Chapter 10 – Externalities and Public Goods (Vocabulary Review)

1. Identifying Externalities

• Key definition
  • Externality: A side effect of an activity that affects bystanders whose interests are not factored into the decision-making process.
  • Leads to market failure → outcomes are inefficient from society’s perspective.
• Types
  • Negative externality → harms bystanders; examples: double-parking, secondhand smoke, in-class phone scrolling.
  • Positive externality → benefits bystanders; examples: exercising, advance study-group prep, flower gardens.
• Consequences for market quantities
  • Negative externalities: “Too much” activity vs. social optimum.
  • Positive externalities: “Too little” activity vs. social optimum.
• Price changes vs. externalities
  • A price change itself is not an externality; buyers & sellers are not bystanders.
• Private vs. social interests
  • Private interest = personal costs/benefits.
  • Social interest = all costs/benefits, including those accruing to others.
  • If choices have external effects, private ≠ social → market failure.

Cost & benefit language

• Marginal Private Cost (MPC): extra cost to producer.
• Marginal External Cost (MEC): extra cost to bystanders.
• Marginal Social Cost (MSC): MSC = MPC + MEC
• Marginal Private Benefit (MPB): extra benefit to consumer.
• Marginal External Benefit (MEB): extra benefit to bystanders.
• Marginal Social Benefit (MSB): MSB = MPB + MEB

Graph illustrations (verbal)

• Gasoline negative externality
  • Example numbers: At 20 m gallons, MPC = 3, MEC = 2 ⇒ MSC = 5.
• Vaccine positive externality
  • Example numbers: At 10 k doses, MPB = 40, MEB = 30 ⇒ MSB = 70.

Key take-aways

• Externalities create a wedge between private & social curves.
• Negative: MSC > MPC → overproduction.
• Positive: MSB > MPB → underproduction.

2. The Externality Problem

• Markets are usually efficient if only buyers & sellers matter.
• When bystanders are affected, equilibrium ignores them → inefficient.

Socially optimal quantity (Q*)

• Apply marginal principle: Produce more while MSB \ge MSC.
• Hence Q^* occurs where MSB = MSC.

Four-step recipe for analysis

1. Predict market equilibrium (set supply = demand).
2. Identify externality (positive/negative, magnitude).
3. Locate socially optimal quantity (set MSB = MSC).
4. Compare equilibrium vs. Q^* → diagnose over- or under-production.

Gasoline case study (negative)

• MEC ≈ 2.10 per gallon.
• Equilibrium Q exceeds Q^* → overproduction.
• Zero pollution not optimal; seek balance of convenience vs. harm.

Flu-shot case study (positive)

• MEB ≈ 10 per shot.
• Equilibrium Q below Q^* → underproduction.

Summary table

• Negative ext. → harm → MPC understates MSC → too much.
• Positive ext. → help → MPB understates MSB → too little.

3. Solving Externality Problems

Goal: Internalize the externality so decision makers feel full costs/benefits.

3.1 Private Bargaining (Coase theorem)

• Conditions: Clear/enforced property rights, negligible bargaining costs.
• Side payments align incentives.
  • Loud music: Pay neighbor 5 to reduce volume.
  • Humana Go365: Insurer pays clients to exercise, internalizing health benefit.
• Effectiveness > fairness; both parties end up better off.

3.2 Corrective (Pigovian) Taxes & Subsidies

• Tax for negative ext.: set Tax = MEC.
  • Gasoline: Tax = 2.10 moves supply vertically → new supply = MSC; quantity falls to Q^*.
• Subsidy for positive ext.: set Subsidy = MEB.
  • Examples: Insurance discounts for alarms, COVID gift cards, Pell Grants.

3.3 Cap and Trade

• Quantity regulation: issue limited pollution permits (cap) that can be traded.
• Efficient firms buy permits, concentrating production among cleaner producers.
• Set cap = Q^* emissions.
• Firm-to-firm permit trading yields cost-minimization (dirty firm sells, clean firm buys).

3.4 Laws, Rules, Regulations

• Direct restrictions: noise ordinances, speed limits, fuel-efficiency standards, workplace safety rules, antivirus requirements.
• Purpose: prohibit or limit behavior creating negative externalities.

Key take-aways (solutions)

• Private bargaining: uses mutually beneficial deals.
• Taxes/Subsidies: make actors face social cost/benefit.
• Cap & trade: fixes quantity, lets price adjust via permits.
• Regulation: outright limit or mandate behaviors.

4. Public Goods & the Tragedy of the Commons

4.1 Classifying goods

• Excludability: feasible to prevent access?
• Rivalry: does one person’s use subtract from another’s?

4.2 Externalities from Non-excludability

• Non-excludable means users who don’t pay still benefit ⇒ externalities.
• If non-rival (public good) → positive externality to bystanders → free-rider problem → underproduction.
• If rival (common resource) → negative externality (each user imposes cost on others) → overuse (tragedy of the commons).

4.3 Free-Rider Problem & Public Goods

• Free riders consume without paying; market ignores their benefits.
• Result: too little or zero supply from private sector.
• Government solutions:
  • Direct provision financed by taxes (military, parks, public schools).
  • Government purchase from private producers (COVID vaccines).

4.4 Tragedy of the Commons & Common Resources

• Rival + non-excludable; users don’t bear full social cost.
• Example: Overfishing—private catch, shared ecosystem damage.
• Solution: Assign ownership rights
  • Convert common resource into property; owner internalizes costs/benefits.
  • Analogous to fencing rangeland, ITQ (individual transferable quotas) for fisheries.

5. Synthesis & Exam Pointers

1. Diagnose externality: positive or negative?
2. Predict direction of market failure: too much vs. too little.
3. Choose remedy: bargaining, tax/subsidy, cap-and-trade, regulation, government provision, property rights—context matters.
4. Quantitative toolkit: apply MSC = MPC + MEC and MSB = MPB + MEB; set MSB = MSC for social optimum.