HE191Principles of EconomicsLecture 4

Chapters 10, 11 and 12Principles of Economics, Fourth Edition

N. Gregory Mankiw

In this lecture, look for the answers to these questions:What is an externality? Why do externalities make market outcomes inefficient?

How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work?

What policies aim to solve the problem of externalities?

What are public goods? What are common resources? Give examples of each.

Why do markets generally fail to provide the efficient amounts of these goods?

How might the government improve market outcomes in the case of public goods or common resources?

What are the efficiency costs of taxes?

Introduction

Recall one of the Ten Principles from Lecture 1: Markets are usually a good way to organize economic activity.Lesson from Lecture 3: In the absence of market failures, the competitive market outcome is efficient, maximizes total surplus.One type of market failure: externalities.Externality: the uncompensated impact of one person’s actions on the well-being of a bystander

Negative externality: the effect on bystanders is adversePositive externality: the effect on bystanders is beneficial

Governments can sometimes improve market outcomes.

Pollution: A Negative Externality

• Example of negative externality: Air pollution from a factory. – The firm does not bear the

full cost of its production, and so will produce more than the socially efficient quantity.

• How govt may improve the market outcome:– Impose a tax on the firm equal to the

external cost of the pollution it generates

Recap of Welfare Economics:The market for gasoline

The market eq’mmaximizes consumer + producer surplus.

Supply curve shows private cost, the costs directly incurred by sellers

Demand curve shows private value, the value to buyers (the prices they are willing to pay)0

1

2

3

4

5

0 10 20 30 Q (gallons)

P$

$2.50

25

0

1

2

3

4

5

0 10 20 30 Q gallons

P$

Analysis of a Negative Externality: The market for gasoline

Supply (private cost)External cost= value of the

negative impact on bystanders

= $1 per gallon(value of harm from smog, greenhouse gases)

Social cost= private + external cost

external cost

0

1

2

3

4

5

0 10 20 30 Q (gallons)

P$

Analysis of a Negative Externality: The market for gasoline

D

SSocial cost

25

•The socially optimal quantity is 20 gallons.• At any Q < 20, value of additional gas exceeds social cost. •At any Q > 20, social cost of the last gallon is greater than its value. •Market eq’m (Q = 25) > social optimum (Q = 20)• One solution: tax sellers $1/gallon, would shift supply curve up $1. The tax is known as corrective tax.

“Internalizing the Externality”

Corrective tax: a tax designed to account for the social costs that arise from a negative externalityAlso called Pigouvian taxes after Arthur Pigou(1877-1959). Internalizing the externality: altering incentives so that people take account of the external effects of their actionsIn the previous example, the $1/gallon tax on sellers makes sellers’ costs equal to social costs.When market participants must pay social costs (private cost + tax), the market eq’m matches the social optimum.

Example of Positive Externality

A more educated population benefits society:lower crime rates: educated people have more opportunities, so less likely to rob and stealbetter government: educated people make better-informed voters

People do not consider these external benefits when deciding how much education to “purchase”Result: market eq’m quantity of education too lowHow government may improve the market outcome:

subsidize cost of education

A C T I V E L E A R N I N G 1: A C T I V E L E A R N I N G 1: Analysis of a positive externalityAnalysis of a positive externality

10

The market for flu shots

D

S

0

10

20

30

40

50

0 10 20 30

P

Q

$ External benefit = $10/shot

• Draw the social value curve.

• Find the socially optimal Q.

• What policy would internalize this externality?

A C T I V E L E A R N I N G 1: A C T I V E L E A R N I N G 1: AnswersAnswers

Socially optimal Q = _____To internalize the externality, use subsidy = _____

11

The market for flu shots

D

S

Social value = private value + external benefit

0

10

20

30

40

50

0 10 20 30

P

Q

$external benefit

25

Private Solution to Externalities

The Coase theorem: If private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own.

