CHAPTER 10 EXTERNALITIES |
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(a) Pigovian Tax
Price of
Pollution
P
1. A Pigovian tax sets the price of pollution . . .
2. . . . which, together with the demand curve, determines the quantity of pollution.
Pigovian
tax
Demand for pollution rights
Quantity of
Pollution
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(b) Pollution Permits |
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pollution permits |
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2. . . . which, together |
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with the demand curve, |
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permits set |
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determines the price |
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the quantity |
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of pollution. |
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of pollution . . . |
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THE EQUIVALENCE OF PIGOVIAN TAXES AND POLLUTION PERMITS. In panel (a), the EPA
sets a price on pollution by levying a Pigovian tax, and the demand curve determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by limiting the number of pollution permits, and the demand curve determines the price of pollution. The price and quantity of pollution are the same in the two cases.
Figure 10-5
achieve any point on the demand curve either by setting a price with a Pigovian tax or by setting a quantity with pollution permits.
In some circumstances, however, selling pollution permits may be better than levying a Pigovian tax. Suppose the EPA wants no more than 600 tons of glop to be dumped into the river. But, because the EPA does not know the demand curve for pollution, it is not sure what size tax would achieve that goal. In this case, it can simply auction off 600 pollution permits. The auction price would yield the appropriate size of the Pigovian tax.
The idea of the government auctioning off the right to pollute may at first sound like a creature of some economist’s imagination. And, in fact, that is how the idea began. But increasingly the EPA has used the system as a way to control pollution. Pollution permits, like Pigovian taxes, are now widely viewed as a costeffective way to keep the environment clean.
OBJECTIONS TO THE ECONOMIC ANALYSIS OF POLLUTION
“We cannot give anyone the option of polluting for a fee.” This comment by former Senator Edmund Muskie reflects the view of some environmentalists. Clean air and clean water, they argue, are fundamental human rights that should not be debased by considering them in economic terms. How can you put a price on clean air and clean water? The environment is so important, they claim, that we should protect it as much as possible, regardless of the cost.
220 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
Economists have little sympathy with this type of argument. To economists, good environmental policy begins by acknowledging the first of the Ten Principles of Economics in Chapter 1: People face tradeoffs. Certainly, clean air and clean water have value. But their value must be compared to their opportunity cost—that is, to what one must give up to obtain them. Eliminating all pollution is impossible. Trying to eliminate all pollution would reverse many of the technological advances that allow us to enjoy a high standard of living. Few people would be willing to accept poor nutrition, inadequate medical care, or shoddy housing to make the environment as clean as possible.
Economists argue that some environmental activists hurt their own cause by not thinking in economic terms. A clean environment is a good like other goods. Like all normal goods, it has a positive income elasticity: Rich countries can afford a cleaner environment than poor ones and, therefore, usually have more rigorous environmental protection. In addition, like most other goods, clean air and water obey the law of demand: The lower the price of environmental protection, the more the public will want. The economic approach of using pollution permits and Pigovian taxes reduces the cost of environmental protection and should, therefore, increase the public’s demand for a clean environment.
QUICK QUIZ: A glue factory and a steel mill emit smoke containing a chemical that is harmful if inhaled in large amounts. Describe three ways the town government might respond to this externality. What are the pros and cons of each of your solutions?
CONCLUSION
The invisible hand is powerful but not omnipotent. A market’s equilibrium maximizes the sum of producer and consumer surplus. When the buyers and sellers in the market are the only interested parties, this outcome is efficient from the standpoint of society as a whole. But when there are external effects, such as pollution, evaluating a market outcome requires taking into account the well-being of third parties as well. In this case, the invisible hand of the marketplace may fail to allocate resources efficiently.
In some cases, people can solve the problem of externalities on their own. The Coase theorem suggests that the interested parties can bargain among themselves and agree on an efficient solution. Sometimes, however, an efficient outcome cannot be reached, perhaps because the large number of interested parties makes bargaining difficult.
