[SQUEAKING][RUSTLING][CLICKING]
JONATHAN GRUBER:
Today, we're going
to talk about externalities.
And we'll start with
some simple theory--
so the theory of externalities.
Now, as I've said before,
the fundamental mantra
of most this course is
that markets know best.
Indeed, as I said, the
first fundamental theorem
of welfare economics--
that powerful-sounding
name-- is the conclusion
that the perfectly competitive
private market will deliver
the welfare-maximizing outcome.
So standard economic starts
from the proposition the market
knows best.
In that, world the government
can only screw things up, OK?
All the government does is
sort of mess up the first best.
Now, either, despite
this, the government
is, in the typical
developed economy, at least,
typically, 25% to 30% of the
economy is the government.
So either these
developed economies
have it totally wrong,
or there are some reasons
why we might actually depart
from the standard 14.01
model of thinking for
reasons for government.
Now, we didn't cover one, which
was imperfect competition.
We talked about it in
perfectly competitive markets,
government policy can
make things better.
What I'll do in the
next two lectures
is talk about two
other kinds of ration--
Oh, I'm sorry.
So for [INAUDIBLE],, we talked
about imperfect competition,
and obviously, redistribution
is another rationale
for government.
We talked about
that last time, too.
If we think that
social welfare is
increased by redistributing
from rich to poor,
despite some leakage--
[AUDIO OUT] So we've
covered two roles.
There's fixing
imperfect markets,
and there's redistribution.
In the next two lectures, we'll
talk about two other roles
for government.
And if this whets your appetite
and you want to learn more,
you could take 14.41, which is a
course all about public policy.
You can learn a lot more.
But we'll talk about
two other reasons.
Today, we're going to
talk about externalities,
which is another justification
for government involvement.
And we're going to dive
right in with an example.
So what's an externality?
An externality occurs whenever
the actions of one party
impact another party in a way
for which the first party does
not receive the
costs and benefits.
So if my actions
impact you, but I
don't bear the cost if
they're negative actions
or their benefits if
they're positive actions,
then that's an externality.
So any time one party's
actions affect another party,
but the first part
does not receive
either the costs or the
benefits of that impact, that's
an externality.
Let's start with the
standard theory example, OK?
The standard example
we always teach now
is the example of
the steel plant
dumping sludge in a river.
So imagine somewhere
in America, there's
a steel plant located on a
river, and they produce steel.
And the production process has
a certain production function.
And one feature of this
production function
is for every unit of steel
produced, a unit of sludge,
a unit of waste, is produced.
And the steel plant dumps
that into the river.
So just given the nature of
their production process,
one unit of steel equals
one unit of sludge
is dumped in the river.
Now, let's imagine
that down this river,
there's a set of fisherman.
And the fishermen make their
living fishing in the river,
and that when the steel plant
dumps sludge in the river,
it flows downriver
and kills their fish,
kills some of their fish, OK?
Now, this is a
classic exempt of what
we call a negative
production externality.
It's production
in the sense it's
coming from the supply side.
It's coming from the
production of the steel.
It's producing this externality.
It's negative because
it's negatively impacting
the fishermen down the stream.
And it's an externality
because the steel plant
doesn't give a shit.
They dump their sludge.
It goes down, and
it kills some fish.
And they care, but they don't
bear the cost of doing so.
The fishermen bear
the cost of doing so.
It's an externality, because
the plant dumps the sludge,
but it's the fishermen
who bear the consequences.
It's a classic
negative production
externality-- "negative"
because it's bad,
"production" because it
comes from the supply side,
"externality" because the costs
are borne by another party,
not by the party
doing the activity.
Graphically, we can analyze that
in something like figure 23-1.
This is a classic
externality diagram.
Here we have the
market for steel.
We look at the market
for steel, because it's
the production of
steel that generates
this negative externality.
We look at the market for steel.
You've got a quantity
of steel being produced,
and a price of steel--
standard market.
You've got a supply
curve and a demand curve.
So in our analysis to date--
and let's be
perfectly competitive.
Our analysis to
date, we say where
supply equals demand
is at point A,
with a quality Q1
and a price P1.
And we would say that is
the welfare maximizing
outcome, perfectly
competitive market, OK?
What this misses, however,
is that the supply curve
f is the private marginal cost.
That's the cost of the
machines, and the building,
and the workers
that make the steel.
But we as a society don't just
care about the private cost.
We care about the social cost.
We care about the fact that--
think of a society with the
social welfare function.
That social welfare function
incorporates both the steel
plant and the fishermen.
So we don't just care about
the steel plant's costs--
the machines and the workers.
We care about the costs
and the fishermen, too.
We care about social
marginal costs.
What are social marginal costs?
That is private marginal
costs plus the damage done
to the negative externality.
And what we're going
to do is we should
assume that's $100 per
unit of steel produced.
We're just making that up.
We're just going to assume
that every steel unit produced
delivers $100 in negative
externality in terms of fish
killed downstream.
Now, that does not have--
I haven't seen this constant.
It doesn't have to be constant.
You can imagine a little
sludge doesn't do much damage,
but if you dump more
sludge, it does more damage.
That would be a non-linear
curve that wouldn't [INAUDIBLE]..
But to make life
easy, imagined sort
in this region,
every unit of steel
produces a unit of sludge that
kills $100 worth of fish, OK?
And meanwhile-- now, on the
other hand, the demand curve--
so the supply curve is
the private marginal cost.