An Example: Dick owns a dog named Spot. Negative externality: Spot’s barking disturbs Jane,

Dick’s neighbor. The socially efficient outcome: maximizes Dick’s +

Jane’s well-being. If Dick values having Spot more than Jane values peace & quiet, the dog should stay.

Coase theorem: The private market will reach the efficient outcome on its own…

The Coase Theorem: An Example

CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500Cost to Jane of Spot’s barking = $800

Socially efficient outcome: Spot goes bye-bye.

Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off.

Private outcome = efficient outcome.

The Coase Theorem: An Example

CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000Cost to Jane of Spot’s barking = $800

Socially efficient outcome: See Spot stay.

Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays.

Private outcome = efficient outcome.

The Coase Theorem: An Example

CASE 3: Benefit to Dick of having Spot = $1000Cost to Jane of Spot’s barking = $800But Jane has the legal right to peace & quiet.

Socially efficient outcome: Dick keeps Spot.

Private outcome: Dick pays Jane $900 to put up with Spot’s barking.

Private outcome = efficient outcome.

The private market achieves the efficient outcome regardless of the initial distribution of rights.

The private market achieves the efficient outcome The private market achieves the efficient outcome regardless of the initial distribution of rights.regardless of the initial distribution of rights.

Why Private Solutions Do Not Always Work

Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargainSometimes when a beneficial agreement is possible, each party may hold out for a better deal.Coordination problems & costs when the number of parties is very large.

Public Policies Toward Externalities

Two approachesCommand-and-control policiesregulate behavior directly. Examples:

limits on quantity of pollution emittedrequirements that firms adopt a particular technology to reduce emissions

Market-based policiesprovide incentives so that private decision-makers will choose to solve the problem on their own.

Market-Based Policy #1: Corrective Taxes

Example: Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO2causes acid rain & other health issues.Policy goal: reducing SO2 emissions 25%Policy options1. Regulation: require each plant to cut emissions by

25%2. Corrective tax: make each plant pay a tax on each

ton of SO2 emissions. Set tax at level that achieves goal.

______

Pays the tax instead of reducing pollution

________________Costs of SO2 reduction

Tax of $111/ton of pollution up to a maximum of 20 tons

____________________________Costs of SO2 reduction

Cuts 10 tons of SO2

Cuts 10 tons of SO2

Regulation to cut 25%

$200/ton for cutting first 10

tons. Costs rise 10% for

each additional 10

tons cut

$100/ton for cutting the first 10 tons. Costs rise by 10% for each additional

10 tons cut

Firm's cost of reducing emission

40 tons40 tonsSO2 emitted

Total costUS ElectricACME

Market-Based Policy #1: Corrective Taxes

The corrective tax is a price on the right to pollute. Under regulation, firms have no incentive to reduce emissions beyond the 25% target. Like other prices, the tax allocates the pollution to the firms who value it most highly (US Electric).A tax on emissions gives ACME the incentive to continue reducing emissions as long as the cost of doing so is less than the tax. If a cleaner technology becomes available, the tax gives firms an incentive to adopt it.In contrast with other taxes, corrective taxes enhance efficiency by aligning private with social incentives.Problem with tax: determining the amount of the tax.

Market-Based Policy #2: Tradable Pollution Permits

Issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons)give 30 permits to each firm establish market for trading permits

Each firm can choose among these options:emit 30 tons of SO2, using all its permitsemit < 30 tons, sell unused permitsbuy additional permits so it can emit > 30 tons

__________________Costs of SO2 reduction

Buys 10 permit for $1,500

Sells 10 permits and earns $1,500

Suppose both agree on price of

$150

$1,500$600Net cost

Willing to buy 10 permits for

$199/ton so it has the right to pollute 40 tons.

ACME can sell the permit for at least $111 so cuts SO2

by 20 tons. It would have 10 permits

to sell.

Each firm has 30 permits with each permit

allowing firm to pollute 1 ton of

SO2

$200/ton for the 1st 10 tons plus 10% for additional 10

tons

$100/ton for 1st 10 tons plus 10% for additional 10 tons

Firm's cost of reducing emission

40 tons40 tonsSO2 emitted

Total costUS ElectricACME

Market-Based Policy #2: Tradable Pollution Permits

A system of tradable pollution permits achieves goal at lower cost than regulation.

