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  1. Interventions Lesson 19: Governments and Externalities

  2. Voluntary Trade Creates Wealth Economic Reasoning Principle # 4: Institutions are the “rules of the game” that influence choices. Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions (controlling behavior) set out and establish the incentive structure and the basic design of the economic system.

  3. The Rules of the Game • Rule of Law exists when rules that govern behavior and interactions among individuals and groups of individuals apply to both the governed and the governing. • Rule of Man exists when laws are applied at the discretion of the governing. • Under the Rule of Force, people own what they can defend.

  4. Types of Government Intervention • Autistic • One way, forced • Aggressor gets nothing in exchange • Homicide

  5. Types of Government Intervention • Binary • There is something in exchange to the aggressor • Robbery, rape • Draft • Taxation

  6. Types of Government Intervention • Triangular • Aggressor interferes with two other parties • Price controls • Contract interference • Qualities of products • Minimum wages • Light bulbs • FDA

  7. Externalities An externality arises when an activity influences the well-being of others with no compensation for that effect. When the impact is adverse, the externality is negative. It is Over done! When the impact is beneficial, the externality is positive. It is Under done!

  8. Externalities? Suppose that you show up at the Prom and another girl is wearing the same dress. Is this a positive or negative externality? Why? In John Grisham’s recent novel, The Appeal, a chemical company pollutes the town drinking water by improperly disposing of chemical waste. Cancer rates in the town soar after several years of dumping. Is this a positive or negative externality? Explain that the “rule of law” in our legal system has established liability laws that attempt to sort out responsibility in these types of situations. This is not true in many less developed countries.

  9. Externalities? Your brother or sister just finished a big homework assignment and is relaxing by watching TV. However, the sound is rather loud. Is this a positive or negative externality? How are such disputes settled in your family? A smoker lights up a cigar as you wait for a bus. Is this a positive or negative externality? Why? Ask about the present and future costs (smelly clothes now and possible health effects later in life).

  10. Addressing the Free Rider Problem Government coercion is necessary to ensure all “beneficiaries” bear part of the cost, as well as “producers.”

  11. Technology – reducing the need for government in the economy For example: technology may provide the ability to exclude and to charge “free riders,” which would create incentives for private producers to enter the market.

  12. In 19th century England, lighthouses were operated more like private goods. The owners of local ports were charged with the service and if they did not pay, the owner of the lighthouse simply turned off the light and ships avoided stopping in that port. Although it can work in the other direction? Street lights as technology leading to new public goods?

  13. Teaser #3: Luke:  "The unemployment rate went up between May and June of 1991.“ Stacey:  "the number of people employed rose between May and June of 1991."  Luke and Stacey seem to be contradicting each other, but both of their claims are correct.  Can you explain why these statements aren't contradictory?

  14. Solution: It's possible for both the unemployment rate and the number of persons employed to increase if the labor force expands.  The unemployment rate is equal to the number of unemployed divided by the labor force (number of unemployed plus employed).  In May of 1991, there were 125,232,000 people in the civilian labor force, of which 116,591,000 were employed and 8,640,000 were unemployed.  The unemployment rate was 8,640,000/125,232,000 = 6.9%.  In June, the civilian labor force had grown to 125,629,000, of which 116,884,000 were employed and 8,745,000 were unemployed.  While the number of employed persons increased over that period, the unemployment rate rose to 8,745,000/125,629,000 = 7.0%.

  15. A free-rider experiment • You have the choice to vote “me” or “us” • I will pay everyone $.05 for each “us” vote • In addition I will pay $.25 to each person who votes “me” • Put your name and vote on a piece of paper

  16. Externalities MB > MC MB of government provision of goods or services may exceed MC if considerable externalities (negative or positive) accompany production BUT don’t forget, government has no costs!!!!!

  17. Externalities • A Positive Externality is when all of the benefits of a choice are not captured by the chooser. • Since the chooser does not get all the benefits of the choice, she will tend to do too little of the activity. • Positive Externalities are inefficient because they result in underproduction

  18. Positive Externalities

  19. Positive Externalities

  20. Positive Externalities

  21. Externalities • A Negative Externality is when all of the costs of a choice are not paid by the chooser. • Since the chooser does not pay all the costs of the choice, she will tend to do too much of the activity. • Negative Externalities are inefficient because they result in overproduction.