The demand curve is the
private marginal benefit.
But in this case, that is the
same as the social marginal
because, there's
no externalities
from the consumption of steel.
We'll come back in a minute
to consumption externalities.
But let's assume for a minute
that my private benefit
from consuming steel
is society's benefit
from consuming steel.
It's not like by
consuming steel,
I create some positive or
negative externality, OK?
So the demand curve is
both a private and social
marginal benefit, but
the private marginal cost
is below the social
marginal cost--
the social marginal cost,
the private marginal cost,
plus the externality damage.
Now, what does this mean?
This means that
the optimal level
of production from society's
perspective is not point a.
It's point c.
From society's perspective,
incorporating the damage
to the fishermen along with
the cost of the steel plant,
then the optimum point is
where the social marginal cost
equals social marginal
benefit, which is 0.2.
So from the society's
perspective,
there should be less
steel production, OK?
Add an amount to 2.2,
which is below 2.1.
But the steel
plant doesn't care.
The steel plant produces T1.
They don't care about
some fishermen downstream.
So you have an overproduction
and a deadweight loss.
Now, here's the key thing
about deadweight loss.
We've talked about
deadweight loss before,
but here's the new trick
with deadweight loss.
Deadweight loss is always
drawn with reference
to social marginal benefit
and cost curves, not private.
So deadweight loss
is relative to what's
best for society, not
what's best for one
particular actor in society.
So the deadweight loss is all
the units between Q2 and Q1
where the social
marginal cost exceeds
the social marginal benefit.
So for that first unit
to the right of Q2,
there's this tiny
deadweight loss.
But as you move further
and further from Q2 to Q1,
the deadweight loss grows.
Because those are
units where there's
a bigger and bigger gap between
the social marginal cost
and the social margin benefit.
The bottom line is, we're
back to chain of logic.
The private steel plant does
what's privately optimal.
That's with private
marginal cost
equal to private
marginal benefit.
That's at point a.
From a social perspective, we
care about social marginal cost
and social marginal benefit.
Social marginal benefit
is the same as private
marginal benefit
in this example.
But social marginal
cost includes the cost
to the fisherman,
so it's higher.
Given that it's higher,
we'd socially optimally
produce less steel, OK?
And therefore, we would want
less production of steel.
Now, once again, there's a
lot of complications here.
For example, what if we,
instead of using less steel,
we just stop them
from polluting?
Well, that would be another end.
There's lots of
complication here,
but for now, just assume
that's the way the production
function works, If you're
going to make steel,
you're going to pollute, OK?
So that's the outcome.
That's what we call--
that's how we think about
a negative production
externality.
Now, externalities can also
happen on the consumption side.
And the classic example
of negative consumption
externality is smoking.
So let's go to figure 23.2.
Now we have the
market for cigarettes.
There's the quantity
of cigarettes
on the x-axis, the price of
cigarettes on the y-axis.
Now, here, we're going to assume
the private marginal costs
curve is equal to the
social marginal cost curve.
That is, there's no--
maybe, when they make tobacco
for cigarettes, they pollute.
But we'll ignore
that for now, OK?
We're just going to
assume that there's
no pollution from
the production side.
But on the consumption side,
when I smoke a cigarette,
I do damage to other people, OK?
Most perniciously,
most obviously,
through secondhand smoke.
I'm very sensitive
to this right now,
because my wife's mom
smoked three packs a day.
My wife now has COPD, Coronary
Obstructive Pulmonary Disease,
and was just in the
hospital with pneumonia,
because her mom smoked
three packs a day,
and so her lungs are weak.
So this is the example
of a negative consumption
externality.
Her mom smoked, and smoked
to the point of point a,
where her private benefit
is equal to private cost
but the social cost includes
my wife, I like to think.
And therefore the benefits
include the negative impacts
on my wife.
So this led my wife's
mom to over-smoke.
Or in general, people
over-smoke because they
don't account for the fact
that there's damage on others.
Therefore, there is
too much smoking.
Too much smoking, because
it doesn't account
for the damage on others.
But in this case, this is
not a change in supply curve.
It's a reduction
in the benefits.
Because the production of
cigarettes hasn't changed.
It's just the value of consuming
cigarettes has changed.
Cigarettes are less
valuable to consume
because you get enjoyment from
smoking-- at least some people
think it's enjoyable.
But offsetting that is the
damage you doing to others.
So that the shift downward of
the marginal benefit curve.
Now, the social
marginal benefit is
below the private
marginal benefit.
And the new equilibrium is where
the social marginal benefit
equals the social
marginal cost, OK?
And therefore, the
optimal level of smoking
is lower than what individuals
would privately choose.
Yeah?
STUDENT: Where did you
get the margin at the end?
Because there is still profit
margin in the business.
JONATHAN GRUBER: Yeah, so
that's a very good question.
I'm going to come back to
what happens when you depart--
we're assuming perfectly
rational people
with perfect information.
I'll come back to this.
This gets more
complicated [INAUDIBLE]..
This is a perfectly
rational person [INAUDIBLE]
even before they know it.
I'm not saying it's--
I'm not saying
they're bad people.
I'm not saying smokers are
bad people, because they're
doing what's privately optimal.
There's nothing bad about
doing what's privately optimal.
But it doesn't matter
if they knew or not.
The point is,
they're doing damage.
From a social perspective,
there's too much smoke.
