Government and Market Failure Externalities and Public Goods Chapter 18 Public Goods: Extending the Analysis A private good is subject to the exclusion principal, people unwilling or unable to pay for the product are barred from obtaining its benefits. It is also divisible. Private firms have the profit incentive to produce these goods. A public good does not fit the exclusion principal, once a good is provided, the producer cannot bar nonpayers from obtaining the benefits. Private firms do not have the profit incentive to produce these goods. Due to the free rider problem, the government must take the initiative of producing these goods. Where a producer cannot exclude nonpayers from receiving benefits from a good, it is difficult, if not impossible, for the producer to profitably offer the good for sale. Government determines the demand for public goods through public votes and surveys. The collective demand curve for a public good is found by summing vertically each individual’s willingness to pay for the last unit of the public good at each possible quantity demanded. The collective demand curve measures society’s marginal benefit of each unit of the public good. The supply of public good is determined by its marginal cost which rises as more of the good is produced. The optimal quantity of the public good is produced when marginal benefit equals marginal cost. Benefit-cost analysis is used to determine whether to provide a particular public good and how much of it to provide There will be a benefit and a cost to the production of public goods: Benefit: the extra satisfaction resulting from the output of more public goods Cost: the loss of satisfaction resulting from the accompanying decline in the production of private goods. Resources should be shifted from the private sector to the public sector if the benefit from extra public goods exceeds the costs resulting from having fewer private goods. They should not be shifted if opposite situation prevails. The following rules may then be applied: 1.) One would increase an activity or project or output as long as the marginal benefit exceeds the marginal cost. 2.) Activity is stopped at or as close as possible to the point where marginal benefit is equal to marginal cost. The marginal benefit = marginal cost rule tells us which plan provides the maximum excess of total benefits over total cost, that is, the plan which yields the maximum net benefit to society. Externalities or Spillovers: A spillover is a cost or benefit accruing to a third party, which or who is external to a immediate market transaction. This can be either positive or negative. Examples: a spillover cost or negative externality could be the cost of breathing polluted air emitted by a plant while a positive externality could be the benefit of worker training program which develops the skill base of the economy in general. Spillover Costs Spillover costs occur when producers shift some of their costs onto the community. Here, the producers’ marginal costs are lower than they should be. Their supply curves do not include or “capture” all the costs legitimately associated with production of their goods. Resources are over-allocated. Example: a polluting producer’s supply curve understates the total cost of production, that is, the producer’s supply curve lies to the right (or below) the full cost supply curve, which would have included the spillover cost Spillover Benefits When spillover benefits occur, the market demand curve lies to the left of (or below) the full-benefits demand curve, that is the demand curve does not include the spillover benefits of the product to society. Resources are under-allocated to this product. Individual Bargaining (Coase Theorem): Government is not needed to remedy spillover costs or benefits where 1.) property ownership is clearly defined, 2.) the number of people involved is small, and 3.) bargaining costs are negligible. Property rights place a price tag on an externality, creating opportunity costs for all concerned. However, many externalities involve large numbers of affected parties, high bargaining costs, and community property such as air and water. In these situations private bargaining cannot be used as a remedy and government intervention becomes critical. Liability Rules and Lawsuits Government has established a framework of laws which define private property and protect society from damages. It has created a recovery system which will permit those suffering from spillover costs to sue for compensation. Government Intervention Government Intervention may be essential when externalities affect a large number of people or when community interests are at stake. There may be several forms of intervention: Direct controls : This includes legislation placing limits on the activity reducing spillover. Such controls forces the firms to incur the actual costs associated with the offending activity. Direct controls raise the marginal costs of production, since the firms must operate and maintain pollution control equipment. The supply curve, which earlier on, did not reflect the spillover costs, shifts left-ward (upward) to the full cost supply curve level. Product price increases, equilibrium output falls and the initial over allocation of resources is corrected. Specific Taxes or Charges on the Good: A tax on a specific unit of a good increases the firm’s marginal costs, shifting the supply curve upward. The equilibrium price increases and the equilibrium output declines to the economically efficient level, thus eliminating the over allocation of the resource. Subsidies and Government Provision: When spillover benefits are large, the government has three options for correcting the under allocation of resources: 1. subsidies to buyers: subsidizing consumers of the product. 2. subsidies to producers: a subsidy to producers is a specific tax in reverse; taxes impose an extra cost on producers, while subsidies reduce producers’ costs. 