Class 8 - Externalities and Public Goods

Tonight we will cover Chapters 10 and 11 and then have an exam review. Exam is next week, Nov 16 over parts 2 and 3. No class on 11/23.

Red Bull is headquartered just outside Salzberg, Austria.

Externalities

Important topic in both micro and macro economics. Basis for government intervention in a market economy.

There are external effects to market decisions.

Examples of market actions that have positive externalities (public goods, external benefits):
buying a swine flu shot, hiring a string quartet.
Education - we're all better off when others get a basic education. There are fewer external benefits to college education. (That's why economists favor public funding of basic ed, but not college ed.)
Medical research.
Publicly funded health care.
Income redistribution.

Govt intervention encourages these transactions in order for the public to receive the positive externalities.

Market transactions that have negative externalities (public bads, external costs):
Buying a cigarette and smoking it - gives harmful second-hand smoke to others
Listening to loud music - bothers others

These transactions may require govt intervention in order to reduce these negative externalities.

See figure 1, pg 205 - you have the classic supply and demand curves.
Supply is a function of the raw materials and labor - fixed and variable expenses of production. This is the private cost. The public cost includes the cost to the environment due to pollution during the process.

To include the total cost, we add in the public costs, shifting the supply curve upward (a higher total price) so we include the cost to the public for cleaning up the environment.

Total cost is private cost plus external costs. Environmental economists try to estimate the external costs, cleanup, lower life expectancy, poorer crops, etc. But it's very difficult.

This explains why, at some point in the future, we'll pay more for petroleum products. Now, we only pay for the private production costs (plus some taxes), which are low. In the future, we'll be paying for the environmental costs as well. (Although there are some positive externalities to low-cost fuel as well.)

For positive externalities, see figure 3, pg 208.

Example: paying to send kids to private school makes them more behaved. That has private value to the parents and also an external benefit to society.

Since these additional benefits apply to the consumers, we shift the demand curve up. This is what society "should do" so that the quantity demanded/supplied is increased.

See Krugman article - The Textbook Economics of Cap-and-Trade. This is very similar to figure 4 on page 214.

The deadweight loss (red triangle) is the amount that producers will no longer be able to earn money from for those additional emissions.

In this scenario, govt is setting the emissions cap. Permit price is determined by the market.

Copenhagen convention may determine the caps for each nation.
In favor: Sierra Club, Environmental Defense Fund

Distinguishing between public and private goods

See Figure 1 pg 226. Matrix is based on work of Paul Samuelson.

Key characteristics:
1. Rivalry in Consumption - is there competition? if one person has more, do others have less?
2. Excludable - can others be kept out

If both, it's a private good. Market system is the best allocator of private goods, especially if there are few external benefits or external costs.

If neither, it's a public good. No rivalry in comsumption and not excludable. Ex: tornado siren.