Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 20: Public Goods and Externalities By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives    Explain what economists mean by the term public goods and the free rider-rider problem Describe the efficiency in the provision and distribution of a public good Define external benefits and external costs and show how their presence results in nonoptimal output levels for goods characterized by such aspects (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives   (continued) Show how clearly defined and enforced property rights can resolve externality problems and thereby ensure an efficient outcome Demonstrate how air pollution can more efficiently be controlled through the establishment of an overall industry pollution target and the assignment of tradable emissions permits to the industry's firms Copyright © 2015 John Wiley & Sons, Inc All rights reserved Explain what economists mean by the term public goods and the free rider-rider problem 20.1 WHAT ARE PUBLIC GOODS? Copyright © 2015 John Wiley & Sons, Inc All rights reserved Public Goods and Externalities  Public goods – those goods that benefit all consumers  Externalities – the harmful or beneficial side effects of market activities that are not fully borne or realized by market participants Copyright © 2015 John Wiley & Sons, Inc All rights reserved What Are Public Goods?  Characteristics:  Nonrival in consumption – a condition in which a good with a given level of production, if consumed by one person, can also be consumed by others  Nonexclusion – a condition in which confining a good’s benefits, once produced, to selected persons is impossible or prohibitively costly  Free-Rider Problem  A consumer who has an incentive to underestimate the value of a good in order to secure its benefits at a lower, or zero, cost  As the group size increases, it is more likely that everyone will behave like a free rider, and the public good will not be provided Copyright © 2015 John Wiley & Sons, Inc All rights reserved Describe the efficiency in the provision and distribution of a public good 20.2 EFFICIENCY IN THE PROVISION OF A PUBLIC GOOD Copyright © 2015 John Wiley & Sons, Inc All rights reserved Efficiency in the Provision of a Public Good   Social marginal benefit curve  the demand curve for a public good  derived by vertically summing the consumers’ marginal benefit curves Efficient output of a public good  Occurs where the social marginal benefit curve intersects the marginal cost curve: MBs = MC Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 20.1 - The Efficient Output of a Public Good Copyright © 2015 John Wiley & Sons, Inc All rights reserved Efficiency in Production and Distribution    Conditions for economic efficiency: – an efficient distribution of products among consumers – efficiency in production – efficiency in output – Output be produced by using the least costly combination of inputs No rationing problem Inefficient to exclude anyone Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 Patents  A patent gives the holder of a patent the exclusive right to make and sell the product or process for 17 years  Temporary legal monopoly power  Benefit: stimulates inventors to devote resources to the production of new knowledge  Cost: after the new knowledge is produced, it is inefficiently employed Copyright © 2015 John Wiley & Sons, Inc All rights reserved 11 Define external benefits and external costs and show how their presence results in nonoptimal output levels for goods characterized by such aspects 20.3 EXTERNALITIES Copyright © 2015 John Wiley & Sons, Inc All rights reserved 12 Externalities Externalities: Side effects borne by people who are not directly involved in the market exchanges External benefits – positive side effects of ordinary economic activities External costs – negative side effects of ordinary economic activities Copyright © 2015 John Wiley & Sons, Inc All rights reserved 13 Externalities and Efficiency  Distinction between externalities and public goods: External effects are unintended side effects of activities undertaken for other purposes  Both are likely to lead to an inefficient allocation of resources Copyright © 2015 John Wiley & Sons, Inc All rights reserved 14 Figure 20.2 - External Costs and Taxes Copyright © 2015 John Wiley & Sons, Inc All rights reserved 15 Figure 20.3 - External Benefits and Subsidies Copyright © 2015 John Wiley & Sons, Inc All rights reserved 16 Show how clearly defined and enforced property rights can resolve externality problems and thereby ensure an efficient outcome 20.4 EXTERNALITIES AND PROPERTY RIGHTS Copyright © 2015 John Wiley & Sons, Inc All rights reserved 17 Externalities and Property Rights  Coase Theorem: As long as property rights are clearly defined and enforced, bargaining between two parties can ensure an efficient outcome  The distributional effects depend on the definition of property rights  Whenever the effects are nonrival over a large group and exclusion is not feasible, the free-rider problem hinders the process of achieving agreement among all concerned Copyright © 2015 John Wiley & Sons, Inc All rights reserved 18 Demonstrate how air pollution can more efficiently be controlled through the establishment of an overall industry pollution target and the assignment of tradable emissions permits to the industry's firms 20.5 CONTROLLING POLLUTION, REVISITED Copyright © 2015 John Wiley & Sons, Inc All rights reserved 19 Market-based Pollution Control Mechanisms Alternatives to “command-and-control” approach to reducing pollution:  Per-emission-unit taxes  Tradable emission permits Copyright © 2015 John Wiley & Sons, Inc All rights reserved 20 Figure 20.4 - A Tax on Pollution Copyright © 2015 John Wiley & Sons, Inc All rights reserved 21 The Market for Los Angeles Smog Tradable emission permits:  set an overall industry pollution level  allocate permits to emit a certain amount of pollution units to each firm  allow the firms to exchange their permits  price at which permits are traded depends upon the bargaining abilities of the two firms Copyright © 2015 John Wiley & Sons, Inc All rights reserved 22 Market-based Pollution Control Mechanisms: Effects Market-based alternatives promise significant efficiencies in production over command-and-control mechanisms for dealing with pollution:  Promote efficiency in production  Ensure that any abatement amount is produced at lowest possible cost Copyright © 2015 John Wiley & Sons, Inc All rights reserved 23 ... economists mean by the term public goods and the free rider-rider problem Describe the efficiency in the provision and distribution of a public good Define external benefits and external costs and show... Figure 20. 3 - External Benefits and Subsidies Copyright © 201 5 John Wiley & Sons, Inc All rights reserved 16 Show how clearly defined and enforced property rights can resolve externality problems and. .. externality problems and thereby ensure an efficient outcome Demonstrate how air pollution can more efficiently be controlled through the establishment of an overall industry pollution target and the assignment