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

2. Chapter Objectives Public goods vs. private goods The optimal quantity of a public good Cost-benefit analysis Externalities Information failures and government intervention 16-2

3. Public Goods Private goods –Rivalry and excludability Public goods –Nonrivalry –Nonexcludability –Free-rider problem –No market demand 16-3

4. Optimal Quantity of a Public Good Supplied by the government Government estimates demand Compare marginal benefit to marginal cost Demand for a public good –Sum individual willingness to pay –Sum vertically 16-4

5. Demand for Public Goods (1) Quantity Of Public Good (2) Adams’ Willingness To Pay (Price) (3) Benson’s Willingness To Pay (Price) (4) Collective Willingness To Pay (Price) 1234512345 $4 3 2 1 0 $5 4 3 2 1 $9 7 5 3 1 ++++++++++ ========== Example: two individuals Graphically… 16-5

6. Demand for Public Goods $9 7 5 3 1 0 P Q 12345 $6 5 4 3 2 1 0 P Q 12345 $6 5 4 3 2 1 0 P Q 12345 Adams Benson Collective Demand and Supply D1D1 D2D2 DCDC S Adams’ Demand Benson’s Demand Collective Demand $3 for 2 Items $4 for 2 Items $7 for 2 Items $1 for 4 Items $2 for 4 Items $3 for 4 Items Connect the Dots Collective Willingness To Pay Optimal Quantity 16-6

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

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

9. Externalities Negative Externalities Positive Externalities 0 D S StSt Overallocation Negative Externalities StSt Underallocation Positive Externalities QoQo QoQo QeQe QeQe P P 0 Q Q D DtDt 16-9

10. Coase Theorem Externalities corrected by individual bargaining –Property ownership defined –Small number people –Bargaining costs negligible Limitations Liability rules and lawsuits 16-10

11. Government Intervention Correct negative externality –Direct controls –Specific taxes Correct positive externality –Subsidize buyers or producers –Government provision 16-11

12. 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

13. Market for Pollution Rights Advantages Real-world examples D 2008 D 2018 S=Supply of Pollution Rights 500 750 1000 $100 $200 P 0 Q Price Per Pollution Right Quantity of 1-Ton Pollution Rights 16-13

14. Optimal Externality Reduction How much pollution abatement? MC = MB 0 Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Q1Q1 MB MC Socially Optimal Amount Of Pollution Abatement 16-14

15. Climate Change Earth has warmed over the last century Human activity contributing factor Carbon dioxide and greenhouse effect Kyoto Protocol 1997 Climate change policies 16-15

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

17. Information Failures Asymmetric information Inadequate buyer information –Gasoline market –Licensing of surgeons Inadequate seller information –Moral hazard problem –Adverse selection problem –Workplace safety Qualification 16-17

18. 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? 16-18

19. 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 16-19

20. Next Chapter Preview… Public Choice Theory and the Economics Of Taxation 16-20