Externalities, Environmental Policy, and Public Goods – Study Notes

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Externalities, Environmental Policy, and Public Goods

Introduction

This chapter explores the concept of externalities, the impact of environmental policy, and the classification of goods in microeconomics. Understanding these topics is essential for analyzing market failures and the role of government intervention in promoting economic efficiency.

Externalities and Economic Efficiency

Definition and Types of Externalities

Externality: A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Externalities can be positive (benefits) or negative (costs).
Negative Externality: Occurs when the actions of individuals or firms impose costs on others (e.g., pollution).
Positive Externality: Occurs when actions confer benefits on others (e.g., education, vaccination).

Private vs. Social Costs and Benefits

Private Cost: The cost borne by the producer of a good or service.
Social Cost: The total cost of producing a good or service, including both private and external costs.
Private Benefit: The benefit received by the consumer of a good or service.
Social Benefit: The total benefit from consuming a good or service, including both private and external benefits.

Market Failure and Deadweight Loss

Externalities cause a divergence between private and social costs or benefits, leading to market failure.
Deadweight Loss (DWL): The reduction in economic surplus resulting from a market not being in equilibrium at the efficient output level.
With negative externalities, markets tend to overproduce goods; with positive externalities, markets tend to underproduce goods.

Graphical Analysis

For negative externalities (e.g., pollution), the social cost curve lies above the private cost curve. The market equilibrium quantity is higher than the efficient quantity.
For positive externalities (e.g., education), the social benefit curve lies above the private benefit curve. The market equilibrium quantity is lower than the efficient quantity.

Example: Pollution in Electricity Production

Producers consider only private costs, leading to overproduction and excessive pollution.
The optimal (efficient) level of production is where marginal social cost equals marginal benefit:

Private Solutions to Externalities: The Coase Theorem

Property Rights and Bargaining

Property Rights: The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.
Externalities often arise due to incomplete or unenforced property rights.

The Coase Theorem

Proposed by Ronald Coase, the theorem states that if property rights are well-defined and transaction costs are low, private parties can negotiate to resolve externalities efficiently, regardless of who holds the rights.
Transactions Costs: The costs in time and resources incurred in the process of agreeing to and carrying out an exchange.

Example: Farmer and Paper Mill

If the farmer owns the stream, they can prevent pollution or charge the mill a fee.
If the mill owns the stream, the farmer can pay the mill to reduce pollution.
Efficient outcome is achieved as long as bargaining is possible and property rights are enforceable.

Government Policies to Deal with Externalities

Corrective Taxes and Subsidies (Pigovian Taxes/Subsidies)

Pigovian Tax: A tax imposed to correct the effects of a negative externality (e.g., carbon tax).
Pigovian Subsidy: A subsidy provided to encourage activities with positive externalities (e.g., education grants).
Optimal tax or subsidy equals the external cost or benefit at the efficient quantity:

Command-and-Control Policies

Government sets quantitative limits on pollution or mandates specific technologies (e.g., catalytic converters in cars).
May not be efficient if firms have different costs of reducing pollution.

Market-Based Policies: Tradable Emissions Permits (Cap-and-Trade)

Government sets a cap on total emissions and issues permits that can be traded among firms.
Firms with lower abatement costs sell permits to those with higher costs, minimizing total cost of pollution reduction.
Example: U.S. sulfur dioxide cap-and-trade program.

Application: Carbon Tax and Global Warming

Economists often recommend a carbon tax to internalize the externality of greenhouse gas emissions.
International coordination is necessary for global effectiveness (e.g., Paris Climate Accords).

Four Categories of Goods

Classification by Rivalry and Excludability

Rivalry: One person's consumption of a good reduces the amount available for others.
Excludability: It is possible to prevent someone from consuming the good.

	Excludable	Nonexcludable
Rival	Private Goods Examples: Big Macs, running shoes	Common Resources Examples: Tuna in the ocean, public pastureland
Nonrival	Quasi-Public Goods Examples: Cable TV, toll roads	Public Goods Examples: National defense, court system

Efficient Provision and Market Failure

Markets efficiently provide private goods because buyers and sellers internalize all costs and benefits.
Public goods suffer from the free rider problem: people can benefit without paying, leading to underprovision.
Common resources are overused due to the tragedy of the commons.
Quasi-public goods may exclude too many people, leading to inefficiency.

Constructing Demand Curves

For private goods, market demand is the horizontal sum of individual demands at each price.
For public goods, market demand is the vertical sum of individual willingness to pay for each quantity.

Efficient Consumption of Common Resources

Common resources are overconsumed because individuals ignore the external cost imposed on others.
Solutions include assigning property rights, community management, or government intervention (taxes, quotas, permits).
Tragedy of the Commons: Overuse of a common resource due to lack of property rights.

Example Table: Four Categories of Goods

Type of Good	Rival?	Excludable?	Example
Private Good	Yes	Yes	Hamburger
Public Good	No	No	National defense
Common Resource	Yes	No	Fish in the ocean
Quasi-Public Good	No	Yes	Cable TV

Summary

Externalities cause market failures by creating a gap between private and social costs or benefits.
Private solutions (Coase theorem) and government interventions (taxes, subsidies, regulation, cap-and-trade) can improve efficiency.
Goods are classified by rivalry and excludability, affecting how markets provide them and the potential for market failure.