Externalities and Public Goods: Production, Consumption, and Market Solutions | Appunti di Economia Politica

Externalities:

Externalities arise whenever the actions of one party make another party worse or better off, yet the

first party neither bears the costs nor receives the benefits of doing so. Externalities are a classic

example of market failures, a problem that causes the market economy to deliver an outcome that

does not maximize efficiency. Externalities can arse either from the production of goods or from their

consumption, and can be negative or positive.

Negative production (consumption) externality: When a firm’s production (individual’s consumptiom)

reduces the well-being of others who are not compensated by the firm (individual).

Pollution from steel production, dumped in a river, hurts fishermen, and smoking at a restaurant

affects the health and enjoyment of others.

Negative production externalities identifies a difference between private and social marginal cost.

Private marginal cost (PMC): The direct cost to producers of producing an additional unit of a good.

Social marginal cost (SMC): The private marginal cost to producers plus any costs associated with the

production of the good that are imposed on others. (The loss from pollution is a cost of production

imposed on others.)

Without market failures SMC=PMC, with externalities SMC=PMC+MD marginal damage done to others

from each unit of production. That implies overproduction associated to a deadweight loss for society.

Private marginal benefit (PMB): The direct benefit to consumers of consuming an additional unit of a

good by the consumer.

Social marginal benefit (SMB): The private marginal benefit to consumers minus any costs associated

with the consumption of the good that are imposed on others. (The loss of health or dining pleasure is

a cost of smoking imposed on others.) SMB=PMB-MD : underproduction

Solution to externalities:

Externalities undermine efficiency because one party does not pay the costs or get all the (net)

benefits of its actions. The solution to this is to internalize the externality: When either private

negotiations or government action lead the party to fully reflect the external costs or benefits of that

party’s actions.

Coase theorem (Part I): When there are well-defined property rights and costless bargaining, then

negotiations between the party creating the externality and the party affected by the externality can

bring about the socially optimal market quantity. This theorem states that externalities do not

necessarily create market failures because negotiation between the parties can lead the offending

producers/consumers to internalize the externality, or account for the external effects in their

production/consumption.

Coase theorem (Part II): The efficient solution to an externality does not depend on which party is

assigned the property rights, as long as someone is assigned those rights.

Problems with Coasian solution: generally arise as more people become involved

Assignment Problem: In many cases, it is impossible to assign blame for externalities to one specific

entity. Coasian solutions are more effective for small and localized externalities than for larger and

more global externalities.

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Externalities : Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so. Externalities are a classic example of market failures, a problem that causes the market economy to deliver an outcome that does not maximize efficiency. Externalities can arse either from the production of goods or from their consumption, and can be negative or positive. Negative production (consumption) externality : When a firm’s production (individual’s consumptiom) reduces the well-being of others who are not compensated by the firm (individual). Pollution from steel production, dumped in a river, hurts fishermen, and smoking at a restaurant affects the health and enjoyment of others. Negative production externalities identifies a difference between private and social marginal cost. Private marginal cost (PMC): The direct cost to producers of producing an additional unit of a good. Social marginal cost (SMC): The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others. (The loss from pollution is a cost of production imposed on others.) Without market failures SMC=PMC, with externalities SMC=PMC+MD marginal damage done to others from each unit of production. That implies overproduction associated to a deadweight loss for society. Private marginal benefit (PMB): The direct benefit to consumers of consuming an additional unit of a good by the consumer. Social marginal benefit (SMB): The private marginal benefit to consumers minus any costs associated with the consumption of the good that are imposed on others. (The loss of health or dining pleasure is a cost of smoking imposed on others.) SMB=PMB-MD : underproduction Solution to externalities: Externalities undermine efficiency because one party does not pay the costs or get all the (net) benefits of its actions. The solution to this is to internalize the externality: When either private negotiations or government action lead the party to fully reflect the external costs or benefits of that party’s actions. Coase theorem (Part I): When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity. This theorem states that externalities do not necessarily create market failures because negotiation between the parties can lead the offending producers/consumers to internalize the externality, or account for the external effects in their production/consumption. Coase theorem (Part II): The efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights. Problems with Coasian solution : generally arise as more people become involved Assignment Problem : In many cases, it is impossible to assign blame for externalities to one specific entity. Coasian solutions are more effective for small and localized externalities than for larger and more global externalities.

