Chapter 4 Externalities, Market Failures, and Policy Interventions

1
Chapter 4 Externalities, Market Failures, and
Policy Interventions

• Learning objectives
• Evaluate positive and negative externalities in
  the context of an otherwise well-functioning
  competitive market.
• Understand the market failures associated with
  externalities, with emphasis on quantifying the
  welfare costs to society.
• Consider the welfare implications of various
  idealized public policy interventions.

2
Positive Externalities

• Illustrative example Open space, viewshed,
  wildlife habitat, watershed benefits of
  pastureland
• Suppose that pastureland is bought and sold in
  otherwise well-functioning competitive markets
  for land
• What happens if market demand only reflects the
  benefits to the private landowner?

3
Positive Externalities

• What is a positive externality?

An unpaid-for benefit to other members of society
generated as a side effect or consequence of an
economic exchange, such as between a buyer and a
seller
4
Positive Externalities

• How might there be unpaid-for benefits to society
  in the previous agricultural land example?

Nearby residents and visitors enjoy the open
space, views, wildlife, and watershed benefits
but do not have to pay for them
Why is this a problem?
5
Positive Externalities

• Unpaid for benefits are wonderful things. That
  isnt the problem

The problem is that the market will not allocate
enough resources to produce the socially optimal
quantity of the thing (pastureland) if only the
farmers benefits are reflected in
willingness-to-pay
6
Positive Externalities
Note MEB is marginal external benefit, the
external benefit per acre of land in this case
7
Positive Externalities

• Thus too much ag. land gets allocated to housing
  and commercial development rather than kept as
  pastureland under market allocation because
  external benefits are not internalized into the
  market demand curve

What are some possible interventions that could
help secure the socially optimal quantity of
pastureland in a market process?
8
Positive Externalities

• One common government intervention is to provide
  subsidies to those who provide society with
  positive externalities

• Williamson Act tax credits for preserving ag.
  land, public funding to acquire conservation
  easements
• Subsidized vaccinations
• Other examples?

Note that altruistic non-government groups like
land trusts or public health organizations can
fulfill some of this intervention function
9
Property Rights and Externalities

• Society can also decide that neighboring
  residents have a property right to some of the
  external benefits described previously, and thus
  that landowners do not have an unlimited right to
  develop their land

How does this tie in with the 5th Constitutional
Amendment concerning takings?
10
Property Rights and Externalities

• One can see that the way that property rights are
  allocated has a huge impact on the way that
  externalities are addressed by social policy

What are the five key categories of property
right and the four ownership regimes?
11
Property Rights and Externalities

• Hierarchy of rights
• Access Non-extractive right to enjoy benefits of
  property. Authorized entrants have access rights,
  such as permission to bike on timber company
  roads.

Withdrawal Right to extract or remove some or
all of the product of the property. Authorized
users have access and withdrawal rights, such as
those with valid CA fishing licenses.
12
Property Rights and Externalities

• Management Right to regulate use (access,
  withdrawal) and improvements. Claimants such as
  farmers who participate in the management of
  government-owned irrigation systems hold these
  rights.

Exclusion Right to exclude others from access,
withdrawal, and management. Proprietors who
collectively govern common-property (ex condo
swimming pool) hold exclusion rights.
13
Property Rights and Externalities

• Alienation Right to sell (alienate) property
  to someone else. Owners of cars have the right to
  sell their cars to someone else.

Frequently, we hold a limited bundle of property
rights to many different things. Usufructuary
rights, for example, are open-ended access
withdrawal rights that may run with the land
(riparian law) or may cover treaty rights (ex
Indian fishing rights). State may be owner in
public trust capacity.
14
Property Rights and Externalities

• Ownership Regimes

• Private property
• Common property
• Government (state) property
• Open access (no propertyres nullis)

15
Property Rights and Externalities

• The issue of who holds what property right
  determines how law and public policy addresses
  externalities

What is the common law, and what is it designed
to protect and enforce?
The term common law refers to the body of legal
principles which evolve through the
interpretation of law by judges, as distinct from
the body of law created through legislation. The
term originally referred to the common law of
England -- general rules applicable to the whole
country, as distinct from local customs.
16
Property Rights and Externalities

• The common law evolved to protect life, property,
  contractual rights and responsibilities, etc.

