# Monopoly and Antitrust Policy

## The Great Deregulation Experiment

Governments at all levels across the United States have regulated prices in a wide range of industries. In some cases, like water and electricity that have natural monopoly characteristics, there is some room in economic theory for such regulation. However, once politicians are given a basis to intervene in markets and to choose prices and quantities, it is hard to know where to stop.

### Doubts about Regulation of Prices and Quantities

Beginning in the 1970s, it became clear to policymakers of all political leanings that the existing price regulation was not working well. The United States carried out a great policy experiment—the deregulation that we discussed in Monopoly—removing government controls over prices and quantities produced in airlines, railroads, trucking, intercity bus travel, natural gas, and bank interest rates. The Clear It Up discusses the outcome of deregulation in one industry in particular—airlines.
One difficulty with government price regulation is what economists call regulatory capture, in which the firms that are supposedly regulated end up playing a large role in setting the regulations that they will follow. When the airline industry was regulated, for example, it suggested appointees to the regulatory board, sent lobbyists to argue with the board, provided most of the information on which the board made decisions, and offered well-paid jobs to at least some of the people leaving the board. In this situation, it is easy for regulators to poorly represent consumers. The result of regulatory capture is that government price regulation can often become a way for existing competitors to work together to reduce output, keep prices high, and limit competition.

### The Effects of Deregulation

Deregulation, both of airlines and of other industries, has its negatives. The greater pressure of competition led to entry and exit. When firms went bankrupt or contracted substantially in size, they laid off workers who had to find other jobs. Market competition is, after all, a full-contact sport.
A number of major accounting scandals involving prominent corporations such as Enron, Tyco International, and WorldCom led to the Sarbanes-Oxley Act in 2002. The government designed Sarbanes-Oxley to increase confidence in financial information provided by public corporations to protect investors from accounting fraud.
The Great Recession, which began in late 2007, was caused at least in part by a global financial crisis, which began in the United States. The key component of the crisis was the creation and subsequent failure of several types of unregulated financial assets, such as collateralized mortgage obligations (CMOs, a type of mortgage-backed security), and credit default swaps (CDSs, insurance contracts on assets like CMOs that provided a payoff even if the holder of the CDS did not own the CMO). Private credit rating agencies such as Standard & Poors, Moody’s, and Fitch rated many of these assets very safe.
The collapse of the markets for these assets precipitated the financial crisis and led to the failure of Lehman Brothers, a major investment bank, numerous large commercial banks, such as Wachovia, and even the Federal National Mortgage Corporation (Fannie Mae), which had to be nationalized—that is, taken over by the federal government. One response to the financial crisis was the Dodd-Frank Act, which majorly attempted to reform the financial system. The legislation’s purpose, as noted on dodd-frank.com is:
All market-based economies operate against a background of laws and regulations, including laws about enforcing contracts, collecting taxes, and protecting health and the environment. The government policies that we discussed in this chapter—like blocking certain anticompetitive mergers, ending restrictive practices, imposing price cap regulation on natural monopolies, and deregulation—demonstrate the role of government to strengthen the incentives that come with a greater degree of competition.

### Key Concepts and Summary

The U.S. economy experienced a wave of deregulation in the late 1970s and early 1980s, when the government eliminated a number of regulations that had set prices and quantities produced in a number of industries. Major accounting scandals in the early 2000s and, more recently, the Great Recession have spurred new regulation to prevent similar occurrences in the future. Regulatory capture occurs when the regulated industries end up having a strong influence over what regulations exist.

### Self-Check Questions

Use the following information to answer the next three questions. In the years before wireless phones, when telephone technology required having a wire running to every home, it seemed plausible that telephone service had diminishing average costs and might require regulation like a natural monopoly. For most of the twentieth century, the national U.S. phone company was AT&T, and the company functioned as a regulated monopoly. Think about the deregulation of the U.S. telecommunications industry that has occurred over the last few decades. (This is not a research assignment, but a thought assignment based on what you have learned in this chapter.)

### Review Questions

### Critical Thinking Questions

### References

Bishop, Todd. 2014. “Microsoft Exec Admits New Reality: Market Share No Longer 90% — It’s 14%.”GeekWire. Accessed March 27, 2015. http://www.geekwire.com/2014/microsoft-exec-admits-new-reality-market-share-longer-90-14/.
Catan, T., & Dezember, R. “Kinder-El Paso Merger to Face Antitrust Scrutiny,” Wall Street Journal. October 19, 2011.
Collins, A. “Tallgrass Energy to Acquire Kinder Morgan Assets for $1.8B.” The Middle Market, Accessed August 2013. http://www.themiddlemarket.com/news/tallgrass-energy-to-acquire-kinder-morgan-assets-for-1-point-8-billion-232862-1.html.
Conoco Phillips. “Why Natural Gas.”  Accessed August 2013. http://www.powerincooperation.com/en/pages/useful.html?gclid=COXg7rH3hrgCFWlp7AodtkgA3g.
De la Merced, M. (2012, August 20).  “Kinder Morgan to Sell Assets to Tallgrass for $1.8 Billion.” The New York Times. August 20, 2012.
The Federal Trade Commission. n.d. “The Federal Trade Commission’s (FTC) Mission.” Accessed March 27, 2015. https://www.ftc.gov/system/files/documents/reports/2014-one-page-ftc-performance-snapshot/150218fy14snapshot.pdf.
Kahn, C. “Kinder Morgan to Buy El Paso Corp. for $20.7B.” USA Today. October 17, 2011.
Kinder Morgan. (2013). “Investor Information.”  Accessed August 2013. http://www.kindermorgan.com/investor/.
Rogowsky, Mark. 2014. “There'd Be No Wireless Wars Without The Blocked T-Mobile Merger, So Where Does That Leave Comcast-TWC?” Forbes.com. Accessed March 12, 2015. http://www.forbes.com/sites/markrogowsky/2014/08/27/t-mobile-and-sprint-continue-to-battle-thanks-to-the-government/.
U.S. Energy Information Administration (a). “Natural Gas Consumption by End User.”  Accessed May 31, 2013. http://www.eia.gov/dnav/ng/ng_cons_sum_dcu_nus_a.htm.
U.S. Energy Information Administration (b).  “Natural Gas Prices.”  Accessed June 28, 2013. http://www.eia.gov/dnav/ng/ng_pri_sum_dcu_nus_a.htm.
The Wall Street Journal. 2015. “Auto Sales.” Accessed April 10, 2015. http://online.wsj.com/mdc/public/page/2_3022-autosales.html.


# Environmental Protection and Negative Externalities

## Introduction to Environmental Protection and Negative Externalities

In 1969, the Cuyahoga River in Ohio was so polluted that it spontaneously burst into flame. Air pollution was so bad at that time that Chattanooga, Tennessee was a city where, as an article from Sports Illustrated put it: “the death rate from tuberculosis was double that of the rest of Tennessee and triple that of the rest of the United States, a city in which the filth in the air was so bad it melted nylon stockings off women’s legs, in which executives kept supplies of clean white shirts in their offices so they could change when a shirt became too gray to be presentable, in which headlights were turned on at high noon because the sun was eclipsed by the gunk in the sky.”
The problem of pollution arises for every economy in the world, whether high-income or low-income, and whether market-oriented or command-oriented. Every country needs to strike some balance between production and environmental quality. This chapter begins by discussing how firms may fail to take certain social costs, like pollution, into their planning if they do not need to pay these costs. Traditionally, policies for environmental protection have focused on governmental limits on how much of each pollutant could be emitted. While this approach has had some success, economists have suggested a range of more flexible, market-oriented policies that reduce pollution at a lower cost. We will consider both approaches, but first let’s see how economists frame and analyze these issues.


# Environmental Protection and Negative Externalities

## The Economics of Pollution

From 1970 to 2020, the U.S. population increased by 63 percent, and the size of the U.S. economy increased by more than 3.8-fold. Since the 1970s, however, the United States, using a variety of anti-pollution policies, has made genuine progress against a number of pollutants.  lists the change in carbon dioxide emissions by energy users (from residential to industrial) according to the U.S. Energy Information Administration (EIA). The table shows that emissions of certain key air pollutants declined substantially from 2007 to 2012. They dropped 740 million metric tons (MMT) a year—a 12% reduction. This seems to indicate that there has been progress made in the United States in reducing overall carbon dioxide emissions, which contribute to the greenhouse effect.
Despite the gradual reduction in emissions from fossil fuels, many important environmental issues remain. Along with the still high levels of air and water pollution, other issues include hazardous waste disposal, destruction of wetlands and other wildlife habitats, and the impact on human health from pollution.

### Externalities

Private markets, such as the cell phone industry, offer an efficient way to put buyers and sellers together and determine what goods they produce, how they produce them and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. However, what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller?
As an example, consider a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood. You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside or “external” to the exchange is called an externality. Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers.
Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. If you love country music, then what amounts to a series of free concerts would be a positive externality.

