ppt Public Goods and Externalities in Managerial Economics

Characteristics and Categories of Goods

• Goods in an economy are categorized based on two fundamental characteristics:

  • Excludability: Only consumers who pay for the good can use it. Those who do not pay are excluded from consumption.

  • Rivalry: When one person consumes the good, it reduces or prevents someone else's ability to consume that same good.

• Using these characteristics, goods are divided into five specific categories as shown in the different forms of public goods (Figure 13.1):

  • Purely Private Goods: These are both excludable and strongly rival. Examples include food and beverages.

  • Purely Public Goods: These are non-excludable and non-rival. Examples include dykes, national defense, street art, and CO2 emission reduction.

  • Quasi Public Goods: These are public goods that can become excludable or rival depending on the situation. For example, a motorway is non-excludable until a toll is charged, and it becomes rival during congestion (traffic jams).

  • Commons (Common Resources): These are non-excludable but rival. Examples include fish stocks in the ocean, a four-leaf clover found in nature, or a public beach/street.

  • Club Goods: These are excludable but non-rival. Examples include streaming services or the Toledo learning platform, where access requires registration (excludability), but one person's use does not hinder another's (non-rivalry).

Purely Public Goods and the Free-Rider Problem

• Characteristics of Public Goods:

  • Non-rivalry in consumption: Consumption by one person does not affect options for others. The marginal cost of allowing an additional consumer to enjoy the good (absent congestion) is effectively zero. However, the cost of providing an additional unit of the good is not zero.

  • Non-excludability: Once the good is offered, no one can be prevented from consuming it, regardless of their willingness to pay.

• The Free-Rider Problem:

  • A free-rider is an individual who enjoys the benefits of a public good without paying for it because they cannot be excluded.

  • Consequences: In a free market, this leads to the underproduction of goods that create welfare for society. Private producers are reluctant to provide these goods because they cannot generate sufficient income to cover costs, resulting in a loss.

  • Government Role: The government typically assumes responsibility for the supply of public goods, financing production through tax collection. The actual production can be outsourced to private firms via public tenders to ensure efficiency.

• Determining the Socially Desirable Supply (The Samuelson Rule):

  • Valuation for Private Goods: Total quantity is the horizontal summation of individual quantities at a given price ($Q = ∑ q_i$).

  • Valuation for Public Goods: Total value is the vertical summation of individuals' Marginal Willingness To Pay (MWTP). If two consumers each enjoy 3 units of a non-rival good, only 3 units need to be supplied.

  • Formula for Social MWTP: The social valuation is the sum of individual valuations ($MWTP_{social} = ∑ MWTP_i$).

  • Optimal Quantity ($q^*$): Social welfare is maximized where the Marginal Social Benefit (MSB) equals the Marginal Cost (MC).

  • Example: A dam height study for Lisa and Bart:

    • For the 100th cm: $MWTP_{Lisa} (€3) + MWTP_{Bart} (€2) = €5$

    • For the 200th cm: $MWTP_{Lisa} (€2) + MWTP_{Bart} (€1) = €3$

    • If the marginal cost is $€3$, then the optimal production level is $q^* = 200$\text{ cm}.

• Critical Considerations:

  • In small, non-anonymous groups or repeated games, cooperative solutions (like cleaning a shared student kitchen) can occur without coercion due to the "warm feeling" of contributing.

  • The political process decides the quantity of public goods, meaning even those who do not value a specific good (e.g., pacifists paying for national defense) must contribute through taxes.

  • Free-riding can be global (e.g., international efforts to reduce greenhouse gases).

Common Resources and the Tragedy of the Commons

• Logic of the Commons:

  • Common resources are non-excludable but rival. The benefit of use is individual, while the cost is shared by society.

  • The Tragedy of the Commons: A parable explaining why shared resources are overconsumed. If individuals act in self-interest without coordination, the resource is often destroyed.

• The Village Sheep/Cow Example:

  • As villagers add extra sheep to common meadows, they gain individual utility. However, each extra sheep reduces the grass available for others (a negative externality).

  • Eventually, the meadow is overgrazed, the grass stops growing, and the village loses its source of income.

• Solutions for Common Resource Depletion:

  • Social Responsibility: Collective care based on shared goals (similar to a cartel aiming for joint profit).

  • Privatization: Dividing the communal resource (e.g., meadows) into private assets to individualize both benefits and costs.

  • Government Intervention: Supervision and implementation of rules/laws regarding usage.

Externalities: Definitions and Mechanisms

• Definition: External effects occur when an economic agent's behavior directly affects the utility or production of others without full market compensation. If full compensation is paid, the effect is no longer an externality.

• Classification of Externalities:

  • Consumption Externality: Caused by consumption behavior (e.g., smoking in a restaurant).

  • Production Externality: Caused by production behavior (e.g., a paper mill polluting water).

