BASIC MICROECONOMICS

(BA-C 211)

November 14, 2020

Environmental Protection
and Externalities

Chapter 11 & 12
PRAYER
CHECKING OF
ATTENDANCE
Quick review..
 What is market structure?

- refers to the characteristics of the market either

organizational or competitive, that describes the
nature of competition and the pricing policy
followed in the market.
4 TYPES MARKET
STRUCTURES
 Assumptions in Perfect Competition

1. Large number of sellers and buyers

2. Product Homogeneity
3. Free entry and exit of firms
4. Profit Maximization
5. No government regulation
If your firm fulfills assumption 1 to 5, then you
are a pure competition market. A perfect
competition market requires number 6 and 7
assumptions be fulfilled.
 Assumptions in Perfect
Competition
6. Perfect mobility of factors of Production
- the factors of production are free to move from one firm to
another throughout the economy. It is also assumed that
workers can move between different jobs.

7. Perfect Knowledge
- It is assumed that all the sellers and buyers have complete
knowledge of the conditions in the market.
 Monopoly
 A monopoly is said to exist when one firm is the
sole producer or seller of a product.
 No close substitutes for the product of that firm
should be available

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 Types of monopoly

1. Natural Monopoly
 where the barriers to entry are something
other than legal prohibition
2. Legal Monopoly
 where laws prohibit (or severely limit)
competition

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 Monopolistic Competition
 Characteristics of monopolistic competition
› Significant number of sellers in a highly competitive
market
› Differentiated products
› Sales promotion and advertising
› Easy entry of new firms in the long run

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 OLIGOPOLY
 Few large firms: each must consider its rivals’ reactions in
response to its decisions about prices, output, and
advertising.
 Standardized or differentiated products
 Entry is hard: economies of scale, huge capital investment
may be the barriers to enter.
 SUMMARY

Pure (or Perfect) Monopolistic

Characteristic Oligopoly Monopoly
Competition Competition
VERY large number of Fairly large number of A few large firms Only ONE firm. The
Number of Firms firms firms dominate an industry firm In the industry

Each firm is so small Firms are small relative A change in one firm's
Price making Changes in the firm's
that changes in its own to the industry, meaning output has significant
output cause changes in
abilities of output do not affect changes in one firms impact on the market
the price, i.e. the firm is
individual firms market price, i.e. firms output have only a slight price, firms are price-
a price-maker!
are price takers impact on market price makers.

Products can be
identical (such as oil) or
Products are slightly
differentiated (such as
differentiated. Firms
Firms all produce Macs and Dells) Unique product, no
will advertise to try and
Type of product identical products, with
further differentiate
Firms will likely use other firm makes
no differentiation advertising to try and anything like it.
product. Branding!
differentiate their
Advertising!
products from
competitors'

Significant barriers to
Completely free entry
Limited barriers to entry, entry exist, preventing
and exit from the There are significant
Entry barriers industry, i.e. NO barriers
firms can enter or leave
barriers to entry
new firms from entering
easily and competing with the
to entry.
monopolist
 LEARNING OBJECTIVES

At the end of the lesson the students are able to:

 Define externalities.
 Differentiate negative and positive
externalities by giving examples.
 Discuss how public and private address
externalities
 Define public goods and it’s characteristics
 Environmental Protection and
Externalities
The problem of pollution arises for every
economy in the world, whether high-income or
low-income, and whether market-oriented or
command-oriented. Every country needs to
strike some balance between production and
environmental quality.
 What is externalities?

 An externality is a cost or benefit of an economic

activity experienced by an unrelated third party.
 The external cost or benefit is not reflected in the
final cost or benefit of a good or service.
 Therefore, economists generally view
externalities as a serious problem that makes
markets inefficient, leading to market failures.
The externalities are the main catalysts that lead
to the tragedy of the commons.
 What is externalities?
 The primary cause of externalities is poorly defined
property rights.
 The ambiguous ownership of certain things may
create a situation when some market agents start to
consume or produce more while the part of the cost
or benefit is covered or received by an unrelated
party.
 Environmental items, including air, water, and
wildlife, are the most common examples of things
with poorly defined property rights.
 Externalities

