4 THE ECONOMICS OF THE PUBLIC SECTOR

1. 4 THE ECONOMICS OF THE PUBLIC SECTOR

2. Market Failure • Recall from Chapter 7: • Adam Smith had argued that the “invisible hand” of the marketplace leads self-interested buyers and sellers to an outcome in which the total surplus of society is maximized. • But that requires properly functioning markets • In reality, markets can fail • When markets fail, government intervention may help CHAPTER 10 EXTERNALITIES

3. 10 Externalities

4. Externalities and Market Inefficiency • An externality is the uncompensated impact of one person’s actions on the well-being of a bystander. CHAPTER 10 EXTERNALITIES

5. Externalities and Market Inefficiency • An externality is the uncompensated impact of one person’s actions on the well-being of a bystander. • Al’s action may affect the well-being of Betty, a bystander, in a negative or positive way. • If Al pays no compensation (when his action has a negative effect on Betty) nor receives a reward (when his action has a positive effect on Betty), the effect of Al’s action on Betty is called an externality. CHAPTER 10 EXTERNALITIES

6. In this case, Al will ignore the effects of his action on Betty when deciding whether or not to take the action • Therefore, Al may take this action even if it is undesirable for society • And, conversely, Al may refuse to take this action even if it is desirable for society • In other words, when actions have external effects, society’s total surplus might not be maximized in the free market equilibrium • Government intervention may therefore be able to increase total surplus CHAPTER 10 EXTERNALITIES

7. Externalities and Market Inefficiency • When the impact of a person’s action on a bystander is harmful, the externality is called a negative externality. • When the impact on the bystander is beneficial, the externality is called a positive externality. CHAPTER 10 EXTERNALITIES

8. Externalities and Market Inefficiency: Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs (loud pets) • Loud stereos in an apartment building CHAPTER 10 EXTERNALITIES

9. Externalities and Market Inefficiency: Negative Externalities • Should we completely ban an activity that has negative externalities? • Should we ban all cars? • Should we ban all smoking in public spaces? • Should we muzzle all dogs? • Should we ban stereos in apartment buildings? CHAPTER 10 EXTERNALITIES

10. Externalities and Market Inefficiency: Positive Externalities • Immunizations • Education • Restored historic buildings • Research into new technologies CHAPTER 10 EXTERNALITIES

11. Externalities and Market Inefficiency: Positive Externalities • Should we take all activities that have positive externalities to the max? • Should we force everybody to take flu shots? • Should we require everybody to get a PhD? • Should we restore all historic buildings? • Should we pay for every research project scientists want to do? CHAPTER 10 EXTERNALITIES

12. Public Policies toward Externalities • How should we determine the extent to which activities that have negative externalities should be tolerated? • We can evaluate virtually any policy proposal by asking how it would affect total surplus. • Recall from Chapter 7, the concept of total surplus. CHAPTER 10 EXTERNALITIES

13. Public Policies toward Externalities • Externalities can cause markets to become inefficient. • We saw in chapter 7 that total surplus is maximized in a perfectly competitive economy. • But when there are externalities, this is no longer true: • total surplus might be less than the maximum achievable. • This might provide a justification for government intervention. CHAPTER 10 EXTERNALITIES

14. Externalities and Market Inefficiency • Negative externalities from the production or consumption of a good can cause markets to produce more than is socially desirable. • Positive externalities cause markets to produce less than is socially desirable. • If and when markets fail (to produce the socially desirable quantity), government intervention may be necessary. CHAPTER 10 EXTERNALITIES

15. Supply (private cost) Equilibrium Demand (private benefit) QMARKET Ch. 7 Recap: Assume there are no externalities in aluminum consumption. Then, the height of the demand curve at, say, the 11th unit of aluminum is the benefit obtainable from the 11th unit when all 11 units are distributed among aluminum consumers so as to maximize the total benefit. Figure 1 The Market for Aluminum Price of Aluminum $10 11 Quantity of 0 Aluminum

16. Supply (private cost) Equilibrium Demand (private benefit) QMARKET Ch. 7 Recap: Assume there are no externalities in aluminum production. Then, the height of the supply curve at, the 11th unit of aluminum is the cost of the 11th unit when all 11 units are distributed among aluminum producers so as to minimize the total cost. Figure 1 The Market for Aluminum Price of Aluminum $10 $3 11 Quantity of 0 Aluminum

