Externalities and Public Goods

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Externalities and Public Goods

• Setup Perfectly competitive markets result in
  outputs and prices which are socially optimal in
  the sense of the maximizing surplus (Pareto
  Optimal). Another way to say this is that
  competition results in output levels for which
  marginal social benefit equals marginal social
  cost. (MSB MSC)

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• We saw that the presence of monopoly, for
  example, could justify government interference
  because monopolies dont produce output levels
  where MSB MSC.
• But even competitive markets may fail under some
  circumstances.

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• In what follows, we will examine the conditions
  under which competitive markets may fail to be
  optimal institutions to produce and distribute
  goods. This topic is known as market failure.

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REASONS FOR MARKET FAILURE

• MONOPOLY POWER
• EXTERNALITIES
• PUBLIC GOODS
• INFORMATION FAILURES

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EXTERNALITIES IN MORE DETAIL

• An externality is a benefit or cost to third
  parties who are not directly involved in a
  transaction.
• Externalities are sometimes called neighborhood
  effects.

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• Externalities can be either beneficial or
  harmful, and can originate with either consumers
  or producers.
• Here are some examples

Hidden slides
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1) Your consuming cigarettes imposes costs on
others nearby in the form of bad smells and
dangerous smoke. 2) Midwestern production of
electricity from burning fossil fuels causes
damaging acid rain in eastern Canada and northern
New York. 3) Your wearing perfume or cologne
makes others near you feel better off. 4) A dam
built for electricity generation provides flood
control to farmers and towns downstream.
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• More examples of externalities
• 1) North Atlantic fishing
• 2) Dormitory noise pollution
• 3) Some kinds of education
• 4) Vaccinations

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How Externalities Work

• The existence of an externality creates a
  difference between either
• a) the private and social cost of production, or
• b) the private and social benefits from
  consumption.
• The consequence is that even competitive markets
  will fail to reach a social optimum.

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• Marginal external cost is the extra social cost
  (over and above the private cost) of producing
  one more unit of the good.
• Marginal external benefit is the extra social
  benefit of consuming one more unit of a good.
• The presence of external benefits and costs means
  there will be a difference between the private
  and social consequences of production.

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• EXAMPLE 1
• Suppose the market in beer is perfectly
  competitive. But beer production creates
  terrible odors, and makes people who live
  downwind from breweries worse off.

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• Heres the situation for a typical beer
  producer
• MPC is the Marginal Private Cost of production.
  Its the same as the firms supply curve, showing
  willingness to sell.
• MPB is the Marginal Private Benefit. It's the
  demand curve for the good, showing willingness to
  pay.

/Q
Supply MPC
A competitive market will lead to Q.
Demand MPB
Q
Q
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The existence of a harmful externality means
there is a difference between the private and
social costs of producing beer.
The difference between private and social cost is
the marginal external cost (MEC)
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This distance is the pollution cost of one more
unit of beer.
Marginal social cost MPC MEC
/Q
Supply MPC
Demand MPB
Q
Q
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This area is the total pollution cost when Q is
produced.
Marginal social cost MPC MEC
/Q
Supply MPC
Demand MPB
Q
Q
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The socially best output is Q(society).
Marginal social cost MPC MEC
/Q
Supply MPC
Demand MPB MSB
Q
Q
Q(society)
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This area is the total pollution cost when
Q(society) is produced.
Marginal social cost MPC MEC
/Q
Supply MPC
Demand MPB
Q
Q
Q(society)
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• The conclusion is that when an externality is
  present, even a competitive beer market will not
  produce the best amount of beer.
• In this example too much beer is produced from
  societys point of view.

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• EXAMPLE 2
• Prof. Brown is trying to decide how much
  schooling to buy for his daughter. He will buy
  years of schooling up to point where the last
  unit bought is just worth it to him. But
  schooling, especially at the elementary level,
  has positive externalities.

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Brown will choose years of schooling by equating
MPB with MPC.
/Q
MPC MSC
MPB
Q
Q
YEARS OF SCHOOLING
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• But the extra (external) benefits from schooling
  mean that Brown will buy too little schooling for
  his daughter if left to his own devices.

This distance is the marginal external benefit.
/Q
MPC MSC
MSBMPBMEB
MPB
Q
Q
Q(Society)
YEARS OF SCHOOLING
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• EXAMPLE 3
• People decide whether or not to get vaccinated
  against diseases by comparing the private
  benefits with the private costs. But
  vaccinations carry important external benefits
  because when you are vaccinated people cannot get
  the illness from you.

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• The horizontal axis here represents the number of
  people getting vaccinated. People will get
  vaccinated only if the benefit to them is at
  least as great as the cost.

