Chapter 6. Reasons for Firm Incentives 49 the cost will be borne by the employers. Nothing is free in business, especially education. No matter what the form, someone will pay the piper. Concluding Comments Our message in this chapter and repeated elsewhere in this textbook, repeated and reinforced with analysis and anecdotes is simple: Incentives are important. They are worthy of serious reflection. But that doesn’t mean to suggest that incentives are all that matter. Surely, many things matter. As noted earlier, leadership, product design, and customer service, as well as company adaptability, culture, and goals, also matter. However, we suspect that all of those good things in business might not matter very much or for long if the incentives are not right. In their effort to get incentives right, it is altogether understandable why some firms will cover the cost of the MBA degree program for some of their workers (and not others). In general, firms can be expected to cover the cost of an MBA when they, the firms, can expect to capture the benefits. On the other hand, the workers themselves can be expected to pay for their own degree expenses when they, the workers, expect to capture the benefits. We hope our discussion of the importance of incentives in understanding the organization and performance of firms serves as an incentive to spend more time thinking and reading about incentives, a subject to which we will return later in the book and course. Review Questions 1. Why are some firms “large” and other firms “small”? Use the concepts of “coordinating costs” in your answer 2. Suppose firms get smaller. Why might that happen? 3. If worker-monitoring costs go down, what will happen to the size of the firm? 4. What have been the various effects of the computer/telecommunication revolution on the sizes of firms? 5. Why would a firm hire its own accountants to keep the books but, at the same time, use outside lawyers to do its legal work? 6. If your firm fears being “held up” by an outside supplier of a critical part to your production process, what can your firm do to reduce the chance of a hold up? CHAPTER 7 Market Failures: External Costs and Benefits In its broadest definitional sense, collective action is the enactment and enforcement of law. The justification for all collective action, for government, lies in its ability to make men better off. This is where any discussion of the bases for collective action must begin. James Buchanan ow much should government involve itself in the marketplace? How much does business want government involvement.” These questions touch on one of the most important economic issues of our time: the division of responsibility between the public and private sectors. In general, economic principles would suggest that government undertake only functions that it can perform more efficiently than the market. As we will see, businesses are not always opposed to government involvement in the economy. Indeed, many businesses have incentives to try to make sure that government is more involved in the economy than is “efficient.” Economics provides a method for evaluating the relative efficiency of government and the marketplace. It enables the United States to identify which goods and services the market will fail to produce altogether, and which it will produce inefficiently. We saw in an earlier chapter that such market failures have three sources: monopoly power, external costs, and external benefits. Now, using the principles and graphic analyses developed in earlier chapters, we will take a closer look at external costs and benefits and at government attempts to capture them and correct market failures. (See later chapters on monopoly and monopsony power.) External Costs and Benefits, Again In a competitive market, producers must minimize their production costs in order to lower their prices, increase their production levels, and improve the quality of their products. Consumers must demonstrate how much they will pay for a product, and in what amount they will buy it. In a competitive market, production will move toward the intersection of the market supply and demand curves -- Q 1 in Figure 7.1. At that point the marginal cost of the last unit produced will equal its marginal benefit to consumers. To the extent that the market moves toward equilibrium in supply and demand, it is efficient in a very special sense. As long as the marginal benefit of anything people do is greater than the marginal cost, people are presumed to be better off if quantity increases. In Figure 7.1, for each loaf of bread up to Q 1 , the marginal benefit of consumption (as H Chapter 7 Market Failures: External Costs And Benefits 2 shown by the demand curve) exceeds the marginal cost of production (as shown by the supply curve). Because the marginal cost of a loaf of bread is the value of the most attractive alternative forgone, people must be getting more value out of each of those loaves than they could from any alternative good. By producing exactly Q 1 loaves—no more and no less—the market extracts the possible surplus or excess benefits from production (see shaded area on the graph) and divides them among buyers and sellers. In this sense, production and distribution of economic resources can be said to be efficient. __________________________________________ Figure 7.1 Marginal Benefit versus Marginal Cost The demand curve reflects the marginal benefits of each loaf of bread produced. The supply curve reflects the marginal cost of producing each loaf. For each loaf of bread up to