Chapter 9

Externalities

and Public

Goods

Outline

Externalities

Private

Solutions to

Externalities

Government

Solutions to

Externalities

Public Goods

Common Pool

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Part II: Foundation of Microeconomics

5. Consumers and Incentives

6. Sellers and Incentives

7. Perfect Competition and the Invisible Hand

8. Trade

9. Externalities and Public Goods

10. The Government in the Economy: Taxation

and Regulation

11. Markets for Factors of Production

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Chapter 9

Externalities and Public Goods

2015.10.30.

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1 Externalities

2 Private Solutions to Externalities

3 Government Solutions to Externalities

4 Public Goods

5 Common Pool Resource Goods

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Q: How can the Queen of England lower her

commute time to Wembley Stadium?

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• There are important cases in which free

markets fail to maximize social surplus.

• This chapter discusses three such cases:

externalities, public goods, and common pool

resources.

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• One common link between these three

examples is that there is a difference between

the private benefits and costs and the social

benefits and costs.

• Government can play a role in improving

market outcomes in such cases.

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9.1 Externalities• Assume that the electricity industry is a perfectly

competitive market

Exhibit 9.1 The Market for Electricity

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• However, the power plant imposes an

externality on the public as a by-product of

producing electricity.

• An externality occurs when an economic

activity has either a spillover cost or a spillover

benefit on a bystander.

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A “Broken” Invisible Hand: Negative Externalties

• The plant imposes a negative externality,

because by producing electricity it creates a

spillover cost that it does not consider when

making production decisions.

• When there are negative externalities present,

the market outcome is no longer efficient.

• This is because negative externalities impose an

additional cost on the society that is not

explicitly recognized by the buyers and sellers

in the market.

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Exhibit 9.2 The Socially Optimal Quantity and Price of Electricity

• Marginal social cost (MSC)= marginal cost + marginal

external cost.

• Taking into account the extra costs imposed on society

by the plant’s pollution, Qoptimal is less than Qmarket .

• Markets will produce too much, resulting in too much

pollution.

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Exhibit 9.3 Deadweight Loss Due to a Negative Externality

• The yellow-shaded triangle represents the deadweight

loss of the negative externality. Why?

• However, pollution is not driven to zero.

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A “Broken” Invisible Hand: Positive Externalties

• An important example of a positive externality is

educational attainment, which not only helps a student

through better employment opportunities and higher

wages but also confers significant benefits on others.

• The most often cited benefits of education are the

following:

• Education increases civic engagement, thereby

contributing to a more informed democratic

society.• An educated workforce is vital for innovation and

adoption of new technologies.• An educated citizenry will be less likely to commit

crime.

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Exhibit 9.4 The Market Equilibrium for Education

• Assume that education is a perfectly competitive market.

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Exhibit 9.5 Deadweight Loss of a Positive Externality

• Marginal social benefit (MSB)=marginal benefit +

marginal external benefit

• Taking into account the extra benefit of education,

Qmarket is less than Qoptimal .

• The yellow-shaded triangle represents the deadweight

loss of the positive externality. Why?

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Pecuniary Externaltities

• More people buying a good and thereby causing a

negative market impact for others is called a pecuniaryexternality.

• Pecuniary externalities exist when market transaction

affect other people, but only through the market price.

• Pecuniary externalities do not create market

inefficiencies.

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9.2 Private Solutions to

Externalities

• One fundamental theme unites the multiple solutions to

externalities, whether public or private: internalizing the

externality. (外部成本內部化)

• When individuals or companies take into account the

full costs and benefits of their actions, economists say

that they are internalizing the externalities.

• When the external effects of their actions are

internalized, the general result is that the market

equilibrium moves toward higher social well-being.

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Private Solution: Bargaining

power plant v.s. local fishermen (there is no law against

polluting the waterways)

• The power plant can eliminate the toxins that it emits by

purchasing and installing scrubbers at the cost of $5

million.

• If the fishermen can convince the power plant to install

the scrubbers, they will receive benefits of approximately

$7 million.

• What is the outcome if the fisherman and power plant

do not communicate?

• The power plant is not interested in spending $5 million

on scrubbers.

