hi this is Ron SIPP cick in this

particular segment we're going to take a

look at what is called a market

imperfection in this case the market

fails it does you go what does it fail

at it fails in operating at the optimal

output level in the optimal price and so

in this case there'll be a role for

government to play in helping the market

find its optimal price and quantity the

particular example we want to look at at

this point is something called a

negative externality a negative

externality is actually a case where a

cost is imposed on an innocent third

party for instance let's think about the

case of air pollution let's talk about

perhaps an electricity company a company

that is taking coal or some other input

natural gas and producing electricity in

that particular case if the electricity

plant releases air pollution into the

air rather than taking the steps to

properly control that pollution it

imposes a cost on third parties people

that have to breathe the air

perhaps incur healthcare costs or clean

cleanliness costs for instance you know

cities where there's lots of air

pollution you have to wash your car more

your house looks dingy or and dirtier

besides the fact that things are just in

general dirty people incur are incurring

health health costs as a result of

breathing that that dirty air those

particulates that are in the air so

pollution in this case is really from

the standpoint of the electricity

company low-cost or no-cost disposal of

a bad smoke is a bad it's it's a

byproduct of the production process in

producing electricity you're going to

get a byproduct called smoke

particularly if you're using something

like coal to to actually produce the

electricity and that bad imposes a

negative externality or an external cost

on third parties so let's go ahead and

move down and we'll take

look at this and we'll also take a look

at how government can help correct this

problem before we look at that though we

need to understand what the problem

actually is so in this case what I've

done is drawn a crude model of the

electricity production process the coal

is input an input of course there are

other inputs that go into making

electricity but coal is of particular

interest because it's a relatively dirty

input the electricity company takes the

call in the process of generating

electricity it's going to be releasing

smoke into the air

this smoke of course is going to go down

and it's going to actually hurt people

who breathe it okay and the health care

costs or cleanup costs of this smoke are

imposed on people who are not really

directly a party to the transaction

notice that smoke is actually a

complement in production with respect to

electricity but the problem is smoke is

a bad not a good so in this case we're

getting complements in production we're

getting a good called electricity but

we're also getting a bad called smoke

now if the electricity company were

serious about taking care of this smoke

it could put a scrubber on this

smokestack and this scrubber let me just

go ahead and spell that out the scrubber

could catch many of the particulates

that are going up in the air and could

capture those particulates and then of

course that those that that it's like a

big cigarette filter that could be

cleaned out maintained of course in

pulling the particulates and literally

tons of these particulates would be

caught in this in this scrubber these

particulates would have to be trucked

away taken to a landfill improperly

disposed of so the the point is when we

run a scrubber on a smokestack is very

very expensive this is a very expensive

treatment of the smoke and the point is

these costs have to be borne by the

electricity company and ultimately

passed on to the consumer so the

polluting electricity company

avoids these costs and basically and

passes these costs on to third parties

by not absorbing these costs into its

cost structure the market is the

electricity market is actually under

costing which ultimately means under

pricing electricity and ultimately over

producing it and we'll see that in just

a minute

so again the main idea to pick up at

this point is that pollution is

basically no-cost or low-cost disposal

to the electricity company with those

costs being imposed on innocent third

parties who have no way to remedy that

that problem unless government steps in

alright so let's go ahead and move down

and and see how this is shown in supply

and in the world of supply and demand so

here is our here is our electricity

market let me go ahead and switch my

color there here's the electricity

market and there are suppliers of

electricity utility companies and there

are demanders of electricity all the

users both household users and

commercial users now the problem is the

supply curve for electricity is only at

this point accounting for what we call

internal costs internal costs are those

costs that are borne directly by the

firm in any internal cost is ultimately

passed on to the consumer in the way of

price so all internal costs must be

passed on to the consumer and and the

reason for this is electricity companies

are profitable those shareholders

require that they earn a profit so the

electricity company is not only going to

pass on all of its internal costs but

have to earn some sort of profit on top

of those internal costs so ultimately

the costs of electricity are borne by

consumers that's a key idea consumers

ultimately pay all of the costs of

electricity because electricity

companies are profitable if electricity

companies were not

they wouldn't stay in business and the

government would have to step in and

subsidize them in that case it could be

and we see this in certain countries

where there's a lot of command we see

government controlled utility companies