Yeah?
Yeah.
STUDENT: [INAUDIBLE]
JONATHAN GRUBER: Right.
STUDENT: [INAUDIBLE]
example [INAUDIBLE]..
JONATHAN GRUBER: Where
does $0.40 come from?
STUDENT: $0.40.
JONATHAN GRUBER: OK, so $0.40
cents per pack is actually
an empirical estimate
of the external cost,
the external damage
done by smoking.
So it's actually
quite interesting, OK?
So basically-- now, this is
without secondhand smoke.
Think about the
exercise in smoking.
So for example, you get
sick, and your medical costs
are higher.
Actually, if you get external
costs, because smokers
start a lot of fires.
Thousands of people die
every year in America
in fires started by smokers.
That's an external cost,
because other people die,
and the fire department--
things like that.
Smokers are less productive,
so firms make less money,
because they have to take smoke
breaks and things like that.
You add all that up, and
you get $0.40 a pack.
Now, that's without
secondhand smoke.
The problem with
secondhand smoke
is, we don't know how
big that affect is.
The estimates are someone
between $0.01 a pack and $2.00
a pack.
So it's just really,
really hard to measure.
And it's really hard to measure
partly because of a really
interesting phenomena.
Which is, you might have
come back to me and said,
wait a second.
What happened to your wife
is not an externality.
Why would-- under what
situation-- here's
a hard question.
Under what set of assumptions
would the damage done
to my wife by her mom's
smoking not be an externality?
Let's say her mom
was still alive.
You could see her
in the hospital.
Yeah.
STUDENT: [INAUDIBLE]
JONATHAN GRUBER: Exactly,
if only [INAUDIBLE] her mom
is going to bear the cost.
But if her mom knew
that by smoking--
this is where information
comes in-- knew
that by smoking, she'd
make her daughter sick,
and chose to smoke anyway,
then it's not an externality.
In that case, in the
marginal benefits for the mom
would be included the
damage done to the daughter.
So what's really
interesting, externalities
is not a strictly
easy thing to measure.
It depends on-- now, the
fisherman [INAUDIBLE]
floats down the river.
That's different.
But here, the
externality is only true
if the mom didn't account.
So the key thing,
the key question
that you have to ask
is not, is do families
maximize a family
utility function
or an individual
utility function?
If her mom was maximizing
her individual [INAUDIBLE]----
sorry to rag on
my mother-in-law--
may she rest in peace--
but it's a good example.
If she was measuring-- if
she was just focusing on her
individual utility--
then she should just
consider the benefits
to her of smoking versus the
cost of a pack of cigarettes.
But if she was maximizing
family utility,
she should take the
benefits to her smoking
minus the damage it does to
her daughter versus the cost
of a pack of cigarettes.
Yeah?
STUDENT: [INAUDIBLE]
JONATHAN GRUBER: Ah, well, no,
But that's-- you're assuming
the family utility function.
That's what I mean by
family utility function.
I mean you care about
people in your family.
Now, basically, the interesting
question is, in other words,
it's just about weight.
Let's say at one extreme,
a purchase is a function,
I don't care about
anyone in my family.
A full family utility
function, I treat them
as if they are myself.
I care about the [INAUDIBLE].
Where do people line in between?
Now, in fact, there's
some evidence on this.
And the evidence is
basically that women
care about their
families more than men.
So there's actually
a number of studies
in developing countries.
There's a cool way to test this.
And the way you test
this is you say,
if family utility
maximization holds,
then it shouldn't
matter who controls
the resources in the family.
If I take $1 from a wife
and give it to a husband,
that shouldn't change
anything, because they're both
maximizing the same
family utility function.
But if there's individual
utility functions,
then who controls the
resources will determine
how the money gets spent.
And there was a quite
striking example from the UK
where they had a tax
break for children.
And it used to be what
happened-- this is back
in the '70s-- it use
to be what happened
was, for every child
in the household,
at the end of the year, a
check got sent to the house.
Well, typically, women were
home and controlled the money
in the house.
So the women got that check.
They then changed the law
and said, no, instead, we're
just going to let take-home
pay be a bit higher.
So instead of
sending a check, let
me see your check each
week, we'll include it
in your take-home pay.
Well, the take-home
pay went to the men.
Men were working, women weren't.
So it's shifted from women
controlling the money
to men controlling the money.
And what they found
was this shift
led to much less being spent on
children's clothes and books,
and much more being spent
on alcohol and tobacco,
which is inconsistent with
a family utility function.
It's consistent with men
caring less about their kids
than women, OK?
So the bottom line is, we don't
have a perfect family utility
function.
Probably we don't have a perfect
individual utility function
either.
Probably, people care
somewhat about their family.
But as long as it's not a
perfectly family utility
function, then there's some
externality on family members
from secondhand smoke.
So $0.40 is clearly too low.
We just don't know how low, OK?
Now, externalities don't
have to be negative.
They can also be positive, OK?
Let's think about a positive
consumption externality.
And let's come to one
of my favorite people
I like talking shade of,
or throwing shade to,
which is my neighbor, OK?
I don't get along with
my neighbor at all,
and basically, part of the
reason I don't get along
with my neighbor is because
my neighbor has a tendency
to start massive
landscaping projects,
and then leave them half
done, and just not do
anything for 10 years.
And it's unattractive.
And so basically, let's
imagine that my neighbor
is looking outside his yard.
