Introduction to Microeconomics

Market Failures: Externalities. Public Goods and Common Resources

Peter Stoyanov

Sofia University “St. Kliment Ohridski”

Faculty of Economics & Business Administration
Lecture slides based on: Parkin, Microeconomics, 9th edition
http://wps.aw.com/aw_parkin_microecon_9/108/27656/7080048.cw/index.html

Fall semester, 2016-2017

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 Externalities

Externalities: Table of Contents

1 Externalities
Externalities: Definition and Identification
Negative externalities
Positive externalities

2 Public Goods and Common Resources

Classifying Goods and Resources
Public Goods
Common Resources

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 Externalities Externalities: Definition and Identification

Externalities: Definition
Definitions
M ARKET FAILURE is situation where the market does not provide the ideal (or
optimal) amount of a good.

Definition
An EXTERNALITY is a side effect of an action that affects the well-being of third
parties, e.g.:
A cost or benefit that arises from production and falls on someone other
than the producer, or
A cost or benefit that arises from consumption and falls on someone other
than the consumer.
Externalities may be:
Positive or negative (imposing respectively a benefit or a cost), and
Consumption or production (depending on the action).

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 Externalities Externalities: Definition and Identification

Examples of Production Externalities

Negative production externalities are quite common. They arise when the
production of a good or service creates a cost (part of) which is
not born by the producer. Examples: pollution; noise from
aircraft or road traffic; destruction of animal species; etc.
Positive production externalities are less common. They arise when the
production of a good or service creates benefits for people not
directly engaged in the production (i.e. third parties). Examples:
bees and orchards (pollination); business clusters (to some
extent); etc.

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 Externalities Externalities: Definition and Identification

Examples of Consumption Externalities

Negative consumption externalities are a common part of everyday life. They

arise when a third party bears a cost when a good is consumed.
Examples: smoking in a confined space poses a health risk to
others; noisy parties, loud car stereos, or talking in class disturb
others.
Positive consumtion externalities are also quite common. They arise when the
consumption of a good creates a benefit to third parties.
Examples: healthcare (esp. vaccinations); education;
beautifying one’s home; wearing good-looking clothes, etc.

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 Externalities Externalities: Definition and Identification

Private vs. Social Costs and Benefits

Most actions have both costs and benefits.

Dealing with externalities begins with distinguishing between PRIVATE and
SOCIAL costs and benefits.

The cost or benefit incurred by the person performing the action, is called
PRIVATE COST / BENEFIT . These affect only him/her.
The cost or benefit incurred by people other than the person performing
the action (i.e. society in general) are EXTERNAL COSTS / BENEFITS.
(External to the person performing the action.)

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 Externalities Externalities: Definition and Identification

Private Costs and Social Costs

APRIVATE COST OF PRODUCTION is a cost that is borne by the producer, and

MARGINAL PRIVATE COST (MC) is the private cost of producing one more unit
of a good or service.
M ARGINAL EXTERNAL COST is the cost of producing one more unit of a good or
service that falls on people other than the producer.
M ARGINAL SOCIAL COST is the marginal cost incurred by the entire society – by
the producer and by everyone else on whom the cost falls – and is the sum of
marginal private cost and marginal external cost. That is,
M SC = M C + M arginal External Cost
We express costs in dollars but must remember that the dollars represent the
value of a forgone opportunity. Marginal private cost, marginal external cost,
and marginal social cost increase with output.

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 Externalities Negative externalities

Example of A Negative Externality

This figure illustrates MC, MEC and

MSC:
MC – marginal private cost
MEC – marginal external cost
(difference between MC and
MSC)
MSC – marginal social cost

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 Externalities Negative externalities

Negative Externalities: Pollution

The figure to the right shows

what happens in an
unregulated market with an
external cost.
The (market equilibrium)
quantity produced is where
marginal private cost equals
marginal private benefit (the
producer maximizes their
private profit).

