Externalities and Public Goods

Why are the dorms so noisy?  Why are the roads so congested at rush-hour in all our major cities? Why do we seem incapable of dealing with the greenhouse effect?  Why do we have overfishing that depletes our oceans?  Why do those study groups always have people who do not do their fair share?   Why do we have state support of colleges such as RIU and locally supported schools?   Why is national defense the responsibility of the government as is the construction of the interstate highway system?

The short answer to all these questions is - market imperfections.  In the last two units we looked at one imperfection - market power - and examined what that did to the market.  What we found was that when firms were in a position to exercise market power, they would exercise power and individuals would find supply of "stuff" was lower and the prices higher than in a competitive situation.  Recognizing the potential problem with market power, the government took an active role in regulating industries where competition was undesirable and discouraging the accumulation of market power with its antitrust laws. 

In this unit we are going to move beyond the problem of market power to a new potential problem - a problem that can be traced to imperfect property rights.  As with the previous units, we will begin with an introduction to the problem using our tutoring example.  Based on our model of the behavior of individuals and firms, we will attempt to "prove" how the market system will end up producing the wrong solution to the allocation problem - society will not be getting what it really wants at least cost.  Once we have established the existence of the problem, we will then move to a discussion of  the potential solutions to the problem. The names given to the two Problems we will discuss here are externalities and public goods. 

Externalities

At a very general level, the existence of externalities can be best viewed as the result of an ownership problem.  The theory is simple - in a market system buyers are paying a price that covers the cost of production.  The value individuals derive from their purchases of "stuff" is just equal to the cost incurred by society in the production of that 'stuff.'  When you bought a textbook for $50, it covered the costs of author, the editors, the graphic designers, the photographers, the producers of the paper it was printed on, the cost of the inks and...  And the best news was the price you paid was the lowest possible price if we were operating in a competitive environment. 

Sometimes, however, all costs are not adequately covered by the price and in these situations the market produces the wrong price.  There are times when there are costs imposed on others who are not compensated for the costs, what we would call  negative externalities.  When your neighbors plays the stereo very loudly and you do not like their choice of music, their decision to listen to music imposes a cost on you, and this would be a negative externality.  It is also possible to have positive externalities, situations where an individual creates benefits for others without receiving any compensation.  The decision by RIU to open a new arena that will bring many new dinner customers into the neighborhood will certainly create extra revenue for the local eateries, but it will not be able to charge the eateries for the additional business.  In this unit we'll now look to see why some costs would be left out of the calculations and how the correct prices could be achieved.  

The Problem

To demonstrate the nature of the problem, let's return to the output decision concerning the number of hours of tutoring help that would be "produced" in a perfectly competitive situation.  You will recall from our earlier discussion (perfect competition) that the important question was: how many hours of tutoring help should be produced when the price paid for each grade point is $1?  The short-run financials of the situation are reproduced below.  Tammy's Tutoring will use the operating rule MC = MR and produce 6 hours of tutoring services that will produce a grade of 60.  The only thing different here is that the last column is now call MPC (marginal private cost).  These are the costs incurred by Tammy and they are the costs upon which the decision will be based.

Short-Run "Private" Financials for Tammy's Tutoring

But what happens if the tutoring business creates a problem for those trying to study in the library next to the tutoring session.  The problem is that the tutoring session use videos that are noisy and disrupt those trying to study in a quiet area.  The number of people negatively affected by the tutoring is related to the number of hours of tutoring taking place.  To make life easy, let's assume that the costs to others of Tammy's tutoring would be $2 an hour.  The table below contains the new cost data if we built these costs into the financials of Tammy.

Short-Run "Social" Financials for Tammy's Tutoring

Let's look at the changes.  The original total cost column is now the total private cost (TPC) column and the total social cost (TSC) column has built in it the extra costs of $2 an hour.  At 5 hours, TSC is now the $38 instead of $28 [5 additional hours @ $2 per hour].  This shows up in a new higher AC and MC figure.  The extra $10 is spread across 54 points bringing the average cost (ASC) to $.70 from $.52.  The marginal cost (MSC) is also higher and is now at $.88 for 54 points.  In fact the column has a new heading, MSC which stands for marginal social cost.  