17. Supply (private cost) Equilibrium Demand (private benefit) QMARKET Ch. 7 Recap: When there are no externalities in aluminum production or consumption, the equilibrium quantity (QMARKET) maximizes social surplus. Figure 1 The Market for Aluminum Price of Aluminum Quantity of 0 Aluminum

18. Welfare Economics Without Externalities: A Recap • When there are no externalities, the equilibrium quantity: • is efficient • maximizes total surplus • Total surplus = total benefits – total costs • is the socially desirable quantity CHAPTER 10 EXTERNALITIES

19. Social, private, and external costs • When the production of aluminum causes pollution … • Social cost of aluminum = private cost + external cost • Private cost is the cost to aluminum producers of the raw materials and labor used in production • External cost is the cost to bystanders of having to deal with the effects of pollution CHAPTER 10 EXTERNALITIES

20. Social cost External Cost Supply (private cost) Optimum Equilibrium Demand (private benefit) QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum Quantity of 0 Aluminum

21. Social cost ExternalCost Supply (private cost) Equilibrium Demand (private benefit) QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum Optimum A G E F B I H C D J K L Quantity of 0 Aluminum

22. Social cost ExternalCost Supply (private cost) Equilibrium Demand (private benefit) QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum Optimum A G E F B I H C D J K L Quantity of 0 Aluminum

23. Externalities and Market Inefficiency: Negative Externalities • The intersection of the demand curve and the social cost curve determines the optimum, which is the socially optimal output level. • Note that the optimum output is less than the equilibrium output. • This means there has been a market failure; the market outcome does not maximize total surplus CHAPTER 10 EXTERNALITIES

24. Public Policies toward Externalities • Can public policy fix the market failure? • Command-and-Control Policy: Regulation • Market-Based Policy: Corrective Taxes • Market-Based Policy: Tradable Pollution Permits CHAPTER 10 EXTERNALITIES

25. Public Policies toward Externalities: Command-and-Control Policies • Such policies usually take the form of regulations: • Forbid certain behaviors. • Require certain behaviors. • Examples: • Requirements that all students be immunized. • Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). CHAPTER 10 EXTERNALITIES

26. Public Policies toward Externalities: Command-and-Control Policies • If the EPA decides it wants to reduce the amount of pollution coming from a specific plant, it could… • tell the firm to reduce its pollution by a specific amount (i.e. regulation). • levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). CHAPTER 10 EXTERNALITIES

27. Price buyers pay Supply Tax Price without tax Price sellers receive Demand Public Policies toward Externalities: Market-Based Policy 1: Corrective Taxes Price Ch. 6 Recap Quantity before tax Quantity after tax Quantity 0

28. Social cost Supply Supply (private cost) Optimum Equilibrium Equilibrium Demand Demand (private value) QOPTIMUM QOPTIMUM QMARKET QMARKET Public Policies toward Externalities: Market-Based Policy 1: Corrective Taxes Price of Price Aluminum We saw in Ch. 6 that a tax (on either buyers or sellers of aluminum) will reduce the quantity bought and sold in the aluminum market. If the per-unit tax is set equal to the per unit external cost, the quantity bought and sold will be reduced to exactly the optimum amount. Problem solved! Per-unit External Cost Corrective Tax Quantity of Quantity of 0 0 Aluminum Aluminum

29. Public Policies toward Externalities: Market-Based Policy 1: Corrective Taxes • A corrective tax solves the problem caused by negative externalities by forcing the consumers and producers of aluminum to internalize the pollution externality of aluminum production • Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. • Corrective taxes are also called Pigovian taxes. • They were originally proposed by the British economist, A. C. Pigou. CHAPTER 10 EXTERNALITIES

30. Public Policies toward Externalities: Market-Based Policy 2: Tradable Pollution Permits • The government can do the following: • require permits for aluminum production • issue QOPTIMUM permits by auctioning them off • Each permit will sell for a price equal to the unit cost of pollution • The effect will be identical to a corrective tax equal to the unit cost of pollution CHAPTER 10 EXTERNALITIES

31. Public Policies toward Externalities: Market-Based Policy 2: Tradable Pollution Permits • The price of each tradable pollution permit will be equal to the unit cost of pollution • Why? CHAPTER 10 EXTERNALITIES

32. Public Policies toward Externalities: Market-Based Policy 2: Tradable Pollution Permits • Corrective taxes on the producers or consumers of pollution • Tradable pollution permitsthatallow thevoluntary transfer of the right to pollute from one firm to another. • 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 high cost. CHAPTER 10 EXTERNALITIES