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 Externalities Negative externalities

Negative Externalities: Pollution

At the market equilibrium,

M SB < M SC, so the market
produces an inefficient
quantity.
At the efficient quantity,
marginal social cost equals
marginal benefit.
With no regulation, the market
OVERPRODUCES and creates a
DEADWEIGHT LOSS .

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 Externalities Negative externalities

Fixing Externalities

Question:
Do we need to fix externalities?
Maybe only the negative ones, such as pollution?

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 Externalities Negative externalities

Fixing Externalities

Question: Do we need to fix externalities? Maybe only the negative ones, such
as pollution?
Answer: All externalities need to be fixed, as they lead to inefficient allocation
of resources. Even the positive externalities are ‘bad’ – the benefit from the
externality that third parties receive (and for which they are not paying)
happens at the expense of misallocation of resources (inefficiency).
Exception: Following the general cost-benefit logic, we would not aim to fix
externalities where the cost of fixing the externality would be higher than the
inefficiency being eliminated.

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 Externalities Negative externalities

Internalizing Externalities

We fix externalities by ‘internalizing’ them (i.e. making the external cost or

benefit internal or private to the on who causes the externality).
We can internalize externalities by:

Persuasion
Taxes and subsidies
Property rights
Voluntary agreements

Beyond internalization – direct regulation

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 Externalities Negative externalities

Internalizing Externalities

Persuasion In quite a lot of cases externalities arise simply because the

persons causing them have not thought that they cause a
discomfort (cost) to someone else, etc. E.g., first try asking your
friend who smokes not to do it close to you...
Taxes and subsidies can be used as corrective devices. A tax aims to adjust for
a negative externality, and a subsidy aims to adjust for a positive
externality. E.g. a tax on pollution, or a subsidy for education.
Property rights are legally established titles to the ownership, use, and
disposal of factors of production and goods and services that are
enforceable in the courts.

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 Externalities Negative externalities

Internalizing Externalities

Voluntary agreements may be made among the affected parties to fix an

externality. The parties sit on a table and discuss... E.g. Nikolay
and Atanas are roommates, and Atanas likes singing early in the
morning, while Nikolay likes to sleep during this time. Lets say
Atanas values his singing at 10 bottles of beer, and Nikolay
values his sleep at 7 bottles.
Now they can reach an agreement that Atanas will ‘pay’ Nikolay
7 bottles of beer. Now both are better off:
Atanas is free to sing in the morning, while
Nikolay takes his bottles... (and saves them, it is too early to
drink! But that’s a Micro II topic – intertemporal
substitution of utility).

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 Externalities Negative externalities

Internalizing Externalities

Direct regulation by the government is a valid way to directly deal with

externalities, esp. negative ones. The government may mandate
that a pollution-producing plant must install pollution-reducing
equipment. Or that all children must attend school at least until
the 8th grade...
Direct regulation may or may not work as intended:
It is not as flexible as the other approaches (does not allow
the regulated entities to maximize profit/utility), ...
... and once in place it is difficult to remove (deregulation).
Also, regulation requires a large bureaucracy which costs
money (and can be ‘captured’).

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 Externalities Negative externalities

Pigou vs. Coase

A RTHUR C ECIL P IGOU was the first to suggest that the government should deal
with externalities via taxes and subsidies. A tax set equal to the marginal
external cost is called a Pigovian tax, and is intended to make the private cost
equal to the social cost (M C + tax = M SC).
R ONALD C OASE argued that the same outcome may be achieved via property
rights assignment. He also stressed the importance of transaction costs.

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 Externalities Negative externalities

The Coase Theorem

Theorem
C OASE T HEOREM : In the case of trivial or zero transaction costs, the property
rights assignment does not matter to the resource allocative outcome.
Other formulations:
1 If property rights exist, only a small number of parties are involved, and
transactions costs are low, then private transactions are efficient.
2 In the case of zero or trivial transaction costs, a property rights assignment
will be undone (exchanged) if it benefits the relevant parties to do so.
3 In the case of zero or trivial transaction costs, the resource allocative
outcome will be the same no matter who is assigned the property right.

