This course offers an introduction to the functions of individual decision-makers—both consumers and producers—within the larger economic system. Emphasis is on the nature and functions of product markets, the theory of the firm under varying conditions of competition and monopoly, and the role of government in promoting efficiency in the economy. Most people make the incorrect assumption that economics is ONLY the study of money. My primary goal in this course is to shatter this belief. During this course, we will be addressing the above questions as well as many more relating to: -the environment -love and marriage -crime -labor markets -education -politics -sports -business My main goal is to show you the way economists think and how to use this analytical system to answer questions related not only to these and other important human issues, but to anything you end up doing with your life after this class. After all, as you will quickly find out, I believe that everything is economics!
5.1. Negative Externalities
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From the course by University of Illinois at Urbana-Champaign
Microeconomics Principles
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From the lesson
Public Goods, Common Resources, and Externalities
And so we have arrived at the last week. This course has gone too fast! This module we will be discussing market failures. A market failure is a situation when the market does not do a good job of distributing resources among members of society. In fact, in all of these cases the market IS the problem.
Meet the Instructors
Dr. José J. Vázquez-CognetClinical Professor
Department of Economics
So here's a question for you. Should we have, should we try to reduce
pollution in Brazil? When you talk about the issue of
pollution. Should the goal of policy makers be to get
rid of all pollution? Well, if you ask this question to an
economist. Most economists will tell you no.
I mean, because the reason we have pollution is because we're creating
something as a result. And we value both.
Whatever we produce that produces pollution.
And we also value the clean air and clean water, that is the problem with pollution.
And the question is, really, not reducing pollution to zero, but trying to find the
optimal level of pollution. Now that sounds like a nonsensical term,
so we have to spend a little time talking about it for, for, for me to try to give
you the argument that economists use to deal with pollution.
This section talks about, there's different ways of calling it but we're
talking about the market failure called externalities.
But the main example of externalities is pollution so a lot of people call this
section the economics of pollution. Let me start with a, a example of
pollution to demonstrate the issue of externalities.
In, in the year 2000 a movie came out, it was really popular in the US, called Erin
Brockovich, and it was, it's a movie version of a true story.
The true story was basically in the 19, I think in the 1970s and 1980s, a power
company in California, were discovered to be polluting the, the water source that
the community was using. As a result of the pollution, a lot of
people in the community were actually starting to have negative health effects
to the point that, actually a lot of them actually died.
And the movie Erin Brokovich basically recreates the, the fight of the
communities people, and their lawyers, and one of the, legal assistants which Erin
Brokovich, in trying to get the, the company, PG&E, to pay damages for, for
their pollution. This is a classic example of an
externality. See BGNE the polluting company, the power
company was polluting the environment. They were creating a cost that someone
else was actually having to pay and not themself.
Alright, so that's a classic definition of an externality.
In general, there's two requirements for an externality to occur.
One is when you have an agent engaging in an activity that imposes a change in
welfare to another agent. For instance, the power company behavior
was changing the welfare of the, the residents of the community that were being
affected unethically. And two the change in welfare goes
uncompensated. Right?
They're, the, the power company was not compensating the members of the community
that had been effected by the pollution negatively.
And that's why they went to court in order to get the company to pay.
So, when you have those two things, you have an, an, an economic agent effecting
the welfare of another agent and that changing welfare goes uncompensated.
You have what, what we call in economics an externality, an external market.
And when you have an externality like that, when you have an, a situation like
that, there's another example of a situation which a market is not going to
do a good job at distributing the resources.
In fact, the market will be the problem in that particular case.
Now in order to understand the issue of externalities and perhaps how to deal with
them let's deal with a, talk about a couple of examples of externality, because
there's millions of examples not only pollution.
Every time you hear a dog barking in the middle of the night that's an externality,
the, the behave, someone's getting enjoyment out of the dog.
Right? A person wants a dog, but, it's imposing a
cost on the neighbor and the cost is, is, goes uncompensated.
