Microeconomics

Chapter 17
Externalities and Public Goods

Microeconomics 1
 Chapter Preview
• Last lectures, we have covered one type of market failures:
imperfect markets.

• In this chapter we will discuss two others: externalities and public

goods.

• For each case, we want to see how resources are inefficiently

allocated.

• We also consider how different government policies address

these two market failures.

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 Externalities
• An externality is the effect of one party’s economic activity on
another party that is not taken into account by the price system.

– Externalities may be positive (benefits) or negative(costs).

– Externalities between firms.
– Externalities between firms and people.
– Externalities between people.

– Externalities are reciprocal in nature.

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Externalities and Allocational Efficiency
• How are resources inefficiently allocated when there are
externalities?

• For efficient allocation of resources what condition must be met?

– Price = social marginal cost of production (MSC)

• Social cost: The cost of production that includes both input costs
(private costs) plus the costs of the externality.

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Externalities and Allocational Efficiency
• A firm will maximize profits by producing at what point?

– Price = marginal private cost (MC)

• If production involves a negative externality the marginal social

cost is greater than the marginal private cost.

• Therefore, profit maximizing behavior (P=MC) will lead to too

much output being produced compared to the allocatively
efficient outcome (P=MSC).

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Externalities and Allocational Efficiency
MSC (social)
Price,
Costs MC (private)

If firms do not account for

a negative externality, too
much is produced (q*>q’).
P*

A profit maximizing firm

But efficient allocation produces where P = MC.
requires that P = MSC.
q’ q* Output

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Externalities and Allocational Efficiency
MSC (social)
Price,
Costs MC (private)
What happens to total
welfare if output fell from
q* to q’.
By reducing output from
P* q* to q’, consumer
spending falls.

By less than the reduction

in total social costs.

So total welfare increases.

q’ q* Output

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 Property Rights, Bargaining and the
Coase Theorem
• What role can property rights and bargaining play in solving the
externality problem?

• Property rights. The legal specification of who owns a good and

the trades the owner is allowed to make with it.

• Common property. Property that may be used by anyone without

cost.

• Private property. Property that is owned by specific people who

may prevent others from using it.

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 Property Rights, Bargaining and the
Coase Theorem
• Costless Bargaining and Competitive Markets

– Consider a situation in which there are two firms. One firm

pollutes and imposes a negative externality on the other.

– Assume that property rights to clean air are given to one of

the firms, but bargaining over how the air is used is allowed.

– With bargaining it is possible that the two firms will achieve

the efficient level of output regardless of who “owns” the air.

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 Property Rights, Bargaining and the
Coase Theorem
• Suppose the polluting firm has ownership rights. Is there a
bargain that would induce the firm to reduce its output to the
efficient level?

– By reducing its output the polluting firm loses some profit.

– But by reducing its output the costs imposed on the other firm
are reduced.

– Therefore, the polluting firm would reduce output for a fee ≥

lost profits but ≤ the costs of the externality.

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 Externalities and Bargaining
MSC (social)
Price,
Costs MC (private)
Loss in profits to the firm
from cutting output.

Cost savings to the affected

firm.
P*
Since the cost savings from
less output > loss in profit
from less output, the firm
harmed by pollution could pay
the polltuing firm to reduce
output to q’.
q’ q* Output

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 Property Rights, Bargaining and the
Coase Theorem
• Suppose now the injured firm has ownership rights. Would the
polluting firm be able to pay the affected firm to allow it to
produce q*?

– No.
– The polluting firm would be willing to pay at most, P*- MC.
– The injured firm would need to receive MSC – MC
– MSC – MC > P* - MC or MSC > P* beyond q’.

• Again, the efficient level of output, q’, is produced.

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 Property Rights, Bargaining and the
Coase Theorem
• The Coase Theorem.
– If bargaining is costless, the social cost of an externality will be
taken into account by the parties, and the allocation of
resources will be the same no matter how property rights are
assigned.

• One possible problem with this are distributional effects. How do

you equitably assign property rights?

• Another problem has to do with the role of transaction costs.

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Externalities With High Transaction Costs
• How can we resolve the externality problem if transaction costs
are too high? Three ways:

1. Legal redress
– If the polluting firm can be sued for the costs, payment of
damages will increase the costs associated with production.

2. Taxation
– Pigouvian Tax. A tax that brings about an equality of private
and social costs.
– Tax = extra costs that the polluting firm imposes on the other
firm.

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 Externalities and Taxation
MSC (social)
Price,
Costs MC (private)

At q’ the cost imposed on

the injured firm is MSC –
MPC.
P*
This is the amount of tax.
Tax = t
The net price received by
P*-t
the polluting firm is P*-t,
which would “force” it to
produce q’.
q’ q* Output

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Externalities With High Transaction Costs
• How can we resolve the externality problem if transaction costs
are too high?

3. Regulation of Externalities: Find the optimal level of pollution.

– MB’s decrease as more pollution is reduced: diminishing

returns from clean air.

– MC’s increase as more pollution is abated.

– The optimal level of pollution reduced is where MB = MC

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 Optimal Pollution Abatement

MB,
MC MC

At RL, MB>MC so reduce more

pollution.

At RH, MC>MB so reduce less

pollution.

The optimal level is where

MB=MC.