 The effect of a market exchange on a third

party who is outside or “external” to the
exchange.
 There are EXTERNAL benefits or external
costs to someone other than the original
decision maker.
 Sometimes called as spillover
 Key Terms

 External Cost
 occurs when producing or consuming a good or service
imposes a cost (negative effect) upon a third party.
 External Benefit
 occurs when producing or consuming a good causes a benefit to a
third party. The existence of external benefits (positive
externalities) means that social benefit will be greater than private
benefit.
 Social Benefit
 Social benefit is the total benefit to society from producing or
consuming a good/service.
 Kinds of Externalities

1. Positive Externality
- exists if the production and consumption of a good
or service benefits a third party not directly involved in
the market transaction.
2. Negative Externality
- occur when the consumption or production of a
good causes a harmful effect to a third party.
 Examples of negative production
externalities include:
 Air pollution: A factory burns fossil fuels to
produce goods. The people living in the nearby
area and the workers of the factory suffer from
the deteriorating air quality.
 Water pollution: a tanker spills oil, destroying
the wildlife in the sea and affecting the people
living in coastal areas.
 Noise pollution: People living near a large
airport suffer from high noise levels.
 Some examples of negative
consumption externalities are:
 Passive smoking: Smoking results in
negative effects not only on the health of a
smoker but on the health of other people.
 Traffic congestion: The more people use
roads, the heavier the traffic congestions are.
 POLLUTION AS A NEGATIVE EXTERNALITY

Pollution is a negative externality. Economists

illustrate the social costs of production with a
demand and supply diagram. The social costs
include the private costs of production incurred
by the company and the external costs of
pollution that are passed on to society.
Figure below shows the demand and supply
for manufacturing refrigerators.
 The demand curve (D) shows the quantity
demanded at each price. The supply curve
(Sprivate) shows the quantity of refrigerators
supplied by all the firms at each price if they are
taking only their private costs into account and
they are allowed to emit pollution at zero cost.
The market equilibrium (E0), where quantity
supplied and quantity demanded are equal, is at
a price of P650 and a quantity of 45,000.

 A Supply Shift. If the firm takes only its own

costs of production into account, then its supply
curve will be Sprivate, and the market
equilibrium will occur at E0. Accounting for
additional external costs of P100 for every unit
produced, the firm’s supply curve will be
Ssocial. The new equilibrium will occur at E1.
 However, as a by-product of the metals,
plastics, chemicals and energy that are used
in manufacturing refrigerators, some
pollution is created. Let’s say that, if these
pollutants were emitted into the air and
water, they would create costs of P100 per
refrigerator produced. These costs might
occur because of injuries to human health,
property values, wildlife habitat, reduction
of recreation possibilities, or because of
other negative impacts.
 Positive production externalities
include:
 Infrastructure development: Building a subway
station in a remote neighborhood may benefit real
estate agents who manage the properties in the area.
Real estate prices would likely increase due to
better accessibility, and the agents would be able to
earn higher commissions.
 R&D activities: A company that discovers a new
technology as a result of research and development
(R&D) activities creates benefits that help the
society as a whole.
 Examples of positive consumption
externalities are:
 Individual education: The increased levels of
an individual’s education can also raise
economic productivity and reduce
unemployment levels.
 Vaccination: Benefits not only a person
vaccinated but other people as well because
the probability of being infected decreases.
 Private solutions to externalities:

 The Coase Theorem is a proposition that if

private parties can bargain without cost over the
allocation of resources, they can solve the
problem of externalities on their own.
 Transactions Costs
› Transaction costs are the costs that parties incur in the
process of agreeing to and following through on a
bargain.
 Coase theorem

– For example:

 Pay the residents of Grand Blvd for

noise from King St.
 Why Private Solutions Do Not Always Work

 Sometimes the private solution approach fails

because transaction costs can be so high that
private agreement is not possible.
 PUBLIC POLICY TOWARD
EXTERNALITIES
 When externalities are significant and private
solutions are not found, government may attempt
to solve the problem through . . .
› command-and-control policies.
› market-based policies or market-oriented
environmental policy.
Command-and-Control Policies

› Usually take the form of regulations:

 Forbid certain behaviors.
 Require certain behaviors.
› Examples:
 Requirements that all students be immunized.
 Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).