If I put a, a, an alarm in my house now all of a sudden, the burglar might not
come to steal, to you know, to rob my house, but he might go to the house next
door. So, in essence, I am, I'm getting a
benefit from the alarm, but I'm imposing a cost on my neighbors by increasing the
likelihood that they will get they'll get their house stole, they'll get their stuff
stolen. Smoking in public places, a clear
externality, right? I'm enjoying the cigarette but I'm
imposing a cost on people who, who may not like to smoke or, or deal with my, with
the smoke from my cigarettes and I'm not compensating those people so that's
another externality. So all those are examples of, of
externalities. And in all those cases, the changing
welfare is, is a negative change. When I drive my car and I pollute the
enviornment, I am effecting other people's clean air negatively.
And I am not compensating them by it. So that's an example of, of an externality
in a negative sense. We call it negative externalities.
Alright? And the case of pollution is, is a case of
a negative externality. A company is polluting the environment in
a negative way. Let's do let's evaluate that in a little
more by using a diagram, so we can see a little more what's happening here.
Let's continue to use a, the, the example of the PGNE.
So this could be down here, this could be the quantity of electricity, and usually
our typical supply and demand mode, this is the price of electricity.
The power company produces electricity, so in that sense it makes sense.
Now you have a demand for that electricity.
All consumers want it. And you have a supply that represents the
cost of producing that electricity, right? There's an operating cost of producing
that electricity. That if this is left to the market's own
devices then there will be a price for that electricity and amount of quantity of
that electricity produced. The problem is that in this cost, right so
these are the private costs of the company, the power company have to pay to
produce this electricity. The social costs, the cost of pollution.
If this is a power company that is polluting the water source of a community
and that community is having adverse health effects as a result.
And this company is not, paying for those costs.
Then the supply curve is not going to take account of those costs.
But those are costs. But they're external costs.
If we were have to, if we add those costs to the production, we will know what, what
tend to happen. Right?
The cost of producing electricity will be a lot more than otherwise without it.
So, this will be the supply curve with all the costs, both the private costs plus the
social costs. And if society is going to try to
determine how, how much they value something, something then the price is
going to send the right signal. Then those social costs of pollution of
the social costs. Which is pollution of creating the
electricity must be part of the price. If not, the market would not going to be a
good job at distributing this resource because what's happening is that once you
in, introduce those costs, you see the result is a reduction in supply, right,
and this here are the pollution cost, and since it's more expensive to produce
electricity, because you not only have to pay for priducing electricty, you have to
account for the cost of pollution for producing electricity.
The price of the electricity will be a lot more, and therefore, the quantity of
electricity will be a lot less. There will be a pollution That is actually
emitted when this amount of electricity is produced.
But we value also electricity and we also value the environment, right?
So if, if society has a right signal. The signal that encompasses all the costs
of, producing electricity. Not only the cost of production, but also
the pollution cost, then we can make a you know an informed decision, as to whether
we're willing to pay this high price. And if we actually value the environment
more, then this cost of pollution will probably be higher, and the higher the
price of electricity. Now, most economies will, will would argue
that we, you know, we are probably going to have some electricity and that will
require some pollution. So in the end whatever electricity we have
and whatever pollution we have, will be the optimal level of pollution.
But the problem we have here is actually more perverse, because the problem is that
Finding out what costs, what this cost are, is actually difficult because usually
they are not beared by the person producing, and also they're hard to
measure, right? How are you going to measure the cost of a
person you know, the cost of life of a person, or, or also the cost of a clean
water vista that is polluted with, by, by the company, right?
Polluting environment and you don't have a, you don't have a nice lake that you can
look at. How do you measure that?
It's also, I think, not tradable in the market.
So the problem that if, if the market is used to this the, if the if this is the
price, the cost that I reveal, the market will never distribute this research
efficiently. Never.
In fact, the market is creating a problem right here.
Because it's, it's sending the wrong signal.
It's telling people that electricity is too cheap.
And then you're going to have too much electricity consumed, and too much of the
environment being polluted. But if there's a way to kind of, measure
this cause then we can find ways to internalize that externalities by, by
having techniques that allows this, this supply curve to be a lot less than before.
And we'll talk about those things in the next section.
>> Produced by OCE Atlas Digital Media at the University of Illinois, Urbana,
Champaigne.
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