Microeconomics: Externalities, Environmental Policy, and Public Goods

Chapter Outline

1. Externalities and Economic Efficiency
2. Private Solutions to Externalities: The Coase Theorem
3. Government Policies to Deal with Externalities
4. Four Categories of Goods

5.1 Externalities and Economic Efficiency

• Externalities: A benefit or cost affecting someone not directly involved in a good/service's production or consumption.
  • Positive Externality: Social benefits exceed private benefits.
  • Negative Externality: Social costs exceed private costs.
• Effects on Efficiency:
  • Externalities cause differences between private/social costs and benefits, leading to inefficiencies.
  • Examples:
    • Negative: Pollution from manufacturing.
    • Positive: Neighbor's home improvement increasing your property's value.

Energy and Pollution

• Electricity Market: Involves sellers (with increasing marginal costs) and buyers (with decreasing marginal benefits).
• Pollution Effects: Social costs of pollution exceed private production costs, leading to inefficiencies.
• Solution: Balance marginal social costs and benefits to achieve optimal production levels.

Types of Externalities

• Negative (e.g., production pollution, cigarette smoke)
• Positive (e.g., college education): Market produces too little; social benefits exceed private benefits.

Market Failure and Externalities

• Market Failure: Occurs when externalities lead to inefficient production levels.
• Causes:
  • Incomplete property rights.
  • Difficulty enforcing property rights.

5.2 Private Solutions: The Coase Theorem

• Coase Theorem: Private bargaining can solve externalities if:
  • Property rights are clear and enforceable.
  • Transaction costs are low.
• Example: A farmer and paper mill sharing a stream can negotiate based on property rights.
• Efficiency: Pollution can be reduced to an optimal, non-zero level where marginal benefits equal marginal costs.

5.3 Government Policies

• Taxes and Subsidies:
  • Negative Externalities: Taxes can internalize costs (e.g., pollution tax for utilities).
  • Positive Externalities: Subsidies can encourage more production/consumption (e.g., education subsidies).
• Pigovian Taxes: Increase efficiency and provide revenue; examples include carbon taxes.

Alternatives to Taxation

• Command-and-Control: Imposes limits or requirements (e.g., catalytic converters in cars).
• Tradable Emissions Permits: Cap-and-trade systems allow trading pollution permits to reduce costs efficiently.
• Example: Sulfur dioxide cap-and-trade reduced pollution costs significantly.

5.4 Four Categories of Goods

• Classifications:
  • Rival: One person's consumption prevents another's.
  • Excludable: Non-payers can be prevented from consuming.
• Goods:
  • Private Goods: Efficiently provided in markets.
  • Public Goods, Common Resources: Prone to free-riding and overuse.

Efficient Consumption and Tragedy of the Commons

• Common Resources: Overconsumed due to lack of exclusion; leads to negative externalities.
• Solutions:
  • Small Areas: Community norms.
  • Large Scale: Legal restrictions like taxes, quotas, or tradable permits.
  • Tragedy of the Commons: Lack of property rights leads to resource overuse.