### Pollution as a Negative Externality

Pollution is a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. The social costs include the private costs of production that a company incurs and the external costs of pollution that pass on to society.  shows the demand and supply for manufacturing refrigerators. The demand curve (D) shows the quantity demanded at each price. The supply curve (Sprivate) shows the quantity of refrigerators that all firms in the industry supply at each price assuming they are taking only their private costs into account and they are allowed to emit pollution at zero cost. The market equilibrium (E0), where quantity supplied equals quantity demanded, is at a price of $650 per refrigerator and a quantity of 45,000 refrigerators.  reflects this information in the first three columns.
However, as a by-product of the metals, plastics, chemicals and energy that refrigerator manufacturers use, some pollution is created. Let’s say that, if these pollutants were emitted into the air and water, they would create costs of $100 per refrigerator produced. These costs might occur because of adverse effects on human health, property values, or wildlife habitat, reduction of recreation possibilities, or because of other negative impacts. In a market with no anti-pollution restrictions, firms can dispose of certain wastes absolutely free. Now imagine that firms which produce refrigerators must factor in these external costs of pollution—that is, the firms have to consider not only labor and material costs, but also the broader costs to society of harm to health and other costs caused by pollution. If the firm is required to pay $100 for the additional external costs of pollution each time it produces a refrigerator, production becomes more costly and the entire supply curve shifts up by $100.
As  and  illustrate, the firm will need to receive a price of $700 per refrigerator and produce a quantity of 40,000—and the firm’s new supply curve will be Ssocial. The new equilibrium will occur at E1. In short, taking the additional external costs of pollution into account results in a higher price, a lower quantity of production, and a lower quantity of pollution. The following Work It Out feature will walk you through an example, this time with musical accompaniment.
Remember that the supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply will coordinate social costs and benefits.
However, when the externality of pollution exists, the supply curve no longer represents all social costs. Because externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure. When there is market failure, the private market fails to achieve efficient output, because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained (a positive externality). In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product.
We can see a general lesson here. If firms were required to pay the social costs of pollution, they would create less pollution but produce less of the product and charge a higher price. In the next module, we will explore how governments require firms to account for the social costs of pollution.

### Key Concepts and Summary

Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.
An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. If those parties imposing a negative externality on others had to account for the broader social cost of their behavior, they would have an incentive to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party obtains benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to under produce output because suppliers are not aware of the additional demand from others. If the parties generating benefits to others would somehow receive compensation for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Johnson, Oscar William. “Back on Track: Earth Day Success Story; The Chattanooga Choo-Choo No Longer Spews Foul Air.” Sports Illustrated. April 30, 1990. http://www.si.com/vault/1990/04/30/121923/back-on-track-earth-day-success-story-the-chattanooga-choo-choo-no-longer-spews-foul-air.
U.S. Energy Information Administration. “Total Energy: Monthly Energy Review.” U.S. Department of Energy. Accessed December 19, 2013. http://www.eia.gov/totalenergy/data/monthly/.


# Environmental Protection and Negative Externalities

## Command-and-Control Regulation

When the United States started passing comprehensive environmental laws in the late 1960s and early 1970s, a typical law specified to companies how much pollution their smokestacks or drainpipes could emit and imposed penalties if companies exceeded the limit. Other laws required that companies install certain equipment—for example, on automobile tailpipes or on smokestacks—to reduce pollution. These types of laws, which specify allowable quantities of pollution and which also may detail which pollution-control technologies companies must use, fall under the category of command-and-control regulation. In effect, command-and-control regulation requires that firms increase their costs by installing anti-pollution equipment. Thus, firms are required to account for the social costs of pollution in deciding how much output to produce.
Command-and-control regulation has been highly successful in protecting and cleaning up the U.S. environment. In 1970, the  Federal government created the Environmental Protection Agency (EPA) to oversee all environmental laws. In the same year, Congress enacted the Clean Air Act to address air pollution. Just two years later, in 1972, Congress passed and the president signed the far-reaching Clean Water Act. These command-and-control environmental laws, and their amendments and updates, have been largely responsible for America’s cleaner air and water in recent decades. However, economists have pointed out three difficulties with command-and-control environmental regulation.
First, command-and-control regulation offers no incentive to improve the quality of the environment beyond the standard set by a particular law. Once firms meet the standard, polluters have zero incentive to do better.
Second, command-and-control regulation is inflexible. It usually requires the same standard for all polluters, and often the same pollution-control technology as well. This means that command-and-control regulation draws no distinctions between firms that would find it easy and inexpensive to meet the pollution standard—or to reduce pollution even further—and firms that might find it difficult and costly to meet the standard. Firms have no reason to rethink their production methods in fundamental ways that might reduce pollution even more and at lower cost.
Third, legislators and EPA analysts write the command-and-control regulations, and so they are subject to compromises in the political process. Existing firms often argue (and lobby) that stricter environmental standards should not apply to them, only to new firms that wish to start production. Consequently, real-world environmental laws are full of fine print, loopholes, and exceptions.
Although critics accept the goal of reducing pollution, they question whether command-and-control regulation is the best way to design policy tools for accomplishing that goal. A different approach is the use of market-oriented tools, which we discussed in the next section.

### Key Concepts and Summary

Command-and-control regulation sets specific limits for pollution emissions and/or specific pollution-control technologies that firms must use. Although such regulations have helped to protect the environment, they have three shortcomings: they provide no incentive for going beyond the limits they set; they offer limited flexibility on where and how to reduce pollution; and they often have politically-motivated loopholes.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions


# Environmental Protection and Negative Externalities

## Market-Oriented Environmental Tools

Market-oriented environmental policies create incentives to allow firms some flexibility in reducing pollution. The three main categories of market-oriented approaches to pollution control are pollution charges, marketable permits, and better-defined property rights. All of these policy tools which we discuss, below, address the shortcomings of command-and-control regulation—albeit in different ways.

### Pollution Charges

A pollution charge is a tax imposed on the quantity of pollution that a firm emits. A pollution charge gives a profit-maximizing firm an incentive to determine ways to reduce its emissions—as long as the marginal cost of reducing the emissions is less than the tax.
For example, consider a small firm that emits 50 pounds per year of small particles, such as soot, into the air. This particulate matter causes respiratory illnesses and also imposes costs on firms and individuals.
 illustrates the marginal costs that a firm faces in reducing pollution. The marginal cost of pollution reduction, like most marginal cost curves, increases with output, at least in the short run. Reducing the first 10 pounds of particulate emissions costs the firm $300. Reducing the second 10 pounds would cost $500; reducing the third ten pounds would cost $900; reducing the fourth 10 pounds would cost $1,500; and the fifth 10 pounds would cost $2,500. This pattern for the costs of reducing pollution is common, because the firm can use the cheapest and easiest method to make initial reductions in pollution, but additional reductions in pollution become more expensive.
Imagine the firm now faces a pollution tax of $1,000 for every 10 pounds of particulates it emits. The firm has the choice of either polluting and paying the tax, or reducing the amount of particulates it emits and paying the cost of abatement as the figure shows. How much will the firm pollute and how much will the firm abate? The first 10 pounds would cost the firm $300 to abate. This is substantially less than the $1,000 tax, so the firm will choose to abate. The second 10 pounds would cost $500 to abate, which is still less than the tax, so it will choose to abate. The third 10 pounds would cost $900 to abate, which is slightly less than the $1,000 tax. The fourth 10 pounds would cost $1,500, which is much more costly than paying the tax. As a result, the firm will decide to reduce pollutants by 30 pounds, because the marginal cost of reducing pollution by this amount is less than the pollution tax. With a tax of $1,000, the firm has no incentive to reduce pollution more than 30 pounds.
A firm that has to pay a pollution tax will have an incentive to figure out the least expensive technologies for reducing pollution. Firms that can reduce pollution cheaply and easily will do so to minimize their pollution taxes; whereas firms that will incur high costs for reducing pollution will end up paying the pollution tax instead. If the pollution tax applies to every source of pollution, then there are no special favoritism or loopholes for politically well-connected producers.
For an example of a pollution charge at the household level, consider two ways of charging for garbage collection. One method is to have a flat fee per household, no matter how much garbage a household produces. An alternative approach is to have several levels of fees, depending on how much garbage the household produces—and to offer lower or free charges for recyclable materials. As of 2006 (latest statistics available), the EPA had recorded over 7,000 communities that have implemented “pay as you throw” programs. When people have a financial incentive to put out less garbage and to increase recycling, they find ways to make it happen.
A number of environmental policies are really pollution charges, although they often do not travel under that name. For example, the federal government and many state governments impose taxes on gasoline. We can view this tax as a charge on the air pollution that cars generate as well as a source of funding for maintaining roads. Gasoline taxes are far higher in most other countries than in the United States.
Similarly, the refundable charge of five or 10 cents that only 10 states have for returning recyclable cans and bottles works like a pollution tax that provides an incentive to avoid littering or throwing bottles in the trash. Compared with command-and-control regulation, a pollution tax reduces pollution in a more flexible and cost-effective way.

