Professional Documents
Culture Documents
Public Economics
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Externality Defined
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Examples of Externalities
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Nature of Externalities
• Arise because there is no market price attached
to the activity (market failure).
• Can be produced by people or firms.
• Can be positive or negative.
• (Public goods are a special case: Positive
externality’s full effects are felt by everyone in the
economy.)
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Graphical Analysis: Negative
Externalities
• For simplicity, assume that a steel firm dumps
pollution into a river that harms a fishery
downstream.
• Competitive markets, firms maximize profits
selling their goods or services (steel…)
– Note that steel firm only care’s about its own profits,
not the fishery’s
– Fishery only cares about its profits (selling fish), not
the steel firm’s.
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Figure 1 – costs and benefits to steel firm,
damage to fishery
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Graphical Analysis, continued
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Graphical Analysis, Implications
• Result 1: Q1>Q*
– Steel firm privately produces “too much” steel, because it
does not account for the damages to the fishery.
• Result 2: Fishery’s preferred amount is 0.
– Fishery’s damages are minimized at MD=0.
• Result 3: Q* is not the preferred quantity for either party,
but is the best compromise between fishery and steel firm.
• Result 4: Socially efficient level entails some pollution.
– Zero pollution is not socially desirable.
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Figure 2
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Graphical Analysis, Intuition
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Calculating gains & losses raises
practical questions
• What activities produce pollutants?
– With acid rain it is not known how much is associated with
factory production versus natural activities like plant decay.
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Graphical Analysis: Positive
Externalities
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Graphical Analysis, continued
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Figure 3 – costs and benefits to university,
MEB = benefit to private firm
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Graphical Analysis, continued
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Graphical Analysis, Implications
• Result 1: R1<R*
– University privately produces “too little” research,
because it does not account for the benefits to the
private firm.
• Result 2: Private firm’s preferred amount is where the MEB
curve intersects the x-axis.
• Result 3: R* is not the preferred quantity for either party, but is
the best compromise between university and private firm.
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Graphical Analysis, Intuition
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Education provision
• Government spends approximately 150 billion CZK on
education annually (Czech Republic, 2015).
• Why such extensive intervention?
– Education primarily a private good.
– Some efficiency concerns – positive externalities:
political stability with more educated population, upbringing
of children, influence on cultural institutions etc..
– Also equity concerns – access to education increases
social mobility.
• Elementary and secondary education is subsidized,
compulsory, and produced by the government. This
cannot be rationalized on efficiency grounds alone.
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What do expenditures for public
education accomplish?
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EXTERNALITIES
Private responses
• Coase theorem
• Mergers
• Social conventions
20
Coase Theorem
• Insight: root of the inefficiencies from
externalities is the absence of property rights –
resources used by externality producing patry
are not owned (are public and free).
• The Coase Theorem states that once property
rights are established and transaction costs are
small, then one of the parties will bribe the other
to attain the socially efficient quantity.
• The socially efficient quantity is attained
regardless of whom the property rights were
initially assigned.
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Illustration of the Coase Theorem
• Recall the steel firm / fishery example. If the
steel firm was assigned property rights to the
river, it would initially produce Q1, which
maximizes its profits and it pollutes the river
without limit.
• If the fishery was assigned property rights, it
would initially mandate zero production,
which minimizes its damages and stops steel
production.
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Figure 4
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Coase Theorem – assign property
rights to steel firm
• Consider the effects of the steel firm reducing production
in the direction of the socially efficient level, Q*. This
entails a cost to the steel firm and a benefit to the
fishery:
– The steel firm (and its customers) would lose surplus
between the MB and MPC curves between Q1 and Q1-1,
while the fishery’s damages are reduced by the area
under the MD curve between Q1 and Q1-1.
– Note that the marginal loss in profits is extremely small,
because the steel firm was profit maximizing, while the
reduction in damages to the fishery is substantial.
– A bribe from the fishery to the steel firm could therefore
make all parties better off.
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Coase Theorem – assign property
rights to steel firm
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Coase Theorem – assign property
rights to fishery
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Coase Theorem – assign property
rights to fishery
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When is the Coase Theorem
relevant or not?
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Private responses, continued
• Mergers
• Social conventions
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Mergers
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Public responses
• Taxes
• Subsidies
• Creating a market
• Regulation
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Taxes
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Taxes
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Public responses
• Subsidies
• Creating a market
• Regulation
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Subsidies
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Public responses
• Creating a market
• Regulation
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Creating a market
SZ1
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Creating a market, continued
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Public responses
• Regulation
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Regulation
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Figure 7
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Common Resources
• Common resources
– Not excludable
– Rival in consumption
• The tragedy of the commons
– Why common resources are used more than desirable
• From society’s standpoint
– Social and private incentives differ
– Arises because of a negative externality
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Common Resources
• „The tragedy of the commons“
– Negative externality
• One person uses a common resource
– Diminishes other people’s enjoyment (benefits)
of it
• Common resources tend to be used excessively
– Government - can solve the problem
• Regulation or taxes
– Reduce consumption of the common resource
– Turn the common resource into a private good
(Coase)
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Common Resources
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