17
Property Rights and Externalities

• Thus we might ask, did common law adequately
  address or externalities?

Key problem If harms are done to an open-access
resource, who has legal standing to sue under
common-law, which protects property?
In a few rare cases, 19th century judges
recognized that water pollution impacted
downstream usufructuary rights holders. Until the
Mineral King decision, users of open access
natural resources were not widely recognized as
having the necessary legal standing to sue. Thus
common law was largely ineffectual in protecting
the environment.
18
Justice William O. Douglas in Sierra Club v.
Morton (Mineral King), 405 US 727 (1972)
"The critical question of 'standing' would be
simplified and also put neatly in focus if we
fashioned a federal rule that allowed
environmental issues to be litigated before
federal agencies or federal courts in the name of
the inanimate object about to be despoiled,
defaced, or invaded by roads and bulldozers and
where injury is the subject of public outrage.
Contemporary public concern for protecting
nature's ecological equilibrium should lead to
the conferral of standing upon environmental
objects to sue for their own preservation The
voice of the inanimate object, therefore, should
not be stilled. That does not mean that the
judiciary takes over the managerial functions
from the federal agency. It merely means that
before these priceless bits of Americana (such as
a valley, an alpine meadow, a river, or a lake)
are forever lost or are so transformed as to be
reduced to the eventual rubble of our urban
environment, the voice of the existing
beneficiaries of these environmental wonders
should be heard."
19
Property Rights and Externalities

• Note Environmental regulations essentially make
  the government a proprietor of air, water,
  fisheries, wildlife, and other former open-access
  resources in a public trust capacity.

Alternatively, land and other non-fugitive
resources can become private property and be
protected under the common law
Alternatively, many resources can become common
property and be protected under common law
20
Negative Externalities
What is a negative externality?
An uncompensated cost borne by members of society
(or the aspects of the natural world they care
about) that comes about as a byproduct of
economic exchange, such as through market
transactions.
Examples?
21
Negative Externalities
Assertion When production of a good or service
generates significant negative externalities,
profit-maximizing firms in a competitive market
will supply too much of that good or service.
Consumers will pay a subsidized price and so will
consume too much.
22
Negative Externalities
First part In a competitive market,
profit-maximizing firms will supply along their
marginal cost curves.

• Defining terms
• Profit total revenue total cost.
• Marginal cost (MC) increase in total cost
  caused by a small increase in output.
• Marginal revenue (MR) increase or decrease in
  total revenue caused by a small increase in
  output. In a competitive market, MR is equal to
  market price P.

23
Negative Externalities
If total cost a bq cq2, then. Marginal
Cost ?TC/?q b 2cq Likewise if total
revenue pq (a-bq)q, then Marginal Revenue
?TR/?q a 2bq A firm selling into a perfectly
competitive market is a price taker, implying
that MR P.
24
Negative Externalities

• Defining terms, continued
• Economic short run Time period in which capital
  is fixed.
• Law of Diminishing Marginal Returns Due to
  congestion effects, in the short run as more is
  produced in a facility of fixed size, the
  marginal cost of output becomes larger and larger.

Example Adding more and more workers at Smugs
Pizza. Costs eventually rise faster than output
due to congestion
25
Negative Externalities
Marginal analysis Start at producing zero.
Should you produce one unit? Yes, if marginal
revenue is greater than or equal to marginal cost.
Given one can profitably be produced, what about
a second unit? Yes, if MR greater than or equal
to MC.
Continue this iterative process until you get to
the point where MR (price) MC. Stop. After
that, producing one more will generate MR lt MC.
26
Negative Externalities
Illustrative Example This table shows a
marginal cost schedule that illustrates the Law
of Diminishing Marginal Returns. As quantity
supplied increases by one unit, the associated
marginal cost increases.
27
The firms MC curve is its supply curve, since
it shows the relationship between price and
quantity supplied
28
Largest available profit where P MC
29
Negative Externalities
The firms marginal cost curve is its supply
curve.
So, why should we care about all of this cost
curve analysis?
Because in an unregulated competitive market
external costs are not accounted for in the
firms marginal cost, which means that the firms
supply decision ignores external costs.
30
Negative Externalities
Marginal social cost
Marginal private cost (borne by the firm, passed
along to consumers via market price)

