Intermediate Microeconomics Module 20 Externalities

435 CHAPTER 20 THE POLICY QUESTION SHOULD THE CITY OF NEW YORK BAN SODA TO ADDRESS THE OBESITY EPIDEMIC ?

In 2012 , Michael , the then mayor of New York , announced the sugary drinks portion cap rule , which would have banned the sale of sweetened drinks in containers larger than 16 oz . in places that fell under New York City regulation , including delis , restaurants , and outlets . The argument for the ban focused on the negative health outcomes associated with the consumption of high amounts of sugar . These negative outcomes , the promoters claimed , were a societal concern , as the affected pooper populations rely more heavily on health care . Here an excerpt from the Washington Post article on March Under ban , sugary beverages larger than 16 ounces could not be sold at in New York City . At restaurants with soda fountains , cups larger than 16 ounces could not be provided . Only outlets that get grades were included , so supermarkets , vending machine operators and convenience stores . did have to worry about the ban . There was no ban on refills . Failure to comply could have led to a 200 fine . It was set to take effect on Tuesday . A sugary beverage is a drink with more than 25 calories per eight ounces , which has either been by the manufacturer or mixed with another caloric sweetener . The ban did not apply to pure or fruit smoothies , drinks that are more than half milk , diet sodas or alcoholic beverages . shakes , ifthey were more than half milk or ice cream , were exempt . But sweetened coffee drinks , if less than half milk , were not . To some people , the attempted ban represents a ridiculous intrusion of the government into the market and individual choice . To others , the ban represents a reasonable government response to an obesity epidemic that puts a strain on and imposes real costs on the public health care system . In order to these conflicting viewpoints , we need to understand the nature and economics of actions that have social costs and benefits . In this chapter , we will study and develop a model to study them . We can use the model to discuss ways to address through private action or government policy . With a general understanding of in place , we can proceed to study the New York City soda ban and analyze its effectiveness in dealing with the particular externality problem of the obesity . Exploring the Policy Question . Is there a true social cost associated with the private consumption of sugary drinks ?

Are a ban on the sale of drinks or a tax on sugar content reasonable policy ?

435 436 PATRICK EMERSON LEARNING OBJECTIVES Social Costs and Benefits Learning Objective Define social costs and benefits . Defining Learning Objective Describe the economic effects of the four categories of . How Lead to Socially Inefficient Outcomes Learning Objective Explain how lead to market failures . Methods of Addressing Market Failures Learning Objective Describe methods of addressing positive and negative , and explain how they work . The Theorem Learning Objective Describe the theorem and explain how it works with . Policy Example Should New York Ban Soda to Address the Obesity Epidemic ?

Learning Objective Apply externality concepts to the policy question of banning sugary drinks . SOCIAL COSTS AND BENEFITS Learning Objective Define social costs and benefits . To understand , it is important to first define the concept of social costs and benefits . Social costs and social benefits are costs and benefits of production or consumption that accrue to everyone in society , including those who are not directly involved in the economic activity . Social costs and benefits are the sum of the private costs and benefits of an economic activity and the external costs and external the costs and benefits that accrue to those not directly involved in the economic activity . A key aspect of external costs and benefits is that they are not reflected in prices . Prices are the private costs of a purchase or the private benefits of a sale . The archetypical example ofan external cost is a factory that , in its production of some good , generates pollution . Examples include smokestack emissions from a power plant or a liquid contaminant from a refinery operation that gets into the nearby water or soil . The owners of the factory pay the private cost of production the total of all of the costs ( including opportunity costs ) they have to pay to produce their good . Private cost of production can include the cost of raw materials , energy , labor , rent , pollution controls , and so on . But there is another cost of production for a factory that soils the air or water the cost to all those who live near the plant and are affected by

