Chapter 9 Notes: Externalities and Public Goods

Externalities

• Externalities occur when an economic activity has either a spillover cost to or a spillover benefit for a bystander.

  • Negative externality: an adverse spillover.

  • Positive externality: a beneficial spillover.

• Private market outcomes can be inefficient when externalities are present. Free markets do not maximize social surplus in these cases.

• Key distinction: private benefits and costs vs social benefits and costs. The social outcome accounts for impacts on bystanders, not just the primary actor.

• Pecuniary externality: when a market exchange affects other people through market prices (not through resource allocation or welfare effects). See Externalities (13 of 16).

• Social vs private perspective often summarized as:

  • Negative externalities lead to too much production/consumption in a free market.

  • Positive externalities lead to too little production/consumption in a free market.

• Social welfare condition (general): the socially optimal quantity satisfies
  MB(Q^) = MSC(Q^)
  where MB is marginal benefit and MSC is marginal social cost.

• Private market outcome satisfies
  MB(Q^{private}) = MPC(Q^{private})
  where MPC is marginal private cost.

• The overarching theme: to address externalities, we must internalize the externality.

• Trade-off question often studied: how can we address inefficient outcomes? Private solutions or government solutions are possible paths.

Private Solutions to Externalities

• Coase Theorem (Private Bargaining): private bargaining can lead to an efficient allocation of resources as if the externality were solved, potentially eliminating the need for government intervention.

• Example setup: Fred and Anne bargaining over an externality (e.g., a brewery next to a beach) shows a range of terms that could lead to an efficient outcome.

  • Range of terms in the example: greater than $30 and less than $50 per day (per the slide data).

• End result: If bargaining is frictionless and property rights are well-defined, the private sector can internalize the externality.

• Limitations of private solutions:
  1) Transaction costs may be too high.
  2) Property rights may not be clearly defined.
  3) Too many agents at the bargaining table can hinder agreement.

• Private solution: “Do the Right Thing” – behavior change (e.g., recycling) can internalize externalities without formal contract.

• Summary concept: private solutions can work when transaction costs are low and bargaining is feasible, but they are not guaranteed in all settings.

Government Solutions to Externalities

• When private solutions fail or are infeasible, governments can step in with two broad policy families:
  1) Command-and-control policies: direct regulatory allocation of resources (e.g., standards, bans, quotas).
  2) Market-based policies: incentives that encourage private agents to internalize the externality (e.g., taxes, subsidies, tradable permits).

• Pigouvian tax (negative externality): a tax designed to incentivize the firm to produce at the socially optimal level. It effectively shifts the private marginal cost curve upward to equal the social marginal cost.

  • Formal intuition: set tax t* so that private outcome with tax aligns with the social optimum.

  • General expression: the tax should equal the marginal external cost at the social optimum
    t^* = MEC(Q^*)
    where MEC is the marginal external cost.

• Pigouvian subsidy (positive externality): a subsidy to increase consumption/production to the socially optimal level when there is a positive externality.

  • General expression: the subsidy should equal the marginal external benefit at the social optimum
    s^* = MEB(Q^*)

• Pay-as-You-Throw: a policy instrument where households or firms pay for the amount of waste they throw away, internalizing the negative externality of excessive waste generation.

• Exhibit references:

  • Exhibit 9.2: The Socially Optimal Quantity and Price of Electricity (illustrates the concept of internalizing externalities to reach a socially optimal outcome).

  • Exhibit 9.3: Deadweight Loss Due to a Negative Externality (illustrates inefficiency from negative externalities).

• Evidence-Based Economics (examples):

  • The King of England commute problem to Wembley and congestion-related policy experiments (e.g., congestion charges) show how policy can alter behavior to improve welfare.

• Oklahoma earthquakes problem (Evidence-Based Economics):

  • Policy context: hydraulic fracturing (fracking) was linked to increased earthquakes; command-and-control restrictions reduced saltwater injection but at a cost.

  • Data snapshot:

  • In part (a): Oklahoma resident values avoiding earthquakes at $100 per year; population ~ 4 million. Total perceived benefit = 4{,}000{,}000 imes 100 = 400{,}000{,}000. The cost to industry for reducing injections is 1{,}000{,}000{,}000 per year. Conclusion: not a good idea under these numbers.

  • In part (b): If half the population values avoidance at $500 and half at $50, the average willingness to pay is
    0.5 imes 500 + 0.5 imes 50 = 275 per year. Total value = 4{,}000{,}000 imes 275 = 1{,}100{,}000{,}000.—now the benefits exceed the costs; policy could proceed.

  • In part (c): The question invites thinking about a market-based approach (e.g., tradable permits or taxes) to regulate hydraulic fracturing rather than strict command-and-control.

Public Goods

• Public goods concepts:

  • Rival vs nonrival: Rival goods are consumed by one person at a time; nonrival goods can be consumed by many simultaneously.

  • Excludable vs non-excludable: Excludable means suppliers can prevent non-payers from consuming; non-excludable means it is difficult or impossible to prevent non-payers from consuming.