### Marketable Permits

When a city or state government sets up a marketable permit program  (e.g., cap-and-trade), it must start by determining the overall quantity of pollution it will allow as it tries to meet national pollution standards. Then, it divides a number of permits allowing only this quantity of pollution among the firms that emit that pollutant. The government can sell or provide these permits to pollute free to firms.
Now, add two more conditions. Imagine that these permits are designed to reduce total emissions over time. For example, a permit may allow emission of 10 units of pollution one year, but only nine units the next year, then eight units the year after that, and so on down to some lower level. In addition, imagine that these are marketable permits, meaning that firms can buy and sell them.
To see how marketable permits can work to reduce pollution, consider the four firms in . The table shows current emissions of lead from each firm. At the start of the marketable permit program, each firm receives permits to allow this level of pollution. However, these permits are shrinkable, and next year the permits allow the firms to emit only half as much pollution. Let’s say that in a year, Firm Gamma finds it easy and cheap to reduce emissions from 600 tons of lead to 200 tons, which means that it has permits that it is not using that allow emitting 100 tons of lead. Firm Beta reduces its lead pollution from 400 tons to 200 tons, so it does not need to buy any permits, and it does not have any extra permits to sell. However, although Firm Alpha can easily reduce pollution from 200 tons to 150 tons, it finds that it is cheaper to purchase permits from Gamma rather than to reduce its own emissions to 100. Meanwhile, Firm Delta did not even exist in the first period, so the only way it can start production is to purchase permits to emit 50 tons of lead.
The total quantity of pollution will decline. However, buying and selling the marketable permits will determine exactly which firms reduce pollution and by how much. With a system of marketable permits, the firms that find it least expensive to do so will reduce pollution the most.
Another application of marketable permits occurred when the U.S. government amended the Clean Air Act in 1990. The revised law sought to reduce sulfur dioxide emissions from electric power plants to half of the 1980 levels out of concern that sulfur dioxide was causing acid rain, which harms forests as well as buildings. In this case, the marketable permits the federal government issued were free of charge (no pun intended) to electricity-generating plants across the country, especially those that were burning coal (which produces sulfur dioxide). These permits were of the “shrinkable” type; that is, the amount of pollution allowed by a given permit declined with time.

### Better-Defined Property Rights

A clarified and strengthened idea of property rights can also strike a balance between economic activity and pollution. Ronald Coase (1910–2013), who won the 1991 Nobel Prize in economics, offered a vivid illustration of an externality: a railroad track running beside a farmer’s field where the railroad locomotive sometimes emits sparks and sets the field ablaze. Coase asked whose responsibility it was to address this spillover. Should the farmer be required to build a tall fence alongside the field to block the sparks, or should the railroad be required to place a gadget on the locomotive’s smokestack to reduce the number of sparks?
Coase pointed out that one cannot resolve this issue until one clearly defines property rights—that is, the legal rights of ownership on which others are not allowed to infringe without paying compensation. Does the farmer have a property right not to have a field burned? Does the railroad have a property right to run its own trains on its own tracks? If neither party has a property right, then the two sides may squabble endlessly, doing nothing, and sparks will continue to set the field aflame. However, if either the farmer or the railroad has a well-defined legal responsibility, then that party will seek out and pay for the least costly method of reducing the risk that sparks will hit the field. The property right determines whether the farmer or the railroad pays the bills.
The property rights approach is highly relevant in cases involving endangered species. The U.S. government’s endangered species list includes about 1,000 plants and animals, and about 90% of these species live on privately owned land. The protection of these endangered species requires careful thinking about incentives and property rights. The discovery of an endangered species on private land has often triggered an automatic reaction from the government to prohibit the landowner from using that land for any purpose that might disturb the imperiled creatures. Consider the incentives of that policy: If you admit to the government that you have an endangered species, the government effectively prohibits you from using your land. As a result, rumors abounded of landowners who followed a policy of “shoot, shovel, and shut up” when they found an endangered animal on their land. Other landowners have deliberately cut trees or managed land in a way that they knew would discourage endangered animals from locating there.
A more productive policy would consider how to provide private landowners with an incentive to protect the endangered species that they find and to provide a habitat for additional endangered species. For example, the government might pay landowners who provide and maintain suitable habitats for endangered species or who restrict the use of their land to protect an endangered species. Again, an environmental law built on incentives and flexibility offers greater promise than a command-and-control approach when trying to oversee millions of acres of privately owned land.

### Applying Market-Oriented Environmental Tools

Market-oriented environmental policies are a tool kit. Specific policy tools will work better in some situations than in others. For example, marketable permits work best when a few dozen or a few hundred parties are highly interested in trading, as in the cases of oil refineries that trade lead permits or electrical utilities that trade sulfur dioxide permits. However, for cases in which millions of users emit small amounts of pollution—such as emissions from car engines or unrecycled soda cans—and have no strong interest in trading, pollution charges will typically offer a better choice. We can also combine market-oriented environmental tools. We can view marketable permits as a form of improved property rights. Alternatively, the government could combine marketable permits with a pollution tax on any emissions not covered by a permit.

### Key Concepts and Summary

Examples of market-oriented environmental policies, also called cap and trade programs, include pollution charges, marketable permits, and better-defined property rights. Market-oriented environmental policies include taxes, markets, and property rights so that those who impose negative externalities must face the social cost.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### References

Environmental Protection Agency. “2006 Pay-As-You-Throw Programs.” Accessed December 20, 2013. http://www.epa.gov/epawaste/conserve/tools/payt/states/06comm.htm.


# Environmental Protection and Negative Externalities

## The Benefits and Costs of U.S. Environmental Laws

Government economists have estimated that U.S. firms may pay more than $200 billion per year to comply with federal environmental laws. That is a sizable amount of money. Is the money well spent?

### Benefits and Costs of Clean Air and Clean Water

We can divide the benefits of a cleaner environment into four areas: (1) people may stay healthier and live longer; (2) certain industries that rely on clean air and water, such as farming, fishing, and tourism, may benefit; (3) property values may be higher; and (4) people may simply enjoy a cleaner environment in a way that does not need to involve a market transaction. Some of these benefits, such as gains to tourism or farming, are relatively easy to value in economic terms. It is harder to assign a monetary value to others, such as the value of clean air for someone with asthma. It seems difficult to put a clear-cut monetary value on still others, such as the satisfaction you might feel from knowing that the air is clear over the Grand Canyon, even if you have never visited the Grand Canyon, but advanced techniques in economics allow one to generate estimates.
Although estimates of environmental benefits are not precise, they can still be revealing. For example, a study by the Environmental Protection Agency looked at the costs and benefits of the Clean Air Act from 1970 to 1990. It found that total costs over that time period were roughly $500 billion—a huge amount. However, it also found that a middle-range estimate of the health and other benefits from cleaner air was $22 trillion—about 44 times higher than the costs. A more recent EPA study estimated that the environmental benefits to Americans from the Clean Air Act will exceed their costs by a margin of four to one. The EPA estimated that “in 2010 the benefits of Clean Air Act programs will total about $110 billion. This estimate represents the value of avoiding increases in illness and premature death which would have prevailed.” Saying that overall benefits of environmental regulation have exceeded costs in the past, however, is very different from saying that every environmental regulation makes sense. For example, studies suggest that when breaking down emission reductions by type of contaminants, the benefits of air pollution control outweigh the costs primarily for particulates and lead, but when looking at other air pollutants, the costs of reducing them may be comparable to or greater than the benefits. Just because some environmental regulations have had benefits much higher than costs does not prove that every individual regulation is a sensible idea.

### Ecotourism: Making Environmentalism Pay

The definition of ecotourism is a little vague. Does it mean sleeping on the ground, eating roots, and getting close to wild animals? Does it mean flying in a helicopter to shoot anesthetic darts at African wildlife, or a little of both? The definition may be fuzzy, but tourists who hope to appreciate the ecology of their destination—“eco tourists”—are the impetus to a big and growing business. The International Ecotourism Society estimates that international tourists interested in seeing nature or wildlife would take 1.56 billion trips by 2020. While COVID-19 prevented this from happening in 2020, it is clear that there is a strong demand for ecotourism.
Realizing the attraction of ecotourism, the residents of low-income countries may come to see that preserving wildlife habitats is more lucrative than, say, cutting down forests or grazing livestock. In South Africa, Namibia, and Zimbabwe, for example, ecotourism has given local communities an economic interest in protecting elephant and rhinoceros populations. Some of the leading ecotourism destinations include Costa Rica and Panama in Central America; the Caribbean; Malaysia, and other South Pacific destinations; New Zealand; the Serengeti in Tanzania; the Amazon rain forests; and the Galapagos Islands. In many of these countries and regions, governments have enacted policies whereby they share revenues from ecotourism with local communities, to give people in those local communities a kind of property right that encourages them to conserve their local environment.
Ecotourism needs careful management, so that the combination of eager tourists and local entrepreneurs does not destroy what the visitors are coming to see. And recent research indicates that wild animals that are continually exposed to tourists and vehicles exhibit stress and atypical behaviors. In general, however, well-managed ecotourism is viewed as a net positive, which provides an alternative to damaging the local environment.