Now the question is: how many points should be produced by the tutoring business?  We know that when Tammy does not consider the side-effects from the tutoring business, the optimal level is 60 points.  This is the solution based on the optimal choice rule MC = MR.  But what if we took the university's perspective and took the additional costs into effect.  In this case the decision should be made on the expanded cost data that gives us the marginal social cost (MSC).  If you look at the second table you will find the optimal level of grades occurs at 5 hours and a grade of 54.  If we move to 60 points, the additional revenue generated would be $1.00, while the additional cost would be $1.17.  It would be a money losing operation if you expanded beyond 5 hours.

The difference between the private and social marginal cost can be seen in the diagram below.  The optimal output for Tammy, when she is unconcerned about the side-effects, would be at the intersection of the MPC and the P = MR line.  The MSC curve lies above the MPC curve, a reflection of the additional costs imposed on others, and if we used the same optimal rule (P = MC), then from the university's point of view the optimal grade generated from the tutoring would be lower.   By including the external costs into the calculation, Tammy's optimal output would decline.

There are numerous other examples of externalities that distort the allocation of resources and produce wrong prices and output levels.  Before moving on to the solution, we will look at a few more examples.   For those of you who live in a dorm, the noise created by others' loud music is a perfect example.  Students playing loud music and creating the noise that makes it difficult for others to study, are imposing a real cost on you if you need to study for an exam.  The same is true when a jewelry factory belches smoke into the air or pumps waste into the sewer system.  The air that neighbors breathe will be damaging to their health and it may also damage the paint on their houses causing them to paint the houses more often.  Those living downstream from the plant are also likely to have lost the enjoyment of swimming in their favorite water hole. 

And what about the times you find yourself in rush hour traffic.  When someone decides to drive to Providence at rush hour they weigh the costs and benefits of the decision, but they do not consider in the calculations the fact that their being on the road slows down everyone else.  For example, what if your decision to drive adds six minutes to the commute of 500 people. If these people are paid $10 and hour for their work, the cost imposed by your driving on society would be $50 ($1.*6/60*500 = $50).  Because you never pay this to the effected people, however, you will not let these costs enter into your decision to drive to Providence.  The same is true of the people in the Midwestern states in the US whose electricity is generated in coal-fired plants. The burning of coal produces sulfur dioxide that is carried by the prevailing winds eastward where it causes damage to eastern lakes and forests when it returns to earth with rain.  Thus some of the cost of electricity production in the Midwest is being paid for by people in the Northeast.

In none of these instances, however, will those who incur the costs be compensated for their losses by those who generate the costs. Those who want to study will receive no compensation for their poorer grades due to their lost study time and when a customer buys the jewelry produced by the jewelry firm, the price does not include the costs imposed on the firm's neighbors for the additional health costs attributed to breathing the polluted air.  Those who lose valuable time because you are on the road will not be compensated and neither will the people living in the Northeast where the acid rain falls.  Coal is a cheap source of electricity because the price does not include the costs imposed by the acid rain that falls on New England.

Another example that is of particular importance to RI is the fishing industry.  Individual fishers acting in their own self-interest can be expected to over fish the seas and eventually the fishing stocks will be depleted.   The problem is that individual firms (fishers) know it is in their best interest to preserve the fishing stock, to limit today's catch so that it would not reduce tomorrow's catch, but that they have no incentive to behave in this fashion. They know there are advantages to restrictions in industry supply, but no advantages to any restrictions in their own supply.  Individual firms have no reason to believe others will exercise restraint and thus they will all tend to overproduce since they do not need to account for the impact of their decision on others. This is an example of the Theory of the Commons.   Resources owned by everyone are actually owned by no one and these resources will be exploited by the natural workings of competitive markets.  This is similar to the situation facing members of a cartel.

The Solutions

Recognizing the problem is half the battle, but now we need to turn our attention to 'correction' of these externalities.  How do we take care of these problems?  How will we move closer to the optimal level?  There are four types of solutions to externality problems - direct regulation, taxation and subsidy, assignment of property / ownership rights, and market permits.  We'll talk about each and use the tutoring situation at RIU.

The most obvious solution would be for the university administration to step in and simply specify the number of hours at 5. This is an example of what we would call the use of command - and - control instruments associated with direct regulation.  The government would achieve the specified goal by setting either design standards that specify use of a specific technology or performance standards that set a performance level.   In the case of the tutoring, it would be the setting of a standard 5 hour limit.  

