ECONOMICS What Does It Mean To Me? Part VI: The Role of Government in Microeconomics/ Externalities.

ECONOMICSWhat Does It Mean To Me?

Part VI:Part VI:The Role of The Role of Government in Government in Microeconomics/Microeconomics/ExternalitiesExternalities

Economic functions of Government:Economic functions of Government:

1) Enforce laws and contracts.1) Enforce laws and contracts.

2) Maintain competition.2) Maintain competition.

3) Redistribute income--providing an 3) Redistribute income--providing an economic safety net.economic safety net.

4) Provide public goods4) Provide public goods

-nonexclusion-nonexclusion

-shared consumption-shared consumption

5) Correct Market Failures5) Correct Market Failures

-provide market information-provide market information

-correct negative externalities-correct negative externalities

-subsidize goods with positive-subsidize goods with positive

externalitiesexternalities

6) Stabilize the economy6) Stabilize the economy

- fight unemployment- fight unemployment

- encourage price stability- encourage price stability

- promote economic growth- promote economic growth

EXTERNALITIES

Externality

When one person’s actions imposes a cost or benefit on the well-being of a bystander.

Externalities usually result

in market failure.

Externalities can be:

1) Positive:Positive: an external benefit is imposed on someone. (examples: gardens, restored historic buildings, research)

2) Negative:Negative: an external cost is imposed on someone. (examples: exhaust from autos, barking dogs, noise from airplanes)

Externalities cause Externalities cause markets to allocate markets to allocate

resources resources inefficiently.inefficiently.

This happens through:

1) CONSUMPTION: consuming a good results in externality.

2) PRODUCTION: producing a good results in externality.

In general, an external cost means the market overproduces the good (ie, paint). An external benefit means the market underproduces the

good (ie, gardens)

Are there benefits for Are there benefits for other people in the other people in the

parking lot when someone parking lot when someone puts their car alarm on?puts their car alarm on?

ANSWER:ANSWER:

Yes, because thieves Yes, because thieves don’t know which cars don’t know which cars have alarms.have alarms.

What about the club?What about the club?

Are there benefits for other Are there benefits for other people in the parking lot people in the parking lot when someone puts the club on when someone puts the club on their car?their car?

ANSWER:ANSWER:

No . . .because No . . .because the thief can SEE the thief can SEE

the club.the club.

Your neighbor puts in Your neighbor puts in a nice garden. Are a nice garden. Are you receiving a you receiving a benefit?benefit?

When you admit you are receiving When you admit you are receiving a positive benefit, your a positive benefit, your

neighbor asks you to pay him neighbor asks you to pay him $100 a month for the benefit.$100 a month for the benefit.

When you say no, When you say no, he puts up a he puts up a fence.fence.

What if you What if you lived next lived next

door to this?door to this?

Do you receive Do you receive a benefit?a benefit?

PROPERTY RIGHTS is the issue?PROPERTY RIGHTS is the issue?

Who owns the air? The rivers? Who owns the air? The rivers? The parks?The parks?

If we can figure out who pollutes If we can figure out who pollutes the stream, we punish the the stream, we punish the

offender because we are not sure offender because we are not sure who owns the stream, but we DO who owns the stream, but we DO

know who pollutes it.know who pollutes it.

We get into trouble when we use We get into trouble when we use this criteria regarding the air.this criteria regarding the air.

The tendency for a society to overuse and therefore abuse common resources

is called:

TRAGEDY OF THE COMMONSTRAGEDY OF THE COMMONS

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What is the difference between a What is the difference between a public good and a private good?public good and a private good?

Exclusion vs. non-exclusionExclusion vs. non-exclusion

andand

Shared consumption (rival Shared consumption (rival good)good)

vs.vs.

non-shared consumption (non-non-shared consumption (non-rival good)rival good)

What defines What defines property rightsproperty rights??

