Microecon Chapter 10 - Externalities and Public Goods

Externality

A side effect of an activity that affects bystanders whose interests are not considered.
→ Can lead to market failures due to inefficient outcomes not in society’s best interest (ether in over/underproduction)

Negative Externality

Side effect that harms bystanders, imposting costs on others.

Positive Externality

Side effect that benefits bystanders, generating benefits for others.

Private Interests

Costs and benefits that an individual personally incurs.

Social Interests

Includes all costs and benefits (whether accrued to an individual or to others)

Marginal Private Cost

Extra costs paid by a seller from producing an additional unit.

→ Also a firm’s supply curve.

Marginal External Cost

Extra costs imposed on bystanders from producing an additional unit
(The seller is not responsible for these costs)

Marginal Social Cost

All marginal costs, regardless of who pays them.

Marginal Private Benefits

Extra enjoyment by the buyer from purchasing an additional unit.
→ Also a buyer’s demand curve.

Marginal External Benefit

Extra benefit accruing to bystanders from an additional unit.

Marginal Social Benefit

All marginal benefit, regardless of who gets it.

Socially Optimal Quantity

That which is most efficient for society as a whole, accounting for the interests of buyers, sellers, and bystanders.

Rational Rule for Society

Produce more of an item as long as the MSB is at least as large as MSC.
→ MSB=MSC

Solutions to Externalities

• Coase Theorem (private bargaining)

• Corrective Taxes and Subsidies

• Cap and Trade

• Laws, Rules, and Regulations

Coase Theorem

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

(Costless refers to the non-need for lawyers or a lengthy legal procedure)

How do Corrective Taxes and Subsidies fix externality problems?

They correct the market price such that people then internalize the externality.

Sets the perfectly competitive market outcome as the socially optimal outcome.

Corrective Tax

That which is designed to induce people to take into account of the negative externality they cause, incentivizing them to do less of the activity.

Corrective Subsidy

That which is designed to induce people to take account of the positive externalities they cause, incentivizing them 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.

Excludable vs. Nonexcludable Goods

Those which someone can easily be excluded from vs. those that someone cannot be easily excluded from.

Rival vs. Nonrival Goods

• Rival: When an individual’s use of something doesn’t allow someone else to use it.

• Nonrival: When one person’s use does not subtract from another’s.

Classification of a good that is both Rival and Excludable

Private Good

Classification of a good that is both Nonrival and Excludable

Club Good

Classification of a good that is both Rival and Nonexcludable

Common Resource

Classification of a good that is both Nonrival and Nonexcludable

Public Good

What kind of externality problem is generated from a Public Good?

The presence of free riders results in too little of a public good being produced by the market.

→ Therefore, the market is underproducing.

What kind of externality problem is generated from a common resource?

This is a tragedy of the commons resulting in too much of a good being used.

What is the Free Rider Problem?

When an individual can enjoy the benefits of a good without bearing the costs.

Bystanders in this situation are enjoying positive externalities.

What is the Tragedy of the Commons?

The tendency to overconsume a common resource.

What is the solution to problems arising from the Tragedy of the Commons?

Assign ownership rights so that someone now owns the common resource, making the costs/benefits of grazing on the commons the costs/benefits of the owner.