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 Market-oriented environmental
policies
Market-oriented environmental policies create
incentives to allow firms some flexibility in
educing pollution. The three main categories of
market-oriented approaches to pollution control
are:
› pollution charges
› marketable permits
› better-defined property rights
 • POLLUTION CHARGES

A pollution charge is a tax imposed on the quantity of

pollution that a firm emits. A pollution charge gives a
profit-maximizing firm an incentive to figure out ways
to reduce its emissions—as long as the marginal cost of
reducing the emissions is less than the tax.
 • MARKETABLE PERMITS

When a city or state government sets up a marketable

permit program, it must start by determining the overall
quantity of pollution it will allow as it tries to meet
national pollution standards. Then, a number of permits
allowing only this quantity of pollution are divided
among the firms that emit that pollutant. These permits
to pollute can be sold or given to firms free.
 • BETTER-DEFINED PROPERTY
RIGHTS

The legal rights of ownership on which others are not allowed to

infringe without paying compensation. Does the farmer have a
property right not to have a field burned? Does the railroad have
a property right to run its own trains on its own tracks? If neither
party has a property right, then the two sides may squabble
endlessly, nothing will be done, and sparks will continue to set
the field aflame. However, if either the farmer or the railroad has
a well-defined legal responsibility, then that party will seek out
and pay for the least costly method of reducing the risk that
sparks will hit the field. The property right determines whether
the farmer or the railroad pays the bills.
Tax and Subsidies

Government uses taxes and subsidies to align private

incentives with social efficiency.
 Tax - A government may impose taxes on goods or
services that create externalities. The taxes would
discourage activities that impose costs on unrelated
parties.
Pigovian taxes are taxes enacted to correct the effects of a
negative externality.
 Subsidies - A government can also provide subsidies to
stimulate certain activities. The subsidies are commonly
used to increase the consumption of goods with positive
externalities.
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Examples of Regulation versus
Pigovian Tax
› If the EPA decides it wants to reduce the amount of
pollution coming from a specific plant. The EPA
could…
› tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
› levy a tax of a given amount for each unit of pollution
the firm emits (i.e. Pigovian tax).
 Public Goods
 Two Key properties
 non-rivalry in consumption
› if I consume more, others do not need to consume less
 non-excludability
› you cannot prevent people from consuming the good
› free rider problem
Positive externalities and public goods are
closely related concepts. Public goods have
positive externalities, like police protection or
public health funding. Not all goods and services
with positive externalities, however, are public
goods. Investments in education have huge
positive spillovers but can be provided by a
private company.
National Defense

F172
Fire Protection
Police
 EVALUATION
For each of the following situations, determine the following: (1)
is the externality positive or negative, (3) what is the externality,
and (4) who is receiving the externality (if anyone)?
1. A neighbor in your neighborhood spends a lot of money on
his yard to make it look nice.
Ans: A positive externality is generated because property values
will rise. The recipients of the externality will be the neighbors.
 Evaluation

2. When commercial airlines fly passengers

across the country, pollution is generated from
the fuel that the airplane is burning.
Ans: A negative externality is generated, and
society as a whole experience the externality.
 Evaluation

3. People smoke in a public setting, resulting in

others inhaling the smoke (second-hand smoke).
Ans: A negative externality is generated with the
recipient being the non-smokers.
 Evaluation

4. You get a flu shot that makes it less likely that

you will get the flu.
Ans: Flu shots create positive externalities for
those who do not get the shot because if those
who get the shot are less likely to get sick, those
who do not get the shot will be less likely to get
the virus.
 Summary
 When a transaction between a buyer and a seller
directly affects a third party, the effect is called
an externality.
 Negative externalities cause the socially optimal
quantity in a market to be less than the
equilibrium quantity.
 Positive externalities cause the socially optimal
quantity in a market to be greater than the
equilibrium quantity.
 Summary
 Those affected by externalities can sometimes
solve the problem privately.
 The Coase theorem states that if people can
bargain without a cost, then they can always
reach an agreement in which resources are
allocated efficiently.
 Summary
 When private parties cannot adequately deal with
externalities, then the government steps in.
 The government can either regulate behavior or
internalize the externality by using Pigovian
taxes or by issuing pollution permits.
 ASSIGNMNET

 How Government can Encourage Innovation.

List a number of different government
policies that can increase the incentives to
innovate.