Chapter 10: Externalities and Public Goods
Externalities
A central theme of Microeconomics is that free markets produce efficient outcomes.
Adam Smith's The Wealth of Nations (1776) introduced the idea that supply and demand forces act as an "Invisible Hand," guiding markets to generate the highest possible well-being for society.
Laissez-faire economics suggests that markets function optimally when free from government intervention.
However, market outcomes often disregard the interests of those not involved in a transaction, leading to inefficiencies in the presence of externalities.
Externality: A side effect of an economic activity that affects others whose interests are not considered.
People often fail to account for the costs their transactions impose on fellow citizens.
The tension between private and societal interests can lead to unfavorable market outcomes.
Example: Greenhouse gas emissions from fossil fuels affect the Earth’s climate.
Negative Externality
A negative externality imposes harm or costs on others.
Examples:
Driving increases pollution.
Driving increases wear and tear on roads.
Driving increases traffic congestion.
Driving increases the probability of accidents.
Environmental Issues:
Paper mills dumping waste into rivers.
Fossil fuel use causing greenhouse gas emissions.
Positive Externality
A positive externality benefits others.
Examples:
Flu/COVID-19 vaccines benefit individuals and reduce the risk of spreading the virus to others.
Some people may not get vaccinated, underestimating the benefits to others, leading to fewer vaccinations than socially optimal.
A garden or home renovations improve not only the owner's property but also the enjoyment and property values of neighbors.
A more educated population leads to:
Better government.
Lower unemployment.
Lower crime rates.
Improved economic efficiency and productivity.
Better international competitiveness.
R&D creates knowledge that others can use.
Market Failure
Externalities lead to market failure because private interests diverge from social interests.
Private interest: Costs and benefits to an individual or company.
Society’s interest: All costs and benefits, including those to individuals and others.
When individual choices affect others, externalities create a conflict between private and social interests, leading to market failure.
Negative externality: Too much is produced because people do more of the activity than is in society’s best interest.
If forced to pay for the costs imposed on others, they might reduce the harmful activity, leading to a more efficient outcome.
Positive externality: Too little is produced because people do less of the activity than is in society’s best interest.
If they considered the benefits to others, they might increase the activity, leading to a more efficient outcome.
Socially Optimal Quantity
Socially optimal quantity: The quantity that is most efficient for society as a whole, considering the interests of buyers, sellers, and affected third parties.
Accounts for all costs and benefits, regardless of who they affect.
Example: Determining how many liters of gas should be produced from a societal perspective.
Marginal principle: Will society benefit from producing one more liter of gas?
Cost-benefit principle: Compare the marginal social benefit and the marginal social cost.
Rational Rule for Society: Produce more of an item if its marginal social benefit is at least as large as the marginal social cost.
The socially optimal quantity is where marginal social benefit equals marginal social cost.
Negative Externalities - Gasoline Example
Marginal Private Cost (MPC): The additional costs paid by the seller to produce one more unit.
Extra labor, electricity, etc., needed to produce one more liter of gas.
Suppose the MPC associated with 20 million liters of gas is 0.2 per liter.
Marginal Social Cost (MSC): All marginal costs, whether paid by buyers, sellers, or others.
MSC = $1.3 + $0.2 = $1.5 per liter
Free Market Equilibrium:
Producing and burning gasoline harms others.
The marginal external cost is 0.20 per liter higher than the marginal private cost (given by the supply curve).
Reflects the choices of:
Buyers, via the demand curve (i.e., their marginal private benefit).
Sellers, via the supply curve (i.e., their marginal private cost).
Others outside the transaction play no role in determining this outcome.
The socially optimal quantity occurs where the ‘social’ curves intersect (marginal social benefit = marginal social cost).
The negative externality causes overproduction of gas (market failure).
The market equilibrium quantity of gas is higher than the socially optimal quantity.
It is not socially optimal for there to be ZERO pollution; the socially optimal quantity seeks the right balance of all costs and benefits.
When businesses don’t account for the full costs of pollution, they produce too much relative to society’s interest.
Positive Externalities - Flu Shots Example
The free market equilibrium reflects the decisions of:
Buyers, via the demand curve (i.e., their marginal private benefit).
Sellers, via the supply curve (i.e., their marginal private cost).
Others play no role in determining this outcome.
Marginal Private Benefit (MPB): The extra enjoyment by the buyer from purchasing one extra unit.
For vaccines: the value of protecting one's own health.
Suppose the MPB associated with 10,000 vaccines is 30.
Marginal Social Benefit (MSB): All marginal benefits, whether to buyers or others.
Vaccine example: MSB = $40 + $30 = $70
The marginal social benefit of each flu shot consumed is 5 to turn it down.
You are better off: You only offer 5.
They are better off: They only accept 5 more than continuing to listen to their music at a loud volume.
Even if it seems unfair, such negotiations are effective at making both parties better off.
Humana Example: US health insurance company paid clients to exercise.