MB

RL R* RH 100% Reduction in
emissions
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Externalities With High Transaction Costs
• Assume that the government has decided on R*. How do they
get there?

– Direct control.

– Charge an effluent fee.

– Issue permits that allow firms to pollute 100 – R* units, and

allow firms to trade permits.

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 Optimal Pollution Abatement
From 0 to R*, it
MB, costs less to Beyond R*, firms
MC reduce pollution MC
would be better
than pay the fee. paying the fee
than paying to
reduce pollution.

Why do we want
Fee: f* to allow firms to
trade their
permits?
Permits MB

R* 100% Reduction in
emissions

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 Public Goods
• What are the characteristics of a public good?

• Nonexclusive goods. Goods that provide benefits that no one can

be excluded from enjoying.

• Nonrival goods. Goods that additional consumers may use at zero

marginal cost.

• Public goods provide nonexclusive benefits to everyone in a

group and can be provided to one more user at zero marginal
cost.

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 Types of Public Goods

Exclusive
Yes No
Hot dogs Fishing ground
Yes Automobiles Public grazing land
Houses Clean air
Rival Bridges National defense
No Swimming pools Mosquito control
Scrambled satellite Justice
signal Ideas

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 Public Goods and Market Failure
• Why is there a market failure in the case of public goods?

– With a private good, the buyer gets the entire benefits from
that good.
– With a public good, the buyer won’t be able to receive the
entire benefits from that good since it is nonexcludable and
nonrival.
– Society’s benefit from the good outweigh the benefits to any
single buyer.
– Since these additional benefits are not accounted for, private
market will tend to produce too little of the good.

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 Public Goods and Market Failure
Willingness
to pay

Total demand = D1 + D2

How does the demand

Demand by Person 2 for a public good differ
than the demand for a
private good?

Demand by Person 1

Quantity of the
public good

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 Public Goods and Market Failure
Willingness
to pay

What Q units are worth to society.

What Q units are worth to Person 2

What Q units are worth to Person 1

Quantity of the
Q public good

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 Solutions to the Public Good Problem
• Free rider. A consumer of a non-exclusive good who does not pay
for it in the hope that other consumers will.

What is the Nash B’s Strategies

equilibrium?
Clean Don’t Clean

A: 2 A: 0
Clean
B: 2 B: 3
A’s Strategies
Don’t A: 3 A: 1
Clean B: 0 B: 1

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 Solutions to the Public Good Problem
• Compulsory taxation and Lindahl Equilibrium

– Lindahl equilibrium. A balance between people’s demand for

a public good and the tax shares that must pay for them.

– Two conditions are met:

• The tax shares paid by all individuals precisely pay for the
level of the public good provided by the government.

• Each person’s tax share is based on their relative demand

for the public good.

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 Solutions to the Public Good Problem
Share of cost 100 Share of cost
0
paid by Smith paid by Jones
S J
Jones’ demand.

60 40

Smith pays 60%;

Jones pays 40%.

S Smith’s demand.
J
0 E* 100 Quantity of
public good

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Revealing the Demand For Public Goods
• What is a problem in using the Lindahl method?

– It requires the government to know people’s demand curves.

– People are unlikely to reveal their true demands: free rider

problem.

• This may be less of a problem for local goods since people “vote
with one’s feet”.

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 Voting for Public Goods
• Majority rule and the Paradox of Voting

Voter Order of Preferences

Smith A B C
Jones B C A
Fudd C A B

• In a vote between A and B: A would win.

• In a vote between A and C: C would win.
• In a vote between C and B: B would win.
• What’s the paradox?

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 Voting for Public Goods
• Single Peaked Preferences and the Median Voter Theorem

– Is there a way that would yield more stable voting outcomes?

– Stable outcomes can always occur if the issue is one

dimensional and voters’ preferences are single peaked.

– In this case, the preferred choice of the median voter would

win.

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 Voting for Public Goods

Since Fudd has two local peaks (A and C) get the

Utility voting paradox.

Fudd

Jones

Smith

A B C Quantity of
public good

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 Voting for Public Goods

Now Fudd has only one local peak.

Utility

Fudd
Fudd: alternative
Jones

Smith

A B C Quantity of
public good

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 Voting for Public Goods
• It is unlike that majority voting will lead to an efficient allocation
of resources.
– Votes by themselves do not provide enough information about
preferences.

• Representative governments and bureaucracies makes the

problem more complex.
– Principal-agent problem.
– Possibility for rent-seeking behavior where firms or
individuals influence government policy to increase their own
welfare.

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Summary
• When transaction costs are low, private negotiations between
parties may result in an efficient allocation regardless of how
property rights are assigned.

• If transaction costs are prohibitive, government intervention may

be necessary but won’t necessarily achieve efficiency.

• Ways to correct for externalities are Pigouvian taxes, fees,

pollution permits, or direct control.

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Summary
• Pure public goods are non-exclusive and non-rival. Since people
will not purchase public goods in efficient amounts, resources will
be under allocated to the provision of these goods.

• Lindahl taxes may achieve the efficient quantity of public goods,

in theory, but due to the free rider problem people have an
incentive to understate their demands.

• Direct voting may produce paradoxical results. In some cases,

majority rule may result in the choice of policies faced by the
median voter.

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