And he's thinking
about the landscape.
And he's thinking,
what's it worth to me
to fix this dirt
pile in my yard--
which is, now, finally,
after 20 years, fading away.
But it was there
for about 20 years.
What's it worth to me to fix
this dirt pile in my yard?
OK, well imagine that
the dirt pile will
cost $1,000 to haul away, but he
only gets $800 of this utility
from looking at it.
So let's say I get $500 of
utility from not looking at it.
And let's say-- this
is totally true-- he
doesn't care about me.
Then he'll say privately, I
shouldn't move the dirt pile.
My benefit from
doing so is $800.
My cost of doing
so is $1,000, OK?
So the cost is a [INAUDIBLE]
if I don't do it.
But socially, he should
get rid of the dirt pile,
because the benefit to
society is the $800 to him
and the $500 to me.
So if he removed
the dirt pile, there
would be a positive externality.
For him to consuming
landscaping services,
there would be a
positive externality,
which is my improved view.
So the positive consumption
externality, OK?
So that is-- you could think
of this thing as figure 23.2,
but just flip it now.
Think of my consumption having
a marginal social benefit.
In that case, unlike
the case of cigarettes,
where there's too
much consumption,
now there's too
little consumption
of landscaping services
by my neighbor,
Because he's not accounting
for the benefit to me, OK?
Yeah?
Let me come to that
in one minute, OK?
Now, finally, there's
one last example,
which is you could have
positive production externality.
And the classic example
of positive production
externality is research and
development by companies.
When companies do
R&D, it benefits them,
but it also produces
general knowledge
that benefits everyone,
including their competitors.
As a result, if you go
back to figure 22, 23.1,
my social marginal costs
of doing R&D are actually
lower than my private
marginal costs,
because I'm producing
benefits for other produces.
It's the opposite of dumping
sludge in the stream.
I'm dumping knowledge
in the stream, OK?
And that knowledge benefits
everybody downstream.
Indeed, the estimates are that
$1.00 of R&D is worth about
twice as much to society as it
is to the individual firm to do
it.
Indeed, if you'd like to
learn more about this,
you can pre-order my new
book, Jump-Starting America,
which talks about how we're
going to make America run
better again by
investing in public R&D.
So I talk all about it.
Very excited about
that right now.
So those are the kinds
of externalities,
positive and negative.
Now, the question
many ask is, so what?
So these things exist.
Why can't people
just figure it out?
Take me and my neighbor, OK?
There's an easy solution here.
I just go to my neighbor,
and I pay him 200 bucks--
or $201.
He's $1 better off.
I'm $299 better off.
Problem solved.
Indeed, there's a famous
economist named Ronald Coase--
Coase-- who proposed that
there is no such thing, really,
as an externality,
because all externalities
can be internalized through
private negotiation.
So as long-- here's the key--
as long as there's
well-defined property rights.
So in the case my neighbor,
there are well-defined property
rights.
He owns the dirt pile.
So I go to him and offer
him money to fix it,
to get rid of it.
Likewise, imagine the
fisherman owns the river.
They could then go to
the steel plant and say,
we are going to charge you for
dumping sludge into the river.
And we'll charge you enough
so that your private costs go
to the social costs, OK?
So basically, Coase said
there's no problem here.
There's no need for government.
The private market
can take care of it.
Well, that's a really
cute argument in theory,
but in practice, it breaks down.
Because think about that
argument for the big
biggest [INAUDIBLE]
in the world today,
which is global warming, OK?
Global warming happens because
I drive my car and people
in Bangladesh drown.
How are they supposed to
come to me and say, John,
you should drive less.
I'm going to pay you to
drive less so I don't drown.
And that's just crazy, right?
It doesn't work for
big externalities.
It doesn't always work
for little externalities.
So think about yourself, OK?
Think about your neighbor
playing music too loud.
You have a 14.01
test the next day.
Your neighbor's
done with finals.
They're partying, playing
their music too loud.
That's a classic negative
externality on you.
Now, in principle,
you should say, well,
I can figure out how
much it's worth to me
and go pay them to
turn their music down.
But in practice, you're not
going to do that, right?
You'd be, like,
a social outcast.
OK?
In fact, people
don't work this way.
There's a famous story about an
economist-- it can't be true,
but it's a wonderful story--
who was on a plane
trying to get work done.
The person next to him
wouldn't stop talking,
so he offered them
5 bucks to shut up.
Now, that would be
the Coasean solution.
But in reality, life
doesn't work that way.
So in fact, the
private market is
unlikely to solve these
kinds of problems.
Yeah?
STUDENT: [INAUDIBLE] what
does it cost [INAUDIBLE]??
JONATHAN GRUBER:
That's another problem.
There's lots of reasons why
you can't-- there's no way.
Even Coase bless
his soul, would not
take the private negotiation
to solve the global warming
problem.
There's no way, OK?
So that means we need
the big bad government.
We need government solutions,
because the private market
has failed.
The private market has failed
because the private equilibrium
is not welfare-maximizing, OK?
So if you go back to
23.1, the private market
has failed because the private
market overproduces steel.
Therefore, there is a role
for the government to,
potentially, fix
this market failure.
It doesn't mean the
government will, OK?
This is the key thing.
I emphasize this in my course.
The way to think about the
logic of government involvement
in the economy is
with two steps.
One is, is there
a market failure?
That is, will the private
market fail to maximize welfare?
