Public Goods

1
Public Goods Externalities
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What are Public Goods?

• Public goods are jointly consumed goods. If one
  person gets the good, everyone gets it. One
  persons consumption of the good does not reduce
  the amount available for others to consume. (The
  good is nonrival in consumption.)
• Also, the good can not divided up into separate
  portions for different individuals. Once a public
  good has been provided to one person, there is no
  easy way to prevent others from consuming it as
  well. (The good is nonexcludable.)

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Examples of Public Goods

• national defense everyone is protected by the
  same defense system
• Dams everyone in the community is protected
  from flooding by the dam

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The Free-Rider Problem of Public Goods

• There is an incentive to not reveal your true
  valuation, since if the good is provided, you are
  going to get the use of it anyway.
• But if everyone refuses to reveal their true
  value of the good and so refused to voluntarily
  pay what it is worth, the good will not be
  provided.
• Someone who enjoys the benefit of a good without
  paying for it is called a free rider.

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Efficient Provision of a Public Good

• The social marginal benefit curve (MBS) is the
  demand curve for a public good.
• It is derived by vertically summing the
  individual consumers marginal benefit curves.
• The efficient level of a public good occurs where
  the social marginal benefit curve intersects the
  marginal cost curve MBs
  MC.

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Suppose there are only two people.Their
individual demand curves or marginal benefit
curves for consumption of the public good are MB1
and MB2.

MC
If we vertically sum MB1 and MB2, we get the
social marginal benefit curve (MBS) or societys
demand curve for the public good. Suppose the
marginal cost of providing the good is MC (500
in this example). Equating the MC and the MBS, we
find the optimal level Q of the public good.
500
325
MBS
D2 MB2
175
D1 MB1
Q
Q
At that level, the marginal benefit to society is
500, and the marginal benefits to the two people
are 175 and 325.
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Externalities

• Spillover effects or side effects of economic
  activities

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External Benefits

• External benefits positive side effects of
  economic activities
• Examples
• my neighbors flower garden that provides
  pleasure to other neighbors.
• Immunization against a contagious disease that
  reduces the likelihood that people who have not
  received the inoculation will get the disease.

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External Costs

• External costs negative side effects of
  economic activities
• Examples
• pollution
• drunk drivers
• litter bugs

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Social Benefits

• social benefits private benefits received by
  the decision-maker any external benefits.
• When there are no external benefits, private and
  social benefits are equal.

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Social Costs

• social costs private costs incurred by the
  decision-maker any external costs.
• When there are no external costs, private and
  social costs are equal.

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Example Suppose a firm is considering a project
that will cost 1500 and generate 1800 in
revenue. The project would also produce 500
worth of aggravation for the neighbors.

• What is the social cost of the project?
• social cost private cost external cost 1500
  500 2000.
• If the firm ignores the effects on the neighbors,
  will the firm undertake the project?
• Yes, because the private benefits (1800) exceed
  the private costs (1500).
• From the point of view of society, should the
  project be undertaken?
• Assuming there are no external benefits, social
  benefits private benefits ext. benefits
  1800 0 1800.
• Since the social costs were 2000, which is
  greater than the social benefits of 1800, the
  project should not be undertaken.

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Coase Theorem

• An acceptable solution to an externality will be
  found if
• ownership of property is clearly defined,
• the number of people involved is small,
• the costs of bargaining are negligible.

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In many situations, many people are affected and
the costs of bargaining are substantial.

• These types of problems are unlikely to be
  resolved appropriately without government
  intervention.

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External Benefits
Suppose that MBE is the marginal external benefit
of a good. MBP is the marginal private benefit or
demand curve for the good. The sum of MBE and MBP
is the marginal social benefit MBS. SMC is the
perfectively competitive supply curve and
marginal cost of production. When the externality
is ignored, the amount of the good produced is
Q1, where the MBP equals the MC. However, the
efficient amount from the viewpoint of society is
Q2, where MBS equals MC.
per unit
S MC
MBS
MBE
DMBP
Q
Q2
Q1
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External Benefits
Suppose a per unit subsidy of A is provided. The
new marginal cost is MC' MC A. When MC' is
equated to MBP, the socially optimally amount of
the good Q2 is produced. The price of the good
paid by the consumer is lower (P2 instead of
P1). The total price including the subsidy paid
by the government, however, P2 A is higher.
per unit
S MC
MBS
A
S' MC'
P2A
P1
P2
MBE
DMBP
Q
Q2
Q1
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External Costs
Suppose that MCE is the marginal external cost of
a good the production of which generates
pollution. MCP is the marginal private cost of
producing the good. The sum of MCE and MCP is the
marginal social cost MCS. D is the demand for the
product. When the pollution is ignored, the
amount of the good produced is Q1, where the D
(or marginal private benefit) equals the
MCP. However, the efficient amount from the
viewpoint of society is only Q2, where MCS equals
D.
per unit
MCS
MCP
MCE
D
Q
Q1
Q2
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External Costs
Suppose a per unit pollution tax of T is
imposed. The new marginal private cost of
producing the good is MCP' MCP T. When MCP'
is equated to demand (or marginal private
benefit), the socially optimally amount of the
good Q2 is produced. The price of the good is
also higher P2 instead of P1.
per unit
MCS
MCP'
T
P2
MCP
P1
MCE
D
Q
Q1
Q2
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Lets focus on the cost of pollution reduction.

• The production of some goods generates pollution.
• To reduce that pollution requires taking steps
  that incur costs.
• One example would be the installation of filters
  on smokestacks.
• Suppose the cost of pollution reduction is not
  the same for all firms.
• What would be the impact of the government
  imposing a per unit pollution tax on all firms?

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Pollution Reduction
Suppose that the marginal cost of pollution
reduction is MCA for firm A and B MCB for firm.
Without a pollution tax, A produces PA400 units
of pollution and B produces PB275 units of
pollution. Notice in this graph that pollution is
measured from the right and pollution reduction
is measured from the left.
MCA
per unit
per unit
MCB
PA 400 PB 275
Pollution reduction
Pollution
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Even with a tax, firms wouldnt reduce pollution
to zero. It costs more to get rid of all
emissions than it does to clean up some of the
emissions and pay the tax on the rest. Firms
clean up to the point where the MC of cleaning up
equals the MC of not cleaning up, that is of
paying the tax on each of the remaining units of
pollution.
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A per unit pollution tax
So firm A will its reduce pollution by 250 units
to PA' 150. Firm B will its reduce pollution
by 225 units to PB' 50. This policy would
reduce total pollution to 200 units, cleaning up
all units that cost less than the tax to
eliminate. The policy eliminates 475 units of
pollution in the least costly way.
MCA
per unit
per unit
MCB
T
PA400 PB275
PB' 50
PA' 150
Pollution reduction
Pollution
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Fixed Pollution Level
Suppose the government were instead to reduce
pollution to 200 units by requiring each firm to
cut back its pollution to 100 units. Firm A have
to eliminate a lot of costly emissions, while
firm B would not have to eliminate some less
costly emissions. The extra cost to A would be
the blue area. The reduction in cost to B would
be the pink area. Clearly the extra cost to B is
more than the savings to A. So a policy that
required firms to cut back to the same pollution
level is a more costly policy.
MCA
per unit
per unit
MCB
T
PA400 PB275
PA' 150 PB' 50
P0100
Pollution reduction
Pollution