1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 15 Chapter Externalities, Public Goods, Imperfect Information, and Social Choice

2. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 35 Chapter Outline 15 Externalities, Public Goods, Imperfect Information, and Social Choice Externalities and Environmental Economics Marginal Social Cost and Marginal-Cost Pricing Private Choices and External Effects Internalizing Externalities Public (Social) Goods The Characteristics of Public Goods Mixed Goods Income Distribution as a Public Good? Public Provision of Public Goods Optimal Provision of Public Goods Local Provision of Public Goods: Tiebout Hypothesis Imperfect Information Adverse Selection: Asymmetric Information Moral Hazard Market Solutions Government Solutions Social Choice The Voting Paradox Government Inefficiency: Theory of Public Choice Rent-Seeking Revisited Government and the Market

3. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 35 EXTERNALITIES, PUBLIC GOODS, IMPERFECT INFORMATION, AND SOCIAL CHOICE market failure Occurs when resources are misallocated or allocated inefficiently. The existence of externalities, public goods, and imperfect information are examples of market failure.

4. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS externality A cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction. Sometimes called spillovers or neighborhood effects.

5. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS marginal social cost (MSC) The total cost to society of producing an additional unit of a good or service. MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production. MARGINAL SOCIAL COST AND MARGINAL-COST PRICING

6. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS FIGURE 15.1 Profit-Maximizing Perfectly Competitive Firms Will Produce Up to the Point That Price Equals Marginal Cost (P = MC)

7. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS Acid Rain and the Clean Air Act Acid rain is an excellent example of an externality and of the issues and conflicts in dealing with externalities. The case of acid rain highlights the fact that efficiency analysis ignores the distribution of gains and losses. That is, to establish efficiency we need only to demonstrate that the total value of the gains exceeds the total value of the losses. Other Externalities

8. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS PRIVATE CHOICES AND EXTERNAL EFFECTS FIGURE 15.2 Externalities in a College Dormitory

9. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS marginal damage cost (MDC) The additional harm done by increasing the level of an externality-producing activity by one unit. If producing product X pollutes the water in a river, MDC is the additional cost imposed by the added pollution that results from increasing output by one unit of X per period. When economic decisions ignore external costs, whether those costs are borne by one person or by society, those decisions are likely to be inefficient. marginal private cost (MPC) The amount that a consumer pays to consume an additional unit of a particular good.

10. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS INTERNALIZING EXTERNALITIES Five approaches have been taken to solving the problem of externalities: (1) government-imposed taxes and subsidies, (2) private bargaining and negotiation, (3) legal rules and procedures, (4) sale or auctioning of rights to impose externalities, and (5) direct government regulation.

11. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS Taxes and Subsidies FIGURE 15.3 Tax Imposed on a Firm Equal to Marginal Damage Cost

12. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS Bargaining and Negotiation Coase theorem Under certain conditions, when externalities are present, private parties can arrive at the efficient solution without government involvement.

13. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS Legal Rules and Procedures injunction A court order forbidding the continuation of behavior that leads to damages. liability rules Laws that require A to compensate B for damages imposed.

14. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS Selling or Auctioning Pollution Rights Singapore is known for its many laws designed to reduce negative externalities. Littering, chewing gum in public, eating on a subway car, failing to flush a toilet, and vandalizing public property are all considered serious offenses that are punishable by imprisonment, fines, and/or public chastisement.

15. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 35 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS Direct Regulation of Externalities Taxes, subsidies, legal rules, and public auction are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against their benefits. Direct regulation of externalities takes place at the federal, state, and local level.

16. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 35 PUBLIC (SOCIAL) GOODS public goods (social or collective goods) Goods that are nonrival in consumption and/or their benefits are nonexcludable. In an unregulated market economy with no government to see that they are produced, public goods would at best be produced in insufficient quantity and at worst not produced at all.

17. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 35 PUBLIC (SOCIAL) GOODS nonrival in consumption A characteristic of public goods: One person’s enjoyment of the benefits of a public good does not interfere with another’s consumption of it. THE CHARACTERISTICS OF PUBLIC GOODS nonexcludable A characteristic of most public goods: Once a good is produced, no one can be excluded from enjoying its benefits.

18. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 35 PUBLIC (SOCIAL) GOODS free-rider problem A problem intrinsic to public goods: Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them. drop-in-the-bucket problem A problem intrinsic to public goods: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays. Consumers acting in their own self-interest have no incentive to contribute voluntarily to the production of public goods. Some will feel a moral responsibility or social pressure to contribute, and those people indeed may do so. Nevertheless, the economic incentive is missing, and most people do not find room in their budgets for many voluntary payments.

19. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 35 PUBLIC (SOCIAL) GOODS MIXED GOODS mixed goods Goods that have characteristics that are part public and part private. INCOME DISTRIBUTION AS A PUBLIC GOOD? If we accept the idea that redistributing income generates a public good, private endeavors may fail to do what we want them to do, and government involvement may be called for. PUBLIC PROVISION OF PUBLIC GOODS When members of society get together to form a government, they do so to provide themselves with goods and services that will not be provided if they act separately.

20. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 35 PUBLIC (SOCIAL) GOODS OPTIMAL PROVISION OF PUBLIC GOODS Samuelson’s Theory FIGURE 15.4 With Private Goods, Consumers Decide What Quantity to Buy; Market Demand Is the Sum of Those Quantities at Each Price The price mechanism forces people to reveal what they want, and it forces firms to produce only what people are willing to pay for, but it works this way only because exclusion is possible.

21. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 35 PUBLIC (SOCIAL) GOODS FIGURE 15.5 With Public Goods, There Is Only One Level of Output, and Consumers Are Willing to Pay Different Amounts for Each Level For private goods, market demand is the horizontal sum of individual demand curves—we add the different quantities that households consume (as measured on the horizontal axis). For public goods, market demand is the vertical sum of individual demand curves—we add the different amounts that households are willing to pay to obtain each level of output (as measured on the vertical axis).

22. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 35 PUBLIC (SOCIAL) GOODS FIGURE 15.6 Optimal Production of a Public Good

23. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 35 PUBLIC (SOCIAL) GOODS optimal level of provision for public goods The level at which resources are drawn from the production of other goods and services only to the extent that people want the public good and are willing to pay for it. At this level, society’s willingness to pay per unit is equal to the marginal cost of producing the good. At the optimal level, society’s total willingness to pay per unit is equal to the marginal cost of producing the good.

24. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 35 PUBLIC (SOCIAL) GOODS The Problems of Optimal Provision To produce the optimal amount of each public good, the government must know something that it cannot possibly know—everyone’s preferences.

25. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 35 PUBLIC (SOCIAL) GOODS Tiebout hypothesis An efficient mix of public goods is produced when local land/housing prices and taxes come to reflect consumer preferences just as they do in the market for private goods. LOCAL PROVISION OF PUBLIC GOODS: TIEBOUT HYPOTHESIS

26. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 35 IMPERFECT INFORMATION adverse selection Can occur when a buyer or seller enters into an exchange with another party who has more information. ADVERSE SELECTION: ASYMMETRIC INFORMATION

27. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 35 IMPERFECT INFORMATION moral hazard Arises when one party to a contract passes the cost of its behavior on to the other party to the contract. MORAL HAZARD It is impossible to know everything about behavior and intentions. If a contract absolves one party of the consequences of its action, and people act in their own self-interest, the result is inefficient.

28. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 35 IMPERFECT INFORMATION MARKET SOLUTIONS Like consumers, profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs. GOVERNMENT SOLUTIONS Information is essentially a public good and is nonrival in consumption. When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody. There is an efficient quantity of information production.

29. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 35 SOCIAL CHOICE social choice The problem of deciding what society wants. The process of adding up individual preferences to make a choice for society as a whole.

30. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 35 SOCIAL CHOICE THE VOTING PARADOX impossibility theorem A proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent, nonarbitrary results.

31. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 35 SOCIAL CHOICE FIGURE 15.7 Preferences of Three Top University Officials TABLE 15.1 Results of Voting on University’s Plans: The Voting Paradox VOTES OF: VoteVP1VP2DeanResult a A versus BABAA wins: A > B B versus CBBCB wins: B > C C versus AACCC wins: C > A a A > B is read “A is preferred to B.”

32. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 35 SOCIAL CHOICE voting paradox A simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem. logrolling Occurs when congressional representatives trade votes, agreeing to help each other get certain pieces of legislation passed.

33. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 35 SOCIAL CHOICE GOVERNMENT INEFFICIENCY: THEORY OF PUBLIC CHOICE To understand the way government functions, we need to look less at the preferences of individual members of society and more at the incentive structures that exist around public officials. RENT-SEEKING REVISITED Theory may suggest that unregulated markets fail to produce an efficient allocation of resources. This should not lead you to the conclusion that government involvement necessarily leads to efficiency. There are reasons to believe that government attempts to produce the right goods and services in the right quantities efficiently may fail.

34. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 35 GOVERNMENT AND THE MARKET GOVERNMENT INEFFICIENCY: THEORY OF PUBLIC CHOICE There is no question that government must be involved in both the provision of public goods and the control of externalities. The question is not whether we need government involvement. The question is how much and what kind of government involvement we should have.

35. CHAPTER 15: Externalities, Public Goods, Imperfect Information, and Social Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 35 adverse selection Coase theorem drop-in-the-bucket problem externality free-rider problem impossibility theorem injunction liability rules logrolling marginal damage cost (MDC) marginal private cost (MPC) marginal social cost (MSC) REVIEW TERMS AND CONCEPTS market failure mixed good moral hazard nonexcludable nonrival in consumption optimal level of provision for public goods public goods (social or collective goods) social choice Tiebout hypothesis voting paradox