ECON — Module 6: Externalities & Public Goods

What are the two properties used to classify goods, and what do they mean?

Excludability: can people be prevented from using the good? Rivalry: does one person's use reduce availability for others? These two properties produce four good types: private, public, common resource, natural monopoly.

Classify these four good types using excludability and rivalry.

Private good: excludable + rival (e.g. a sandwich). Public good: non-excludable + non-rival (e.g. national defence). Common resource: non-excludable + rival (e.g. ocean fish). Natural monopoly good: excludable + non-rival (e.g. a toll road with no congestion).

A congested toll road — what type of good is it?

A PRIVATE good. It is excludable (toll stops non-payers) AND rival (congestion means one driver's use reduces others' ability to use it). Common mistake: students call it a public good because it's government-owned — ownership is irrelevant to classification.

A non-congested toll road — what type of good is it?

A NATURAL MONOPOLY good (club good). Excludable (toll gate) but non-rival (no congestion means one driver's use doesn't reduce availability for others). Once the road is built, adding users costs almost nothing.

What is a negative production externality? Give a real example.

A negative production externality occurs when a firm's production imposes costs on third parties not reflected in the market price. The firm overproduces relative to the socially efficient quantity. Example: a factory releasing pollution into the Manukau Harbour — nearby residents bear costs the firm doesn't pay for.

What is a positive production externality? Give an example.

A positive production externality occurs when a firm's production generates benefits for third parties beyond what the market captures. The firm underproduces relative to the socially efficient quantity. Example: urban beekeeping — bees pollinate neighbouring gardens at no cost to those residents.

What is a negative CONSUMPTION externality? Give an example.

Occurs when a consumer's use of a good imposes costs on third parties. Example: a loud party in a quiet neighbourhood — neighbours bear the cost of the noise without any say in the transaction.

What is a positive CONSUMPTION externality? Give an example.

Occurs when a consumer's use of a good generates benefits for third parties. Example: getting a Covid-19 vaccination — you reduce the chance of infecting others, a benefit they didn't pay for. This is why the correct answer is vaccination, not urban beekeeping (which is a PRODUCTION externality).

In a negative production externality, how do MPC, MSC, and the market outcome relate?

MPC (marginal private cost) is LESS THAN MSC (marginal social cost) because the firm ignores external costs. The market produces MORE than the socially efficient quantity. The social optimum is where MSC = MSB, which is at a lower quantity than the market equilibrium.

In a positive production externality, what is the relationship between MPC, MSC, and MSB at the socially efficient quantity?

At the socially efficient quantity: MSC = MPB (not MPC < MSC). With a positive production externality, the firm's MPC is HIGHER than MSC — society's cost of production is lower than the firm thinks because external benefits offset some costs. So MSC = MPB < MPC at the socially efficient quantity. Common exam trap: don't confuse production and consumption externalities here.

For a negative externality, what policy tool corrects the market failure, and how does it work?

A Pigouvian TAX equal to the external cost per unit. It raises the firm's private cost up to the social cost, reducing output to the socially efficient quantity. For consumption externalities, a tax on the consumer achieves the same result.

For a positive externality, what policy tool corrects the market failure, and how does it work?

A SUBSIDY equal to the external benefit per unit. It lowers the effective cost (or raises the effective benefit), increasing production or consumption to the socially efficient quantity. Example: government subsidising vaccinations to increase uptake.

In a negative CONSUMPTION externality: what type of good, what market result, and what remedy?

Negative consumption externality → overconsumption → deadweight loss to society → remedy is a TAX on consumption. Example: cigarettes — smokers impose second-hand smoke costs on others, so a tax reduces consumption toward the social optimum.

In a negative PRODUCTION externality: what fills the blanks? "In the case of a negative ___ externality, there's ___ of a good, resulting in a ___ to society, which might be remedied by imposing a ___ on the good."

Production; overproduction; loss; tax. The firm produces too much because it doesn't bear the full social cost — a tax internalises that cost and brings output down to the efficient level.

Why do public goods tend to be underprovided by the private market?

Because they are non-excludable — you can't stop people from consuming them even if they don't pay. This creates the free-rider problem: individuals have no incentive to pay voluntarily because they'll get the benefit anyway. Markets therefore underproduce public goods, requiring government provision.