This Document Contains Chapters 15 to 16 Chapter 15: Monopolistic Competition and Product Differentiation What’s New in the Fifth Edition? • Updated business cases Chapter Objectives • Define monopolistic competition. • Explain why oligopolists and monopolistically competitive firms differentiate their products. • Explain how monopolistically competitive firms determine price and profit in the short run and in the long run. • Explain the trade-off between lower prices and greater product diversity in a monopolistically competitive industry. • Discuss the economic significance of advertising and brand names. Teaching Tips The Meaning of Monopolistic Competition Creating Student Interest • Ask students to identify markets that might be considered monopolistic competition. For each example considered, discuss the number of firms, the type of product, and evidence of entry and exit. When discussing the type of product, have students think about what exactly it is about the good that makes it different from those of its competitors. • In a previous chapter you may have had them think about examples of homogeneous goods—markets in which brand does not matter—and now you are asking them to think about heterogeneous goods—markets in which brand does matter. Keep in mind that not all students will agree that brand matters in each case. Presenting the Material • Make clear that the most important feature of monopolistic competition is many sellers, which makes it clearly different from monopoly. Give some examples of markets that fit this type of market structure: cosmetics, fast food, retail clothing stores, restaurants, coffee houses, hair salons, and nail salons. Product Differentiation Creating Student Interest • Ask students to consider the market for toothpaste (or some other market with considerable product differentiation). What is the purpose and function of toothpaste? (To clean your teeth.) Ask students what features they look for in choosing a toothpaste (and what features they ignore). Use their responses to create a list. Students should be able to come up with a long list of features: gel versus paste, flavors, whitening, plaque fighting, pump versus tube, and many more. There are a lot of differences in toothpastes, but in the end they all clean your teeth. While they may have a favorite toothpaste brand/type, if they forgot theirs and could borrow another kind, would they? Presenting the Material • Have students identify both the costs and benefits of product differentiation in the athletic shoe market. Have them consider the athletic shoes sold at discount stores versus name-brand athletic shoes (Nike, Under Armour, Adidas, etc.) versus specially branded name-brand athletic shoes (Michael Jordan, Steph Curry, DB, etc.). Use cost-benefit analysis to explain when a firm will engage in product differentiation and when it will not. Understanding Monopolistic Competition Creating Student Interest • Have students create a list of firms in the area that have recently entered or exited. Discuss what type of products the firms sell. How many other firms sell the same product? Make sure students understand that firms can easily enter and exit a monopolistically competitive market. Presenting the Material • Use Handout 15-1 to provide a concrete example of monopolistic competition. Explain that firms in monopolistic competition have some market power because they can differentiate their product, and also they face a downward-sloping demand curve. Draw a graph to illustrate the profit-maximizing output and the level of profit. Point out to the students that in the short run this looks just like the monopoly outcome. In the long run, the monopolistically competitive firm will earn zero economic profit just like the perfectly competitive firm. Be sure to discuss what happens to the firm’s demand and marginal revenue curves when firms enter this industry (where firms are earning positive profit). Illustrate the long-run equilibrium and make sure students understand why economic profit will be equal to zero. Monopolistic Competition versus Perfect Competition Creating Student Interest • Ask students to name a “monopolistic” industry. See how long it takes for someone in the class to ask whether you mean a monopoly or a monopolistically competitive industry. Use the confusion to point out the difference between the two market structures and the importance of being clear about which one you are talking about (by not simply saying “monopolistic”). Ask what makes a monopolistically competitive firm competitive and what makes it like a “mini-monopoly.” Presenting the Material • Use the characteristics of market structures (number of firms, type of product, control over price, ease of entry) to show that monopolistic competition has characteristics in common with both perfect competition and monopoly (hence the hybrid name). Like perfect competition, monopolistic competition has multiple firms and easy entry. Therefore, the long-run result is the same as perfect competition (zero economic profit). As in monopoly, firms in monopolistic competition sell a unique (or at least differentiated) product and have some control over price. Therefore, they can earn a profit in the short run by differentiating their product. • Engage students in a debate about whether a monopolistically competitive industry is inefficient. Discuss the two possible