And two is, can the
government actually
make it better as opposed
to making it worse?
So just because if I have a
market failure, it doesn't mean
there's a role for
the government.
It means there's a potential
role for the government.
Well, let's talk
about, theoretically,
what the government
might do, and, in fact,
what the government
actually does do.
So theoretically, the
government has two options.
The first option is regulation.
So going to figure 23.1,
the government could summon
and say, hey, steel plant,
we've done the math,
and you're optimal level
of steel production is 2.2,
so we're going to
regulate you so you
can't produce more than 2.2.
And if the government
did that, we
would get to the
optimal outcome.
If the government said,
I'm setting a max at Q2,
then we get the optimal
outcome, which is 2.2 will be
[INAUDIBLE].
The problem with that
is exactly the problem
we talk about when we talk
about regulating monopolies,
which is that requires a
huge amount of government
information.
They need to know the shape
of the supply-- they need
to know the shape
of the supply curve,
the shape of the demand
curve, and the size
of the externality.
They need to know
all three things--
supply, and the size
of the externality--
in order to get that right.
And if they get it
wrong, they could
lead to-- if they
get it too wrong,
they could shut
down a steel plant
that's still totally
valuable to have running.
So we have this
conversation at length
with monopoly regulation--
all the same problems of life.
That's why economists
typically prefer
a simpler solution,
which is taxation,
or, what we call in economics
"corrective taxation."
And this is exciting, because
when I taught taxes last time
and the time before, taxes
caused deadweight loss.
Taxes caused inefficiencies.
But actually, in the
case of externalities,
taxes can reduce
deadweight loss.
How's that?
Let's go to figure 23.3.
Back to the steel market.
Imagine I don't know
supply and demand curves.
I just know the size
of the externality.
It's $100 a unit of steel.
So I simply go to
the steel plant
and say, look, for every
unit of steel you produce,
I'm going to charge you $100.
You do what you want.
I don't know where
you're going to end up,
but I'll charge you $100.
That means that
the steel plant--
the steel plant's private
marginal cost curve
will now align with the
social marginal cost curve.
You've essentially done
what Coase wanted us to do.
You've internalized
the externality,
but done through government
action rather than
private negotiation.
You said, you are
imposing a social cost
above and beyond
your private cost.
We are going to
essentially make you
consider-- it's like moving
to a family utility function.
We're going to make
you consider all
of society in your decision.
We'll make you internalize
the damage you're
imposing in your decision.
And the way we're
going to internalize
that is by charging
you for the extra costs
you're imposing on society, OK?
So that is what we call
"corrective taxation," OK?
And corrective taxation
leads to the optimal outcome.
If we say to your steel plant,
for every unit you produce,
we are now going to tax
you by amount MD, which
is the marginal damage, then it
leads them to actually choose
point B--
which is confusing, because it
was point C on the other graph,
OK?
To choice point D--
OK, it was D on
the other graph--
which is the optimal outcome.
You could say that the
system is that [INAUDIBLE]----
which is the optimal outcome.
It will cause them to choose
the optimal outcome, OK?
So we've essentially
got the private market
to do the right thing by
forcing them to internalize
the externality,
much as Coase would
hope it would happen
through private negotiation,
we've caused to happen
through corrective taxation.
Likewise, we can think of
the same thing with smoking.
So go back to figure 23.2
Imagine I levied a tax of $0.40
a pack on cigarettes.
Then the marginal benefit of
smoking would fall by $0.40.
My willingness to pay--
remember, we [INAUDIBLE]
analyze taxes [INAUDIBLE].
When we say you have
a tax, it essentially
shifts down the demand
curve, tax on consumers.
It lowers my willingness to pay.
I'm only now willing to
pay $0.40 less a pack,
because I have to pay
$0.40 in tax every pack.
That shifts my
demand curve down.
Plus, the private
marginal benefit
now equates to social
marginal benefit.
Boom-- no more
externalities of smoking.
So here's the crazy thing.
Taxes have now removed
the deadweight loss.
Taxes haven't created
the deadweight loss.
Taxes have removed
the deadweight loss.
So in a perfectly competitive
market with no market failure,
taxes create deadweight loss.
But once there is market
value, taxes can actually
offset deadweight loss, OK?
And that's the theoretical case
for government intervention.
Theoretically, the government
can make things better
through opposing
corrected taxation.
OK?
Questions about that?
Yeah?
STUDENT: Elasticity
plays into it.
If somebody is
really inelastic, has
really inelastic consumption
of cigarettes, would this tax--
JONATHAN GRUBER: You
just need a bigger tax.
STUDENT: OK.
JONATHAN GRUBER: Yeah.
So basically, the way
elasticity plays into it-- now,
if they're totally
inelastic, you'd
have to wear something else,
Nothing's ever perfectly.
But essentially, you could take
the diagram, and essentially--
no, I'm sorry.
No, let me back up.
I said that incorrectly.
Elasticity doesn't matter for
the actual government policy.
All I want to do is impose the
size of the externality, OK?
If, demand is inelastic, that
could mean people love smoking.
And as a result, you won't
reduce smoking that much.
But that's OK,
because basically,
all we care about is
correcting the externality, OK?
We're not trying
to punish smokers.
We're not trying to
achieve an optimal--
and that's the difference
between regulation
and taxation.
Regulation says, no, I know what
the right level of smoking is.
I'm going to impose this.
