Lecture 11: Introductory Microeconomics: Externalities, Public Goods, and Asymmetric Information

Externalities and Market Failure Mitigation

• Overview of Lecture 11

  • Focus: Externalities and methods to mitigate market failure.

  • Key Topics: Coasian bargaining, Public goods, Common goods, and Asymmetric information.

  • Specific Applications: Kindergarten subsidies and knowledge production.

  • Course Code: Economics 10004 (Introductory Microeconomics), Lecture 11, Semester 1, 2026, University of Melbourne.

• Positive Externalities in Production

  • Market Equilibrium vs. Social Optimum:

    • Market Equilibrium ($PMB = PMC$):

      • Consumer Surplus (CS): $A$

      • Producer Surplus (PS): $B + E$

      • Positive Externality: $C + F$

      • Deadweight Loss (DWL): $D + G$

    • Social Optimum ($SMB = SMC$):

      • Consumer Surplus (CS): $A + B + C + D$

      • Producer Surplus (PS): $E + F + G$

      • Deadweight Loss (DWL): $-$

  • Visual Components: The graph displays curves for Private Marginal Cost (PMC), Social Marginal Cost (SMC), and Private Marginal Benefit (PMB) which equals Social Marginal Benefit (SMB).

• Negative Externalities in Consumption

  • Market Equilibrium vs. Social Optimum:

    • Market Equilibrium ($PMB = PMC$):

      • Consumer Surplus (CS): $A + B$

      • Producer Surplus (PS): $C + D + E$

      • Negative Externality: $-A - D - F$

      • Deadweight Loss (DWL): $F$

    • Social Optimum ($SMB = SMC$):

      • Consumer Surplus (CS): $B + C$

      • Producer Surplus (PS): $E$

      • Deadweight Loss (DWL): $-$

  • Visual Components: The graph shows PMC = SMC, with separate curves for Social Marginal Benefit (SMB) and Private Marginal Benefit (PMB).

Case Study: Kindergarten Subsidies

• Problem Context

  • Kindergarten attendance generates external benefits: better long-run outcomes for children and higher female labor force participation.

  • Variables (in thousand children):

    • $PMB = 100 - 2Q$

    • $PMC = 3Q$

    • $SMB = 120 - 2Q$

• Equilibrium Calculations

  • Market Outcome ($PMB = PMC$):

    • $100 - 2Q = 3Q$

    • $100 = 5Q$

    • $Q^{*} = 20$

    • The market provides 20 thousand units.

  • Efficient Outcome ($SMB = SMC$):

    • Note: $SMC = PMC = 3Q$

    • $120 - 2Q = 3Q$

    • $120 = 5Q$

    • $Q^{**} = 24$

    • The market under-provides kindergarten relative to the social optimum (24 > 20).

• Pigouvian Subsidy Solution

  • Goal: Find the subsidy ($s$) such that producers receive $Ps$ and consumers pay $Pd$, where $Ps - s = Pd$ at $Q^{**} = 24$.

  • Determining Prices at $Q = 24$:

    • $Pd = PMB = 100 - (2 \times 24) = 52$

    • $Ps = PMC = 3 \times 24 = 72$

  • Subsidy Calculation:

    • $s = 72 - 52 = 20$

  • Result: The optimal Pigouvian subsidy is $\$20$ per child.

• Interaction Links (Mon 10am - Tue 2pm)

  • Mon 10am: https://flux.qa/GLFHHZ

  • Mon 1pm: https://flux.qa/D5JWNH

  • Mon 3pm: https://flux.qa/LU5BGM

  • Tue 11am: https://flux.qa/NV3XN4

  • Tue 2pm: https://flux.qa/HATHX2

Coasian Bargaining: Private Solutions to Externalities

• The Coase Theorem

  • Definition: Bargaining is viewed as the most efficient way to resolve negative externalities by creating a market-like solution.

  • Core Principle: If property rights are well-defined and bargaining is costless, negotiations between the creator of the externality and the affected party will lead to the socially optimal quantity ($Q^{**}$).

  • Property Right Invariance: The efficient quantity reached does not depend on which party holds the property rights, provided rights are assigned clearly.

    • Example: In cases of pollution, if polluters have rights, victims can pay them not to pollute. If victims have rights, the polluter may compensate the victims.

• Limitations of the Coase Theorem

  • The cost of negotiation is shared between parties without external intervention, but real-world application faces several obstacles:

    • The Assignment Problem: Difficult to assign property rights when many agents are affected (e.g., global warming).

    • The Holdout Problem: In joint or shared ownership, every owner has veto power; all must agree to the solution.