When private bargaining is costly:
It becomes impossible to get all people affected by climate change together to work toward a solution due to:
Millions of polluters.
Located in many different countries.
Billions of people impacted.
Impacts those who are yet to be born.
Solution 2: Corrective Taxes and Subsidies
Problem: People ignore the external costs (or benefits) of their choices.
Solution: Introduce something these people cannot ignore.
Use a tax/subsidy to correct the market price to incentivize people to internalize the externality.
Negative externality solution:
Corrective tax equal to the external cost to incentivize people to account for the negative externality they cause.
This incentivizes people to do less of the activity.
Positive externality solution:
Corrective subsidy equal to the external benefit to induce people to account for the positive externalities they cause.
This incentivizes people to do more of the activity.
Negative externalities in the market for gasoline:
The tax makes the costs of the negative externality internal to the producer’s cost-benefit calculations.
The new quantity in the market now corresponds to the socially optimal quantity, correcting the overproduction issue.
Solution 2: Corrective Subsidy
Corrective subsidy: Leads people to consider the positive externalities that their actions generate.
Set the corrective subsidy equal to the marginal external benefit.
Examples:
Insurance companies subsidize costs of a home alarm system/winter tires via cheaper insurance rates.
Manitoba Covid-19 vaccine lottery: 25,000 scholarships for those aged 12-17.
Alberta: $
Relatively inefficient firms: $ to Firm 2 for their permit.
Firm 2: What brings me the most money: using my permit ($), or selling my permit ($$$)?
Result: Firm 1 buys the permit from Firm 2.
Solution 4: Laws, Rules, and Regulations
Laws, rules, and regulations can help solve externality problems:
Noise restrictions deter noisy neighbors.
Automaker fuel efficiency regulations reduce gas usage and pollution.
Safety laws reduce endangerment of workers.
Summary: Solving Externality Problems
Ways of achieving efficient outcomes by getting others to internalize their externalities:
Private bargaining: Side payments can motivate people to change their behavior in a manner aligned with the socially optimal outcome.
Corrective taxes and subsidies:
Taxes correct negative externalities by inducing a person to feel the full cost of their actions.
Subsidies correct positive externalities by getting a person to feel the full benefits of their actions.
Cap and Trade concentrates production among efficient businesses.
Laws, rules, and regulations reduce or prohibit behavior that generates negative externalities.
Public Goods and Common Resources
Excludable: When someone can be easily excluded from using something.
Example: Excluding someone from using a car by not giving them the keys.
Nonexcludable: When someone cannot be easily excluded from using something.
Example: Not being able to stop neighbors from also enjoying fireworks set off in a backyard.
Rival: When someone's use of something comes at someone else’s expense.
Example: Buying a cupcake makes one less cupcake available for someone else.
Nonrival: When one person’s use doesn’t subtract from another’s.
Example: Watching something on TV doesn’t prevent others from watching the same show.
Four Classifications of Goods
Issues with Nonexcludable Goods
Whenever one can’t exclude nonpayers from using a good, there will be a free-rider problem.
Free-rider problem: When someone can enjoy the benefits of a good without bearing the costs.
Free riders' viewpoint: Why pay for something that can be enjoyed for free?
Free riders don’t pay for the benefits they receive because the good is nonexcludable.
The problem: If no one pays for the good, no business produces it, resulting in market underproduction or failure to provide the good.
Nonrival & Nonexcludable → Public Goods
The externality issue stems from the presence of free riders.
Result: too little of a public good is produced by the market.
Rival & Nonexcludable → Common Resource
The externality issue creates a ‘tragedy of the commons’.
Result: people use too much of a common resource.
Government Support for Public Goods
The problem: Free riders prevent businesses from effectively getting all people who enjoy the good to pay for it.
Result: The private sector will not provide public goods.
Solution: The government can help to provide public goods.
Government can directly provide the public good using tax money.
Military, public parks, public education.
Tragedy of the Commons
Common resource: A good that is rival and also nonexcludable.
Private gains, but shared costs.
Tragedy of the commons: The tendency to overconsume a common resource.
Fishing example:
Private gain: You can profit from catching a fish.
Shared cost: You reduce the number of fish left for others and disrupt the ecosystem.
The problem: People do not pay the full social cost of their actions when using common resources.
Result: The common resource will be overused.
Tragedy of the commons: Origin story
The name dates back to when most towns had a central grassy area called the commons.
Shepherds would bring their sheep to graze on the free grass in the field.
Since it cost the shepherds nothing, each one grazed their flock on the commons too often, resulting in a dead, overgrazed field.
They overconsumed a common resource.
Everyone would have been better off if they had agreed to limit consumption of the common resource.
Metaphor illustrates that free access to a finite resource can ultimately doom it through over-exploitation of the resource.
Solution: Assign Ownership Rights
Assign ownership rights so that someone now owns the common resource.
The owner has an incentive to ensure it is not overused, so they can continue to profit from it year after year.
The costs and benefits of grazing on the commons become the owner’s costs and benefits.