Taxation is, look, I don't know
the right level of smoking is.
Many people frickin'
love smoking.
Imagine if there
was externalities
to consumption of insulin, OK?
Who wants to say, no,
less insulin, because--
you want to say, no, we have
to have a ton less insulin.
We should say, no, we should
tax for the externalities they
impose.
But if they still choose
to do a lot of insulin,
then they're still doing the
socially optimal decision.
It's a really good question,
because it highlights
the key nature
here, is this is why
this framework, traditionally,
was very controversial
with environmental advocates.
Environmental advocates
hated this framework,
but they're like--
they called it a
"pollution absolution."
Guess what absolution is.
It's this thing that
these corrupt monks
used to give before Martin
Luther came along to reform
the church back in the 1400s.
Monks would come along and
say, yeah, I know you sinned,
but if you give me
one coin, or whatever,
I'll say your sin's absolved.
So the monks would sort of bribe
people to get into heaven, OK?
It's called absoltuion.
So for many, this was
called pollution absolution.
Environmentalists hate this
way of thinking about it.
They're like, wait,
you're letting
people pay to get out of
the damage they're doing?
And the answer is, yeah,
it's the right thing to do.
Because in fact, if
people pay and don't
change their behavior,
that means they just
love doing that activity.
And why should you penalize
them just because they
love doing that activity?
We should penalize them to the
extent they're hurting others,
not care about the
enjoyment they get from it.
So if people, for some
reason, just love smoking,
let them smoke.
But make them account
for the damage they're
doing to other people, OK?
It's a great question.
Other questions?
Yeah?
STUDENT: [INAUDIBLE] if a
person does [INAUDIBLE]----
JONATHAN GRUBER: Great question.
I'm going to come back to it
at the end of the lecture.
Great question.
OK, let me talk-- that's a great
segue to what do we talk now,
which is, let's move
from theory to practice.
Let's talk about actual
government policy,
and what governments do,
and how it's informed
by this kind of framework.
Let's start with
environmental externalities--
the classic piece.
The classic case of
negative externalities
is the pollution in
the environment, OK?
G environmental
science, for example,
we produce electricity.
The emissions from that
electricity, the sulfur,
and the nitrous oxide--
sulfur dioxide, nitro us
oxide-- go into the air.
They form particulate
when get into our lungs
and causes us to get sick.
They cause acid rain,
which falls and erodes
[INAUDIBLE] cities,
and buildings,
and things like that.
And then, of course,
we have global warming,
which is the single
biggest issue facing--
maybe not you, almost certainly
your kids, and definitely
their grandkids, OK?
Depends how long
you're going to live.
You guys aren't going
to make it to 2100.
Yeah, probably not you.
Your kids when they're old,
and your grandkids for sure--
which is, basically, the
amount of fossil fuels
we burn if it's loaded.
We now-- and the amount
of carbon dioxide
in the atmosphere
is now the highest
in at least 200,000 years.
And by estimates, including
from the Trump administration,
this will lead to massive
warming of the earth.
And by the year 2100,
global temperatures
could rise as much as
10 degrees Fahrenheit.
Now, for those of you
from North Dakota,
that might not sound so bad.
Even right now in Boston,
it might not sound so bad.
Remember the great
line from The Simpsons
when it snows and
Homer goes, Hey, Lisa,
said there's 10 feet
of global warming.
But basically, the truth is it's
very bad, because basically,
it leads to enormous rises
in sea level by as much,
essentially, as 3 feet.
And just think about that.
That means, for example,
Bangladesh is gone.
Bangladesh has 100
million people,
150 million people-- gone.
Cape Cod's gone.
New York City, largely gone.
Florida, gone.
Basically, America
becomes the Midwest.
Basically, essentially,
you've got--
and to put it in economic terms,
the Trump administration's
calculations suggest the US
will be 10% poorer by 2100
as a result of global warming.
This is real.
The conflicts are real.
But it's a classic
externality, because it's
the ultimate externality.
Because every single time you
drive, you contribute to it.
And every single time
someone in Australia
drives, they contribute to it.
Because it all just
goes in the air,
and mixes together, and create
one level of global warming.
It's a completely
global externality.
Any pollution of emissions
anywhere has the same effect.
And the effect is
very distant in space.
So if you're in Minnesota, the
effect is not nearly as bad
as if you're in Bangladesh.
It's the city is time, because
the effect is going to be way
in the future, not on you.
It's a classic Externality,
because the effects clearly
don't affect you.
And they arise from
your consumption.
Yeah?
STUDENT: [INAUDIBLE]
JONATHAN GRUBER: Oh, yeah.
Well, it's not-- the
time part is what
makes it a bad externality.
As long as when
I drive, I do not
pay any extra cost for
the marginal damage
I'm going to the environment,
then It's an externality.
It doesn't matter if it's going
to affect now or in the future.
OK, the bottom line
is, when you drive,
you are likely making
the environment worse.
Ah, OK, you live in
that environment.
But the problem is you,
particularly here in Boston,
aren't going to
feel, necessarily,
the consequences of global
warming, at least initially.
So you're right.
If you lived in your own little
world, that's a great one.
Remember, externalities
is you bear it.
If you'll be in your
own little world
where you drove, and
made your own little rain
clouds like Charlie Brown, and
you covered all the conflicts,
then it wouldn't
be an externality.
But the truth is,
that's not true.
Many, many people
suffer the consequences.
