Category: Ch5: Externalities, Environmental Policy, and Public Goods

Solved Problem: Do Firms Always Raise Their Prices When Their Costs Go Up?

Supports: Microeconomics and Economics, Chapter 12,  and Essentials of Economics, Chapter 9.

The entrance to the Lincoln Tunnel, which connects New Jersey to Midtown Manhattan. (Photo from the Associated Press via the New York Times.)

This spring, New York City will begin charging an additional fee—referred to as a congestion price or congestion toll—on vehicles entering the borough of Manhattan below 60th Street. The purpose of the fee is to reduce the congestion and pollution that additional vehicles cause when driving in that part of the city. (Note that the fee can be thought of as Pigovian tax because it is intended to address a negative externality caused by driving a vehicle. We discuss Pigovian taxes in Microeconomics and Economics, Chapter 5, Section 5.3, and in Essentials of Economics, Chapter 4, Section 4.5.)

Trans-Bridge Lines operates buses between the Lehigh Valley in Pennsylvania and Manhattan. The firm will have to pay a fee of $24 each time one of its buses enters Manhattan. An article in the (Allentown, PA) Morning Call quotes the president of Trans-Bridge Lines as objecting to the fee: “It doesn’t make sense and punishes bus operators who are part of the solution to the congestion problem.” However, the article also notes that “Trans-Bridge is not considering fare increases at this time.”

If Trans-Bridge’s cost of providing bus service between the Lehigh Valley and Manhattan increases by $24 per bus, shouldn’t the firm raise the price it charges passengers? Does the failure of Trans-Bride to raise ticket prices following the enactment of the fee mean that the firm isn’t its maximizing profit? Briefly explain. 

Solving the Problem

Step 1:  Review the chapter material.This problem is about what costs firms take into account when determining the profit-maximizing price to charge in the short run, so you may want to review Microeconomics or Economics, Chapter 12, Section 12.2, “How a Firm Maximizes Profit in a Perfectly Competitive Market” (Essentials of Economics, Chapter 9, Section 9.2)

Step 2: Answer the two questions by explaining what type of cost the $24 fee is and whether the fee should affect the profit-maximizine price Trans-Bridge Lines should charge passengers for a ticket on a bus going to Manhattan. The fee is a flat $24 per bus and, so, it doesn’t change with the number of passengers on a bus. Therefore, the fee is a fixed cost to Trans-Bridge. Trans-Bridge should set the price of a ticket so that the last ticket sold on a bus increases the firm’s marginal cost and marginal revenue by the same amount. Because the $24 fee doesn’t change the marginal cost (or the marginal revenue) to the firm of transporting another passenger, the fee doesn’t change the firm’s profit-maximizing price. The answer to the first question in the problem is that an increase (or decrease) in a firm’s fixed cost won’t cause the firm to change its profit-maximizing price in the short run. The answer to the second question follows from the answer to the first question: That Trans-Bridge isn’t raising the price of a ticket following the enactment of the doesn’t mean that the firm isn’t maximizing profit.

Extra credit: Note that in the answer we refer to Trans-Bridge’s decision in the short run. It’s possible that the $24 fee will cause Trans-Bridge to suffer an economic loss on at least some of the bus trips it offers during different times during the day. As we discuss in Microeconomics and Economics, Chapter 12, Section 12.4 (Essentials of Economics, Chapter 9, Section 9.4), in that case, Trans-Bridge will continue to offer those bus trips in the short run, but, if nothing else changes, it will stop offering the trips in the long run.

9/16/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the current status of a soft-landing, and the green economy.

Join authors Glenn Hubbard & Tony O’Brien as they discuss the economic landscape of inflation, soft-landings, and the green economy. This conversation occurred on Saturday, 9/16/23, prior to the FOMC meeting on September 19th-20th.

A Reporter for NPR Encounters the Challenge of Network Externalities on an EV Road Trip

An electric vehicle (EV) charging station. (Photo from the Associated Press via the Wall Street Journal.)

