© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 14 Prepared by: Fernando Quijano and Yvonn Quijano Externalities,

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Externalities, Public Goods, Externalities, Public Goods, Imperfect Information, and Imperfect Information, and

Social ChoiceSocial Choice


ExternalitiesExternalities

• An An externalityexternality is a cost or benefit is a cost or benefit resulting from some activity or resulting from some activity or transaction that is imposed or transaction that is imposed or bestowed upon parties outside the bestowed upon parties outside the activity or transaction. Sometimes activity or transaction. Sometimes called called spilloversspillovers or or neighborhood neighborhood effects.effects.


ExternalitiesExternalities

• When When external costsexternal costs are not are not considered in economic decisions, we considered in economic decisions, we may engage in activities or produce may engage in activities or produce products are not “worth it.”products are not “worth it.”

• When When external benefitsexternal benefits are not are not considered, we may fail to do things considered, we may fail to do things that are indeed “worth it.” The result is that are indeed “worth it.” The result is an inefficient allocation of resources.an inefficient allocation of resources.


Marginal Social Cost andMarginal Social Cost andMarginal-Cost PricingMarginal-Cost Pricing

• Marginal social costMarginal social cost ( (MSCMSC)) is the is the total cost to society of producing an total cost to society of producing an additional unit of a good or service.additional unit of a good or service.

• MSCMSC is equal to the sum of the is equal to the sum of the marginal costs of producing the marginal costs of producing the product and the correctly measured product and the correctly measured damage costs involved in the damage costs involved in the process of production.process of production.


Marginal Social Cost andMarginal Social Cost andMarginal-Cost PricingMarginal-Cost Pricing

• At q*, marginal social cost exceeds the price paid by At q*, marginal social cost exceeds the price paid by consumers. Output is too high. Market price takes into consumers. Output is too high. Market price takes into account only part of the full cost of producing the good.account only part of the full cost of producing the good.


Private Choices and External EffectsPrivate Choices and External Effects

• Marginal private Marginal private costcost ( (MPCMPC) is the ) is the amount that a amount that a consumer pays to consumer pays to consume an consume an additional unit of a additional unit of a particular good.particular good.



• Marginal benefitMarginal benefit ((MBMB) is the benefit ) is the benefit derived from each derived from each successive hour of successive hour of music, or the music, or the maximum amount maximum amount of money Harry is of money Harry is willing to pay for willing to pay for an additional hour an additional hour of music.of music.



• Harry would play Harry would play the stereo until the stereo until MB MB = = MPCMPC, or eight , or eight hours.hours.

• However, this However, this result would be result would be socially inefficient socially inefficient because Harry because Harry does not consider does not consider the cost imposed the cost imposed on Jake.on Jake.



• Marginal damage Marginal damage costcost ( (MDCMDC) is the ) is the additional harm additional harm done by increasing done by increasing the level of an the level of an externality-externality-producing activity producing activity by one unit.by one unit.



• Marginal social Marginal social costcost ( (MSCMSC)) is the is the total cost to society total cost to society of playing an of playing an additional hour of additional hour of music.music.

• Playing the stereo beyond more than five hours is Playing the stereo beyond more than five hours is inefficient because the benefits to Harry are less than the inefficient because the benefits to Harry are less than the social cost for every hour above five.social cost for every hour above five.


Internalizing ExternalitiesInternalizing Externalities

• A tax per unit equal to A tax per unit equal to MDCMDC is imposed on the firm. The firm is imposed on the firm. The firm will weigh the tax, and thus the damage costs, in its decisions.will weigh the tax, and thus the damage costs, in its decisions.


The Coase TheoremThe Coase Theorem

• Government need not be involved in Government need not be involved in every case of externality.every case of externality.

• Private bargains and negotiations Private bargains and negotiations are likely to lead to an efficient are likely to lead to an efficient solution in many social damage solution in many social damage cases without any government cases without any government involvement at all. This argument is involvement at all. This argument is referred to as the referred to as the Coase TheoremCoase Theorem..


The Coase TheoremThe Coase Theorem

• Three conditions must be satisfied for Three conditions must be satisfied for Coase’s solution to work:Coase’s solution to work:

• Basic rights at issue must be assigned Basic rights at issue must be assigned and clearly understood.and clearly understood.

• There are no impediments to bargaining.There are no impediments to bargaining.

• Only a few people can be involved.Only a few people can be involved.