points of inefficiency: firms sell for a price greater than marginal cost and produce at a point at which average total cost is not minimized, suggesting there is excess capacity. Now point out a benefit of monopolistic competition, which is more choice for consumers. Controversies About Product Differentiation Creating Student Interest • Ask students to think of three recent purchases. To what extent did advertising or brand names influence their decision? What was it about the advertising that influenced them? Why do some consumers say that they are not influenced by advertising? • Use Handout 15-2 to discuss advertising in the various market types. • Ask students how much they think a domain name on the web is worth to a business. For example, how much is a website such as www.lasvegas.com worth? • Ask students whether the quality of a Nike athletic shoe is really superior to that of a store brand purchased at Walmart or whether Air Jordans are better than a regular Nike athletic shoe. • Ask students if they think they can tell the difference in taste between Sam’s Club cola and Coca-Cola. Presenting the Material • Make sure students understand that the goal of advertising is to increase profit. Through advertising, firms are attempting to differentiate their product, and make demand for their product more inelastic. If successful, advertising will shift the firm demand curve to the right. Monopoly firms have an incentive to advertise because they also want to shift the demand curve for their product to the right. Perfectly competitive firms can advertise as a group in order to shift the demand curve for their product. Individual firms in a perfectly competitive market have no incentive to advertise because they sell a homogeneous good. • Use the following table to provoke a discussion about the value of a brand name. The World’s 10 Most Valuable Brands 2011 Rank Brand 2011 brand value (US$ in billions) 1 Apple 153.285 2 Google 111.498 3 IBM 100.849 4 McDonald’s 81.016 5 Microsoft 78.243 6 Coca-Cola 73.752 7 AT&T 69.916 8 Marlboro 67.522 9 China Mobile 57.326 10 General Electric 50.318 (Source: www.millwardbrown.com/BrandZ.) Common Student Pitfalls • Confusion over the term monopolistic. Students may confuse monopolistic competition with monopoly. Explain that the “monopolistic” aspect of monopolistic competition means that firms attempt to convince consumers that they have a unique product. • Advertising and information. Students may be confused about whether an ad actually conveys useful information. Explain that an ad can tell a consumer about product availability, location, and features. But an ad also may contain no useful information, as some students suspect. Chapter Outline Opening Example: The fast-food industry is an example of a monopolistically competitive market in which firms offer competing, differentiated products that are close but not perfect substitutes. I. The Meaning of Monopolistic Competition A. Monopolistic competition is a market structure in which there are many competing producers in an industry, each producer sells a differentiated product, and there is free entry into and exit from the industry in the long run. II. Product Differentiation A. Product differentiation plays a crucial role in monopolistic competition; it is the only way firms can gain market power. 1. Firms differentiate their products by: a. style or type b. location c. quality III. Understanding Monopolistic Competition A. Monopolistic competition in the short run 1. Because there are many firms in a monopolistically competitive industry, firms cannot collude to increase their market power. 2. A monopolistically competitive firm faces a downward-sloping demand curve and a downward-sloping marginal revenue curve. 3. In the short run, a monopolistically competitive firm has an upward-sloping marginal cost curve and a U-shaped average total cost curve. 4. To maximize profits in the short run, a monopolistically competitive firm should choose an output level at which marginal revenue is equal to marginal cost. 5. The key to whether a firm with market power is profitable or unprofitable in the short run lies in the relationship between its demand curve and its average total cost curve. 6. If the average total cost curve is below the demand curve at the profit-maximizing level of output, then the monopolistically competitive firm is profitable. 7. If the average total cost curve is above the demand curve at the profit-maximizing level of output, then the monopolistically competitive firm is unprofitable. 8. Text Figure 15-1, shown next, illustrates monopolistic competition in the short run. B. Monopolistic competition in the long run 1. Entry and exit affect the demand curve of every firm in the market. 2. If firms are earning economic profits, new firms will enter the market, shifting the demand curve for the existing firms to the left. 3. If firms are incurring losses, firms exit the industry, shifting the demand curve for existing firms to the right. 4. The market is in long-run equilibrium when there is no exit or entry. 5. In the long run, a monopolistically competitive industry ends up in zero-profit equilibrium: Each firm makes zero profit at its profit-maximizing quantity (see text Figure 15-3, shown next). 