Secretary of Energy Jennifer Granholm recently took a road trip in a caravan of electric vehicles (EVs). The road trip “was intended to draw attention to the billions of dollars the White House is pouring into green energy and clean cars.” A reporter for National Public Radio (NPR) went on the trip and wrote an article on her experience.

One conclusion the reporter drew was: “Riding along with Granholm, I came away with a major takeaway: EVs that aren’t Teslas have a road trip problem, and the White House knows it’s urgent to solve this issue.” The problem was that charging stations are less available and less likely to be functioning than would be needed for a road trip in an EV to be as smooth as a similar trip in a gasoline-powered car. The reporter noted that in her experience with her own EV: “I use multiple apps to find chargers, read reviews to make sure they work and plot out convenient locations for a 30-minute pit stop (a charger by a restaurant, for instance, instead of one located at a car dealership).”

EVs exhibit network externalities. As we discuss in Microeconomics and Economics, Chapter 10, 10.3 (Essentials of Economics, Chapter 7, Section 7.3), Network externalities are a situation in which the usefulness of a product increases with the number of consumers who use it. For example, the more iPhones people buy, the more profit firms and individuals can earn by creating apps for the iPhone. And the more apps that are available, the more useful an iPhone becomes to people who use it.

In this blog post, we discuss how Mark Zuckerberg’s Meta Platforms (which was originally named Facebook) has had difficulty selling Oculus augmented reality headsets. Many people have been reluctant to buy these headsets because they don’t believe there are enough software programs available to use the headsets with. Software designers don’t have much incentive to produce such programs because not many consumers own a headset necessary to use the programs.

The difficulty that Meta has experienced with augmented reality headsets can be overcome if the product is sufficiently useful that consumers are willing to buy it even if complementary products are not yet available. That was the case with the iPhone, which experienced strong sales even before Apple opened its app store. Or to take an historical example relevant to the current situation with EVs: When the Ford Motor Company introduced the Model T car in the early twentieth century, many people found that owning a car was such an advance over using a horse-drawn vehicle that they were willing to buy one despite there being realtively few gas stations and repair shops available. Because so many cars were being sold, entrepreneurs had an incentive to begin opening gas stations and repair shops, which increased the attractiveness of using a car, thereby further increasing demand.

As the NPR reporter’s experience shows, consumers choosing between buying an EV or a gasoline-powered car are in a situation similar to that faced by early twentieth century consumers in choosing between cars and horse-drawn vehicles. One difference between the two situations is that Congress and the Biden administration are attempting to ease the transition to EVs by subsidizing the construction of charging stations and by providing tax credits to people who buy EVs.

4/29/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss a hard vs. soft landing, the debt ceiling, and an economics view of the CHIPS act passed in 2022.

Join authors Glenn Hubbard & Tony O’Brien as they discuss the state of the landing the economy will achieve – hard vs. soft – or “no landing”. Also, they address the debt ceiling and the barriers it might present to a recovery. We also delve into the Chips Act and what economics has to say about the subsidy of a particular industry. Gain insights into today’s economy through our final podcast of the 2022-2023 academic year! Our discussion covers these points but you can also check for updates on our blog post that can be found HERE .

U.S. Carbon Dioxide Emissions in a Global Context

Photo from the New York Times.

As we discuss in Microeconomics and Economics, Chapter 5, Section 5.3, carbon dioxide (CO2) emissions contribute to climate change, including the increases in temperatures that have been experienced worldwide. We’ve found that students are interested in seeing U.S. CO2 emissions in a global context.  

The first of the following figures shows for the years 1960 to 2020, the total amount of CO2 emissions by the United States, China, India, the 28 countries in the European Union, lower-middle-income countries (including India, Nigeria, and Vietnam), and upper-middle-income countries (including China, Brazil, and Argentina). The second of the figures shows the percentage of total world CO2 accounted for by each of the three individual countries and by the indicated groups of countries. in the United States and in the countries of the European Union both total emissions and the percentage of total world emissions have been declining over the past 15 years. Emissions have been increasing in China, India, and in middle-income countries. The figures are from the Our World in Data website (ourworldindata.org). (Note that the reductions in emissions during 2020 largely reflect the effects of the slowdown in economic activity as a result of the Covid-19 pandemic rather than long-term trends in emissions.)