437 the pollution . The social cost of production includes both the private cost of production and this external cost , the cost that to society and not to the plant owners . Only the plant owners pay the private cost of production , but society as a whole pays the entire social cost . This is just one example of external costs and benefits . Consumers might also impose external costs through their consumption for example , a cigarette smoker in a bar pays the private price for smoking in the form of the cost of the cigarette and the cost of their own negative health consequences . But there is also an external cost the cost to the others in the bar who have to put up with the irritating and smelly smoke as well as potential negative health consequences of secondhand smoke . The smoker pays the private costs but not the external cost , so the social cost of smoking in a bar exceeds the private cost . Another example is the societal cost of treating illnesses if a person with such an illness requires public assistance to pay their medical bills . An example of social benefits in production is the classic story of the beekeeper that lives next to the apple orchard . The beekeeper produces honey and gets a private benefit from the honey the total of the sale of the honey . But in keeping bees next to the orchard , the beekeeper is also helping increase the apple orchards harvest of apples through the pollination that the bees facilitate . The extra revenue the owner of the orchard sees from the impact of the neighboring bees does not accrue to the beekeeper and is thus external . The social benefit of an economic activity includes the private benefit and the external . There can be external benefits in consumption as well . Consider a homeowner who buys a lot of ers and makes a lovely flower garden in their front yard . The homeowner gets a private benefit from the consumption of the flowers , but the neighbors also lovely garden not only is pleasing to look at but can cause home values to increase as well . The nicer the street of houses looks , the higher the price a house on the street will command . Here again , then , we have both private and external benefits with the consumption of these flowers for the flower garden . DEFINING Learning Objective Describe the economic effects of the four categories of . are the costs or benefits associated with an economic activity that affects people not directly involved in that activity . In other words , exist when there are external costs or fits associated with an economic activity . can be present in both consumption activities and production activities . All ofthe economic actions we take , like driving our cars and maintaining our homes , have private and costs . Driving a car takes gasoline , and you have to pay to maintain and insure your vehicle . Painting your house makes it more attractive , helps prolong its life , and increases its resale value . But many economic activities have associated costs and benefits that accrue to as well . We call these costs and benefits . Markets are efficient only when all the costs and benefits of an action are private . When external costs and benefits exist , private markets fail to achieve efficiency . The market equilibrium results in too many activities for which there are negative , costs imposed on individuals not directly involved in the economic activity . The market equilibrium results in too few activities for which there are positive , benefits that accrue to individuals not directly involved in an economic activity . can be categorized and doing so makes it easier to identify and analyze them . There are four categories , depending on whether they are positive or negative and consumption or production . Positive production

438 PATRICK EMERSON . Negative production . Positive consumption . Negative consumption The clearest way to understand the effect of relative to the market outcome is to start with the familiar equilibrium . In a graph of this equilibrium , the supply curve is a private marginal cost ( curve , and the demand curve is a private marginal benefit ( curve . To go from the private to the true social cost and benefits , which include , we need to account for external marginal costs and marginal benefits by drawing a social marginal benefit ( curve and a social marginal cost ( curve . How do the private marginal benefit ( demand ) curve and private marginal cost ( supply ) curve change with ?

When negative production are present , to get the social marginal cost curve , we have to add the external marginal cost ( to the private marginal cost ( supply ) curve . When negative consumption are present , to get the social marginal benefit curve , we have to subtract the from the private marginal benefit ( demand ) curve . When positive production are present , to get the social marginal cost curve , we have to subtract the external marginal benefit ( from the private marginal cost ( supply ) curve . When positive consumption are present , to get the social marginal benefit curve , we have to add the to the private marginal ( demand ) curve . Note that each externality generates deadweight difference in the total surplus generated by the private free market and what should be generated when we take into account the social costs and benefits . Table summarizes the effects of each type of externality . Table Effects of Type of externality External marginal cost or benefit Effect on social marginal benefit or cost curve External marginal cost Raises the social marginal cost above the supply Positive production External marginal benefit Lowers the social marginal cost below the supply curve Negative consumption External marginal cost Lowers the social marginal benefit below the demand External marginal benefit Raises the social marginal benefit above the demand curve 203 HOW LEAD TO SOCIALLY INEFFICIENT OUTCOMES Learning Objective Explain how lead to market failures . contribute to inefficient economic outcomes . We can begin to see this with a simple ple You are a smart economics student on the eve of an exam . You study until you feel the marginal benefit of extra study is no longer greater than the marginal cost . Part of the marginal cost is the cost of not listening to music at a high volume , which is your favorite late evening activity . So you close the , put away your economics notes , and crank up the stereo . You have successfully your own utility and , for that alone , deserve an A in economics for the night . However , you also have a roommate who studies chemistry and has an exam tomorrow . Your mate still needs to study for a few more hours , and your loud music will make it hard to concentrate . Your loud music listening imparts an external cost to your roommate , or an externality . If you took into account the effect of the music on your roommate , your calculation of the optimal amount of time ing to music would change , as can be seen in figure .

