Externalities and Public Goods

Agenda

  • Definition of an externality

  • Positive and negative externalities

  • Inefficiencies created by externalities

  • Corrections to markets with externalities

  • Public Goods

  • Categorizing goods

  • Tragedy of the Commons

Externalities

Definition of Externality

  • Externality: The uncompensated impact (or side effect) of one person’s or firm’s actions on the well-being of a bystander.

Types of Externalities

  • Positive externality:

    • Impact is positive but benefit is infeasible to charge for.

    • Examples:

    • Vaccines

    • A neighbor with a beautiful garden

  • Negative externality:

    • Impact is negative but cost is infeasible to charge for not providing.

    • Examples:

    • An industry that pollutes as part of its production process.

    • Construction noise

    • Smoking

    • Antibiotics (noted as potential for both positive and negative externality)

    • Driving (congestion)

Externalities and Market Inefficiency

Definition of Market Failure

  • Market failure: A situation defined by an inefficient distribution of goods and services in the free market, causing total surplus not to be maximized.

Externalities and Inefficiency

  • Negative externality leads to:

    • Too much production in a free market.

  • Positive externality leads to:

    • Too little production in a free market.

  • Markets with externalities are inefficient because:

    • There is no market for the externality.

    • There might be a market for the good/activity generating the externality, but not for the externality itself.

Marginal Costs and Externalities

Example: Market for Gas

  • Marginal Private Cost (MPC): Cost of producing an additional liter (supply curve).

  • Marginal External Cost (MEC): Cost on bystanders of an additional unit, e.g., pollution.

  • Marginal Social Cost (MSC): All marginal costs related to the good (private + external).

    • Formula: MSC = MPC + MEC

  • Critical Question: How much gas is it socially efficient to produce?

Socially Optimal Quantity

Efficient Production Considerations

  • The efficient quantity of gas to be produced should consider the interests of buyers, sellers, and bystanders based on the Rational Rule for Society:

    • Produce more of an item as long as its marginal social benefit is at least as large as its marginal social cost.

  • Analysis Steps:

    • Predict market equilibrium quantity (involving only buyers and sellers).

    • Assess externalities involved (positive or negative).

    • Find socially optimal quantity that benefits all parties, including bystanders.

    • Evaluate any difference between market equilibrium quantity and socially optimal quantity.

Negative Externalities and Market Inefficiency

Market Equilibrium Quantity Definitions

  • Demand: Marginal private benefit.

  • Supply: Marginal private cost.

  • Bystanders are not involved in the equilibrium.

Example of Negative Externality: Gasoline

  • The pollution generated by gasoline will harm bystanders:

    • Suppose the marginal external cost is 0.20 per liter.

    • Therefore, marginal social cost is 0.20 higher than the marginal private cost.

  • Socially optimal quantity: Where the marginal social benefit equals marginal social cost.

    • Demand represents the marginal social benefit.

Comparison of Market Equilibrium and Social Optimum

  • Market equilibrium arises for quantities larger than what is socially optimal, causing overproduction and resultant pollution due to negative externality; businesses do not account for this negative impact.

  • Thus, achieving zero negative externalities is not the goal, but rather achieving social optimum is necessary.

Positive Externalities and Market Inefficiency

Market for Flu Shots

  • Market equilibrium occurs where supply equals demand, but externalities must be assessed.

  • Positive Externality of Flu Shots: Prevents others from getting the flu, leading to external benefits.

    • Suppose marginal external benefit is 10.

    • Marginal social benefit becomes 10 higher than the marginal private benefit.

Socially Optimal Quantity for Flu Shots

  • Similar comparison of equilibrium quantity vs. social optimum:

    • Market equilibrium quantity is smaller than socially optimal quantity, leading to underproduction of flu shots and insufficient realization of positive externalities.

Summary of Externalities and Market Inefficiency

  • Market equilibrium quantity is inefficient when it generates an externality:

    • Negative externalities harm bystanders, causing marginal private cost to underestimate the marginal social cost, resulting in overproduction.

    • Positive externalities benefit bystanders, and marginal private benefit underestimates marginal social benefit, leading to underproduction.