In the case of auto emissions, it would be the the government's specification that a catalytic converter be required on all cars.  The federal government takes a similar approach with regard to water quality when it imposes on communities the need to meet certain standards for sewer waste.  An example of this command would be the treaty signed in 1990 that would eventually ban the use of freon gas, a propellant in aerosol cans believed to be destroying the ozone layer in the atmosphere.  A second example, one that has produced mixed results, was the 1992 treaty in Rio at which the industrialized countries agreed to decrease in carbon dioxide emissions believed to be contributing to the greenhouse effect.

But there are other ways, ways to achieve the goals that may have some advantages over the command approach.  If we return to the tutoring, let's assume the university decided to charge a tax of $2 for each hour of tutoring.  What would this do to the financials of Tammy?  What you find is that the financials would look exactly like the ones above.  What used to be the TSC column is now the TPC + tax column.  When there are three hours used, the tax will be equal to 6  (3*2) so the Total Cost (TPC + tax) will be 24.  What would happen here is the costs that had been external to the company are now internal and now you could expect Tammy to choose 5 hours as the optimal size. 

Short-Run "Private" Financials for Tammy's Tutoring with a Tax

This would be an example of  the use of taxes and subsidies to achieve the right price and resource allocation. The nature of the negative externality problem and the solution are described in the diagram below, a diagram that looks very much like the one above.  The intersection of the firm's Marginal Revenue (MR) and Marginal Private Cost (MPC) curves provide us with the firm's optimal choice of output.  The problem is that society is incurring additional costs reflected in the Marginal Social Cost (MSC) and thus the optimal output from society's point of view is at the intersection of the MR and MSC curves.

The government can, however, impose a tax on the output that would bring the two costs into line.  When a tax equal to the difference between the private and social costs is imposed, then the tax would 'force' the firm to account for these costs and output would decrease.  For example, suppose you had reliable evidence the cost of pollution was $3,000 for each automobile produced, the cost of each additional unit of output was $6,000 (MPC), and additional revenue from selling one more unit was $9,000 (MR).  In this situation the firm sees MR > MPC ($9,000 > $6,000) and it will expand production.  If we 'force' the firm to pay the additional social cost in the form of a tax of $3,000, then  MR = MPC ($9,000 = $6,000 + $3,000) and the firm will not expand production.  By imposing the tax we have lowered the firm's optimal choice for production. 

This approach is easily generalizable.  Consider how you might deal with pollutants emitted from cars. You could design a tax on each car based on the amount of pollutants it generates. The tax would be lower on the more energy-efficient cars and steeper taxes on the environmentally damaging ones.  This would tend to lower the "full-price" of the smaller cars which would lower demand for them - precisely why the big three auto makers who built large cars resisted this type of a tax.  To reduce acid rain you could impose a tax on each ton of coal so the electric utilities would build the cost into their calculations.  If you wanted to reduce the effluent from the jewelry companies ending up in the waterways of Rhode Island, you could impose a tax on water consumption.  Finally, if you wanted to lower highway congestion, you could impose a tax during peak periods to bring the private cost of driving more in line with the social costs.

There is still another option.  We could attempt to establish ownership rights, a concept pioneered by R. H. Coase who received the Nobel Prize in 1991 for his work on this topic.  Coase proved that under certain restrictive assumptions, the optimal solution to the pollution problem could be achieved with a simple assignment of property rights. In the case of the the air polluting firm, the pollution problem would disappear if either the residents or the firm could be given ownership of the air.

To understand the logic of the property value assignment approach, we need to begin by assuming the firm pollutes because it benefits from the pollution and the level of pollution produced is directly related to the level of output produced.  Furthermore, the marginal benefits (profits) to the firm from the production of the output decline with higher output, precisely what you would expect if the firm faces a downward sloping demand curve for its product.  Also assume the marginal costs of the pollution increase as output increases - the damage done to society by the pollution increases as output increases.  In the situation depicted in the diagram below, at an output level of 65, the marginal benefit to the firm from polluting is $17, while the marginal costs incurred by those downstream would be $26. 

In the situation where there was no ownership of the resource, these costs and benefits, while very real,  would not enter into the output or input decisions of the firm.  The profit maximizing firm would continue to expand as long as MR > MC. In this situation, however, the firm was not getting charged for the pollution created, so its MC would be 0 and it would therefore continue to expand production until MR = 0 (somewhere far to the right on the diagram). 

