Chapter 7
Market Inefficiencies:
Externalities and
Public Goods
Previously
• A price ceiling is a legal maximum price.
• A price floor is a legal minimum price.
• Nonbinding price ceilings and price floors will NOT
affect market equilibrium price. Market equilibrium will
be the optimal result.
• Binding price ceilings and price floors don’t allow the
market to reach equilibrium. Shortages or surpluses will
be the result.
Big Questions
1. What are externalities, and how do they affect markets?
2. What are private goods and public goods?
3. What are the challenges of providing nonexcludable
goods?
Market Inefficiencies: Externalities and Public Goods
Externality Property Rights
• Third-party problem (internal • Coase theorem
cost/benefit ≠ social cost/benefit). Public Goods, Private Goods, Common
• Positive externality vs. negative Resources, and Club Goods
externality.
• Excludable and rival
Correcting externality (internalizing the • Tragedy of the commons (possible
externality) solutions)
• Negative externality
1. Tax the product.
2. Regulate production.
3. Encourage research and development of
alternative substitutes to the product.
• Positive externality
1. Finance and/or subsidize production
and consumption of the good.
2. Laws requiring consumption.
3. Encourage research and development of
similar goods.
Here’s a question for you . . .
What is the optimal level of pollution?
• Zero?
Why can’t we have zero pollution?
Externalities—1
What are externalities?
•
Market failure
• Occurs when?
Externalities are one type of market failure.
Externalities—2
What are internal costs?
•
What are external costs?
•
What are social costs?
•
Third-Party Problem—1
An externality exists when
• internal _____ ≠ social _____.
• internal ________ ≠ social ________.
Third-party problems:
• Occur when?
Third-Party Problem—2
Negative externalities
• ________ experienced by third parties.
• _________________ of the good is consumed and produced.
Positive externalities
• __________ experienced by third parties.
• _________________ of the good is consumed and produced.
Practice What You Know—1
Which of the following activities would most likely create a negative
externality?
A. eating a slice of pizza
B. smoking a cigarette
C. taking a nap
D. getting a college degree
Practice What You Know—2
Which of the following activities is most likely to create a positive
externality?
A. eating a slice of pizza
B. smoking a cigarette
C. taking a nap
D. getting a college degree
Correcting for Negative Externalities
Correcting for Externalities—1
Internalizing the externality
•
• So, he or she is aware of how his or her actions will impact the
social welfare of the community, positively or negatively.
Correcting for Externalities—2
For negative externalities:
• Make firm recognize the external cost.
•
•
•
• The firm’s cost will ________ the social cost.
• The supply curve shifts to the _______.
Practice What You Know—3
Suppose good X creates a negative externality. Which of the
following would NOT be an appropriate way to correct the negative
externality?
A. Subsidize the production of good X.
B. Tax the production of good X.
C. Limit how much of good X can be produced.
D. Require the producers of good X to pay for external costs that
arise.
Correcting for Positive Externalities
Correcting for Externalities—3
For positive externalities:
• Help individuals realize external benefits.
•
•
•
• The consumer realizes the __________________.
• The demand curve shifts to the ________.
Property Rights
Externalities often arise because of a lack of clearly defined
____________________.
Property rights
•
Private property
• Provides exclusive right of ownership that allows for the use
and exchange of property.
Property Rights Create Incentives
1. Incentive to ___________
2. Incentive to ___________
3. Incentive to ___________
4. Incentive to _____________________
The Coase Theorem—1
Two adjacent farmers, no fences:
• One raising cattle
• One growing wheat
Scenario 1: The cattle rancher is liable for damages
the cows cause.
Options for cattle rancher:
• Put up a fence.
• Pay damages to wheat farmer.
• Rancher will consider costs of both to make
choice.
The Coase Theorem—2
Scenario 2: The wheat farmer does not have a legal right to
cattle-free fields.
Options for farmer:
• Put up a fence.
• Accept occasional cattle damage.
Result?
•
The Coase Theorem—3
What is the Coase theorem?
•
Private and Public Goods
Economists differentiate private and public goods based on two
characteristics:
Excludable
•
Rival
•
Private Goods
Private goods:
• Are both ____________ and _________ in consumption.
• Most goods we purchase and consume are private goods.
Public Goods
What are public goods?
•
•
Free-rider problem:
•
Practice What You Know—4
Which of the following is an example of a public good?
A. a free outdoor Christmas light display
B. a college football game
C. a parking spot with a parking meter
D. a college education
Club Goods and Common Resources
Club goods:
• __________ and _____________.
Common resource goods:
• _______ and ________________.
What Type of Good Is This Park?
Four Types of Goods
Consumption Consumption
Empty cell
Rival Nonrival
Excludable
Empty Cell Empty cell
Yes
Excludable
Empty cell Empty Cell
No
Practice What You Know—5
Membership at your local fitness facility is what type of good?
A. private good
B. club good
C. common resource good
D. public good
Cost-Benefit Analysis
Cost-benefit analysis:
•
The costs are easier to compute than the benefits are.
• People might misrepresent the value of the good to them.
Tragedy of the Commons
Tragedy of the commons:
• Occurs when?
Original example:
• Cattle grazing on a common ground shared by all cattle farmers.
Tragedy of the Commons: Example
• The commons can be sustained indefinitely with a capacity of
around 100 cows.
• Suppose 100 farmers are each allowed to have 1 cow freely graze
in the commons.
• One farmer thinks: What if I bring 2 cows?
• 100 cows? 101 cows? No difference!
• But suppose that ALL the farmers are thinking the same thing?
• Can the commons support 200 cows?
The Tragedy
The commons get destroyed,
even though this was in nobody’s
best interest.
Common Property Incentives
Incentive to ________
Incentive to ________
Incentive to ______________
Possible Solutions—1
Proactive management
•
•
Possible Solutions—2
Cap and trade:
•
• Firms that can control emissions cheaply will sell their
permits.
• Firms who face very high costs to reduce emissions will
purchase permits.
• Creates ____________________ for pollution.
• Internalizes the externality.
Conclusion
Inefficiencies occur because of poor incentives.
Externalities:
• Arise from the result of diverging social and private
costs (or benefits).
• Can be corrected by forcing economic agents to
internalize them.
Efficient level of pollution?
• Must use cost-benefit analysis.
