Chapter 9
Externalities and
Public Goods
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9 Externalities and Public Goods
Key Ideas
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.
3. One common link between these three examples is that there is 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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9.1 Externalities
A “Broken” Invisible Hand: Negative Externalities
Negative externality
An economic activity that has
a negative spillover effect
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9.1 Externalities
A “Broken” Invisible Hand: Negative Externalities
We Make Sweaters, Inc.
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9.1 Externalities
A “Broken” Invisible Hand: Negative Externalities
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9.1 Externalities
A “Broken” Invisible Hand: Negative Externalities
Exhibit 9.2 The Socially Optimal Quantity and Price of Electricity
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9.1 Externalities
A “Broken” Invisible Hand: Negative Externalities
Exhibit 9.3 Deadweight Loss Due to a Negative Externality
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Analyze…
o The European Union has banned certain pesticides for two years after
studies found links between the use of these insecticides and a decline in
the bee population. In particular, research has shown that the use of
imidacloprid, clothianidin, and thiamethoxam on flowering crops have
adversely affected the honeybee population in North America and Europe.
• Consider the private market for these pesticides. Use supply and
demand curves to show the equilibrium level of pesticides that
will be produced and consumed.
• How might the impact of the insecticide on honeybees be
modeled as a marginal external cost? Show the deadweight loss
from this externality in the graph you drew for the first part of this
question.
• Is the private market outcome socially efficient?
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9.1 Externalities
A “Broken” Invisible Hand: Positive Externalities
Positive externality
An economic activity that has a
positive spillover effect
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9.1 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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9.1 Externalities
A “Broken” Invisible Hand: Positive Externalities
Exhibit 9.4 The Market Equilibrium for Education
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9.1 Externalities
A “Broken” Invisible Hand: Positive Externalities
Exhibit 9.5 Deadweight Loss of a Positive Externality
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Analyze..
o Malaria is spread by mosquitos. That is, a mosquito spreads malaria by
biting an infected person and later infusing malaria into a different
person. A study by Jeffrey Sachs et al shows a strong correlation
between the incidence of malaria in a country and poverty. While
malaria is known to exist in poor countries, it has also been found that
the incidence of malaria exacerbates poverty. One of the simplest and
effective ways of preventing the occurrence of malaria is by using
Insecticide Treated Nets (ITNs).
• Consider the private market for ITNs. Use supply and demand curves to
show the equilibrium level of nets that will be produced. Is this outcome
socially efficient?
• In the graph, how would you account for the ITNs’ effect on poverty?
What happens to the level of output in the market?
• How could the government encourage the production of the efficient
number of ITNs?
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9.1 Externalities
Pecuniary Externalities
Pecuniary externality
When a market exchange affects
other people through market prices
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9.1 Externalities
How can we address inefficient
outcomes?
• Private solutions
• Government solutions
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9.2 Private Solutions to Externalities
Private Solution: Bargaining
Profits Per Day
Without With Filter
Filter
Fred $130 $100
Anne $90 $140
Can Fred and Anne come to an agreement?
Range of terms: greater than $30 and less than $50
What is Anne gave 40 to Fred to use Filter?
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9.2 Private Solutions to Externalities
The Coase Theorem
Coase Theorem
States that private bargaining will result in an efficient allocation of
resources
However, a large number of participants and/or if communication between
the parties is difficult (high transactions costs), the Coase Theorem probably
won’t hold.
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9.3 Government Solutions to Externalities
What if private solutions do not work?
