Externalities and Public Goods
1. There are important cases in which free markets
fail to maximize social surplus.
2. This chapter discusses three such cases:
externalities, public goods, and common
pool resources.
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Externalities and Public Goods
3. One common link among these three examples is
that there is a difference between the private
benefits and costs and the social benefits and
costs.
4. Government can play a role in improving market
outcomes in such cases.
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Externalities A “Broken” Invisible
Hand: Negative Externalities
We Make Sweaters, Inc.
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Externalities A “Broken” Invisible
Hand: Negative Externalities
Free yarn?
Free labor?
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Externalities A “Broken” Invisible
Hand: Negative Externalities
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Externalities A “Broken” Invisible
Hand: Negative Externalities
Negative externality
An economic activity that has a negative spillover
effect, so that
Marginal Social Cost ≡MSC > MPC
and/or
Marginal Private Benefit ≡MPB > MSB
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Externalities A “Broken” Invisible
Hand: Negative Externalities
The Socially Optimal Quantity and Price of Electricity
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Externalities A “Broken” Invisible
Hand: Negative Externalities
Deadweight Loss Due to a Negative Externality
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Externalities A “Broken” Invisible
Hand: Positive Externalities
Positive externality
An economic activity that has a positive spillover
effect, so that
Marginal Social Benefit ≡MSB > MPB
and/or
MPC > MSC
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Externalities A “Broken” Invisible
Hand: Positive Externalities
Social benefits of education:
• Higher individual wages = more tax revenues
• Less reliance on social programs
• Decreased crime
• More innovation
• Better functioning society
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Externalities A “Broken” Invisible
Hand: Positive Externalities
The Market Equilibrium for Education
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Externalities A “Broken” Invisible
Hand: Positive Externalities
Deadweight Loss of a Positive Externality
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Externalities: Pecuniary Externalities
Pecuniary externality
When a market exchange affects other people
through market prices
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Externalities
How can we address inefficient outcomes?
• Private solutions
• Government solutions
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Private Solutions to Externalities
Private Solution: Bargaining
Can Fred (the sweater maker) and Anne (the
downstream microbrewer) come to an agreement?
Profits Per Day
Without Filter With Filter
Fred $130 $100
Anne $90 $140
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Private Solutions to Externalities
Private Solution: Bargaining
Can Fred and Anne come to an agreement?
Profits Per Day
Without Filter With Filter
Fred $130 $100
Anne $90 $140
Range of terms: greater than $30 and less than $50
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Private Solutions to Externalities: The
Coase Theorem
Coase Theorem
Private bargaining will result in an efficient
allocation of resources if:
a. Property rights are well defined
b. Transaction costs are minimized
Information is perfect
The affected parties are few
c. There are no income or wealth effects
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Private Solutions to Externalities: The
Coase Theorem
Will the Coase Theorem hold if:
• The beach-goers (instead of the brewery) try to
come to an agreement with Fred?
Why or why not?
• The costs and benefits of pollution reduction are
not common knowledge?
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Private Solutions to Externalities
Private Solution: Doing the Right Thing
Why do you recycle?
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Government Solutions to Externalities
What if private solutions do not work?
Government solutions:
• Command-and-control—direct regulation
• Market-based policies—provide incentives
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Government Solutions to Externalities
Corrective Taxes
Effect of a Pigouvian Tax
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Government Solutions to Externalities
Corrective Taxes
Pigouvian tax
The tax necessary to incentivize a firm to
produce the socially optimal level of output.
If the tax is equal to the difference between
MPC and MSC, then the market will reach the
socially efficient outcome.
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Government Solutions to Externalities
Corrective Taxes
Pigouvian taxes also work on individuals
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Examples of Pigouvian garbage taxes
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Examples of Pigouvian garbage taxes
▪ North Berwick, Maine
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Examples of Pigouvian garbage taxes
• C.D. Howe Institute Commentary
• Aurora, Illinois (pop. 132,300) • A 39-percent reduction in waste
sent to landfill; 20-percent increase in recyclables diverted.
• City of Stratford, Ontario(pop. 29,300) • A 62-percent increase in
recycling; reduction in residential garbage of 35 percent.
• City of Barrie, Ontario (pop. 103,700)• A 39-percent reduction in
waste sent to landfill; 20-percent increase in recyclables diverted.
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Government Solutions to Externalities
Corrective Subsidies
Effect of a Pigouvian Subsidy on the Education Market
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Government Solutions to Externalities
Corrective Subsidies
Pigouvian subsidy
The subsidy necessary to make an economic
agent increase consumption to the socially
optimal level
If the subsidy is equal to the difference between
MPB and MSB, then the market will reach the
socially efficient outcome.
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Externalities and Public Goods
Evidence-Based Economics Example:
What can the
government do to
lower the number of
earthquakes in
Oklahoma?