• Bargaining will bring the contending Bargaining will bring the contending parties to the right solution regardless parties to the right solution regardless of where rights are initially assigned.of where rights are initially assigned.


Indirect and Direct RegulationsIndirect and Direct Regulations

• Taxes, subsidies, legal rules, and Taxes, subsidies, legal rules, and public auction are all methods of public auction are all methods of indirectindirect regulation designed to regulation designed to induce firms and households to induce firms and households to weigh the social costs of their weigh the social costs of their actions against the benefits.actions against the benefits.

• DirectDirect regulation includes legislation regulation includes legislation that regulates activities that, for that regulates activities that, for example, are likely to harm the example, are likely to harm the environment.environment.


Public GoodsPublic Goods

• Public goodsPublic goods ( (socialsocial or or collective collective goodsgoods) are goods that are nonrival ) are goods that are nonrival in consumption and/or their benefits in consumption and/or their benefits are nonexcludable.are nonexcludable.

• Public goods have characteristics Public goods have characteristics that make it difficult for the private that make it difficult for the private sector to produce them profitably sector to produce them profitably (market failure).(market failure).


The Characteristics of Public GoodsThe Characteristics of Public Goods

• A good is A good is nonrival in consumptionnonrival in consumption when A’s consumption of it does not when A’s consumption of it does not interfere with B’s consumption of it. interfere with B’s consumption of it. The benefits of the good are The benefits of the good are collective—they accrue to everyone.collective—they accrue to everyone.

• A good is A good is nonexcludablenonexcludable if, once if, once produced, no one can be excluded produced, no one can be excluded from enjoying its benefits. The good from enjoying its benefits. The good cannot be withheld from those that cannot be withheld from those that don’t pay for it.don’t pay for it.



• Because people can enjoy the Because people can enjoy the benefits of public goods whether benefits of public goods whether they pay for them or not, they are they pay for them or not, they are usually unwilling to pay for them. usually unwilling to pay for them. This is referred to as the This is referred to as the free-rider free-rider problemproblem..



• The The drop-in-the-bucket problemdrop-in-the-bucket problem is is another problem intrinsic to public another problem intrinsic to public goods: The good or service is goods: The good or service is usually so costly that its provision usually so costly that its provision generally does not depend on generally does not depend on whether or not any single person whether or not any single person pays.pays.



• Consumers acting in their own self-Consumers acting in their own self-interest have no incentive to interest have no incentive to contribute voluntarily to the contribute voluntarily to the production of public goods.production of public goods.

• Most people do not find room in their Most people do not find room in their budgets for many voluntary budgets for many voluntary payments. The economic incentive payments. The economic incentive is missing.is missing.


Public Provision of Public GoodsPublic Provision of Public Goods

• Public provision does not imply Public provision does not imply public production of public goods.public production of public goods.

• Problems of public provision include Problems of public provision include frequent dissatisfaction. Individuals frequent dissatisfaction. Individuals don’t get to choose the quantity they don’t get to choose the quantity they want to buy—it is a collective want to buy—it is a collective purchase. We are all dissatisfied! purchase. We are all dissatisfied!


Optimal Provision of Public GoodsOptimal Provision of Public Goods

• With private goods, consumers decide what quantity to With private goods, consumers decide what quantity to buy; market demand is the sum of those quantities at buy; market demand is the sum of those quantities at each price.each price.


Optimal Provision of Public GoodsOptimal Provision of Public Goods

• With public goods, there is only one With public goods, there is only one level of output, and consumers are level of output, and consumers are willing to pay different amounts for willing to pay different amounts for each level.each level.

• The market demand for a public The market demand for a public good is the vertical sum of the good is the vertical sum of the amounts that individual households amounts that individual households are willing to pay for each potential are willing to pay for each potential level of output.level of output.


Optimal Production of a Public GoodOptimal Production of a Public Good

• Optimal production Optimal production of a public goodof a public good means producing as means producing as long as society’s total long as society’s total willingness to pay per willingness to pay per unit Dunit D(A+B)(A+B) is greater is greater

than the marginal cost than the marginal cost of producing the good.of producing the good.


Local Provision of Public GoodsLocal Provision of Public Goods

• According to the According to the Tiebout hypothesisTiebout hypothesis, , an efficient mix of public goods is an efficient mix of public goods is produced when local land/housing produced when local land/housing prices and taxes come to reflect prices and taxes come to reflect consumer preferences just as they do consumer preferences just as they do in the market for private goods.in the market for private goods.