Now, what do-- yeah.
STUDENT: [INAUDIBLE]
JONATHAN GRUBER: That's right.
The key issues is discount.
There's a ton of really
deep and hard issues here.
How do you think about
discount when the damage
is 100 years from now?
So let's say you took a
standard interest rate today.
Today, interest rates are low--
3%.
Well, it's still
true that 100 years
from now, that means damages are
worth 20% of what they're worth
today.
At a higher discount rate,
they're worth effectively 0.
We're basically saying, if you
have any form of discounting
of any reasonable
magnitude, you're
basically saying
your great-grandkids
don't matter today.
Well, that seems implausible.
So there's a lot of deep work on
multi-generational discounting.
How do we think about
discounting for hazards which
are way, way off in the future?
Now, it turns out, even with
reasonable discount rates,
the cost is still huge
today, because they're
so enormous in future.
Even if we discount them
back, they're still big today.
But that's the kind
of difficult issues
that is really exciting
and interesting stuff.
So what do we do?
Well, in Europe, they've
gone the taxation route.
A gallon of gas in France is $7.
Macron has just proposed
increasing the tax,
and it's causing Paris to burn--
ironically, increasing
global warming.
But typically, in
Europe, gasoline
is many, many times more
expensive than in the US.
And basically, they have carbon
taxes that try to control this.
But it proved very difficult
to do that in the US.
Indeed, when Bill Clinton
proposed a $0.03 tax
on gasoline when
he first elected,
it basically cost
him the the Congress.
Think about that, $0.03.
That's a daily swing
in the price of gas.
Gas taxes are very hard
to impose in the US.
So that's why there's been
a move away from a taxation
approach towards a
regulation approach.
Even though
regulations [INAUDIBLE]
have other weaknesses,
there's been
a move toward trying to
cap global emissions,
trying to regulate a
cap on global emissions.
And this began with the
first such agreement
negotiated in Kyoto in 1990--
in December '97.
I was at that.
That was pretty cool.
I was part of the Clinton
administration delegation
that went over there.
And it was crazy, because
basically, you had all these--
think about how hard this
is to really negotiate.
So let's say you're India.
And you come, and you
say, wait a second.
Let me be clear.
In 1997, of all the
stuff in the air,
the US was responsible
for about 30% of it,
and the rest the world
combined with 70%.
Then you come in and
say, wait a second.
We haven't done anything
to the environment, OK?
We're ready to grow.
We want our air conditioning.
We want our cars.
We want our-- and you say,
you say, no, wait a second,
you can't have that because
we screwed up the environment.
Screw you!
OK, you guys, screwed it up?
You guys fix it.
It's a pretty hard
negotiation you have to do.
Plus, the costs are quite large.
So it was actually pretty cool.
I was there for four days.
I slept four hours.
In Japan, they have this
cool coffee in a can
that you just sort of live on.
And we negotiated
an agreement which
was not going to
solve the problem,
but it was going to slow
the growth of emissions.
But America was never actually
going to ratify the agreement,
so it never went anywhere.
Fast forward to 20 years later
to three years ago in Paris.
We signed another
climate agreement
called the Paris
Climate Accord, which
was similar to Kyoto
in that it set targets
that countries could meet.
And we were successful
that more countries
participated in Kyoto.
Countries like India and
China didn't participate.
But now, most countries
that participated
in the Paris Agreement limiting
emissions are-- the US.
In that case,
signed it, but now,
the Trump administration
has backed off it.
So we're were not enforcing
the Paris Agreement.
Now, you can completely
understand politically
why a leader would not want to
enforce an agreement like this.
You're imposing pain today
for the benefit the people
you'll never even meet, OK?
First of all, they live in
other countries, by and large.
Second of all, they're going
to be 100 years from now.
So politically, it is
unbelievably challenging.
But the problem is, by the
time those people are drowning,
it's too late.
Basically, even if today,
if we just suddenly stopped
using any fossil fuel
today-- which is impossible--
but let's say that we stop
using any fossil fuels today,
temperatures would still rise
for something like 300 years
before they start
to fall again, OK?
So basically, this is an
incredibly hard problem
because the costs
are super distant--
the benefits are of fixing
it are super distant
if the costs were
imposed today, And that's
a very, very hard problem.
That's why this is probably the
single biggest social problem
facing the world over
the next 100 years,
is how do we deal with--
the economics of
the answer is easy.
I mean, it tells you what to do.
It's easy.
You post taxes or regulations.
You essentially
phase out of being
a fossil fuel-based economy.
OK so theoretically,
it's no problem.
The problem is all
political, which is basically
how you get people who
are going to to bear
the cost in the near
term without [INAUDIBLE]??
And that's it's an
enormous challenge.
Yeah.
That's a deep question
about the nature--
essentially, there's a
different equilibrium
where they have more faith
in the government in New York
City than in the US.
Maybe that's because
you're settled
by Frontier, Venture,
people who never never like
to be told what to.
Do I didn't quite
know what that is.
But in any case, this
is different attitudes
towards the
government in general.
And I think, essentially, if
you're going to deal with this,
you're going to have
to essentially trust--
think of a social
welfare function,
which is not everybody
today, but everyone
everyone in the whole future
with some form of discount.
You've got to trust that
social welfare function, which
is the governments.
In Europe, they trust
that more than in the US.
But look, I don't want to
minimize how hard this is, OK?