Q 1 , the marginal benefits exceed the marginal cost. The shaded area shows the maximum welfare that can be gained from the production of bread. When the market is at equilibrium (when supply equals demand), all those benefits will be realized. These results cannot be achieved unless competition is intense, buyers receive all the product’s benefits, and producers pay all the costs of production. If such optimum conditions are not achieved, the market fails. Part of the excess benefits shown by the shaded area in the figure will not be realized by either buyers or sellers. When exchanges between buyers and sellers affect people who are not directly involved in the trades, they are said to have external effects, or to generate externalities. Externalities are the positive or negative effects that exchanges may have on people who are not in the market. They are third-party effects. When such effects are pleasurable they are called external benefits. When they are unpleasant, or impose a cost on people other than the buyers or sellers, they are called external costs. The effects of external costs and benefits on production and market efficiency can be seen with the aid of supply and demand curves. External Costs Figure 7.2 represents the market for a paper product. The market demand curve, D, indicates the benefits consumers receive from the product. To make paper, the producers must pay the costs of labor, chemicals, and pulpwood. The industry supply curve, S 1 , shows the cost on which paper manufacturers must base their production decisions. In a Chapter 7 Market Failures: External Costs And Benefits 3 perfectly competitive market, the quantity of the paper product that is bought will be Q 2 , and the price paid by consumers will be P 1 . ____________________________________ FIGURE 7.2 External Costs Ignoring the external costs associated with the manufacture of paper products, firms will base their production and pricing decisions on supply curve S 1 . If they consider external costs, such as the cost of pollution, they would operate on the basis of supply curve S 2 , producing Q 1 instead of Q 2 units. The shaded area shows the amount by which the marginal cost of production of Q 2 -- Q 1 units exceeds the marginal benefits to consumers. It indicates the inefficiency of the private market when external costs are not borne by producers. ___________________________________________ Producers may not bear all the costs associated with production, however. A by- product of the production process may be solid or gaseous waste dumped into rivers or emitted into the atmosphere. The stench of production may pervade the surrounding community. Towns located downstream may have to clean up the water. People may have to paint their houses more frequently or seek medical attention for eye irritation. Homeowners may have to accept lower prices than usual for their property. All these costs are imposed on people not directly involved in the production, consumption, or exchange of the paper product. Nonetheless, these external costs are part of the total cost of production to society. In a perfectly competitive market, in which all participants act independently, survival may require that a producer impose external costs on others. An individual producer who voluntarily installs equipment to clean up pollution will incur costs higher than those of its competitors. It will not be able to match price cuts, and so in the long run may be out of business -- and some producers may not care whether they cause harm to others by polluting the environment. Even socially concerned producers cannot afford to care too much about the environment. The supply curve S 2 incorporates both the external production costs of pollution and the private costs borne by producers. If producers have to bear all those costs, the price of the product will be higher (P 2 rather than P 1 ), and consumers will buy a small quantity (Q 1 rather than Q 2 ). Thus the true marginal cost of each unit of paper between Q 1 and Q 2 is greater than the marginal benefit to consumers. If consumers have to pay for external costs, they will value other goods more highly than those units. In a sense, then, the paper manufacturers are overproducing, by Q 2 -- Q 1 units. The marginal cost of those units exceeds their marginal benefit by the shaded triangular area. Chapter 7 Market Failures: External Costs And Benefits 4 Other examples of external costs that encourage overproduction are the highway congestion created by automobiles and the noise created by airplanes in and around airports. The argument can also be extended to include less obvious costs, like the death and destruction caused by speeding and reckless driving. If government does not penalize such negligent behaviors, people will produce them, at a potentially high external costs to others. In the same way, adult bookstores, X-rated movie houses, and massage parlors impose costs on neighboring businesses. Their sordid appearance drives away many people who might otherwise patronize legitimate businesses in the area. External Benefits Sometimes market inefficiencies are created by external benefits. Market demand does not always reflect all the benefits received from a good. Instead, people not directly involved in the production, consumption, or exchange of the good receive some of its benefits. To see the effects of external benefits on the allocation of resources, consider the market for flu shots. The cost of producing vaccine includes labor, research and production equipment, materials, and