Firms with low cost of reducing pollution sell whatever permits they can.Firms with high cost of reducing pollution buy permits.

Result: Pollution reduction is concentrated among those firms with lowest costs.Market decides the value of the pollution permit.

Public Goods and Common Goods

We consume many goods without paying: parks, national defense, clean air & water. When goods are free, the market forces that normally allocate resources are absent. The private market may fail to provide the socially efficient quantity of such goods. One of the Ten Principles from Chapter 1: Governments can sometimes improve market outcomes.

Important Characteristics of Goods

A good is excludable if a person can be prevented from using it.

excludable: fish tacos, dial-up internet servicenot excludable: FM radio signals, national defense

A good is rival in consumption if one person’s use of it diminishes others’ use.

rival: fish tacosnot rival: An MP3 file of Coldplay’s latest hit song

The Different Kinds of Goods

Private goods: excludable, rival in consumptionexample: food, clothing, shoes

Public goods: not excludable, not rivalexample: national defense, uncongested parks

Common resources: rival but not excludableexample: fish in the ocean, common grazing land, forest

Natural monopolies: excludable but not rivalexample: Telecom, cable TV, software, electric power etc

The Different Kinds of Goods

With public goods and common resources, externalities arise because something of value has no price attached to it. So, private decisions about consumption and production can lead to an inefficient outcome.Public policy can potentially raise economic well-being.

Common Resources

Common resources are not excludable.Additional problem with common resources:rival in consumption

Each person’s use reduces others’ ability to use which creates a tragedy of commonsThe tragedy is due to an externality: Allowing one’s flock to graze on the common land reduces its quality for other families. People neglect this external cost, resulting in overuse of the land.

Role for govt: ensuring they are not overused

Tragedy of commons

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__2700500

__2800401

__2800400

__2799399

__2600300

__2000200

1000100

Additionaloutput per

cow

Output of Milk (gallons)

No. ofCowsIf there is one herder,

cows<400 will graze landIf there are 100 herders, each with 4 cows

q of each cow = 7 gal and each herder gets = 28 galOne herder grazes a 5th cow: q of each cow = 6.98 gal and he gets = 34.9 galAll herders graze a 5th cow: q of each cow = 5.4 gal and each herder gets = 27 gal

Policy Options to Prevent Overconsumption of Common Resources

Policy OptionsRegulate use of the resourceImpose a corrective tax to internalize the externality

example: hunting & fishing licenses, entrance fees for congested national parks

Auction off permits allowing use of the resourceexample: spectrum auctions by the U.S. Federal Communications Commission

if the resource is land, convert to a private good by dividing and selling parcels to individuals

Public goodExample

Will Lee, Tan and Lim pay for the maintenance of a park adjacent to their homes? Scenario

Lee, Tan and Lim own adjacent propertiesTheir properties are adjacent to a park The cost of maintaining the park is $1,200 per monthLee earns twice as much as Tan and Tan earns twice as much as LimLee is willing to pay $800, Tan $400 and Lim $200The benefit, $1,400 > than the cost, $1,200

NOTE: Demand for public goods are added vertically:$800 + $400 + $200 = $1,400

Public Goods

The OutcomeSharing is efficient (Benefit > cost)Barriers to sharing the cost

Cost of negotiationFree rider: a person who receives the benefit of a good but avoids paying for it

If good is not excludable, people have incentive to be free riders, because firms cannot prevent non-payers from consuming the good.

Reluctance to share information makes measuring the benefits difficult

Public Goods

Cost-benefit analyses are imprecise, so the efficient provision of public goods is more difficult than that of private goods. Public goods are difficult for private markets to provide because of the free-rider problem. Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it.

