LECTURE 9
EXTERNALITIES AND PUBLIC GOODS
Module: 4ECON005C Module Leader:
Exploring Economics Zohid Askarov
Semester 1
Externalities and Public Goods
LECTURE OUTLINE
1. Externalities
2. Ways of Correcting Market Failure
3. Stock Externalities
4. Externalities and Property Rights
5. Common Property Resources
6. Public Goods
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Carbon Emission/Waste Dumping
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EXTERNALITIES IN OUR DAILY LIVES
An externality is a cost or a benefit that arises from:
• Production that falls on someone other than the
producer
• Consumption that falls on someone other than the
consumer
Negative externality
A production or consumption activity that creates an
external cost.
Positive externality
A production or consumption activity that creates an
external benefit.
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EXTERNALITIES IN OUR DAILY LIVES
Four types of externalities:
• Negative production externalities
• Positive production externalities
• Negative consumption externalities
• Positive consumption externalities
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EXTERNALITIES IN OUR DAILY LIVES
Negative Production Externalities
Pollution is the major example of this type of externality.
Others are noise and congestion.
Positive Production Externalities
Example: Orchards provide positive production
externalities to honey producers, who in turn provide
positive production externalities to orchards.
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EXTERNALITIES IN OUR DAILY LIVES
Negative Consumption Externalities
Smoking tobacco in a confined space
Noisy parties
Positive Consumption Externalities
Education is a major example of this type of externality.
Others are a flu vaccination and restoration of an
historic building
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Externalities
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NEGATIVE EXTERNALITIES: POLLUTION
Private Costs and Social Costs
Marginal private cost is the cost of producing an
additional unit of a good or service that is borne by the
producer of that good or service.
Marginal external cost is the cost of producing an
additional unit of a good or service that falls on people
other than the producer.
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NEGATIVE EXTERNALITIES: POLLUTION
Marginal social cost is the marginal cost incurred by
the entire society—by the producer and by everyone
else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal
private cost (MC) and marginal external cost (MEC).
MSC = MC + MEC
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EXTERNAL COST
FIGURE 18.1 EXTERNAL COST
In (a), a profit-maximizing firm produces at q1, where price is equal to MC.
The efficient output is q*, at which price equals MSC.
In (b), the industry’s competitive output is Q1, at the intersection of industry supply MC and demand D.
The aggregate social cost is as the shaded triangle between MSCI, D, and output Q1.
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Externalities
Positive Externalities and Inefficiency
Marginal external benefit Increased benefit that
accrues to other parties as a firm increases output by
one unit.
FIGURE 18.2
EXTERNAL BENEFITS
When there are positive externalities, marginal social
benefits MSB are higher than marginal benefits D.
The difference is the marginal external benefit MEB.
A self-interested homeowner invests q1 in repairs,
determined by the intersection of the marginal benefit
curve D and the marginal cost curve MC.
The efficient level of repair q* is higher and is given by
the intersection of the marginal social benefit and
marginal cost curves.
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Ways of Correcting Market Failure
An Emissions Standard
emissions standard Legal limit on the amount of pollutants that a firm
can emit.
The firm meets the standard by installing pollution-abatement equipment.
Firms will find it profitable to enter the industry only if the price of the
product is greater than the average cost of production plus abatement—
the efficient condition for the industry.
An Emissions Fee
emissions fee Charge levied on each unit of a firm’s emissions.
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Ways of Correcting Market Failure
FIGURE 18.4
THE EFFICIENT LEVEL OF EMISSIONS
The efficient level of factory emissions is the
level that equates the marginal external cost of
emissions MEC to the benefit associated with
lower abatement costs MCA. The efficient level
of 12 units is E*.
Here the marginal abatement cost curve is a
series of steps, each representing the use of a
different abatement technology.
With no effort at abatement, the firm’s profit-maximizing level of emissions is 26, the level at
which the marginal cost of abatement is zero.
We can encourage the firm to reduce emissions to E* in three ways: (1) emissions standards; (2)
emissions fees; and (3) transferable emissions permits.
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Ways of Correcting Market Failure
FIGURE 18.5
STANDARDS AND FEES
The efficient level of emissions at E* can be
achieved through either an emissions fee or
an emissions standard.
Facing a fee of $3 per unit of emissions, a
firm reduces emissions to the point at which
the fee is equal to the marginal cost of
abatement.
The same level of emissions reduction can
be achieved with a standard that limits
emissions to 12 units.
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THE CASE FOR FEES
FIGURE 18.6
THE CASE FOR FEES
With limited information, a
policymaker may be faced with
the choice of either a single
emissions fee or a single
emissions standard for all firms.
The fee of $3 achieves a total
emissions level of 14 units more
cheaply than a 7-unit-per-firm
emissions standard.
With the fee, the firm with a lower
abatement cost curve (Firm 2)
reduces emissions more than the
firm with a higher cost curve
(Firm 1).
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THE CASE FOR STANDARDS
FIGURE 18.7
When the government has limited
information about the costs and
benefits of pollution abatement, either
a standard or a fee may be preferable.