When people cannot solve the problem of externalities privately, the government often steps in. Yet, even now, society should not abandon market forces entirely. Rather, the government can address the problem by requiring decisionmakers to bear the full costs of their actions. Pigovian taxes on emissions and pollution permits, for instance, are designed to internalize the externality of pollution. More and more, they are the policy of choice for those interested in protecting the environment. Market forces, properly redirected, are often the best remedy for market failure.
CHAPTER 10 EXTERNALITIES |
221 |
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IN THE NEWS
Children as Externalities
A NEGATIVE EXTERNALITY
of their proclivities. The invisible hand of the market fumbles, leading resources astray. Thus, because a driver’s private motoring costs do not reflect the costs he imposes on others in the form of pollution and congestion, he uses the car more than is socially desirable. Likewise, it is argued, smokers take too little care to ensure that their acrid fumes do not damage other people around them.
Governments typically respond to such market failures in two ways. One is higher taxes, to make polluters pay the full cost of their anti-social behavior. The other is regulation, such as emission standards or bans on smoking in public places. Both approaches might work for children.
For children, just like cigarettes or mobile phones, clearly impose a negative externality on people who are near them. Anybody who has suffered a 12hour flight with a bawling baby in the row immediately ahead, or a bored youngster viciously kicking their seat from behind, will grasp this as quickly as they would love to grasp the youngster’s neck. Here is a clear case of market failure: parents
do not bear the full costs (indeed young babies travel free), so they are too ready to take their noisy brats with them. Where is the invisible hand when it is needed to administer a good smack?
The solution is obvious. All airlines, trains, and restaurants should create child-free zones. Put all those children at the back of the plane and parents might make more effort to minimize their noise pollution. And instead of letting children pay less and babies go free, they should be charged (or taxed) more than adults, with the revenues used to subsidize seats immediately in front of the war-zone.
Passengers could then request a no-children seat, just as they now ask for a no-smoking one. As more women choose not to have children and the number of older people without young children increases, the demand for childfree travel will expand. Well, yes, it is a bit intolerant—but why shouldn’t parents be treated as badly as smokers? And at least there is an obvious airline to pioneer the scheme: Virgin.
SOURCE: The Economist, December 5, 1998, p. 20.
222 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
Summar y
When a transaction between a affects a third party, the effect is Negative externalities, such as socially optimal quantity in a equilibrium quantity. Positive technology spillovers, cause the quantity to be greater than the
Those affected by externalities problem privately. For instance, confers an externality on another businesses can internalize the Alternatively, the interested parties problem by negotiating a contract Coase theorem, if people can
an agreement in which resources
. In many cases, however, among the many interested parties is
theorem does not apply.
cannot adequately deal with
as pollution, the government often the government prevents socially
by regulating behavior. Other times it externality using Pigovian taxes. Another environment is for the government to
of pollution permits. The end is largely the same as imposing
polluters.
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Key Concepts |
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externality, p. 206 |
Pigovian tax, p. 216 |
internalizing an externality, p. 209 |
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Questions for Review |
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1.Give an example of a negative example of a positive externality
2.Use a supply-and-demand diagram of a negative externality in
3.In what way does the patent an externality problem?
4.List some of the ways that the externalities can be solved without intervention.
Problems and Applications
a nonsmoker sharing a room with to the Coase theorem, what
your roommate smokes in the efficient? How do you and your
solution?
taxes? Why do economists prefer as a way to protect the
pollution?
1.Do you agree with the following statements? Why or why not?
a.“The benefits of Pigovian taxes as a way to reduce pollution have to be weighed against the deadweight losses that these taxes cause.”
b.“A negative production externality calls for a Pigovian tax on producers, whereas a negative
consumption externality calls for a Pigovian tax on consumers.”
2.Consider the market for fire extinguishers.
a.Why might fire extinguishers exhibit positive externalities in consumption?
b.Draw a graph of the market for fire extinguishers, labeling the demand curve, the social-value
224 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
different countries but is distributed equally around the globe within a year. In an article in The Boston Globe (July 3, 1990), Martin and Kathleen Feldstein argue that the correct approach to global warming is “not to ask individual countries to stabilize their emissions of carbon dioxide at current levels,” as some have suggested. Instead, they argue that “carbon dioxide emissions should be reduced in countries where the costs are least, and the countries that bear that burden should be compensated by the rest of the world.”
a.Why is international cooperation necessary to reach an efficient outcome?
b.Is it possible to devise a compensation scheme such that all countries would be better off than under a system of uniform emission reductions? Explain.
