1. Externalities and Public Goods
From free-riding to the
Coase theorem

2. Externalities and Public Goods
Up until now we have made several implicit assumptions when analysing “agents”
Agents are independent : their welfare depends only on their own consumption / production decisions
But maybe people’s satisfaction/welfare depends indirectly on what other people decide?
Does this influence the market outcome? How?
How can these effects be taken into account?

3. Externalities and Public Goods
The characteristics of goods are “well behaved”
Goods and services are always clearly defined, dividable into measurable units and exchangeable on a specified market
But what about goods or services that can’t be divided, valued (priced), or exchanged on a market?
What does economics have to say about these kinds of goods?

4. Externalities and Public Goods
Public goods and free riding
Externalities and inefficiency
The Coase theorem

5. Public goods and free riding
Goods can be classified according to two fundamental, intrinsic properties :
Rivalry : Two agents cannot simultaneously benefit from the consumption of a given unit of a good
Exclusion (through price): an agent can only dispose of a given unit of a good once he has paid its price. This concept is closely linked to the existence of property rights.

6. Public goods and free riding
Typology of goods
Exclusion Possible?
Yes No
Rival?
Private Good
Car, medical drugs
Impure Public good
Congested road
14th July Fireworks
Club Good
Pay per view TV, Patents
Public Good
Public lights
Defence

7. Public goods and free riding
A “pure” public good satisfies three conditions:
1. Impossibility of exclusion (possibility of freeriding)
One cannot restrict the use of the good to specific agents (i.e. To those who pay)
Examples:
Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?

8. Public goods and free riding
A “pure” public good satisfies three conditions:
2. Non-congestion (Non-rivalry)
The satisfaction obtained from the good does not depend on the number of users
Examples:
Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?

9. Public goods and free riding
A “pure” public good satisfies three conditions:
3. Compulsory consumption
The agent cannot decide not to consume the good (has no choice in the matter)
Examples:
Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?

10. Public goods and free riding
As a result, for public goods, the coordination of agents cannot happen on the market
Everybody is a consumer whether they want it or not.
A supplier of the public good cannot exclude people who refuse to pay the good (free riders)
This supplier has not way of recuperating his costs
There is a market failure on public goods: they will not be provided on a free market

11. Public goods and free riding
The central aspect of this was shown by Ronald Coase
Free-riding and externalities occur when property rights are either:
Not defined: who owns light of a lighthouse or the security provided by a police force?
Not enforceable: there is a lack of institutions to enforce the property rights (example: “free” internet downloads)
As a result, there is no market to extract compensation from freeriders

12. Externalities and Public Goods
Public goods and free riding
Externalities and inefficiency
The Coase theorem

13. Externalities and inefficiency
An externality is a possible cause of market failures.
It corresponds to the direct (non-market) impact of an agents decision on another agent’s welfare
External economies, external effects, externalities
In production (the bees and orchard example)
In consumption (internet or telephone)
This impact can be negative or positive
Negative : leads to over-investment
Positive : leads to under-investment

14. Externalities and inefficiency
Definition of a negative externality
The Marginal social cost (msC) is larger that the marginal private cost (mpC)
msC > mpC
In other words, I do not bear all the costs of my production/consumption decisions,
Some costs “leak” out and are borne by other agents

15. Externalities and inefficiency
msC C
mpC
The polluter pays principle internalises the externality by making the polluter carry the negative externality p* q* q1
Marginal external cost q

16. Externalities and inefficiency
Example of negative production externalities
The effect of oil spills on local fishermen
My neighbour's trees shading my garden from the sun
Examples of negative consumption externalities
Smokers in restaurants
Neighbours playing techno very loudly at 3am!

17. Externalities and inefficiency
What policies can be used to remove the inefficiency ?
Regulation (emission standards, smoking bans)
Taxation (problem: what is the optimal level of taxes what is the size of the externality?)
Importantly, in terms of policy there is an optimal level of pollution !!
It is not socially desirable to reduce it to zero.

18. Externalities and inefficiency
Definition of a positive externality
The Marginal social benefit (msB) is larger that the marginal private benefit (mpB)
msB > mpB
In other words, I do not reap all the benefits of my production/consumption decisions,
some benefits “leak” out and benefit other agents

19. Externalities and inefficiencyB
mpB
Example : intellectual property rights attempt to increase the marginal private benefit by capturing the externality
msB p*
Marginal external benefit q1 q* q

20. Externalities and inefficiency
Example of positive production externalities
The classical bees/orchard example
Technological innovations (spillovers)
Examples of positive consumption externalities
Network goods (internet, telephone)
Homeownership
Education
Vaccination

21. Externalities and inefficiency
What policies can be used to remove the inefficiency ?
Subsidies (tax deductions on mortgages, public network infrastructure investment)
Intellectual property rights (IPR)
Regulations
As for the optimal level of pollution, there is an optimal level of intellectual protection!
It is not socially desirable to reduce IPR to zero

22. Externalities and Public Goods
Public goods and free riding
Externalities and inefficiency
The Coase theorem

23. The Coase theorem Named after Ronald Coase (Nobel 1991)
No state intervention is required to correct externalities if:
There are defined property rights (remember what was said above)
There are no transaction costs between agents
In this ideal case, all the state has to do is define some property rights, and the market will internalise the externality

24. The Coase theorem Coase’s initial work: Radio stations
Initially, no frequency bands are defined: radio stations can interfere
Negative production externality
The state needs to create frequency bands
enforceable property rights
Interactions between agents produce :
The allocation of these bands between the various radio stations
The compensation of externalities is carried out by transactions between stations

25. The Coase theorem In real life, however, transaction costs exist
Asymmetric/imperfect information about the externality
Proving the existence of an externality can take a lot of time and effort (see Erin Brockovich vs Pacific Gas),
Asymmetric relations between agents
Imagine a litigation between a big chemical consortium and a local association on pollution.
What is the likelihood of the association making its case with no external help ?

26. The Coase theorem
In that case, a 2nd role appears for the state: Reduce transactions costs between agents
Encourage the creation of consumers rights associations (increase coordination between agents)
Create environmental watchdogs with a monitoring mission (reduces the information asymmetries)
Reinforce legal / mediation /dispute resolution institutions (reduces the transaction costs)

27. The Coase theorem
This decentralised approach to reducing externalities is becoming increasingly popular
In theory it is cheaper: Taxes on pollution do provide an income, but monitoring costs are usually higher
In theory it is also more efficient: The state doesn’t need to figure out what the size of the externality is, which is a problem with taxation or regulation
Recent example: the market for Carbon dioxide