  • Negative Externality: Causes disadvantages or external costs (MEC).

  • Positive Externality: Provides benefits or external benefits (MEB).

  • Network Externality: Benefits increase as the number of users grows.

• Key Cost/Benefit Formulas:

  • $MSC = MC + MEC$ (Marginal Social Cost = Marginal Private Cost + Marginal External Cost)

  • $MSB = MB + MEB$ (Marginal Social Benefit = Marginal Private Benefit + Marginal External Benefit)

• Equilibrium and Efficiency:

  • Market Equilibrium ($E$): Where $MC = D$

  • Social Optimum ($P$): Where $MSC = MSB$

  • In a free market with negative externalities: There is overproduction (q_E > q_P) and the price is too low (p_E < p_P). Social welfare loss is the area between MSC and demand for units produced beyond $q_P$.

  • In a free market with positive externalities: There is underproduction (q_E < q_P) and the price is too high. The good is undervalued.

• Specific Examples:

  • Negative Production: Paper factory pollution leads to external health costs for neighbors.

  • Positive Consumption: Education increases individual salary (private benefit) but also increases national GDP and workplace productivity (external benefits).

  • Positive Production: Research and Development (R&D) creates knowledge that others can use ($MSC = MC - MEB$).

Environmental Policy Instruments: Standards and Taxes

• Emission Standards (Regulation):

  • Uniform Standards: The same ceiling is imposed on everyone. This is often cost-inefficient because it ignores that some firms can reduce pollution more cheaply than others.

  • Differentiated Standards: Efforts are divided so that "cheap" reducers do more. Efficiency is reached when the equimarginal cost principle is met: $MC_1 = MC_2$.

• Environmental Taxes (Pigouvian Taxes):

  • Output Tax: A tax per unit of product. Optimal when $t = MEC$. It shifts the supply curve to coincide with $MSC$.

  • Emission Tax: A tax per unit of pollution. This allows firms to choose between paying the tax or investing in cleaner technology. Firms will reduce pollution as long as the marginal cost of reduction is less than the tax (MC < t). The optimal reduction point for the firm is $MC = t$.

  • Incomplete Internalization: If t < MEC, there is too much pollution. If t > MEC, there is too little production compared to the Pareto efficient level.

Tradable Emission Permits

• The Mechanism:

  • The government sets an overall annual cap on pollution. Permits are distributed to firms.

  • Firms can buy or sell permits on a market. Those with low reduction costs sell permits; those with high costs buy them.

  • At the year's end, firms must possess enough permits to cover their actual emissions or pay high fines.

• The European Emissions Trading System (ETS):

  • Established in 2005 to meet the Kyoto Protocol and Paris Agreement targets.

  • Annual reduction factors for the emission cap: 1.7% initially, 2.4% from 2021, 4.3% for 2024–2027, and 4.4% from 2028.

  • The equilibrium price of permits is determined where the sum of individual marginal cost functions ($∑ MC_i$) equals the perfectly inelastic supply of permits.

• Comparison of Instruments:

  • Both Pigouvian taxes and permits follow the equimarginal cost principle and achieve cost efficiency.

  • Permits allow the government to determine the maximum pollution amount in advance.

  • If permits are distributed for free, the government does not take funds from the sector, unlike a tax.

Questions and Discussion

• Question on Free-Riding: The free-riding problem in public goods stems from the fact that no one can be excluded from consumption (Option D).

• Identifying Public Goods: The formula for calculating the area of a circle (Option A) is a public good, as it is non-rival and non-excludable (general knowledge). Options like a barrel of beer (rival/excludable), Toledo (excludable), or a stadium seat (rival/excludable) do not fit.

• Socially Efficient Quantity Calculation:

  • Demand: $Q = 200 - 2P → P = 100 - 0.5Q$

  • Supply: $Q = 2P → P = 0.5Q$

  • Positive Externality ($MEB$): $€40$

  • Private Equilibrium: $100 - 0.5Q = 0.5Q → Q = 100$

  • Social Optimum (MSB = MC): $(100 - 0.5Q) + 40 = 0.5Q → 140 = Q$

  • Answer: 140 (Option C).

• Inelastic Demand and Negative Externality: If demand is perfectly price inelastic (vertical), the market quantity remains unchanged regardless of price. In the socially optimal situation (internalizing the externality), the price is higher to reflect social costs, but the quantity remains unchanged (Option A).

• Permit Trading Example (3 Firms):

  • Total reduction needed: From 200 units to 120 units (80 unit reduction).

  • Regulatory/Quota method: Each firm reduces to 40 permits. Costs: A (€600), B (€1000), C (€100). Total: €1700.

  • Trading method: Firm C (lowest cost at €10) reduces all 50 units and sells permits to Firm B (highest cost at €25). If C sells 40 permits to B at price $P$ (10 < P < 25), the total social cost drops to €1100, saving society €600.