### Marginal Benefits and Marginal Costs

We can use the tools of marginal analysis to illustrate the marginal costs and the marginal benefits of reducing pollution.   illustrates a theoretical model of this situation. When the quantity of environmental protection is low so that pollution is extensive—for example, at quantity Qa—there are usually numerous relatively cheap and easy ways to reduce pollution, and the marginal benefits of doing so are quite high. At Qa, it makes sense to allocate more resources to fight pollution. However, as the extent of environmental protection increases, the cheap and easy ways of reducing pollution begin to decrease, and one must use more costly methods. The marginal cost curve rises. Also, as environmental protection increases, one achieves the largest marginal benefits first, followed by reduced marginal benefits. As the quantity of environmental protection increases to, say, Qb, the gap between marginal benefits and marginal costs narrows. At point Qc the marginal costs will exceed the marginal benefits. At this level of environmental protection, society is not allocating resources efficiently, because it is forfeiting too many resources to reduce pollution.
As society draws closer to Qb, some might argue that it becomes more important to use market-oriented environmental tools to hold down the costs of reducing pollution. Their objective would be to avoid environmental rules that would provide the quantity of environmental protection at Qc, where marginal costs exceed marginal benefits. The following Clear It Up feature delves into how the EPA measures its policies – and the monetary value of our lives.

### Key Concepts and Summary

We can make a strong case, taken as a whole, that the benefits of U.S. environmental regulation have outweighed the costs. As the extent of environment regulation increases, additional expenditures on environmental protection will probably have increasing marginal costs and decreasing marginal benefits. This pattern suggests that the flexibility and cost savings of market-oriented environmental policies will become more important.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Ryan, Dave. “New Report Shows Benefits of 1990 Clean Air Amendments Outweigh Costs by Four-to-One Margin,” press release, November 16, 1999. United States Environmental Protection Agency. Accessed December 19, 2013. http://www.epa.gov/oar/sect812/r-140.html.
National Center for Environmental Economics (NCEE). “Frequently Asked Questions on Mortality Risk Valuation.” United States Environmental Protection Agency. Accessed December 19, 2013. http://yosemite.epa.gov/ee/epa/eed.nsf/pages/MortalityRiskValuation.html#whatvalue World Tourism Organization, “Tourism 2020 Vision.” Accessed December 19, 2013. http://www.world-tourism.org/market_research/facts/market_trends.htm.
Viscusi, Kip W. Fatal Tradeoffs: Public and Private Responsibilities for Risk. New York: Oxford University Press, 1995.


# Environmental Protection and Negative Externalities

## International Environmental Issues

Many countries around the world have become more aware of the benefits of environmental protection. Yet even if most nations individually took steps to address their environmental issues, no nation acting alone can solve certain environmental problems which spill over national borders. No nation by itself can reduce emissions of carbon dioxide and other gases by enough to solve the problem of global warming—not without the cooperation of other nations. Another issue is the challenge of preserving biodiversity, which includes the full spectrum of animal and plant genetic material. Although a nation can protect biodiversity within its own borders, no nation acting alone can protect biodiversity around the world. Global warming and biodiversity are examples of international externalities.
Bringing the nations of the world together to address environmental issues requires a difficult set of negotiations between countries with different income levels and different sets of priorities. If nations such as China, India, Brazil, Mexico, and others are developing their economies by burning vast amounts of fossil fuels or by stripping their forest and wildlife habitats, then the world’s high-income countries acting alone will not be able to reduce greenhouse gases. However, low-income countries, with some understandable exasperation, point out that high-income countries do not have much moral standing to lecture them on the necessities of putting environmental protection ahead of economic growth. After all, high-income countries have historically been the primary contributors to greenhouse warming by burning fossil fuels—and still are today. It is hard to tell people who are living in a low-income country, where adequate diet, health care, and education are lacking, that they should sacrifice an improved quality of life for a cleaner environment.
Can rich and poor countries come together to address global environmental spillovers? At the initiative of the European Union and the most vulnerable developing nations, the Durban climate conference in December 2011 launched negotiations to develop a new international climate change agreement that covers all countries. The outcome of these negotiations was the Paris Climate Agreement, passed in 2015. The Paris Agreement committed participating countries to significant limits on CO2 emissions. To date, 196 entities have signed on, including the two biggest emitters of greenhouse gases—China and the United States.  The U.S. contribution to the agreement was the Clean Power Plan, which planned to reduce power plant CO2 emissions across the U.S. by 17% to pre-2005 levels by 2020, and to further reduce emissions by a cumulative 32% by 2030.  In early 2017, the Trump Administration announced plans to back out of the Paris Climate Agreement. Trump opposed the Clean Power plan, opting instead to shift focus to the use of natural gas. This represented a significant blow to the success of the Paris Agreement. However, on his first day in office, President Biden, on behalf of the United States, rejoined the Paris Climate Agreement.
If high-income countries want low-income countries to reduce their emission of greenhouse gases, then the high-income countries may need to pay some of the costs. Perhaps some of these payments will happen through private markets. For example, some tourists from rich countries will pay handsomely to vacation near the natural treasures of low-income countries. Perhaps some of the transfer of resources can happen through making modern pollution-control technology available to poorer countries.
The practical details of what such an international system might look like and how it would operate across international borders are forbiddingly complex. However, it seems highly unlikely that some form of world government will impose a detailed system of environmental command-and-control regulation around the world. As a result, a decentralized and market-oriented approach may be the only practical way to address international issues such as global warming and biodiversity.

### Key Concepts and Summary

Certain global environmental issues, such as global warming and biodiversity, spill over national borders and require addressing with some form of international agreement.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### References

European Union. “Durban Conference Delivers Breakthrough for Climate.” Press release. December 11, 2012. Accessed December 19, 2013. http://europa.eu/rapid/press-release_MEMO-11-895_en.htm?locale=en.


# Environmental Protection and Negative Externalities

## The Tradeoff between Economic Output and Environmental Protection

We can analyze the tradeoff between economic output and the environment with a production possibility frontier (PPF) such as the one in . At one extreme, at a choice like P, a country would be selecting a high level of economic output but very little environmental protection. At the other extreme, at a choice like T, a country would be selecting a high level of environmental protection but little economic output. According to the graph, an increase in environmental protection involves an opportunity cost of less economic output. No matter what their preferences, all societies should wish to avoid choices like M, which are productively inefficient. Efficiency requires that the choice should be on the production possibility frontier.
Economists do not have a great deal to say about the choice between P, Q, R, S and T in , all of which lie along the production possibility frontier. Countries with low per capita gross domestic product (GDP), such as India, place a greater emphasis on economic output—which in turn helps to produce nutrition, shelter, health, education, and desirable consumer goods. Countries with higher income levels, where a greater share of people have access to the basic necessities of life, may be willing to place a relatively greater emphasis on environmental protection.
However, economists are united in their belief that an inefficient choice such as M is undesirable. Rather than choosing M, a nation could achieve either greater economic output with the same environmental protection, as at point Q, or greater environmental protection with the same level of output, as at point S. The problem with command-and-control environmental laws is that they sometimes involve a choice like M. Market-oriented environmental tools offer a mechanism for providing either the same environmental protection at lower cost, or providing a greater degree of environmental protection for the same cost.

### Key Concepts and Summary

Depending on their different income levels and political preferences, countries are likely to make different choices about allocative efficiency—that is, the choice between economic output and environmental protection along the production possibility frontier. However, all countries should prefer to make a choice that shows productive efficiency—that is, the choice is somewhere on the production possibility frontier rather than inside it. Revisit Choice in a World of Scarcity for more on these terms.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems


# Positive Externalities and Public Goods

## Introduction to Positive Externalities and Public Goods

As economist Mariana Mazzucato explores in her well-known work The Entrepreneurial State, what makes a smartphone smart? What allows its apps to help you navigate new towns while getting updates about your home, all while your hands are on the steering wheel and your children are in the back seat watching their shows? For starters, the internet, cell tower networks, GPS, and voice activation. Each of these, and many other technologies we rely on, were developed with intensive government support. For example, GPS, which enables many cell phone functions beyond the frequently used mapping and ride-sharing applications, was developed by the U.S. Department of Defense over several generations of satellite tracking and complex computer algorithm development. The U.S. government still provides GPS for many of the world’s users.
We do not often think of the government when we consider our leading products and entrepreneurs. We think of Apple, Google, Lyft, Tesla, Fitbit, and so on—creative innovators who built on the tools provided by these government efforts, using them in transformative ways. We may not think of the estimated $19 billion per year that the U.S. spends to maintain the GPS system, but we would certainly think of it if it suddenly went away. (Beyond the impact on our daily lives, economists estimate U.S. businesses alone would lose about $1 billion per day without GPS.)
Mazzucato is one of several prominent economists advocating for an embrace of continued government-sponsored innovations in order to build economic prosperity, reduce inequality, and manage ongoing challenges such as drought, coastal changes, and extreme weather. She argues that competitive, private sector markets are often resistant to the risks involved with large-scale innovation, because failed experiments and lack of uptake lead to massive corporate and personal losses. Governments can take on riskier research and development projects. Because government spending is fueled by taxpayers, and all innovation leads to some level of employment change, these proposals are certainly complex and challenging to implement.
This chapter deals with some of these issues: Will private companies be willing to invest in new technology? In what ways does new technology have positive externalities? What motivates inventors? What role should government play in encouraging research and technology? Are there certain types of goods that markets fail to provide efficiently, and that only government can produce? What happens when consumption or production of a product creates positive externalities? Why is it unsurprising when we overuse a common resource, like marine fisheries?


