1. Externalities, Public Goods and Common Resources
Chapters 10, 11

3. Externality
The uncompensated impact of one person’s actions on the well-being of a bystander.
Examples: automobile exhaust, historic buildings, barking dogs, R&D.

4. Social Optimum
Point at which the marginal benefit equals marginal cost.

5. Figure 1 The Market for Aluminum
Price of
Aluminum
Supply
(private cost)
Demand
(private value)
QMARKET
Equilibrium
Quantity of
Aluminum
Copyright © South-Western

6. Figure 2 Pollution and the Social Optimum
Price of
Social
cost
Aluminum
Cost of
pollution
Demand
(private value)
Supply
(private cost)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
Copyright © South-Western

7. Positive Externalities
Beneficial third party effects.

8. Figure 3 Education and the Social Optimum
Price of
Education
Social
value
Supply
(private cost)
Demand
(private value)
QOPTIMUM
QMARKET
Quantity of
Education
Copyright © South-Western

9. Internalizing the Externality
Altering incentives so that people take account of the external effects of their actions.

10. Private Solutions Moral codes. Private charities.
Contracts (Coase theorem)

11. Coase Theorem
In the absence of transactions costs, private economic actors can solve the problem of externalities among themselves.

12. Public Policies to Deal with Externalities
Regulation specifying maximum allowable level of a negative externality.
Taxes (for negative externalities) & subsidies (for positive externalities).
Permits (licenses).

13. Pigovian Taxes
Arthur Pigou ( ), Professor of Economics, Cambridge University
Tax the good that creates the negative externality.
Reduces Q to optimal level.

14. How would you model a subsidy paid to providers of a positive externality?

15. Figure 1 The Effects of a Tax
Price
Demand
Supply
Price buyers
pay
Price sellers
receive
Quantity
with tax
Size of tax
Price
without tax
Quantity
Quantity
Copyright © South-Western

16. Tradable Pollution Permits
Environmental agency decides the appropriate level of pollutants and issues (or auctions off) permits for exactly that level.

17. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Demand for
pollution rights P
Pigovian
tax Q 1.
A Pigovian
tax sets the
price of
pollution . . .
Quantity of 2.
. . . which, together
with the demand curve,
determines the quantity
of pollution.
Pollution
Copyright © South-Western

18. Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(b) Pollution Permits
Price of Q
Supply of
pollution permits
Pollution
Demand for
pollution rights P 2.
. . . which, together
with the demand curve,
determines the price
of pollution.
Quantity of 1.
Pollution
permits set
the quantity
of pollution . . .
Pollution
Copyright © South-Western

19. Summary
When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality.
Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity.
Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

20. Summary
When private parties cannot adequately deal with externalities, then the government steps in.
The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

21. Firm
Pollution
Level
Unit cost to reduce A
70 units
$20 B 80
$25 C 50
$10
The government gives each firm 40 tradable pollution permits to reduce aggregate pollution level to 120 units.
1. What is the total cost of reducing pollution?
2. What would be the cost if the permits were not tradable?

22. Public Goods & Common Resources

23. Definitions
Excludability: the property of a good whereby a person can be prevented from using it.
Rivalry: the property of a good whereby one person’s use diminishes other people’s use.

24. Figure 1 Four Types of Goods
Rival?
Yes No
Private Goods
Natural Monopolies •
Ice-cream cones
Clothing
Congested toll roads •
Fire protection
Cable TV
Uncongested toll roads
Yes
Excludable?
Common Resources
Public Goods •
Fish in the ocean
The environment
Congested nontoll roads •
Tornado siren
National defense
Uncongested nontoll roads No
Copyright © South-Western

25. Free Rider Problem
Receiving the benefit of a good without paying for it.
e.g. viewer of public television

26. Tragedy of the Commons

27. Question.
Why is the commercial value of ivory a threat to the elephant, while the commercial value of beef is a guardian of the cow?

29. BEIJING, March 4 (Reuters) - China is to change its constitution to protect private property in a revolutionary manoeuvre that waters down its core Communist ideology to raise the status of entrepreneurs once deemed the running dogs of capitalism. Five decades after seizing power, nationalising private property and waging bloody campaigns against landlords, China's parliament is set to amend the state constitution to add the words, "private property obtained legally is inviolable". One aim of the amendments, to be ratified during the annual session of the National People's Congress that opens on Friday, is to give further impetus to the burgeoning private sector that is fuelling China's breakneck economic growth.