Hi. Welcome to macroeconomics. This is Kate. This tutorial is on the international regulatory environment. As always, my key terms are in red, and examples are in green. So in this tutorial, we'll look at why and when private firms fail to produce the optimal amount for society. We'll also see how negative externalities lead to overproduction in the marketplace. And finally, I'll identify and walk you through some examples of global initiatives that are currently striving to reduce climate change.
So first of all, let's note that in most cases, free markets do function wonderfully without regulation. And that's because producers have the profit motive to provide consumers with what they want at prices that they're willing to pay. And they produce something called the optimal level of output. And this is produced when producers equates marginal cost with marginal benefit.
So when firms bear the full cost, it's in their best interest to produce this optimal amount, because it will be what's profit maximizing. I'll walk you through an example in a few slides. But first of all, let's remind ourselves what marginal cost and marginal benefit are. Marginal cost is the additional cost incurred when producing one additional unit. Marginal benefit is the amount of utility gained by consuming an additional single unit of product.
So sometimes though, a market does fail to produce this efficient allocation of goods and services. And that's known as a market failure in economics. Often, and in the case of this tutorial, it's going to be due to externalities, which are either costs or benefits that accrue to third parties who don't participate in that particular market. And the definition is here for you-- the effects of a good or service to a third party. And they can be negative or positive, but today we're focusing on the negative externalities. So these are costs, then, of a good or service to a third party.
Pollution emitted from a private firm is a good example, and that's the one we're going to use. So what is the private firm's incentive, let's say, to voluntarily switch from an unsustainable to a sustainable inputs? Let's use the example of pollution from an industrial plant. So let's say a company knows that its production process is going to emit pollution. They can decide how much to pollute versus how green to make their process, how much they're going to clean up.
Well we know that today, at least, it's still more expensive to produce cleanly, let's say using solar power, than using a non-renewable resource like coal. So what they do is they weigh costs and benefits to make the most efficient decision for their company. And if they end up going very green and using a renewable source like solar power, that might really increase their production costs and anger stockholders.
Companies have to be very careful about this, because those stockholders have an interest in this, and they can't do something that's going to seriously anger their investors. Unfortunately, what does this leave out of the equation? Well it leaves out of the equation the fact that their pollution might very well impact people living downwind. So let's say that it does. These people are going to face higher health care costs, potentially. They have nothing to do with this market, if they're not buying the product, yet they're faced with the cost of its pollution. They're exposed to this negative externality. And so the company's decision, and then therefore the pollution output, is neglecting to take these third party costs into consideration.
When we look at it this way from the individual firm, we're doing a microeconomic analysis. A microeconomic theory is just a theory underlying the study of the firm in consumer behavior. So if we're looking at it from one firm's standpoint-- let's just say, for example, that the market price of the good they're selling is $150. That would be the marginal revenue, the additional revenue that the firm is taking in when they sell one more. Let's say that the marginal cost to them to produce it is $100. Well, you can easily see that they're profiting $50 per unit. So the logical, or profit maximizing, firm is absolutely going to continue to produce this product as they're adding to profit.
But what if, like we said, the production process is emitting pollution? And if we could put a cost on that in a dollar amount-- let's just say that we can say it's causing $75 worth of damage per unit produced. Well, the market price is still $150. But let's look at it from a societal standpoint. Let's call this the marginal social benefit. So society is saying they value this worth $150 if people are buying it. OK.
Now the cost to produce, we know that for that individual firm, it's only costing them $100. But the marginal social cost has now increased to $175, because of this damage being emitted in terms of pollution. You can see now that if the firm were exposed to, or had to bear that full social cost, their profit would actually be negative, and they would not have continued to produce this amount.
So if the full cost to society were realized, it wouldn't continue producing. And so now you can see, just using this example, why firms are overproducing goods from society's view in the case of negative externalities. So the big idea is when firms don't bear the full costs of their production decisions, they will overproduce. They'll produce a greater than the optimal amount for society, since society is burdened with a cost not borne by the firm. And that's what a negative externality is.
Now if we look at this from a macroeconomic standpoint, it gets a little scarier. When many firms make these decisions to overproduce pollution, the impact is huge on society and can actually lead to global climate change. In this case, the question then is posed-- should governments intervene in the form of regulation?
In our own country, the Environmental Protection Agency is one such group that has initiatives to try to reduce some of these negative externalities. They have an Economic Justice Initiative. And you can see that Economic Justice is one of your key terms. It's the idea that all people, regardless of geographical location, race, gender, and national identity should be conferred basic quality of life rights. And it includes fair pay, housing, access to medical care, education, among other characteristics like environmental protection.
So I'm not going to read this whole thing to you, but I did go to the Environmental Protection Agency's website-- you can access it here, this is the link-- to their Environmental Justice Initiative. And you can see that they are taking steps to try to make sure that people all have equal access to a healthy environment in our own country.
But due to growing awareness of anthropomorphic, or man made climate change, nations worldwide are starting to come together to discuss plans. Mitigation is all about modifying activities to reduce further emissions and climate changing behaviors. So to try to stop any further damage from occurring. But M is about actually developing infrastructure to keep people safe from the more volatile climates that we're exposed to because of the climate change.
The Copenhagen Consensus is one of these organizations. And it's a nonprofit organization that commissioned a panel of five economists. Four of them are Nobel laureates, actually. So these are very, very well known economists. And again, I'm not going to read you the whole thing here. But if you go to their website, this link, you can see that basically they're saying we turned to scientists to look at this issue of global warming, but now we need a policy response. And so they put together this panel of economists who are trying to outline the costs and benefits of each way to respond to global warming.
Then we have the United Nations IPCC, or Intergovernmental Panel on Climate Change. And this a global organization who focuses on the impact of climate change. It was established in 1988 by the UN, and it includes 2,000 scientists and researchers. Previously, they were pretty conservative on their stances. But their chairperson has been recently more vocal in basically saying look, yeah, carbon emissions need to be reduced.
And that's in response to this man, Doctor James Henson, back in 1988 testified before Congress about very dangerous carbon levels and their impact on nonreversible climate change. And back then, he set a threshold for what would be beyond dangerous, basically. In mid 2013, unfortunately, it was exceeded. And so that's why the IPCC has come out and basically been more vocal about this.
Consequently in 2007, the IPCC and former US Vice President Al Gore won the Nobel Peace Prize for their efforts to increase knowledge on climate change and to start to establish a framework for what can be done to counteract it. The UNFCCC is the United Nations Framework Convention on Climate Change. And really, it started as an environmental treaty signed in 1992 on greenhouse gas emissions.
It was not a binding, or it set no limits, but it did provide a framework for negotiating future treaties. The 1997 Kyoto protocol is the most well known and most recent. And the UN members who signed this make up the COP, or Conferences of the Parties. And it has been in a couple of phases here-- binding obligations to reduce emissions. They meet annually to talk about it.
The US does attend, but isn't a formal number. And we did not sign the protocol, and we have not committed to climate change reductions. Why not? Cost, cost, cost. It would require adopting new production techniques which are more expensive than our current methods.
So here's what we talked about in this tutorial. You can take a look at it. Thanks so much for listening, have a great day.
Also economic equity; the concept that all people, regardless of geographical location, race, gender, and national identity, should be conferred basic quality of life rights that include fair pay, housing, access to medical care, and education, among other characteristics.
The effects of a good or service to a third party; can be negative or positive.
Amount of utility gained by consuming an additional single unit of product.
Additional cost incurred when producing one additional product.
The theory underlying the study of firm and consumer behavior.