1. Externalities and Public Goods
Lecture 7 – academic year 2013/14
Introduction to Economics
Fabio Landini

2. Where we are… Lecture 1 : Demand and supply model
Lecture 2: Elasticity and its application
Lecture 4: Demand, Supply and economic policy
Lecture 5: Demand, Supply and economic efficiency
Lecture 5: Surplus of consumers and producer

3. What do we do today? The “external” effects of economic activities
How do we internalize externalities?
The different typologies of economic goods: private goods, public goods, common resources and natural monopolies

4. The KYOTO Protocol – since 1997
The Kyoto Protocol, signed in December 1997 at the UNFCCC COP3 (Conference Of Parties), represents the executive instruments of the Framework Convention
The countries that are subject to the emission constraint are 39 and they include the European countries (including the East countries), Japan, Russia, United States, Canada, Australia and New Zealand

5. The KYOTO Protocol – since 1997
The European Directive 2003/87/CE “Emissions Trading” regulate the exchange of quotas for the emission of greenhouse gas. The final aim is to establish an European market for the emission quotas.
During the first three years ( ), the emissions of large combustion plants, such as oil refineries, plants for the production of ferrous metal, mineral goods (concrete, lime, etc.) and the plants for the production of paper and cartboard

6. Market efficiency: A brief recap
In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus.
“The invisible hand” (of the market) maximize the total benefit of society
Markets are usually good instruments to organize the economic activity
Sometimes, however: “markets fail”

7. Externalities: definition and effects
When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality. Whenever they do not take into account the “third party”, the equilibrium prices and quantities are not efficient. Therefore the externalities cause an inefficient allocation of resources, i.e. market failure.

8. The effects of externalities on society
In the presence of externalities:
Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market).
The externalities can be negative or positive
However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged ≠ optimal quantity.

9. Negative externalities
Costs on other individuals (consumers or producers) that are not directly involved in the market exchange.
Example: smoke of cigarettes, cars’ exhaust gas

10. Positive externalities
Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange. Example: Vaccines, restoration of a piece of Art, investment in new technologies.

11. Externalities and market inefficiency
Negative externalities in production
Qmarket > Qoptimum (socially desirable quantity)
social costs > private costs
Positive externalities in production
Qmarket < Qoptimum
social costs < private costs

12. Externalities and market inefficiency
Negative externalities in consumption
Qmarket > Qoptimum (socially desirable quantity)
Social benefit < private benefit
Positive externalities in consumption
Qmarket < Qoptimum
Social benefit > private benefit

13. Negative externalities in production
Social cost
Cost of
pollution
Price of aluminium
Supply
(private cost)
QOPTIMUM
Optimum
Equilibrium
Demand
(private value)
Quantity of aluminium
QMARKET

14. Positive externalities in production
Price of Robot
Supply (private cost)
Value of technological diffusion
Social cost
Optimum
Equilibrium
QOPTIMUM
Demand
(private value)
QMARKET
Quantity
of Robot

15. Negative externalities in consumption
Price of alcoholic drinks
Supply (private cost)
QOPTIMUM
Optimum
Social value
Equilibrium
Demand
(private value)
QMARKET
Quantity of
alcoholic drinks

16. Positive externalities in consumption
Price of education
QOPTIMUM
Optimum
Social value
Supply (private cost)
Equilibrium
Demand
(private value)
QMARKET
Quantity of
education

17. How to obtain Qoptimum? 1. Government intervention
Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities. “To internalize an externality” means to alter market incentive with subsidies and taxes, so as to induce individuals to take adequately into account the external effects of their actions.

18. Obtaining optimal production
If the externality is negative: internalization through a tax – the tax reduces the quantity that is exchanged in equilibrium until the social optimum obtains If the externality is positive: internalization through a subsidy – the subsidy increase the quantity that is exchanged in equilibrium until the social optimum obtains

19. How to obtain Qoptimum? 2. Private solution
Public intervention is not always either necessary or efficacious to deal with externalities.
Example of private solutions:
Ethical codes and social sanctions.
NGOs (in the “no-profit” sector).
Integration of different types of activities.
System of contracts (Coase’s theorem).

20. Externalities and public goods
A case in which externalities are of particular relevance is when we deal with specific types of economic goods, called public goods and common resources
Example: knowledge (technological spillover), environment (pollution)
What are public goods and common resources?