Property rights are established by Property rights are established by formal and informal rulesformal and informal rules about the about the privileges and limitations on the privileges and limitations on the ownershipownership, use, and , use, and transfertransfer of of

goods and resources. These rights goods and resources. These rights are specified in various municipal are specified in various municipal ordinances, other legislation, ordinances, other legislation, court decisions (common law), court decisions (common law),

tradition and custom.tradition and custom.

Property rights need to be:Property rights need to be:

1) clearly defined1) clearly defined

2) exclusive2) exclusive

3) enforceable3) enforceable

4) transferable4) transferable

Consider each of the items below:Consider each of the items below:

Are they . . . . .?Are they . . . . .?

ClearlyClearly

Defined?Defined? Exclusive?Exclusive? Transferable?Transferable? Enforceable? Enforceable?

skateboardskateboard

gungun

library booklibrary book

hamburgerhamburger

Garden viewGarden view

Bottled waterBottled water

Lake waterLake water

Stream waterStream water

What is a free-rider?What is a free-rider?

Someone who uses the good but Someone who uses the good but doesn’t pay for it.doesn’t pay for it.

Free riders occur when there are Free riders occur when there are nonexclusion and shared nonexclusion and shared

consumption.consumption.

Spraying for mosquitoesSpraying for mosquitoes

Police & fire protectionPolice & fire protection

National defenseNational defense

Street lightsStreet lights

An Overview of U.S. Water LawAn Overview of U.S. Water Law

Riparian Common LawRiparian Common Law - people who own land along - people who own land along streams, lakes and springs have a right to streams, lakes and springs have a right to “reasonable use” of the water.“reasonable use” of the water.

First -in-time, First-in-rightFirst -in-time, First-in-right - the first person to - the first person to divert water and use it has the first right. People divert water and use it has the first right. People who come later can take what is left.who come later can take what is left.

Use-it or Lose-it -Use-it or Lose-it - If a person with water rights If a person with water rights doesn’t use all the water he claims a right to, he doesn’t use all the water he claims a right to, he permanently loses his right to the portion he permanently loses his right to the portion he doesn’t use.doesn’t use.

An Overview of U.S. Water Law (cont.)An Overview of U.S. Water Law (cont.)

Salvaged water rule Salvaged water rule - If a person is able to save - If a person is able to save water (I.e. by better irrigation system), he cannot water (I.e. by better irrigation system), he cannot sell the extra water or even keep his right to it.sell the extra water or even keep his right to it.

Beneficial use Beneficial use - People may not establish water - People may not establish water rights unless they are using the water for rights unless they are using the water for “beneficial use”. (I.e.) Agriculture is recognized “beneficial use”. (I.e.) Agriculture is recognized in all states, but only a few states recognize in all states, but only a few states recognize recreation or fishing.recreation or fishing.

Public Interest Public Interest - Water rights--especially the right - Water rights--especially the right to transfer--are limited by the “public interest>” to transfer--are limited by the “public interest>” Laws and courts define “public interest” as things Laws and courts define “public interest” as things like protecting an economic area or environment or like protecting an economic area or environment or public health and safety.public health and safety.

Even though water Even though water is essential for is essential for life and diamonds life and diamonds are not, water is are not, water is cheap and diamonds cheap and diamonds are expensive?are expensive?

Why?Why?

It has to do with the elasticity of the It has to do with the elasticity of the supply curve and the amount of supply curve and the amount of

consumer/producer surplusconsumer/producer surplus

Pri

ce

Quantity

Consumer Consumer SurplusSurplus

Q

S

Pri

ce

Quantity

Producer Producer SurplusSurplus

S

Q

P

P

DD

With DIAMONDS, With DIAMONDS, supply is very supply is very inelastic.inelastic.

With WATER, With WATER, supply is very supply is very

elastic.elastic.

Why would a farmer in the desert Why would a farmer in the desert of Southern California grow rice--of Southern California grow rice--a crop that requires a great deal a crop that requires a great deal

of water?of water?

How much water do you NEED to live How much water do you NEED to live per day?per day?

