Externalities and Public Goods DERYA GÜLTEKİN-KARAKAŞ Chapter 18 Externalities and Public Goods DERYA GÜLTEKİN-KARAKAŞ 1

Topics to be Discussed Externalities Public Goods Chapter 18 2

Externalities Negative Positive Action by one party imposes a cost on another party Positive Action by one party benefits another party Chapter 18 4

External Cost Scenario Steel plant dumping waste in a river The entire steel market effluent can be reduced by lowering output (fixed proportions production function) Chapter 18 5

External Cost Scenario Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. Marginal Social Cost (MSC) is MC plus MEC. Chapter 18 6

External Costs Firmaların MC eğrilerinin P1 q1 Q1 MSC MSCI MEC MECI q* When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. MEC MECI The differences is the marginal external cost MEC. q* P* Q* The industry competitive output is Q1 while the efficient level is Q*. The profit maximizing firm produces at q1 while the efficient output level is q*. Price Price MC S = MCI D P1 Aggregate social cost of negative externality Firm output Industry output Firmaların MC eğrilerinin 16

External Cost Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run. Chapter 18 17

Externalities Positive Externalities and Inefficiency Externalities can also result in too little production, as can be shown in an example of home repair and landscaping. Chapter 18 18

External Benefits Value MSB D P1 MC P* MEB Repair Level q* q1 When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. q* P* A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair. D MC P1 q1 Is research and development discouraged by positive externalities? Repair Level Chapter 18 25

Public Goods Question When should government replace firms as the producer of goods and services? Chapter 18 100

Public Goods Public Good Characteristics Nonrival For any given level of production the marginal cost of providing it to an additional consumer is zero. Nonexclusive People cannot be excluded from consuming the good. Chapter 18 101

Public Goods Not all government produced goods are public goods Some are rival and exclusive Education Parks Chapter 18 102

Efficient Public Good Provision Benefits (dollars) D1 D2 D When a good is nonrival, the social marginal benefit of consumption (D) , is determined by vertically summing the individual demand curves for the good. $7.00 $5.50 Marginal Cost $1.50 Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50. $4.00 Output 1 2 3 4 5 6 7 8 9 10 Chapter 18 105

Public Goods Public Goods and Market Failure How much national defense did you consume last week? Chapter 18 106

Public Goods 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. Chapter 18 107

Public Goods Establishing a mosquito abatement company How do you measure output? Who do you charge? A mosquito meter? Chapter 18 108