6. In the long run, firms will earn zero economic profits, and each firm’s average total cost curve will be tangent to its demand curve at the profit-maximizing level of output. IV. Monopolistic Competition versus Perfect Competition A. Price, marginal cost, and average total cost 1. Monopolistically competitive firms and perfectly competitive firms are similar in that in the long run both receive a price that is equal to their average total cost. This is illustrated in text Figure 15-4, shown next. 2. They differ in the following ways: a. The price a perfectly competitive firm earns is equal to its marginal cost. A monopolistically competitive firm earns a price that is above its marginal cost. For this reason, monopolistically competitive firms are willing to sell more than they are currently selling at the going price. b. Firms in perfect competition earn a price that is equal to their minimum average total cost, while monopolistically competitive firms produce less than the quantity that would minimize average total cost. c. Firms in monopolistic competition have excess capacity. B. Is monopolistic competition inefficient? 1. Some mutually beneficial trades go unrealized. 2. The excess capacity leads to wasteful duplication: There are too many varieties of products. 3. Consumers, however, do benefit from the diversity of products in monopolistic competition. V. Controversies About Product Differentiation A. The role of advertising 1. Advertising is only worthwhile in industries in which firms have some market power. 2. Advertising that provides product information has economic usefulness. 3. Advertising influences consumers even when the ad provides little information. a. Consumers may not be as rational as economists assert. b. Ads can “signal” consumers about the availability and quality of a product. 4. Is advertising a waste of resources? a. If ads only work by manipulating the weak-minded, they are an economic waste. b. To the extent that advertising conveys important information, it is economically productive. B. Brand names 1. Consumers often pay more for brand-name products than identical and cheaper store-brand items. 2. Brand names can convey information on product quality and reliability. Case Studies in the Text Economics in Action Abbondanza!—This EIA discusses product differentiation in the pasta sauce industry. Ask students the following questions: 1. Why did Prego and Ragu offer only one type of pasta in the 1980s? (Food suppliers at the time thought they should provide an “ideal version” of foods to satisfy American tastes.) 2. How was Prego able to distinguish itself from Ragu? (By offering sauces of differing flavors and textures, which appealed to customer tastes.) Hits and Flops in the App Store—This EIA explains how the download of apps has fallen due to customer fatigue. Ask students the following questions: 1. How is the app market a monopolistic competitive market? (Apps are differentiated by platform, function, and variation within function.) 2. What recent changes have led to decline in app demand? (Consumers have become fatigued, resulting in zero profits for developers.) The Perfume Industry: Leading Consumers by the Nose—This EIA explains why profit in the perfume industry remains high instead of being driven to zero as new firms enter the industry. Ask students the following questions: 1. Does the perfume industry have barriers to entry? (No, it is easy to purchase ingredients and bottle them. However, many perfumes sold these days are successful because they are linked to celebrities.) 2. Is perfume sold by many firms and is it a differentiated good? (Yes and yes.) 3. How do sellers of perfume differentiate their product? (They package the perfume in fancy and elaborate bottles, and they find celebrities to endorse the perfume.) Business Case The Dollar Shave Club: How to Avoid a Case of Razor Burn—This business case discusses the long rivalry between the two companies and new up-starts in the razor market. Companies spend millions of dollars on advertising in an attempt to capture sales and market share. Handout 15-1 Date _________ Name ____________________ Class ________ Professor ________________ Monopolistic Competition Complete the following table. (1) Quantity (2) Price (3) Total revenue (4) Marginal revenue (5) Total cost (6) Average total cost (7) Marginal cost (8) Profit 0 $17 -- $10 — — 1 16 18 2 15 23 3 14 25 4 13 27 5 12 30 6 11 32 7 10 38 8 9 48 9 8 62 1. Which columns are this firm’s demand curve? 2. What is the profit-maximizing price and output for this monopolistic competitor? 3. What is profit for this firm at the profit-maximizing level of output? 4. What is likely to happen in the long-run in this industry? Answers (1) Quantity (2) Price (3) Total revenue (4) Marginal revenue (5) Total cost (6) Average total cost (7) Marginal cost (8) Profits 0 $17 $0 -- $10 — — –$10 1 16 16 16 18 18 8 –2 2 15 30 14 23 11.5 5 +7 3 14 42 12 25 8.3 2 +17 4 13 52 10 27 6.8 2 +25 5 12 60 8 30 5.6 3 +32 6 11 66 6 32 5.3 4 +34 7 10 70 4 38 5.4 6 +32 8 9 72 2 48 6 10 +24 9 8 72 0 62 6.9 14 +10 1. Which columns are this firm’s demand curve? Columns (1) and (2) make up the demand curve for this firm. 2. What is the profit-maximizing price and output for this monopolistic competitor? The profit-maximizing price is $11, and the output is 6. 3. What is profit for this firm at the profit-maximizing level of output? Total profits at this level of production are $34. 