12.Some people object to market-based policies to reduce pollution, claiming that they place a dollar value on cleaning our air and water. Economists reply that society implicitly places a dollar value on environmental cleanup even under command-and-control policies. Discuss why this is true.
13.(This problem is challenging.) There are three industrial firms in Happy Valley.
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INITIAL |
COST OF REDUCING |
FIRM |
POLLUTION LEVEL |
POLLUTION BY 1 UNIT |
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70 units |
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The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution permits.
a.Who sells permits and how many do they sell? Who buys permits and how many do they buy? Briefly explain why the sellers and buyers are each willing to do so. What is the total cost of pollution reduction in this situation?
b.How much higher would the costs of pollution reduction be if the permits could not be traded?
226 |
PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR |
in Chapter 1: Governments can sometimes improve market outcomes. When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts. In such cases, government policy can potentially remedy the market failure and raise economic well-being.
THE DIFFERENT KINDS OF GOODS
excludability
the property of a good whereby a person can be prevented from using it
rivalr y
the property of a good whereby one person’s use diminishes other people’s use
private goods
goods that are both excludable and rival
public goods
goods that are neither excludable nor rival
common r esources goods that are rival but not excludable
How well do markets work in providing the goods that people want? The answer to this question depends on the good being considered. As we discussed in Chapter 7, we can rely on the market to provide the efficient number of ice-cream cones: The price of ice-cream cones adjusts to balance supply and demand, and this equilibrium maximizes the sum of producer and consumer surplus. Yet, as we discussed in Chapter 10, we cannot rely on the market to prevent aluminum manufacturers from polluting the air we breathe: Buyers and sellers in a market typically do not take account of the external effects of their decisions. Thus, markets work well when the good is ice cream, but they work badly when the good is clean air.
In thinking about the various goods in the economy, it is useful to group them according to two characteristics:
Is the good excludable? Can people be prevented from using the good?
Is the good rival? Does one person’s use of the good diminish another person’s enjoyment of it?
Using these two characteristics, Figure 11-1 divides goods into four categories:
1.Private goods are both excludable and rival. Consider an ice-cream cone, for example. An ice-cream cone is excludable because it is possible to prevent someone from eating an ice-cream cone—you just don’t give it to him. An ice-cream cone is rival because if one person eats an ice-cream cone, another person cannot eat the same cone. Most goods in the economy are private goods like ice-cream cones. When we analyzed supply and demand in Chapters 4, 5, and 6 and the efficiency of markets in Chapters 7, 8, and 9, we implicitly assumed that goods were both excludable and rival.
2.Public goods are neither excludable nor rival. That is, people cannot be prevented from using a public good, and one person’s enjoyment of a public good does not reduce another person’s enjoyment of it. For example, national defense is a public good. Once the country is defended from foreign aggressors, it is impossible to prevent any single person from enjoying the benefit of this defense. Moreover, when one person enjoys the benefit of national defense, he does not reduce the benefit to anyone else.
3.Common resources are rival but not excludable. For example, fish in the ocean are a rival good: When one person catches fish, there are fewer fish for the next person to catch. Yet these fish are not an excludable good because it is difficult to charge fishermen for the fish that they catch.
4.When a good is excludable but not rival, it is an example of a natural monopoly. For instance, consider fire protection in a small town. It is easy to
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES |
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Rival? |
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No |
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Private Goods |
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Natural Monopolies |
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• Ice-cream cones |
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• Fire protection |
• Clothing |
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• Cable TV |
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• Congested toll roads |
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• Fish in the ocean |
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• The environment |
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Figur e 11-1
FOUR TYPES OF GOODS.
Goods can be grouped into four categories according to two questions: (1) Is the good excludable? That is, can people be prevented from using it? (2) Is the good rival? That is, does one person’s use of the good diminish other people’s use of it? This table gives examples of goods in each of the four categories.
exclude people from enjoying this good: The fire department can just let their house burn down. Yet fire protection is not rival. Firefighters spend much of their time waiting for a fire, so protecting an extra house is unlikely to reduce the protection available to others. In other words, once a town has paid for the fire department, the additional cost of protecting one more house is small. In Chapter 15 we give a more complete definition of natural monopolies and study them in some detail.
