UNIT 4: PUBLIC GOODS

In this unit we examine in detail one of the causes of market failure. We take a
detailed look at public goods and how they contribute to sub-optimal allocation of
resources by private markets. It is argued that the provision of public goods should
be by the government. Hence it is imperative to under the conditions under which
the public goods can be efficiently provided.

Objectives

 Students understand the conceptual meaning of public goods and the conditions
under which public goods can be optimally be provided by the private sector.
 Students understand the concept of free-riding and how it leads to market failure
in the provision of Public Goods.

What is a Public Good?

Typically in the study of microeconomics the goods that are studies can be referred
to as Private goods. Examples (in microeconomics) will usually make a mention of
goods such as pizza, apples, mangoes etc. All these good have common attributes
that render them to be classified as Pure Private goods. The polar opposite of Pure
Private goods are Pure Public Goods. A Pure Public good is a good that possess
two characteristics; non-rival and non-excludable in consumption.

 Consumption of a good is non-rival – once provided, the additional cost of

another person consuming the good is zero.
 Consumption of the good is non-excludable – To prevent anyone from
consuming the good is either very expensive or impossible.

Examples of public goods are national defense, mosquito abatement, and

weather prediction, among others.

Characteristics of Public Goods

There are several attributes of Public Goods that deserve to be pointed. These are:

a) Private Goods are not necessarily provided exclusively by the Private

Sector
The Public Sector sometimes provides goods that are excludable and rival
goods. These goods are known as Publicly Provided Private Goods. A good is
not “public” just because it is provided by government. Roads are an example of
a good provided by government that is not a public good. (Non-payers can be

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 excluded from a road by having toll booths. And when roads are congested,
additional drivers do reduce others’ enjoyment of the roads.) Also, a good is not
public just because it is not provided by government. Lighthouses are an
example of a public good that has sometimes been provided by private
entrepreneurs.
b) Even Though Everyone Consumes the Same Quantity of the Good, It need
not be valued equally by all

Public goods are usually provided in uniform amounts. For example, everyone
has access to the same amount of streetlights along a given street. However,
people will attach different valuations to the benefits that they accrue from the
street lighting.

c) Classification as a Public Good is not an absolute; It depends on market

conditions and the state of Technology

The ‘publicness’ of a good is a matter of degree. The degree to which the good is public
may depend on market conditions and the state of technology. For instance, scenic
viewing may be considered a pure public good when the number of sightseers are
limited, however, as the number increases, the degree increasingly become rival in
consumption. Hence, a good that may have been non-rival in one instance maybe rival
in another.

d) A commodity can satisfy one Part of the Definition of a Public Good and Not
the other

Efficient Provision of Public Goods

The fact that public goods are non-excludable makes it very difficult to provide these
goods efficiently through private market transactions. Also, the amount of benefit each
person receives may differ and is hard to measure, and that can make it even harder to
provide these goods privately.

Under what conditions are public goods efficiently provided?

Assume a two-person economy with a private good and a public good.

Assume that the two persons consume both the private good and a public good.

Assume further that the public good and private good are priced as Pa and Pb,
respectively. Further assume that Pb is equal to unity (i.e, Pb = 1).

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The marginal rate of substitution of the public good for the private good for individual 1
1 Pa 2 Pa
is given as given as MRS ab= =P a. And for individual 2 as MRS ab= =P a
Pb Pb

The provision of a pure public is such that once an amount has been provided one
individual cannot exclude another from consuming the good. Individual one and
individual two will each have a demand curve for the public good. Assume that the
Individual 1 is willing to pay 7 ZMK to consume 20 units of the public good and that
individual 2 is willing to pay 3 ZMK to consume 20 units of the public. The price that
each individual is willing to pay represents the marginal benefit from consuming the 20 th
Unit of the public good. Hence to obtain the group demand curve for the good, the
individual demand curves are summed vertically. Assume the marginal cost of providing
the 20th Unit is 6 ZMK. If at present the individuals are consuming 19 units, then it
makes economic sense to supply the two individuals the 20 th unit since the Marginal
benefit of the 20th Unit (10 ZMK) exceeds the marginal cost of providing the unit, 6ZMK.

Hence the condition for the efficient provision of the public good is that

MRS 1ab+ MRS 2ab=MRT ab

The condition gives the condition at which the most efficient level of the public good will
be produced.

The marginal cost of provision for the public good and public private good are MC a and
MC b, respectively. Recall that for two private goods there price ratios are equal to the
marginal cost ratios, which in turn gives the marginal rate of transformation of producing
the two goods, thus

MC a
MRT ab=
MCb

Free-Rider Problems
Given that public goods are non-excludable and non-rival. The provision of public goods
requires that people reveal their true valuation for a given amount of a public good.
Thus each individual Marginal rate of substitution must be accurately revealed.
However, since the public good is non-excludable, an incentive exists for people to
undervalue their valuation of the public good (or even value the benefit from the public
good as Zero).

An individual who undervalues his/her valuation of a public good in a bid to consume of

the good when others have paid for it is known as a free-rider.