Marginal external cost (uncompensated costs borne
by the environment and society example PCB
contamination by Monsanto in Aniston, AL)
31
Negative Externalities
Thus there are two supply curves
The supply curve based on marginal private cost.
This is the supply curve that firms supply along
in the absence of environmental regulation or
reputational enforcement.
The supply curve based on marginal social cost.
This is the supply curve that reflects the full
social cost of production.
32
Marginal social cost
Marginal private cost
33
(No Transcript)
34
Area ABC Gross gains from trade to buyers and
sellers
Area BCDE Total external cost
Area ABC Area BCDE True net gains from trade
to all who are affected
Area AFD Max. avail. gains from trade w/
Pigouvian tax
35
Negative Externalities
Simple algebra of negative externalities
Suppose as before that demand is given by the
equation P a bq, and (private-cost) supply is
given by the equation P c dq. If marginal
external cost is e, then what is the equation
for (social-cost) supply?
Assuming that society allows firms to freely
pollute (the free market solution), derive the
reduced-form solutions for equilibrium p and q,
and describe the equation for true net gains from
trade.
36
Negative Externalities
The mathematics of negative externalities
True net gains from trade
q
?(a-c-e) (bd)qdq
0
Where q is the free market equilibrium
quantity, derived by ignoring marginal external
cost e.
37
Negative Externalities
The mathematics of negative externalities
What if instead firms were charged a per-unit tax
equal to e, and thus supplied along the
social-cost supply curve how does this change
the reduced-form solutions for p and q? By how
much are the true net gains from trade increased?
38
Negative Externalities
The mathematics of negative externalities
This (idealized) tax increases the true net gains
from trade by the amount equal to deadweight
social loss
q
DWL ? a c (bd)qdq
q
Where q is the free market equilibrium
quantity based on private-cost supply (ignoring
e), and q is the socially optimal quantity based
on the social-cost supply.
39
Negative Externalities
The mathematics of negative externalities
Note With constant marginal external cost e
and linear S and D curves, DWL simplifies to
DWL eq-q)/2
This is the classic deadweight loss triangle,
equal to marginal external cost multiplied by
one-half the quantity of excess production of the
good (e.g., electricity) that occurs when the
market ignores externalities.
40
Negative Externalities
How does the preceding analysis of externalities
change if we have non-linear demand and/or
supply?
What if demand is perfectly inelastic (i.e., the
good is a necessity with no substitutes)?
What if marginal external cost is increasing in
q? Why might that occur?
41
Negative Externalities
Theory of Efficiency-Enhancing Policy
Interventions
Pigouvian tax Tax per unit of output (e.g.,
electricity) equal to marginal external cost,
with tax revenues being used to compensate those
harmed and/or fix environmental harms.
42
Theory of Efficiency-Enhancing Policy
Interventions
What happens if the Pigouvian tax is less than
the cost per unit of cleaning up?
What happens if the Pigouvian tax is greater than
the cost per unit of cleaning up?
How does a Pigouvian tax (or environmental tax in
general) affect the market viability of less
polluting alternatives, and research and
development to find clean alternatives?
43
Theory of Efficiency-Enhancing Policy
Interventions

• For a Pigouvian tax to fully resolve the
  inefficiency due to negative externalities, the
  following must hold
• Ability to accurately measure marginal external
  cost
• Ability of the political system to produce an
  efficient environmental policy
• Ability to monitor emissions, charge appropriate
  tax, and enforce this system

44
Excel Exercise, Negative Externalities

• Demand P a - bq
• Private-cost supply P c dq
• Marginal external cost e
• In sheet 2 (label Externalities) of your
  homework file, program into Excel the
  reduced-form solutions for the free market and
  socially optimal equilibrium p, q, total
  external cost, deadweight social loss, and true
  net gains from trade.
• Using the following parameters (a 2000, b 1,
  c 100, d 2, and e 300), plot demand,
  social-cost supply, and private-cost supply in a
  diagram for different values of p and q in a
  fully labeled diagram.
• For the parameter values in 2. above, derive p,
  q, p, q, total external cost, deadweight
  social loss, and true net gains from trade.
• Perform sensitivity analysis on deadweight social
  loss by varying the parameter value for e (e
  100, 300, 500). Provide a brief narrative
  interpretation.