1. Externalities and Public Goods
Chapter 20
Externalities and Public Goods
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Main Topics Externalities and inefficiency
Remedies for externalities: the private sector
Remedies for externalities: the public sector
Common property resources
Public goods
20-2

3. Externalities
Competitive markets may not allocate resources efficiently when the assumptions of the model are violated
Example: assumed that each consumer’s well-being depends only on her own consumption
An action creates an externality if it affects someone with whom the decision-maker has not engaged in a related market transaction
Negative externality if it harms someone else
Polluting causes health problems in a community, neglecting a garden reduces neighbors’ home values
Positive externality if it benefits someone else
Pollution abatement reduces health effects on community, carefully tended garden raises the value of surrounding homes
20-3

4. Negative Externalities and Inefficiency
Presence of a negative externality in a competitive market will usually allocate economic resources inefficiently
An external cost is the economic harm that a negative externality imposes on others
Each firm produces up to the point at which its marginal cost curve equals the market price
But socially efficient level of production for any particular firm equates marginal social cost and marginal social benefit
Marginal social cost = marginal cost to the producer + marginal external cost
Therefore the firm’s equilibrium production level is socially excessive and inefficient
20-4

5. Negative Externalities and Inefficiency
Similar result holds for the entire market
When firms ignore external costs, they are willing to produce too much output at any given price
The good is priced too cheaply in equilibrium
Because output is priced incorrectly, consumers demand too much
The externality creates deadweight loss
Society’s loss equals the vertical distance between the demand curve and the marginal social cost curve
20-5

6. Figure 20.1: Negative Externality in a Competitive Market
20-6

7. Positive Externalities and Inefficiency
Competitive equilibria are inefficient when either positive or negative externalities are present
An external benefit is the economic gain that a positive externality provides to others
Firm output will be inefficiently low from society’s perspective
Like a negative externality, a positive externality creates deadweight loss
20-7

8. Figure 20.2: Positive Externality in a Competitive Market
20-8

9. Remedies for Externalities: Private Sector
Whenever the allocation of resources is inefficient it is possible to arrange mutually beneficial trades
Private parties thus have incentives to identify inefficiencies and negotiate solutions
When private negotiations fail to address market failures associated with externalities, government policies can potentially improve economic efficiency
Policies that support markets (e.g., establishing clear property rights)
Quantity controls (e.g., emissions standards)
Policies that correct private incentives (e.g., taxes, fees, subsidies)
20-9

10. Property Rights and Negotiation
Outcome of a negotiation depends on the parties’ property rights
Party who holds the relevant property rights is in a stronger bargaining position
Usually emerges with a more favorable deal
Assignment of property rights does not affect the level of pollution but does affect profits
Coase theorem: regardless of how property rights are assigned, voluntary agreements will remedy externalities
If bargaining is frictionless
Sometimes used as a justification for laissez faire policies
Coase did not believe that bargaining is frictionless
20-10

11. Limitations of Bargaining
Every externality can be traced to missing markets
Private negotiations lead to transactions that the parties would have made if the required markets weren’t missing
Many factors that cause externalities also hinder bargaining
Bargaining can be impractical
Difficult logistics, substantial time and effort
Property rights may be ambiguous
Limited information can lead to an impasse
Contracts may be difficult to enforce
20-11

12. Quantity Controls
Government can attempt to address an externality by regulating the activity that produces it
An emissions standard is a legal limit on the amount of pollution that a person or company can produce
When engaged in a particular activity
Example: Aircraft noise abatement
Setting a socially efficient abatement standard requires information about abatement costs and benefits
Private parties may have an incentive to exaggerate their costs (or benefits)
Government may have trouble learning the truth
Can lead to an inefficient standard and deadweight loss
20-12

