Externalities & Public Goods Econ 206(A) Tutorial 8 Externalities & Public Goods

Seminar Topic 1 Is the market always the most efficient solution to the problem of resource allocation?

Externalities Defn: indirect products of production or consumption (can be positive or negative) In the presence of externalities, the market mechanism does not produce the optimum level of production. In this case we have `market failure’ (social optimum does not equal private optimum)

Seminar Topic 2 What is meant by social opportunity cost? Provide examples.

Negative Externalities Social Cost incorporates private opportunity cost (given by market supply) and social opportunity cost. Production externalities affect supply. Social cost > private cost when there are negative externalities. The market produces too much of a good/service.

Negative Externalities in Production MSC Price, p MPC = S E* p* E1 p1 MPB = D q* q1 Quantity, q

Positive Externalities - Production Social cost < private cost when there are positive production externalities. For instance: production of the good by one firm reduces the cost of production of other firms. The market produces too little of a good/service. An example is general training provided by firms.

Externalities in Production: Benefits Price, p MPC = S MSC E1 p1 E* p* MPB = D q1 q* Quantity, q

Externalities in Consumption Negative: Social benefit < Private Benefit when there are negative consumption externalities. i.e. another individuals consumption of a good, reduces others benefit. For instance; negative effects of car travel on others consumption (pollution, increased congestion). Too much is consumed in the market

Externalities in Consumption: Costs Price, p E* E1 s p* MPB = D MSB q* q1 Quantity, q

Externalities in Consumption Positive: Private Benefit < Social Benefit when there are positive consumption externalities. i.e. another individuals consumption of a good increases others benefit. For instance; increased use of public transport reduces traffic congestion and increases others benefit from less congestion, pollution etc. Too little is consumed in the market (from society’s point of view)

Externalities in Consumption: Benefits Price, p E1 E* s p* MSB MPB = D q1 q* Quantity, q

Market Failure Where the market produces a sub-optimal level of production (either too little or too much). This occurs because producers and consumers do not consider the full `social’ costs (or benefits) of production/consumption when making economic decisions.

Seminar Topic 3 Should students contribute to the cost of their university education?

Private vs Public Goods Public goods have the following features: They are non-rival (consumption of the good/service by one individual does not reduces its value to others) They are non-excludable. You cannot prevent someone from consuming the good/service.

Public goods Many non-rival goods have high external benefits but low individual private benefit. This means individuals would not provide the good as the private costs far exceed the private benefits (think infrastructure, roads, street lights, telephone lines). Non-excludable goods have a `free rider’ problem. Why pay for something that you can use for free?