Solving the Externality Problem

Internalizing Externalities

  • Strategies to internalize the externalities include:

    1. Corrective taxes/subsidies

    2. Cap and trade

    3. Private bargaining

    4. Laws, rules, regulations

    5. Government support for public goods

    6. Assign ownership rights for common resource problems

Taxes and Subsidies Considerations

  • Negative externalities linked to overproduction can be corrected through taxes which reduce quantity produced.

  • Positive externalities associated with underproduction can be addressed with subsidies to increase quantity produced.

  • The amount of the corrective tax/subsidy should equal the marginal external cost/benefit.

Solutions to Negative Externalities: Taxes

  • Market leads to overproduction, but imposition of a tax equal to the marginal external cost brings the quantity down to the socially optimal level, internalizing the externality as a cost for sellers and buyers (corrective tax).

Solutions to Positive Externalities: Subsidies

  • Without external intervention, markets underproduce positive externalities.

  • Introducing a subsidy equal to the marginal external benefit adjusts production to the socially optimal quantity by providing additional benefits to sellers/buyers (corrective subsidy).

Cap and Trade System

  • Introduces a more efficient approach to achieve social optimum through tradable pollution permits.

    • Cap: Government sets a limit on total pollution allowed.

    • Trade: Industries trade these permits, allowing firms that can reduce pollution cost-effectively to sell their permits to those for which it is expensive.

    • This system effectively establishes a market for externalities like pollution.

Private Bargaining: Coase Theorem

  • Suggests that if parties can negotiate without costs over the allocation of resources, they may resolve externality issues independently of how property rights are assigned.

Coase Theorem Example

  • Situation with cattle and crop farms:

    • If the cost of a fence is 2,000 and damage to crops is 4,000, the property right allocation does not affect socially efficient outcomes as both parties lean towards building the fence.

    • If crop damage drops to 1,000, the cattle farmer ends up not building the fence as the cost-benefit analysis favors not proceeding.

Potential Limitations of Private Solutions

  • Real-world obstacles may inhibit bargaining such as high transaction costs or difficulties in coordination between multiple parties.

Regulation for Externalities

  • Regulations often aim to address negative externalities through:

    • Noise restrictions

    • Speeding laws

    • Fuel efficiency requirements

    • Treatment of hazardous materials

Summary of Externalities

  • Externalities yield inefficient market outcomes and solutions can be governmental or private, such as negotiations, taxes, or regulations.

Different Kinds of Goods

  • Private goods are defined by availability based on:

    • Excludability: Ability to prevent people from using it.

    • Rival in consumption: Use diminishes availability for others.

Four Categories Based on Criteria

  1. Private goods (excludable and rival)

  2. Public goods (non-excludable and non-rival)

  3. Common resources (non-excludable and rival)

  4. Club goods (excludable and non-rival)

Issues with Non-excludable Goods

  • Non-excludable goods face externalities:

    • If goods are non-rival & non-excludable: free-riders lead to underproduction

    • If rival & non-excludable: overuse due to the Tragedy of the Commons.

Public Goods

  • Characteristics:

    • Non-excludable

    • Non-rival

  • Examples:

    • National defense, fireworks, lighthouses.

  • Markets cannot ensure efficient provision due to free-riding incentives.

Government Provision of Public Goods

  • Government can provide public goods effectively due to tax collection measures, curbing free-riding tendencies.

  • Cost-benefit analysis helps determine the quantity, which is challenging empirically but serves as the best estimation.

Public Goods Provision Example

  • A local government considers installation of traffic lights, failing if voter communication or understanding of the social value is limited, leading to inefficient public decision-making.

Common Resources

  • Common Resources: e.g., fisheries, clean air, and water.

    • Non-excludable

    • Rival in consumption

  • Market provisioning typically fails due to the Tragedy of the Commons.

    • Individuals acting in self-interest deplete or spoil resources collectively, since individual use creates negative externalities.

Regulation Solutions for Common Resources

  • Possible solutions:

    • Restrict access.

    • Charge entrance fees.

    • Require licenses for hunting/fishing.

    • Implement toll roads.

Summary of Goods and Externalities

  • Public Goods: Non-excludable, non-rival; cause free-riding, resolved through government provision or alternative social arrangements.

  • Common Resources: Non-excludable, rival; faced with the Tragedy of the Commons, necessitating regulatory measures to manage resource access effectively.