Public goods and externalities examples and exercises Lecture

Public goods and externalities: examples and exercises Lecture 12 – academic year 2014/15 Introduction to Economics Fabio Landini

Example of the bridge: two-ways table Ye s Tax No Excludable Rival (PRIVATE GOOD) Rival (COLLECTIVE GOOD) Excludable Many Not Excludable Not Rival (NATURAL MONOPOLY) Not Rival (PUBLIC GOOD) N. persons Few 2

INTRO The book says that both public good entail externalities. A) Are the externalities associated with public goods positive or negative? Give an example. B) Would the quantity of public good produced thorough free market be higher or lower than the efficient one? 3

INTRO A) The externalities associated with public goods are usually positive. Since the benefit that a person receives from a public good does not affect the benefit of other persons, the social value of public good is higher than its private value. Example: national defence, knowledge, … B) Since public goods are not excludable, the quantity produced by the free market is zero, and is thus inferior to the efficient one. 4

Index of examples/exercises • INTRO • Ex. 12. 1 (externalities and alcohol consumption) • Ex. 12. 2 (permit I) • Ex. 12. 3 (firms and R&D) • Exercise on public good • Ex. 12. 4 (the Economist) • Ex. 12. 5 (permit II) 5

Ex. 12. 1 The higher alcohol consumption, the higher the number of car accidents, and thus the higher the risk of driving. Are there externalities in the market for alcoholic beverages? 6

Ex. 12. 1 Market for alcohol beverages Price Supply (social cost) B A C Demand Social value Qo Qm Quantity 7

Ex. 12. 1 In because of the externalities due to the increase in car accident, the social value curve is below the demand curve. The equilibrium in a free market is given by Qm, whereas the socially efficient one is Qo. 8

Ex. 12. 2 Firm A B Level of pollution (units) Cost to reduce pollution (units) 110 30 50 10 In order to bring the level of global pollution to 80 units, the Government assigns to each firm 40 tradable permits to pollute one unit. 9

Ex. 12. 2 a) Who offer the permits in the market? How many? Who purchases them? How many? Explain the motivations behind buyer’s and seller’s decision. b) How much would the cost to reduce pollution be if permits were not tradable? 10

Ex. 12. 2 a) Each permit is worth 10 for B and 30 for A (=unitary cost to reduce pollution). Since A’s cost are higher than B’s, A wishes to maintain her level of pollution (she will keep her 40 permits and is willing to buy 40 permits more). Who sells this additional permits to A? Firm B. 11

Ex. 12. 2 Therefore: A pollutes 80 units and reduce pollution for 30 units (cost = 900). B sells her 40 permits e reduces pollution for 50 units (cost = 500). Total cost for reducing pollution = 1. 400 (900+500). 12

Ex. 12. 2 b) If the permits were not tradable, both firms could pollute 40 units. A must reduce pollution for 70 units (cost=2. 100) and B for 10 units (cost=100). Total cost for reducing pollution= 2. 200 (+800 with respect to the case with tradable permits). 13

Ex. 12. 3 People tend to argue that firms tend not carry out basic research (BR) at an efficient level. Why is this so? a) Which type of good is BR? b) Which type of policy has been adopted by US? c) It is generally believed the adopted policy increases the technological capabilities of firms with respect to competitors. Is this argument coherent with the adopted classification? 14

Ex. 12. 3 a) BR is a public good: it generates spillover that can benefit many other social actors. Firms do not take into account these externalities in drafting their balance sheet; they consider only the company’s expected future profits. => It follows that the amount of BR carried out by private firms is below the social optimum. 15

Ex. 12. 3 b) In the US firms receive subsidies to carry out BR through public institutions, e. g. NIH (National Institute of Health) and NSF (National Science Foundation). c) Scientific knowledge spreads rapidly (especially today) and it tends to be not excludable. Exclusion can obtain if firms of other countries are not allowed to access internally produced knowledge (e. g. though patents). 16

Ex. 12. 3 The advantage of US firms is probably the one of first mover. However, ones research and knowledge spread, the firms of other countries will be equally competitive. 17

Exercise on public goods 100 inhabitants of a urban district are worried about their SECURITY. N. Guards 24 h Tot. Cost (Euro) Individual benefit for each inhabitant (Euro) 0 0 0 1 150 10 2 300 16 18

