MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 20: Public Goods and Externalities

Copyright 2012John Wiley & Sons, Inc. 2 Learning Objectives Explain what economists mean by the term “public goods” and how the free-rider problem inhibits the provision of the efficient output of such goods. Define external benefits and external costs and show how their presence results in nonoptimal output levels for goods characterized by such aspects. (continued)

Copyright 2012John Wiley & Sons, Inc. 3 Learning Objectives (continued) Show how clearly defined and enforces property rights can resolve externality problems and thereby ensure an efficient outcome. Demonstrate how air pollution can more efficiently be controlled through the establishment of an overall industry pollution target and the assignment of tradable emissions permits to the industry’s firms.

Copyright 2012John Wiley & Sons, Inc. 4 Public Goods and Externalities Public goods – those goods that benefit all consumers Externalities – the harmful or beneficial side effects of market activities that are not fully borne or realized by market participants

Copyright 2012John Wiley & Sons, Inc. 5 What Are Public Goods? Characteristics: Nonrival in consumption – a condition in which a good with a given level of production, if consumed by one person, can also be consumed by others Nonexclusion – a condition in which confining a good’s benefits, once produced, to selected persons is impossible or prohibitively costly Free-Rider Problem A consumer who has an incentive to underestimate the value of a good in order to secure its benefits at a lower, or zero, cost As the group size increases, it is more likely that everyone will behave like a free rider, and the public good will not be provided.

Copyright 2012John Wiley & Sons, Inc. 6 Efficiency in the Provision of a Public Good Social marginal benefit curve the demand curve for a public good derived by vertically summing the consumers’ marginal benefit curves Efficient output of a public good Occurs where the social marginal benefit curve intersects the marginal cost curve: MB s = MC

Copyright 2012John Wiley & Sons, Inc. 7 Figure The Efficient Output of a Public Good

Copyright 2012John Wiley & Sons, Inc. 8 Efficiency in Production and Distribution Conditions for economic efficiency: –an efficient distribution of products among consumers –efficiency in production –efficiency in output –Output be produced by using the least costly combination of inputs No rationing problem Inefficient to exclude anyone.

Copyright 2012John Wiley & Sons, Inc. 9 Patents A patent gives the holder of a patent the exclusive right to make and sell the product or process for 17 years Temporary legal monopoly power Benefit: stimulates inventors to devote resources to the production of new knowledge Cost: after the new knowledge is produced, it is inefficiently employed

Copyright 2012John Wiley & Sons, Inc. 10 Externalities Externalities: Side effects borne by people who are not directly involved in the market exchanges External benefits – positive side effects of ordinary economic activities External costs – negative side effects of ordinary economic activities

Copyright 2012John Wiley & Sons, Inc. 11 Externalities and Efficiency Distinction between externalities and public goods: External effects are unintended side effects of activities undertaken for other purposes. Both are likely to lead to an inefficient allocation of resources.

Copyright 2012John Wiley & Sons, Inc. 12 Figure External Costs and Taxes

Copyright 2012John Wiley & Sons, Inc. 13 Figure External Benefits and Subsidies

Copyright 2012John Wiley & Sons, Inc. 14 Externalities and Property Rights Coase Theorem: As long as property rights are clearly defined and enforced, bargaining between two parties can ensure an efficient outcome. The distributional effects depend on the definition of property rights. Whenever the effects are nonrival over a large group and exclusion is not feasible, the free-rider problem hinders the process of achieving agreement among all concerned.

Copyright 2012John Wiley & Sons, Inc. 15 Market-based Pollution Control Mechanisms Alternatives to “command-and-control” approach to reducing pollution: Per-emission-unit taxes Tradable emission permits

Copyright 2012John Wiley & Sons, Inc. 16 Figure A Tax on Pollution

Copyright 2012John Wiley & Sons, Inc. 17 The Market for Los Angeles Smog Tradable emission permits: set an overall industry pollution level allocate permits to emit a certain amount of pollution units to each firm allow the firms to exchange their permits price at which permits are traded depends upon the bargaining abilities of the two firms

Copyright 2012John Wiley & Sons, Inc. 18 Market-based Pollution Control Mechanisms: Effects Market-based alternatives promise significant efficiencies in production over command-and- control mechanisms for dealing with pollution: Promote efficiency in production Ensure that any abatement amount is produced at lowest possible cost

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