where the utility companies actually do

not cover all of their costs in other

words they do not pass all of their

costs on to consumers which means they

need to be subsidized by the government

what I'm assuming here is this is a

market system where all of the

electricity costs must be passed on to

the consumer so the electricity user

ultimately covers all of the costs of

production the problem is these internal

costs are under estimating under

estimating the true costs of production

after all the electricity companies are

not properly disposing of their waste so

if we were to account for all of the

costs of producing electricity the

supply curve for electricity would be

where it would be much further to the

watt to the left and so notice I now

draw sorry about that let me go ahead

and erase that with my racing function I

can get it to work I think I can so let

me go back to my pen and notice I've

introduced a new supply curve in here

this is called s2 and asked to accounts

for internal internal and external costs

so in other words what I'm now including

is not only internal costs but I'm

including the external costs that have

been imposed on third parties so if this

market were to account for all of the

costs of production where would its

supply curve be it would be further to

the left external costs are these

negative are these negative

externalities okay

so external costs equal negative

externalities notice that by imposing or

including these external costs on the

market or int into the cost structure

the supply curve is further to the what

it's further to the left which means

what the price is what the price is

higher and the quantity is what the

quantity is lower so in essence if we

forced consumers to pay for the cleanup

costs of electricity in other words to

pay for the proper disposal of the

byproducts the smoke or whatever that

comes out of electricity production

consumers would have to pay more for

electricity and not as much electricity

would be consumed which says something

very very important cleanliness is

costly let's go ahead make a note of

that that's that's worth noting I know

some people think cleanliness is next to


I'm not going to make that argument all

I'm saying is cleanliness cleanliness is

costly so if you want a cleaner

environment if you want a cleaner


you basically have to incur higher cost

in other words cleanliness is what


you could say this - cleanliness is

scarce oh yeah yeah yeah in a civilized

world where people mess things up dirty

things up if you don't think you do this

think of your bedroom right now

or think of your kitchen or think of

other areas in your home as you use your

home you inevitably make things dirty it

takes time but not really time time

devoted to cleaning up its time not

devoted to other things time not devoted

to to maybe something you'd like to do a

hobby or something or it's time not

devoted to working per se at a job where

you could earn income so keeping your

house clean means you give up

something which means cleanliness is

costly it is impossible to live in a

civilized world where there are human

beings in close quarters without

imposing without making things dirty and

without needing cost to be incurred to

keep things clean okay cleanliness is

costly and the obviously in a market

setting where companies are producing

things they're going to be making a mess

when they produce things and some of the

things that are produced electricity for

instance is very very dirty very dirty

now America has even with coal done a

much better job than some some other

nations with coal we hear the horror

stories for instance in mainland China

we're walking around Beijing the capital

of mainland China when you walk around

for a day 24 hours or so you're on the

ground in mainland China for a day

you're gonna breathe the equivalent of

three to four packs of the smoke just in

the air you're gonna it's it's the

equivalent of smoking three or four

packs of cigarettes it's that dirty and

all sorts of measures need to be taken

by the citizens of Beijing to not

breathe this stuff they have to wear

breathing apparatus and they have to

limit the amount of time they spend a

walking and you know working in certain

areas of the city

it's extremely the air quality in

Beijing is extremely low why because

companies are not required to deal with

their external costs rivers in Beijing

extremely dirty why because companies

are not required at least to a two to

the same standard as America to keep to

keep to keep pollutants out of the

waterways so waterways in Airways are

just terribly dirty and this is this is

the cost of this is a cost inherent with

manufacturing manufacturing heavy

manufacturing say what you will about

made in China but making manufacturing

in China means less pollution in America

and until China begins to

force these companies to impose until

the the governments of China begin to

force these companies to clean up and

keep their air and waterways clean China

will always have an advantage because in

America we force manufacturers to

produce much more cleanly than the

Chinese do so manufacturing in China you

automatically have a cost advantage

because there's not as much pressure on

you to to produce cleanly okay so let's

go ahead and now look at the question of

what what what can government do what

can government do about this problem and

there's a number of number of options

here so this is going to be a case where

government has a role to play in causing

the market to operate at the right at

the at the right output rate now let me

just let me back up a second here I'm

getting all excited and getting a lot

ahead of myself where should this market

operate this market should operate where

this the optimal the optimal quantity is