In this chapter we examine goods that are not excludable and, therefore, are available to everyone free of charge: public goods and common resources. As we will see, this topic is closely related to the study of externalities. For both public goods and common resources, externalities arise because something of value has no price attached to it. If one person were to provide a public good, such as national defense, other people would be better off, and yet they could not be charged for this benefit. Similarly, when one person uses a common resource, such as the fish in the ocean, other people are worse off, and yet they are not compensated for this loss. Because of these external effects, private decisions about consumption and production can lead to an inefficient allocation of resources, and government intervention can potentially raise economic well-being.
QUICK QUIZ: Define public goods and common resources, and give an example of each.
PUBLIC GOODS
To understand how public goods differ from other goods and what problems they present for society, let’s consider an example: a fireworks display. This good is not excludable because it is impossible to prevent someone from seeing fireworks, and it is not rival because one person’s enjoyment of fireworks does not reduce anyone else’s enjoyment of them.
228 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
THE FREE-RIDER PROBLEM
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The citizens of Smalltown, U.S.A., like seeing fireworks on the Fourth of July. Each |
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of the town’s 500 residents places a $10 value on the experience. The cost of |
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putting on a fireworks display is $1,000. Because the $5,000 of benefits exceed the |
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$1,000 of costs, it is efficient for Smalltown residents to see fireworks on the Fourth |
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of July. |
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Would the private market produce the efficient outcome? Probably not. Imag- |
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ine that Ellen, a Smalltown entrepreneur, decided to put on a fireworks display. |
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Ellen would surely have trouble selling tickets to the event because her potential |
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customers would quickly figure out that they could see the fireworks even without |
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a ticket. Fireworks are not excludable, so people have an incentive to be free riders. |
fr ee rider |
A free rider is a person who receives the benefit of a good but avoids paying for it. |
a person who receives the benefit of a |
One way to view this market failure is that it arises because of an externality. |
good but avoids paying for it |
If Ellen did put on the fireworks display, she would confer an external benefit on |
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those who saw the display without paying for it. When deciding whether to put |
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on the display, Ellen ignores these external benefits. Even though a fireworks dis- |
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play is socially desirable, it is not privately profitable. As a result, Ellen makes the |
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socially inefficient decision not to put on the display. |
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Although the private market fails to supply the fireworks display demanded |
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by Smalltown residents, the solution to Smalltown’s problem is obvious: The local |
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government can sponsor a Fourth of July celebration. The town council can raise |
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everyone’s taxes by $2 and use the revenue to hire Ellen to produce the fireworks. |
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Everyone in Smalltown is better off by $8—the $10 in value from the fireworks mi- |
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nus the $2 tax bill. Ellen can help Smalltown reach the efficient outcome as a pub- |
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lic employee even though she could not do so as a private entrepreneur. |
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The story of Smalltown is simplified, but it is also realistic. In fact, many local |
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governments in the United States do pay for fireworks on the Fourth of July. More- |
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over, the story shows a general lesson about public goods: Because public goods |
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are not excludable, the free-rider problem prevents the private market from sup- |
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plying them. The government, however, can potentially remedy the problem. If |
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the government decides that the total benefits exceed the costs, it can provide the |
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public good and pay for it with tax revenue, making everyone better off. |
SOME IMPORTANT PUBLIC GOODS
There are many examples of public goods. Here we consider three of the most important.
National Defense The defense of the country from foreign aggressors is a classic example of a public good. It is also one of the most expensive. In 1999 the U.S. federal government spent a total of $277 billion on national defense, or about $1,018 per person. People disagree about whether this amount is too small or too large, but almost no one doubts that some government spending for national defense is necessary. Even economists who advocate small government agree that the national defense is a public good the government should provide.
Basic Resear ch The creation of knowledge is a public good. If a mathematician proves a new theorem, the theorem enters the general pool of knowledge