Topic 5: Externalities and Public Goods (Ch. 18 K&R)

Transcription

1 Topic 5: Externalities and Public Goods (Ch. 8 K&R) We discuss externalities, why they lead to inefficiencies and how society can deal with them. We also discuss a special kind of commodity called a public good. Public goods are closely related to externalities and are often associated with efficiency problems. What is efficiency? [An important definition is that of a Pareto efficient allocation: An allocation where a consumer cannot be made better off without the other consumer(s) being worse off.] Externalities and Public Goods Externalities and Public Goods Externalities Example : Your neighbour plays music at 04:00 in the morning. (How about smoking in public places?) Example : Your neighbour plays music at :00. Example 3: Factories emit sulphur oxides and nitrogen oxides into the air, chemicals react with water vapour to create acids that fall to earth in the rain/snow with tremendous harmful effects on plants and animals. Example 4: Upstream firm pollutes river. Example 5: Upstream firm cleans river. Example 6: Tax competition: Country A reduces taxes thereby affecting tax revenues collected by country B. Externalities and Public Goods 3 Externality: is an action taken by one person (firm, country) that directly affects some other (and effect is transmitted not though the price system). If affects consumption then it is a consumption externality (negative or positive). If affects production then it is a production externality (negative or positive). But why externalities? Externalities and Public Goods 4 Crucial feature of externalities is that there are goods people (firms) care about that are not sold in the market. A market system in which individuals pursue their private interests will not take into account externalities. Hence the level of consumption (and production) will be inefficient (marginal benefit (MB) not equal to marginal cost (MC)). Why? Illustration: A production externality p benefit from cutting production from x to x* MSC=MPC+MEC MPC MEC Externalities and Public Goods 5 MEC=marginal external cost MSC=marginal social cost MPC=marginal production cost x* x Externalities and Public Goods 6

2 So externalities exist because there are missing markets. This implies that externalities cannot be traded. Why? Because property rights are not well defined. Example: Your neighbours may think they have the right to play the trumpet at 04:00 in the morning (but surely you also think you have the right to silence!) A two firm example: Firm is responsible for pollution while firm is affected by it (theme park). Firm produces pollution which is priced at zero price, and also ignores damage it causes to theme park (social cost). Suppose now Firm could charge Firm for the amount of pollution it generates. In this case Firm s private decision takes into account pollution. Property right given to firm Externalities and Public Goods 7 Externalities and Public Goods 8 Coase Theorem As long as property rights are well defined trade between agents will result in an efficient allocation. In general the amount of the externality generated in the efficient solution will depend on the assignment of property rights (except in one very special case). Recall Coase Theorem: Assuming there are no bargaining costs, once ownership rights to a resource are established, bargaining achieves an efficient allocation of resources. (that is as long as property rights are assigned to someone an efficient allocation will be achieved). Externalities and Public Goods 9 Externalities and Public Goods 0 Observations p x* x MSC MPC Though particular ownership of the resource is irrelevant from an efficiency point of view it is relevant from the point of view of income distribution. Problem of externalities cannot be solved if cost of bargaining deters parties from finding their way to the efficient solution. Asymmetric information (benefit is private information). Externalities and Public Goods Externalities and Public Goods

3 Government responses to externalities Regulation (typical in environmental issues): Under regulation firm is told to cut pollution by certain amount or face legal sanctions. Corrective taxes. If a good is produced inefficiently because its input price is too low then tax it! How? Use a Pigouvian tax! A Pigouvian tax is a tax levied upon each unit of polluter s output in an amount equal to the marginal damage in inflicts at the efficient level of output. p tax revenue MSC(=MEC+MPC) D S(=MPC) x* x Externalities and Public Goods 3 Externalities and Public Goods 4 Problems with Pigouvian taxes Government must be able to estimate marginal damage and this is a difficult task. Which activities produce pollutants? (though acid rain is measurable we do not know how much of it is associated with production activities and natural activities (plant decay)). Which pollutants do harm? It is often difficult to pinpoint the effect of a given pollutant What is the value of the damage done? (KR pp. 608). A well known inefficiency: The tragedy of the commons So far we have seen that if property rights are not well defined then outcomes are inefficient. Another example: the tragedy of the commons. Consider n farmers who graze cows on a common field. i Each ith farmer owns g cows with total number n n G = g + g g + g Externalities and Public Goods 5 Externalities and Public Goods 6 Suppose costs c to buy a cow. The value to a farmer of grazing a cow when G graze field is v(g) per cow. Assume that the more cows graze the less per cow output produced (average output decreasing). Study the outcomes in two markets: private ownership (a villager owns the field) and collective ownership (all villagers own the field). Externalities and Public Goods 7 Externalities and Public Goods 8 3