• Definitions from the slides:

  • Rival goods: Goods that only one person can consume at a time.

  • Nonrival goods: Goods that more than one person can consume at the same time.

  • Excludable goods: Must be paid for to be consumed.

  • Non-excludable goods: Can be consumed even if not paid for.

• Four types of goods (Exhibit 9.10):

  • High excludability, high rivalry: Ordinary private goods (e.g., clothes, food, furniture).

  • Low rivalry, high excludability: Club goods (e.g., cable TV, pay-per-view TV, Wi-Fi, music downloads).

  • Low excludability, low rivalry: Public goods (e.g., national defense, early warning systems, Earth protection programs).

  • Low excludability, high rivalry: Common pool resource goods (e.g., fish, water, natural forests, food at a picnic).

• Free rider problem: When individuals do not pay for a good because it is non-excludable; solution is often government-mandated funding or provision.

• Private provision of public goods: Occurs when private citizens voluntarily contribute to the production or maintenance of a public good (e.g., cookie monster salary as a humorous private provision example).

• Market demand for public goods is constructed differently from private goods (Exhibit 9.12). For public goods, total social willingness to pay is the sum of individual willingnesses rather than the horizontal summation used for private goods (Exhibit 9.11).

• Equilibrium in public goods provision (Exhibit 9.13): The socially optimal provision point is where the sum of individual marginal benefits equals the marginal cost of provision.

• Private provision limits: Even for public goods, private generosity may be insufficient due to the free rider problem and under-provision relative to the social optimum.

• Private provision data exhibits:

  • Exhibit 9.14 Total Giving in the United States Over Time.

  • Exhibit 9.15 Giving Money by Region of the World in 2018.

• Practical issues with charity: Money may not go to areas of most need, giving can be volatile, and in downturns charitable contributions may fall when they’re needed most.

Common Pool Resource Goods

• Definition and intuition:

  • Common pool resources are open-access and deplete through use, which creates externalities even though the resource is individually owned or accessible.

  • Tragedy of the commons: When common pool resources are overused due to lack of proper incentives or governance.

• Why resources become endangered:

  • The combination of open access (no effective exclusion) and depletion through use leads to overexploitation.

• Examples:

  • Buffalo (common pool resource) vs cows (private property) as a historical illustration of resource governance differences.

• Solutions to the tragedy of the commons:

  • Private ownership defined by the government.

  • Government regulation (e.g., fishing limits, quotas).

  • Tax on use (to internalize the externality and reduce overuse).

Evidence-Based Economics

• Real-world policy experiments illustrated in the slides:

  • King of England–style congestion policy: what policy deters congestion and reduces commute times (e.g., congestion charges).

  • Exhibit 9.16: Results of the Congestion Charge shows effects on traffic and welfare.

• Oklahoma earthquakes policy problem (detailed in exams problems):

  • Problem framing: reduce saltwater injection to lower earthquake risk; command-and-control regulation vs market-based solutions.

  • Data-driven decision making:

  • Scenario (a): If each resident values avoiding earthquakes at $100/year with 4 million residents and a $1 billion annual cost to industry, the net benefit is negative (benefits < costs).

  • Scenario (b): If half the population values avoidance at $500 and half at $50, the average value is $275/year; total benefits ($1.1 billion) exceed the costs ($1 billion); policy favorable.

  • Scenario (c): What market-based approach could work? Options include tradable permits, cap-and-trade systems, or incentive-based mechanisms to reduce saltwater injection without imposing uniform command-and-control bans.

Key Takeaways

• Externalities cause divergence between private and social welfare; internalizing them is essential for efficiency.

• There are viable private solutions (Coase bargaining) but not always feasible due to costs and coordination problems.

• Government policy can be designed in two broad ways: command-and-control vs market-based, with Pigouvian taxes/subsidies as classic market-based tools.

• Public goods suffer from non-excludability and non-rivalry, leading to the free-rider problem and under-provision in private markets; government provision or private philanthropy often plays a role.

• Common pool resources face the tragedy of the commons; effective governance (property rights, regulation, or pricing) is required to avoid overuse.

• Evidence-based economics emphasizes evaluating policy choices with costs and benefits, including quantitative estimates of social value vs. private costs.

• Throughout, the theme remains: identify who bears costs and benefits, define property rights clearly, and decide whether private bargaining, regulation, or a hybrid approach best internalizes the externality and maximizes social welfare.

Key equations and definitions to remember

• Social optimum condition: MB(Q^) = MSC(Q^)

• Private optimum condition (no externalities): MB(Q^{private}) = MPC(Q^{private})

• Pigouvian tax (negative externality): t^* = MEC(Q^*)

• Pigouvian subsidy (positive externality): s^* = MEB(Q^*)

• Public goods provision involves summing individuals’ marginal benefits to determine the socially optimal quantity (as opposed to the horizontal summation used for private goods). This leads to the public goods equilibrium concept shown in Exhibit 9.13.