QE to the optimal price is PE - why

because this price and this quantity

account for all of the cost of

production so if the market is allowed

just to operate on its own what will it

do it will what it will under price it

will under price so a free market the

free market will under price under price

electricity and the free market will

what the free market will over produce

electricity in this case

yeah well that's that's not bad that's

good cheap electricity lots of it that's

good but keep in mind electricity in

this case is a high pollution product so

what we're saying is we're under pricing

and we're over producing a high

pollution product a very product that is

imposing external costs

on third parties that is not desirable

so point one is is is a isn't is a

market outcome market outcomes sorry I'm

really have a lot of room there that is

what we would call sub optimal

suboptimal means less than optimal the

optimal market outcome the optimal

market outcome would be point two

because we're properly pricing and

producing electricity okay all right so

what can government do to move us from

point one towards point two what can

government do to increase the price of

electricity reduce the quantity in other

words shift the supply curve to the

right let's take a look at that

one option would be regulation so let's

write that out okay and what black there

there we go so government regulation of

the polluter so this this is relatively

straightforward increased regulations in

other words impose a regulation on the

polluting utility company say to the

utility company look you must scrub

scrub your smoke and we expect it to be

at a certain level of cleanliness which

we are going to establish will determine

the health standard you have to meet the

standard if you don't meet the standard

we shut you down so this increase in

regulation does what it's going to

increase the cost of production and this

electricity company is going to need to

put a scrubber on its smokestack this

increases the internal cost of

electricity the effect of that is to

decrease the supply of electricity okay

this of course is a leftward leftward

shift this leftward shift in electric

and and the electricity supply curve

does two things yet what increases PE

and decreases QE which is exactly what

we're looking for alright so basically

what we've done is we've converted this

is very important we have converted

external costs to internal costs okay


there's a second a second method that

governments often use this is less

severe gives gives businesses a little

bit more choice in how to deal with the

problem but you could you could tax the

polluter you could tax the polluter it's

been write that out what I mean tax the

polluter well we impose a tax on the

basis of how much the firm pollutes

the more you pollute the more you get

taxed the less you pollute the less you

get taxed and what we do is we take

measurements we measure your air quality

which is fairly easy to do you can set a

standard and we can set a set a no tax

standard you know there's a certain

level of pollution might be acceptable

but anything above a certain level would

require you to pay a tax on the amount

you pollute well taxes do what they

increase the cost of production they're

an internal cost and again if you

increase the internal costs of the firm

you decrease the firm's supply which

again is leftward and that has the

impact of driving the price of

electricity up and decreasing the

quantity this is almost equivalent to

what we'd call a sin tax we're basically

taxing the polluter for bad behavior and

we let the beat that we let the polluter

behave that way but we make them pay

more for for sinning for polluting if

you will so this is the syntax now you

can imagine here that if I mean taxed on

the amount I pollute I have an incentive

to try to figure out ways to produce

without polluting and avoid these taxes

whenever you impose taxes the person

being taxed looks for ways to avoid it

so this is going to encourage the

polluter to look for ways to produce the

product without tax without polluting in

essence you're going to convert again

external cost

to internal costs you know you're

encouraging the firm to come up with

methods to avoid polluting and that is

going to lead them to incur costs

internal costs that reduce pollution and

it has you know roughly the same effect

as regulation it's not a severe in that

the regulator the regulated firm is

forced to abide by the rule where the

taxed firm can they actually choose to

pollute but has to pay more to pollute

okay but nevertheless you've created an

economic incentive for the firm to stop

polluting there's a third option that I

want to look at and let me go ahead and

move move this up a little bit and that

third option would be to create

government could create a market or what

are called eces EC's our environmental

credits and buy credits and again the

government is involved in all three of

these here the gut let me just put the

we just put a little government creates

a little edge in there the government

creates a market for environmental

credits you go what what do you mean by

that all right let me show you an

example here this is a very primitive

example of this very basic example but

just give you a kind of an idea let me

go ahead and use an example here suppose

there are two companies there's ABC

company and ABC is a dirty company and

it's a relatively a messy producer say

there's a company XYZ company and XYZ

company is a relatively green clean

company okay green and clean all right

so what do you mean ABC is dirty it

pollutes at a relatively high level so

say it's polluting its Stan

pollution is ten parts per billion 10

ppb so this is a measurement of

dirtiness the higher the measurement the