4 No Exclusion Exclusion Private ownership The villager would Maximisation gives MB=MC MB consists of v(g) and max { G v ( G ) c G } What happens now if the decision is private? G G v(g) Collective ownership The payoff to each farmer is { i i n max g v( g + g g +... g + g n ) c g i } i g Then each farmer has free and unrestricted access to field (and takes as given behaviour of all others). Max. outcome is inefficient. Why? i i * i An additional cow gives g v( g + g ) and costs c The harm to all farmers is g i = G n Externalities and Public Goods 9 Externalities and Public Goods 0 Graphical illustration of tragedy of the commons In other words because farmers ignore the social cost of their action and therefore collective ownership results in inefficient outcomes. MP/AP MP=marginal product c=cost of cow AP=average product n n n Externalities and Public Goods Externalities and Public Goods Classification of goods Public Goods Rivalry Pure private good: food... Common-access resources: fish... No Rivalry Public good: fire protection Pure public goods: national defence Pure public good: a good which is provided in equal amounts (non-exclud.,non-rivalry). Many public goods are provided by the government (national defence, street lighting, streets, sidewalks...). Public goods are a particular example of consumption externality (once it is provided all must consume it: e.g. National defence). Externalities and Public Goods 3 Externalities and Public Goods 4 4

5 What is the ideal amount of a public good? Particular externality but provision of a public good is very cumbersome. Why? Because it has to be agreed by all common. [Public good cannot be provided in different amounts but must be consumed equally]. Example (rather cumbersome, see Varian) with some maths : roommates and. Must decide whether to buy TV or not. TV must go in the living room and both can watch (even if one has not paid: so it becomes a public good). Is it worth it for them to acquire TV? Externalities and Public Goods 5 Externalities and Public Goods 6 Let w, w be wealth Let g, g be contribution to TV Let x, x be wealth left Budget constraints then are x + g = w x + g = w TV is bought if and only if g + g c Utilities are u ( x, G ), u ( x, G ) Reservation price: the price at which you are indifferent between paying and having the TV and not paying and not having the TV That is, u ( w r,) = u( w,0) So reservation price depends (in general) on wealth! Externalities and Public Goods 7 Externalities and Public Goods 8 Recall that an allocation is Pareto efficient if there is no way to make one person better off without making another worse off For the TV to be provided both must be made better off (Pareto improvement). There are only two allocations of interest. ( w, w,0) (public good not provided). ( x, x,) (public good provided) Externalities and Public Goods 9 A Pareto improvement (to provide public good) exists if and only if u ( w,0) < u ( x,) u ( w,0) < u ( x,) After some straightforward manipulation above becomes u ( w r,) = u ( w,0) < u ( x,) = u ( w g,) u ( w r,0) = u ( w,0) < u ( x,) = u ( w g,) Externalities and Public Goods 30 5

6 Observations In turn this gives w r < w g g < r w r < w g g < r This is the condition that must be satisfied if and allocation ( w, w,0) is Pareto inefficient (necessary condition) A sufficient is the sum of the willingness to pay exceeds the cost of TV. The condition of Pareto improvement depends only on each agent s willingness to pay and the total cost.. Whether or not it is efficient to provide the public good depends on the distribution of wealth. 3. Whether they will acquire the TV depends on the method employed to make joint decisions (free riding again). Externalities and Public Goods 3 Externalities and Public Goods 3 6