4. What is likely to happen in the long-run in this industry? New firms will enter this industry to capture some of the profit. This will stop when no firm is making a profit. Handout 15-2 Date_________ Name____________________________ Class________ Professor________________ Market Structures and Advertising Complete the following table by filling in the market model’s characteristics. Answer: Chapter 16: Externalities What’s New in the Fifth Edition? • Updated business cases Chapter Objectives • Define the concept of an externality and explain why the private market produces an inefficient quantity in the presence of an externality. • Discuss the Coase theorem, which explains how private individuals can sometimes remedy externalities through bargaining. • Define and explain how standards, emissions taxes, and tradable emissions permits can be used to reduce emissions of a pollutant. • Define and discuss the concept of a positive externality. • Define and discuss the concept of a network externality. Teaching Tips External Costs and Benefits Creating Student Interest • Ask students to consider the idea of having zero pollution. First, is it possible to have zero pollution? The discussion of this question will center on the definition of pollution. If pollution is the creation of any waste from production and consumption, it is impossible to live without polluting. For example, squirrels will use up acorns and leave acorn shells and squirrel waste—is this pollution? If pollution is defined as the creation of more waste than the environment can absorb, then it is more conceivable that we could have zero pollution. Next, even if it is possible, would we want to achieve zero pollution? What would we have to do to achieve zero pollution? We would have to reduce the waste created by production and consumption or pay to deal with the waste we create so that it does not enter the environment as pollution (e.g., recycle or process the waste). Any of these choices is likely to have significant costs. The costs of reducing pollution need to be weighed against the benefits of reducing pollution (improved environment, better health, reduced costs of environmental damage). Unless the cost of reducing pollution is 0 or the benefits are infinite, it will not be efficient to reduce pollution to zero. A third question is to ask students if they think there is too much pollution, and if so why? Student responses will vary here depending on how environmentally aware they are. At the very least, they will all be aware of global warming and you can use this issue to start them thinking about the costs versus the benefits of pollution. Presenting the Material • Explain that pollution imposes costs on society as a whole and benefits for individual firms who are polluting. The benefits go to firms that do not have to pay for pollution-reducing equipment. The marginal social cost shown in the graph below is more intuitive for students to understand. The greater the quantity of pollution, the harder it is for the natural world to handle the damage, and the additional costs to society rise. The marginal social benefit of pollution represents the willingness of polluters to pay for the right to pollute; their willingness to pay is equal to the cost of reducing pollution by that quantity of emissions. In the graph below, as we move from point A to point B, it becomes progressively harder to achieve lower amounts of pollution and therefore more expensive to achieve these lower amounts of pollution. To produce less pollution, a polluter would have to spend a greater amount of money on pollution-reducing equipment or production methods; therefore, the marginal social benefit of producing that unit of pollution is high. The socially optimal quantity of pollution is where marginal social cost and marginal social benefit are equal. Discuss the idea that emissions of a pollutant by the firm impose an external cost on members of society. In the absence of regulation, firms have no incentive to consider this external cost. The incentive of the firm is to maximize profit, and therefore firms have little incentive to voluntarily spend money to reduce their emissions. Reducing emissions will increase production costs, and this will result in lower profit and/or higher prices for the goods being sold. Voluntarily incurring higher cost to reduce emissions puts firms at a competitive disadvantage. Having established the existence of the pollution problem, the question is what to do about it. Discuss the Coase theorem to show that two parties can in theory bargain and come to an agreement that makes them both better off. Use a roommate example where one person in the apartment either plays music too loudly or does not clean up after themselves. Discuss the different ways that the two people in the apartment could bargain and come up with a solution. Students often fail to appreciate the point of the Coase theorem, which is to show that inefficient emissions arise from the existence of an external cost that is not being realized. Bargaining forces one of the parties to realize the external cost and compensate the other party for the damages being imposed. Pollution is not eliminated, but it is moved to an efficient level. • Use Handout 16-1 to help students discern positive versus negative externalities. Policies Toward Pollution Creating Student Interest • Ask students to consider activities like smoking or