L06 Chapter 5 – Externalities and Public Goods

The Club

Anti Theft Device

Assume you car is parked and has the

club in place.

◦ Does this have an effect on the chance that

other cars are stolen? Why?

Externalities Def: A benefit or cost that affects someone

who is not directly involved in the production

or consumption of a good.

Example:

◦ Sweaty gym clothes

◦ Positive Externality

Purchase of Subway Sandwich

Only two parties benefit, you and Subway No

Externality

Purchase of college education

You AND society benefits

Less Crime, better health, more informed voters

etc…

Positive Externalities

Def: Benefits to third parties other than buyers or sellers not reflected in prices Examples: Identify the primary parties and the third

parties

Fire prevention mechanisms for your apartment

Nice Landscaping

Education

Externalities

◦ Negative Externality

Producers of electricity

Pay to get the coal, build the plant, pay the

workers etc

Is that the only cost of electricity consumption

and production?

What other costs are there?

____________________________________

____________________________________

Example: Coal Ash spill in Tennessee

December 27, 2008 – 5.4 million cubic yards

Thought question: Is the optimal level of pollution

zero?

Negative Externality

Def: costs to third parties other than the

buyers and sellers of an item not reflected

in the market price

◦ Examples – Identify the primary parties and

the third parties

Construction on an empty lot next to your house

Commercial aircraft flying over a neighborhood

Driving

Smoking

Others?

Effects of Externalities

Previous Lecture Markets maximize surplus

◦ Only true in a market without externalities

◦ With externalities, Surplus is reduced

◦ Externalities are a source of Deadweight loss

Private Cost: The cost borne by the producer of the

good or service

◦ Trucks, workers, coal

Social Cost = Private cost + any external costs

◦ Trucks, workers, coal + Asthma, pollution etc..

Private benefit: The benefit received by the consumer

of a good

◦ Higher wage

Social benefit = Private Benefit + any external benefit

◦ Higher wage + lower crime for all of society

Externalities and Inefficiency •What will happen to this graph

once we take into account the

extra costs borne by society?

•_______________________

________________________

•When we take into account all

MC and all MB, then we are at

the efficient equilibrium •Q2 is efficient because at that point

MB = MC for society as a whole.

•Q1 is inefficient, Why?

•______________________

_______________________

_______________________

•In other words, society could

save resources by reducing

output.

•Producing at Q1 causes deadweight

loss because marginal costs are

greater than the marginal benefits.

Key Point: In a market with a negative externality,

too much will be produced at the market

equilibrium

Market

Equilibrium

Externalities and Inefficiency •What happens in this graph when we

taken into account the extra benefits

society gets from people getting

educated?

•___________________________

____________________________

__________________________

•When we take into account all MC

and MB, then we are at the efficient

equilibrium

•Q2 is efficient because at that point

MB = MC for society as a whole.

•Q1 is inefficient, Why?

•________________________

________________________

___________.

•In other words, society could be

better off by producing more

education.

•Producing at Q1 causes deadweight

loss because marginal benefits are

greater than marginal cost.

•Key Point: When there is a positive

externality, the market equilibrium is

below the efficient equilibrium

•The market produces too little of

the good

Cause of Externalities

Lack of Property rights

◦ Def: The rights individuals or businesses have to the

exclusive use of their property including the right to

sell it.

Car vs Air

Externalities result from incomplete property

rights

Musical Example of Property Rights And the sign said anybody caught trespassing would be shot on sight

So I jumped on the fence and yelled at the house, Hey! what gives you the right

To put up a fence to keep me out or to keep mother nature in

If God was here, he'd tell you to your face, man you're some kinda sinner

How to get regain the surplus that

was lost due to externalities Two general methods

1. Solutions that do not involve the

government

Private solutions

2. Solutions that do involve the government

Private Solutions to Externalities

The Coase Theorem If negotiations are

possible, then bargaining will result in the

efficient solution to the problem of

externalities.

◦ No outside party, like the government is

required to make the decision.

Laws are required, but the government’s decision is

not.

Example

Example of Private Solutions to

Property Rights You like to BBQ, your

neighbor hates BBQ

smoke

You are good friends

What can you do to solve

this problem?

What if you have the legal

right to BBQ?

What if your neighbor has

the legal right to clean air?

Example of Private Solutions to Externality

Smoke From

BBQ 0 1 2 3

BBQer’s Total

Value $0 $30 $50 $60

Neighbor’s Total

Value $35 $30 $20 $0

Total Value $35 $60 $70 $60

•Assume negotiations are possible

•BBQers have the right to BBQ.

•BBQs can be compensated (given money) to reduce their level

of BBQing

•Any compensation (money) that the neighbor gives to the

BBQer must be subtracted from the neighbor’s total value.

•Neighbors have the right to smoke free air

•Neighbors can be compensated (given money) for the

smokiness of the air.

•Any compensation (money) that the BBQer gives to the neighbor

must be subtracted from the BBQer’s total value.

How to regain Surplus lost from

Externalities: Government Solutions

This is where the market settles

This is where society is best off

S2 Marginal

Social Cost

•What do we know of

that will move us from

S1 to S2?

•_______

•A tax forces

producers to take into

account the external

costs

•A tax in the case of

externality eliminates

the dead weight lost.

•That is because the

tax helps to equate

society’s MC to

society’s MB

DWL

How to Regain Surplus Lost from

Externalities

This is where the market settles

This is where society is best off

D2 Marginal

Social

benefit

•What Do we know

of that will move us

from D1 to D2?

•__________

•A subsidy helps us

to take into account

the external benefits

of our actions

•A subsidy in this

case eliminates the

deadweight loss

•That is because the

subsidy helps to

equate society’s MB

to society’s MC

DWL

Public Goods

What we are going to do

◦ Definitions

◦ Examples

◦ Graphs

◦ Rivalry – If someone consumes a good, then

no one else can

◦ Excludability – If you don’t pay, you don’t get

the good.

◦ Private Goods: Goods that are rival and

Excludable

Result in no Externalities

Public Goods

Public Good

◦ you can’t stop people from consuming it

(nonexcludable)

◦ Your consumption doesn’t affect other’s

consumption (nonrivalrous)

Public goods are associated with

externalities because no one has a

property right to a public good.

Public goods lead to free riding Benefiting from a good without paying for it.

Public Goods

Examples of Rivalry

◦ Is Satellite TV rivalrous?

___________________

◦ Is it Satellite TV excludable?

___________________

◦ Is it a public good then?

______________________________________

_______________

Public Goods

Example of Excludability

◦ Is fishing international waters excludable?

_________________________________

Think Whale Wars

◦ Is it rivalrous?

_________________________________

◦ Is it a public good?

_________________________________

Public Good Examples

National Defense

◦ Rivalrous? Excludable?

◦ ______________________

______________________

____________________

Fireworks show

◦ Rivalrous? Excludable?

◦ ______________________

______________________

_____________________

Market Demand for a Purely Private

good. Private good – Think Horizontal

Each Individual chooses how much they want at each

price

Demand for a purely Private good is the horizontal

summation of the individual demand curves.

Adding Quantities

Demand for Pure Public Goods

Public Good – Think

Vertical

All consumers must

consume the same

quantity of the good

Demand for public good

is the maximum

individuals are willing to

pay for the amount of the

good that is available

Demand for public good

is the vertical summation.

Adding Prices

Example

Elephants in Central Africa

◦ Lots of Killing despite government efforts

◦ Why?

◦ _______________________

◦ Assign property right to tribes

Tribes sell permits to hunt elephants

Have incentive to maintain health of herd

Elephant Population increased 400% in 10 years

Solving the Public

Good problem