Chapter 16 Public Goods, Externalities, and Information Asymmetries McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Public goods vs. private goods The optimal quantity of a public good Cost-benefit analysis Externalities Information failures and government intervention WHEN FREE MARKETS DON’T WORK!!! 16-2

Public Goods Private goods Public goods Rivalry and excludability Nonrivalry- eg. GPS Nonexcludability eg Military Defense Free-rider problem eg living in sight view of Yankee stadium field No market demand in large part due to the first 3 above—market demand for a bridge? 16-3

Optimal Quantity of a Public Good Supplied by the government Government estimates demand? How? Compare marginal benefit to marginal cost (MB=Demand Curve, MC= Supply Curve) Demand for a public good Sum individual willingness to pay Sum vertically NEXT PAGE---THIS IS DIFFERENT THAN ARE USUAL MEANS OF SUMMING UP DEMAND 16-4

Demand for Public Goods Example: two individuals (1) Quantity Of Public Good (2) Adams’ Willingness To Pay (Price) (3) Benson’s Willingness To Pay (Price) (4) Collective Willingness To Pay (Price) 1 2 3 4 5 $4 3 2 1 + $5 4 3 2 1 = $9 7 5 3 1 Graphically… REMEMBER BOTH CAN USE THIS PRODUCT WITHOUT HARMING THE OTHERS USE 16-5

Demand for Public Goods $9 7 5 3 1 P Q 2 4 Collective Demand S Optimal Quantity $7 for 2 Items $3 for 4 Items Collective Willingness To Pay DC Connect the Dots Collective Demand and Supply $6 5 4 3 2 1 P Q Benson’s Demand $4 for 2 Items D2 $2 for 4 Items Benson $6 5 4 3 2 1 P Q Adams’ Demand $3 for 2 Items $1 for 4 Items D1 Adams 16-6

Cost-Benefit Analysis Provide a public good? Education? Defense? Health Care How much should be provided? Pre-school? Resources are limited Marginal-cost-marginal-benefit rule Allocate government resources to maximize net benefit 16-7

Externalities Market failure Negative externality Positive externality Requires government action Negative externality External cost Overproduction Positive externality External benefit Underproduction 16-8

Externalities Negative Externalities? Such as? Positive Externalities? Q Negative Externalities St St Positive Externalities S Dt D D Overallocation Underallocation Qo Qe Qe Qo Negative Externalities? Such as? Positive Externalities? Such as? 16-9

Coase Theorem Externalities corrected by individual bargaining Property ownership defined Small number people Bargaining costs negligible Limitations Liability rules and lawsuits Example- neighbors wall is deteriorating, creating an eyesore 16-10

Government Intervention Correct negative externality Direct controls- limits on production? Cap N Trade? Specific taxes (fines?) Correct positive externality Subsidize buyers or producers Government provision 16-11

Market Based Approach Tragedy of the commons Resource lacks defined ownership Air, lakes, etc. No incentive to maintain Market for externality rights Right to pollute Can be bought and sold 16-12

Boy, do I have Problems! Average Bluefin tuna size and # have declined precipitously – how can we create sustainable fisheries?-What economic TERM leads to overfishing? If health insurance companies are required to accept everyone why might that lead to fewer people having insurance? What economic “term” does this deal with? How can government ensure that inclusion doesn’t lead to fewer getting insurance?

MORAL HAZARD!!! Why would getting homeowner’s insurance cause me to more recklessly take care of my property? What is the term in economics that deals with this issue? Have you ever taken more of a risk because you didn’t have to fully accept the loss?

Using economic analysis how should the Town determine whether to have a one public swimming pool? Two? Why am I far more likely to buy a “certified” used BMW 325 IS car for $15,000 than the identical make/model/year/mileage from Bob Smith for $12,000?

Make an Economic Argument that Tort reform (limits on lawsuits) will lead to negative externalities. Make an Economic Argument that Tort Reform will lead to positive externalities.

Market for Pollution Rights Advantages Real-world examples P Q Price Per Pollution Right Quantity of 1-Ton Pollution Rights D2018 S=Supply of Pollution Rights D2008 $200 $100 500 750 1000 16-17

Optimal Externality Reduction How much pollution abatement? MC = MB (WHAT HAPPENS IF TOO MUCH ABATEMENT? MC Socially Optimal Amount Of Pollution Abatement Cost of Pollution Abatement (Dollars) Society’s Marginal Benefit and Marginal MB Q1 16-18

Climate Change Earth has warmed over the last century Human activity contributing factor Carbon dioxide and greenhouse effect Kyoto Protocol 1997 Climate change policies 16-19

Climate Change Carbon-Dioxide Emissions, Tons Per Capita, Selected Nations 2005 0 5 10 15 20 25 United States Australia Canada Czech Republic Germany Japan United Kingdom Spain Italy France Source: OECD Environmental Data 16-20

Information Failures Asymmetric information Inadequate buyer information Gasoline market Licensing of surgeons Inadequate seller information Moral hazard problem Adverse selection problem Workplace safety Qualification 16-21

Lojack: A Case of Positive Externalities Crime reduction expenditures $300 billion Some redistribute vs. reduce crime Lojack car recoveries 95% vs. 60% External benefits Catch thieves Locate and stop chop shops MSB 15 times the MC Underallocation Policy to encourage use of Lojack? 16-22

Key Terms private goods public goods free-rider problem cost-benefit analysis marginal-cost-marginal-benefit rule externalities Coase theorem tragedy of the commons market for externality rights optimum reduction of an externality cap-and-trade program climate-change problem asymmetric information moral hazard problem adverse selection problem 16-23

Public Choice Theory and the Economics Of Taxation Next Chapter Preview… Public Choice Theory and the Economics Of Taxation 16-24