Holdout Problem : can arise when property rights are held by more than one party: shared property rights gives each owner power over all the others. Each person has veto power and so may demand enormous payments. The free rider problem : When an investment has a personal cost but a common benefit, individuals will underinvest. Individuals may not want to pay enough to reduce pollution. Transaction costs and negotiating problems : It is hard to negotiate when there are large numbers of individuals on one or both sides of the negotiation, and to aggregate divergent interests. Bottom Line: Sometimes market may be able to internalze some small-scale and localized externalities, otherwise government must address larger externalities. Public-Sector Remedies for Externalities Public policy makers employ three types of remedies to resolve the problems associated with negative externalities: Corrective taxation to discourage use and Subsidies to encourage use. Taxes and subsidies change the private marginal cost or marginal benefit without affecting the social marginal cost or benefit. They can therefore be used to internalize the externality by taxing/subsidizing the producer/consumer an amount equal to the MD, which implies SMC=PMC. Quantity regulation ignores the fact that the plants have different marginal costs, for this reason taxes are preferred to quantity regulation because taxes give firms more flexibility in choosing their optimal amount of reduction, allowing them to choose the efficient level. Taxes leads to lower costs less control over the amount of the externality. Pure public goods : Goods that are perfectly non-rival in consumption and are non-excludable. Non-rival in consumption: One individual’s consumption of a good does not affect another’s opportunity to consume the good. Non-excludable: Every individuals has the opportunity to consume a good. Impure public goods: Goods that satisfy the two public good conditions (non-rival in consumption and non- excludable) to some extent, but not fully. Demand curves represent the number of goods that each individual would demand at each price, but it also represent the social marginal benefit (SMB) of that good consumption. Market supply curve represent the marginal cost (MC) of producing that good, and in a market without failure it also represent the social marginal cost (SMC). In the private market equilibrium occurs when SMC=SMB Consumers demand different quantities of the good at the same market price, and market respect those different tastes by horizontally adding up demands and meeting them with an aggregate supply. Private goods are produced until MC=MB=P. For Public goods individuals cannot choose their own specific consumption, because whatever amount is provided must be consumed equally by all. For this reason to arrive to market demand of public goods, we do not sum horizontally the single demands (of quantities demanded at the given price) as in the private market; instead we sum vertically by adding the prices that each individual in willing to pay for the fixed market quantity. The socially optimal level of production is the intersection oof the supply with with the vertically summed demand. The social-efficiency-maximizing condition for public goods is sumMRS=MC