Answer:Answer: 1 1/2 liters 1 1/2 liters

What is the average per capita What is the average per capita consumption of water per day in the consumption of water per day in the

State of Florida?State of Florida?

Answer:Answer: 169 gallons 169 gallons

Compare this toCompare this to

130 gal/day130 gal/day in Massachusetts and in Massachusetts and Rhode IslandRhode Island

AndAnd

325 gal/day325 gal/day in Nevada in Nevada

When is a When is a basketball an basketball an alternative to alternative to

water?water?

When is coal an When is coal an alternative to alternative to a waterfall?a waterfall?

What are some other ways to conserve What are some other ways to conserve water?water?

XeriscapeXeriscape

RocksRocks

MassageMassage

BroomBroom

DenimDenim

MulchMulch

Drip Drip irrigationirrigation

CompostCompost

Night Night wateringwatering

Safflower oilSafflower oil

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If I were your If I were your neighbor, what could neighbor, what could you do to stop me you do to stop me from polluting? from polluting?

What if we decide it’s What if we decide it’s YOURYOUR property?property?

1) Call the police1) Call the police

2) Assault and battery??2) Assault and battery??

3) Pay me to stop.---You’ve upped 3) Pay me to stop.---You’ve upped my opportunity cost---at some my opportunity cost---at some point it’s worth it to me to point it’s worth it to me to stop.stop.

What if we decide it’s What if we decide it’s MYMY property? property?

1) Outdo my Opportunity Cost 1) Outdo my Opportunity Cost (money, friendship)(money, friendship)

2) Petition or threaten (fine, tax) 2) Petition or threaten (fine, tax)

3) You can PAY me to stop (what is it 3) You can PAY me to stop (what is it worth to you?)worth to you?)

People’s use responds to incentives.People’s use responds to incentives.

Consider the following taxing Consider the following taxing methods to control water usage:methods to control water usage:

Mayor asks bill = $.002/gal.Mayor asks bill = $.002/gal.

Flat fee = $10/monthFlat fee = $10/month

Flat fee = $30/monthFlat fee = $30/month

MC = 0MC = 0

Billed at $.01/gal.Billed at $.01/gal.

Billed at $.05/gal.Billed at $.05/gal.MC >MBMC >MB

The government has dealt effectively The government has dealt effectively with most water issues.with most water issues.

BUT. . . . .what BUT. . . . .what about GARDENS???about GARDENS???

So . . .So . . .

Your neighbor plants a garden and it is Your neighbor plants a garden and it is beautiful.beautiful.

But 5 years later, the garden has grown and you But 5 years later, the garden has grown and you can no longer see the lake.can no longer see the lake.

Do you have a right to your Do you have a right to your view?view?

Today, there are thousands of Today, there are thousands of lawsuits over condos and owner’s lawsuits over condos and owner’s rights or trees loosing leaves in rights or trees loosing leaves in

your neighbor’s yard.your neighbor’s yard.

If your cat is in your If your cat is in your neighbor’s yard, is it neighbor’s yard, is it your neighbor’s cat?your neighbor’s cat?

What if your cat kills a What if your cat kills a bird in your neighbor’s bird in your neighbor’s

yard?yard?

Coase TheoremCoase Theorem

The proposition that if private The proposition that if private parties can bargain without cost parties can bargain without cost over the allocation of resources, over the allocation of resources,

they can solve the problem of they can solve the problem of externalities on their own.externalities on their own.

Is this Is this pollution?pollution?

Exercise Exercise

ExternalitiesExternalities

Positive Positive (+benefit)(+benefit)

Negative Negative (+cost)(+cost)

Production Production (honey)(honey)

Consumption Consumption (education)(education)

Consumption Consumption (cigarettes)(cigarettes)

Production Production (pollution)(pollution)

In review:In review:

What is efficient?

S = MC to Society

D = MB to Society

Efficiency occurs when MC

= MB for society.

For a perfectly competitive

market with no externalities and for a good that is not a public good, the market is efficient.