Imperfect Information andImperfect Information andAdverse SelectionAdverse Selection

• Most voluntary exchanges are Most voluntary exchanges are efficient, but in the presence of efficient, but in the presence of imperfect information, not all imperfect information, not all exchanges are efficient.exchanges are efficient.

• Adverse selectionAdverse selection can occur when can occur when a buyer or seller enters into an a buyer or seller enters into an exchange with another party who exchange with another party who has more information.has more information.


Moral HazardMoral Hazard

• Moral hazardMoral hazard arises when one party arises when one party to a contract passes the cost of his to a contract passes the cost of his or her behavior on to the other party or her behavior on to the other party to the contract.to the contract.

• The moral hazard problem is an The moral hazard problem is an information problem, in which information problem, in which contracting parties cannot always contracting parties cannot always determine the future behavior of the determine the future behavior of the person with whom they are person with whom they are contracting.contracting.


Market SolutionsMarket Solutions

• As with any other good, there is an As with any other good, there is an efficient quantity of information efficient quantity of information production.production.

• Like consumers, profit-maximizing Like consumers, profit-maximizing firms will gather information as long firms will gather information as long as the marginal benefits from as the marginal benefits from continued search are greater than continued search are greater than the marginal costs.the marginal costs.


Government SolutionsGovernment Solutions

• Information is nonrival in consumption.Information is nonrival in consumption.

• When information is very costly for When information is very costly for individuals to collect and disperse, it individuals to collect and disperse, it may be cheaper for government to may be cheaper for government to produce it once for everybody.produce it once for everybody.


Social ChoiceSocial Choice

• Social choiceSocial choice is the problem of is the problem of deciding what society wants. The deciding what society wants. The process of adding up individual process of adding up individual preferences to make a choice for preferences to make a choice for society as a whole.society as a whole.


The Impossibility TheoremThe Impossibility Theorem

• The The impossibility theoremimpossibility theorem is a is a proposition demonstrated by proposition demonstrated by Kenneth Arrow showing that no Kenneth Arrow showing that no system of aggregating individual system of aggregating individual preferences into social decisions will preferences into social decisions will always yield consistent, nonarbitrary always yield consistent, nonarbitrary results.results.


The Impossibility TheoremThe Impossibility Theorem

Preferences of Three Top University OfficialsPreferences of Three Top University Officials

VP1 prefers A to B and B to C. VP2 prefers B to C and C to A. The dean VP1 prefers A to B and B to C. VP2 prefers B to C and C to A. The dean prefers C to A and A to B.prefers C to A and A to B.

OPTION AOPTION A OPTION BOPTION B OPTION COPTION C

Hire more Hire more facultyfaculty

No changeNo change Reduce the size of the Reduce the size of the facultyfaculty

RankingRanking

11 XX XX XX

22 XX XX XX

33 XX XX XX

• If A beast B, and B beats C, how can C beat A? The results are inconsistent.

VP1 VP2

Dean


The Voting ParadoxThe Voting Paradox

• The The voting paradoxvoting paradox is a simple demonstration of how is a simple demonstration of how majority-rule voting can lead to seemingly majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly contradictory and inconsistent results. A commonly cited illustration of inconsistency described in the cited illustration of inconsistency described in the impossibility theorem.impossibility theorem.

Results of Voting on University’s Plans: The Voting ParadoxResults of Voting on University’s Plans: The Voting Paradox

VOTES OF:VOTES OF:

VoteVote VP1VP1 VP2VP2 DeanDean ResultResultaa

A versus BA versus B AA BB AA A wins: A > BA wins: A > B

B versus CB versus C BB BB CC B wins: B > CB wins: B > C

C versus AC versus A AA CC CC C wins: C > AC wins: C > AaaA > B is read “A is preferred to B.”A > B is read “A is preferred to B.”


Rent-Seeking RevisitedRent-Seeking Revisited

• There are reasons to believe that There are reasons to believe that government attempts to produce the government attempts to produce the right goods and services in the right right goods and services in the right quantities efficiently may fail.quantities efficiently may fail.

• The existence of an “optimal” level of The existence of an “optimal” level of public-goods production does not public-goods production does not guarantee that governments will guarantee that governments will achieve it.achieve it.

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© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 14 Prepared by: Fernando Quijano and Yvonn Quijano Externalities,