Governments in many countries have attempted to slow the pace of climate change by enacting policies to reduce CO2emissions. (According to estimates by the U.S. Environmental Protection Agency, CO2 accounts for about 76 percent of all emissions worldwide of greenhouse gases that contribute to climate change. Methane and nitrous oxide, mainly from agricultural activity, make up most of the rest of greenhouse gas emissions.) In August 2022, Congress and President Biden enacted additional measures aimed at slowing climate change. Included among these measures were government subsidies to firms and households to use renewable energy such as rooftop solar panels, tax rebates for some buyers of certain electric vehicles, and funds for utilities to develop power sources such as wind and solar that don’t emit CO2. The measures have been estimated to reduce U.S. greenhouse gas emissions by somewhere between 6 percent and 15 percent. Because the United States is responsible for only about 14 percent of annual global greenhouse gas emissions, the measures would likely reduce global emissions by only about 2 percent.

The figures shown above make this result unsurprising. Because the United States is the source of only a relatively small percentage of global greenhouse emissions, reductions in U.S. emissions can result in only small reductions in global emissions. Although many policymakers and economists believe that the marginal benefit from these reductions in U.S. emissions exceed their marginal cost, the reductions can’t by themselves do more than slow the rate of climate change. A key reason that India, China, and other middle income countries have accounted for increasing quantities of greenhouse gases is that they rely much more heavily on burning coal than do the United States, the countries in the European Union, and other high-income countries. Utilities switching to generating electricity by burning coal rather than by burning natural gas has been a key source of reductions in greenhouse gas emissions in the United States.

The two figures above measure a country’s contribution to CO2 emissions by looking at the quantity of emissions generated by production within the country. But suppose instead that we look at the quantity of CO2 emitted during the production of the goods consumed within the country? In that case, we would allocate to the United States CO2 emitted during the product of a good, such as a television or a shirt, that was produced in China or another foreign country but consumed in the United States.

For the United States, as the following figure shows it makes only a small difference whether we measure CO2emissions on the basis of production of goods and services or on the basis of consumption of goods and services.  U.S. emissions of CO2 are about 7 percent higher when measured on a consumption basis rather than on a production basis. By both measures, U.S. emissions of CO2 have been generally declining since about 2007. (1990 is the first year that these two measures are available.)

Sources: Hannah Ritchie, Max Roser and Pablo Rosado, “CO₂ and Greenhouse Gas Emissions,” OurWorldInData.org, https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions; Greg Ip, “Inflation Reduction Act’s Real Climate Impact Is a Decade Away,” Wall Street Journal, August 24, 2022; Lisa Friedman, “Democrats Designed the Climate Law to Be a Game Changer. Here’s How,” New York Times, August 22, 2022; Hannah Ritchie, “How Do CO2 Emissions Compare When We Adjust for Trade?” ourworldindata.org, October 7, 2019; and United States Environmental Protection Agency, “Global Greenhouse Gas Emissions Data,” epa.gov, February 22, 2022.

Is Subsidizing Electric Cars an Effective Way to Slow Climate Change?

Some governments have been subsidizing purchases of electric vehicles, or more broadly, fuel-efficient vehicles to slow climate change. How well do such policies work? Are they more or less efficient than other policies intended to reduce carbon dioxide emissions? 

A subsidy is a payment by the government that provides an incentive for people to take an action they otherwise wouldn’t, such as buying an electric car. Subsidies have the potential downside that they may involve payments to people to do something they would have done anyway.  For instance, in the United States in 2021, buyers of electric cars were eligible for a credit of up to $7,500 against their federal income taxes. Suppose that you become aware of this subsidy only after you have already purchased an electric car. In that case, the federal government has wasted $7,500 because you would have bought the electric car even without the subsidy. The same would be true if you knew about the subsidy before you bought but because of the subsidy you bought a higher-priced electric car rather than a lower-priced one.

These complications make it difficult for policymakers to assess the efficiency of subsidizing fuel-efficient cars as a means of slowing climate change. Two recent academic papers address this difficulty.  

