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Samenvatting - Applied Welfare Economics (2130TEWECP)
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APPLIED WELFARE ECONOMICS – SUMMARYPART 1: INTRODUCTION AND THE ROLE O F THE GOVERNMENT
1 PUBLIC GOODS AND EXTERNALITIES
IMPLICATIONS OF EXTERNALITIES
Externality as a by-product along with goods/services
- the actions of an agent have positive or negative side-effects on the well-being of agents
- cost of production for society is not incorporated in the price of the good for the consumer or the
producer → just imposed on society
Examples
- Pollution: water, air
- Imposing infection risk on others (Covid19)
- Accident risks
- Noise
Consider as an example the production of a chemical product
- suppose the production leads to emissions of various pollutants (nitrogen oxides NOx, CO2, etc.)
The marginal external cost 𝑀𝐸𝐶 is the value of the damage inflicted on society (mainly health effects)
The marginal social cost 𝑀𝑆𝐶 is the sum of the marginal production cost and the marginal external cost
Graphical illustration:
- MEC is increasing: the more you produce, the higher impact on society
- In case of no government intervention, what is the eq?
o Intersection of MPC and D: output of Q1 and P1
o External cost is not incorporated by anyone: high production
- What is the social optimum with government intervention?
o Q* and P*
o In the higher price you incorporate the externalities
1
, o Intersection of MSC and D → this is the better outcome of society
Producers consider the private cost, but typically ignore the external cost in their production decisions
- they produce where demand equals supply; quantity 𝑄_1 is sold at market price 𝑃_1
This is more than what is socially desirable
- consumers are not willing to pay the full marginal social cost of the units between 𝑄^∗ and 𝑄_1
There is too much output produced and too much pollution from a social perspective
Social optimum (𝑃^∗, 𝑄^∗ ) VS Market outcome (𝑃_1, 𝑄_1):
- At social optimum:
o less consumer surplus: −(𝐵+𝐺+𝐾)
o lower externality costs: +(𝑀+𝑁+𝐾)
o higher producer surplus: +(𝐵+𝐺−𝑁)
- Welfare gain of the social optimum equals 𝑀⇔ welfare loss of the market solution equals 𝑀
A PRIVATE SOLUTION TO NEGATIVE EXTERNALITIES
Coase Theorem:
- A property right is a legal rule that gives economic agents exclusive control over the use of an asset or
resource
o can be applied to objects (parcel of land) or ideas (patent)
- Property rights may resolve the externality problem and restore efficiency
o the externality is ‘internalized’; taken into account in agents’ decisions
o example:
▪ community surrounding polluting firm has legal right to clean air
▪ cost of externality no longer “external” to the producer
Example:
- Coase studied a simple problem of two farms:
o farm A raises cattle, farm B produces corn
o the cattle of farm A damage the corn of farm B when they roam on B’s land
2
, o a fence can be built by farm A, but this is costly
- Efficient outcome (no negotiation, just the most efficient):
o if the cost of the fence is smaller than the damage, building a fence maximizes joint pay-off
o if the cost of the fence is larger than the damage, not building a fence maximizes joint pay-off
- Questions:
o Will bargaining between farms A and B automatically lead to an efficient outcome?
o If so, who should pay for the fence?
o Can the owner of farm B require the owner of farm A to construct a fence?
o Does it matter whether the property rights are assigned to the owners of farm A or farm B?
- 1 Give property right to farm A: cattle is allowed to roam on farm B’s land
o but B can pay A to build a fence
▪ if the cost of the fence is smaller than the damage, B will pay A to build a fence
▪ if the cost of the fence is larger than the damage: no fence
o → efficient outcome
- 2 Give property right to farm B: cattle is not allowed to roam on farm B’s land
o but A can compensate B for the damage
▪ if the cost of the fence is smaller than the damage, farm A will build a fence
▪ if the cost of the fence is larger than the damage, A will compensate B for the
damage: no fence
o → efficient outcome
- Conclusion
o Independent of who gets the property right, bargaining leads to the efficient outcome
▪ the fence is built when it is socially optimal to do so
o Who gets the property right does have different distributional effects
▪ if A has property right, B pays
▪ if B has property right, A pays
The Coase Theorem states that, regardless of how property rights are assigned, the allocation of resources will
be efficient
- when the parties can costlessly bargain
Government intervention is not needed
- bargaining between the parties will lead to the efficient outcome
o local disputes between neighbors
o conflicts between two firms
- if bargaining is costless
Problems with the Coase solution:
- There may be large numbers of injured parties
o pollution
o congestion (traffic, internet)
- → transaction costs of organizing negotiations extremely high; Coase solution infeasible
- Incomplete/asymmetric information
- Distributional effects are very different depending on who gets the property right
3
,GOVERNMENT SOLUTIONS TO NEGATIVE EXTERNALITIES
Optimal unit taxes:
- The optimal tax equals the marginal external cost 𝑀𝐸𝐶
- It raises the equilibrium price from 𝑃_1 to 𝑃^∗; production of the polluting good down from 𝑄_1 to
𝑄^∗
EXERCISE 1
- Given:
o inverse demand 𝑃 = 24 − 𝑄
o marginal private cost 𝑀𝑃𝐶 = 2 + 𝑄
0 𝑖𝑓 𝑄 < 2
o marginal external cost 𝑀𝐸𝐶 = {
−2 + 𝑄 𝑖𝑓 𝑄 > 2
- Question: find the optimal tax
- Solution:
o use that 𝑀𝑆𝐶 = 𝑀𝑃𝐶 + 𝑀𝐸𝐶
▪ for Q > 2, MSC = (2 + Q) + (−2 + Q) = 2Q
o Set 𝑀𝑆𝐶 = 𝑀𝐵
▪ 2Q = 24 − Q ⇒ Q = 8 (so Q > 2)
o Optimal tax 𝑇 = 𝑀𝐸𝐶 = (−2 + 8) = 6
o
4
, EXERCISE 2
Interpret the following graph
- Solution: positive externality
o MSB is higher than MPB (Q* is more than the private eq)
PUBLIC GOODS
Two characteristics:
- Nonrival: consumption of a good by one person does not reduce the quantity that can be consumed
by others
- Nonexclusive: no one can be excluded from consuming the good after it is produced
Public goods benefit all consumers even if individual consumers do not pay for the provision of the good
- Examples: climate change improvements, national defense, legal security, local parks and fishing
grounds
Optimal provision of public goods:
- Optimal provision requires, as always, marginal cost equal to marginal benefit
o the marginal benefit of an extra unit is the sum of the marginal willingness’ to pay of all
individuals 𝑖 = 1, … , 𝑁:
▪ ∑N i=1 MWTPi = MC
o opposite reasoning as private good: P is the same for everybody, Q is chosen
▪ Public good: Q is the same for everybody, MWTP will vary
- Graphically, the vertical sum of individual demand curves must intersect the 𝑀𝐶 curve
Example:
- Consider two consumers with the following 𝑀𝑊𝑇𝑃 (inverse demand) for the public good:
o P1 = 100 − Q (if Q<100)
o P2 = 200 − Q
- Determine the optimal provision of the public good when:
o its marginal cost is 𝑀𝐶 = 50
o its marginal cost is 𝑀𝐶 = 240
5
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