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 Resolution of Free-Riding
Provision of public goods should be left to the government. The argument is that
government can somehow find out everyone’s true preferences, and then, using its
coercive power, force everyone to pay for the public goods.

UNIT 6: EXTERNALITIES
In this Unit we continue with our detailed study of one of the causes of market failure.
Having shown how public goods are a market failure and how they lead to market
failure we do the same for externalities in this Unit.

Objectives

 Students understand the conceptual meaning of Externalities and the conditions

under the presence of externalities lead to sub-optimal provision of goods that
generate externalities.
 Students should be able to relate the concepts of market failure and externalities

Definitions of an Externality

a) The uncompensated impact of one person’s actions on the well-being of a

bystander.
b) An externality exists when the consumption or production choices of one agent
enters the utility or production function of another agent without that agent’s
permission or compensation.

An externality can only exist when the welfare of some agent, or group of agents,
depends on an activity under the control of another agent. Under these circumstances,
an externality arises when the effect of one economic agent on another is not taken into
account by normal market behavior. Externalities are a type of market failure. When an
externality exists, the prices in a market do not reflect the true marginal costs and/or
marginal benefits associated with the goods and services traded in the market. A
competitive economy will not achieve a Pareto optimum in the presence of externalities,
because individuals acting in their own self-interest will not have the correct incentives
to maximize total surplus (i.e., the “invisible hand” of Adam Smith will not be “pushing
folks in the right direction”).
Externalities may be related to production activities, consumption activities, or both.
Production externalities occur when the production activities of one individual imposes
costs or benefits on other individuals that is not transmitted accurately through a market.
In this course we shall only examine production externalities, for example, air pollution
from burning coal, ground water pollution from fertilizer use, or food contamination and
farm worker exposure to toxic chemicals from pesticide use.

The Nature of Externalities

Externalities have the following characteristics:
a. Externalities can be produced by Consumers as well as Firms
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Firms produce production externalities whilst Consumers will produce consumption
externalities such as an externality produced from smoking cigarettes.
b. Externalities are reciprocal in nature
The victim of an externality may also be regarded as a polluter. For example, If Peter
and Jane’s economic activities are dependent on a stream. Peter has a factory
upstream and Jane fishes in the stream downstream. When Peter discharges effluent in
the stream without compensating Jane, Jane is said to suffer from the negative
externality imposed on by Peter. However, by her fishing activities downstream, Jane
reduces the capacity of the stream to absolve Peter’s waste from the manufacturing
process. Hence, Jane can also be said to be imposing a negative externality on Peter.
c. Externalities can be Positive.

d. Public Goods can be viewed as a Special kind of Externality

A graphical Analysis of Externalities

Consider the production of Commodity X that generates some negative externality in
terms of pollution. Pollution will be considered an externality if the firm that generates
the pollution does not compensate the sufferers of the pollution. It was argued in the
previous lecture that market equilibrium denotes Pareto efficient outcomes in the
absence of among other things, externalities. The demand curve reflects the individual’s
marginal benefit from the consumption of an extra unit of a commodity, and the market
or industry supply curve reflects the marginal costs of producing an extra unit of a
commodity. At the intersection of the two curves, the marginal benefits just equal the
marginal costs. However, when externalities are present, the industry’s supply curve will
not reflect marginal social costs, only marginal private costs – costs directly borne by
the producers. In this instance, there will be excess production of Commodity X, yielding
Negative externalities (see Figure below).

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 PRICE

Marginal Social Cost

Supply curve (marginal private cost)

Demand Curve (Marginal Benefit)

QUANTITIY OF X

In the Figure above, the presence of a negative externality means that the marginal
social costs exceed marginal private costs, and the market equilibrium will entail an
excessive production of commodity X. Q m is market equilibrium and Q e is the efficient
level of output.

PRIVATE SOLUTIONS TO EXTERNALITIES

There are circumstances under which private markets can deal with externalities without
assistance from the government. That is economic agents acting on their own can
resolve the externalities. These are:

INTERNALIZING EXTERNALITIES
Internalization of externalities is the process whereby the costs that are likely to be
imposed on third parties upon are instead confined within the unit(s) producing the other
costs. In other words, the unit producing the costs is made to bear the blunt of the costs.
For example, a small manufacturing plants located within close proximity to each other
are likely to impose external costs on each other.
To internalize costs economic units of sufficient size must be formed such that most of
the consequences of any action occur within the unit. For example, a factory upstream
and a fishing business downstream, if the two are separate economic units, each will

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impose externalities on the other. When the two are merged into one economic unit,
each entity will take into account the likely consequences of its action on the welfare
being of the other entity, hence a single economic unit, the externalities will be
internalised.

BARGAINING AND THE COASE THEOREM

The Coase theorem asserts that whenever, an externality emerges, it can be resolved
by a bargaining process involving all parties to the transaction. However, before the
parties bargain property rights must be assigned to either party. The Coase theorem
argues that provided that the costs to the parties of bargaining are low, an efficient
solution will always emerge.