Common Resources and Public goods: Conclusion

Public goods tend to be under-provided, while common resources tend to be over-consumed. These problems arise because property rights are not well-established:

Nobody owns the air, so no one can charge polluters. Result: too much pollution.Nobody can charge people who benefit from national defense. Result: too little defense.

The govt can potentially solve these problems with various policy options.

Government Provisionof Public Goods and Tax

ExampleWill government maintain the park if there is an “equal tax” rule”? Assume

There is a “nondiscrimination” tax rule.A majority of the citizens must approve the provision of a public good.

The OutcomeA head tax or lump-sum tax will collect $400 each from Lee, Tan and Lim.Lim has a $200 reservation price, and will vote against it.

A lump-sum tax is a regressive tax.Lump-sum Tax

A tax that collects the same amount from every taxpayer

Regressive TaxA tax under which the proportion of income paid in taxes declines as income rises.

Government Provisionof Public Goods and Tax

ExampleWill the government maintain the park if there is a proportional tax on income?

Proportional Income TaxOne under which all taxpayers pay the same proportion of their incomes in taxes

With a proportional tax:Lee pays $685.71; Tan pays $342.86 and Lim pays 171.43All amounts are below their reservation prices.They would have a well-maintained park.Economic surplus would increase:

Lee: $800 - $685.71 = $114.29Tan: $400 - $342.86 = $57.14Lim: $200 – 171.43 = $28.57Total increase in surplus = $200

Government Provisionof Public Goods and Tax

Taxes and Efficiency

One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. The costs to taxpayers include:

the tax payment itself, deadweight lossesand administrative burden

Recall from Chapter 8: Taxes on private goods causes deadweight loss. The fall in taxpayers’ well-being exceeds the revenue the govt collects.

Administrative Burden

includes the time and money people spend to comply with tax lawsencourages the expenditure of resources on legal tax avoidance

e.g., hiring accountants to exploit “loopholes”to reduce one’s tax burden

could be reduced if the tax code were simplifiedbut would require removing loopholes (Note: Singapore’s tax administrative burden is lower than the United States)

Income vs. Consumption Tax

The income tax reduces the incentive to save:If income tax rate = 25%, 8% interest rate = 6% after-tax interest rateThe lost income compounds over time.

Some economists advocate taxing consumption instead of income.

would restore incentive to savebetter for individuals’ retirement income security and long-run economic growthExample: GST

A lump-sum tax is the same for every personExample: lump-sum tax = $4000/person

A lump-sum tax is the most efficient tax: causes no deadweight lossIt does not alter equilibrium quantity and price of private goodsminimal administrative burdenno need to hire accountants, keep track of receipts, etc.

Yet, not used because perceived as unfair:in dollar terms and relative to income, the poor pay as much as the richIn our example, Lim would be forced to pay for public goods more than he values such goods.

Lump-Sum Taxes

Taxes and Equity

Another goal of tax policy: equity –distributing the burden of taxes “fairly.”Agreeing on what is “fair” is much harder than agreeing on what is “efficient.”Yet, there are several principles people apply to evaluate the equity of a tax system.

The Benefits Principle

Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt servicesTries to make public goods similar to private goods – the more you use, the more you pay.Example: Gasoline taxes, in our example: making Lee, Tan and Lim pay for maintenance of the park

The Ability-To-Pay Principle

Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burdenrecognizes that the magnitude of the sacrifice depends not just on the tax payment, but on the person’s income and other circumstances

a $10,000 tax bill is a bigger sacrifice for a poor person than a rich personProportional tax in our example

Three Tax Systems

Proportional tax: taxpayers pay the same fraction of income

Regressive tax: high-income taxpayers pay a smaller fraction of their income than low-income taxpayers (Lump sum tax)

Progressive tax: high-income taxpayers pay a larger fraction of their income than low-income taxpayers

The Trade-Off Between Efficiency and Equity

The goals of efficiency and equity often conflict:E.g., lump-sum tax is the least equitable but most efficient tax.

Political leaders differ in their views on this tradeoff. Economics

can help us better understand the tradeoffcan help us avoid policies that sacrifice efficiency without any increase in equity