PRICE

QUANTITY

What is efficient?

MC

Market Price

Another way to measure

efficiency would be where

Profit Maximizing

Output is found where P = MC

PRICE

QUANTITY

What happens when the firms’ marginal cost of production is not equal to the marginal cost to

society?

Or if the marginal benefit to consumers is not equal to the marginal

benefit to society?

NEGATIVE EXTERNALITY IN NEGATIVE EXTERNALITY IN PRODUCTION:PRODUCTION:

Example: Pollution

S = MPC to Firm

D = MB to Society

PRICE

QUANTITY

MSC

MC is the private cost to the firm.

Marginal social cost (MSC) is cost to society

= MC + externality.

The market overproduces and charges a The market overproduces and charges a price that is too low.price that is too low.

Because of the Because of the externality, the cost externality, the cost to society is larger to society is larger than the cost to than the cost to

producers.producers.

QQoptimum

optimum

Qmarket

Qmarket

POSITIVE EXTERNALITY IN POSITIVE EXTERNALITY IN PRODUCTION:PRODUCTION:

Example: Honey

S = MSC

D = MB to Society

PRICE

QUANTITY

MPC to firm

MC is the private cost to the firm.

Marginal social cost (MSC) is cost to society

= MC + externality.

The market underproduces and charges a The market underproduces and charges a price that is too high.price that is too high.

QQoptimum

optimum

Qmarket

Qmarket

NEGATIVE EXTERNALITY IN NEGATIVE EXTERNALITY IN CONSUMPTION:CONSUMPTION:

Example: Cigarettes

MC

D = MB to Buyer

PRICE

QUANTITY

D gives the private benefit in

consumption.

Marginal social benefit (MSB) = D +

externality.

The market overproduces and charges a price that is too high.

MSB

Overproduction in Overproduction in this case raises MC.this case raises MC.

Qmarket

Qmarket

POSITIVE EXTERNALITY IN POSITIVE EXTERNALITY IN CONSUMPTION:CONSUMPTION:

Examples: Education, Charities

MC

D = MB to Buyer

PRICE

QUANTITY

D gives the private benefit in consumption.

Marginal social benefit (MSB) = D + externality.

The market underproduces and charges a The market underproduces and charges a price that is too low.price that is too low.

MSB

Underproduction in Underproduction in this case lowers MC.this case lowers MC.

The social value of The social value of education is greater education is greater than the private than the private

value.value.

QQoptimum

optimum

Qmarket

Qmarket

SOLUTIONS:

1) Assign property rights => internalize externality

(Negotiate if mutually beneficial)

2) Government involvement

Tax on negative externality (Pigovian tax)

Subsidy for positive externality

Permits

Pigovian TaxPigovian Tax

Named after economist, Arthur Pigou

•A tax on firms based on the external costs they generate.

•Internalizes the externality and reimburses society for the external costs.

•The term “pollution tax” is used when the tax may not be equal to marginal external cost.

Pri

ce

of

Po

l luti

on

Quantity of Pollution

Demand for Pollution Rights

A Pigovian tax sets the A Pigovian tax sets the priceprice of pollution……. of pollution…….

Pigovian Tax

Q

P

…………which, together with which, together with the demand curve the demand curve determines the determines the quantity quantity of pollution.of pollution.

Pri

ce

of

Po

l luti

on



Pollution permits sets the Pollution permits sets the quantityquantity of pollution….. of pollution…..

Supply of pollution permits

Q

P

…………which, together which, together with the demand curve with the demand curve determines the determines the price price of of pollution.pollution.

Pri

ce

of

Po

l luti

on



Pigovian Tax

Q

PP

ric

e o

f P

ol lu

tio

n




Q

P

Notice that in both cases, Notice that in both cases, price and quantity are the price and quantity are the same. . . .same. . . .

