out if to produce and how much by comparing costs and benefits. Surveys to establish value of public goods Willingness to pay: Accuracy incentive to lie; hypothetically statement Yes-no vote: will vote if value = tax o Efficient to install if value to society is at least as great as it costs o Does not capture the intensity of the preference, ie actual value