Government solutions:
• Command-and-control—direct regulation
the government could allow the production of 400, but
mandate the use of certain technologies (eg. Catalytic
converter) that lower pollution levels at that quantity. The
problem with this approach is that the focus is on the
technology. Firms adopt it, just meeting the standards,
when they could be incentivized to develop or find the most
cost-effective technology
• Market-based policies—provide incentives
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9.3 Government Solutions to Externalities
Corrective Taxes and Subsidies
Exhibit 9.6 Effect of a Pigouvian Tax on a Power Plant
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9.3 Government Solutions to Externalities
Corrective Taxes and Subsidies
Pigouvian tax
The tax necessary to incentivize a
firm to produce the socially optimal
level of output
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9.3 Government Solutions to Externalities
Corrective Taxes and Subsidies
Pigouvian subsidy
The subsidy necessary to make an
economic agent increase
consumption to the socially optimal
level
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9.3 Government Solutions to Externalities
Corrective Taxes and Subsidies
Exhibit 9.7 Effect of a Pigouvian Subsidy on the Education Market
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9.4 Public Goods
So far, have only been talking
about private goods
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9.4 Public Goods
How many people can eat this apple?
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9.4 Public Goods
Rival goods
Goods that only one person can
consume at a time
Nonrival goods
Goods that more than one person at a
time can consume
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9.4 Public Goods
Can you eat this apple without paying for it?
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9.4 Public Goods
Excludable goods
Must be paid for in order to consume
them
Nonexcludable goods
Can be consumed, even if they are not
paid for
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9.4 Public Goods
Exhibit 9.8 Four Types of Goods
Rival, excludable goods are private goods. Only one person at a time can consume them, and
you don’t get them if you don’t pay for them. These are private goods because the market has an
incentive to provide them—if you don’t pay, you don’t get them.
The market will also have an incentive to provide Club Goods—again because it can exclude
those who don’t pay. These goods typically have a very high fixed cost associated with them, so
firms will not provide these goods at MC (as in the perfect competition model) because the
marginal cost is very low. The market will not provide the two types of goods that are
nonexcludable. Common pool resources are rival in consumption, so if one person consumes it,
others cannot .
9.4 Public Goods
How much are you willing to pay for
national defense?
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9.4 Public Goods
BOMB
HERE
FIRST
What if you
didn’t contribute?
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9.4 Public Goods
Government Provision of Public Goods
Free rider problem
When an individual does not pay for
a good because it is nonexcludable
Solution: The government makes paying
for it mandatory
If the government provides public goods, it must find a way to pay
for them, which it does through tax collections. Therefore, paying
for public goods becomes mandatory, not voluntary.
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9.4 Public Goods
Government Provision of Public Goods
What’s the “right” amount of a public good?
the “right” amount of a good has been defined as that where the
marginal benefit is equal to the marginal cost. The situation is no
different in the provision of public goods. The government should
provide them until the point where the marginal social benefit is
equal to the marginal social cost.
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9.4 Public Goods
Government Provision of Public Goods
Exhibit 9.9 Constructing a Market Demand Curve for a Private Good
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9.4 Public Goods
Government Provision of Public Goods
With a public good, both
individuals can consume the
good at the same time. What
we want to know is how much
value is placed on each unit,
not how many units people
will consume. Therefore, we
want to know how much
everyone values a given
amount of public good. So, the
market demand curve is
derived by adding together
the individual demand curves
vertically—to add together
each person’s value.
Exhibit 9.10 Constructing a Marke
Demand Curve for a Public Good
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9.4 Public Goods
Government Provision of Public Goods
Equilibrium
occurs like
others—where
marginal social
benefit is equal
to marginal
social cost.
Exhibit 9.11 The Equilibrium Point for Providing a Public Good
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good
• 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 up 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 $5 $4 $3
2 degrees $4 $3 $2
3 degrees $3 $2 $1
4 degrees $2 $1 $0
They know that each time they raise the temperature by one degree, their heating bill
goes up by $8.
a. Find the marginal social benefit from making it 1, 2, 3, or 4 degrees warmer.
b. By how many degrees should they raise the temperature?
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9.5 Common Pool Resources
Rival but Not excludable
Tragedy of the commons
When common pool resources are
over-used
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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
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9 Externalities and Public Goods
Non Rival but Excludable: Highways, Public spaces
How can the Queen
of England lower
her commute time to
Wembley Stadium?
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9 Externalities and Public Goods
Exhibit 9.14 Results of the Congestion Charge
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