  22. Negative Externalities

  23. Negative Externalities

  24. Negative Externalities

  25. Positive ? Negative ? Might depend which way the wind blows !

  26. Global Warming OR ???

  27. Captain Planet Captain Planet, he's our heroGonna take pollution down to zero He's our powers magnifiedAnd he's fighting on the planet's side Captain Planet, he's our heroGonna take pollution down to zero Capt. Planet doesn’t understand marginal analysis

  28. Marginal Analysis “EPA cleanups of superfund sitescost an average of $12 billionfor every cancer case prevented.” “Super Fund Follies” Dec., 1999

  29. What's Wrong with this Picture?

  30. Concepts: Incentives, adverse selection and moral hazard Adverse selection suggests that speeders will be more likely to sign up for this kind of insurance, while moral hazard suggests they'll have little incentive to slow down once they're insured. Both of these problems mean that the insurance company would have to pay out a lot of claims.  The problems of adverse selection and moral hazard plague many insurance markets. 

  31. Externalities A River Spills Through It

  32. Market Failures? • When property rights are poorly defined the Benefits and Costs of an activity may not be correctly considered when choices are made. • Many times, the wrong choice is made if the all of the costs or all of the benefits of an activity are not captured by the person making the decision.

  33. Solutions • The problem of externalities can be solved by establishing and enforcing property rights. • When there is a property right, the chooser is forced to consider the full • value or cost of her decisions. For Example………

  34. When the Resource can be Owned • Ronald Coase • If people can negotiate at low cost, the efficient outcome will occur regardless of who owns the property right

  35. Coase Theorem • If all parties involved can easily organize payments so as to pay each other for their actions, then an efficient outcome can be reached without government intervention. • Government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. • Property rights be well defined • People act rationally • Transaction costs be minimal • If all of these conditions apply, the private parties can bargain to solve the problem of externalities.

  36. Coase Theorem • For example, with a steel factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. • Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for the regulation and enforcement with taxes.

  37. Coase Theorem • The case of the vaccinations would also not satisfy the requirements of the Coase Theorem. • Potential external beneficiaries of vaccination are the people themselves, the people would have to self-organize to pay each other to be vaccinated. • Such an organization that involves the entire populace would be indistinguishable from government action.

  38. Coase Theorem • A logger is planning to clear-cut a forest in a way that has a negative impact on a nearby resort, the resort-owner and the logger could, in theory, get together to agree to a deal. • The resort-owner could pay the logger not to clear-cut – or could buy the forest. • What if the forest literally does not belong to anyone; the question of "who" owns the forest is not important, as any specific owner will have an interest in coming to an agreement with the resort owner (if such an agreement is mutually beneficial). • Remember Coase disregards property rights

  39. Pollution Benefits Factory $10,000 Injures Fisherman $20,000 Optimal Outcome – Clean Up

  40. Pollution Benefits Factory $20,000 Injures Fisherman $15,000 Optimal Outcome – Pollute

  41. Pollution Benefits Factory $20,000 Injures Fisherman $15,000 Suppose the Factory Own the Lake. What will happen? The Lake will be polluted

  42. Pollution Benefits Factory $20,000 Injures Fisherman $15,000 Suppose the Fishermen Own the Lake. What will happen? The Lake will be polluted

  43. Pollution Benefits Factory $10,000 Injures Fisherman $20,000 Suppose the Fishermen own the Lake. The Lake will be cleaned up.

  44. Pollution Benefits Factory $10,000 Injures Fisherman $20,000 Suppose the Factory own the Lake. The Lake will be cleaned up.

  45. Challenges • Supposes low bargaining costs. • Most resources aren’t fully owned. • Air • Animals • Fish

  46. Hard Choices Would your answer change if you only had $300,000 to spend?

  47. Hard Choices Would your answer change again if spending money cleaning up the environment meant spending less on education or healthcare?

  48. How to Clean Up? Total Pollution 3000T Suppose that the Optimal Level of Pollution is 1500T. What can we do?

  49. How to Clean Up? Plan 1: Every firm must reduce by 50%.

  50. How to Clean Up? Each firm must reduce by 50%...Total Costs $162,500.