Government Response to an Externality - Essay Example

?Lessons 13, 14 and 15 Government Response to an Externality. a. Governments can respond to externalities by command-and-control policies that attempt to directly regulate economic behavior by either forbidding or mandating it. For example, they can forbid or limit release of certain toxins into the environment, or they can mandate certain safety equipment be installed on all vehicles. Governments may also use market-based policies to influence behavior by attempting to cause the costs (or benefits) of externalities to be considered in market decisions. For example, imposing a tax (reflecting the societal cost) per unit of pollution allows the market to determine the level of pollution warranted by benefits of the good in question. b. An example of a good with a positive externality is occupied housing. Certainly, the individuals housed benefit from shelter, security, and an ability to organize their lives and families in a way that would not likely be feasible if they were homeless. Owners enjoy rents (implicit if the property is owner-occupied) on the home. These are primarily private benefits. Occupied housing tends to be better maintained, improving neighborhood property values) over the long term and neighborhoods with higher occupancy rates tend to have lower crime rates. Both of these are primarily public benefits. An example of a good with a negative externality is a car with an extremely loud stereo system. While the audiophile-owner may enjoy the experience (a private benefit), those who are forced to experience the sound against their will are faced with a nuisance (a public cost). 2. Monopolies. a. If Bart charges $15, then he sells a meal for a total profit of $10. If he charges $8, he'll sell two meals for a total profit of $6. If he charges $7, he'll sell three meals at a total profit of $6. It's in Bart's best interest to charge $15.00 and sell a single meal. The producer surplus in this case is $10 and there is no consumer surplus. b. Without advanced knowledge of who would be willing to pay which price, it would be difficult for him to price discriminate, but there are some strategies he might pursue. One is to institute “haggling.” If every transaction is negotiated, it is possible that those willing to pay a higher price might be persuaded to part with more cash for the same meal than a less well-funded customer (though this increases transaction costs). It might also be possible for Bart to create categories of customers, through some sort of discounting mechanism, which would make it more likely that those willing to pay more would spend more. He might create three cosmetically different, though essentially similar, meals (though this pushes the boundaries of the premise, since the meals would no longer be the same). Ideally, he would be able to sell three meals, one each for $15, $8 and $7. In reality, with imperfect information, he'd likely not do this well. c. Bart would be able to sell three meals, one each for $15, $8 and $7. The producer surplus will be $15 and there will be no consumer surplus. d. If all three meals were purchased by one person, it would be difficult for Brad to price discriminate, except, perhaps, by the use of discount cards or some similar device that needed to be presented upon ordering or paying. Assuming he could not price discriminate and the consumers presented a united, three meals or nothing front, we would expect three meals sold at $7 each. e. If there were another restaurant in town, it would be much more difficult for Bart to price discriminate. He would need to depend on factors such as market friction, customer loyalty or location preference (i.e., Bart's restaurant is easier to get to) or collusion with his competitor to maintain some degree of monopoly power if he wanted to continue to price discriminate. As the number of competitors increased the situation would increasingly resemble a perfect competition model and Bart would become a price taker. f. It would be very difficult to effectively price discriminate in a competitive marketplace. Bart would either need to find some way to establish some degree of monopoly power, for instance through location or product differentiation, or would need to collude with his competitors. Collusion need not be overt. If, for instance, it was simply a common practice to offer student's with three letter names a discount, than Bart could safely price discriminate in that fashion. 3. Monopoly pricing. The dry cleaning industry often discriminates in pricing for cleaning men's vs. women's cleaning. Without price discrimination, consumer surplus would almost certainly be less, after all, the purpose of price discrimination to convert consumer surplus into producer surplus. Without price discrimination, women would pay less than they currently do, which would tend to increase the quantity of dry cleaning they demand. As a result, men would likely see some degree of price increase. 4. Product Bundling. Let’s consider two different bundling scenarios: the example in the question and one involving bundling of video games. In the book's scenario, I really want a burger and I probably want a drink to help wash it down. My demand for them is relatively price inelastic, so a small change in price isn't going to greatly influence my likelihood to purchase them. On the other hand, I'm not all that excited about getting fries. I'll eat them if they're available, but I won't pay much for them, i.e., my demand for them is relatively price elastic. Bundling them with the burger and drink gives me the ability to purchase them at a relatively low marginal price. From the restaurant's perspective, their marginal cost of producing an order of fries is likely quite low, so offering me fries at a lower price as part of the bundle is a net win for them. When video games are bundled, it is often the case that a newer, more popular game is bundled with a less popular game. Left to its own devices, the less popular game might simply sit on the store shelves with little prospect of being sold. Demand for the more popular game is likely to be relatively price inelastic – after all everyone has “just got to have it.” The less popular game is going to go from few units sold to none sold pretty rapidly, so its demand is relatively price elastic. By bundling the two together the manufacturer capitalizes on the inelasticity of the more popular game while incurring the relatively low marginal cost of adding the less popular game to the bundle. It seems likely, then that firms will bundle goods together where there is a relatively popular good that is relatively price inelastic and another good that may be less popular but has a low marginal cost to the firm. This allows the firm to capitalize on the popularity and inelasticity of one good to move a higher volume, perhaps at a higher price, of a less popular, more elastic good. 5. Cost Benefit Analysis. It would seem, at first glance, that if recycling programs are not viable without government subsidies, they are not economically justifiable. However, if there are externalities, societal benefits to recycling, not taken into consideration by the free market, subsidies may be an appropriate way to influence the market to take these benefits into consideration. This is exactly the position of some recycling proponents. Proponents argue that there are benefits to society from recycling (e.g., reduced consumption of virgin materials, reduced energy consumption, reduced waste and decreased release of toxins into the environment). (http://www.alternativeconsumer.com/2009/11/16/recycling-pros-and-cons/, http://www.ehow.com/facts_4827664_pros-cons-recycling-water-bottles.html, http://answers.google.com/answers/threadview/id/778064.html). Some argue that these benefits are not reflected in the market for recycled materials, and that subsidies are appropriate and necessary to cause the market to take these benefits into consideration. Opponents of subsidized recycling programs (http://www.perc.org/pdf/ps28.pdf, http://en.wikipedia.org/wiki/Recycling_in_the_United_States#Criticism) beg to differ. They argue that most of these benefits, to the extent they exist, are indeed reflected in the market price of recycled goods. For instance, if it takes fewer virgin raw materials and less energy to produce a unit of recycled material then this will be reflected in the market price of the material. This contributes, for instance, to the economic viability of recycled aluminum. There is agreement that the release of toxins into the environment in the production of virgin materials is an externality (and their reduction would be an external benefit), but opponents of subsidized recycling argue that recycling also releases toxins, some the same as those released in virgin material production, others unique to recycling. The market, rather than politically influenced subsidies, is the best way to account for the societal cost of the released toxins. No one, or nearly no one, argues against all recycling. Most “recycling opponents” are perfectly happy with recycling that is economically sustainable without subsidies or government mandates (which are, effectively, another form of subsidy). They believe that if recycling is worthwhile, it will pay for itself. On the other hand, proponents of subsidized recycling seem to start from the assumption that we cannot continue to consume and throw away resources and that recycling is necessary. To the extent the market does not reflect these values, the market is incorrect and must be corrected through the use of subsidies and mandates. Read More