1. Externalities and Public Goods
Chapter 18
Externalities and Public Goods

2. Externalities
Externalities arise between producers, between consumers, or between producers and consumers
Externalities are the effects of production and consumption activities not directly reflected in the market
They can be negative or positive
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3. Externalities Negative
Action by one party imposes a cost on another party
Plant dumps waste in a river, affecting those downstream
The firm has no incentive to account for the external costs that it imposes on those downstream
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4. Externalities Positive Action by one party benefits another party
Homeowner plants a beautiful garden where all the neighbors benefit from it
Homeowner did not take their benefits into account when deciding to plant
Immunizations another example
Education….
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5. Negative Externalities and Inefficiency
Scenario – plant dumping waste
Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production
Marginal Social Cost (MSC) is MC plus MEC
We can show the competitive market firm decision and the market demand and supply curves
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6. Negative Externalities and Inefficiency
The MC curve for the firm is the marginal cost of production
Firm maximizes profit by producing where MC equals price in a competitive firm
As firm output increases, external costs on fishermen also increase, measured by the marginal external cost curve
From a social point of view, the firm produces too much output
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7. The profit maximizing firm efficient output level is q*.
External Costs
There is MEC of production from the waste released. The MSC is true cost of production.
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
Firm will produce q1 at P1.
MSC
Price
Price MC
MSCI D
S = MCI P* Q* P1 P1 Q1 q* q1
MECI
MEC
Firm output
Industry output
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8. External Costs MC S = MCI D P1 q1 Q1 MSC MSCI MEC MECI q* P* Q* Price
By not producing at the efficient level, there is a social cost on society. MC
S = MCI D P1 q1 Q1
MSC
MSCI
Firm output
Price
Industry output
MEC
MECI q* P* Q*
Aggregate
social cost of
negative
externality
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9. External Cost
Negative externalities encourage inefficient firms to remain in the industry and create excessive production in the long run
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10. Positive Externalities and Inefficiency
Externalities can also result in too little production, as can be shown in an example of immunizations
Immunizations generate external benefits to the neighbors, community, etc.
Shown by the Marginal External Benefit curve (MEB)
Marginal Social Benefit (MSB) curve adds MEB +D
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11. External Benefits Value MSB D P1 MC P* MEB Immunizations q1 q*
When there are positive
externalities (the benefits
of immunizations to others),
marginal social benefits
(MSB) are higher than
marginal private benefits (D). D MC P1 q* P* q1
A self-interested individual
invests q1 in immunizations. The
efficient level of immunizations
q* is higher. The higher price
P1 discourages them.
MEB
Immunizations
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12. Ways of Correcting Market Failure
Assumption: The market failure is pollution
Output decision and emissions decision are independent
Firm has chosen its profit-maximizing output level
MSC is marginal social cost of emissions
Equivalent to MEC from before
Upward sloping because of substantially increasing harm as pollution increases
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13. The Efficient Level of Emissions
Dollars/ Unit
of Emissions
MSC
MCA E0 6
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost. 4
At E1 the marginal
social cost is greater
than the marginal cost of abatement. E1
The efficient level of
emissions is where
MCA = MSC. E* 2
Level of Emissions 2 4 6 8 10 12 14 16 18 20 22 24 26
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14. Ways of Correcting Market Failure
MCA is marginal cost of abating emissions
Additional cost to firm of controlling pollution
Downward sloping because when emissions are high, there is little cost to controlling them
Large reductions require costly changes in production process
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15. Ways of Correcting Market Failure
If the firm does not consider abatement, their profit maximizing level is 26 units of emissions
Level where MCA is zero
The socially efficient level of emissions is 12 where the MSC equals the MCA
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16. The Efficient Level of Emissions
Dollars/ Unit
of Emissions
MSC
MCA E0 6
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost. 4
At E1 the marginal
social cost is greater
than the marginal cost of abatement. E1
The efficient level of
emissions is where
MCA = MSC. E* 2
Level of Emissions 2 4 6 8 10 12 14 16 18 20 22 24 26
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17. Ways of Correcting Market Failure
Firms can be encouraged to reduce emissions to the efficient level in three ways:
Emissions standards
Emissions fees
Transferable emissions permits
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18. Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emissions Standard
Set a legal limit on emissions at E* (12)
Enforced by monetary and criminal penalties
Increases the cost of production and the threshold price to enter the industry
Emissions Fee
Charge levied on each unit of emission
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19. Standards and Fees MSC 3 MCA E* 12 Standard Fee Dollars/ Unit
of Emissions
MSC
MCA 3 12 E*
Standard
Fee
Level of Emissions
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20. Standards and Fees MSC E* 3 MCA 12 Cost is less than the
Dollars/ Unit
of Emissions
MSC
MCA
Cost is less than the
fee if emissions were
not reduced. E*
Fee 3
Total Fee
of Abatement
Total
Abatement Cost 12
Level of Emissions
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21. Ways of Correcting Market Failure
Fees vs. Standards
Standards yield more certainty on emissions levels and less certainty on the cost of abatement
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22. Ways of Correcting Market Failure
Fees vs. Standards
Fees have certainty on cost and uncertainty on emissions
Preferred policy depends on the nature of uncertainty and the slopes of the cost curves
What if we don’t know costs and benefits AND if firms costs vary?