talking on a cell phone while driving. Do these activities have externalities associated with them? Research indicates that secondhand smoke and distracted driving are both hazards to other individuals that result when a person smokes or talks on a phone while driving. Ask the students what they think should be done about these behaviors? The possible solutions include doing nothing, letting individuals work out their own solutions, government regulation (taxes, permits), and prohibition. As part of this discussion, you may want to point out the difference between political and economic analysis of the optimal solution (and try to keep them focused on determining the efficient level of the activity). Presenting the Material • Carefully define and explain each of the three approaches to regulating emissions—the standard, the tax, and the tradable emissions permit system. Begin with the standard, as it is the most common approach in the United States. The EPA website has an abundance of information on environmental regulation if you care to expand on the topic. The advantages of setting a standard (say, limiting each firm’s emissions to a certain level) include the perception that it is fair (in treating all firms equally) and that it sets an exact limit on the level of emissions. The disadvantage of the standard is that it does not reach the desired emissions target at lowest total cost because firms have different costs of reducing emissions. The emissions tax can in theory achieve the same reduction in emissions at a lower cost to the firms in total, not including the actual tax revenue paid. With a standard, emissions are essentially free. With the emissions tax, the firm must pay a dollar amount per unit emitted. Firms therefore have an incentive to reduce emissions as long as the tax is greater than the cost of reducing emissions, as measured by marginal benefit. The advantages of the tax include minimizing the amount spent by firms on pollution control in total. Also, the existence of the tax gives firms a continued incentive to develop cleaner technologies and thereby avoid having to pay a tax. Another advantage of the tax is the government collects revenue, which can be used in a variety of ways, including funding research and development of cleaner technologies. On the downside, the costs of production for the firm will rise and this will push up prices of goods and services. The third option is the tradable emissions permit system. Each firm is issued a certain number of permits, each of which allows for some level of emissions. Firms are then allowed to use the permits to cover their emissions, or they can choose to sell unused permits to other firms. Each firm has an incentive to reduce emissions and sell permits if they think the cost of reducing emissions will be less than the price of a permit. Permit prices will be determined by supply and demand as with any regular good sold in a market. A good example of a permit system currently in use in the United States is the RECLAIM program in California. You can look it up online and find current data about the program. • Use Handout 16-2 to help students see the differences in the policies toward pollution. Positive Externalities Creating Student Interest • In this section, the discussion is expanded to include external benefits. Have students think of examples of an activity of an individual or firm that creates a benefit for them that they do not pay for. To get them started, you can present examples like a bakery that creates a pleasant smell for passersby (as opposed to a firm emitting toxic pollution); a roommate playing music that you enjoy (as opposed to disturbing your studying with loud music you don’t enjoy); a neighbor who creates beautiful landscaping that you enjoy and that enhances the value of your own property (as opposed to piling trash in their front yard); a college student getting an education (as opposed to squandering their talents and creating no social benefit, and/or becoming a criminal). Presenting the Material • Make sure students understand that the preserved farmland example in this section is just the opposite of the emissions example in the last section. With emissions of a pollutant, the incentive of the firm is to not control emissions because this is costly and will reduce profit. As a result, society ends up with too many emissions. The firms fail to consider the external costs imposed on members of society. With preserved farmland, owners of the land have an incentive to sell to developers if they can earn a higher profit by doing so. As a result, society ends up with too little preserved farmland. The owners of the land fail to consider the external benefits that society will realize from preserving farmland. The graphical analysis is similar, just with a different story. From a policy perspective, states can choose to impose higher taxes and subsidize owners of land so they have an incentive to preserve the land. Network Externalities Creating Student Interest • Tell students they have an amazing opportunity to buy a new car. This car has all of the features they are looking for in a car and it is being sold for a very competitive price. The only catch—the car runs on natural gas. Will they buy it? Students should realize that finding fuel for the car will be challenging and therefore they may not want to buy the car. Since