MessedUp Markets I

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Messed-Up Markets I Externalities
Externality A cost or benefit not paid or
received by the individuals making the production
or consumption decisions. Such markets have
equilibria in which the quantity produced does
not maximize economic welfare. In these cases,
society can do better by devising policies to
move the quantity in the right direction.
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Example 1. Pollution
Donora, PA October 31, 1948. 20 people died and
6,000 people out of a population of 14,000 were
sickened over a five-day period by pollution
emitted from the local zinc factory.
Donora was among first US proof that industrial
pollution kills. 1950 First Federal Conference
on Air Pollution 1963 First Clean Air Act
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Pollution was so bad in some places, water burned.
The Cuyahoga River fire became a rallying point
for the Clean Water Act.
The Cuyahoga River on fire, 1952. Cleveland, OH
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In Bhopal, 1984, 20,000 are killed and 120,000
maimed when the Union Carbide plant released a
cloud of methyl isocyanate
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But in some places, its not accidents that
destroy the quality of life. In some cities,
pollution has made life hell on a daily basis . .
. .
Union Square Pittsburgh, 1906.
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In Pittsburgh, the lights stayed on all day. . .
.
Pittsburgh at 1000am. 1940s
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. . . ladies walked around with masks on their
faces, . . . .
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. . . buildings got dirty, . . . .
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. . . and the Steelers had to develop a wicked
running game .
Bill Dudley, 1942 Auditioned for the Addams Family
Byron Whizzer White, 1938 Led the league in
rushing
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. . . which no doubt distracted them from their
cheerleaders . . .
The Steelerettes, 1961
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. . . who couldnt be seen across the field on
most days anyway..
The Steelerettes, 1961
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The social cost of pollution.
The socially-optimal output level sets the full
cost equal to the willingess to pay.
The market output level has the firms cost equal
to the willingess to pay.
Pollution costs reduce the socially-optimal
output level below the free-market level.
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Some policies that attain the social optimum.
A price floor limits consumer demand
A tax reduces the incentives to produce and
consume.
A quota limits producer output
A price caps limits producer output
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Some policies that attain the social optimum.
A tax reduces the incentives to produce and
consume.
The correct tax is exactly equal to the cost of
the pollution. This is called a Pigouvian tax.
A Pigouvian tax internalizes the externality,
making the pollution cost part of the private
production cost
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Example 2. Education
Society appears to believe that the education of
young people has a social value over and above
what students can get for themselves in terms of
higher wages.
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Except. . . . . .
The social benefit of MBA students as revealed by
FIU tuition fees
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A subsidy is appropriate when the social benefit
exceeds the private benefit.
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Example 3 Vaccinations
Benefit of having a vaccine is lower the greater
the fraction of the population already vaccinated.
This externality generates unstable cycles in
vaccination rates.
Externalities associated with vaccinations can
lead to instability in vaccination rates.
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Pertussis (whooping cough) vaccination rates and
disease incidence in the United Kingdom.
Low disease incidence induces decline in
vaccination rate . . .
. . . which raises the disease incidence rate .
. . .
. . . which in turn raises the vaccination rate
again.
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Example 4 Network Externalities
The personal benefit increases with the fraction
of the population already having the item.
This externality makes it hard to get a market
going, and hard to unseat a successful product.
Network externalities can create two stable
outcomes.
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Do keyboards suck?
1868 Christopher Sholes, patented the QWERTY
layout. Sholes arranged his keyboard to avoid
jamming keys most likely to be struck in close
succession were at opposite sides of the machine
1936 August Dvorak patented the Dvorak
Simplified Keyboard (DSK) claiming that it
dramatically reduced necessary finger
movements. Although supposedly faster, it never
took off.
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Example 5. Lojack versus The Club.
The club is a visible deterrent and hurts your
neighbors. The Lojack is an invivisble deterrent
and helps you neighbors.
When your neighbor installs a burglar alarm,
thoughtful burglars are encouraged to choose a
different target like your house. Its rather
as if your neighbor had hired an exterminator to
drive all the vermin next door. On the other
hand, if your neighbor installs video cameras
that monitor the street in front of your house,
he might be doing you a favor. So the spillover
effects of self protection can be either good or
bad. Landsburg (1997)
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Auto theft rates and the Lojack.
Non-Lojack cities.
Lojack cities.
Years pre and post Lojack arrival
Incentives matter! cities with Lojack were the
ones in which auto theft declined most rapidly,
even though only a modest fraction of autos had
Lojack.
Incentives matter! cities with most rapid growth
in auto theft were the ones in which Lojack was
introduced.
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Private Solutions to Externalities The Coase
Theorem
Trains travelling through farmland shower sparks,
and damage crops. Are there too many trains?
Should we place a Pigouvian tax on trains?
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The Coase Theorem say not necessarily.
Get farmers and railroad together, and they might
be able to work out an efficient solution for
themselves. Farmers could offer to pay the
railroads not to run the trains. If the cost of
the payment necessary to stop a train from
running is less than the damage to the corn field
when the train is running, then it is worth
making such a deal and the train wont run. If
the necessary payment exceeds the cost of the
damage, then it is not worth making the deal, and
the train will run. It turns out that farmers,
making this calculation, will stop just enough
trains and not too many -- so that the number
of trains left running after the deals have been
struck is exactly the number that maximizes
economic welfare.
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The farmers calculation .
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Total compensation paid by farmers under the
Coase Theorem.
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Is this unfair? Trains are causing the damage, so
why should farmers be forced to pay?
Answer 1 Trains by themselves are not causing
any damage. It is the juxtaposition of the
railroad and the corn fields that result in
damage. Thus the farmers, by having cornfields
next to the railroad, are contributing just as
much to the damage of the corn as are the trains.
Answer 2 If you still dont like the fact that
the farmers must pay for the damage, Government
can change the rules Pass a law stating that
farmers have the right not to have their
cornfields burned. Then the railroad will have
to pay the farmers.
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Compensation paid by railroads under the Coase
Theorem.
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The Policy Challenge Measuring Externalities
When the Coase Theorem does not work, Government
must devise the right policy. To do this, it
must know the cost or value of the
externality. This is a challenging task because
there are no markets to observe.
The text contains some examples of how economists
have gone about this task.
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Summary
In the presence of externalities, the market will
attain an equilibrium in which economic welfare
is not maximized. In contrast to the examples
of policy intervention seen in Chapter 5, an
appropriate policy can, in the presence of
externalities, raise economic welfare. However,
the Coase Theorem states such interventions may
not always be necessary. When the Coase Theorem
does not provide a way out, the government must
be able to measure the size of the externality.
This can be quite difficult in practice.
Economists have tricks up their sleeves, but in
all cases we can only obtain rough estimates of
the size of an externality, and hence only rough
guidelines about the correct size of the tax or
subsidy.