Exercise on public goods Questions: a)Is the surveillance service a public good for inhabitants? Why? b)If one inhabitant decided to the pay the surveillance service by her own, how many guards would she hire? c)If 50 inhabitants made an agreement in which all pay one share of the cost of surveillance, how many guards would they hire? 19

Exercise on public goods a) The surveillance service is a public good because, once produced, it is NOT EXCLUDABLE and NOT RIVAL 20

Exercise on public goods b) If one inhabitant took the initiative to pay by her own the surveillance service, she would not hire ANY guards. In fact the marginal benefit of hiring one guard (10 Euro) would be much higher than the marginal cost(150 Euro) 21

Exercise on public goods c) If 50 inhabitants made an agreement in which all pay one share of the cost of surveillance, then they can decide to hire 2 guards: Cost = 300/50 = 6 Euro each Benefit= 16 Euro 22

Ex. 12. 5 The Economist , 19/03/1994: “in the last decade, world’s fishing areas have been exploited near to their depletion”. Then, analysis of the problem and possible solutions, both private and public: a) “Fishers cannot be blamed for over-exploitation, somehow, they behave rationally ad they have always done”. In which sense is over-exploitation rational from the fishers’ point of view? 23

Ex. 12. 5 b) “A community, tighten by common obligations and interests, is able to self-manage a common resource”. Explain. 24

Ex. 12. 5 c) “Until 1976 most part of the world’s fishing areas were open to everybody, making it impossible to apply any policy for preservation. Since then, international law has extended the national jurisdiction from 12 to 200 miles form the coast”. Explain how this agreement can contribute to (partially) solve the problem. 25

Ex. 12. 5 d) Several governments encourage fishing by giving aids to fishers. Explain in which way these incentives favoured over-exploitation. e) “Only if fishers will be granted an exclusive right on a specific fishing area management as efficient as the one of a farmer on her own land will obtain”. Find argument in support of this statement. f) Are there other policy interventions that could be implemented in order to reduce over-exploitation of world’s fishing areas? 26

Ex. 12. 5 a) “Fishers cannot be blamed for over-exploitation, somehow, they behave rationally ad they have always done”. In which sense is over-exploitation rational from the fishers’ point of view? ? a) Over-exploitation is rationale for fishers because they are using a collective resource, thus they do not pay the costs associated with the reduction of fishes available to others In free market, the quantity of fish that is sold exceeds the socially efficient quantity. 27

Ex. 12. 5 b) “A community, tighten by common obligations and interests, is able to self-manage a common resource”. Explain. b) One possible solution to the problem could derive from regulating the quantity of fish that can be caught, e. g. , imposing a tax or auctioning some permits to fish. Problem: MANY nations have access to oceans. This would require some forms of international cooperation, which is difficult to implement in because of the large dimension of the sea. 28

Ex. 12. 5 c) “Until 1976 most part of the world’s fishing areas were open to everybody, making it impossible to apply any policy for preservation. Since then, international law has extended the national jurisdiction from 12 to 200 miles form the coast”. Explain how this agreement can contribute to (partially) solve the problem. c) The recognition of property rights to individual nations could be a viable solution, given that each nation would then have a higher incentive to find a solution. Each nation could introduce a tax or create permits, ensuring monitoring over an area of smaller size. 29

Ex. 12. 5 d) Several governments encourage fishing by giving aids to fishers. Explain in which way these incentives favoured over-exploitation. d) So long as governmental authorities, such as the Coast Guard in US, protect fishers and help them when they need so, fishers will never pay the total cost of their fishing (private plus social cost) and will thus catch as much fish as they can. 30

Ex. 12. 5 e) “Only if fishers will be granted an exclusive right on a specific fishing area management as efficient as the one of a farmer on her own land will obtain”. Find argument in support of this statement. e) If fishers owned a specific fishing area, they would not over-exploit it because they would necessarily pay the cost. This is an example in which property rights help preventing over-exploitation of a collective resource. 31

Ex. 12. 5 f) Are there other policy interventions that could be implemented in order to reduce over-exploitation of world’s fishing areas? f) The alternatives include: fishing regulation, tax on fishers, auctioning of fishing permits or taxation of fish that is sold; in general all these interventions would help reducing the quantity of fish that is exchanged in equilibrium bringing it closer to the efficient quantity. 32