USING THE LEGAL SYSTEM

When property rights are not perfectly defined, the legal system can provide protections
against externalities. The system of common law does not allow one party to injure
another, and “injury” can be interpreted to include a variety of economic costs imposed
on others.

SOCIAL CONVENTIONS
Social conventions are customs or ways of acting or doing things that are widely
accepted and followed.
Certain social conventions can be viewed as attempts to compel people to take into
account the externalities that they generate. Schoolchildren are taught that littering is
not responsible and not “nice”. A child learns that even though they bear a small cost
by holding on to candy wrapper until he finds garbage can, he must incur this cost
because it is less than the cost imposed on other people by having them to view his
unsightly garbage.

FAILURE OF PRIVATE SOLUTIONS

If private solutions to the elimination of externalities work perfectly there could be no
need for government intervention. However, private solutions may fail due to the
following reasons:
a) Public good (free rider) problems

Many externalities involve the production of a public good and it may be difficult to
exclude anyone from the benefits of the goods. For instance, If non-smokers get
together to compensate smokers for not smoking, it pays any individual non-smoker to
claim that he is almost indifferent to letting others smoke. He will attempt to free ride on
the efforts of others to induce the smokers not to smoke

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 b) Information Asymmetries

Smokers may try to persuade non-smokers that they require a lot of compensation to
induce them not to smoke. In such bargaining situations (plagued by information
asymmetry), one party may risk the possibility of not arriving at a mutually
advantageous agreement in order to get more out of any bargain.

c) Transaction Costs

The costs of getting individuals together to internalise externalities voluntarily may be

significant. Transactions are huge when dealing with externalities using litigation.

d) Uncertainty

Uncertainty about the extent of injury suffered from the externality compounds the
problem of transaction costs and there is also some ambiguity about the outcome of
most law suits.

PUBLIC SECTOR SOLUTIONS TO ENVIRONMENTAL EXTERNALITIES

Every production process will produce some level of pollution as a by-product. The
problem is not that private sector production produces pollution but that the private
sector does not take into account the effect of their pollution on the environment. It must
be made clear that there exists a socially efficient level of pollution. That is there is a
level of pollution at which the benefits to society are equal to the costs that the society
incurs. For the socially efficient level of pollution to be attained the government must
make the firms to account for the costs they impose on society when they pollute as a
result of their production activities. The government will achieve its objective of ensuring
a socially efficient level of pollution by market based solutions and Direct Regulation.
We in turn examine the two public sector solutions to the resolution of externalities.

a) Market Based Solutions

Market based solutions are solutions that use marketlike mechanisms to induce
firms and individuals to take into account the effects of their actions on others.
These marketlike mechanisms primarily consist of three forms: fines and taxes,
subsidies for pollution abatement, and marketable permits.

i) Fines and Taxes

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 Fines and Taxes are used to align a firms’ marginal private costs with the social
marginal cost of its production activities. The solution lies in levying fees or taxes
that in proportion to the amount of pollution that is emitted. A properly calculated tax
presents the individual with the true social costs and benefits of its actions. The tax
or levy should align the firms’ marginal private costs with the marginal social cost of
the firms’ production activities. The difference between the marginal social cost and
the firms’ marginal private cost is the marginal cost of pollution. Hence levying the
firm an amount equal to the marginal cost of pollution will ensure that the socially
efficient level of pollution is produced. The fines that are designed to ensure that
marginal private costs are equated to marginal social costs are known as Pigovian
taxes.

ii) Subsidizing Pollution Abatement

One of overcoming excessive pollution is through pollution abatement. That is firms’ can
install technologies that will reduce the amount of pollution that is produced. However,
firms may have little incentives to spend on pollution abatement as the results of such
expenditures will not directly accrue to the firms but to the surrounding communities.
Hence, from a social point of view, there will be little expenditures on pollution
abatement. Rather than taxing pollution, the government could subsidize pollution
abatement expenditures. This can be achieved by giving a subsidy equal to the
difference between the marginal social benefit of pollution abatement and the firm’s
marginal private benefit, the efficient level of pollution abatement expenditures is
attained.

iii) Marketable Permits

Marketable permits limit the amount of pollution that a firm can emit. A firm is allowed to
emit a given number of pollutants. The firms are allowed to trade the permits. Hence, a
firm that only emits half its allowable limit can free trade the other half with a firm that
wants to pollute beyond its permitted level.

Firms will be willing to sell the permit as long as the market price is greater than the
marginal cost that the firm will incur in reducing pollution and firms will be willing the buy
the permits if the marginal cost of reducing pollution is greater than the price of the
marketable permit. Thus in equilibrium each firm will reduce pollution to a level where
the marginal cost of the pollution reduction is equal to the market price of the permit.

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 b) Regulations

The public sector will at times utilize direct regulation to control externalities. For
example, emission standards for motor vehicles; detailed regulations relating to the
disposal of toxic waste; banning of smoking in public spaces.

There are two types of regulations:

i) Performance – based regulations

This is the type of regulation that focuses on controlling the final outcome of the
production processes. For example, enforcement of automobile emission standards.

ii) Input regulations

For example the government may prohibit the use of certain grades of coal.

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