1
PUBLIC
GOODS,EXTERNALITY
AND MARKET FAILURE
PROF. VANITA SINGH
MDI, GURGAON
2 ATTRIBUTES OF GOODS
• We have seen that markets are better at providing the efficient level of some goods and services than
others.
• This is related to some important attributes of the goods and services: whether their consumption is
rival and/or excludable.
• Rivalry: The situation that occurs when one person’s consuming a unit of a good means no one else can
consume it.
• Excludability: The situation in which anyone who does not pay for a good cannot consume it.
3 FOUR TYPES OF GOODS
Rival and Non-rival and
Excludable Excludable
Private Goods Quasi-public
Rival and
Non-rival and
Non-
Non-
excludable
Excludable
Common
Public Goods
Resources
4 PUBLIC GOODS
• Demand-side market failure arise when demand curves underreport how much
consumers are willing and able to pay
• This shifts demand curves to the left and equilibrium output is is below social optimum
• Underreporting of demand reaches its extereme form in the case of public goods
• Markets may fail to produce public goods as the demand curve may not reflect none of
its potential consumers’ willingness to pay
5 PUBLIC GOODS
• Nonrivalry (in consumption): One person’s consumption of a good doesn’t affect
consumption of the good by others. Example: Street lighting, GPS
• Non-excludability: No effective way to exclude individuals from the benefit of the good.
• These two characteristics create a free-rider problem
• Once a producer has provided a public good, everyone, including non-payers benefit
• Quasi-Public Goods: Exclusion is possible, however, rivalry exists in consumption of these
goods
6 EXTERNALITY
• Externality is a cost or benefit from production or consumption that accrues to a third
party that is external to the market transaction.
• Positive externality :Vaccination against infectious diseases
• Negative externality: Pollution from energy plants
• Pollution is an example of an externality: a benefit or cost that affects someone who is
not directly involved in the production or consumption of a good or service.
7 MARKET FAILURE AND EXTERNALITY
• If there are negative or positive externalities, the market equilibrium will not result in the
efficient quantity being produced.
• There will be deadweight loss.
• This is an example of market failure: a situation in which the market fails to produce the
efficient level of output.
• The larger the externality, the greater is likely to be the size of the deadweight loss—the
extent of the market failure.
8 WHAT CAUSES EXTERNALITY?
• Externalities arise because of incomplete property rights, or from the difficulty of enforcing property rights in certain situations.
• Suppose a farmer and a paper mill share a stream.
• If no-one owns the stream, the paper mill will discharge waste into the stream, making it unusable for the farmer.
• If the farmer owns the stream, he can
• Prevent the mill from discharging into the stream, or
• Allow the mill to discharge for a fee, if that is beneficial to him.
• Either way, good property rights avoid the market failure.
• Property rights: The rights individuals or businesses have to the exclusive use of their property, including the right to buy or
sell it.
9 EXTERNALITIES IN ELECTRICITY PRODUCTION
MARKET
• When firms produce electricity, they have costs of production:
• Buildings
• Equipment
• Fuel
• Labor, etc.
• Those firms make their decisions about how much to produce
based on these private costs.
• But the social cost is higher: the cost to society includes both
the private cost and the external cost of the pollution.
• Cost of Pollution (a negative externality) is an example of
social cost
10 NEGATIVE EXTERNALITIES AND INEFFICIENCY
• Externalities are not reflected in market price thus,
they can be a source of economic inefficiency
• Firms do not take into account the harms
associated with negative externalities – excess
production
• marginal external cost Increase in cost
imposed externally as one or more firms
increase output by one unit.
• marginal social cost Sum of the marginal
cost of production and the marginal external
cost.
11 POSITIVE EXTERNALITY
• Positive externalities occur when people who are not directly involved in a market
transaction receive benefits without having to pay for them.
• These non-paying beneficiaries are referred to as “free riders”
• In presence of positive externality market demand curve fails to include willingness to pay of
free riders
• Failure to include all benefits shift market demand curve to left
• Markets fail to produce all units for which benefits exceed costs
• Thus, products with positive externality are under-produced
12 COLLEGE EDUCATION – A CASE OF POSITIVE
EXTERNALITY
• College educations have positive
externalities.
• The marginal social benefit from a college
education is greater than the marginal
private benefit to college students.
• Because only the marginal private
benefit is represented in the market
demand curve D1, the quantity of college
educations produced, QMarket, is too low.
13 THE COASE THEOREM
• Nobel laureate Ronald Coase argued that private parties could solve the externality problem
through private bargaining, provided
• Property rights are assigned and enforceable, and
• Transaction costs are low.
• Transaction costs: The costs in time and other resources that parties incur in the process
of agreeing to and carrying out an exchange of goods or services.
• The Coase Theorem also requires that parties have full information about the costs and
benefits involved.
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• This graph shows pollution reduction, which has
both costs and benefits.
• 10 units of pollution reduction is “too much”;
the cost of the last unit exceeds the benefit.
• 7 units of pollution reduction is “too little”; the
benefit of the next unit exceeds the cost.
• 8.5 units is efficient; the marginal cost just
equals the marginal benefit.
15 GOVERNMENT INTERVENTION – TAXES
• Utilities do not bear the cost of pollution, so they produce
too much.
• If the government imposes a tax equal to the cost of the
pollution, the utilities will internalize the externality.
• The supply curve will shift up, from S1 to S2.
• The market equilibrium quantity falls to the economically
efficient level
16 GOVERNMENT INTERVENTION – SUBSIDY
• The subsidy will cause the demand curve to
shift up, from D1 to D2.
• The market equilibrium quantity will shift from
QMarket to QEfficient, the economically efficient
equilibrium quantity.
• Producers receive the price PEfficient, while
consumers pay a price P, which is equal to
PEfficient minus the amount of the subsidy.
17 THANK YOU!!
