Econ 102 - CHAPTER 10: Externalities and Public Goods

Externality

Side effect on bystanders not reflected in market prices.

• A price change is not an externality

Negative Externality

A side effect that harms bystanders.

• Choices that impose costs on others

overproduction.

Marginal Social Cost = MPC + MEC

Market failure: There is too much of this activity taking place

Positive Externality

A side effect that benefits bystanders.

• Choices that generate benefits for others

underproduction

Marginal Social Benefit = MPB + MEB

Market failure: There is too little of this activity taking place

Marginal Private Cost (MPC)

extra costs paid by the seller from producing one extra unit.

• Gas Example: Money spent on extra labor, electricity, etc., to produce another gallon of gas.

• This is the firm’s supply curve

Marginal External Cost (MEC)

extra cost imposed on bystanders from producing one extra unit.

• Gas Example: The additional pollution from this extra gallon of gas

Marginal Social Cost (MSC)

All marginal costs, no matter who pays them.

MSC = marginal private cost + marginal external costs

Marginal Private Benefit (MPB)

The extra enjoyment by the buyer from purchasing one extra unit.

• Vaccine Example: The value of protecting your own health, plus the value of being able to do activities that require a vaccination.

• This is the buyer’s demand curve!

Marginal External Benefit (MEB)

The extra benefit accruing to bystanders from one extra unit.

• Vaccine Example: The additional vaccine further reduces the risk that the virus is passed on to other members of society

Marginal Social Benefit

All marginal benefits, no matter who gets them.

MSB = Marginal Private Benefit + Marginal External Benefit

Socially optimal quantity

The quantity that is most efficient for society as a whole, including the interests of buyers, sellers, and bystanders.

when marginal social benefit = marginal social cost

Four-Step Recipe for Analyzing Externalities

1. Find equilibrium quantity (where supply = demand)

2. Identify the externality (positive or negative).

3. Find socially optimal quantity (where MSB = MSC).

4. Compare the two:

   • If equilibrium > optimal → overproduction (negative externality).

   • If equilibrium < optimal → underproduction (positive externality).

Solving Externality Problems

1. Private Bargaining (Coase Theorem)

2. Corrective Taxes & Subsidies

3. Cap and Trade

4. Laws, Rules, and Regulations

Coase Theorem

If bargaining is costless and property rights are clearly established and enforced, then externality problems can be solved by private bargains

Two examples of private bargaining:

1. Neighbor’s loud music (negative externality issue)

2. Humana Health Insurance (positive externality issue)

Corrective Tax/Subsidy

Problem: People ignore the external costs (or benefits) of their choices.

Solution: Introduce something these people cannot ignore.

Corrective Tax

Negative externality solution:
Set the corrective tax = marginal external cost.

Corrective tax: This tax incentivizes people to do less of the activity.

Corrective Subsidy

Positive externality solution:
Set the corrective subsidy = marginal external benefit.

Corrective subsidy:
This subsidy incentivizes people to do more of the activity.

Cap and trade

A quantity regulation implemented by allocating a fixed number of permits, which can then be traded.

Private goods

Rival and Excludable

Ex:

Cars
Cupcakes
A can of coke
Airline seat

Solution:
Government provides or funds public goods using tax revenue.

Common Resources

Rival and Non-Excludable

Ex:

Fish in Ocean
National Parks (to some extent)
Highways (to some extent)

Private gains but shared costs.

Tragedy of the commons:
The tendency to over consume a common resource.

• Overuse of goods

Solutions

1. Assign ownership rights (privatize the resource).

2. Set quotas or limits (like fishing permits).

3. Government management (parks, conservation laws).

Club Goods

Non-Rival and Excludable

Ex:

Email
Cable TV (HBO)
Satellite Radio (SiriusXM)

Public goods

Non-Rival and Non-Excludable

Ex:

National Defense
Public Broadcasting (NPR)
Public Education

Free Rider problem:

• When someone can enjoy the benefits of a good without bearing the costs

• market is underproduction