Pri

ce

of

Po

l luti

on



Pigovian Tax

Q

PP

ric

e o

f P

ol lu

tio

n




Q

P

Notice also that the pigovian tax Notice also that the pigovian tax line is perfectly elastic--firms can line is perfectly elastic--firms can pollute as much as they want as long pollute as much as they want as long as they pay a tax. . .as they pay a tax. . .

Pri

ce

of

Po

l luti

on



Pigovian Tax

Q

PP

ric

e o

f P

ol lu

tio

n




Q

P

. . .while in the second panel, the . . .while in the second panel, the EPA sets the quantity of pollution, EPA sets the quantity of pollution, and the supply of pollution is and the supply of pollution is completely inelastic.completely inelastic.

Economists usually prefer pigovian taxes to regulation as a way to deal with pollution because they reduce

pollution at a lower cost to society.

Using pigovian taxes to internalize externalities will cause market price to reflect the true social costs of production and force firms to bear

the full social cost of their production activities.

Now, suppose that two firms are Now, suppose that two firms are awarded permits and have met the awarded permits and have met the government standard.government standard.

Firm 1 then decides it wants to Firm 1 then decides it wants to increase its emissions by 100 tons increase its emissions by 100 tons and firm 2 agrees to reduce its and firm 2 agrees to reduce its emissions by 100 tons if firm 1 emissions by 100 tons if firm 1 pays it $5 million.pays it $5 million.

Should the government allow two Should the government allow two factories to make this deal?factories to make this deal?

If the EPA allows the firms to If the EPA allows the firms to make this deal, it will have make this deal, it will have created a new scarce resource: created a new scarce resource:

pollution permitspollution permits..

A market to trade these permits A market to trade these permits will develop and that market will develop and that market will be governed by the forces will be governed by the forces

of supply and demand.of supply and demand.

The CLEAN AIR The CLEAN AIR ACT of 1990ACT of 1990

established the right to buy and sell

emission rights for sulfur-dioxide

pollution.

COCO22 emission permits have been emission permits have been traded since 1995 on the traded since 1995 on the

Chicago Exchange.Chicago Exchange.

Carbon emissions trading has been steadily increasing in recent years. According to the World Bank's Carbon Finance Unit, 374 million metric

tonnes of carbon dioxide equivalent (tCO2e) were exchanged through

projects in 2005, a 240% increase relative to 2004 (110 mtCO2e), which was itself a 41% increase relative to

2003 (78 mtCO2e).

The world's only mandatory carbon trading program is the

European Union Emissions Trading European Union Emissions Trading SchemeScheme (or EUETS). Created in

conjunction with the Kyoto Kyoto ProtocolProtocol, a 1997 international

treaty that took effect in 2005, it caps the amount of carbon

dioxide that can be emitted from large installations, such as

power plants and factories, in the EU's 25 member countries. Source: WikipediaSource: Wikipedia

NASH EQUILIBRIUM is a situation where economic actors interacting with each other each choose their best strategy given the strategies

that others have chosen.

This is also called GAME THEORY.

John Nash

1994 Nobel Prize, Economics

Game TheoryGame Theory has has become a major tool become a major tool for dealing with for dealing with

pollution problems.pollution problems.

Game Theory can be illustrated by what is called THE PRISONER’S DILEMMA.

The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that

each would spend 1 year in jail. But they suspect that the two have pulled off some bank robberies but they have no evidence. They put Bonnie and

Clyde in separate rooms and offer a deal.

“Right now, we can lock you up for one year. But if you testify against your partner, we will

set you free and your partner will get 20 years in prison. If you both confess to the crime, we can avoid the cost of a trial and

you both get 8 years.”

Bonnie’s Decisionconfess

confess

Remain silent

Remain silent

Clyde’s Decision

8 years eachBonnie - 20 yrs

Clyde goes free

Bonnie goes free

Clyde - 20 yrs.1 year each

Each prisoner has two strategies, confess or remain silent. However, the sentence that each gets

depends upon the actions of the other.

