Microeconomics
Module 11: Public Goods and Externalities
Why It Matters: Public Goods and Externalities
• Decisions made by firms and individuals in
markets often have a spillover on other
people whether good or bad
• Goods can be public or private
• A good is not private because it was provided
by a private business and vice versa
• Private/public is a description of how the goods
are consumed
Externalities
• When a market doesn’t operate efficiently it is called market failure
• The effect of a market exchange on a third party who is outside or ”external” to the
exchange is called an externality
• Example: an outdoor country music concert happens a half-mile away from your home and
you can hear the music from your backyard
• Because externalities that occur in market transactions affect other parties beyond
those involved, are sometimes called spillovers
• Externalities can be negative or positive
• If you hate country music then the listening to it would be a negative externality
and vice versa if you love country music it would be a positive externality
Positive Externalities in Public Health Programs
• The standard of living in the last several centuries has changed because
people are living longer
• The rise in life expectancy seems to stem from three primary factors:
1. Systems for providing clean water and disposing for human waste
helped to prevent the transmission of many diseases
2. Changes in public behavior (washing hands, precautions with
tobacco and smoking)
3. Medicine advancements (immunizations, penicillin, antibiotics)
• These advances in public health have all been closely linked to positive
externalities and public goods
The Definition of a Public Good
• Public goods have two defining characteristics:
1. Nonexcludable, meaning that it is costly or impossible to exclude someone from using
the good
• If Larry buys a private good like a slice of pizza, he excludes others, Like Lorna, from eating pizza
2. Nonrivalrous, meaning that when one person uses the public good, another can also
use it
• National defense is a public good that does not rival any other consumers
• A number of government services are examples of public goods
• Positive externalities and public goods are closely related concepts
• Police protection or public health funding have positive externalities
• Not all goods and services with positive externalities are public goods,
however
Common Resources and the “Tragedy of the
Commons”
• Goods that are nonexcludable and rivalrous are called common resources
• For example, in the Caribbean the queen conch is a common resource, they easily
found in the wild and therefore tend to be overharvested
• Ecologist Garret Hardin called it the “Tragedy of the Commons” when he addressed
the overharvesting common resources in a 1968 article in the magazine Science
• To address the issue of overharvesting conch, economists typically advocate simple
devices like fishing licenses, harvest limits, and shorter fishing seasons
• The United States banned harvesting conch in1986
Free Riders
• When individuals make decisions about buying a public good, a free rider
problem can arise
• Free rider: people who have an incentive to let others pay for the public
good and then to “free ride” on the purchases of others
Table 1. Contributing to a Public Good as a Prisoner’s Dilemma
– Samuel (S) Contribute Samuel (S) Do Not Contribute
R pays $4, receives $6, net gain R pays $4, receives $3, net gain
+$2 –$1
Rachel (R) Contribute
S pays $4, receives $6, net gain S pays $0, receives $3, net gain
+$2 +$3
R pays $0, receives $3, net gain
+$3 R pays $0, receives $0
Rachel (R) Do Not Contribute
S pays $4, receives $3, net gain S pays $0, receives $0
–$1
The Role of Government in Paying for Public
Goods
• The key insight in paying for public goods is to find a way of assuring
that everyone will make a contribution and to prevent free riders
• Government spending and taxes are not the only way to provide
public goods
• Some public goods will also have a mixture of public provision at no
charge along with fees for some purposes
• Examples: radio, city parks
Marginal Private Benefits
• Individual demand reflects the marginal
benefits a consumer receives from some
product
• When we sum all individual demands,
we get the market demand
• Market demand captures the marginal
private benefits (MPB) of the product,
since it measures the benefits received
by the consumers who purchase the
product
Positive Externalities and Private Benefits
• Market competition can provide an incentive for discovering new
technology
• Gregory Lee, CEO of Samsung said, “Relentless pursuit of new innovation is
the key principle of our business and enables consumers to discover a world
of possibilities with technology.”
• An innovative firm knows that it will usually have a temporary edge over its
competitors and thus an ability to earn above-normal profits before
competitors can catch up
• In some cases, competition can discourage new technology
• Such inventors such as Eli Whitney, Thomas Edison, and Gordon Gould found
that their inventions less profitable then they expected
The Positive Externalities of New Technology
• When a firm invests in new
technology, the private benefits,
or profits, that the firm receives are
only a portion of the overall social
benefits
• The social benefits of an
innovation take into account the
value of all the positive
externalities of the new idea or
product
• Positive externalities are beneficial
spillovers to a third party, or parties
Why Invest in Human Capital?
• An investment in anything usually requires a certain upfront cost with an
uncertain future benefit
• Using education as an example, once the numbers are crunched, does the
investment pay off for the student?
• Almost universally, economists say that the answer is a clear “Yes”
Table 2. Usual Weekly Earnings of Wage and Salary Workers, Fourth Quarter 2016
– Less than a High School Degree High School Degree, No College Bachelor’s Degree
Median Weekly Earnings (full-time
workers over the age of 25) $519 $698 $1,270
Negative Externalities: Pollution
• A negative externality exists when the cost to society of a economic
agent’s action is greater than the cost to the agent
• The problem of pollution arises for every economy in the world
• Every country needs to strike some balance between production
and environmental quality
• Traditionally, policies for environmental protection have focused on
governmental limits on how much of each pollutant can be emitted
• Economists have suggested a range of more flexible,
market-oriented policies that reduce pollution at a lower cost
The Economics of Pollution
• Over the past 50 years population in the U.S. has increased by
one-third and the U.S. economy has doubled.