Consider, however, what would happen if the people owned the air and were able to charge for it.  In this situation they would charge the firm for the costs they incurred as a result of the firm's production.  In the example above, if the firm wanted to produce 65 units of output, it would receive a bill for $25 for the pollution it generated.  This is obviously more than the firm gets in benefits from pollution so it would cut back on production. It would cut back as long as MC > MB so we would eventually end up at the intersection of the two curves at an output level of about 45 where the firms were paying approximately $20 for the right to pollute.

What would happen if we allowed the firms to have the ownership rights to the air? In this situation where the firm owned the air rights, then the people would 'bribe' the firm to lower production until MC = MB.  As long as MC > MB, people would benefit by paying the firm to lower output. For example, at 65 units of output, the people would pay the firm more to lower production than the firm would get from production ( $25 vs. $17).  We would end up in the same place.   The level of output and pollution would be the same, the difference would be one of who ended up with the money.

The result is the externality can be corrected by the assignment of property rights and the ownership of the rights did not matter.  Regardless of who received the ownership rights, we ended up at the same point, where MC = MB.  In a world with zero transactions costs, the assignment of ownership did not alter the 'equilibrium' situation although it did effect the distribution of income.  When the firms owned the rights, they would receive payments for the rights which would tilt the distribution of income in their favor.

The beauty of this solution is that it leaves no role for the government in correcting externalities other than the assignment of property rights. The limitation is that very often the assumption of zero transactions costs is inappropriate which leads one to look for alternative 'corrections.'  For example, what if the situation were such that we were dealing with one polluting firm and 10,000 downstream neighbors.  There is likely to be a substantial cost of getting the 10,000 people organized to press their case which would weaken the Coasian solution.

A final option that has become more popular in recent years is the selling of rights to pollute.  Again the idea is quite simple. The reason firms pollute is that it is the cheapest way to produce their 'stuff' and we accept that there will be some pollution associated with production.  What the government does not know is how best to reduce the pollution costs and who will need to invest the most to reduce costs. What the government can do in this situation is set a target level of pollution and then give the rights to that pollution to firms who can then sell the right to pollute. The result is those firms where the cost of clean-up will be highest will pay for the right to pollute and they are free to choose what method they adopt to lower pollution levels.  

The most notable example of this approach has been Title IV of the Clean Air Act amendments of 1990 that set a goal of reducing SO2 emissions by 10 million tons from the 1980 levels.  Based on the early results, the approach appears to have reduced pollution below the target without excessive regulatory costs.  [For a review of the results of this experiment see the articles by Schmalensee et. al and Stavins in Journal of Economic Perspectives, Summer 1998].  

We have thus looked at four solutions to the pollution problem. None of them is without flaw, although economists would tend to rank direct regulation as the least desirable solution in most externality situations. The exception would be where there are irreversible externalities as would be the case with nuclear waste. The preference against direct regulation stems from the fact that it does not harness the power of incentives and creativity.  To see the difference, let's return to the problem of auto exhaust pollution. The catalytic converter is an example of what we get with direct regulation. The converter was a cost imposed on all car producers and it provides no incentive to innovate, to improve the pollution situation. If there had been a tax per unit of pollutant, however, the major auto companies would have had an incentive to find a better solution so they would have gained a competitive advantage in the market place. If they could design a better system that reduced pollution below existing levels, then this would lead to lower taxes which would mean lower prices for their autos. You could expect firms in this situation to continue their research to find ways to further lower pollution, something certainly missing with the catalytic converter regulation.

The debate over the appropriate solution to externalities will not be resolved quickly, but we can be assured that externalities will not soon disappear.  In fact, the problem of externalities is likely to increase - a direct side-effect of the ever shrinking world you hear of often.  If the world does in fact continue to get smaller, the odds increase that you will bear the consequences of someone else's transaction and the need for solutions will only increase.   Furthermore, the solutions to many of the externalities will need to be international in scale since many of the most pressing environmental problems such as global warming are truly international in scale. 

Public Goods

Now let's turn our attention to a problem many of you have encountered.  Why do you have so many problems with study groups? Why are there always group members who do not do their fair share?  It turns out this is just an example of a larger, society-wide problem encountered when we have public goods.   In solving the group problem we will better understand why we have state supported colleges and locally supported schools, why national defense, police and fire departments, and the courts are government funded operations.  It has something to do with the characteristics of the goods.

