Public goods and externalities:

two more “market failures”

• another market failure (discussed in the
previous lecture) is due to “monopoly
power”
• these three market failures plus income
distribution are the main rationales for
government intervention in a market
economy
 Public Goods
• Two Key properties
• non-rivalry in consumption
– if I consume more, others do not need to
consume less
• non-excludability
– you cannot prevent people from consuming the
good
– free rider problem
 National Defense

F172
Fire Protection
Police
Lighthouse?
 How much of a public good
should be produced?
• Mimic the market:
– produce up to the point where marginal benefit
equals marginal cost
• examples:
– number of police on the street
– size of national defense force
 Cost-Benefit Analysis
• when the choice is to produce or not
produce
• Because benefits come in the future they
must be discounted
 Numerical Example:
Should PAPD buy a new computer?
Time Costs Benefits

This year $1,000 0

Next year 0 $500

Two years 0 $600

from now
 Present Discounted Value of
Benefits
• PDV = 500/(1+i) + 600/(1+i)2
• if i = .05 then
• PDV = 500/(1.05) + 600/(1.05)2
= 476 + 544 = 1020
– thus the PAPD should make the investment in
the computer
 Higher discount rates mean that fewer
projects will meet cost-benefit test. Thus
discounting enters political debate.

i PDV
.04 1035
.05 1020
.06 1005
.07 991
 Externalities
• Definition: When the costs of producing or
the benefits of consuming spill over to other
people.
• Negative externalities
• Positive externalities
A Negative Externality: Pollution
 Positive Externalities
• Education
• Innovative ideas
• Research
 The Economic Impact of
15_01
Negative Externalities
DOLLARS Marginal
social cost

Marginal private cost is

less than marginal social
Deadweight cost by this amount.
loss

Marginal private cost

as viewed by private firms
(market supply curve)

Marginal benefit
A B (market demand curve)

QUANTITY OF
Efficient quantity The market generates ELECTRICITY
this quantity.
 The Economic Impact of
Positive Externalities
15_02

DOLLARS

Marginal cost
Deadweight
loss (market supply curve)

Marginal social benefit

is greater than
marginal private benefit
by this amount.

Marginal social benefit

Marginal private benefit as

viewed by consumers of goods
C D (market demand curve)

QUANTITY OF
EDUCATION
The market generates Efficient quantity
this quantity.
 What are the possible remedies
for externalities?
• Private Remedies Let the individuals work
it out themselves
– Need to define property rights
– But transaction costs and free rider problem
might prevent the private remedy
 Command and control
• A common form of “social regulation” used
by EPA
– scrubbers
– CAFÉ standards
• Usually not very flexible or efficient
 Using Taxes or subsidies
• make them feel the pain or the gain
• more flexible than command and control
• but can’t be sure about the total amount
 The Tax Remedy for a
Negative Externality
15_03

DOLLARS
Marginal social cost equals
marginal private cost viewed
by private firms with tax

Marginal private cost viewed

Tax by private firms without tax

Marginal benefit
(market demand curve)
A B
QUANTITY OF
ELECTRICITY
Efficient quantity Quantity produced Inefficient quantity
decreases to lower,
more efficient level.
 The Subsidy Remedy for a
Positive Externality
DOLLARS
15_04

Marginal cost
(market supply curve)
Subsidy

Marginal social benefit

equals marginal private
benefit plus subsidy

Marginal private benefit

C D without subsidy

QUANTITY OF
EDUCATION
Inefficient Quantity produced Efficient
quantity increases to higher, quantity
more efficient level.
Why don’t you draw it by hand?
 Tradable Permits
• Examples
– SO2 (acid rain)
– CO 2 (global warming)
• Permit allows each firm to emit a certain amount of
pollutants
• Total number of permits issued equals emission
limit for the region each year
• Firms that are better at reducing emissions sell
permits to firms that are worse at it.
End of Lecture