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• This market outcome is not socially efficient because

total well-being could be increased.• If the power plant and the fishermen can communicate,

a deal will be brokered in which the fishermen give an

amount of money between $5 million and $7 million to

the power plant, and the power plant installs the

scrubbers.• Consider the opposite case where there is a law against

the power plant polluting the waterways.• If the power plant chose not to shut down, it would then

have installed the scrubbers, thereby eliminating the

water pollution.• Regardless whether the law permits the power plant to

pollute or not, the economically efficient outcome is

achieved either way.

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The Coase Theorem• The insight— that negotiation leads to the socially

efficient outcome regardless of who has the legal

property right (ownership of property or resources)—

is called the Coase Theorem, after the Nobel Laureate

economist, Ronald Coase.

• Private bargaining will lead to an efficient allocation of

resources.

• Government intervention is not necessary to solve

externality problems.

• The initial property right allocation is an important

determinant of the distribution of surplus.

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born 1910.12.29 published 2011.8.1

Nobel Prize in Economics (1991)

died 2013.9.2

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Potential problems in applying the Coase theorem and

private solutions to solve the externality problem.

• The assumption that the parties involved can negotiate

economically is critically important. As long as the

transaction costs associated with negotiating are not too

high, the efficient economic outcome can be achieved.

• Whether the property right is clearly defined is

important.

• The number of agents on each side of the bargaining

table matters. Transaction costs rises with the number of

agents.

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Private Solution: Doing the Right Thing

Do you buy Energy Star goods?

• ENERGY STAR is a voluntary labeling program to

reduce greenhouse-gas emissions.

• The ENERGY STAR program has worked because it

involves a social enforcement mechanism: it gives us

information about “green products” and invokes a moral

code that we should “do the right thing” and purchase

them.22 / 47

Chapter 9

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Resource GoodsWhy do you recycle?

• The moral code of doing one’s part is internalizing

externalities.

• Shame, guilt, and the risk that we will be publicly decries

are all effective social enforcement mechanism.

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9.3 Government

Solutions to

Externalities

Government respond to exernalities in two main ways

1. Command-and-control policies, in which government

directly regulates the allocation of resources.

2. Market-based policies, in which the government provides

incentives for private organizations to internalize the

externality.

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Government Regulation: Command-and-Control Policies

• Under command-and-control regulation, policymakers

either directly restrict the level of production or mandate

the use of certain technologies.

• This type of regulatory action that

command-and-controls certain technique typically

provides few incentives for producers to search for more

cost-effective ways to reduce pollution itself.

• This happens because regulators have directed attention

to the wrong target— they mandate the technology that

the producer must use.

• This pushes the producer to develop efficient methods to

use the mandated technology.

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Government Regulation: Market-Based Approaches

• A market-based approach internalize externalities by

harnessing the power of market forces.

• With the market-based approach, the method for

reducing pollution is essentially left to the emitter.

• There is a greater incentive to develop new ways to

reduce pollution than in the command-and-control

approach.

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Corrective Taxes and Subsidies

• A corrective tax (or Pigouvian tax) is a tax designed to

induce agents who produce negative externalities to

reduce quantity toward the socially optimal level.

• The corrective tax internalize the pollution externality.

Exhibit 9.6 Effect of a Pigouvian Tax

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Exhibit 9.7 Effect of a Pigouvian Subsidy on the Education Market

• A corrective subsidy (or Pigouvian subsidy) is designed

to induce agents who produce positive externalities to

increase quantity toward the socially optimal level.

• Estimate the marginal social benefit of education, the

levy a corrective subsidy in this amount to to increase the

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Pay As You Throw: Consumers Create Negative Externalities

Too!

• “Pay-As-You-Throw” programs charge people a small

price for each bag of trash they produce.

• These programs reduce the amount of trash people

throw out.

• Moving to a Pay-As-You-Throw program reduced

household trash by more than a ton per year!

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• 垃圾費隨水費 versus 隨袋徵收

台北市的垃圾費與垃圾量

平均每人年產 垃圾費 計價方式

年度 垃圾 (公斤)

1996 576 水費之50% 隨水費徵收

1997 561 水費之63% 隨水費徵收

1998 593 6.3元/度自來水 隨水費徵收

1999 533 7.3元/度自來水 隨水費徵收

2000 481 4.0元/度自來水,0.5元/公升 2000.7.1 起隨袋徵收

2001 377 0.5, 0.45/公升 隨袋徵收

2002 281 0.45/公升 隨袋徵收

2003 251 0.45/公升 隨袋徵收

2004 226 0.45/公升 廚餘回收

2005 205 0.45/公升 廚餘回收

2006 199 0.45/公升 廚餘回收

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9.4 Public GoodsTwo characteristics that differentiate public goods

and private goods.1. Excludability:

• Private goods: excludable, people can be kept from

consuming them if they have not paid for them.• Public goods: non-excludable, it is not possible to

exclude people from using them.