transportation. Assuming that all those costs are borne by the producers, the market supply curve will be S in Figure 7.3. __________________________________________ Figure 7.3 External Benefits Ignoring the external benefits of getting flu shots, consumers will base their purchases on demand curve D 1 instead of D2. Fewer shots will be purchased than could be justified economically -- Q 1 instead of Q 2 . Because the marginal benefit of each shot between Q 1 and Q 2 (as shown by demand curve D 2 ) exceeds it marginal cost of production, external benefits are not being realized. The shaded area abc indicates market inefficiency. ___________________________________ Individuals receive important personal benefits from flu shots. The fact that many millions of people pay for them every year shows that there is a demand, illustrated by curve D 1 in Figure 7.3. In getting shots for themselves, however, people also provide external benefits for others. By protecting themselves, they reduce the probability that the flu will spread to others. When others escape the medical expenses and lost work Chapter 7 Market Failures: External Costs And Benefits 5 time associated with flu, those benefits are not captured in the market demand curve, D 1 . Only in the higher societal demand curve, labeled D 2 , are those benefits realized. Left to itself, a perfectly competitive market will produce at the intersection of the market supply and market demand curves (S and D 1 ), or at point c. At that point the equilibrium price will be P 1 and the quantity produced will be Q 1 . If external benefits are considered in the production decision, however, the marginal benefit of flu shots between Q 1 and Q 2 (shown by the demand curve D 2 ) will exceed their marginal cost of production (shown by the supply curve). In other words, if all benefits, both private and external, were considered, Q 2 shots would be produced and purchased at a price of P 2 . At Q 2 , the marginal cost of the last shot would equal its marginal benefit. Social welfare would rise by an amount equal to the triangular shaded area abc. Because a free market can fail to capture such external benefits, government action to subsidize flu shots may be justified. On such grounds governments all over the world have mounted programs to inoculate people against diseases like smallpox. The external benefits argument has also been used to justify government support of medical research. It can also be extended to services such as public transportation. City buses provide direct benefits to the general population. An informed and articulate citizenry raises both the level of public discourse and the general standard of living. 1 Public parks and environmental programs can also provide external benefits that are not likely to be realized privately, because of their high cost to individuals. Again, government action may be required to supplement private efforts. The Pros and Cons of Government Action More often than not, exchanges between buyers and sellers affect others. People buy clothes partly to keep warm in the winter and dry in the rain, but most people value the appearance of clothing at least as much as its comfort. We choose clothing because we want others to be pleased or impressed (or perhaps irritated). The same can be said about the cars we purchase, the places we go to eat, the records we buy, even the colleges we attend. We impose the external effects of our actions deliberately as well as accidentally. The presence of externalities in economic transactions does not necessarily mean that government should intervene. First, the economic distortions created by externalities are often quite small, if not inconsequential. So far our examples of external costs and benefits involved possibly significant distortions of market forces. In Figure 7.4, however, the supply curve S 2 , which incorporates both private and external costs, lies only slightly to the left of the market supply curve, S 1 . The difference between the market output level, Q 2 , and the optimum output level, Q 1 , is small, as is the market inefficiency, shown by the shaded triangular area. Therefore little can be gained by government intervention. 1 The ratio of public to private benefits varies by educational levels. Elementary school education develops crucial social and communication skills; its private benefits are virtually side effects. At the college level, however, the private benefits to students may dominate the public benefits. Thus elementary education is supported almost entirely by public sources, while college education is only partially subsidized. Chapter 7 Market Failures: External Costs And Benefits 6 This limited benefit must be weighed against the cost of government action. Whenever government intervenes in any situation, agencies are set up, employees are hired, papers are shuffled, and reports are filed. Almost invariably, suits are brought against firms and individuals who have violated government rules. In short, significant costs can be incurred in correcting small market inefficiencies. If the cost of government intervention exceeds the cost of the market’s inefficiencies, government action will actually increase inefficiency. A second reason for limiting government action is that it generates external costs of its own. If government dictates the construction methods to be used in building homes, the way mothers deliver their babies, or the hair lengths of government workers, the people who set the standards impose a cost—which may be external to them—on those