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23. Ways of Correcting Market Failure
Transferable Emissions Permits
Permits help develop a competitive market for externalities
Agency determines the level of emissions and number of permits
Permits are marketable
High cost firm will purchase permits from low cost firms
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24. Ways of Correcting Market Failure
The market for externalities is appealing since it combines the system of standards with the system of fees (as well as its use of the market)
The agency who administers the system determines the total number of permits and therefore the total amount of emissions
Marketability of the permits allows pollution abatement to be achieved at minimum cost
Don’t need to know firm’s individual costs --- those with high costs will buy permits from lower cost firms
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25. In Sum The total cost of abatement for the industry is reduced
Not every firm is subject to a standard
The entire industry is subject to a standard
Results in minimizing abatement costs from the point of view of the industry as a whole
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26. Public Goods Characteristics Nonrival: fireworks display Nonexclusive
For any given level of production, the marginal cost of providing it to an additional consumer is zero
One person’s consumption of the good does not preclude another
Nonexclusive
People cannot be excluded from consuming the good – makes it difficult or impossible to charge for their use
Example – lighthouse, national defense
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27. Public Goods Non-rival but exclusive Nonexclusive but rival
TV signal
Bridge
Concert
Nonexclusive but rival
Ocean in some respects like fishing
National Forests & logging
Don’t confuse positive externalities with public goods (education?)
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28. Efficiency and Public Goods
Efficient level of private good is where marginal benefit equals marginal cost: S = D
Same principle applies to pubic goods – just measured differently
For a public good, the value of each person must be considered
Can add demand of all those who value good
Calculated differently than for private goods
Must equate the sum of these marginal benefits to the marginal cost of production
Previously added quantities at each price: NOW – add prices at each quantity
Vertical addition as opposed to horizontal addition
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29. Efficient Public Good Provision
Benefits
(dollars)
D1 is demand for consumer 1.
D2 is demand for consumer 2.
D is total demand for all consumers. D
$7.00
$5.50 MC D2
$4.00
Efficient output occurs
where MC = total MB
2 units of output.
MB is $ $4.00 or $5.50. D1
$1.50
Output
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30. Public Goods and Market Failure
Free Riders
There is no way to provide some goods and services without benefiting everyone
Households do not have the incentive to pay what the item is worth to them
Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it
Public goods thus provided by governments if to be produced efficiently
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31. The Demand for Clean Air
Clean Air is a public good
Nonexclusive and nonrival
No market and no observable price at which people are willing to trade clean air for other goods
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32. The Demand for Clean Air
Choosing where to live
Study in Boston correlates housing prices with the quality of air and other characteristics of the houses and their neighborhoods
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33. The Demand for Clean Air
Dollars
Low Income
Middle Income
High Income
3000
2500
2000
1500
1000
500
Nitrogen Oxides
(pphm) 1 2 3 4 5 6 7 8 9 10
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34. The Demand for Clean Air
Findings
The amount of people who are willing to pay for clean air increases substantially as pollution increases
Higher income earners are willing to pay more (the gap between the demand curves widen)
National Academy of Sciences found that a 10% reduction in auto emissions yielded a benefit of $2 billion---somewhat greater than the cost
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