There's enormous disagreement
about how fast we should go.
In fact, I was originally--
one of the reasons
I went to Kyoto
was because the economists
in the Clinton administration
were opposed to how strict
the Kyoto targets were.
We thought it was too severe.
And I actually, in
1997, was the subject,
I believe, of one of the
very first spam attacks.
I got spammed by hundreds--
which, at that point,
was enormous-- of environmental
activists saying how terrible I
was because I didn't want to
restrict emissions more, OK?
Basically, there's huge
disagreement in this.
But it's a topic
we can't ignore.
It's a critical topic.
Likewise, another critical
source of externalities.
Is health externalities.
Now, we've talked about
smoking, but there's
lots of externalities.
So smoking, the externalities
are actually not that large.
$0.40 a pack is not that large.
Depends on if you
use secondhand smoke.
Compare that to drinking.
The externalities for
drinking are enormous,
because drunk drivers
kill people, OK?
Indeed, there are
13,000 deaths per year.
To be politically
incorrect, let me say it--
that is our 9/11s every year
from people drunk driving.
400,000 people are injured
every year from drunk driving.
That's a classic externality.
If I kill someone in my
car, maybe my license
will get taken away.
But m I'm not bearing the
full cost of killing, OK?
Yeah.
STUDENT: [INAUDIBLE]
JONATHAN GRUBER: That's
a great question.
This is-- I'm trying to compress
my whole course into one
lecture, which is hard.
But there are estimates
of value of a life.
Typically, we say a life
is worth about $10 million.
We can talk another time
about where that comes from.
But basically, if you
take those valuations,
the externalities from
drunk driving are enormous.
And yet, we have very, very low
taxes on alcohol [INAUDIBLE]..
Yeah?
This is a great question.
We could go all day on this.
Absolutely, they are.
And this is why nobody
likes economists.
For example, we think babies'
lives aren't worth as much
as your lives.
Why?
Because you've got more
embedded human capital.
You've formed more connections.
The value of your
life is worth more.
Tell that to the parent
of a newborn, OK?
So there's all sorts of
interesting and difficult
issues in valuing life.
That's a whole separate field.
But in any case, the bottom
line is, since life's valuable,
there is an important
externality.
Now, let's come to the
interesting case, a very hot
topic, which is illegal drugs.
Now, let's talk about
cigarettes for a second.
Cigarettes impose
externalities, but I never
said the answer with to
ban cigarettes or make
them illegal.
I said the answer
was to tax them
to the extent of
their externalities.
So let's say we could properly
measure secondhand smoke
or whatever.
We do it.
So indeed, cigarette taxes
today probably exceed
any reasonable expert
of externality.
I'm one of the biggest
anti-smoking advocates
out there, and I would
admit cigarette taxes today,
which average nationally
several dollars a pack,
probably exceed the
externalities of smoking.
Moreover, then, illegal
drugs, we don't just tax them.
We ban them.
Until recently, in all
states, we banned marijuana.
We still banned other
drugs everywhere.
Why?
Think about it.
The framework I taught you
so far does not say you
should ban anything.
If I love doing
cocaine, you should
tax the externalities I do.
Indeed, let's go further.
There aren't many externalities
to most illegal drugs, OK?
Guys who do cocaine, they
may get in car accidents--
or heroin-- but they largely
just kill themselves.
They don't do a lot
of social damage.
They largely just
kill themselves.
Indeed, what are
the externalities
from illegal drugs?
They come from
fighting illegal drugs.
It's the crime that comes since
the drugs are illegal, OK?
That should be
externalized from drugs.
So for that reason,
economists, for decades,
have argued drugs should
be legal-- all drugs.
Because if you think about it,
they should be legal and taxed.
Because the externalities
largely come to the fact
that they're illegal.
You think about all
the deaths in Mexico.
Think about what
would happen in Mexico
if drugs were legal in America.
Suddenly, the price
would collapse,
the cartels would have no money
to make, and they'd break up,
and there wouldn't be all
these deaths in Mexico.
Those deaths in
Mexico are our on us.
It's on the US
consumers who demand
these illegal goods
from Mexico that create
the demand for crime in Mexico.
It's probably-- if
drugs were legal,
it wouldn't be a problem.
So why not legalize drugs?
Well, we only have one minute.
So the answer is because we
don't think this model applies
in all [INAUDIBLE].
In particular, we don't
think people always
make rational decisions.
And this framework computes
rational decisions.
We think that people
make mistakes.
And if the mistakes
are severe enough,
then taxation is not
the right answer.
You need an outright ban.
And that's why we do.
That's why we say, look,
we think that people,
most people try illegal drugs
before the time they're 18.
We think that people
before they're 18
don't have fully formed
prefrontal cortexes.
They're not fully rational.
They get addicted, and that
has lifelong consequences.
Therefore, we make
the drugs illegal,
because we think that the
costs of those consequences
are so large that we don't
want to take a chance.
But that raises the whole
debate we should all be having
about marijuana legalization.
Is that true of marijuana?
The externalities of marijuana
are really small, OK?
Indeed, the damage
you do to yourself
is actually pretty small--
much less than smoking.
So how do we think about
whether marijuana should
be legal or illegal,
versus cocaine and heroin,
and how much it should be taxed?
So that's the kind of set of
interesting issues you raise.
We talk about those.
So anyway, if you find that
more interesting, take 14.41.
We'll spend many lectures
talking about it.
