Externalities

1. PART FOUR: THE ECONOMICS OF THE PUBLIC SECTOR Externalities Chapter 10

2. What did we learn so far? • Part One introduced some basic concepts of economics as well as some of its tools as a science • Part Two took a first look at markets and how they work through the forces of supply and demand • Such as market equilibrium, elasticities, price floors and ceilings, taxes, etc. • Part Three analysed the implications of the market system for the welfare of society by using the concept of surplus • Welfare economics allowed us to evaluate the market economy as a whole plus issues such as taxation and international trade • The emphasis was on markets and private sector

3. What do we learn in Part Four? • Private sector is not able to satisfy all the needs of modern complex human societies • Market failures such as externalities also require collective will and action by the society • That’s why strong governments and the public sectors exists in every market economy • Part Four looks at the public sector from the perspective of economists • Ch.10 deals with externalities and their economic implications • Ch.11 introduces public goods that markets are unable to provide for the society • Ch.12 reviews public finance and the tax systems

4. What do we learn in this chapter? • In Ch.7 we claimed that the economic well-being of society is measured by the sum of consumer and producer surplus • A market economy maximises the benefits to society through the “invisible hand” of the market • Unless there are market failures which could be due to the existence of market power and externalities • Market power will be analysed in Part Five • Ch.10 analyses in detail externalities at consump-tion or production, from demand as well as supply • Then proceeds to establish the conditions and methods of government intervention in the case of market failures due to externatilities

5. Market failure and externalities • What is an externality? • When a market outcome affects parties other than the buyers and sellers in the market, the side-effects created are called externalities • Externalitiescause markets to be inefficient, and thus fail • Alternatively, an externatilty is the impact of one person’s actions on the well-being of a bystander • In the presence of externalities, society’s interestin a market outcome extends beyond the well-being of buyers and sellers in the market • The well-being of bystanders and society as a whole also needs to be taken into account

6. Negative externalities • Externalities that are costs to some other people are called negative externalities • These are uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods • The act of producing or consuming goodssometimes generates costs tothose who are not compensated for these costs, such as in • Automobile exhaust • Cigarettesmoking • Alcohol drinking • Pollution, noise, trafic jams are typical negative externatilities from everyday life

7. Positive externalities • Externatilities that are benefits to some other people are called positive externalities • These are unpaid benefits that are received by individuals who are not directly involved in the production or consumption of goods • The act of producing or consuming goodssometimes generates benefits to those who have not paid for these benefits, such as • Immunizations • Restored historic buildings • Education • Scientific and technological research • Scientific progress is a positive externality

8. Negative externalities and market inefficiency • Negative externalities lead to market failure • Negative externalities can occur whenproduction or consumption lead markets to produce larger quantities than aresocially desirable • We can distinguish between production and consumption externalities • Production externalities: social costs of production becomegreater than the private costs toproducers (i.e. alumunium smelting pollutes rivers) • Consumption externalities: social value is smaller than private value to consumers (i.e. drinking causes trafic accidents )

9. Price of Aluminum Negative externalities in production Social cost Cost of pollution Supply (private cost) Optimum Equilibrium Demand (private value) 0 QOPTIMUM QMARKET Quantity of Aluminum

10. Price of Alcohol Negative externalities in consumption Supply (private cost=social cost) Cost of drinking Equilibrium Optimum Demand Demand (Social value) (private value) 0 QOPTIMUM QMARKET Quantity of Alcohol

11. Social versus private • The slides above distinguished between social and private value as well as social and private cost • This is a very important distinction for economics that needs to be well understood • Without externalities, in a competitive market equilibrium, social value is equal to private value and social cost is equal to private cost • The value of consumption to the individual is equal to its value to society • The cost of production to the individual is equal to its cost to society • Externalities break this equality even for competitive markets

12. Negative externalities in production and consumption • The optimal level of output for society is determined at the intersection of the social-demand curve and the social-cost curve • Optimum price makes optimum output possible • Negative externality prevents the formation of optimum price and output in market equilibrium • Market equilibrium price is below optimum price • Market equilibrium quantity is above optimum quantity • Price no longer reflects either the social costs of production or the social value of the good or service in question

13. Attainment of the optimal output • How can we move this market to optimum equilibrium where social and private costs and values are equal? • Internalising an externality involves altering incentives so that people take into account the external effects of their actions • The government may intervene to internalise an externality by imposing a tax on the producer in order to reduce the equilibrium quantity to the socially desirable quantity • In other words, the move towards optimum requires an increase in the market price which can happen through a government intervention

14. Positive externalities and market inefficiency • Positive externalities in production or consumption lead to market failure • For production, the social costs of production are lessthan the private cost to producers (i.e. techno-logical research spillovers) • For consumption, the social value to is bigger than private value (i.e. education makes better citizens) • Again, positive externalities imply a non-optimum market equilibrium • Market equlibrium price is above optimum price • Market equilibrium quantity is below optimum quantity