439 Cost A Benefit External marginal cost Dead Weight Loss ( Quantity of Loud Music Figure 207 Negative consumption In figure , the effect ofthe loud music can be seen clearly it imparts an external marginal cost , which we have to subtract from the private marginal benefit to get the social marginal benefit . When the social marginal benefit curve is shifted below the demand curve ( the new intersection between the curve and the supply curve ( determines the socially optimal amount of loud music , This is below the amount of loud music that is delivered by the free market , Because too much ofthe good is consumed , there is deadweight loss , as shown in the pink triangle . The socially inefficient outcome occurs because the individual economic actor makes decisions based on their private costs and benefits . Rational economic actors , as we have learned , will continue to or produce until the private marginal benefit of the activity equals the private marginal cost . These actors do not take into account the costs or benefits their actions have on society . As we will see in the next section , there is a potential role for government to intervene in markets to try to improve efficiency . As noted earlier , in all cases of , we get deadweight loss . We are now in a position to the deadweight loss associated with and socially inefficient outcomes . METHODS OF ADDRESSING MARKET FAILURES Learning Objective Describe methods of addressing positive and negative and explain how they work . Now that we have mastered the essential idea of , both positive and negative , and seen how their presence can lead to inefficient is appropriate to think about ways that policy could be used to correct this inefficiency .

440 PATRICK EMERSON Let start by dividing the into negative and positive , as the policy prescriptions are quite different . Negative We can focus on two characteristics of negative in designing policies to address them . In equilibrium , the amount produced or consumed is too high relative to the social optimum . In equilibrium , the private marginal cost curve ( production externality ) or the private marginal benefit curve ( consumption externality ) does not align with the social marginal cost and benefit curves . Quantity Controls Limiting the Economic Activity One way to address the externality is to focus on the outcome and limit the amount of activity that an economic actor can do . For example , if the production of a good produces harmful pollution , a ment could , theoretically , limit the amount of the production of the good to the socially optimal amount . In , we can see the socially optimal amount is , so setting a production quota at that point will achieve the socially optimal level . Cost A Benefit ( Quantity Figure Quantity controls to achieve the

441 Limiting the Externality Another way to address the externality is to regulate the externality itself . For example , a government could mandate pollution controls for the factory . This has the effect of closing the gap between the and the social cost because the external cost is lowered . Eventually , if the pollution is eliminated , the negative externality is eliminated as well , and the private marginal cost and the social marginal cost coincide . Taxes Adjusting the Cost of the Economic Activity Both limiting the economic activity and limiting the externality pose challenges . For our pollution ple , you have to know a lot about the markets and the available technologies to determine the right quantity of restrictions and pollution controls . A potentially simpler alternative is to tax the activity so that the private marginal cost equals the social marginal cost or the private marginal benefit equals the social marginal benefit . This type of tax has a special name a tax . It is named after the English economist , Arthur , who first proposed such taxes as a way to restore socially efficient market solutions . Figure shows how a tax equal to the external marginal cost will align the with the and achieve the socially optimal amount of output . Cost A Benefit ( Quantity Figure tax equal to the external marginal cost

442 PATRICK EMERSON Positive Again , we can focus on both the failure to produce or consume enough of the economic activity that has a positive externality and the fact that the private marginal benefit is below the social marginal benefit and the private marginal cost is higher than the social marginal cost . Quantity Controls Expanding the Economic Activity It is not generally thought to be the role of the federal government to compel the consumption or the production of a good . For this reason , quantity controls are somewhat mon . Examples of this type of regulation are laws that compel auto manufacturers to install equipment or design cars with pedestrian safety features . At other levels , communities often have codes that set minimum standards for property upkeep . Newer planned communities often have covenants that regulate the upkeep of property . owners in these communities are required to follow the covenants . Figure shows how such a control over home maintenance can work to achieve the socially optimal level . Cost A Benefit ( Home Maintenance Figure , home maintenance with or neighborhood covenant Tax Credits , Tax Breaks , and Subsidies Increasing the Benefit of the Economic Activity Like the case of negative , a potentially simpler alternative to quantity controls is to simply give credits ( or tax breaks ) for the activity so that the private marginal cost equals the social marginal cost

443 or the private marginal benefit equals the social marginal benefit . An example is a city credit that store owners can claim if they spend money improving their storefront , as in figure . Cost A Benefit ( Storefront Improvement Figure Achieving optimal storefront maintenance with a tax credit THE THEOREM Learning Objective Describe the theorem and explain how it works with . The common feature of all is that there are costs benefits to economic activity that are not accounted for in the price of the activity . Another way of saying the same thing is that markets for these external costs and benefits do not exist . For example , there is no market for the factory that to pay for the medical bills of neighbors . In 1960 , economist and lawyer Ronald considered what would happen if a market did exist for these costs and benefits . The way he saw the problem was that property rights to control the use of a good or not well defined in the case of an factory . That is , if neighbors do not have the right to clean air , there is no incentive for the factory to pay for or take into account the neighbors medical bills , shorter , and diminished quality of life due to the odor from the factory . The theorem states that if property rights are well defined and negotiations among the actors are costless , the result will be a socially efficient level of the economic activity in question . It is one ofthe most important and influential theorems in economics .