The Theorem is important because:

It tells us that, under certain circumstances, the market can internalize
the externalities.
Provides a benchmark in the analysis – shows what will happen with zero
or trivial transaction costs.
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 Externalities Negative externalities

Dealing with Pollution

Economists deal with the issue of pollution by looking at three principal

points.
1 Identify pollution as a negative externality.
2 Do we need to fix it? (Is no pollution better than some pollution?)
No pollution is obviously good, but pollution is a by-product of the
production of other things which bring utility – which may have to be
given up in order to eliminate pollution. So (the benefit of) eliminating
pollution has to be balanced against the cost of losing the benefits those
other goods bring.
3 Should the market or the government be used to deal with the pollution?
1 Government – taxes
2 Government – standards for pollution, regulation, emission charges
3 Market – (transferable) pollution permits; property rights

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 Externalities Negative externalities

Fixing Pollution: Property Rights

Pollution can be dealt with by

assigning property rights (to
the air, water, etc. being
polluted).
The figure illustrates the
outcome – now M SC = M C,
i.e. private marginal cost is
equal to social marginal cost.
The full cost of production
(incl. pollution) is matched
against the full social benefit of
the product produced.
The outcome is efficient.

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 Externalities Negative externalities

Fixing Pollution: Pigovian Tax

Pollution can be dealt with by

imposing a tax. The Pigovian
tax is equal to the Marginal
External Cost.
Now M SC = M SB again, so
the outcome is efficient.
Also, the government collects
tax revenue.
Caution: The government must
know the polluter’s MC and
the MSC!

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 Externalities Negative externalities

Fixing Pollution: Charges and Permits

E MISSIONS C HARGES M ARKETABLE P ERMITS

The government sets a price per Each firm is assigned a permitted
unit of pollution, so that the more a amount of pollution per period and
firm pollutes, the higher are its firms may trade the permits.
emissions charges. The market price of a permit
For the emissions charge to induce confronts polluters with the social
the firm to generate the efficient marginal cost of their actions and
level of pollution, the government leads to an efficient outcome.
would need a lot of information This method was used successfully
that is usually unavailable. to decrease lead pollution in the
United States.

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 Externalities Positive externalities

Positive externalities: Knowledge

K NOWLEDGE comes from education and research and creates external benefits.
Private Benefits and Social Benefits:

A private benefit is a benefit that the consumer of a good or service

receives, and marginal private benefit (MB) is the private benefit from
consuming one more unit of a good or service.
An external benefit is a benefit that someone other than the consumer
receives. Marginal external benefit is the benefit from consuming one
more unit of a good or service that people other than the consumer enjoy.
Marginal social benefit is the marginal benefit enjoyed by the entire
society – by the consumer and by everyone else on whom the benefit falls.
Marginal social benefit is the sum of marginal private benefit and marginal
external benefit. That is: M SB = M B + M arginal External Benef it.

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 Externalities Positive externalities

Positive externalities: Knowledge

The figure illustrates the

market outcome for knowledge
(education).
The private market
underproduces as education
generates an external benefit.
Thus a deadweight loss is
created.

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 Externalities Positive externalities

Government Action in the Face of External Benefits

Four devices that the government can use to achieve a more efficient allocation
of resources in the presence of external benefits are

Public provision
Private subsidies
Vouchers
Patents and copyrights

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 Externalities Positive externalities

Knowledge: Public Provision

Under PUBLIC PROVISION, a

public authority that receives
payment from the government
produces the good or service.
The government estimates the
efficient number of students,
and sets the price (tuition) so
that it equals private marginal
benefit at the efficient quantity.
The rest of the cost of
education is covered by the
government.

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 Externalities Positive externalities

Knowledge: Private Subsidies

A SUBSIDY is a payment by the

government to private
producers.
If the government pays the
producer an amount equal to
the marginal external benefit
for each unit produced, the
quantity produced is efficient.