3. government provisions: where spillover benefits are extremely large, government may decide to provide the product as a public good. A Market for Externality Rights “Rights” to air, water, and certain land resources are commonly held and these resources are freely available. As a result, there is no incentive to maintain them or use them carefully thus leading to over-consumption and pollution. Operation of the Market: An appropriate pollution-control agency determines the amount of pollutants which can be discharged into the water or air of a specific region annually while maintaining the water or air quality at some acceptable level. Advantages: As the demand for pollution rights increases over time, the growing revenue from the sale of a fixed quantity of pollution rights could be devoted to environmental improvement, at the same time, the rising price of pollution rights should stimulate the search for improved pollution-control techniques. Society’s Optimal Amount of Externality Reduction The marginal cost (MC) to the firm and hence to society (the opportunity cost of the extra resources used) rises as more and more pollution is reduced. At some point MC may rise so high that it exceeds society’s marginal benefit (MB) of further pollution abatement (reduction). Therefore, additional actions to reduce pollution will therefore lower society’s well being; total cost will rise more than total benefit. Optimal reduction of an externality occurs where society’s marginal benefit and marginal cost of reducing that externality are equal (MB=MC). When MC exceeds MB, additional pollution reduction moves society toward economic efficiency. When MC exceeds MB, additional abatement reduces economic efficiency. A Closer Look at Pollution: Both national and global aspects of environmental pollution are extremely disturbing and need our urgent attention. Causes: The Law of Conservation of Matter and Energy This law holds that matter can be transferred to other matter or into energy but can never vanish. All inputs used in the production processes will ultimately result in an equivalent amount of waste. The volume of current level of waste seems to overwhelm the natural recycling and absorptive process. Some of the other causes are discussed below. Massive Population growth is creating tremendous pressures on our eco-system. In several nations prosperity is accompanied with rising per capita consumption where each person consumes and disposes of more output, a rising gross domestic product means a rising gross domestic garbage. The recent technological change favoring plastics and throwaway containers and packaging have intensified the problem. The “tragedy of the commons” takes place where society will over use and thus abuse common resources to which no one holds property rights. There is no incentive to incur internal costs associated with reducing or eliminating pollution when these costs can be transferred externally to the commons, or to society. Anti-pollution Policy in the United States The Superfund Law(1980): Established direct controls, specific taxes, and stringent regulations for toxic waste. It asserted Federal control over contaminated dump sites and assigned liability for the improperly dumped waste to the firms producing, transporting, and dumping waste. Clean Air Act of 1990: 1. forces factories and businesses to install “maximum achievable control technology” to reduce emissions. 2. required 30 to 60 percent reduction in tailpipe emissions from automobiles 3. a 50 percent reduction in the use of CFCs 4. forces coal-burning utilities to cut their emissions of sulfur dioxide by about 50 percent Trading of Pollution Rights: Utilities trade emissions credits provided by the government. Utilities may obtain credits by reducing sulfur dioxide emissions by more than the specified amount. They can then sell their emission credits to other utilities which find it less costly to buy the credits than install additional pollution-control equipment. Solid waste Disposal and Recycling Market for recyclable inputs (the case for glass) The demand for recyclable glass derives from manufacturers which use recycled glass as a resource in producing new glass, this demand curve slopes downward, manufactures will increase their purchases of recyclable glass as its price falls. The supply curve for recyclable glass slopes upward in the typical fashion because higher prices increase the incentive for households to recycle. Policy The government wants to encourage recycling as an alternative to land dumps or incineration. It could provide, Demand incentives The government could increase recycling by increasing the demand for recycled inputs Supply incentives Example, providing roadside pickup of recyclable goods such as glass, aluminum cans and newspapers at a low monthly fee. Information Failures Market failure occurs because of asymmetric information, that is, unequal knowledge possessed by the parties to a market transaction. Buyers and sellers do not have identical information about price, quality or some other aspect of the good or service. Moral hazard problem is the tendency of one party to a contract to alter her behavior after the contract is signed in ways which could be costly to the other party. This is a case of inadequate information relating to buyers. The moral hazard problem has several applications, some are: Drivers may be less cautious because they have car insurance Medical malpractice insurance may increase the amount of malpractice Guaranteed contract with professional athletes may reduce the quality of their performance Unemployment compensation insurance may lead some workers to shirk Government insurance on bank deposits may encourage banks to make risky loans. The adverse selection problem arises when information known by the first party to a contract is not known by the second and, as a result, the second party incurs major costs. Unlike the moral hazard problem, which arises after a person signs a contract, the adverse selection problem arises at the time a person signs a contract. The labor market also illustrates how inadequate information about employers relating to their work safety codes might produce market failures. The government can remedy such situations by providing all relevant information to the labor force, pass laws so that firms must provide workers with complete information about workplace practices, establish a standard for workplace safety etc. Qualification There many ways to overcome information difficulties, examples are: 1.) firms offer product warranties to overcome the lack of information about themselves and their products. 2.) private firms and organizations specialize in providing information to buyers and sellers, i.e. Consumer Reports and Mobil Travel Guide.