444 PATRICK EMERSON Suppose that the neighbors combined medical and other costs , per unit of output , are 10 . Suppose also that the marginal private cost of output is constant at 100 per unit . The marginal social cost is then the 100 private cost plus the 10 external cost , or 110 per unit of output . Defining clean air as a property right and allowing for free negotiation enables the neighbors to at 10 their willingness to pay for clean air or , conversely , their willingness to accept the dirty air . So for each unit of output , neighbors will demand to be compensated exactly the amount of their true loss 10 . Since they have the right to clean air , the factory owners are obliged to pay them , and thus the cost to the factory owners is exactly equal to the social cost , or . We know now that this will result in a socially efficient outcome . Students often are surprised to learn that it does not matter who has the property rights , only that they are well defined . Suppose that the factory owners instead had the right to pollute the air as much as they like . Neighbors would be willing to pay the factory owners 10 a unit to reduce emissions from the current level . In this scenario , the opportunity cost of producing each extra unit has suddenly increased by 10 . So again , the is now 110 , not 100 the and the socially efficient level of output will result . The transfer of wealth is quite different here , so assigning property rights has big implications in terms of the relative welfare of the groups . But in terms of the socially efficient level assignment of property rights has no impact . You may think that implementing the theorem is an ideal policy solution for , but a few words of caution are in order . The assumption of costless negotiation is quite improbable in tice . In order for it to be true in the example of the polluting factory , the neighbors all have to be able to identify themselves and band together , correctly assess the values of the damage done to them per unit of output and be able to demand the money from the factory owners . Costless negotiation is unlikely to be the case in any similar situation . An interesting application of the theorem has happened in sparsely populated areas of eastern Oregon , where residents have been paid by a company to put up with the noise turbines ( residents must sign a waiver promising not to complain about the noise ) Oregon law gives the right to peace and quiet to the residents , so for the turbines to exist , the residents must agree to live with the noise . In this case , because the area is sparsely populated and it is pretty easy to determine who is affected ( just use a decibel meter ) negotiation is relatively easy . POLICY EXAMPLE SHOULD NEW YORK BAN SODA TO ADDRESS THE OBESITY EPIDEMIC ?

Learning Objective Apply externality concepts to the policy question of banning sugary drinks . Let return now to the proposed soda ban in New York City , applying the economic tools , concepts , and models from this chapter . Step Understand the External Cost of the Consumption of Sugary Drinks We need to examine the link between sugary beverages and personal health and . We can then try to relate these personal issues to social costs . A number of studies have demonstrated a connection between consuming soft drinks and negative health consequences . The following points are from the Harvard School of Public Health Sugary drink portion sizes have risen dramatically over the past forty years , and children and adults are ing more soft drinks than ever .

445 On any given day , half the people in the United States consume sugary drinks one in four get at least 200 calories from such drinks , and percent get at least 567 to four cans of soda . Sugary drinks ( soda , energy drinks , sports drinks ) are the top calorie source in teens diets ( 226 calories per day ) beating out pizza ( 213 calories per day ) Sugary drinks increase the risk of obesity , diabetes , heart disease , and gout . A study on men and women found that people who increased their sugary drink consumption by one 12 oz . serving per day gained more weight over average , an extra pound every four people who did not change their intake . Other studies have found a significant link between sugary drink consumption and weight gain in children . One study found that for each 12 oz . soda children consumed each day , the odds of becoming obese increased by 60 percent during one and a . People who consume sugary drinks to two cans a day or a 26 percent greater risk of developing type diabetes than people who rarely have such drinks . Risks are even greater in young adults and Asians . A study that followed forty thousand men for two decades found that those who averaged one can of a sugary beverage per day had a 20 percent higher risk of having a heart attack or dying from a heart attack than men who rarely consumed sugary drinks . A related study in women found a similar sugary disease link . A study of eighty thousand women found that those who consumed a can a day of sugary drink had a 75 percent higher risk of gout than women who rarely had such drinks . Researchers found a similarly elevated risk in men . And from Mic Currently , 58 percent of New York City adults and 40 percent of New York City public school children are weight or obese . Other studies have attempted to quantify the social cost of negative health consequences associated with obesity . The following information is from Reuters Obese men rack up an additional a year in medical spending , especially for hospitalizations and scription drugs , john and Chad of University reported in January in of Health Economics . Obese women account for an extra a year . Using data from men ( average 28 ) and women ( average 27 ) ages twenty to , among whom 28 percent were obese , the researchers found even higher costs among the uninsured annual medical spending for an obese person was compared with 51 for the . Nationally , that comes to 190 billion a year in additional medical spending as a result of obesity , lated , or percent of US health care expenditures . Those extra medical costs are partly borne by the , in the form of higher taxes to support Medicaid and higher health insurance premiums . Obese women raise such expenditures to a year each , and obese men , 967 a year , and found . In addition , there have been studies about the extra cost of heavier drivers on the roads in terms of road wear and tear and extra fuel use . There is also this an obese man is 64 percent less likely to be arrested for a crime than a healthy man . For the sake of our exercise , let accept the link between sugary drinks and social costs .