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 Externalities Positive externalities

Knowledge: Vouchers

A VOUCHER is a token that the

government provides to
households, which they can
use to buy only the specified
goods or services.
The figure shows how vouchers
can achieve a more efficient
outcome – the student pays
part of the education with the
voucher, and covers the rest in
cash (dollar price).
Proponents of vouchers claim
vouchers are better than
subsidies as the consumer
(student or parents) can
monitor the school more
efficiently than the govt.
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 Externalities Positive externalities

Knowledge: Patents and Copyrights

I NTELLECTUAL PROPERTY RIGHTS give the creator of knowledge the property

right to the use of that knowledge.
The legal device for establishing an intellectual property right is the PATENT or
a COPYRIGHT.
A PATENT or COPYRIGHT is a government-sanctioned exclusive right given to an
inventor of a good, service or productive process to use to produce, use and
sell the invention for a given number of years.

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 Public Goods and Common Resources

Public Goods and Common Resources:

Table of Contents

1 Externalities
Externalities: Definition and Identification
Negative externalities
Positive externalities

2 Public Goods and Common Resources

Classifying Goods and Resources
Public Goods
Common Resources

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 Public Goods and Common Resources Classifying Goods and Resources

Classifying Goods and Resources (1)

What is the essential difference between:

A city police department and a private security firm

Fish in the Atlantic Ocean and fish in a fish farm
A live concert and a concert on television

These and all goods and services can be classified according to whether they
are

EXCLUDABLE or NON - EXCLUDABLE and

RIVAL or NON - RIVAL .

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 Public Goods and Common Resources Classifying Goods and Resources

Classifying Goods and Resources (2)

Excludable A good is excludable if only the people who pay for it are able to
enjoy its benefits. Brinks’s security services, East Point Seafood’s
fish, and a concert are examples.
Non-excludable A good is non-excludable if everyone benefits from it
regardless of whether they pay for it. The services of the LAPD,
fish in the Pacific Ocean, and a concert on network television are
examples.
Rival A good is rival if one person’s use of it decreases the quantity
available for someone else. A Brinks’s truck can’t deliver cash to
two banks at the same time. A fish can be consumed only once.
Non-rival A good is non-rival if one person’s use of it does not decrease the
quantity available for someone else. The services of the LAPD
and a concert on network television are non-rival.

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 Public Goods and Common Resources Classifying Goods and Resources

Classifying Goods and Resources (3)

The two sets of criteria can be organized as a matrix:

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 Public Goods and Common Resources Public Goods

Public Goods

The Free-Rider Problem

A FREE RIDER enjoys the benefits of a good or service without paying for it.
Because no one can be excluded from the benefits is a public good, everyone
has an incentive to free rise.
Public goods create a FREE - RIDER PROBLEM – the absence of an incentive for
people to pay for what they consume.
The value of a private good is the maximum amount that a person is willing
to pay for one more unit of it.
The value of a public good is the maximum amount that all the people are
willing to pay for one more unit of it.
To calculate the value placed on a public good, we use the concepts of total
benefit and marginal benefit.

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 Public Goods and Common Resources Public Goods

Marginal Social Benefit of a Public Good

T OTAL BENEFIT is the dollar value that a person places on a given quantity of a
good.
The greater the quantity of a good, the larger is a person’s total benefit.
M ARGINAL BENEFIT is the increase in total benefit that results from a one-unit
increase in the quantity of a good.
The marginal benefit of a public good diminishes with the quantity of the good
provided.

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 Public Goods and Common Resources Public Goods

The Demand Curve of a Public Good (1)

The economy’s MARGINAL SOCIAL BENEFIT of a public good is the sum of the
marginal benefits of all individuals at each quantity of the good provided.
The economy’s marginal social benefit curve for a PUBLIC GOOD is the vertical
sum of all individual marginal benefit curves.
The marginal social benefit curve for a public good contrasts with the demand
curve for a PRIVATE GOOD, which is the horizontal sum of the individual
demand curves at each price.
The MARGINAL SOCIAL COST of a public good is determined in the same way as
that of a private good.
The EFFICIENT QUANTITY OF A PUBLIC GOOD is the quantity that at which
marginal social benefit equals marginal social cost.

