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AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 1
Externalities
AGEC689: Economic Issues and Policy
Implications of Homeland Security
AGEC689: Economic Issues and Policy AGEC689: Economic Issues and Policy
Implications of Homeland Security Implications of Homeland Security
Yanhong Jin
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 2
Externality defined
Externality defined
Externalities exist when the activities of one or
more agents affect the welfare of other agents and
the welfare of other agents was not considered in
decisions determining the level of activity .
Externalities are types of market failure.
Under an externality, market prices do not reflect true
marginal costs and/or benefits associated with the goods
or services created by the activity when they are traded in
the market. Externalities lead to suboptimal outcomes.
Types of externalities:
Positive externalities
Negative externalities
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 3
Externalities & Homeland Security
Externalities & Homeland Security
We cannot protect everything. Allocating more money on
protecting one target will cause less to be available for
protection of others and not all interests may be considered
(negative externality).
Closure or quarantine of certain areas will affect not only
animal operations but also local businesses, households and
linked parts of the economy (negative externality).
Certain policies that potentially thwart one type of terrorism
attacks may also eliminate attacks in other venues (positive
externality).
An economic sanction against one country resulting from a
group of terrorists may also affect the welfare of those who
are good citizens (negative externality).
Certain trade actions may influence domestic and
international welfare of parties not directly involved
(negative externality).
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AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 4
Externalities and Animal Disease Outbreaks
Externalities and Animal Disease Outbreaks
Production externality (negative externalities)
Water/air pollution from carcass disposal
Illegally moving animals from a quarantine zone.
An outbreak in one region may increase the production cost in another one
(spatial spill-over effects).
An outbreak may increase the production cost in the future in the same region
(contemporary spill-over effects)
Demand-side externality (negative/positive externalities)
Consumers preferences may change towards meat or meat imports in general
and, hence, farmers out of the disease outbreak area will be affected as well.
Externality of international trade relating to disease outbreak
Cattle farmers in California cannot export beef if there is an FMD outbreak in
Texas according to the current trade rules.
Japan closed the whole import market to the U.S. when an US BSE case occurs.
Austrailian and Japanese producers gained, non target US lost
Externality relating to preventive investment (positive externality)
A farmers investment in preventive actions will reduce the likelihood of disease
outbreak for him and his neighbors as well.
A farmer is passively protected by actions of neighbors.
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 5
Production Negative Externality and the Failure of
Competitive Markets
Production Negative Externality and the Failure of
Competitive Markets
MPC: marginal private cost
MEC: marginal externality cost
MSC: marginal social cost (vertical
sum of MPC and MEC)
MSB=MPB in this case (No
externality in the demand side.
Social optimum at B where
MSB=MSC
Social benefits=ABQ*O
Social costs=OBQ*
Social welfare=ABO
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 6
Production Negative Externality and the Failure of
Competitive Markets (cont)
Production Negative Externality and the Failure of
Competitive Markets (cont)
MPC: marginal private cost
MEC: marginal externality cost
MSC: marginal social cost
(vertical sum of MPC and MEC)
MSB=MPB in this case (No
externality in the demand side.
Free market outcome at C
where MPB=MPC
Social benefits=ACQ
c
O
Social
costs=CQ
c
O+OEC=OEQ
c
Social welfare=ABO-BEC
Deadweight loss=BEC
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AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 7
Policies Relating to Production Negative Externality
Policies Relating to Production Negative Externality
Tax, t*=P*-P
P
=MEC(Q*): A tax of
t* shifts the MPC upwards by t*.
Prices under tax:
consumer price=P*
Producer price=P
p
Welfare distribution
Consumer surplus=ABP*
Producer surplus=OFP
P
Government revenue=P*BFP
P
External cost=OBF
Social welfare=ABO
Output quota, Q=Q*=
Welfare distribution
Consumer surplus=ABP*
Producer surplus=OFBP
*
Government revenue=zero
External cost=OBF
Social welfare=ABO
What policy will producers prefer,
tax or output restriction?
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 8
Positive externalities Relating to the Preventive Investment
and Failure of Competitive Markets
Positive externalities Relating to the Preventive Investment
and Failure of Competitive Markets
MPC=Marginal private cost equals marginal social cost
MSC in this case, no production externality.