# Positive Externalities and Public Goods

## Investments in Innovation

Market competition can provide an incentive for discovering new technology because a firm can earn higher profits by finding a way to produce products more cheaply or to create products with characteristics consumers want. As Gregory Lee, CEO of Samsung said, “Relentless pursuit of new innovation is the key principle of our business and enables consumers to discover a world of possibilities with technology.” An innovative firm knows that it will usually have a temporary edge over its competitors and thus an ability to earn above-normal profits before competitors can catch up.
In certain cases, however, competition can discourage new technology, especially when other firms can quickly copy a new idea. Consider a pharmaceutical firm deciding to develop a new drug. On average, it can cost $800 million and take more than a decade to discover a new drug, perform the necessary safety tests, and bring the drug to market. If the research and development (R&D) effort fails—and every R&D project has some chance of failure—then the firm will suffer losses and could even be driven out of business. If the project succeeds, then the firm’s competitors may figure out ways of adapting and copying the underlying idea, but without having to pay the costs themselves. As a result, the innovative company will bear the much higher costs of the R&D and will enjoy at best only a small, temporary advantage over the competition.
Many inventors over the years have discovered that their inventions brought them less profit than they might have reasonably expected.
1. Eli Whitney (1765–1825) invented the cotton gin, but then southern cotton planters built their own seed-separating devices with a few minor changes in Whitney’s design. When Whitney sued, he found that the courts in southern states would not uphold his patent rights.
2. Thomas Edison (1847–1931) still holds the record for most patents granted to an individual. His first invention was an automatic vote counter, and despite the social benefits, he could not find a government that wanted to buy it.
3. Gordon Gould came up with the idea behind the laser in 1957. He put off applying for a patent and, by the time he did apply, other scientists had laser inventions of their own. A lengthy legal battle resulted, in which Gould spent $100,000 on lawyers, before he eventually received a patent for the laser in 1977. Compared to the enormous social benefits of the laser, Gould received relatively little financial reward.
4. In 1936, Alan Turing delivered a paper titled, "On Computable Numbers, with an Application to the Entscheidungsproblem," in which he presented the notion of a universal machine (later called the “Universal Turing Machine," and then the "Turing machine") capable of computing anything that is computable. The central concept of the modern computer was based on Turing’s paper. Today scholars widely consider Turing as the father of theoretical computer science and artificial intelligence; however, the UK government prosecuted Turing in 1952 for engaging in same-sex sexual acts and gave him the choice of chemical castration or prison. Turing chose castration and died in 1954 from cyanide poisoning.
A variety of studies by economists have found that the original inventor receives one-third to one-half of the total economic benefits from innovations, while other businesses and new product users receive the rest.

### The Positive Externalities of New Technology

Will private firms in a market economy underinvest in research and technology? If a firm builds a factory or buys a piece of equipment, the firm receives all the economic benefits that result from the investments. However, when a firm invests in new technology, the private benefits, or profits, that the firm receives are only a portion of the overall social benefits. The social benefits of an innovation account for the value of all the positive externalities of the new idea or product, whether enjoyed by other companies or society as a whole, as well as the private benefits the firm that developed the new technology receives. As you learned in Environmental Protection and Negative Externalities, positive externalities are beneficial spillovers to a third party, or parties.
Consider the example of the Big Drug Company, which is planning its R&D budget for the next year. Economists and scientists working for Big Drug have compiled a list of potential research and development projects and estimated rates of return. (The rate of return is the estimated payoff from the project.)  shows how the calculations work. The downward-sloping DPrivate curve represents the firm’s demand for financial capital and reflects the company’s willingness to borrow to finance research and development projects at various interest rates. Suppose that this firm’s investment in research and development creates a spillover benefit to other firms and households. After all, new innovations often spark other creative endeavors that society also values. If we add the spillover benefits society enjoys to the firm’s private demand for financial capital, we can draw DSocial that lies above DPrivate.
If there were a way for the firm to fully monopolize those social benefits by somehow making them unavailable to the rest of us, the firm’s private demand curve would be the same as society’s demand curve. According to  and , if the going rate of interest on borrowing is 8%, and the company can receive the private benefits of innovation only, then the company would finance $30 million. Society, at the same rate of 8%, would find it optimal to have $52 million of borrowing. Unless there is a way for the company to fully enjoy the total benefits, then it will borrow less than the socially optimal level of $52 million.
Big Drug’s original demand for financial capital (DPrivate) is based on the profits the firm receives. However, other pharmaceutical firms and health care companies may learn new lessons about how to treat certain medical conditions and are then able to create their own competing products. The social benefit of the drug takes into account the value of all the drug's positive externalities. If Big Drug were able to gain this social return instead of other companies, its demand for financial capital would shift to the demand curve DSocial, and it would be willing to borrow and invest $52 million. However, if Big Drug is receiving only 50 cents of each dollar of social benefits, the firm will not spend as much on creating new products. The amount it would be willing to spend would fall somewhere in between DPrivate and DSocial.

### Why Invest in Human Capital?

The investment in anything, whether it is the construction of a new power plant or research in a new cancer treatment, usually requires a certain upfront cost with an uncertain future benefit. The investment in education, or human capital, is no different. Over the span of many years, a student and her family invest significant amounts of time and money into that student’s education. The idea is that higher levels of educational attainment will eventually serve to increase the student’s future productivity and subsequent ability to earn. Once the student crunches the numbers, does this investment pay off for her?
Almost universally, economists have found that the answer to this question is a clear “Yes.” For example, several studies of the return to education in the United States estimate that the rate of return to a college education is approximately 10-15%. Data in , from the U.S. Bureau of Labor Statistics’ Usual Weekly Earnings of Wage and Salary Workers, Fourth Quarter 2021, demonstrate that median weekly earnings are higher for workers who have completed more education. While these rates of return will beat equivalent investments in Treasury bonds or savings accounts, the estimated returns to education go primarily to the individual worker, so these returns are private rates of return to education.
What does society gain from investing in the education of another student? After all, if the government is spending taxpayer dollars to subsidize public education, society should expect some kind of return on that spending. Economists like George Psacharopoulos have found that, across a variety of nations, the social rate of return on schooling is also positive. After all, positive externalities exist from investment in education. While not always easy to measure, according to Walter McMahon, the positive externalities to education typically include better health outcomes for the population, lower levels of crime, a cleaner environment and a more stable, democratic government. For these reasons, many nations have chosen to use taxpayer dollars to subsidize primary, secondary, and higher education. Education clearly benefits the person who receives it, but a society where most people have a good level of education provides positive externalities for all.

### Other Examples of Positive Externalities

Although technology may be the most prominent example of a positive externality, it is not the only one. For example, vaccinations against disease are not only a protection for the individual, but they have the positive spillover of protecting others who may become infected.  When a number of homes in a neighborhood are modernized, updated, and restored, not only does it increase the homes' value, but other property values in the neighborhood may increase as well.
The appropriate public policy response to a positive externality, like a new technology, is to help the party creating the positive externality receive a greater share of the social benefits. In the case of vaccines, like flu shots, an effective policy might be to provide a subsidy to those who choose to get vaccinated.
 shows the market for flu shots. The market demand curve DMarket for flu shots reflects only the marginal private benefits (MPB) that the vaccinated individuals receive from the shots. Assuming that there are no spillover costs in the production of flu shots, the market supply curve is given by the marginal private cost (MPC) of producing the vaccinations.
The equilibrium quantity of flu shots produced in the market, where MPB is equal to MPC, is QMarket and the price of flu shots is PMarket. However, spillover benefits exist in this market because others, those who chose not to purchase a flu shot, receive a positive externality in the form of a reduced chance of contracting the flu. When we add the spillover benefits to the marginal private benefit of flu shots, the marginal social benefit (MSB) of flu shots is given by DSocial. Because the MSB is greater than MPB, we see that the socially optimal level of flu shots is greater than the market quantity (QSocial exceeds QMarket) and the corresponding price of flu shots, if the market were to produce QSocial, would be at PSocial. Unfortunately, the marketplace does not recognize the positive externality and flu shots will go under-produced and under-consumed.
How can government try to move the market level of output closer to the socially desirable level of output? One policy would be to provide a subsidy, like a voucher, to any citizen who wishes to get vaccinated. This voucher would act as “income” that one could use to purchase only a flu shot and, if the voucher were exactly equal to the per-unit spillover benefits, would increase market equilibrium to a quantity of QSocial and a price of PSocial where MSB equals MSC (which equals MPC given the assumption that there are no spillover costs in producing the vaccine). Suppliers of the flu shots would receive payment of PSocial per vaccination, while consumers of flu shots would redeem the voucher and only pay a price of PSubsidy. When the government uses a subsidy in this way, it produces the socially optimal quantity of vaccinations.