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Externalities and Public Goods
The Number of Earthquakes in Oklahoma
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Externalities and Public Goods
Results of the March 2015 Command-and-Control Regulation
in Kansas
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Externalities and Public Goods
• The government used a command and control policy to reduce
earthquakes in Kansas which cut in half the amount of fracking
wastewater injections from 16000 barrels to 8000 barrels per day.
• Could a Pigouvian tax have worked as well in this case.
• What should Oklahoma do?
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Government Solutions to Externalities
Government Regulation: Command-and-Control
Policies
Would you put a catalytic converter on your car if it
were optional? Could a Pigouvian tax work?
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Public Goods
So far, we have only been talking
about private goods
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Public Goods
How many people can eat this apple?
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Public Goods
Rival good Private Public
Goods that only one person
can consume at a time
Nonrival goods
Public
Goods that more than one Private
person at a time can
consume
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Public Goods
Can you eat this apple without paying for it?
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Public Goods
Private Private
Excludable goods
Must be paid for in order to
consume them
Non excludable goods Public Public
Can be consumed, even if they
are not paid for
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Public Goods
Four Types of Goods
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Public Goods
How much are you willing to pay for national
defense?
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Public Goods
BOMB
HERE
What if you didn’t contribute? FIRST
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Public Goods Government Provision of
Public Goods
Free rider problem
When an individual does not pay for a good
because it is non-excludable
Solution
The government makes paying for it mandatory
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Public Goods Government Provision of
Public Goods
What’s the “right” amount of a public good?
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Public Goods Government Provision of
Public Goods
Constructing a Market Demand Curve for a Private Good
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Public Goods Government Provision of
Public Goods
Constructing a Market Demand Curve for a Public Good
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Public Goods Government Provision of
Public Goods
Constructing a Market Demand Curve
for a Public Good
With a public good, what we
want to know is how much
value is placed on each unit,
not how many units people
will consume.
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Public Goods Government Provision of
Public Goods
The Equilibrium Point for Providing a Public Good
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Public Goods: Private Provision of
Public Goods
Did you pay for Cookie Monster’s,
or Animal’s, salary?
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Public Goods: Private Provision of
Public Goods
What’s wrong with charity?
• Money may not go to the areas of most critical need
• Too variable
• When economy is in downturn (needed the most),
giving decreases
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Common Pool Resource Goods
Why would people who fish be in favor of limits on how
many fish they can catch?
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Common Pool Resource Goods
Tragedy of the commons
When common pool resources are overused
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Externalities and Public Goods
Why aren’t cows extinct?
Why did bison reach the brink of extinction?
Buffalo were common Cows were
pool resources private property
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Externalities and Public Goods
Solutions to tragedy of the commons:
• Private ownership (defined by the government)
• Government regulation (fishing limits, for example)
• Tax on use
• Many interesting solutions (other than
privatization) in Elinor Ostrom’s “Governing the
Commons”. She won the Nobel prize in 2009.
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Governing the Open Access Resources
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Practice problem 1
Three roommates—Tinker, Evers, and Chance—share an apartment. It is
really cold outside and they are considering turning up the thermostat in
the apartment by 1, 2, 3, or 4 degrees. Their individual marginal benefits
from making it warmer in the apartment are as follows:
Tinker Evers Chance
1 degree $10 $8 $6
2 degrees $8 $5 $5
3 degrees $6 $4 $3
4 degrees $4 $2 $0
They know that each time they raise the temperature in the apartment by
1 degree, their heating bill goes up by $16.
Practice problem 1
a) To maximize social benefit, they should raise the temperature by
how much?
b) If they split the heating bill equally and decided on the heat
increase by majority voting, how much would they increase the
heating bill?
c) Is that outcome efficient? Why or why not?
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Practice problem 2
Suppose demand is QD=12−P and supply is QS=2P. There is a constant
positive externality of $2 per unit (marginal external benefit,
MEB = $2). Find the market equilibrium quantity and the socially
optimal quantity. Calculate any deadweight loss and show it graphically.
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Practice problem 3
A college campus must decide whether to spend $40,000 to clear sidewalks of
snow during the winter. There are 4,000 students. One thousand of these
students are willing to pay up to $30 each to walk on a snowless sidewalk. The
other 3,000 are willing to pay $8 each.
a) What is the efficient outcome? Why?
b) Suppose the university imposed a $10 fee to cover the cost. This would raise
the $40,000 necessary. What is the likely outcome if the decision to clear snow
were put up for a university-wide vote?
c) A university administrator proposes the following: the 3,000 students willing
to pay $8 must in fact pay $8 each. This raises $24,000. The students willing to
pay $30 have to pay only $16 each (for $16,000 more, for a total of $40,000).
Would this scheme work? Why or why not?
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