Chia-Wen Chen of Academia Sinica in Taiwan, We-Min Hu of National Chengchi University in Taiwan, and Christopher Knittel of the Massachusetts Institute of Technology have analyzed a Chinese government program that subsidizes the purchase of fuel-efficient cars. Because the study used data from 2010 and 2011, these vehicles were fuel-efficient gasoline powered cars rather than electric cars.  They find that only about 44 percent of the subsidies went to car buyers who would otherwise not have bought a fuel-efficient car. “Thus, about 56 percent of the program’s payments were ineffective ….” 

The authors calculate that the subsidy cost about $89 per metric ton of carbon dioxide reduced, which is high relative to other policies, such as a carbon tax. With a carbon tax, the government taxes energy consumption on the basis of the carbon content of the energy. (We discuss a carbon tax in the opener to Chapter 5.) The authors conclude: “Paying more than $89 for a metric ton of carbon dioxide is not a cost effective way to reduce carbon dioxide; if the main policy objective of China’s subsidy program on fuel-efficient vehicles was to reduce carbon dioxide emissions, then our results suggest that it was an ineffective way to achieve this goal.”

Jianwei Xing of Peking University, Benjamin Leard of Resources for the Future, and Shanjun Li of Cornell University analyze the efficiency of the U.S. federal income tax credit for purchasing an electric vehicle. As with the study just discussed, they find that consumers who use the credit to buy an electric vehicle were likely to have otherwise bought a hybrid vehicle (a vehicle that combines an electric motor with a gasoline engine) or a relatively fuel-efficient gasoline powered car. They also find, as with the other study, that the federal subsidy is inefficient because while it increased electric vehicle sales by 29 percent, “70 percent of the [tax] credits were obtained by households that would have bought an EV without the credits.”

Because the design of a particular subsidy for buying an electric car will affect the subsidy’s efficiency, these studies are not conclusive evidence that all programs of subsidizing electric cars will be inefficient. But their results show that two existing programs in large markets—China and the United States—are, in fact, inefficient.  

As we note in Chapter 5, many economists favor a carbon tax as a way to reduce carbon emissions rather than policies, such as the federal electric vehicle tax credit, that target a particular source of carbon emissions. Economists can contribute to debates over public policy by using economic principles to identify programs that are more or less likely to efficiently achieve policy goals. They can also, as the authors of these two papers do, use statistical methods to analyze the effects of particular policies. 

Sources: Chia-Wen Chen, We-Min Hu, and Christopher R. Knittel, “Subsidizing Fuel-Efficient Cars: Evidence from China’s Automobile Industry,” American Economic Journal: Economic Policy, Vo. 13, No. 4, November 2021, pp. 152-184; Jianwei Xing, Benjamin Leard, and Shanjun Li, “What Does an Electric Vehicle Replace,” National Bureau of Economic Research, Working Paper 25771, February 2021.

10/24/20 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the economics of issues raised during the Final 2020 Presidential Debate.

Authors Glenn Hubbard and Tony O’Brien discuss the economic impacts of what was discussed in the final Presidental debate on 10/22/20. They discuss wide-ranging topics that were raised in the debate from reopening the economy & schools, decreasing participation of women in the workforce due to COVID, healthcare, environment, and general tax policy. Listen to gain economic context on these important items. Click HERE for the New York Times article discussed during the Podcast:

Just search Hubbard O’Brien Economics on Apple iTunes and subscribe!

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COVID-19 Update: Externalities During a Pandemic

Supports:  Hubbard/O’Brien, Chapter 5, Externalities, Environmental Policy, and Public Goods; Essentials of Economics Chapter 4, Market Efficiency & Market Failure

Apply the Concept: Should the Government Use Command-and-Control Policies to Deal with Epidemics?

Here’s the key point:   To deal with the negative externalities from an epidemic, a command-and-control policy may be more effective than a market-based policy.

The Externalities of Spring Break during the Coronavirus Epidemic

            When we think of negative externalities, we are typically thinking of externalities in production.   For example, a utility company that produces energy by burning coal causes a negative externality by emitting air pollution that imposes costs on people who may not be customers of that utility company.   During the coronavirus epidemic, some public health experts identified a significant negative externality in consumption.

