12/21/2015 Microeconomics Externalities and Public Goods Chapter By Tran Thi Kieu Minh, MSc Externalities • The uncompensated impact of one person’s actions on the well-being of a bystander • Market failure • Negative externality: Impact on the bystander is adverse ▫ Exhaust from automobiles ▫ Barking dogs • Positive externality: Impact on the bystander is beneficial ▫ Restored historic buildings ▫ Research into new technologies Externalities and Market Inefficiency • Externalities  Cause markets to allocate resources inefficiently • Welfare economics: a recap ▫ Demand curve – value to consumers  Prices they are willing to pay ▫ Supply curve – cost to suppliers ▫ Equilibrium quantity and price  Efficient  Maximizes sum of producer & consumer surplus 12/21/2015 The market for aluminum Price of Aluminum Externalities and Market Inefficiency Supply (private cost) • Negative externalities ▫ Pollution ▫ Cost to society (of producing aluminum) Equilibrium  Larger than the cost to the aluminum producers ▫ Social cost - supply Demand (private value)  Private costs of the producers  Plus the costs to those bystanders affected adversely by the negative externality Quantity of Aluminum QMARKET The demand curve reflects the value to buyers, and the supply curve reflects the costs of sellers The equilibrium quantity, QMARKET, maximizes the total value to buyers minus the total costs of sellers In the absence of externalities, therefore, the market equilibrium is efficient ▫ Social cost curve – above the supply curve Pollution and the social optimum Price of Aluminum External Cost Externalities and Market Inefficiency Social cost (private cost and external cost) Supply (private cost) • Positive externalities ▫ Education Optimum  Benefit of education – private  Externalities: better government, lower crime rate, higher productivity and wages Equilibrium Demand (private value) QOPTIMUM QMARKET ▫ Social value – demand  Higher than private value Quantity of Aluminum In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET ▫ Social value curve  Above demand curve 12/21/2015 10 Education and the social optimum Price of Aluminum Optimum Externalities and Market Inefficiency Supply (private cost) External Benefit Equilibrium Social value (private value and external benefit) • Government – correct market failure ▫ Taxing goods that have negative externalities ▫ Subsidizing goods that have positive externalities Demand (private value) QMARKET QOPTIMUM Quantity of Aluminum In the presence of a positive externality, the social value of the good exceeds the private value The optimal quantity, QOPTIMUM, is therefore larger than the equilibrium quantity, QMARKET 12 The Different Kinds of Goods • Excludability ▫ Property of a good ▫ A person can be prevented from using it • Rivalry in consumption ▫ Property of a good ▫ One person’s use diminishes other people’s use 12/21/2015 14 Four types of goods The Different Kinds of Goods Rival in consumption? Yes Yes Excludable? No No Private goods Natural monopolies - Ice-cream cones - Clothing - Congested toll roads - Fire protection - Cable TV - Uncongested toll roads Common resources Public goods ▫ Public goods - Fish in the ocean - The environment - Congested nontoll roads - Tornado system - National defense - Uncongested nontoll roads ▫ Common resources Goods can be grouped into four categories according to two characteristics: (1) A good is excludable if people can be prevented from using it (2) A good is rival in consumption if one person’s use of the good diminishes other people’s use of it This diagram gives examples of goods in each category • Types of goods ▫ Private goods  Excludable & Rival in consumption  Not excludable & Not rival in consumption  Rival in consumption & Not excludable ▫ Natural monopoly  Excludable & Not rival in consumption 13 15 The Different Kinds of Goods • Public goods & Common resources ▫ Not excludable ▫ People cannot be prevented from using them ▫ No price attached to it ▫ Positive externalities ▫ Negative externalities 16 Public Goods • The free-rider problem ▫ Free rider  Person who receives the benefit of a good but avoids paying for it ▫ Public goods – not excludable  Free-rider problem prevents the private market from supplying the goods  Government - can remedy the problem     If total benefits of a public good > its costs Provide the public good Pay for it with tax revenue Make everyone better off 12/21/2015 17 Public Goods 18 Public Goods • Some important public goods ▫ National defense • The difficult job of cost–benefit analysis ▫ Government  Very expensive public good  Decide what public goods to provide  In what quantities ▫ Basic research ▫ Cost–benefit analysis  General knowledge  Compare the costs and benefits to society of providing a public good  Doesn’t have any price signals to observe  Government findings on the costs and benefits ▫ Fighting poverty  Welfare system  Food stamps  Rough approximations at best 19 Common Resources • Common resources ▫ Not excludable ▫ Rival in consumption • Some important common resources ▫ Clean air and water ▫ Congested roads ▫ Fish, whales, and other wildlife 20 Common Resources • The tragedy of the commons ▫ Parable - why common resources are used more than desirable  From society’s standpoint ▫ Social and private incentives differ ▫ Arises because of a negative externality ▫ Negative externality  One person uses a common resource  Diminishes other people’s enjoyment of it  Common resources tend to be used excessively ▫ Government - can solve the problem  Regulation or taxes  Reduce consumption of the common resource  Turn the common resource into a private good ... - Cable TV - Uncongested toll roads Common resources Public goods ▫ Public goods - Fish in the ocean - The environment - Congested nontoll roads - Tornado system - National defense - Uncongested... of goods The Different Kinds of Goods Rival in consumption? Yes Yes Excludable? No No Private goods Natural monopolies - Ice-cream cones - Clothing - Congested toll roads - Fire protection - Cable... Public Goods 18 Public Goods • Some important public goods ▫ National defense • The difficult job of cost–benefit analysis ▫ Government  Very expensive public good  Decide what public goods