446 PATRICK EMERSON Step Categorize the Externality In this case , we have a classic negative consumption is an external cost to an consumption of the good , and therefore the social marginal benefit is lower than the private benefit . Step Show the Social inefficiency in Terms of Deadweight Loss Because this consumption activity , drinking sugary drinks , is associated with external costs , the socially optimal level of consumption is lower than the market outcome . This results in deadweight loss . We can see the deadweight loss in figure . Step Consider Whether the Solution Will Have the Desired Effect How do we incorporate the large soda ban into the model ?

What this ban does is increase the cost per ounce for producers . How ?

Well , it is cheaper to sell in bulk ( see chapter ) so if producers are forced to sell in smaller packages , the cost per ounce will increase . This effect will raise the private marginal cost ( supply ) curve . if you raise it enough , you can reduce soda consumption to the socially optimal level . But in the real world , we do always have a good idea of where to stop the private marginal cost . is this added cost proportional to the external cost ?

is it greater or less than the external cost ?

From this exercise , we can conclude that the policy has the potential to achieve its aims , but there is a question about the magnitude of the effect of the policy relative to the magnitude of the cost of the problem . Step Consider Possible Policy Alternatives What about an outright ban on sugary drinks ?

This clearly would go too far in the sense that it is well below the socially efficient level of drink consumption . A tax on sugary drinks seems like a much simpler policy . in fact , this is a common and popular policy solution to other goods that produce negative , like cigarettes and alcohol . But again , the challenge is to get the amount of the tax right so that the socially efficient level is reached . EXPLORING THE POLICY QUESTION . Do you think the ban on the sale of sugary drinks in large quantities is a good idea from a policy perspective ?

Why or why not ?

Do you think such a ban would have the desired effect ?

Reading the articles above , how much discretion do you think local authorities should have to address ?

Do you think the true nature of this problem is an external cost that consumers do take into account when making consumption choices , or is it more a question of ignorance about the potential negative health consequences ?

If the latter , can you think of alternate policy solutions ?

447 REVIEW AND RELATED LEARNING OUTCOMES Social Costs and Benefits Learning Objective Define social costs and benefits . Defining Learning Objective Describe the economic effects of the four categories of . How Lead to Socially Inefficient Outcomes Learning Objective Explain how lead to market failures . Methods of Addressing Market Failures Learning Objective Describe methods of addressing positive and negative and explain how they work . The Theorem Learning Objective Describe the theorem and explain how it works with . Policy Example Should New York Ban Soda to Address the Obesity Epidemic ?

Learning Objective Apply externality concepts to the policy question of banning sugary drinks . LEARN KEY TOPICS Terms Social cost Social costs are costs of production or consumption that accrue to everyone in society , including those who are not directly involved in the eco nomic activity . The social cost of production includes both the private cost of production and this external cost , the cost that to society and not to the plant owners . Only the plant owners pay the private cost of production , but society as a whole pays the entire social cost . Social Social are of production or consumption that accrue to everyone in society , including those who are not directly involved in the economic activity . An example of social in production is the classic story of the beekeeper that lives next to the apple orchard . The beekeeper produces honey and gets a private from the honey the total revenue of the sale of the honey . But in keeping bees next to the orchard , the beekeeper is also helping increase the apple orchard harvest of apples through the pollination that the bees facilitate . The extra the owner of the orchard sees from the impact of the neighboring bees does not accrue to the beekeeper and is thus external . The social of an economic activity includes the private and the external .

448 PATRICK EMERSON are the costs or associated with an economic activity that affects people not directly involved in that activity . In other words , exist when there are external costs or associated with an economic activity . can be present in both sumption activities and production activities . Property rights Property rights are the rights to control the use of a good or resource . theorem The theorem states that if property rights are well and negotiations among the actors are costless , the result will be a socially level of the economic activity in question . Graphs Negative consumption Cost A Benefit External marginal cost Dead Weight Loss ( Quantity of Loud Music Figure Negative consumption