13. Policies that Correct Private Incentives
Some policies address externalities by forcing people to internalize external costs and benefits
Impose taxes or fees, provide subsidies, expose decision-makers to legal liability
Pigouvian taxation involves the use of taxes or fees to remedy negative externalities
A Pigouvian tax forces a decision-maker to internalize the marginal external costs associated with her activity
Weigh it against marginal benefit
Make a socially efficient decision
Ideal Pigouvian tax reproduces the price that the good in question would command in an efficient competitive equilibrium
20-13

14. Figure 20.5: Pigouvian Tax on Noise
Airline produces noise up to the point where MCA equals the tax of $10,000 per decibel
Socially efficient outcome is achieved, with noise at 80 decibels
20-14

15. Liability Rules
Another mechanism for addressing negative externalities
Under a liability rule a party who takes an action that harms others must compensate the affected parties for their losses
Liability rules induce decision-makers to internalize all external costs
Lead to efficient choices
In some cases, the government needs less information to effectively use a liability rule than an emissions standard or Pigouvian tax
Liability rules raise other difficulties because of their legal nature
20-15

16. Pitfalls for Policies that Correct Private Incentives
Liability rules and Pigouvian taxes both force decision-makers to internalize harm caused to others
But harms often have multiple causes
In such cases efforts to correct private incentives can lead to inefficiency
Typical liability rule holds one source of external cost accountable
Inefficient if more than one group’s choices contribute to the external costs
Ideal rule would force all parties contributing to the externality to bear a portion of the social costs
20-16

17. Consequences of Policy Errors
Errors in setting a tax vs. a standard may have different implications for efficiency
This consideration can provide a reason for preferring one approach over the other
Which policy is better?
Depends on the slopes of the marginal social cost (MSC) and marginal cost of abatement (MCA) curves
Standard is superior when the MCA curve is relatively flat and the MSC curve is relatively steep
Tax is superior when the MCA curve is relatively steep and the MSC curve is relatively flat
20-17

18. Figure 20.8: Consequences of Policy Errors
20-18

19. Minimizing Total Cost of Abatement
External costs of pollution may depend on the total emission of many parties
In so, an emissions tax guarantees that reduction in the overall level of pollution will be achieved at the lowest possible cost
Emissions standard does not guarantee this
Each firm will pollute up to the point at which the marginal cost of abatement equals the tax rate
Firms produce different amounts of pollution but will share the same marginal cost of abatement
Any change in firms’ emissions that leaves total pollution unchanged will increase overall abatement costs
20-19

20. Figure 20.9: Emissions Tax
20-20

21. Tradable Emissions Permits
A tradable emissions permit entitles a firm to generate a specified amount of a given pollutant
Transferable, one firm can sell it to another
Total emissions are limited by the number of permits the government issues
Enables the government to reduce the level of pollution to any desired target
Can achieve any given reduction in total emissions at the lowest possible abatement cost
Competitive market for permits may emerge
Each firm will generate pollution up to the point at which marginal cost of abatement equals the market price of a permit
Note that the market does not set the level of pollution
20-21

22. Sample Problem 1 (20.8):
Inoculations create external benefits by reducing other people’s exposure to communicable diseases. Suppose the market demand curve for inoculations is Qd = P, where Qd is millions of inoculations and P is the price per inoculation. Suppose also that the market for inoculations is competitive and that the market supply curve is
Qd = 2P - 8. Finally, suppose that the marginal external benefit of inoculations is MEB = Q. Find thee socially efficient level of inoculations, the competitive equilibrium, the deadweight loss created by the externality, and the optimal Pigouvian subsidy.