there are not many natural gas fueling sites, many people will not want to buy cars that run on natural gas. Now ask students if there are any downsides to owning a Mac computer. As students, they may not perceive any. However, in the business world, many programs run only on Windows-based computers. Presenting the Material • To present this topic, discuss a variety of examples. For each example, make sure students understand that the dominant product may not end up being the superior product. Once established, the dominant product is difficult to beat. Common Student Pitfalls • The benefits of pollution. Students may have difficulty understanding or accepting that there are benefits of pollution. Make sure they understand that production and consumption inevitably result in waste. The waste either can be cleaned up (or otherwise managed in some way) or emitted into the environment. The benefit of polluting (emitting the waste into the environment) is that resources do not have to be used to clean up (or otherwise manage) the waste. So the benefit of polluting is lower production costs. • Measuring the marginal social cost of pollution. Students may be confused by the idea of social cost (or benefit). In previous discussions, all costs have been private costs incurred by an individual or a firm. Here we are introducing the concept of external costs, or costs that are incurred by society as a whole. Emphasize that social costs represent the sum of each person’s willingness to pay to avoid a unit of pollution. The amount a person is willing to pay to avoid a unit of pollution is equal to the amount of damage the person would incur if that unit of pollution was emitted. Chapter Outline Opening Example: The opening example discusses the costs and benefits of fracking. Although this technology has led to lower energy prices (a benefit), there is also evidence that the fracking process has contaminated underground drinking water supplies (a cost). I. External Costs and Benefits A. Pollution leads to an external cost because, in the absence of government intervention, those who pollute have no incentive to take into account the costs that this pollution imposes on others. B. External costs and benefits are known as externalities; external costs are negative externalities, and external benefits are positive externalities. C. Externalities can lead to individual decisions that are not optimal for society as a whole. D. The socially optimal quantity of pollution 1. The socially optimal quantity of pollution equates the marginal social benefits of pollution with its marginal social costs. 2. Left to itself, a market economy will not arrive at the socially optimal quantity of pollution. D. Why a market economy produces too much pollution 1. The marginal social benefit (MSB) of a unit of pollution is the saved opportunity cost from not having to reduce pollution by that one unit. The MSB is enjoyed by the polluter. 2. The marginal social cost (MSC) of a unit of pollution includes the health and other costs of a unit of pollution. The MSC is borne by society. 3. The polluter has a nonzero private marginal cost (MC) of pollution only if it is required to pay for the right to pollute. 4. If the polluter is not required to pay for the right to pollute, its private MC is zero. It will therefore produce pollution up to the point where the MSB of polluting is also zero. Polluters, therefore, will spend nothing to reduce the amount of pollution they generate. This is illustrated in text Figure 16-2, shown next. 5. The benefit to polluters of the last unit of pollution is very low—virtually zero. 6. The marginal social cost (MSC) imposed on the rest of society by the last unit of pollution may be large. 7. If the marginal social cost of the last unit of pollution is large, some people could be made better off without others being made worse off. H. Private solutions to externalities 1. According to the Coase theorem, even in the presence of externalities an economy can always reach an efficient solution as long as transaction costs are sufficiently low. 2. The implication of Coase’s analysis is that externalities need not lead to inefficiency because individuals have incentives to make mutually beneficial deals. 3. When individuals take external costs or benefits into account, they internalize the externality. 4. In many situations involving externalities, high transaction costs prevent individuals from making efficient deals. 5. When transaction costs prevent the private sector from dealing with externalities, government can provide a solution. II. Policies Toward Pollution A. In 1970 Congress adopted the Clean Air Act (CAA), which established the Environmental Protection Agency. The CAA was amended in 1977 and 1990. For more information, go to www.epa.gov. B. Environmental standards 1. The government’s main policy tool to deal with externalities is environmental standards. 2. Most current environmental standards are inflexible and wind up being inefficient. C. Emissions taxes 1. An emissions tax is more efficient than environmental standards because it ensures that the marginal benefit of pollution is equal for all sources of pollution, while an environmental standard does not. This is illustrated in text Figure 16-3, shown next. 2. Taxes can be used to discourage any activity that generates negative externalities. 