Chapter 4

Markets, Externalities,
and Public Goods

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 Learning Objectives

1. Define and illustrate economic efficiency.

2. Describe competitive market equilibrium.
3. Define externalities, categorize different types of
externalities, and provide examples.
4. Explain and illustrate why externalities cause market
failure.
5. Explain what an open-access resource is and why it is
subject to overuse.
6. Explain the distinguishing characteristics of public
goods and why they give rise to free riding.

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 Economic Efficiency and Market Equilibrium

• Economic efficiency is a criterion for evaluating the performance of

an economic system, from the perspective of the society:
• Do we use minimum inputs to produce outputs?
• What quantity of output should be produced? (Normative
economics)

• Market equilibrium is the outcome of market economy, determined

by interaction of buyers and sellers in voluntary exchanges
• What quantity is produced in fact? (Positive economics)

• Is market equilibrium efficient? If not, what causes the market failure?

How to make remedy to improve efficiency?

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 Economic Efficiency

• The central idea of economic efficiency is that there should be a

balance between the value of what is produced and the value of what
is used up to produce it - a balance between willingness to pay and
the marginal costs of production, both from the standpoint of the
whole society.
• 2 equivalent ways to understand efficient quantity qe:
• MWTP = MC or MB = MC
• Max Net value (= TWTP – TC) or Max NB (= TB – TC)

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 FIGURE 4.1 The Socially Efficient Rate of Output

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 Inefficiency and Deadweight Loss (DWL)

• For the whole society, when MB is not equal to MC, or NB is not

maximized, efficiency is not achieved.
• The size of the inefficiency loss can be measured by the deadweight
loss (DWL), which is the missing NB, compared to the optimal case.

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 Efficiency and Equity

• From the standpoint of society at large, production is at an efficient

level when marginal benefits equal marginal production costs, that is,
when net benefits are maximized, no matter to whom those net
benefits accrue. Efficiency doesn’t distinguish among people.
• Equity is tied closely to the distribution of income and wealth in a
society.
• Efficiency and equity are two different criteria of assessing economic
outcomes
• An outcome that is efficient need not necessarily be equitable.
• An outcome that is equitable need not necessarily be efficient.

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 Markets

• A market is an institution in which buyers and sellers of goods and

services, carry out mutually agreed-upon exchanges.
• Buyers’/sellers’ desires are represented by the demand/supply curve
• At the competitive equilibrium, no surplus/shortage, no change in
price and quantity traded, when quantity demanded equals quantity
supplied:
Qd = Qs

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 FIGURE 4.2 The Market Model

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 Exercise

Demand: P = 100 – 2Qd, Supply: P = 2Qs.

Solve for: equilibrium price and equilibrium quantity, consumer surplus
and producer surplus.

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 Markets and Social Efficiency

• Do markets produce results that are efficient from the standpoint of

society? (qm = qe?)
• When environmental values are concerned, there are likely to be very
substantial differences between market values and social values
• external costs: market supply curves are not the true marginal
social cost curves
• external benefits: market demands are not true social marginal
willingness to pay
• Market equilibrium is not efficient: market failure.
• It calls for public intervention to improve efficiency.

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 External Costs

• When making decisions, producers consider private costs of the firm,

but do not take into account external costs, which are real costs to
some members of society – external to firms but internal to society.
• Example: cost inflicted on people through environmental degradation

Social costs = Private costs + External (environmental) costs

MSC = MPC + MEC

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 EXAMPLE 4.1 External Costs Associated with Driving
Automobiles

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 FIGURE 4.3 External Costs and Market Outcomes

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 Market Failure Caused by External Costs

• Efficiency: MSB = MSC => qe

• Equilibrium: MPB = MPC => qm
• Given MEC => MSC > MPC => qm > qe: market failure
• The private market system produces too much at too low of a price
compared to socially efficient results - overproduction

• The paper mill is essentially using a productive input it is not paying

for - the services of the river, which provides the firm with a cheap way
to dispose of its production residuals.

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 Exercise

Demand: P = 100 – 2Qd, Supply: P = 2Qs. MEC = Q.

Solve for: equilibrium price and equilibrium quantity, socially efficient
quantity and price, and DWL.