• Despite the gradual reduction in emissions from fossil fuels, many
important environmental issues remain
• There are still high levels of air and water pollution
• Other issues include:
• Hazardous waste disposal
• Destruction of wetlands and other wildlife habitat
• Impact on human health from pollution
Pollution as a Negative Externality
• Pollution is a negative
externality
• The social costs include the
private costs of the
production incurred by the
company and the external
costs of pollution that are
passed on to society
• In a market with no
antipollution restrictions, firms
can dispose of certain wastes
absolutely free
Regulating Pollution
• In the 60s and 70s the U.S. began passing laws comprehensive environmental
laws specifying how much pollution could be emitted out of a smokestack or
a drainpipe
• This law also imposed penalties if that limit was exceeded
• Some laws required the installation of certain equipment
• These laws fall under the category of effluent standards
• Effluent standards require that firms increase their costs by installing anti-pollution
equipment
• Firms are thus required to take the social costs of pollution into account
Command-and-Control Regulation
• Command-and-control regulations have been highly successful in protecting and
cleaning up the U.S. environment
• Some examples of command-and-control regulation is the creation of the
Environmental Protection Agency (EPA) and the Clean Air Act
• Three difficulties with command-and-control environmental regulation:
1. Once the regulation is satisfied, polluters have zero incentive to do better
2. It is inflexible
• For some firms it is easy to meet the pollution standard or reduce it, and others find it very difficult
3. The regulations are written by legislators and the EPA, so they are subject to compromises in
the political process
Benefits and Costs of Clean Air and Water
• The benefits of a cleaner environment can be
divided into four areas:
1. People may stay healthier and live longer
2. Certain industries that rely on clean air and water
(farming, fishing, tourism) may benefit
3. Property values may be higher
4. People may simply enjoy a cleaner environment
• It’s difficult to put a monetary value for a clean
environment
• The value of clean air for someone with asthma is
worth more than someone who doesn’t have
asthma
Ecotourism: Making Environmentalism Pay
• Ecotourism can mean several different things
• Ecotourism needs careful management
• The combination of eager tourists and local entrepreneurs can destroy what
visitors come to see
• Even though there are many negative opinions about ecotourism, sometimes
it’s better than low-income people in poor countries damaging their local
environment in order to survive
Marginal Benefits and Marginal Costs
• When the quantity of
environmental protection is so low
that pollution is extensive, there
are usually a lot of relatively
cheap ways to reduce pollution
• The marginal benefits from these
ways are quite high
• As environmental protection
increases, the cheap, easy ways
to reduce pollution decrease
Intellectual Property Rights
• There are a number of government policies that increase incentive to
innovate:
• Guaranteeing intellectual property rights
• Government assistance with costs of R&D
• Cooperative research ventures between universities and companies
• Intellectual property rights include patents which give the inventor the
exclusive legal right to make, use, or sell the invention for a limited time
Problems with Patents
• Patents are not perfect, for example:
• Countries that already have patents have shown in economic studies that inventors
only receive a small portion of the profits of their inventions
• Patents on technology become irrelevant due to technology advancing so quickly
• Not every new idea can be protected with a patent or a copyright
• Patents occasionally cover too much or be granted too easily
• The 21 year time period for a patent is somewhat arbitrary
Patents Filed and Granted, 1981-2012
Effluent Changes
• An effluent (or pollution) charge is a tax
imposed on the quantity of pollution
that a firm emits
• Under an effluent charge system, firms
are allowed to pollute, as long as they
pay the charge for every unit of
pollution
• A pollution charge gives a
profit-maximizing firm an incentive to
figure out ways to reduce its emissions
• A pollution charge gives a profit-maximizing
firm an incentive to figure out ways to
reduce its emissions
Marketable Permits
Table 1. How Marketable Permits Work
– Firm Alpha Firm Beta Firm Gamma Firm Delta
Current
emissions—permits
200 tons 400 tons 600 tons 0 tons
distributed free for
this amount
How much pollution
will these permits 100 tons 200 tons 300 tons 0 tons
allow in one year?
Actual emissions one
150 tons 200 tons 200 tons 50 tons
year in the future
Buys
Buyer or seller of Doesn’t buy or Sells permits for Buys permits for
permits for
marketable permit? sell permits 100 tons 50 tons
50 tons
Quick Review
• What are externalities and market failure?
• How do markets not always allocate goods efficiently, due to externalities?
• What are some characteristics of public goods?
• What are some common resources and the tragedy of the commons?
• What is the free rider problem?
• What are positive externalities, including new technology?
• How are private and social benefits different?
• How do they cause market failure?
• What are negative externalities and examples of negative externalities?
• How do the differences between private costs and social costs cause market
failure?
More Quick Review
• What is command-and-control regulation?
• What are the benefits and costs of environmental protection?
• How do you apply marginal analysis to illustrate the marginal costs and
marginal benefits of reducing pollution?
• What are some ways that some U.S. government policies encourage
innovation?
• How can pollution charges or marketable permits impact firm decisions?
• What is the significance of marketable permits and property rights?
• Which government and market policies are most appropriate for various
situations?