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 Public Goods and Common Resources Public Goods

The Demand Curve of a Public Good (2)

The following figures illustrate the construction of the market demand curve
for satellites

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 Public Goods and Common Resources Public Goods

Provision of Public Goods

Private Provision If a private firm tried to produce and sell a public good,
almost no one would buy it.
The free-rider problem results in too little of the good being
produced.
(Efficient Public Provision) Because the government can tax all the consumers
of the public good and force everyone to pay for its provision,
public provision overcomes the free-rider problem.
If two political parties compete, each is driven to propose the
efficient quantity of a public good.
A party that proposes either too much or too little can be beaten
by one that proposes the efficient amount because more people
vote for an increase in net benefit.

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 Public Goods and Common Resources Public Goods

Voting and public provision

Two parties, Doves and Hawks,

agree on everything except the
number of satellites.
If Doves propose 1 satellites
and Hawks propose 3, voters
are equally unhappy and the
election is too close to call.
If Doves increase the number
of satellites to 2, it will win the
election if Hawks propose 3.
If Hawks decrease the number
of satellites to 2, it will win the
election if Doves propose 1.
Both parties propose 2
satellites and each party gets
50 percent of the votes.
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 Public Goods and Common Resources Public Goods

Principle of Minimum Differentiation

The attempt by politicians to appeal to a majority of voters leads them to the

same policies – an example of the principle of minimum differentiation.
The principle of minimum differentiation is the tendency for competitors to
make themselves similar so as to appeal to the maximum number of clients
(voters).
(The same principle applies to competing firms such as McDonald’s and Burger
King).

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 Public Goods and Common Resources Public Goods

Inefficient Public Provision. Rational Ignorance

If competition between two political parties is to deliver the efficient quantity
of a public good, bureaucrats must cooperate and help achieve this outcome.

Objective of Bureaucrats Bureaucrats want to maximize their department’s

budget. A bigger budget increases their status and power.
Bureaucrats might try to persuade politicians to provide more
than the efficient quantity.
Rational ignorance is the decision by a voter not to acquire information about
a policy or provision of a public good because the cost of doing
so exceeds the expected benefit.
For voters who consume but don’t produce a public good, it is
rational to be ignorant about the costs and benefit.
For voters who produce a public good, it is rational to be well
informed.
When the rationality of uninformed voters and special interest
groups is taken into account, the political equilibrium results in
over-provision of a public good.
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 Public Goods and Common Resources Public Goods

Bureaucratic over-provision of a Public Good

If rationally ignorant voters enable

the bureaucrats to achieve their
goal of maximizing their budget:
public good might be
over-provided and
a deadweight loss created.

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 Public Goods and Common Resources Public Goods

Types of Political Equilibrium

The two types of political equilibrium – efficient provision and inefficient

over-provision of public goods – correspond to two theories of government:

Social interest theory predicts that political equilibrium achieves efficiency

because well-informed voters refuse to support inefficient policies.
Public choice theory predicts that government delivers an inefficient
allocation of resources – that government failure parallels market failure.

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 Public Goods and Common Resources Public Goods

The Government Is Large and Grows

The size of the government has grown substantially over the past several
centuries...

Source:
http://www.usgovernmentspending.com/spending_chart_1900_2016USp_13s1li001lcn_F1tH0t
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 Public Goods and Common Resources Public Goods

Why Government Is Large and Grows

Two possible reasons are

Voter preferences: government grows because the voters’ demand for

some public goods is income elastic.
Inefficient over-provision: inefficient over-provision might explain the size
of government but not its growth rate.

If government grows too large relative to the value voters place on public
goods, there might be a voter backlash that leads politicians to propose smaller
government. (In a functioning democracy, of course.)
Privatization is one way of coping with overgrown government and is based on
distinguishing between PUBLIC PROVISION and PUBLIC PRODUCTION of public
goods.