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 Open-Access Resources

• One source of external costs: open-access resource — a resource

or facility that is open to uncontrolled access by individuals who wish
to use the resource. For example, ocean fishery, forest, atmosphere.
• The added costs that one user of a common-property resource inflicts
on other users of that resource are in fact costs that are external to
that user but internal to the whole group of users – external costs.
• When a single individual is making a decision about whether and how
much to utilize a common-property resource, she takes into account
the private costs and benefits, ignoring external costs.
• MEC >0 => MSC > MPC => qm > qe: overuse => depletion of
common resources: “Tragedy of the Commons”

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 Open-Access Resources - Example

• Initially four firms are situated near a lake. They use water from the lake
and discharge emissions back into the lake. To treat water for reuse,
each firm spends $40,000/year.
• Suppose now a new firm enters. There will now be more discharge. So,
treatment cost now is $60,000/year for a firm. (More firms, more
discharge, lower ambient quality)
1) What is the MPC when the 5th firm operates on the shores of the lake?

2) What is the MSC when the 5th firm operates on the shores of the lake?

• But the new firm is only going to think about the private cost and enter.

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 TABLE 4.1 Travel Times Related to the Number of Cars on the
Road

Already 50 cars on road. If you choose to use the road, MPC =? MSC
=? Your alternative route takes 18 minutes. What is your choice? Is your
choice socially efficient?

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 Open-Access Resources - Examples

• Open-access resources => external costs => market failure: tragedy

of the commons
• Other examples of the same kind of effect:
• When a fisher enters a fishery; in catching a portion of the stock,
he leaves fewer to be caught by other fishers.
• When one farmer puts animals on a common pasture, he or she
reduces the forage available to other herds on that pasture.
• When one person cuts wood from a communal forest, she leaves
fewer trees for other users and makes it more difficult for them to
supply themselves with wood.
• Assimilative capacity of environment is an open-access resource.

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 External Benefits

• An external benefit is a benefit that accrues to somebody who is

outside, or external to, the decision about consuming or producing the
good or resource that causes the externality.
• When the use of an item leads to an external benefit, the market
willingness to pay for that item will understate the social willingness to
pay.
Social benefits = Private benefits + External benefits
MSB = MPB + MEB

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 Market Failure Caused by External Benefits

• Efficiency: MSB = MSC => qe

• Equilibrium: MPB = MPC => qm
• Given MEB => MSB > MPB => qm < qe: market failure
• The private market system produces too little at too high of a price
compared to socially efficient results - underproduction

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 Public Goods

• Public goods are defined by two technical characteristics:

• Non-excludable: Once the services are made available to one
person, others cannot be excluded from making use of the same
services.
• Non-rival: One person’s consumption of the good does not reduce
the quantity available to others
• Public goods inherently involve large-scale external benefits
• Examples: lighthouse, radio signal
• Environmental quality improvement is a public good.

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 Four Types of Goods

Excludable( 排他 ) Non-excludable( 非排
他)

House, cars, pizza Tree, parking space,

Rival( 竞争性 )
-Private Good( 私人商品 ) Library computer,
books, washroom
-Open-access
resource( 开放获取资
源 )/common
resource( 公共资源 )
casino, night clubs, movie, Air, firework,Public
Non-rival( 非竞争
PNE, cable TV Wifi
性)
-Club Goods

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 Efficient Provision of Public Goods

• Non-rival => aggregate marginal WTP is the sum of the individual

marginal WTP – a vertical summation of individual WTP curves.
• MSB = MSC => qe

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 TABLE 4.2 Individual and Aggregate Demand for Lowering
Lake Pollution

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 Market Failure: (1) External Benefits

Once a public good is made available to one consumer, it also becomes

available to all others, and others can share the same benefits
=> external benefits: MSB > MPB => qm < qe (underprovision)

Max=Qm<Qe

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 Min Qm (0)<Qe
Market Failure: (2) Free Riding

• Non-excludable => everyone may have an incentive to free ride by

underpaying relative to the true benefits she or he receives.
• Free riding is a ubiquitous phenomenon in the world of public goods,
or in fact for any good for which its consumption produces external
benefits. Because of the free-riding impulse, private, profit-motivated
firms will have difficulty covering their costs if they go into the
business of supplying public goods. Because of these reduced
revenues, private firms will normally undersupply goods and services
of this type: qm < qe

• Government can remedy by using compulsory taxation to finance the

costs of public goods.

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 Exercise

Two households live beside a lake contaminated by fertilizer runoff from

surrounding farms. Fertilizer runoff causes algae to grow in the lake (bad for fish
population and also the scenery), and this lowers amount of dissolved oxygen in
the lake water. To improve water quality, both households could hire a private firm
for treatment.
• MC treatment = 5+2*Q ; MWTPA= 14-2*QA and MWTPB=6-QB.
[Q is quantity of dissolved oxygen in parts per million (ppm)]

Solve for market equilibrium quantity and efficient quantity.

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