            The coronavirus epidemic became widespread in the United States during March 2020—when many colleges were on spring break.  By mid-March several states including California, Washington state, and New York closed non-essential businesses such as hotels and restaurants, as well as parks and beaches. But many hotels, restaurants, and beaches in spring break destinations such as Florida remained open and   were packed with college students.  Many students realized that because of the crowds, they might catch the virus.

Why take the risk? There are two possible explanations.   First, many students likely agreed with an American University senior who was quoted in the Wall Street Journal as saying, “It’s a risk to be down here with crowds … [but] it’s my last spring break. I want to live it up as best I can.”  Second, some spring breakers were relying on early reports that people in their 20s who caught the virus would experience only mild symptoms or none at all.  But even young people with mild symptoms could spread the virus to others, including people older than 60 for whom the disease might be fatal.

            So, in March 2020 there was an externality in consumption from college students taking spring break beach vacations because people in large crowds spread the virus. In other words, the students’ marginal private benefit from being on the beach was greater than the marginal social benefit, taking into account that being on the beach might spread the virus.

            The following figure shows the market for spring break beach vacations. The price of a vacation includes transportation costs, renting a hotel room, meals, and any fees to use the beach.  Demand curve D1 is the market demand curve and represents the marginal private benefit to students from vacationing on a crowded beach during spring break.  But spring breakers don’t bear all the cost of potentially contracting the coronavirus by being on a crowded beach because the cost of their spreading the virus is borne by others. So, there is negative externality from vacationing on the beach equal to the vertical distance between D1, which represents the marginal private benefit, and D2, which represents the marginal social benefit, including the chance of spreading the virus by contracting it on a crowded beach.

Because of the externality, the actual number of people taking spring break beach vacations in March 2020, QMarket, was greater than the efficient number, QEfficient.  In Section 5.3 of the Hubbard and O’Brien textbook, we show that when there is an externality in production, a tax equal to the per unit cost of the externality will result in the efficient level of output because the tax causes firms to internalize the externality.  In a similar way, a tax on spring break beach vacations equal to the per unit cost of the externality would shift the marginal private benefit curve, D1, down to where it became the same as the marginal social benefit curve, D2.  By leading spring breakers to internalize the cost of the externality, the tax would cause the market quantity of beach vacations to decline to the efficient quantity, QEfficient.

In practice, however, imposing a tax on people taking a beach vacation would be difficult for two key reasons: (1) In March 2020, there were many aspects of the coronavirus, including how it spread and its fatality rate, that made calculating the value of the negative externality difficult, and  (2) collecting a tax on the many spring breakers crowded on beaches would have been administratively difficult. In the face of these factors, governors and mayors used the command-and-control approach in March of closing beaches, hotels, and restaurants rather than the market-based approach of levying a tax.

Sources: Arian Campo-Flores and Craig Karmin, “The Last Place to be Hit With Coronavirus Worries? Florida Beaches,” Wall Street Journal, March 21, 2020; Aimee Ortiz, “Man Who Said, ‘If I Get Corona, I Get Corona,’ Apologizes,” New York Times, March 24, 2020; and Ryan W. Miller, “’If I Get Corona, I Get Corona’: Coronavirus Pandemic Doesn’t Slow Spring Breakers’ Party,” usatoday.com, March 21, 2020.

Question 

According to news reports, some college students on spring break in March 2020 were unaware that partying on the beach put them at risk of contracting the coronavirus. Many also assumed that no one younger than 30 was at risk of becoming seriously ill from the virus, although, in fact, the virus did kill people in their 20s. Suppose that every student on spring break were completely informed about the risks of partying on the beach.  Using the figure above, briefly explain how each of the following would have been affected. Draw a graph to illustrate your answer.

a. the demand curve, D1

b. the demand curve, D2

c. QMarket

d. QEfficient

e. PMarket

f. PEfficient

g. Size of the deadweight loss

Instructors can access the answers to these questions by emailing Pearson at christopher.dejohn@pearson.com and stating your name, affiliation, school email address, course number.