/person
N is the private amount demanded. Society would
want N people vaccinated.
MSCMPC
MSB
MPB DEMAND
of people
N
N
THE MARKET IN SMALLPOX VACCINATIONS
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• Solutions to externalities problems
• 1) Economists generally favor taxes and
  subsidies linked to the value of the externality
• 2) Direct regulation
• 3) Subsidize pollution control equipment
• 4) Sell or grant tradable pollution rights.
• 5) Coases Theorem -- Assign property rights
• 6) Internalize the externality through mergers

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PUBLIC GOODS IN MORE DETAIL

• A pure public good is a good or service that is
  consumed in its entirety by everyone. When one
  person consumes another unit of a public good we
  all consume more.
• The most common example is national defense.

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• Public goods have two special properties compared
  to private consumption goods.
• Nonrivalry When one person consumes a unit of a
  public good the amount available to be consumed
  by everyone else is not diminished.
• Nonexcludability Once a public good is produced
  it is difficult or impossible to exclude people
  from consuming it.

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• Because public goods are nonrival and/or
  nonexcludable, these goods will tend to be under
  produced, or maybe not produced at all if left to
  the private market.
• Public goods are not the same as publicly
  provided goods. Just because government provides
  a good does not make it a public good.

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• Examples of public goods

Hidden slide
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1) On the air TV and radio signals 2) Public
parks without an admission fee 3) Freeways not
during rush hour 4) Clean air 5) Ideas
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• Some public goods can be excludable but not
  rival
• 1) Crossing a toll bridge when it isnt crowded.
• 2) Scrambled on the air TV signals.
• One way to explain nonrivalry in consumption is
  by saying that the marginal cost of providing the
  good to one more consumer is zero.

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• Some public goods may be nonexcludable but rival
• 1) Air that is polluted by smoking.
• 2) The ocean is not excludable, but fishing is
  rival.
• Production of public goods is sometimes said to
  suffer from the free rider problem. This
  arises directly from the nonexcludability
  property of public goods.

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• Public good summary
• If public goods are produced in private markets,
  they will be under produced because social
  benefits will exceed private benefits.

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• Solutions to the public goods problem
• 1) Using technologies that provide for exclusion
  (toll roads, cable TV)
• 2) Government ownership
• 3) Clubs or cooperatives

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INFORMATION FAILURES IN MORE DETAIL

• Information failures occur when one party to a
  transaction lacks information on product quality,
  or cannot monitor the behavior of a person with
  whom they have a contract.
• Note that information failures result from
  asymmetric or lopsided information about products
  or actions, not just the absence of information.

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• The usual way to deal with uncertainty or lack of
  perfect information is to buy insurance of some
  sort.
• Examples Health insurance
• Fire and theft insurance

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• Adverse selection occurs when one party to a
  contract has better information than the other
  party. Adverse selection is sometimes called the
  problem of hidden characteristics.
• Examples Health insurance.
• Life insurance.
• Used cars.
• Used computers.

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• When there is adverse selection, insurance
  markets will fail to provide the socially best
  amount of insurance at fair rates.
• People who would be willing to pay fair prices
  for health insurance may find themselves unable
  to do so.

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• In the case of asymmetric information in markets
  for used cars or used computers the consequence
  is that only bad ones (lemons) will be traded.
  People willing to pay a fair price for a good
  used car or computer will be unable to find one.

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• Solutions to the problem of adverse selection.
• Many of the solutions employ what economists call
  signaling.
• 1) Market search
• 2) Consumer Reports Magazine
• 3) Reputation
• 4) Standardization (McDs, Holiday Inn)
• 5) Warranties and guarantees
• 6) Physical exams for life insurance
• 7) Pooling through groups for health insurance

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• Some governmental solutions
• Licensing of occupations
• National health care
• Lemons laws

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• Moral hazard occurs when it is difficult or
  impossible to monitor the actions of a person
  with whom you have a contract. It is sometimes
  referred to as the problem of hidden actions, or
  the failure to take care.

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• Examples of moral hazard
• 1) Getting an employee to do your bidding (the
  problem of shirking).
• 2) You buy fire insurance and stop replacing the
  batteries in the smoke detectors.
• 3) You sign an apartment lease that includes
  heat, and you leave the door open all winter.
• 4) You buy life insurance and then commit
  suicide.
• 5) You cant buy human capital payoff
  insurance.

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• Solutions to the problem of moral hazard.
• Generally, the problem can be solved by creating
  appropriate incentives.
• 1) Worker commissions based on performance.
• 2) Copayments and deductibles in insurance
  contracts.
• 3) Leases that provide incentives for good care
  of the premises.