worse the pollution so 10 parts per

billion 10 10 particulates per per

billion of this particular thing that we

don't want in the air ok and then say

say that XYZ company is a relatively

clean company in that it only pollutes

at 6 parts per billion so it pollutes

but it pollutes much less 40% less than

ABC the dirty company ok let's say that

the government has determined a standard

and the standard is let's say 8 parts

per billion

so the standard goes all the way across

and that's 8 parts per billion and

that's called the standard and that's

considered satisfactory so if you hit

the standard you're ok you're not in

trouble but if you're above the standard

you're in trouble so what do we got here

we've got we've got ABC company which is

what 2 parts per billion above standard

we've got XYZ company which is what 2

parts per billion below standard so XYZ

is you know making the government very

happy because it's relatively clean

compared to standard ABC is not making

the government very happy because it's

actually 2 parts per billion above

standard what we're going to do is we're

going to penalize ABC company for its

dirtiness by requiring it to buy it will

have to buy 2 environmental credits why

it essentially is 2 parts per

in above standard it now effectively

must buy it owes to environmental

credits in essence it is its dirtiness

has created a situation where it's in

debt it's in debt to society whereas XYZ

company because it's 2 parts per billion

below standard it is in a position where

it may sell to environmental credits in

other words if they're like they're like

little gold stars XYZ gets two gold

stars for being below standard and has

the right to sell these as credits to

some dirty firm so you can see what

happens here I've made this very simple

and straightforward XYZ is in a position

to sell these to environmental credits

to another producer in its area who

requires to environmental credits so in

other words X Y Z can profit from its

cleanliness and ABC incurs a cost for

its what for its dirtiness and this of

course creates a wonderful incentive you

reward clean companies and allow them to

sell environmental credits and you

effectively punish dirty companies

requiring them to pay for their

dirtiness and in essence you create an

incentive for dirty companies to get

cleaner and create an incentive for

clean companies to get even cleaner and

of course if everyone is below standard

then you can simply lower the standard

alright so if both of these companies

and all other companies in this

particular geographic area who are who

are polluting the air if everyone's

below standard that means a lower

standard is appropriate you can set a

lower standard when everyone can beat

standard and this of course creates

market pressure on both types of firms

to get cleaner the dirty firm must get

cleaner so it doesn't incur costs and

yet and the clean firms have an

incentive to be cleaner because they can

profit from their cleanliness so this is

a you know very primitive now these

these environmental credit systems can

be configured in different ways but this

is just a very simple example of how one

could work and you can see that this

creates market incentives so let's make

a note here you just go ahead and change

the color here the EC system which is

effectively a government created market

creates an incentive to be what to be to

be clean alright so again the issue is

the issue is negative externalities that

in the process of producing something

you're going to make things dirty if the

firm incurs those costs and embeds them

in the price of the product

there's no than those cost being the

cleanup costs there's no problem the

market operates where it should but if

firms fail to internalize the cost of

cleanup and impose external costs on

third parties which let's face it many

firms do they do it either intentionally

or inadvertently then the government can

step in and cause the market to actually

operate in a better place by forcing

companies to address their external

costs and this again is called the case

of negative externalities now rather

than drawing drawing this I'm just going

to mention that governments can

obviously over regulate over tax and and

over compensate for pollution and that's

rather simple to see let me just go

ahead and move us up back back up to our

to our diagram that and I'm not going to


this but but I can I can just go ahead

and show you what it looks like by

looking at this model the government has

obviously overreacted don't don't do

this to your picture but the government

has overreacted if it pushes supply too

far to the right so if it pushes supply

over here to s3 it's over compensated

for external costs and it's pushed

prices where it's actually pushed prices

too high and has pushed the output rate

too low now it's distorting the market

so so long as government doesn't over

regulate an over tax it benefits the

market but when the government over

taxes and over regulates it it distorts

the market so the argument here is going

to center around how big are those

external costs and that's that that's

the problem how big are they how how

detrimental how how costly is a certain

type of pollution to third parties that

becomes the question and of course

science is helpful in trying to decide

this but there's still a lot of

uncertainty and it's still unclear how

certain types of pollution actually

affect affect people

so no easy task to figure that out so

governments will usually be either under

under performing not doing enough or

they'll be too heavy-handed which means

they're doing too much and again this is

usually because of a lack of information

it's difficult to assess how large those

external costs are okay that wraps up

our our our study of negative