OR you can use the PAYOFF MATRIX

Bonnie’s Decison

Clyde’s Decison

Clyde’s Decison

confess

confess

confess

Remain

silent

Remain

silent

Remain silent

B: 8 years

C: 8 years

B: free

C: 20 years

B: 20 years

C: free

B: 1 year

C: 1 year

Iraq’s DecisionHigh prod.

High prod.

Low prod.

Low prod.

Iran’s Decision

$40 billion each

Iraq - $30 billion

Iran - $60 billion

Iraq - $60 billion

Iran - $30 billion$50 billion

each

In the real world, this dilemma is played out by real players. Once a negotiation is reached, each

country must decide whether they should keep their agreement.

U.S.’s DecisionArm.

Arm

Disarm

Disarm

USSR’s Decision

Both at risk US at risk

USSR safe

US safe

USSR at riskBoth safe

It can be used in the arms race…...

Firm 1Yes

Yes

No

No

Firm 2

Firm 1: $1.5m

Firm 2: $1.5m

Firm 1: 0

Firm 2: $2m

It can be used in the everyday economic decisions……Consider 2 firms which must

decide whether to make a new product or not….

Firm 1: $2m

Firm 2: 0

Firm 1: 0

Firm 2: 0

SAMPLE AP TEST QUESTIONSAMPLE AP TEST QUESTION

PricePrice

Quantity of Good X

D-MSBD-MSBMR

Marginal Social Cost

Marginal Private Cost

Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Is this a Is this a negative or negative or

positive positive externality?externality?

NegativeNegative

Why?Why?

MSC > MPCMSC > MPC

The production of Good X creates an The production of Good X creates an externality.externality.

PricePrice

Quantity of Good X

D-MSBD-MSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Identify the Identify the socially socially optimum optimum output.output.

Q2Q2

Why?Why?

MSC=MSBMSC=MSB

The production of Good X creates an The production of Good X creates an externality.externality.

PricePrice

Quantity of Good X

D-MSBD-MSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Identify the Identify the unregulated unregulated

firm’s output.firm’s output.

Q1Q1

Why?Why?

At Q1, MPC At Q1, MPC = MR= MR

Suppose that good X is produced by a Suppose that good X is produced by a profit-maximizing monopoly.profit-maximizing monopoly.

PricePrice

Quantity of Good X

D-MSBD-MSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

How much will How much will it be?it be?

$3$3Why?Why?

Optimum Optimum Quantity at Quantity at

Q = MRQ = MR

To produce socially optimum To produce socially optimum output, should the government tax output, should the government tax

or subsidize the firm?or subsidize the firm?

subsidizesubsidize

Suppose that good X is produced by a Suppose that good X is produced by a profit-maximizing monopoly.profit-maximizing monopoly.

PricePrice

Quantity of Good X

D-MSBD-MSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Why?Why?

D=MPC or D=MPC or MSB=MPCMSB=MPC

Identify equilibrium output in Identify equilibrium output in the absence of regulation.the absence of regulation.

Q3Q3

Suppose that good X is produced in a Suppose that good X is produced in a perfectly competitive industry.perfectly competitive industry.

PricePrice

Quantity of Good X

D-MSBD-MSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

How much?How much?

$5$5

To produce at socially optimum To produce at socially optimum output, should the government tax output, should the government tax

or subsidize?or subsidize?

TaxTax

Suppose that good X is produced in a Suppose that good X is produced in a perfectly competitive industry.perfectly competitive industry.

The EndThe End

Created by: Created by:

Virginia Meachum, Economics Teacher, Coral Virginia Meachum, Economics Teacher, Coral Springs High SchoolSprings High School

Sources:Sources:

FTE Economics of Water and the EnvironmentFTE Economics of Water and the Environment

AP MicroEconomics Test Question (2005)AP MicroEconomics Test Question (2005)

ECONOMICS What Does It Mean To Me? Part VI: The Role of Government in Microeconomics/ Externalities.

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Transcript of ECONOMICS What Does It Mean To Me? Part VI: The Role of Government in Microeconomics/ Externalities.