Principles of Microeconomics - Chapter 5: Externalities and Public Goods

Externality

A benefit or cost affecting someone not directly involved in producing or consuming a good or service.

Negative Externality

An external cost imposed on others; tends to cause too much of a good to be produced.

Positive Externality

An external benefit received by others; tends to cause too little of a good to be produced.

Pollution

An example of a negative externality.

Private Cost

The cost borne by the producer of a good or service.

Social Cost

Total production cost, including private costs and external costs.

Marginal Private Cost

The additional cost directly borne by the producer from producing one more unit.

Marginal Social Cost

The additional total cost to society from producing one more unit, including external costs.

Negative Production Externality

Makes marginal social cost greater than marginal private cost.

Negative Externality and Output

Market quantity is too high compared with the efficient quantity.

Negative Externality and Price

Market price is too low because it does not include the external cost.

Negative Externality and Deadweight Loss

Overproduction creates a deadweight loss because social cost exceeds social benefit for some units.

Private Benefit

The benefit received directly by the consumer of a good or service.

Social Benefit

Total benefit from consumption, including private benefit and external benefits.

Marginal Private Benefit

The additional benefit received by the consumer from one more unit.

Marginal Social Benefit

The additional total benefit to society from one more unit.

Positive Consumption Externality

Makes marginal social benefit greater than marginal private benefit.

Education

A common example of a positive externality in consumption.

Positive Externality and Output

Market quantity is too low compared with the efficient quantity.

Externalities and Market Failure

Externalities cause the market equilibrium to differ from the efficient quantity.

Market Failure

A situation in which the market fails to produce the efficient level of output.

Externality Size and Deadweight Loss

A larger externality generally creates a larger deadweight loss.

Main Cause of Externalities

Incomplete property rights or difficulty enforcing property rights.

Property Rights

Rights to exclusively use property, including the right to buy or sell it.

Efficient Level of Pollution

The level where the marginal benefit of pollution equals the marginal cost of pollution.

Efficient Pollution Reduction

The level where marginal benefit from reducing pollution equals marginal cost of reducing pollution.

Is Zero Pollution Always Efficient?

No. A nonzero amount of pollution may be efficient if eliminating more pollution costs more than the benefit.

Too Little Pollution Reduction

Marginal benefit of additional reduction is greater than marginal cost.

Too Much Pollution Reduction

Marginal cost of additional reduction is greater than marginal benefit.

Coase Theorem

Private bargaining can solve an externality if property rights are enforceable and transaction costs are low.

Requirements of the Coase Theorem

Enforceable property rights, low transaction costs, and full information about costs and benefits.

Transaction Costs

Costs in time and resources involved in agreeing to and carrying out an exchange.

Coase Theorem and Ownership

The efficient outcome theoretically does not depend on who initially holds the property rights.

Why Can High Transaction Costs Prevent Coase Bargaining?

Bargaining becomes difficult or too expensive, especially when many people are affected.

Internalizing an Externality

Making decision makers account for the external costs or benefits of their actions.

Tax for a Negative Externality

A tax equal to the external cost can reduce output to the efficient level.

Effect of Corrective Tax on Supply

Shifts the supply curve upward by making producers account for the external cost.

Subsidy

Payment to producers or consumers to encourage production or consumption of a good.

Subsidy for a Positive Externality

Encourages more production or consumption, moving quantity toward the efficient level.

Effect of Subsidy on Positive Externality

Increases quantity from the market quantity toward the efficient quantity.

Pigovian Tax

A corrective tax designed to make decision makers account for a negative externality.

Pigovian Subsidy

A corrective subsidy used to increase activity that creates positive externalities.

Purpose of Pigovian Taxes and Subsidies

To bring market output closer to the economically efficient level.

Double Dividend of a Pigovian Tax

It can increase efficiency and generate tax revenue that may allow other taxes to be reduced.

Why Can Cigarettes or Soda Create Negative Externalities?

Some medical costs may be shared with others through public or private health insurance.

Command-and-Control Approach

Government limits pollution quantities or requires specific pollution-control methods.

Command-and-Control Example

Requiring automobile manufacturers to install catalytic converters.

Problem With Command-and-Control

Firms may have different pollution-reduction costs, so requiring equal reductions may be inefficient.

Efficient Pollution Reduction Across Firms

Firms with lower reduction costs should reduce more pollution than firms with higher costs.

Tradable Emissions Allowances

Government-issued rights to emit pollution that firms may buy and sell.

Cap-and-Trade

A system that caps total emissions and allows firms to trade emissions allowances.

How Cap-and-Trade Works

Firms with high pollution-reduction costs buy allowances from firms with lower reduction costs.

Benefit of Cap-and-Trade

Achieves a given amount of pollution reduction at the lowest possible cost.

Carbon Tax

A tax on carbon emissions intended to make firms and households account for their external costs.

Rivalry

One person's consumption of a unit prevents someone else from consuming that same unit.

Excludability

People who do not pay for a good can be prevented from consuming it.

Private Good

Rival and excludable.

Private Good Examples

Big Macs and running shoes.

Common Resource

Rival but nonexcludable.

Common Resource Examples

Tuna in the ocean and public pasture land.

Public Good

Nonrival and nonexcludable.

Public Good Examples

National defense and the court system.

Quasi-Public Good

Nonrival but excludable.

Quasi-Public Good Examples

Cable TV and toll roads.

Four Categories of Goods

Private goods, common resources, public goods, and quasi-public goods.

Why Markets Work Well for Private Goods

The person paying for the good generally receives its benefits.

Free Rider

Someone who receives the benefit of a good without paying for it.

Free-Rider Problem

People may avoid paying for public goods because they can receive the benefits anyway.

Why Public Goods May Be Underprovided

Consumers can free ride and may not reveal their true willingness to pay.

Why Common Resources Are Overconsumed

They are nonexcludable but rival, so users have little incentive to conserve them.

Why Quasi-Public Goods Can Be Inefficient

Profit maximization may cause too many people to be excluded.

Demand Curve for a Private Good

Constructed by horizontally adding the quantities each consumer demands at each price.

Demand Curve for a Public Good

Constructed by vertically adding each consumer's willingness to pay for each quantity.

Horizontal Addition of Demand

Add the quantities consumers demand at the same price; used for private goods.

Vertical Addition of Demand

Add consumers' willingness to pay for the same quantity; used for public goods.

Efficient Quantity of a Public Good

Where marginal social benefit equals marginal social cost.

Problem Measuring Demand for Public Goods

Consumers may have little incentive to reveal their true willingness to pay.

Cost-Benefit Analysis

Can help determine the efficient quantity of a public good.

Tragedy of the Commons

Overuse of a common resource caused by lack of clearly defined or enforced property rights.

Common Resource as an Externality

Using the resource reduces what remains for others, creating a negative externality.

Efficient Use of a Common Resource

Occurs where marginal benefit equals marginal social cost.

Common Resource Market Outcome

Individuals ignore external costs, causing the resource to be overused.

Small-Scale Solution to Tragedy of the Commons

Community norms and traditions can restrict access when few people are involved.

Large-Scale Solution to Tragedy of the Commons

Taxes, quotas, or tradable permits can restrict access when many people are involved.

Negative Externality Graph

MSC lies above MPC; Qmarket is greater than Qefficient.

Positive Externality Graph

MSB lies above MPB; Qmarket is less than Qefficient.

Efficient Equilibrium

Occurs where marginal social benefit equals marginal social cost.