who do not share their standards. We may agree with some government rules, but strenuously object to others. On balance, such government intervention is as likely to hurt us as help us. Figure 7.4 Is Government Action Justified? Because of external costs, the market illustrated produces more than the efficient output. Market inefficiency, represented by the shaded triangular area, is quite small—so small that government intervention may not be justified on economic grounds alone. Government dictates in educational institutions have sometimes imposed onerous costs on students. For instance, until the late 1960s, the University of Virginia had a dress code that required male students to wear coats and ties. Colleges routinely set the hours by which students should return to their dormitories and expelled those who rebelled. At the University of California, students were once forbidden to engage in on- campus political activity. Costs are imposed on those who must obey such rules. The more centralized the government that is setting the standards, the less opportunity people will have to escape the rules by moving elsewhere. In certain markets, government action may not be necessary. Over the long run, some of the external costs and benefits that cause market distortions may be internalized. That is, they may become private costs and benefits. Suppose the development of a park would generate external benefits for all businesses in a shopping district. More customers would be attracted to the district, and more sales would be made. An alert entrepreneur could internalize those benefits by building a shopping mall with a park in Chapter 7 Market Failures: External Costs And Benefits 7 the middle. Because the mall would attract more customers than other shopping areas, the owner could benefit from higher rents. When shopping centers can internalize such externalities, economic efficiency will be enhanced—without government intervention. When Walt Disney built Disneyland, he conferred benefits on merchants in the Anaheim area. Other businesses quickly moved in to take advantage of the external benefits –the crowds of visitors—spilling over from the amusement park. Disney did not make the same mistake twice. When he built Disney World in Orlando, he bought enough land so that most of the benefits of the amusement park would stay within the Disney domain. Inside the more than six thousand acres of Disney-owned land in Florida, development has been controlled and profits captured by the Disney Corporation. Although other businesses have established themselves on the perimeters of Disney World, their distance from its center makes it more difficult for them to capture external benefits from the amusement park. Methods of Reducing Externalities Government action can undoubtedly guarantee that certain goods and services will be produced more efficiently. The benefits of such action may be substantial, even when compared with the costs. In such cases, only the form of government intervention remains to be determined. Government action can take several forms; persuasion; assignment of communal property rights to individuals; government production of goods and services; regulation of production through published standards; and control of product prices through taxes, fines, and subsidies. Economists generally argue that if government is going to intervene, it should choose the least costly means sufficient for the task at hand. Persuasion External costs arise partly because we do not consider the welfare of others in our decisions. Indeed, if we fully recognized the adverse effects of our actions on others, external cost would not exist. Our production decisions would be based as much as possible on the total costs of production to society. Thus government can alleviate market distortions by persuading citizens to consider how their behavior affects others. Forest Service advertisements urge people not to litter or to risk forest fires when camping. Other government campaigns encourage people not to drive if they drink, to cultivate their land so as to minimize erosion, and to conserve water and gas. Although such efforts are limited in their effect, they may be more acceptable than other approaches, given political constraints. Persuasion can take the form of publicity. The government can publish studies demonstrating that particular products or activities have external costs or benefits. The resultant publicity may in turn encourage those activities with external benefits and discourage those activities with external costs. The government has, for example, used this method in the case of cigarettes, publishing studies showing the external costs of smoking. Chapter 7 Market Failures: External Costs And Benefits 8 Assignment of Property Rights As we saw in Chapter 1, when property rights are held communally or left unassigned, property tends to be overused. As long as no one else is already using the property, anyone can use it without paying for its use. Costs that are not borne by users, of course, are passed on to others as external costs. When public land was open to grazing in the West 150 years ago, for instance, ranchers allowed their herds to overgraze. The external cost of their indiscriminate use of the land has been borne by later generations, who have inherited a barren, wasted environment. Thus the assignment of property rights can eliminate some externalities. If land rights are assigned to individuals, they will bear the cost of their own neglect. If owners allow their cattle to strip a range