The standard is preferable when the
marginal external cost curve is steep
and the marginal abatement cost
curve is relatively flat.
Here a 12.5 percent error in setting
the standard leads to extra social
costs of triangle ADE.
The same percentage error in setting
a fee would result in excess costs of
ABC.
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Ways of Correcting Market Failure
Tradable Emissions Permits
tradable emissions permits System of marketable permits, allocated
among firms, specifying the maximum level of emissions that can be
generated.
Each permit specifies the number of units of emissions that the firm is
allowed to put out. Excess emissions are subject to substantial monetary
sanctions. The total number of permits is chosen to achieve the desired
maximum level of emissions. Permits are marketable: They can be
bought and sold.
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Bargaining and Economic Efficiency
Economic efficiency can be achieved without government intervention when the externality
affects relatively few parties and when property rights are well specified.
TABLE 18.4: PROFITS UNDER ALTERNATIVE EMISSIONS CHOICES (DAILY)
FACTORY’S FISHERMEN’S TOTAL
PROFIT PROFIT PROFIT
($) ($) ($)
No filter, no treatment plant 500 100 600
Filter, no treatment plant 300 500 800
No filter, treatment plant 500 200 700
Filter, treatment plant 300 300 600
As Table 18.4 shows, the factory can install a filter system to reduce its effluent, or the
fishermen can pay for the installation of a water treatment plant. The efficient solution
maximizes the joint profit of the factory and the fishermen.
Maximization occurs when the factory installs a filter and the fishermen do not build a
treatment plant.
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TABLE 18.5: BARGAINING WITH ALTERNATIVE PROPERTY RIGHTS
RIGHT TO CLEAN WATER
NO COOPERATION RIGHT TO DUMP ($)
($)
Profit of factory 500 300
Profit of fishermen 200 500
RIGHT TO CLEAN WATER
COOPERATION RIGHT TO DUMP ($)
($)
Profit of factory 550 300
Profit of fishermen 250 500
Without cooperation, the fishermen earn a profit of $200 and the factory $500. With
cooperation, the profit of both increases by $50.
If the fishermen are given the property neither party can be made better
off by bargaining, having the factory install the filter is efficient.
Coase theorem Principle that when parties can bargain without cost and to their mutual
advantage, the resulting outcome will be efficient regardless of how property rights are
specified.
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Public Goods
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CLASSIFYING GOODS AND RESOURCES
Excludable vs. Non-excludable
Rivalrous vs. Non-rivalrous
11.1 CLASSIFYING GOODS AND RESOURCES
Examples of excludable items are
• The security services of Brink’s
• Fish in a fish farm
• A live concert
Examples of nonexcludable items are
• The services of the city police department
• Fish in the Pacific Ocean
• A concert on network television
11.1 CLASSIFYING GOODS AND RESOURCES
A Fourfold Classification
Private Goods
A private good is a good or service that can be
consumed by only one person at a time and only by
those people who have bought it or own it.
A private good is both rival and excludable.
For example, a can of coke.
11.1 CLASSIFYING GOODS AND RESOURCES
Public Goods
A public good is a good or service that can be
consumed simultaneously by everyone and no one can
be excluded from enjoying its benefits.
It is both nonrival and nonexcludable.
For example, a flood-control levee.
CLASSIFYING GOODS AND RESOURCES
Figure 11.1 shows this fourfold classification of goods
and services.
COMMON RESOURCES
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 Earth’s atmosphere.
The traditional example from which the term derives is
the common grazing land surrounding middle-age
villages.
11.2 PUBLIC GOODS AND THE FREE-RIDER PROBLEM
The Free-Rider Problem
Public goods create a free-rider problem.
A free rider is a person who enjoys the benefits of a
good or service without paying for it.
Because of the free-rider problem, the market would
provide too small a quantity of a public good.
To produce the efficient quantity, government action is
required.
Public Goods
Public Goods and Market Failure
Suppose you want to offer a mosquito abatement program for your community. The
program is worth more to the community than the $50,000 it will cost. Can you make a
profit by providing the program privately? You would break even if you assessed a $5.00
fee to each of the 10,000 households in your community. But you cannot force them to pay
the fee, let alone devise a system in which those households that value mosquito
abatement most highly pay the highest fees.
Unfortunately, mosquito abatement is nonexclusive. As a result, households have no
incentive to pay what the program really is worth to them.
free rider Consumer or producer who does not pay for a nonexclusive good in the
expectation that others will.
With public goods, the presence of free riders makes it difficult or impossible for markets to
provide goods efficiently. The public good must therefore be subsidized or provided by
governments if it is to be produced efficiently.
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Suggested Reading
• For this lecture
• Pindyck & Rubinfeld (2018). “Microeconomics”, 8th edition. Chapter 18.
Alternatively
• Bade & Parkin (2015). “Foundations of Microeconomics”, 7th edition.
Chapters 10, 11.
• Or any Microeconomics textbook, sections on Externalities and Public
Goods.
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