to decide if they should be undertaken. Costs and benefits are measured through the Cash-flow accounting : a method that calculates costs solely by adding up what the government pays for inputs to a project and calculates benefits solely by adding up income or government revenues generated by the project. Important is also the opportunity cost , which states that the social marginal cost of any resource is the value of that resource in its next best use. In a competitive market opportunity cost = MC = p Economic costs are only those costs associated with diverting the resource from its next best use. Rents are payments to resource deliverers that exceed those necessary to employ the resource. If labor is efficiently employed, then wages are a social cost, any other costs are transfers. Another costs are the future maintenance costs, which must be discounted to compare them to today’s construction costs. To do this we compare the present discount value of these costs: a dollar next year is worth 1 + r times less than a dollar now because the dollar could earn r % interest if invested. Social discount rate : The appropriate value of r to use in computing PDV for social investments. Economic benefits of public projects: we can show that the time that individuals save from driving faster is spent at work, valuing their time saved at their wage. (in practice Individuals can’t freely trade off leisure and hours of work; jobs may come with hour restrictions). An alternative approach to measure benefits is contingent valuation : Asking individuals to value an option they are not now choosing, that they do not have the opportunity to choose, or that is not yet available to them, and than adding up the preferences to value a public good. But there is a (Isolation of issues) different value for sum of single issues or issues asked in combination, or (Order of issues) Asking about an issue first or second. An alternative is to use revealed preference : letting the actions of individuals reveal their valuation. Market prices potentially reveal preference, based on how much people are willing to pay. These 3 approach were also used to estimate the value of life: life’s value is the present discounted value of the lifetime stream of earnings (lifetime wage), or estimate the extra cost consumers pay for a product that reduces the risk of death by a quantifiable amount (reveal pr) The extra safety is called compensating differential : additional (or reduced) wage payments to workers to compensate them for the negative (or positive) amenities of a job, such as increased risk of mortality (or a nicer office). A particularly issue for cost-benefit analysis is that many projects have costs that are mostly immediate and benefit that are mostly long term, and choosing the proper discount rate can be difficult. Common Counting Mistakes : counting secondary benefits, counting labor as a benefit or double-counting benefits. Distributional Concerns : Costs and benefits may not go to the same people. Uncertainty : Costs and benefits are often highly uncertain. An alternative to cost-benefit analysis is the cost-effectiveness analysis : For projects that have immeasurable benefits, or are viewed as desirable regardless of the level of benefits, we can compute only their costs and choose the most cost-effective project. Lindahl pricing : An approach to financing public goods in which individuals honestly reveal their

willingness to pay, and the government charges them that amount to finance the public good. Government aggregate then those willingnesses to measure the social marginal benefit, comparing it to the social marginal cost and determine the optimal amount of public good. Lindahl pricing corresponds to the concept of benefit taxation , in which individuals are taxed for a public good according to theie valuation of the benefit they recive from that good. Lindahl pricing faces several problems that keep it from being used in practice: Preference revelation problem : Individuals have an incentive to lie about their WTP, to lower their price. Preference knowledge problem : Individuals may not know their WTP. Preference aggregation problem : It is difficult to aggregate individual preferences into a social welfare function. Majority voting : The typical mechanism used to aggregate individual votes into a social decision, whereby individual policy options are put to a vote and the option that receives the majority of votes is chosen. To consistently aggregate preferences, majority voting must satisfy three goals: Dominance, Transitivity, Independence of irrelevant alternatives Arrow’s Impossibility Theorem : There is no social decision (voting) rule that converts individual preferences into a consistent aggregate decision without either (a) restricting preferences or (b) imposing a dictatorship. The problem in some cases is that the preferences are not single peaked. Single-peaked preferences are preferences with only a single local maximum, or peak, so that utility falls as choices move away in any direction from that peak. With single-peaked preferences, voting works well, leading to the Median Voter Theorem : Majority voting will yield the outcome preferred by the median voter if preferences are single-peaked. The government has only to find the median voter right in the middle of the distribution of social preferences and implement the level of public goods preferred by that voter. Median voter outcome is certainly convenient but might be not socially efficient because it do not reflect the intensity of preferences. The median voter model may apply to representative democracies, where the assumption is that all politicians care about the number of votes they get, choosing the outcome that is preferred by the median voter. Assumption of the median voter model: Single-dimensional voting : The median voter model assumes that voters are basing their votes on a single issue. In reality representatives are elected on a bundle of issues, and people may be at different points of the voting spectrum on different issues. Only two candidates : The model assumes only two candidates, there is no stable equilibrium in the model with three or more candidates because there is always an incentive to move in response to your opponent’s positions No ideology or influence : The median voter theory assumes that politicians care only about maximizing votes, but in practice politicians care about their position and convinctions and may be able to shift the views of the voters toward their position No selective voting : The median voter theory assumes that all people are affected by public goods vote. In fact, only a fraction of citizens vote. No money The median voter theory ignores the role of money as a tool of influence in elections. Full information The median voter model assumes perfect information along three dimensions:Voter knowledge of the issues, politician knowledge of the issues, politician knowledge of voter preferences,

Externalities and Public Goods: Production, Consumption, and Market Solutions, Appunti di Economia Politica

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