Study Notes on Externalities and Public Goods

Externalities and Public Goods

Introduction

  • Discussion focuses on externalities and public goods within introductory economics.

  • Emphasizes the need for future study in public economics, specifically in relation to Morgan theory.

Externalities

Definition of Externalities

  • Externalities: Activities of one agent that affect the welfare of another agent outside of the market mechanism.

    • Key characteristic: Effects are outside the market mechanism.

Example of Non-Externality

  • Big Tech Company in Small Town:

    • A big tech firm moving to a small town causes rent prices to rise due to high wages.

    • This is not considered an externality as the market mechanism (higher rent) is involved.

    • Supply and demand concepts apply to explain the increase in rent prices.

Example of Externality

  • Pollution:

    • A factory upstream polluting a river negatively affects nearby residents.

    • The impact is not a result of market prices but rather environmental degradation, making it an externality.

Characteristics of Externalities

  • Externalities arise primarily in areas devoid of a market mechanism.

  • Can be caused by either consumers or firms.

    • Consumer Externality Example: Effects of smoking on non-smokers.

    • Firm Externality Example: Air pollution from manufacturing processes leading to negative health outcomes.

  • Reciprocity of Externalities:

    • An air-polluting firm causes harm to neighbors; conversely, if pollution is restricted, it may harm the firm.

    • Both perspectives are significant and require consideration in welfare evaluations.

Positive Externalities

  • Vaccination as a Positive Externality:

    • Primary benefit received by the individual getting vaccinated (internal benefit).

    • External benefit: Reduction in disease transmission due to collective vaccination efforts.

Relationship with Public Goods

  • Public goods will be discussed as a special type of externality.

Additional Examples of Externalities

  • Noise from nightclubs: A negative externality affecting local residents.

  • Air pollution: Negative impact from factories.

  • Positive impact example: Beekeepers' bees aiding nearby orchards.

Non-Externality Cases

  • Higher gas prices due to geopolitical events: A market-based change rather than an externality.

  • Increased rent when tech companies move to a town: Market response rather than non-market externality.

Graphical Representation of Externalities

Positive Externality Example: Vaccination

  • Marginal Cost of Vaccine: Constant at $5.

  • Marginal Private Benefit: Defined as $12 - q.

  • Marginal Social Benefit: Higher than private benefit, defined as $15 - 3q.

  • To find equilibrium, compare marginal cost with marginal benefits to determine effective quantity.

  • Efficient Quantity: 10 vaccines, where marginal social benefit equals marginal cost at $5, achieving efficiency in vaccination rates.

Market Equilibrium Situation

  • Market quantity: 7 vaccines due to individuals only considering personal benefits.

  • Deadweight Loss: Quantity differential (3 vaccines) signifies forgone social benefits.

  • Calculation of losses through areas under marginal benefit and cost curves.

Solutions to Externalities

Pigovian Solutions

  • Positive Externality: Propose subsidizing vaccination based on external benefits (e.g., $3 subsidy to equalize marginal costs).

  • Negative Externality: Implementing taxes to internalize costs and reduce harmful behaviors (e.g., pollution).

Negative Externality: Pollution Example

  • Marginal Social Cost: Defined as q.

  • Marginal Private Cost: Defined as q/2.

  • Efficient production occurs at the point where marginal social cost equals marginal benefit, identifying optimal quantity through graphical analysis.

Coase Theorem

  • If transaction costs are low and property rights are clear, private bargaining can resolve externality issues efficiently.

  • Illustrates the importance of defined property rights and negotiation in solving externality dilemmas.

Introduction to Public Goods

Definitions of Key Concepts

  • Rivalry: A good is rival if consumption by one individual reduces availability for others. (Example: Candy)

  • Non-Rivalry: Consumption does not prevent others from consuming. (Example: Firework display)

  • Excludability: A good is excludable if it is possible to prevent non-payers from accessing it.

  • Non-Excludable: It's not feasible to prevent access. (Example: Public fireworks)

Classification of Goods

  • Private Goods: Rival and excludable (e.g., groceries).

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

  • Club Goods: Non-rival but excludable (e.g., private beach).

  • Common Resources: Rival but non-excludable (e.g., fishing in open water).

Free Rider Problem

  • People benefiting from a public good without contributing (not paying), leading to inefficiencies in provision.

  • Representation in group dynamics, where some do less work yet benefit equally.

Aggregate Demand for Public Goods

Willingness to Pay

  • To determine efficient quantity of public goods, using vertical summation of individual willingness to pay instead of horizontal summation used for private goods.

Voting and Cost Distribution

  • Discusses how collective decision-making can impact public good provision, emphasizing the need for equitable cost distribution among participants.

Mechanism Design

  • Innovatively proposes means of eliciting individuals' willingness to pay through structured incentives, leveraging game theory to inform public good provision.