3. Taxes designed to reduce external costs are known as Pigouvian taxes. 4. The main problem with emissions taxes is that government officials in practice usually are not sure how high the tax should be set. D. Tradable emissions permits 1. Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. 2. The key point is that these permits are tradable. Firms that find it easier to reduce pollution will sell some of their permits to those that find it more difficult. 3. Just like emissions taxes, tradable permits provide polluters with an incentive to take the marginal social cost of pollution into account. 4. Emissions taxes and tradable permits provide incentives for polluters to create and use less-polluting technologies. 5. The main problem with tradable emissions permits is that it is difficult to determine the optimal quantity of pollution, so governments may issue too many or too few permits. III. The Economics of Climate Change and the Great Energy Transition 1. Science has conclusively shown that emissions of greenhouse gases are changing Earth’s climate. 2. These emissions come primarily from the burning of fossil fuels. 3. To prevent catastrophic climate change, humans will need to move to relying on clean energy sources, sometimes referred to as the great energy transition. IV. Positive Externalities A. Preserved farmland: an external benefit 1. Preserved farmland is an example of a good that will tend to be undersupplied by the private market. 2. The marginal social cost of preserved farmland is upward sloping and represents lost profits to farmers if they had been allowed to sell their land to developers. 3. The marginal social benefit of preserved farmland is downward sloping and represents the benefits to society in terms of beauty, access to fresh food, and preservation of wildlife. 4. Left to their own devices, owners of farmland will not consider the external benefits of preserving the farmland, as represented by the marginal social benefit. 5. The socially optimal quantity of preserved farmland is the level at which the marginal social benefit is equal to the marginal social cost. B. Positive externalities in today’s economy 1. A technology spillover is an external benefit that results when knowledge spreads among individuals and firms. 2. In the U.S. economy, the most important source of external benefits is the creation of knowledge. 3. Knowledge tends to be created in research clusters. Research clusters tend to develop around major universities. V. Network Externalities A. A network externality exists when the value of a good to an individual is greater when a large number of other people also use the good. B. The external benefits of a network externality 1. The marginal benefit of the good to any one individual depends on the number of other people that also use the good. 2. Examples include computer operating systems and cars that run on gasoline as opposed to an alternative fuel. 3. The product with the largest network will eventually dominate the market. Since gaining market share is crucial, there is an incentive to sell the good for a low price to gain market share. Case Studies in the Text Economics in Action How Much Does Your Electricity Really Cost?—This EIA discusses the results of a study that attempts to measure the total external cost of carbon emissions for energy produced by burning natural gas and coal. Ask students the following questions: 1. What does the TEC/TVC ratio measure? (TEC is the total external cost; TVC is the total value to society of the good being produced. If the ratio exceeds 1 then there is too much production and pollution.) 2. How do you measure the cost to society of carbon emissions? (The social cost of carbon puts a price on each unit of carbon emissions. There is no exact value for the social cost of carbon so studies usually use a range of values, or pick an average value.) Cap and Trade—This EIA presents examples of tradable emissions permits in the United States and the European Union. In the United States tradable permits are used to address acid rain and in Europe tradable permits are used to address greenhouse gases. Ask students the following questions: 1. Has the cap and trade system for sulfur dioxide emissions in the United States been successful? (Yes, there has been a large reduction in pollution and lower pollution reduction costs in comparison with a non–market-based solution.) 2. Has the cap and trade system for greenhouse gas emissions in the European Union been successful? (Yes, but it has been slow because they initially issued too many permits.) The Impeccable Economic Logic of Early-Childhood Intervention Programs—This EIA explains the positive externalities of early childhood intervention programs that make the benefits of such programs outweigh the costs. Ask students the following questions: 1. Why are the benefits of early childhood intervention programs so high? (Since the intervention is early in a child’s life, the benefits are received over many years.) 2. Given the “impeccable logic” of these programs, why do you think there aren’t more of them? (The costs are incurred immediately, the benefits received over time; the benefits are difficult for the general public to observe directly.) The Microsoft Case—This EIA presents the antitrust case against Microsoft. The case involved network externalities for Windows operating systems. Ask students the following questions: 1. What was the network externality involved in the Microsoft antitrust case discussed in the EIA? (The Windows operating system.) 