15. Price of Robot Value of technology spillover Positive externalities in production Supply (private cost) Social cost Equilibrium Optimum Demand (private value) 0 QMARKET QOPTIMUM Quantity of Robots

16. Price of Education Positive externalities in consumption Value of Supply education (private cost=social cost) Optimum Equilibrium Demand (Social value) Demand (private value) 0 QMARKET QOPTIMUM Quantity of Education

17. Attainment of the optimal output • How can we move this market to optimum equilibrium where social and private costs and values are equal to one another? • The government can internalisepositive externality by subsidising production • A subsidy means paying the producer to produce more than the equilibrium quantity so that the socially desirable quantity is supplied • Again an intervention in the market price by the government is required to attain optimum output and price • Many cases for government subsidies (arts, museums, parks, etc) rests on this argument

18. Government policy toward externalities • We can now summarise how the government may attempt to internalise the externalities, either though • Imposing a tax on goods in the case of negative externalities • Giving a subsidy to goods in the case of positive externalities • This is easy to say but faces major difficulties in real life due to several reasons • Measuring correctly negative or positive externalities is not a very easy task • Obviously, producers facing negative externalities will try to resist taxes while those with positive externalities will demand unjustified subsidies

19. Private solutions to externalities • What is the reaction of economists to externalities? • Many economists are scared of the consequences of government intervention even to correct externalities • They try to find ways that make government action unneccessary to the problemof externalities • Private solutions which work without government intervention may include • Moral codes and social sanctions • Charitable volontary organizations • Integrating different types of businesses • Contracting between parties • Let us now review the theory that lies behind private solutions to externalities

20. Coase Theorem • Ronald Coase is an US economist who developed the theory of private solutions • The Coase theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own • Private bargaining can internalise the external effects, resulting in efficient solutions • Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible • Transaction costs are the costs that partiesmust incur to agree and follow throughon a bargain

21. Neighbor’s barking dog • Below is an example of negative externality • Mehmet has a dog often barking at night but his neighbor Ayşe dislikes the noise • Private solution implies that Ayşe pays Mehmet to stop having a dog • Private solution through contracting requires: • Negative value of barking is higher for Ayşe than the positive value of having a dog is for Mehmet • Bargaining between Mehmet and Ayşe is not very tedious and effort consuming • First condition says that welfare will be optimised only if total value increases • Second condition refers to transaction costs

22. Public policy toward externalities • Transaction costs are very important in real life and thus limit practical private solutions to externalities • When externalities are significant and private solutions are not available, the public asks the government to attempt to solve the problem • There is always a big debate in public about the basic attitude of government • The method can be either • command-and-control policies or • market-based policies • As a principle, economist prefer the market-based policies to administrative command-and-control policies

23. Command-and-Control policies • Command-and-control usually means administrative measures in the form of public regulations such as • Forbiding by law certain behaviors • Requiring again by regulation certain behaviors • Examples of command and control policies: • Requirements that all students beimmunized • Stipulations on pollution emissionlevels • Administrative measures can be very expensive to monitor to make sure they are enforced • Market players may choose not to apply if the risk of getting caught is small or the penalty negligeable • Total cost to social welfare could be higher than that of the externalities

24. Market-Based policies • Economists prefer governments to use the market forces through taxes and subsidies to align private incentives with social efficiency • Taxes that are enacted to correct the effects ofa negative externality are called Pigovian taxesafter the English economist Pigou who proposed them • A more recent proposal is tradable pollution permits • Theseallow thevoluntary transfer of the right to pollute from one firm to another • A market for these permits will rapidly develop • A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a highcost

25. Equivalence of Pigovian taxes and pollution permits (b) Pollution Permits (a) Pigovian Tax Price of Price of Pollution Pollution Supply of pollution permits P Pigovian P tax 1.A Pigovian tax sets the price of Demand for Demand for pollution... pollution rights pollution rights 0 Q Quantity of 0 Q Quantity of Pollution Pollution 2....which, together 2....which, together 1.Pollution with the demand curve, with the demand curve, permits set determines the quantity determines the price the quantity of pollution. of pollution. of pollution... Many economist believe tradable pollution permits are better than taxes to solve pollution problems

26. Conclusion • Uncompensated effects that the production or consumption of goods have on third parties are called externalities • Externalities involve crucial public issues such as pollution, traffic jams, education, scientific research • Negative externalities result in a market equilibrium beyond the social optimum with too much production • Positive externalities result in a market equilibrium short of social optimum with too little production • Solutions to externalities can be reached through private agreements (Coase Theorem) if transaction costs are low

27. Conclusion • When transaction costs are high, private solutions are no longer feasable and public policy though government intervention is required • Governments may intervene through administrative measures also called command-and-control policies • These have high monitoring and enforcement costs • Another alternative is market-based policies • Taxes for negative externalities and subsidies for positive externalities give incentives to market players to align private interest with social goals • Economist usually prefer market solutions to administrative measures