### Societal Change as an Innovation Outcome

Economist Carlota Perez draws on the lessons of past innovations to understand the current state of our economy. She demonstrates that prior technological turning points, such as the proliferation of railroads and the emergence of mass production, created initial periods of employment and wealth shifting but eventually led to greater well-being and economic growth. After difficult transition periods and sometimes economic meltdowns during the “installment” phase of widespread new technologies, many economies and the people within them have benefited from prolonged periods of economic and lifestyle improvement, including lower unemployment and better quality of life.
Most prior innovation periods, such as the Industrial Revolution, had one significant downside: negative impacts on the environment, such as pollution and habitat destruction. Perez notes that our current revolution—in information and communications technology (ICT)—has the potential for significant positive externalities related to the environment. ICT is shifting many areas of society (and therefore industry) to digital experiences and services that do not require fossil fuels or similar natural resources. Vehicle sharing, product rental-reuse networks, and new manufacturing methods offer the promise of far less consumable consumption. And even though the appearance of delivery trucks and shipping boxes gives the impression of environmental damage, most studies indicate that online shopping is better for the environment than individuals shopping in person. (This is partly attributed to greater efficiency in a few trucks driving to a neighborhood rather than everyone in the neighborhood driving to several stores.) Consumers and governments can spur on those environmental benefits by choosing or partnering with companies that focus on furthering their environmental impact, such as by using solar power to fuel their computer servers or by using electrically powered delivery trucks.
Like other innovations, ICT has created some employment and economic opportunities while it has reduced others. Increased globalization and efficiencies have shuttered businesses and reduced wages in some areas. Perez’s research indicates that those types of employment shifts can be managed through proper regulation and investment (especially in human capital), particularly as firms in the relevant industries become mature and profitable. The prospects aren’t simple: ICT has created megafirms like Amazon and Apple, which despite pleasing their consumers can wield significant power over governments and employees. But on the environmental and societal front at least, ICT has offered a wealth of opportunities and externalities.

### Key Concepts and Summary

Competition creates pressure to innovate. However, if one can easily copy new inventions, then the original inventor loses the incentive to invest further in research and development. New technology often has positive externalities; that is, there are often spillovers from the invention of new technology that benefit firms other than the innovator. The social benefit of an invention, once the firm accounts for these spillovers, typically exceeds the private benefit to the inventor. If inventors could receive a greater share of the broader social benefits for their work, they would have a greater incentive to seek out new inventions.

### Self-Check Questions

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### References

Arias, Omar and Walter W. McMahon. “Dynamic Rates of Return to Education in the U.S.” Economics of Education Review. 20, 2001. 121–138.
Biography.com. 2015. “Alan Turing.” Accessed April 1, 2015. http://www.biography.com/people/alan-turing-9512017.
Canty Media. 2015. “The World: Life Expectancy (2015) - Top 100+.” Accessed April 1, 2015. http://www.geoba.se/population.php?pc=world&type=15.
Hyclak, Thomas, Geraint Johnes, and Robert Thornton. Fundamentals of Labor Economics. Boston: Houghton Mifflin Company, 2005.
McMahon, Walter. Education and Development: Measuring the Social Benefits. Oxford: Oxford University Press, 2000.
McTigue, Kathleen. 2019. "Economic Benefits of the Global Position System to the Private Sector." National Institute of Standards and Technology. https://www.nist.gov/news-events/news/2019/10/economic-benefits-global-positioning-system-us-private-sector-study.
Mazzucato, Mariana and Carlota Perez. 2014. "Innovation as Growth Policy: The Challenge for Europe." Science Policy Research Unit. https://www.sussex.ac.uk/webteam/gateway/file.php?name=2014-13-swps-mazzucato-perez.pdf&site=25.
Mazzucato, Mariana. The Entreprenurial State: Debunking Public vs. Private Sector Myths. Public Affairs, 2015.
National Institute of Health. 2015. “Global Competitiveness—The Importance of U.S. Leadership in Science and Innovation for the Future of Our Economy and Our Health.” Accessed April 1, 2015. http://www.nih.gov/about/impact/impact_global.pdf.
National Science Foundation. 2013. “U.S. R&D Spending Resumes Growth in 2010 and 2011 but Still Lags Behind the Pace of Expansion of the National Economy.” Accessed April 1, 2015. http://www.nsf.gov/statistics/infbrief/nsf13313/.
Ostrom, Elinor. Governing the Commons: The Evolution of Institutions for Collective Action. Cambrige University Press, 1990.
Perez, Carlota. 2009. "Long Run Economic Transformation: After the Crisis." OME Annual Report 2009–2010.
Psacharopoulos, George. “Returns to Investment in Education: A Global Update.” World Development 22, 1994. 1325–1343.
Salientes-Narisma, Corrie. “Samsung Shift to Innovative Devices Pay Off.” Inquirer Technology. Accessed May 15, 2013. http://technology.inquirer.net/23831/samsungs-shift-to-innovative-devices-pays-off.


# Positive Externalities and Public Goods

## How Governments Can Encourage Innovation

A number of different government policies can increase the incentives to innovate, including: guaranteeing intellectual property rights, government assistance with the costs of research and development, and cooperative research ventures between universities and companies.

### Intellectual Property Rights

One way to increase new technology is to guarantee the innovator an exclusive right to that new product or process. Intellectual property rights include patents, which give the inventor the exclusive legal right to make, use, or sell the invention for a limited time, and copyright laws, which give the author an exclusive legal right over works of literature, music, film/video, and pictures. For example, if a pharmaceutical firm has a patent on a new drug, then no other firm can manufacture or sell that drug for 20 years, unless the firm with the patent grants permission. Without a patent, the pharmaceutical firm would have to face competition for any successful products, and could earn no more than a normal rate of profit. With a patent, a firm is able to earn monopoly profits on its product for a period of time—which offers an incentive for research and development. In general, how long can “a period of time” be? The Clear It Up discusses patent and copyright protection timeframes for some works you might know.
 illustrates how the total number of patent applications filed with the U.S. Patent and Trademark Office, as well as the total number of patents granted, surged in the mid-1990s with the invention of the internet, and is still going strong today.
While patents provide an incentive to innovate by protecting the innovator, they are not perfect. For example:
1. In countries that already have patents, economic studies show that inventors receive only one-third to one-half of the total economic value of their inventions.
2. In a fast-moving high-technology industry like biotechnology or semiconductor design, patents may be almost irrelevant because technology is advancing so quickly.
3. Not every new idea can be protected with a patent or a copyright—for example, a new way of organizing a factory or a new way of training employees.
4. Patents may sometimes cover too much or be granted too easily. In the early 1970s, Xerox had received over 1,700 patents on various elements of the photocopy machine. Every time Xerox improved the photocopier, it received a patent on the improvement.
5. The 20-year time period for a patent is somewhat arbitrary. Ideally, a patent should cover a long enough period of time for the inventor to earn a good return, but not so long that it allows the inventor to charge a monopoly price permanently.
Because patents are imperfect and do not apply well to all situations, alternative methods of improving the rate of return for inventors of new technology are desirable. The following sections describe some of these possible alternative policies.

### Policy #1: Government Spending on Research and Development

If the private sector does not have sufficient incentive to carry out research and development, one possibility is for the government to fund such work directly. Government spending can provide direct financial support for research and development (R&D) conducted at colleges and universities, nonprofit research entities, and sometimes by private firms, as well as at government-run laboratories. While government spending on research and development produces technology that is broadly available for firms to use, it costs taxpayers money and can sometimes be directed more for political than for scientific or economic reasons.
The first column of  shows the sources of total U.S. spending on research and development. The second column shows the total dollars of R&D funding by each source. The third column shows that, relative to the total amount of funding, 22.7% comes from the federal government, about 69% of R&D is done by industry, and less than 4% is done by universities and colleges.  (The percentages below do not add up to exactly 100% due to rounding.)
In the 1960s the federal government paid for about two-thirds of the nation’s R&D. Over time, the U.S. economy has come to rely much more heavily on industry-funded R&D. The federal government has tried to focus its direct R&D spending on areas where private firms are not as active. One difficulty with direct government support of R&D is that it inevitably involves political decisions about which projects are worthy. The scientific question of whether research is worthwhile can easily become entangled with considerations like the location of the congressional district in which the research funding is spent.

### Policy #2: Tax Breaks for Research and Development

A complementary approach to supporting R&D that does not involve the government’s close scrutiny of specific projects is to give firms a reduction in taxes depending on how much research and development they do. The federal government refers to this policy as the research and experimentation (R&E) tax credit. According to the Treasury Department: “. . . the R&E Credit is also a cost-effective policy for stimulating additional private sector investment. Most recent studies find that each dollar of foregone tax revenue through the R&E Tax Credit causes firms to invest at least a dollar in R&D, with some studies finding a benefit to cost ratio of 2 or 2.96.”

### Policy #3 Cooperative Research

State and federal governments support research in a variety of ways. For example, United for Medical Research, a coalition of groups that seek funding for the National Institutes of Health, (which is supported by federal grants), states: “NIH-supported research added $69 billion to our GDP and supported seven million jobs in 2011 alone.” The United States remains the leading sponsor of medical-related research, spending $117 billion in 2011. Other institutions, such as the National Academy of Sciences and the National Academy of Engineering, receive federal grants for innovative projects. The Agriculture and Food Research Initiative (AFRI) at the United States Department of Agriculture awards federal grants to projects that apply the best science to the most important agricultural problems, from food safety to childhood obesity. Cooperation between government-funded universities, academies, and the private sector can spur product innovation and create whole new industries.