23. Common Property Resources
A common property resource is a resource that more than one person is free to use without payment
Examples: Lakes, air, oceans
Generally, each person’s use of a common property resource reduces its value to others
Creates a negative externality
Consider a large lake, the only source of fish for nearby towns, where anyone can become a fisherman free of charge
The marginal social cost of fishing exceeds the marginal private cost
Each fisherman fails to account for the fact that his decision to catch fish reduces the fish population and raises the cost of fishing for future fishermen
Competitive level of fishing is socially excessive
Remedies for market failures associated with common property resources are the same as for negative externalities
20-23

24. Figure 20.13: Common Property Resources and Overfishing
Fish (pounds)
Price per pound of fish ($)
MSC
MEC
2000
Dmarket
Smarket
1500
Qefficient
1000
Qequilib
500
20-24

25. Public Goods: Basics A public good is nonrival and nonexcludable
A good is nonrival if more than one person can consume it at the same time without affecting its value to others
Marginal cost of providing it is zero
A good is nonexcludable if there is no way to prevent a person from consuming it
Examples of public goods: national defense, construction of lighthouses
Governments often provide public goods
Not all goods provided by a government are public goods
20-25

26. Efficient Provision of Public Goods
Socially efficient level of production is where marginal social cost equals marginal social benefit
Whether good is private or public
To determine the marginal social benefit of a public good, add up the gains to all affected individuals
Important difference from process for private good
Sum individual curves vertically for a public good
Example: security patrols on a city block
Three stores would receive marginal benefit of $7.50, $45, and $40 from the first hour of patrolling
Marginal social benefit is the vertical sum, $92.50, for a quantity of one hour
20-26

27. Figure 20.14: Provision of a Public Good
20-27

28. Public Goods and Market Failure
If someone decides to contribute to a public good, other people will benefit
The contribution creates a positive externality
Competitive markets produce too little output when positive externalities are present
If provision of a public good is left entirely to the independent actions of private parties, the level of production will be inefficiently low
Market failure associated with public goods is due to free riding
A free rider contributes little or nothing to a public good while benefiting from others’ contributions
20-28

29. Public Policy Toward Public Goods
Governments address the market failures associated with public goods in a variety of ways:
Provide some public goods (national defense)
Contribute to non-profit organizations that provide them (public radio and television)
Subsidize private contributions to many public goods (environmental protection)
Subsidization often takes the form of tax deductibility for contributions to charitable causes that support public goods
These are variants of the methods used to address externalities
Efficient public provision of a public good need not entail public production
Market failure of public goods related to demand, not production
Governments often rely on the private sector to produce public goods
Example: U.S. obtains military equipment from private defense contractors
20-29

30. Gathering Reliable Information
To provide a public good efficiently, the government must have information about individual preferences
Cannot simply ask; answers will depend on who consumers expect to foot the bill for the public good
A Groves mechanism is a way to set the level of a public good that induces everyone to report their preferences correctly
Produces a socially efficient outcome
Ask each citizen to report the total benefit he would receive from the public good
Calculate teach individual’s marginal benefit as though he told the truth
Each consumer’s contribution toward the public good is based on the quantity of public good that would be optimal with and without his reported benefits
Consumer will be worse off if he exaggerates or understates his benefits than if he tells the truth
Groves mechanism gives consumers a strong incentive to tell the truth
20-30

31. Figure 20.15: The Groves Mechanism
20-31

32. Public Decision-Making
The field of political economy examines the economic consequences of public sector decision-making
Example: determine whether public intervention is justified
Weigh the consequences of a market failure against the likely consequences of a government failure
When markets fail, the public sector may be able to improve the allocation of resources, in principle
Do democratic mechanisms promote socially efficient government decision-making?
Assume a policy is overturned if more than 50% of voters prefer an alternative
20-32

33. Median Voter Theorem
Median voter theorem: if voters have single-peaked preferences, a majority of them prefer the median ideal policy to all others
A voter’s preferences are single-peaked if her net benefit from an activity increases with the activity’s level until her ideal is reached
Declines thereafter
Median voter is the voter who has the median ideal policy among all voters
Majority rule leads to the selection of the median ideal policy
20-33

34. Figure 20.16: Majority Rule and the Level of a Public Good
20-34

35. Sample Problem 2 (20.13):
Give three examples of public goods, other than the ones discussed in the text. Explain why they are nonrival and nonexcludable (or at least approximately so).
From the text: national defense, lighthouses, pest control.