I. Negative Externalities
A. Many choices have costly side effects that selfish agents do not factor into their decisions. Economists call these costly side effects "negative externalities."
1. Clearest-cut case: theft.
2. More relevant to IO: air pollution.
3. Contrast with: Worker safety trade-offs.
B. How do you measure negative externalities? The same way we always do: willingness to pay.
C. How do you diagram negative externalities? In addition to the demand curve, draw a "social benefits curve." With negative externalities, the social benefits curve lies below the demand curve.
D. Social optimum is at the intersection of the social benefits curve and the supply curve, but market equilibrium is at the intersection of the demand curve and the supply curve.
E. Thus, it is efficient to produce less than the competitive level.
1. Draw the deadweight loss.
2. Strange implication: Given negative externalities, monopoly can be a blessing in disguise!
F. Negative externalities are also often called "public bads," especially when the externalities are large relative to demand (so the socially optimal quantity is close to zero).
G. The key: non-excludability.
1. There is no feasible way to exclude non-payers from the cleaner air.
2. Since you do not have to pay to use it, selfish people will not pay to use it.
3. And if no one will pay for it, why would selfish producers provide it?
H. Economists often call this a market failure, since self-interested behavior leads to inefficient results.
I. Insight from Friedman: "It is easy to misinterpret problems of market failure as unfairness rather than inefficiency... The problem with public goods is not that one person pays for what someone else gets but that nobody pays and nobody gets, even though the good is worth more that it would cost to produce." (p.278)
II. Positive Externalities
A. Positive externalities are the other side of the coin. Positive externalities are beneficial side effects that selfish agents don't factor into their decisions.
1. IO example: beauty products.
B. How to diagram? Draw a social benefits curve above the demand curve.
C. Notice: It is efficient to produce more than the competitive level.
1. (Q: Why isn't this true in the absence of externalities?)
2. Draw the deadweight loss.
D. Positive externalities are also often called "public goods," especially when the externalities are large relative to demand (so the equilibrium quantity is close to zero).
E. Non-excludability is once again the key attribute. If you can't exclude, there is no incentive to pay; if there is no incentive to pay, there is no incentive to produce.
III. Understanding Externalities
A. Many textbook treatments of externalities and public goods/bads also emphasize "non-rivalrousness" - the low or zero marginal cost of providing them. But I see this as a distraction, so we'll ignore it.
B. David Friedman's two caveats:
1. Must distinguish benefits from external benefits. (E.g. education).
2. Must include both positive and negative externalities in your calculations. (Important case: "pecuniary externalities").
C. Important exception: Inframarginal externalities.
D. Some popular and plausible examples: air pollution, national defense, highways and roads (especially local roads), law enforcement (especially victimless crimes)...
E. Some popular but dubious examples: education, health and safety, fire, R&D...
F. Some unpopular but plausible examples (depending on the society): censorship, persecution of religious minorities...
IV. Correcting for Negative Externalities
A. A common initial reaction people have to negative externalities is: "Ban it!"
B. Obvious objection: The cure is worse than the disease. Many valuable activities (like driving) – and even many activities essential to life (like breathing!) - have negative externalities.
C. If they grasp this point, many people's next impulse is to set quantitative limits – like emissions inspections, or technological mandates - like new emissions standards for cars.
1. A particularly crazy variant: "Best Available Technology."
2. Perverse effects of technological mandates: Since they raise the price of new cars, they encourage people to keep driving old cars that pollute a lot more.
D. These approaches are highly inefficient. Quantitative limits and technological mandates ignore heterogeneity: Some firms can reduce pollution more cheaply than others; some people may value polluting more than others; some technologies may cost more than they are worth.
1. Application: Carpool lanes.
E. More efficient regulatory solutions that take heterogeneity into account exist:
2. Tradable permits
F. Advantage: This gets you the same pollution level at a lower price. Firms that can easily switch to less polluting technologies sell their permits to firms where reducing pollution is expensive.
G. Complication: Getting the margin right. A tax on cars reduces the number of cars produced, but does nothing to discourage people who own cars from polluting.
H. Further complication: If government has the power to tax negative externalities, political forces may lead it to tax all sorts of things with no negative externalities to speak of. More on this later.
V. Correcting for Positive Externalities
A. A common initial reaction people have to positive externalities is: "This is a job for government, not the market."
B. Obvious objection: Overkill. There is no need for government to take over the whole industry just because of some positive externalities.
C. A much less intrusive option is for government to subsidize activities with positive externalities.
D. Getting the margin right: Suppose there are positive externalities of voter education, but not math. If you subsidize ALL education, adjusting for the externalities of voter education leads to an inefficiently high level of mathematical education.
E. Further complication: If government has the power to subsidize positive externalities, political forces may lead it to subsidize all sorts of things with no positive externalities to speak of. More on this later.
VI. Externalities, Property Rights, and Coasean Bargaining
A. The economist Ronald Coase pointed out that government action to correct externalities is often premature.
B. Another solution to the externality problem is to define property rights, then allowing parties to bargain. So long as "transactions costs" are low, externalities won't be a problem.
1. Caveat: Common sense ethics tells us to distinguish e.g. polluters from pollutees. But from an economic point of view it can be equally efficient to make polluters pay pollutees for the right to pollute, or have pollutees pay the pollutees to pollute less.
C. Corollary: eliminating property rights can turn any situation into a public goods problem. (E.g. provision of food).
D. Interesting IO applications:
2. Smoking sections
Annual Growth Rate Per Cap. GDP in 50 years
III. How Productive Efficiency Improves
A. Return to the simple Bertrand model with two equally efficient competitors. Question: What happens if one firm's MC suddenly falls?
B. Answer: The lower-cost firm takes over the market and reaps monopoly profits.
C. More important point: The firm only earns these monopoly profits as long as it remains the most efficient. If another firm comes along with even lower costs, it loses everything.
D. Aspiring firms want to figure out lower-cost methods of production in order to become the next market leader; market leaders want to figure out lower-cost methods of production in order to remain the market leader. Competitive innovation is a "leapfrog" race.
E. This simple story highlights the two routes by which productive efficiency increases:
1. Individual firms reducing their costs
2. Selection – lower-cost firms are more likely to survive and expand
F. Interesting empirical studies have compared these two channels. Big finding: Selection matters a lot.
1. In manufacturing, about 70% of efficiency improvement comes from selection
2. In retailing, practically 100% of efficiency improvement comes from selection!
G. Notice that many people are likely to be angry when a market leader is replaced by an upstart. New ideas often hurt market leaders and the workers who depend upon them.
H. A vital point, well-emphasized in Cox and Alm: This "churn" is essential for growth. In the long-run, practically everyone is better off if we take the "hard-hearted" course and let failing firms and industries die.
I. This suggests that one of the main reasons socialism and government ownership fail is precisely because they leave almost no role for selection. Unsuccessful capitalist firms go bankrupt; unsuccessful government industries get more subsidies to keep them afloat.