### Key Concepts and Summary

Public policy with regard to technology must often strike a balance. For example, patents provide an incentive for inventors, but they should be limited to genuinely new inventions and not extend forever.
Government has a variety of policy tools for increasing the rate of return for new technology and encouraging its development, including: direct government funding of R&D, tax incentives for R&D, protection of intellectual property, and forming cooperative relationships between universities and the private sector.

### Self-Check Questions

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### References

United States Department of the Treasury. “Research and Experimentation Tax Credit.” Accessed November 2013. http://www.treasury.gov/press-center/news/Pages/investing-in-us-competitiveness.aspx.
U.S. Patent and Trademark Office. 2015. “U.S. Patent Statistics: Calendar Years 1963–2014.” Accessed April 10, 2015. http://www.uspto.gov/web/offices/ac/ido/oeip/taf/us_stat.pdf.
United for Medical Research. “Profiles of Prosperity: How NIH-Supported Research Is Fueling Private Sector Growth and Innovation.” Introduction. Accessed January 2014. http://www.unitedformedicalresearch.com/wp-content/uploads/2013/07/UMR_ProsperityReport_071913a.pdf.


# Positive Externalities and Public Goods

## Public Goods

Even though new technology creates positive externalities so that perhaps one-half or two-thirds of the social benefit of new inventions spills over to others, the inventor still receives some private return. What about a situation where the positive externalities are so extensive that private firms could not expect to receive any of the social benefit? We call this kind of good a public good. Spending on national defense is a good example of a public good. Let’s begin by defining the characteristics of a public good and discussing why these characteristics make it difficult for private firms to supply public goods. Then we will see how government may step in to address the issue.

### The Definition of a Public Good

Economists have a strict definition of a public good, and it does not necessarily include all goods financed through taxes. To understand the defining characteristics of a public good, first consider an ordinary private good, like a piece of pizza. We can buy and sell a piece of pizza fairly easily because it is a separate and identifiable item. However, public goods are not separate and identifiable in this way.
Instead, public goods have two defining characteristics: they are nonexcludable and non-rival. The first characteristic, that a public good is nonexcludable, means that it is costly or impossible to exclude someone from using the good. If Larry buys a private good like a piece of pizza, then he can exclude others, like Lorna, from eating that pizza. However, if national defense is provided, then it includes everyone. Even if you strongly disagree with America’s defense policies or with the level of defense spending, the national defense still protects you. You cannot choose to be unprotected, and national defense cannot protect everyone else and exclude you.
The second main characteristic of a public good, that it is non-rival, means that when one person uses the public good, another can also use it. With a private good like pizza, if Max is eating the pizza then Michelle cannot also eat it; that is, the two people are rivals in consumption. With a public good like national defense, Max’s consumption of national defense does not reduce the amount left for Michelle, so they are non-rival in this area.
A number of government services are examples of public goods. For instance, it would not be easy to provide fire and police service so that some people in a neighborhood would be protected from the burning and burglary of their property, while others would not be protected at all. Protecting some necessarily means protecting others, too.
Positive externalities and public goods are closely related concepts. Public goods have positive externalities, like police protection or public health funding. Not all goods and services with positive externalities, however, are public goods. Investments in education have huge positive spillovers but can be provided by a private company. Private companies can invest in new inventions such as the Apple iPad and reap profits that may not capture all of the social benefits. We can also describe patents as an attempt to make new inventions into private goods, which are excludable and rivalrous, so that no one but the inventor can use them during the length of the patent.

### The Free Rider Problem of Public Goods

Private companies find it difficult to produce public goods. If a good or service is nonexcludable, like national defense, so that it is impossible or very costly to exclude people from using this good or service, then how can a firm charge people for it?
When individuals make decisions about buying a public good, a free rider problem can arise, in which people have an incentive to let others pay for the public good and then to “free ride” on the purchases of others. We can express the free rider problem in terms of the prisoner’s dilemma game, which we discussed as a representation of oligopoly in Monopolistic Competition and Oligopoly.
There is a dilemma with the Prisoner’s Dilemma, though. See the Work It Out feature.

### The Role of Government in Paying for Public Goods

The key insight in paying for public goods is to find a way of assuring that everyone will make a contribution and to prevent free riders. For example, if people come together through the political process and agree to pay taxes and make group decisions about the quantity of public goods, they can defeat the free rider problem by requiring, through the law, that everyone contributes.
However, government spending and taxes are not the only way to provide public goods. In some cases, markets can produce public goods. For example, think about radio. It is nonexcludable, since once the radio signal is broadcast, it would be very difficult to stop someone from receiving it. It is non-rival, since one person listening to the signal does not prevent others from listening as well. Because of these features, it is practically impossible to charge listeners directly for listening to conventional radio broadcasts.
Radio has found a way to collect revenue by selling advertising, which is an indirect way of “charging” listeners by taking up some of their time. Ultimately, consumers who purchase the goods advertised are also paying for the radio service, since the station builds in the cost of advertising into the product cost. In a more recent development, satellite radio companies, such as SiriusXM, charge a regular subscription fee for streaming music without commercials. In this case, however, the product is excludable—only those who pay for the subscription will receive the broadcast.
Some public goods will also have a mixture of public provision at no charge along with fees for some purposes, like a public city park that is free to use, but the government charges a fee for parking your car, for reserving certain picnic grounds, and for food sold at a refreshment stand.
In other cases, we can use social pressures and personal appeals, rather than the force of law, to reduce the number of free riders and to collect resources for the public good. For example, neighbors sometimes form an association to carry out beautification projects or to patrol their area after dark to discourage crime. In low-income countries, where social pressure strongly encourages all farmers to participate, farmers in a region may come together to work on a large irrigation project that will benefit all. We can view many fundraising efforts, including raising money for local charities and for the endowments of colleges and universities, as an attempt to use social pressure to discourage free riding and to generate the outcome that will produce a public benefit.

### Common Resources and the “Tragedy of the Commons”

There are some goods that do not fall neatly into the categories of private good or public good. While it is easy to classify a pizza as a private good and a city park as a public good, what about an item that is nonexcludable and rivalrous, such as the queen conch?
In the Caribbean, the queen conch is a large marine mollusk that lives in shallow waters of sea grass. These waters are so shallow, and so clear, that a single diver may harvest many conch in a single day. Not only is conch meat a local delicacy and an important part of the local diet, but artists use the large ornate shells and craftsmen transform them. Because almost anyone with a small boat, snorkel, and mask, can participate in the conch harvest, it is essentially nonexcludable. At the same time, fishing for conch is rivalrous. Once a diver catches one conch another diver cannot catch it.
We call goods that are nonexcludable and rivalrous common resources. Because the waters of the Caribbean are open to all conch fishermen, and because any conch that you catch is a conch that I cannot catch, fishermen tend to overharvest common resources like the conch.
The problem of overharvesting common resources is not a new one, but ecologist Garret Hardin put the tag “tragedy of the commons” to the problem in a 1968 article in the magazine Science. Economists view this as a problem of property rights. Since nobody owns the ocean, or the conch that crawl on the sand beneath it, no one individual has an incentive to protect that resource and responsibly harvest it. To address the issue of overharvesting conch and other marine fisheries, economists have advocated simple devices like fishing licenses, harvest limits, and shorter fishing seasons. One approach that has been turned to more recently is the implementation of catch shares, whereby regulators establish a total allowable catch, and then fishermen are allocated a portion of that total allowable catch. Catch shares appear to slow the race to fish. When the population of a species drops to critically low numbers, governments have even banned the harvest until biologists determine that the population has returned to sustainable levels. In fact, such is the case with the conch, the harvesting of which the government has effectively banned in the United States since 1986.
The tragedy of the commons is a frequent economic and social framework for discussions about a range of common resources, even extending into digital resources such as open media repositories and online libraries. Prominent economist Elinor Ostrom, the first woman to receive the Nobel Prize in Economics, proposed an alternate version, sometimes referred to as the "non-tragedy of the commons." After extensive fieldwork in areas as diverse as Indonesia, Kenya, Maine (U.S.), and Nepal, she challenged the notion that people would only avoid depletion of common resources if they were forced to by regulatory laws and property rights. She noted that farmers working shared land could communicate and cooperate in order to maximize and preserve the fields over time. She argued that when those who benefit most from a resource are in close proximity to it (like a farm field that directly serves a town), the resource is better managed without external influence.

