Study Notes on Markets, Externalities, and Public Goods
Chapter 4: Markets, Externalities, and Public Goods
What is Efficiency?
Efficiency is a key consideration in production decisions.
The decision to produce the next unit hinges on comparing Marginal Cost (MC) and Marginal Benefit (MB):
If $MC < MB$, produce the unit (YES).
If $MC = MB$, produce the unit (YES).
If $MC > MB$, do not produce the unit (NO).
Efficiency on the Graph
Production is considered efficient at the point where Marginal Cost equals Marginal Willingness to Pay (MWTP):
At this point, the cost of producing one more unit is equal to the MWTP.
The efficient price (Pe) and efficient quantity (qe) maximize both consumer and producer surplus, represented in a graph as areas (a+b).
Efficiency Defined
Production is efficient when:
Marginal benefits equal marginal production costs.
Net benefits are maximized, often measured by total surplus (the sum of consumer surplus and producer surplus).
Efficiency vs. Equity
Efficiency focuses on maximizing the size of the economic pie—evaluating if net benefits are maximized.
Equity concerns the distribution of the pie—how benefits are shared among individuals.
Market Production Decisions
In a market:
Producers will produce where price equals marginal cost ($P=MC$).
If $P < MC$, firms won’t produce.
If $P > MC$, firms will produce more.
$P > MB$ implies consumers will not purchase, which leads to qm as the quantity produced.
Is qm = qe?:
The equality depends on whether private MC aligns with social MC.
In cases of external costs or benefits, qm does not equal qe, leading to a market failure.
What is an Externality?
An externality refers to a situation in which the welfare of a firm, individual, or household depends on the actions of another party.
Types of externalities:
Positive externalities: Benefits received by others not involved in the transaction.
Negative externalities: Costs imposed on others not involved in the transaction.
Can arise from both consumption and production decisions.
Private Costs vs. External Costs
Private costs: Costs that firms typically consider in their decision-making (input costs).
External costs: Costs imposed on others outside the firm’s decision-making, such as:
Environmental degradation.
Pollution.
Noise.
Congestion.
Social costs: The sum of private costs and external costs.
Modeling External Costs
Example of paper production:
Imposes external costs such as wastewater discharge that affects the ecosystem and public health.
Results in a disparity between social efficient output $q*$ and market quantity $qm$ where:
QM > q* (market output is too high), and PM < p* (market price is too low).
Quantifying External Costs
Cumulative emissions from 1990-2022 illustrate the impact of pollutants by country:
Example data shows the U.S. Power Sector would rank as the 6th largest emitter globally.
Annual Damages from U.S. Power Sector
2010: $245 billion.
2017: $133 billion.
Reduction efforts contributed significantly to these declines:
Installation of emissions control technologies accounted for $63 billion.
Transition to cleaner power sources yielded $60 billion in damage reductions (Holland et al. 2018).
Defining Impact of Damages
Determining who is affected varies; for instance:
Local communities downstream are directly impacted by pollution.
Individuals valuing affected natural resources (e.g., fish) also feel the effects, even from afar.
Willingness to Pay (WTP) to change a harmful action indicates impact.
Open Access Resources
Open access resources: Resources that are freely accessible to all without regulations, leading to potential overuse.
Example of unregulated fisheries:
Anyone can fish if they have means, but this leads to depletion for others without accounting for external costs.
Case Study: Road Use and Congestion
Scenario: Considering usage of a congested road versus an alternative route.
Individual choices based on limited time cost versus societal cost reveal inefficiencies.
Example demonstrates that:
Individual decisions may lead to greater societal losses due to increased congestion.
Net social loss calculated from travel time inefficiencies shows the failure of market equilibrium in congestion.
External Benefits
External benefit: Positive effects received by individuals not directly involved in a transaction.
Example of education:
A student's investment in education has direct benefits (higher earnings) and societal benefits (greater productivity).
When this occurs, market WTP (demand) is less than social WTP.
Characteristics of Public Goods
Public goods possess two main properties:
Non-rival: One person utilizing the good does not reduce availability to others.
Non-excludable: Once provided, it cannot exclude non-payers from its benefits.
Examples include clean air, clean water, biodiversity, and climate stability.
Public goods tend to be underprovided in private markets due to these characteristics.
Example of Public Goods and Cleanup
Given a contaminated lake, the willingness to pay for cleanup differs among individuals:
Marginal willingness to pay varies by person and aggregate figures convey total societal benefit versus marginal costs of cleanup.
Graphing Public Goods
The market demand curve for public goods is derived from vertical summation of individual demand curves (reflecting combined MWTP) versus standard goods where curves are summed horizontally.
Rivalry impacts the functioning of the market and its efficiency.
Public Goods vs. Private Goods Visual Representation
Illustrate differences in demand and output levels for public and private goods in graphical form depicting efficient levels.
Free-Riding
Free-rider phenomenon: Occurs when individuals benefit from public goods without contributing equitably to their provision.
Results in underprovision of goods, as individuals have no incentive to accurately reflect their WTP in contributions.
Examples: Common scenarios include utilizing neighbors' resources (such as Wi-Fi) and collaborative works where contributions are uneven.