    • Transaction Costs and Negotiating Problems: Bargaining is not always costless or feasible.

    • Wellbeing Distribution: While the quantity is optimal regardless of rights allocation, the distribution of economic wellbeing (wealth) is significantly affected by who holds the rights.

• Internalizing Externalities

  • Small-scale/Local: Markets are often able to internalize these locally.

  • Large-scale/Global: Government intervention is preferred for aggregating interests.

  • Real-world Application: Emission Trading Schemes (ETS) in the European Union.

• Other Private Solutions

  • Charities and Non-for-profit organizations.

  • Moral codes and social sanctions (e.g., societal pressure against negative external behaviors).

  • Shifting consumer preferences: Changing how people value goods to counter production externalities (e.g., UN: Food and Climate Change).

Public Goods and Common Resources

• Characteristics of Goods

  • Excludability: Can a consumer be prevented from using the good?

  • Rivalry in Consumption: Does one consumer's use diminish another's ability to use it?

• Definitions

  • Public Goods: Non-excludable and non-rival (e.g., National defense, knowledge).

  • Common Goods: Non-excludable but rival (e.g., Public roads, the environment).

  • Core Problem: Since they are available for free, they lead to externalities, free-riding, and under-supply.

• Interaction Links (Wed 11am - Thu 5pm)

  • Wed 11am: https://flux.qa/DUVN7L

  • Wed 1pm: https://flux.qa/Q4MVWT

  • Thu 11am: https://flux.qa/49QNW9

  • Thu 1pm: https://flux.qa/B93DLK

  • Thu 5pm: https://flux.qa/UUQDVN

Knowledge Production and the Under-Supply Problem

• The Economic Case for Under-supply

  • Scenario: Development of a chemical formula for a life-saving drug.

  • Costs: $PMC = SMC = \$50$.

  • Societal Willingness to Pay ($PMB$):

    • Maya: $\$10$

    • Omar: $\$20$

    • Zheng: $\$30$

    • Danielle: $\$40$

  • Calculation of SMB: Since knowledge is non-rival (one person's use doesn't prevent others), the Social Marginal Benefit is the sum of all individual benefits.

    • $SMB = 10 + 20 + 30 + 40 = \$100$

  • Efficiency Verdict: Since SMB (\$100) > SMC (\$50), it is socially efficient to produce the knowledge.

• The Market Failure Outcome

  • In a competitive market, each individual compares their own $PMB$ with the $PMC$.

  • Result: No individual has $PMB \ge PMC$ (the highest is Danielle at $\$40$ vs $\$50$ cost).

  • Each member ignores the benefits to others, so the formula is not produced.

• Free-Riding Mechanics

  • Incentive: A person receives benefits without paying.

  • New Scenario: Suppose $PMC = SMC = \$25$.

    • Both Zheng ($PMB = 30$) and Danielle ($PMB = 40$) have benefits exceeding cost.

    • However, each prefers the other to pay so they can free-ride.

  • Net Gain Matrix:

    • Zheng produces (Danielle free-rides): Zheng gets $30 - 25 = \$5$, Danielle gets $\$40$.

    • Danielle produces (Zheng free-rides): Zheng gets $\$30$, Danielle gets $40 - 25 = \$15$.

  • Conclusion: The formula is NOT produced because each waits for the other to bear the cost.

• Methods for Optimal Provision

  • Government Supply: Uses cost-benefit analysis to find the socially optimal quantity.

  • Finance through Taxation:

    • Lindahl Tax: Consumers pay a price based on their individual Marginal Benefit ($MB$). Total revenue covers costs.

    • Considerations: Lindahl taxes act as progressive taxes (assuming WTP increases with income), but it is often impossible to detect an individual's true willingness to pay.

Asymmetric Information

• Adverse Selection

  • Definition: One party knows more than the other before a transaction.

  • Experience Goods: Goods whose quality is only known after purchase (e.g., used cars).

  • Market Outcome: Low-quality sellers are eager to sell, while high-quality sellers withdraw. This leads to an adverse selection problem where the offer itself signals low quality.

• Moral Hazard

  • Definition: One party engages in risky behavior because another party (e.g., insurance) bears the cost of that behavior.

  • Context: Occurs after parties have signed a contract.

  • Insurance Example: Since individual actions are unobservable, coverage is based on outcomes, leading to riskier behavior by the insured.

• Institutional Solutions to Asymmetric Information

  • Legal Systems (e.g., "Lemon Laws").

  • Quality Inspection and Certification.

  • Reputation Systems.

  • Market Signals: Warranties and Service Agreements.