33. Pigovian P tax 1. A Pigovian tax sets the Demand for price of pollution rights pollution . . . Q 2. . . . which, together with the demand curve, determines the quantity of pollution. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (a) Pigovian Tax Price of Pollution Quantity of 0 Pollution

34. Supply of pollution permits P Demand for pollution rights Q 1. Pollution 2. . . . which, together permits set with the demand curve, the quantity determines the price of pollution . . . of pollution. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (b) Pollution Permits Price of Pollution Quantity of 0 Pollution

35. Externalities and Market Inefficiency • A technology spillover is a positive externality that is created when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. • Education benefits the student and also all members of society who are affected by the student CHAPTER 10 EXTERNALITIES

36. Supply (private cost) Equilibrium Optimum Social benefit Demand (private benefit) QOPTIMUM QMARKET Figure 3 Education and the Social Optimum Price of Education Quantity of 0 Education

37. Public Policies toward Externalities • When an activity—such as education—has positive externalities: • The social value of the good exceeds the private value of the good. • The optimal output level is more than the equilibrium quantity. • The market produces a smaller quantity than is socially desirable. CHAPTER 10 EXTERNALITIES

38. Public Policies toward Externalities: Corrective Subsidies • What can be done to get the market to increase education to the optimal level? • A subsidy for either students (buyers of education) or educational institutions (sellers) will work. • A subsidy will make students and educational institutions internalize the positive externality of education CHAPTER 10 EXTERNALITIES

39. Public Policies toward Externalities: Corrective Subsidies • Recall that technology spillovers are positive externalities • Therefore, the equilibrium level of spending on research will be less than the socially desirable level • Government intervention may promote technology-enhancing industries • Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. • The patent is then said to internalize the externality. CHAPTER 10 EXTERNALITIES

40. PRIVATE SOLUTIONS TO EXTERNALITIES • Government action is not always needed to solve the problem of externalities. • In some cases, the free market ends up maximizing total surplus even when there are externalities CHAPTER 10 EXTERNALITIES

41. PRIVATE SOLUTIONS TO EXTERNALITIES • Moral codes and social sanctions • Charitable organizations • Integrating different types of businesses • Contracting (bargaining, negotiations) between those causing the externalities and those affected by the externalities CHAPTER 10 EXTERNALITIES

42. Private Solutions to Externalities: The Coase Theorem • The Coase Theorem is the proposition—due to Ronald Coase—that if people can bargain without transaction costs over the allocation of resources, they can solve the problem of externalities on their own, without government intervention. • Transaction costs are the costs that people incur in the process of agreeing to and following through on a bargain. CHAPTER 10 EXTERNALITIES

43. Bob, Spot, and Jane and Ronald Coase Bob and Jane are room mates. Bob gets Spot, a noisy dog, as a birthday gift. Coase Theorem: Private solutions to externalities can work

44. Bob, Spot, and Jane and Ronald Coase • Note that when the free market outcome is not optimal, bargaining between Bob and Jane will bring about the optimal outcome, irrespective of who is favored by the law • The law is important in other ways, however. For example, in one case in which the law favors Bob , Jane has to pay a $500 compensation to Bob to get him to return Spot CHAPTER 10 EXTERNALITIES

45. Coase Theorem: Exercise • In the case of pollution by an aluminum factory, how might production of the socially desirable amount be brought about without taxation by the government? • Why might Coase’s solution fail, as a practical matter, in this case? CHAPTER 10 EXTERNALITIES

46. Private Solutions to Externalities: Why Private Solutions Do Not Always Work • Sometimes the private solution fails because transaction costs are so high that private agreement is not possible. • Bob might get greedy and try to haggle with Jane for more than $500 • Change the story by substituting three people (Jan, Jeanne and Joan) instead of Jane. Jan, Jeanne and Joan may find it hard to raise $500 for Bob’s compensation. Each might try to free ride on the others. CHAPTER 10 EXTERNALITIES

47. Policy Exercises • Should we punish the use of SUV’s and promote the use of smaller cars? • Should we force car makers to sell cars with higher mileage? • Should we limit the use of gasoline by each car owner? • Should we tax gasoline? • Should we tax all fuels based on the damage each fuel causes? CHAPTER 10 EXTERNALITIES

48. Any Questions? CHAPTER 10 EXTERNALITIES

49. Summary • When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. • Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. • Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. CHAPTER 10 EXTERNALITIES

50. Summary • Those affected by externalities can sometimes solve the problem privately. • The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. CHAPTER 10 EXTERNALITIES