Most goods and services produced in a market economy possess two characteristics - excludability and depletability.  Excludability means there is a way to keep people who do not pay for something from benefiting from the good or service.  If you buy a computer, you can exclude others from using it.   Depletability means the value of the good or service is used up by someone when they consume it.  If you are using a computer, then it is not available to be used by someone else at that time.  There is a class of goods and services called public goods, however, that lack these two properties. There are some goods and services that it is virtually impossible to exclude non payers from consuming and once they are produced, the consumption of these goods by one person does not reduce what is available to others.

The classic textbook example is defense - the industry that provides national security.  Before we look at that example, let's return to the group.  Why are they so often dysfunctional?  Why are there so often people who will not do the work?  What do we know about the grade for the project?  Usually it is a group grade that is assigned so that an individual's grade is not directly related to the person's contribution.  So what happens when the work needs to be done.  Peter, a student with slug tendencies is considering his options.  He is fairly confident that Sheila, a bit of a perfectionist with a high GPA, will not let the group project fail.  He also knows he cannot be excluded from the group grade and the grade he gets will not deplete the grades others get.   So what does he do?  He becomes a free-rider and allows the group to do the work and he is more than willing to share in the credit.

Now we can return to the the issue of national defense.  To understand the problem, compare your answers to the two questions: How much would you pay for security and how much would you pay for a TV?  When we talk about the TV, you pay a price to have your own TV. You do not get the benefit from the TV unless you purchase it and you can certainly exclude those who do not pay. When we talk about defense, however, we are talking about a service that is available to all in a community regardless of your payment for the security.  Free-spirit Fred is certainly not going to spend his "fair" share because he is confident paranoid Paul will pay enough to get the security.  Once the community invests in defense, you will benefit from the security regardless of your contribution.  In this situation we are likely to have some individuals not willing to pay their 'fair' share because they know that others will pay and they can get it for nothing.  Once again we find the 'free rider' problem which is at the heart of the public good problem.

While we may find considerable agreement among economists on the existence of this market imperfection, we find considerable disagreement on where to draw the line between public and private goods.  President Clinton, in his first term in office, attempted to move the line when he proposed a form of national health coverage to replace the existing system. Closer to home, you are likely to see a continued debate over the privatization of education. Education has long been thought to be a public good because we all benefit from a more educated population, but in recent years there has been a growing concern expressed about the quality of education. It is a debate you can expect to hear more of as the baby boomers' kids move through the educational system.  It is certainly one we will discuss in class.

Another area where the government has taken an active role in providing a public good is in the promotion of research and development. One of the marvels of the market system has been the ability to provide economic growth which has been the result of technological changes resulting from innovation. In a perfect world we would expect to see an adequate amount of innovation since the innovations would take place as long as the benefits derived from the innovations exceeded the costs. Unfortunately, there are two reasons to believe that a competitive system would provide us with inadequate levels of innovation.

First, there is the problem of who would spend money today on research if once the product of that research came to market others could duplicate it through reverse engineering. In this situation, the competitors who were able to duplicate the process would be able to sell the product at lower cost because they would not have to finance all of the development costs. From the short-term perspective, society would be better off since it would be getting the new good or service at lower cost.  In the long-run, however, we may find there will be little incentive to innovate which will slow down the rate of technological change.  In a dynamic sense, society would be well served by the government's active promotion of innovation.

The promotion of innovation by the government can also be justified on the grounds the benefits to basic research often extend far beyond those earned by the innovator.  In fact one thing we have always been very bad at is predicting the impact of technology.  A classic case was IBM's gross underestimate of the market for computers.  Another would be the development of the steam engine.  Those who designed the steam engine as a means to pump water our of coal mines could never have imagined the impact the engine would have on the production process in a wide array of industries, how it would replace water power as the primary means of driving machinery in America's factories.

How then does the government promote research. One of the key pieces of the strategy has been the patent system. The US Constitution grants to authors and inventors the exclusive right to their writing and inventions.   At the present time the patent runs for 17 years during which time no other producer can use the product in the production of some other good or to duplicate it. This allows for the profit to be earned for that time, an inducement to spend the time and the money on the innovation. The government also can promote R&D with subsidies and universities, including URI, are some of the primary beneficiaries of this research funding.

Externalities and public goods are sources of market imperfections that will be the center of much heated public debate in upcoming years.  You will hear much about the problems of global warming and acid rain as well as debates over the social security and public education and the basic principles of externalities and public goods introduced in this unit should help you steer your way through the claims and counter claims. Now it is time to move on to a discussion of the labor market.