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 Public Goods and Common Resources Common Resources

The Tragedy of the Commons and Sustainable

Production

The TRAGEDY OF THE COMMONS is the absence of incentives to prevent the

overuse and depletion of a commonly owned resource.
Examples include the Atlantic Ocean cod stocks, South Pacific whales, and the
quality of the earth’s atmosphere. The traditional example from which the
term derives is the common grazing land surrounding middle-age villages.
S USTAINABLE PRODUCTION is the rate of production that can be maintained
indefinitely.
This production rate depends on the existing stock of fish and the number of
boats that go fishing. For a given fish stock, as more boats go fishing, the
quantity of fish caught increases. But with too many boats fishing, the quantity
of fish caught decreases.

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 Public Goods and Common Resources Common Resources

Common Resources: Overfishing (1)

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 Public Goods and Common Resources Common Resources

Common Resources: Overfishing (2)

Marginal private benefit, MB, is the

average catch per boat.
Marginal private benefit decreases
as the number of boats increases.
The marginal cost per boat is MC
(assumed constant).
Equilibrium occurs where, MB
equals MC.
In equilibrium, the resource is
overused
because no one takes into account
the effects of her/his actions on
other users of the resources.

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 Public Goods and Common Resources Common Resources

The Efficient Use of the Commons (1)

The quantity of fish caught by each boat decreases as the number of boats
increases. But no one has an incentive to take this fact into account when
deciding whether to fish. The efficient use of a common resource requires
marginal social cost to equal marginal social benefit.
M ARGINAL S OCIAL B ENEFIT
Marginal social benefit is the increase in the total fish catch that results from
an additional boat. Marginal social benefit equals the marginal catch of a
boat, not the average catch per boat.

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 Public Goods and Common Resources Common Resources

The Efficient Use of the Commons (2)

With no external costs, the

marginal social cost MSC
equals marginal cost MC.
Resources are used efficiently
when MSB equals MSC.

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 Public Goods and Common Resources Common Resources

Achieving an Efficient Outcome

It is harder to achieve an efficient use of a common resource than to define the

conditions under which it occurs. Three methods that might be used are:

Property rights
Production quotas
Individual transferable quotas (ITQs)

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 Public Goods and Common Resources Common Resources

Achieving an Efficient Outcome: Property Rights (1)

By assigning property rights, common property becomes private property.

When someone owns a resource, the owner is confronted with the full
consequences of her/his actions in using that resources.
The social benefits become the private benefits.
But assigning property rights is not always feasible.

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 Public Goods and Common Resources Common Resources

Achieving an Efficient Outcome: Property Rights (2)

By setting a production quota

at the efficient quantity, a
common resource might
remain in common use but be
used efficiently.
It is hard to make a production
quota work.

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 Public Goods and Common Resources Common Resources

Individual Transferable Quotas (ITQs) (1)

An INDIVIDUAL TRANSFERABLE QUOTA (ITQ) is a production limit that is

assigned to an individual who is free to transfer (sell) the quota to someone
else.
A market in ITQs emerges.
If the efficient quantity of ITQs is assigned, the market price of an ITQ
confronts resource users with a marginal cost of M C + price of IT Q.
With M C + price of IT Q equal to M SB, the quantity produced is efficient.

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 Public Goods and Common Resources Common Resources

Individual Transferable Quotas (ITQs) (2)

The market price of an ITQ

increases the marginal cost to
M C0 + price of IT Q.
Users of the resource make
M B equal
M C0 + price of IT Q, and the
outcome is efficient.

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 Public Goods and Common Resources Common Resources

Public Choice and Political Equilibrium

It is easy for economists to agree that ITQs make it possible to achieve an

efficient use of a common resource.
It is difficult to get the political marketplace to deliver that outcome.
In 1996, Congress killed an attempt to use ITQs in the Gulf of Mexico and
the Northern Pacific Ocean.
Self-interest and capture of the political process sometimes beats the
social interest.

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