### Positive Externalities in Public Health Programs

One of the most remarkable changes in the standard of living in the last several centuries is that people are living longer. Scientists believe that, thousands of years ago, human life expectancy ranged between 20 to 30 years. By 1900, average life expectancy in the United States was 47 years. By 2015, life expectancy was 79 years; due to COVID-19, life expectancy declined slightly to 77 years in 2020. Most of the gains in life expectancy in the history of the human race happened in the twentieth century.
The rise in life expectancy seems to stem from three primary factors. First, systems for providing clean water and disposing of human waste helped to prevent the transmission of many diseases. Second, changes in public behavior have advanced health. Early in the twentieth century, for example, people learned the importance of boiling bottles before using them for food storage and baby’s milk, washing their hands, and protecting food from flies. More recent behavioral changes include reducing the number of people who smoke tobacco and precautions to limit sexually transmitted diseases. Third, medicine has played a large role. Scientists developed immunizations for diphtheria, cholera, pertussis, tuberculosis, tetanus, and yellow fever between 1890 and 1930. Penicillin, discovered in 1941, led to a series of other antibiotic drugs for bringing infectious diseases under control. In recent decades, drugs that reduce the risks of high blood pressure have had a dramatic effect in extending lives.
These advances in public health have all been closely linked to positive externalities and public goods. Public health officials taught hygienic practices to mothers in the early 1900s and encouraged less smoking in the late 1900s. Government funded many public sanitation systems and storm sewers because they have the key traits of public goods. In the twentieth century, many medical discoveries emerged from government or university-funded research. Patents and intellectual property rights provided an additional incentive for private inventors. The reason for requiring immunizations, phrased in economic terms, is that it prevents spillovers of illness to others—as well as helping the person immunized.

### Key Concepts and Summary

A public good has two key characteristics: it is nonexcludable and non-rival. Nonexcludable means that it is costly or impossible for one user to exclude others from using the good. Non-rival means that when one person uses the good, it does not prevent others from using it. Markets often have a difficult time producing public goods because free riders will attempt to use the public good without paying for it. One can overcome the free rider problem through measures to assure that users of the public good pay for it. Such measures include government actions, social pressures, and specific situations where markets have discovered a way to collect payments.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Cowen, Tyler. Average Is Over: Powering America Beyond the Age of the Great Stagnation. Dutton Adult, 2013.
Hardin, Garret. “The Tragedy of the Commons.” Science 162 (3859): 1243–48 (1968).


# Labor Markets and Income

## Introduction to Labor Markets and Income

In a market economy like the United States, income comes from ownership of the means of production: resources or assets.  More precisely, one’s income is a function of two things:   the quantity of each resource one owns, and the value society places on those resources.
Recall from the chapter on Production, Costs, and Industry Structure, each factor of production has an associated factor payment.  For the majority of us, the most important resource we own is our labor.  Thus, most of our income is wages, salaries, commissions, tips and other types of labor income. Your labor income depends on how many hours you work and the wage rate an employer will pay you for those hours.  At the same time, some people own real estate, which they can either use themselves or rent out to other users.  Some people have financial assets like bank accounts, stocks and bonds, for which they earn interest, dividends or some other form of income.

Each of these factor payments, like wages for labor and interest for financial capital, is determined in their respective factor markets.  For the rest of this chapter, we will focus on labor markets, but other factor markets operate similarly.  Later in Chapter 17 we will describe how this works for financial capital.


# Labor Markets and Income

## The Theory of Labor Markets

The labor market, like all markets, has a demand and a supply.  Why do firms demand labor?  Why is an employer willing to pay you for your labor?  It’s not because the employer likes you or is socially conscious.  Rather, it’s because your labor is worth something to the employer--your work brings in revenues to the firm.  How much is an employer willing to pay?  That depends on the skills and experience you bring to the firm.
If a firm wants to maximize profits, it will never pay more (in terms of wages and benefits) for a worker than the value of their marginal productivity to the firm.  We call this the first rule of labor markets.
Suppose a worker can produce two widgets per hour and the firm can sell each widget for $4 each.  Then the worker is generating $8 per hour in revenues to the firm, and a profit-maximizing employer will pay the worker up to, but no more than, $8 per hour, because that is what the worker is worth to the firm.
Recall the definition of marginal product.  Marginal product is the additional output a firm can produce by adding one more worker to the production process.  Since employers often hire labor by the hour, we’ll define marginal product as the additional output the firm produces by adding one more worker hour to the production process.  In this chapter, we assume that workers in a particular labor market are homogeneous—they have the same background, experience and skills and they put in the same amount of effort.  Thus, marginal product depends on the capital and technology with which workers have to work.
A typist can type more pages per hour with an electric typewriter than a manual typewriter, and the typist can type even more pages per hour with a personal computer and word processing software.  A ditch digger can dig more cubic feet of dirt in an hour with a backhoe than with a shovel.
Thus, we can define the demand for labor as the marginal product of labor times the value of that output to the firm.
On what does the value of each worker’s marginal product depend?  If we assume that the employer sells its output in a perfectly competitive market, the value of each worker’s output will be the market price of the product. Thus,
Demand for Labor = MPL x P = Value of the Marginal Product of Labor
We show this in , which is an expanded version of
Note that the value of each additional worker is less than the value of the ones who came before.

### Demand for Labor in Perfectly Competitive Output Markets

The question for any firm is how much labor to hire.
We can define a Perfectly Competitive Labor Market as one where firms can hire all the labor they want at the going market wage.  Think about secretaries in a large city.  Employers who need secretaries can probably hire as many as they need if they pay the going wage rate.
Graphically, this means that firms face a horizontal supply curve for labor, as Figure 14.3 shows.
Given the market wage, profit maximizing firms hire workers up to the point where: Wmkt = VMPL

### Demand for Labor in Imperfectly Competitive Output Markets

If the employer does not sell its output in a perfectly competitive industry, they face a downward sloping demand curve for output, which means that in order to sell additional output the firm must lower its price.  This is true if the firm is a monopoly, but it’s also true if the firm is an oligopoly or monopolistically competitive.  In this situation, the value of a worker’s marginal product is the marginal revenue, not the price.  Thus, the demand for labor is the marginal product times the marginal revenue.
The Demand for Labor = MPL x MR = Marginal Revenue Product
Everything else remains the same as we described above in the discussion of the labor demand in perfectly competitive labor markets.  Given the market wage, profit-maximizing firms will hire workers up to the point where the market wage equals the marginal revenue product, as  shows.

### What Determines the Going Market Wage Rate?

In the chapter on Labor and Financial Markets, we learned that the labor market has demand and supply curves like other markets.  The demand for labor curve is a downward sloping function of the wage rate.  The market demand for labor is the horizontal sum of all firms’ demands for labor.  The supply of labor curve is an upward sloping function of the wage rate.  This is because if wages for a particular type of labor increase in a particular labor market, people with appropriate skills may change jobs, and vacancies will attract people from outside the geographic area.  The market supply of labor is the horizontal summation of all individuals’ supplies of labor.
Like all equilibrium prices, the market wage rate is determined through the interaction of supply and demand in the labor market.  Thus, we can see in  for competitive markets the wage rate and number of workers hired.
The FRED database has a great deal of data on labor markets, starting at
the wage rate and number of workers hired.

The United States Census Bureau for the Bureau of Labor Statistics publishes The Current Population Survey, which is a monthly survey of households (you can find a link to it by going to the FRED database found in the previous link), which provides data on labor supply, including numerous measures of the labor force size (disaggregated by age, gender and educational attainment), labor force participation rates for different demographic groups, and employment.  It also includes more than 3,500 measures of earnings by different demographic groups.
The Current Employment Statistics, which is a survey of businesses, offers alternative estimates of employment across all sectors of the economy.
The FRED database, found in the previous link, also has a link labeled "Productivity and Costs" has a wide range of data on productivity, labor costs, and profits across the business sector.

### Key Concepts and Summary

A firm demands labor because of the value of the labor’s marginal productivity.  For a firm operating in a perfectly competitive output market, this will be the value of the marginal product, which we define as the marginal product of labor multiplied by the firm’s output price.  For a firm which is not perfectly competitive, the appropriate concept is the marginal revenue product, which we define as the marginal product of labor multiplied by the firm’s marginal revenue.  Profit maximizing firms employ labor up to the point where the market wage is equal to the firm’s demand for labor.  In a competitive labor market, we determine market wage  through the interaction between the market supply and market demand for labor.

### Self-Check Questions

### Review Questions

### References

AFL-CIO. “Training and Apprenticeships.” http://www.aflcio.org/Learn-About-Unions/Training-and-Apprenticeships.
Cook, Lisa D. 2020. "Policies To Broaden Participation in the Innovation Process." The Hamilton Project. https://www.hamiltonproject.org/assets/files/Cook_PP_LO_8.13.pdf.
Darity Jr., William A. 1998. "Evidence of Discrimination in Employment: Codes of Color, Codes of Gender." Journal of Economic Perspectives 12 (2): 63–90.
Central Intelligence Agency. “The World Factbook.” https://www.cia.gov/library/publications/the-world-factbook/index.html.
Clark, John Bates. Essentials of Economic Theory: As Applied to Modern Problems of Industry and Public Policy. New York: A. M. Kelley, 1907, 501.
United Auto Workers (UAW). “About: Who We Are.” http://www.uaw.org/page/who-we-are.
United States Department of Labor: Bureau of Labor Statistics. “Economic News Release: Union Members Summary.” Last modified January 23, 2013. http://www.bls.gov/news.release/union2.nr0.htm.
United States Department of Labor, Bureau of Labor Statistics. 2015. “Economic News; Union Members Summary.” Accessed April 13, 2015. http://www.bls.gov/news.release/union2.nr0.htm.