of its grass, they will no longer be able to raise their cattle there—and the price of the land will decline with its productivity. Some resources, such as air and water, cannot always be divided into parcels. In those cases, the property rights solution will work poorly, if at all. Government Production Through nationalization of some industries, government can attempt to internalize external costs. The argument is that because government is concerned with social consequences, it will consider the total costs of production, both internal and external. On the basis of that argument, governments in the United States operate schools, public health services, national and state parks, transportation systems, harbors, and electric power plants. In other nations, government also operates major industries, such as the steel and automobile industries. Government production can be a mixed blessing. When other producers remain in the market, government participation may increase competition. Sometimes it means the elimination of competition. Consider the U.S. Postal Service, which has exclusive rights to the delivery of first-class mail. As a government agency, the Post Office is not permitted to make a profit that can be turnover to shareholders. Because of its market position with little competition for home delivery of mail, however, it may tolerate higher costs and lower work standards than competitive firms. Some government production, such as the provision of public goods like national defense, is unavoidable. In most cases, however, direct ownership and production may not be necessary. Instead of producing goods with which externalities are associated, government could simply contract with private firms for the business. That is precisely how most states handle road construction, how several states handle the penal system, and how a few city governments provide ambulance, police, and firefighting services. Taxes and Subsidies Government can deal with some external costs by taxing producers. Pollution can be discouraged by a tax on either the pollution itself or the final product. Taxing the Chapter 7 Market Failures: External Costs And Benefits 9 pollution emitted by firms internalizes external costs, increasing total costs to the producer. Imposing such taxes should have a twofold effect in reducing pollution. First, many producers would find the cost of pollution control cheaper than the pollution tax. Second, the tax would raise the prices of final products, reducing the number of units consumed -- and hence reducing the level of pollution. The size of the tax can be adjusted to achieve whatever level of pollution is judged acceptable. If a tax on $1 per unit produced does not reduce pollution sufficiently, the tax can be raised to $2. In terms of Figure 7.2, the ideal tax would be just enough to encourage producers to view their supply curve as S 2 instead of S 1 . The resulting cutback in production from Q 2 to Q 1 would eliminate market inefficiency, represented by the shaded area abc. Theoretically, the government could achieve the same result by subsidizing firms in their efforts to eliminate pollution. It could give tax credits for the installation of pollution controls or pay firms outright to install the equipment. In fact, until 1985, the federal government used tax credits to encourage the installation of fuel-saving devices, which indirectly reduced pollution. Production Standards Alternatively, the government could simply impose standards on all producers. It could rule, for example, that polluters may not emit more than a certain amount of pollutants during a given period. Offenders would either have to pay for a cleanup or risk a fine. A firm that flagrantly violated the standard might be forced to shut down. Choosing the Most Efficient Remedy for Externalities Selecting the most efficient method of minimizing externalities can be a complicated process. To illustrate, we will compare the costs of two approaches to controlling pollution, government standards versus property rights Suppose five firms are emitting sulfur dioxide, a pollutant that causes acid rain. The reduction of the unwanted emissions can be thought of as an economic good whose production involves a cost. We can assume that the marginal cost of reducing sulfur dioxide emissions will rise as more and more units are eliminated. We can also assume that such costs will differ from firm to firm. Table 7.1 incorporates these assumptions. Firm A, for example, must pay $100 to eliminate the first unit of sulfur dioxide and $200 to eliminate the second. Firm B must pay $200 for the first unit and $600 for the second. Although the information in the table is hypothetical, it reflects the structure of real-world pollution clean-up costs. The technological fact of increasing marginal costs faces firms when they clean up the air as well as when they produce goods and services. Suppose the Environmental Protection Agency (EPA) decides that the maximum acceptable level of sulfur dioxide is ten units. To achieve that level, the EPA prohibits firms from emitting more than two units of sulfur dioxide each. If each firm were emitting five units, each would have to reduce its emissions by three units. The total cost . sense, collective action is the enactment and enforcement of law. The justification for all collective action, for government, lies in its ability to make. things in business might not matter very much or for long if the incentives are not right. In their effort to get incentives right, it is altogether understandable