Summary
Externalities
- 1. When pollution can be directly observed and controlled, government policies should be geared directly to producing the socially optimal quantity of pollution, the quantity at which the marginal social cost of pollution is equal to the marginal social benefit of pollution. In the absence of government intervention, a market produces too much pollution because polluters take only their benefit from polluting into account, not the costs imposed on others.
- 2. The cost to society of pollution from a power plant is an example of an external cost; the benefit to neighbors of beautiful flowers planted in your yard is an example of an external benefit. External costs and benefits are jointly known as externalities, with external costs called negative externalities and external benefits called positive externalities.
- 3. According to the Coase theorem, when externalities exist, bargaining will cause individuals to internalize the externalities, making government intervention unnecessary, as long as property rights are clearly defined and transaction costs—the costs of making a deal—are sufficiently low. However, in many cases transaction costs are too high to permit such deals.
Externalities and Public Policy
- 4. Governments often deal with pollution by imposing environmental standards, an approach, economists argue, that is usually inefficient. Two efficient (cost-minimizing) methods for reducing pollution are emissions taxes, a form of Pigouvian tax, and tradable emissions permits. The optimal Pigouvian tax on pollution is equal to its marginal social cost at the socially optimal quantity of pollution. These methods also provide incentives for the creation and adoption of production technologies that cause less pollution.
- 5. When a good or activity yields external benefits, or positive externalities, such as technology spillovers, then an optimal Pigouvian subsidy to producers moves the market to the socially optimal quantity of production.
- 6. High-technology goods are frequently subject to network externalities, which arise when the value of the good to an individual is greater when a large number of people use the good. Such goods are likely to be subject to positive feedback: if large numbers of people buy the good, other people are more likely to buy it, too. So success breeds greater success and failure breeds failure: the good with the larger network will eventually dominate, and competing products will disappear.
Public Goods and Common Resources
- 7. Goods may be classified according to whether or not they are excludable, meaning that people can be prevented from consuming them, and whether or not they are rival in consumption, meaning that one person’s consumption of them affects another person’s consumption of them.
- 8. Free markets can deliver efficient levels of production and consumption for private goods, which are both excludable and rival in consumption. When goods are nonexcludable, nonrival in consumption, or both, free markets cannot achieve efficient outcomes.
- 9. When goods are nonexcludable, there is a free-rider problem: consumers will not pay for the good, leading to inefficiently low production. When goods are nonrival in consumption, any positive price leads to inefficiently low consumption.
- 10. A public good is nonexcludable and nonrival in consumption. In most cases a public good must be supplied by the government. The marginal social benefit of a public good is equal to the sum of the marginal benefits to each consumer. The efficient quantity of a public good is the quantity at which marginal social benefit equals the marginal social cost of providing the good. As with a positive externality, the marginal social benefit is greater than any one individual’s marginal benefit, so no individual is willing to provide the efficient quantity.
- 11. A common resource is rival in consumption but nonexcludable. It is subject to overuse, because an individual does not take into account the fact that his or her use depletes the amount available for others. This is similar to the problem with a negative externality: the marginal social cost of an individual’s use of a common resource is always higher than his or her individual marginal cost. Pigouvian taxes, the creation of a system of tradable licenses, and the assignment of property rights are possible solutions.
- 12. Artificially scarce goods are excludable but nonrival in consumption. Because no marginal cost arises from allowing another individual to consume the good, the efficient price is zero. A positive price compensates the producer for the cost of production but leads to inefficiently low consumption.
The Economics of the Welfare State
- 13. The welfare state absorbs a large share of government spending in all wealthy countries. Government transfers are the payments made by the government to individuals and families. Poverty programs alleviate income inequality by helping the poor; social insurance programs alleviate economic insecurity. Welfare state programs also deliver external benefits to society through poverty reduction and improved access to health care, particularly for children.
- 14. Despite the fact that the poverty threshold is adjusted according to the cost of living but not according to the standard of living, and that the average American income has risen substantially over the last 30 years, the poverty rate, the percentage of the population with an income below the poverty threshold, is no lower than it was 30 years ago. There are various causes of poverty: lack of education, the legacy of discrimination, and bad luck. The consequences of poverty are particularly harmful for children.
- 15. Median household income, the income of a family at the center of the income distribution, is a better indicator of the income of the typical household than mean household income because it is not distorted by the inclusion of a small number of very wealthy households. The Gini coefficient, a number that summarizes a country’s level of income inequality based on how unequally income is distributed across quintiles, is used to compare income inequality across countries.
- 16. Both means-tested and non-means-tested programs reduce poverty. The major in-kind benefits programs are Medicare and Medicaid, which pay for medical care. Due to concerns about the effects on incentives to work and on family cohesion, aid to poor families has become significantly less generous even as the negative income tax has become more generous. Social Security, the largest U.S. welfare state program, has significantly reduced poverty among the elderly. Unemployment insurance is also a key social insurance program.
- 17. Most Americans are covered by employment-based private health insurance; the majority of the remaining are covered by Medicare (for those over 65) or Medicaid (for those with low incomes). The Patient Protection and Affordable Care Act (ACA) was passed in 2010 with the objectives of reducing the number of uninsured and reducing the rate of growth of health care costs.
- 18. Debates over the size of the welfare state are based on philosophical and equity-versus-efficiency considerations. Although high marginal tax rates to finance an extensive welfare state can reduce the incentive to work, means-testing of programs in order to reduce the cost of the welfare state can also reduce the incentive to work unless carefully designed to avoid notches.
- 19. Politicians on the left tend to favor a bigger welfare state and those on the right to oppose it. This left–right distinction is central to today’s politics.