21. Typologies of economic goods
The goods available in our economy can be distinguished along two dimensions:
Excludability
and
Rivalry

22. Typologies of economic goods
Excludability
An individual can be prevented from using a good (e.g. laws usually recognize the private property of a good)

23. Typologies of economic goods
Rivalry
The consumption of a good by an individual prevents the simultaneous consumption of the same good by other individuals

24. Example of a public good: A bridge
A bridge connects two shores of a river
Given a certain dimension of the bridge, if the n. of people using the bridge increases (congestion): consumption rivalry
If there is a fee for the bridge (those who don’t pay cannot use it): consumption excludability

25. Rivalrous Non-rivalrous
Example of the bridge
Free access
Rivalrous
Non-rivalrous
Many
N. people
Few

26. Non-excludable Excludable Example of the bridge Fee yes No
Given number of people

27. Example of the bridge: two-ways table Fee Yes No
Excludable
Rivalrous
Non-excludable
Non-rivalrous
Many
N. people
Few

28. Example of the bridge: two-ways table Fee Yes No
Excludable
Rivalrous
(PRIVATE GOODS)
Non-excludable
(COMMONS)
Excludabe
Non-rivalrous
(NATURAL MONOPOLY)
(PUBLIC GOODS)
Many
N. people
Few

29. Four types of economic goods (1)
Private goods
Both excludable and rivalrous
Example: ice-cream, CDs, etc.
Public goods
Neither excludable nor rivalrous
Example: national defence, scientific knowledge

30. Four types of economic goods (1)
Commons
Rivalrous, but non-excludable
Example: sea fishes
Natural monopoly
Excludable, but non-rivalrous
Example: drinkable water

31. Public goods and externalities
Non-excludable goods  all can benefit without paying the price, p = 0
Access to the good cannot be limited; private value = 0, social value > 0
But: production costs > 0 (scarce resources)
Who is it going to produce the good, if not paid?
Therefore: positive externalities of a public good (autonomously, market produces too few).

32. The problem of free riding
A free rider is a person who can enjoy the benefit of a good without paying the price

33. It is convenient for me NOT to pay!!!
In order to build the bridge, a voluntary contribution equal to 10 is requested…..
The bridge is built
The bridge is not built
I contribute
(I pay 10) 90
- 10
I do not contribute
(I don’t pay)
100
It is convenient for me NOT to pay!!!

34. The problem of free riding
Since public goods are non-excludable, each individual can refuse to pay the good, hoping that other people will pay in his/her place.
If everybody reasons the same, the good is not produced.
IMPORTANT: the presence of free riding makes it impossible to rely on the market to supply public goods.

35. Solution of the free riding problem
If the benefits > costs (social value > 0), public authorities can produce the good by relying on taxes.
Example: fireworks by Moena’s Municipality
500 inhabitants; value for each inhabitant =10 €; cost of fireworks = 1000 €.
Fireworks tax for each inhabitant = 2€, it covers the costs.
Consumer surplus = 8€ (= 10€ - 2€).

36. The need for a State to produces public goods, whose cost is financed via taxes, represents the main economic justification for the existence of taxation (and thus for the fight against tax evasion): that is the “minimum State”.

37. Common resources Common resources are non-excludable
They are freely available for anybody to exploit
But they are rival: the consumption of the good by one individual reduces the possibility for other individual to consume

38. Examples of common resources
Air and clean water
Congested streets
Fishes, whale and other wild species

39. The tragedy of the commons
When an individual, by using a resource, diminishes the availability of the resource for others we encounter the tragedy of the commons.
Common resources tend to be over-exploited
This generates a negative externality.

40. The tragedy of the commons
The public administration can:
Impose a tax on usage;
Regulate the use of the resource;
Transform the common resource in a private good (by defining and enforcing individual property rights on the resource.

41. The importance of property rights
When the absence of property rights is the cause of market failures, public intervention can potentially solve the problem in 3 ways
By defining property rights, which enable the market to operate efficiently;
By regulating individual behaviour;
By producing a good that the market does not supply.

42. Conclusion
When the transaction between consumer and producer has effects on a third party, there is an externality. Negative (positive) externalities imply that the quantity exchanged in the market equilibrium is superior (inferior) to the social optimum. The solution to the problem of externalities can be pursued both by private parties and public intervention

43. Conclusion
Economic goods differ in terms of excludability and rivalry.
The market can function when goods are private i.e. both excludable and rivalrous.
Public goods are neither excludable nor rivalrous, hence the market does not function well.
In because of free riding, it is the public sector who is responsible to supply public goods.

44. Conclusion Collective resources are rivalrous but not excludable.
Since individuals do not pay for the use of the resource, there is a tendency toward over- exploitation.
Public administration may limit the use of common resources via access regulation and taxes