Externalities and Public Goods

Negative Externality

a cost of an activity that falls on people other than those who pursue that activity

an activity will be undertaken at a level grater than what is socially optimal

Positive Externality

a benefit of an activity received by people other than those who pursue the activity

an activity will be undertaken at a level less than what is socially optimal

What do people tend to make decisions based on?

the costs they actually incur and the benefits they actually receive - private costs/benefits

When is the Socially-Optimal Level of some good?

when the marginal social benefit is equal to the marginal social cost

Coase Theorem

if contracting is possible at no cost, people can always arrive at efficient solutions to the problems caused by externalities

requires that negotiations are costless, not always true in practice

Excludability

a person can be prevented from using a particular good

Rivalry

one person’s use of a good diminishes other peoples use

4 Sets of ‘Goods’

Public Goods

non-excludable and non-rivalrous in consumption

lower incentive to actually own the good, or contribute towards its upkeep

Free Riding

the individually optimal thing to do is to not contribute towards a public good and just reap the benefits from everybody else paying in

however if everyone thinks this, the good would be sub-optimally provided or not provided at all which leads to market failure

What does Free Riding Prevent?

private markets from supplying public goods