2. Why were Microsoft’s actions in the computer market considered harmful? (By bundling Internet Explorer with Windows they gave themselves an unfair advantage; they created unnecessary monopolies and discouraged innovation.) For Inquiring Minds Talking, Texting, and Driving—This FIM discusses the negative externalities of driving while talking or texting on a cell phone (the risk to other drivers, as it tends to cause erratic driving). Global Comparison Economic Growth and Greenhouse Gases in Six Countries—The greenhouse gas emissions of the United States, Canada, Australia, China, Uzbekistan, and India are presented and discussed in this Global Comparison. Business Case Snapchat and Instagram: Not Your Grandmother’s Social Networking Platforms—This business case discusses the decline in popularity of Facebook by teens and a movement toward using Snapchat and Instagram—an example of a network externality. Web Resources The United States Environmental Protection Agency website has information and data related to topics in this chapter: http://www.epa.gov/. The EPA also has an education center on its website: http://www.epa.gov/teachers/. There are two excellent classroom experiments related to externalities on the Expernomics website. 1. “An experiment on externality rights” by Jim Stodder (http://w3.marietta.edu/~delemeeg/expernom/s96.html 2. “A Pollution Rights Trading Game” by Rachel Nugent (https://marietta.edu/~delemeeg/expernom/F93.PDF) Handout 16-1 Date _________ Name ________________________ Class ________ Professor ________________ Is It Positive or Negative? Are the following positive or negative externalities? Why? • Students holding onto library reserve books over the time limit • Smoking on campus expos students to secondhand smoke • College graduates add to the nation’s supply of skilled workers and add to productivity • Biotech firms invent new medicines • Using energy-saving light bulbs reduces the pollution from electricity-generating plants • Pop-ups and spam • Alcohol consumption at parties near the campus • Crowded freeways with heavy truck use expos the surrounding communities to increased health risks • Restoring the Amazon forest can reduce global levels of pollution • Students talking on cell phones as they walk around campus Answers • Students holding on to library reserve books over the time limit (Negative externality) • Smoking on campus exposes students to secondhand smoke (Negative externality) • College graduates add to the nation’s supply of skilled workers and add to productivity (Positive externality) • Biotech firms invent new medicines (Positive externality) • Using energy-saving light bulbs reduces the pollution from electricity-generating plants (Positive externality) • Pop-ups and spam (Negative externality, unwanted email advertising) • Alcohol consumption at parties near the campus (Negative externality) • Crowded freeways with heavy truck use expose the surrounding communities to increased health risks (Negative externality) • Restoring the Amazon forest can reduce global levels of pollution (Positive externality) • Students talking on cell phones as they walk around campus (Negative externality) Handout 16-2 Date _________ Name _____________________ Class ________ Professor ________________ The following table shows the MB of polluting to firm A and firm B (which represents the MC of abatement of pollution to the firms). A. Imagine an environmental standard where each firm is allowed to emit 11 units. 1. What is the total cost of this standard to firm A? 2. What is the total cost of this standard to firm B? 3. What is the total cost to the industry made up of these two firms? B. Now suppose that a tax of $24 per unit of emissions is imposed. 1. How many units of emissions will firm A choose to emit and at what cost? 2. How many units of emissions will firm B choose to emit? 3. What is the total cost to this industry for the reduction in emissions? C. Now suppose each firm is issued 11 permits in a tradable emissions permits market. 1. Who will purchase permits? Who will sell? 2. Where will the price of permits sell? Answers: A. Imagine an environmental standard where each firm is allowed to emit 11 units. 1. What is the total cost of this standard to firm A? ($180 = sum of the MB from 20 to 11 units) 2. What is the total cost of this standard to firm B? ($90) 3. What is the total cost to the industry made up of these two firms? ($270) B. Now suppose that a tax of $24 per unit of emissions is imposed. 1. How many units of emissions will firm A choose to emit and at what cost? (14 at $84) 2. How many units of emissions will firm B choose to emit? (8 at $156) 3. What is the total cost to this industry for the reduction in emissions? ($84 + $156 = $240) C. Now suppose each firm is issued 11 permits in a tradable emissions permits market. 1. Who will purchase permits? Who will sell? (Firm A has the higher cost so they will want to buy permits. Firm B is willing to sell because it has a lower cost.) 2. Where will the price of permits sell? (The price will fall between the two firms’ marginal benefit, representing the cost of reducing emissions.) Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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