2. Rivalry in consumption:• Private goods: rival in consumption, they can not

be consumed by more than one person at a time.• Public goods: non-rival in consumption, one

person’s consumption does not preclude

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Exhibit 9.8 Four Types of Goods

1. Ordinary Private Goods: excludable, rival.

2. Club Goods: excludable, non-rival.

3. Common Pool Resource Goods: non-excludable, rival.

4. Public Goods: non-excludable, non-rival.

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Government Provision of Public Goods• Public goods suffer from what economists call a

free-rider problem, in which a person has no incentive

to pay for a good because failure to pay does not prevent

consumption.

• What makes public goods different from private goods is

precisely their non-rival and non-excludable nature.

• Their non-excludability represents a distinct

opportunity for government to step in and provide them

because it can levy taxes for their provision.

• The government should expand production until

marginal benefits equal marginal cost.

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The Free-Rider’s Dilemma

• You and 9 other students are given $10.

• You can anonymously, and simultaneously, contribute

any portion of it back to a public goods account.

• The contributions collected will be doubled and the

redistributed equally among you and the 9 other

students.

• How much of your $10 would you contribute?

• To maximize the group’s take-home earnings, everyone

should contribute the full $10, and take-home $20.

(Why?)

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• Why do experiments show that contributions average

less than $2, with around half of participants

contributing nothing?

• If you give $1 to the group account, then the group as a

whole receives $2, but you yourself are only guaranteed

20 cents of that dollar back.

• A simple illustration. Assume that everyone else

contributes everything ($10) to the group account. What

are your payoffs if you contribute nothing versus if you

contribute everything?

• Contribute zero payoff: $10+ $9×2010 = 28.

• Contribute everything payoff : $0+ $10×2010 = 20.

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Exhibit 9.9 Constructing a Market Demand Curve for a Private Good

• To construct the market demand curve for private good,

we sum the total quantity demanded of all consumers at

a given price to compute the market demand at that

price.

• We add the individual demand curve horizontally.36 / 47

Chapter 9

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Exhibit 9.10 Constructing a MarketDemand Curve for a Public Good

• The market demand curve for public goods is found by

vertically summing the individual demand curves

because the public good is non-rival.

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Exhibit 9.11 The Equilibrium Point for Providing a Public Good

• At Qoptimal , total surplus is maximized because all of the

gains in the market are reaped.

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Private Provision of Public Goods• Private provision of public goods refers to any situation

in which private citizens make contributions to the

production or maintenance of a public good.

Exhibit 9.12 Total Giving in the United States Over Time

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Exhibit 9.13 Giving Money by Region of the World in 2010

• “Have you donated money to a charity in the past

month?”

• A majority of people answer “Yes” in developed

countries.

• Even in underdeveloped countries, the proportion of

people giving is above 10 percent.40 / 47

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• Charismatic species and those that most resemble

humans, such as panda bears and monkeys, receive the

most support.

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9.5 Common Pool

Resource Goods• Common pool resource goods are not excludable and

rival.

• The externality involved with a common pool resource

aries because of the combination of open access and

depletion through use.

• Individuals use too much of the resource because they

do not consider how others are affected, a classic

negative externality.

• Such overuse can result in the tragedy of the commons,

which occurs when a common resource is used too

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Solutions to tragedy of the commons:

• Piguvion tax or government regulation.

• Self-regulate by users that implements a

maximum usage.

• Privatization of the resource (assign property

rights). This gives the owner incentives to

regulate access in a way that maximizes the

resource’s value to the owner.

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• Why aren’t cows extinct? But African elephants

are at risk of being extinct.

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What kind of goods are the following goods

belong to?

• 教育。

• 健保。

• 古蹟。

• 十分瀑布。

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Q: How can the Queen of England lower her

commute time to Wembley Stadium?

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• In the late 1990s, traffic become so congested in central

London that travel speed dipped below the 19th-century

average— before the introduction of the car!

• A daily flat charge of 5 pounds per day called

“congestion charge” is implemented in 2003.

Exhibit 9.14 Results of the Congestion Charge

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