MPB=Marginal Private Benefit
MSB=Marginal Social Benefit=MPB+MEB
where MPB=marginal private benefit (reducing the
potential own loss), and MEB=marginal external benefit
(reducing the potential loss of the neighboring farmers.
Social optimum at S (Ps, Q*)
where MSB=MSC
Social benefits=ASQ*O
Social costs=OSQ*
Social welfare=ASO
Q Q
c
Ps
Pc
$
MSB
MPB
S
A
C
Q* O
MPC=MSC F
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 9
Positive externalities and Failure of Competitive Markets
Positive externalities and Failure of Competitive Markets
Free market outcome at C
(Pc, Q
c
) where MPB=MPC
Social benefits=ACQ
c
O+AFC
Social costs=CQ
c
O
Social welfare=AFCO
Deadweight loss=FSC
Q Q
c
Ps
Pc
$
MSB
MPB
S
A
C
Q* O
MPC=MSC F
P*
MPC=Marginal private cost equals marginal social cost
MSC in this case, no production externality.
MPB=Marginal Private Benefit
MSB=Marginal Social Benefit=MPB+MEB
where MPB=marginal private benefit (reducing the
potential own loss), and MEB=marginal external benefit
(reducing the potential loss of the neighboring farmers.
Individual farmers invest too little on preventive
actions compared with the socially optimal level.
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AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 10
Polices relating to Positive externalities of
Preventive Investment
Polices relating to Positive externalities of
Preventive Investment
Subsidy=Ps-P*=MEB(Q*)
Prices:
Consumer price=P*
Producer price=Ps
Welfare distribution
Consumers surplus=AGP*
Producers surplus=PsSO
Government
expenditure=PsSGP*
External benefit=ASG
Social welfare=ASO
MSB
Q Q
c
Ps
Pc
$
MPB
S
A
C
Q* O
MPC=MSC F
P*
G
H
Production quota Q=Q*, price=P*
Welfare distribution
Consumers surplus=AGP*
Producers surplus=P*HO-HGS
External benefit=ASG
Social welfare=ASO
What policy will
producers prefer, tax
or output restriction?
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 11
Numerical Example of Positive Externality
Numerical Example of Positive Externality
Problem Statement on private preventive investment
Private marginal benefit: MPB=20-2Q
Marginal private cost: MPC=4+Q
Marginal external benefit: MEB=2+Q
Under competitive markets without
regulation:
Equilibrium
Pm=9.33, Qm=5.33
Welfare
Consumers Surplus=28.44
Producers Surplus=14.22
External benefit=24.89
Social welfare=67.56
Under competitive markets with regulation
A subsidy of $11 will achieve the
social optimum
Equilibrium
Q*=9
Consumer price P*=2.0
Producer price=13
Welfare
CS=9*(20-2)/2=81
PS=9*((11+2)-(4+13)/2)=40.5
ES=9*(2+11)/2=58.5
Government expense=9*11=99
Social welfare=81+99-99=81
AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 12
Positive vs. negative externality
Positive vs. negative externality
Positive Externalities
Basic principle: beneficiary pays-- subsidy
Subsidy liked by industry.
Negative Externalities
Basic principle: polluter pays -- tax
Restricted, tradable quota liked by
industry
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AGEC689: Economic Issues and Policy Implications of Homeland Security Yanhong Jin at TAMU 13
What can we do with the externalities
associated with animal disease outbreaks?
What can we do with the externalities
associated with animal disease outbreaks?
Basic principle: Find a way to internalize either external benefits if
positive externalities exists or the external costs if negative
externalities exist.
Water/air pollution from carcass disposal: pollution tax,
standard, cap and tradable permit etc.
Illegally moving animals from a quarantine zone: substantial
penalty that greatly reduces the incentive to move animals
Consumers preferences affect farmers out of the affected zones:
governmental support like subsidy
Externality of international trade relating to disease outbreak:
trade regionalization (AI cases)
Externality relating to preventive investment: subsidy, linking
compensation package with preventive investment,