Externalities and Public Goods

Setup: Perfectly competitive markets result in outputs and prices which are socially optimal in the sense of the maximizing surplus. Another way to say this is that competition results in output levels for which marginal social benefit equals marginal social cost. (MSB = MSC)

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We saw that the presence of monopoly, for example, could justify government interference because monopolies dont produce output levels where MSB = MSC. But even competitive markets may fail under some circumstances.

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In what follows, we will examine the conditions under which competitive markets may fail to be optimal institutions to produce and distribute goods. This topic is known as market failure.

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EXTERNALITIES
An externality is a benefit or cost to third parties who are not directly involved in a transaction. Externalities are sometimes called neighborhood effects.

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Externalities can be either beneficial or harmful, and can originate with either consumers or producers. Here are some examples:

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How Externalities Work

The existence of an externality creates a difference between either a) the private and social cost of production, or b) the private and social benefits from consumption.

The consequence is that even competitive markets will fail to reach a social optimum.
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Marginal external cost is the extra social cost (over and above the private cost) of producing one more unit of the good.
Marginal external benefit is the extra social benefit of consuming one more unit of a good. The presence of external benefits and costs means there will be a difference between the private and social consequences of production.
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EXAMPLE 1: Suppose the market in beer is perfectly competitive. But beer production creates terrible odors, and makes people who live downwind from breweries worse off.

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Heres the situation for a typical beer producer: MPC is the Marginal Private Cost of production. Its the same as the firms supply curve, showing willingness to sell. MPB is the Marginal Private Benefit. It's the demand curve for the good, showing willingness to pay.
$/Q Supply = MPC

A competitive market will lead to Q*.

Demand = MPB Q*
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Q
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The existence of a harmful externality means there is a difference between the private and social costs of producing beer. The difference between private and social cost is the marginal external cost (MEC)

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$/Q

This distance is the pollution cost of one more unit of beer.

Marginal social cost = MPC + MEC Supply = MPC

Demand = MPB Q*
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Q
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This area is the total pollution cost when Q* is produced.

$/Q

Marginal social cost = MPC + MEC Supply = MPC

Demand = MPB Q*
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Q
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The socially best output is Q(society).

Marginal social cost = MPC + MEC Supply = MPC

$/Q

Demand = MPB = MSB Q(society)

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Q*

Q
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This area is the total pollution cost when Q(society) is produced.

$/Q

Marginal social cost = MPC + MEC Supply = MPC

Demand = MPB Q(society)

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Q*

Q
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The conclusion is that when an externality is present, even a competitive beer market will not produce the best amount of beer.

In this example too much beer is produced from societys point of view.

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EXAMPLE 2: Prof. Brown is trying to decide how much schooling to buy for his daughter. He will buy years of schooling up to point where the last unit bought is just worth it to him. But schooling, especially at the elementary level, has positive externalities.

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Brown will choose years of schooling by equating MPB with MPC.

$/Q

MPC = MSC

MPB Q Q* YEARS OF SCHOOLING

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But the extra (external) benefits from schooling mean that Brown will buy too little schooling for his daughter if left to his own devices.
$/Q

This distance is the marginal external benefit.

MPC = MSC

MSB=MPB+MEB MPB Q Q* Q(Society)

YEARS OF SCHOOLING
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EXAMPLE 3: People decide whether or not to get vaccinated against diseases by comparing the private benefits with the private costs. But vaccinations carry important external benefits because when you are vaccinated people cannot get the illness from you.

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The horizontal axis here represents the number of people getting vaccinated. People will get vaccinated only if the benefit to them is at least as great as the cost.
$/person N is the private amount demanded. Society would want N* people vaccinated.

MSC=MPC MSB MPB = DEMAND N N* # of people

THE MARKET IN SMALLPOX VACCINATIONS

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Solutions to externalities problems: 1) Economists generally favor taxes and subsidies linked to the value of the externality 2) Direct regulation 3) Subsidize pollution control equipment 4) Sell or grant tradable pollution rights. 5) Coases Theorem -- Assign property rights 6) Internalize the externality through mergers

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PUBLIC GOODS
A pure public good is a good or service that is consumed in its entirety by everyone. When one person consumes another unit of a public good we all consume more. The most common example is national defense.

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Public goods have two special properties compared to private consumption goods.

Nonrivalry: When one person consumes a unit of a public good the amount available to be consumed by everyone else is not diminished.
Nonexcludability: Once a public good is produced it is difficult or impossible to exclude people from consuming it.

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Because public goods are nonrival and/or nonexcludable, these goods will tend to be under produced, or maybe not produced at all if left to the private market. Public goods are not the same as publicly provided goods. Just because government provides a good does not make it a public good.

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Examples of public goods:

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Some public goods can be excludable but not rival:

1) Crossing a toll bridge when it isnt crowded. 2) Scrambled on the air TV signals. One way to explain nonrivalry in consumption is by saying that the marginal cost of providing the good to one more consumer is zero.

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Some public goods may be nonexcludable but rival:

1) Air that is polluted by smoking. 2) The ocean is not excludable, but fishing is rival. Production of public goods is sometimes said to suffer from the free rider problem. This arises directly from the nonexcludability property of public goods.

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Public good summary: If public goods are produced in private markets, they will be under produced because social benefits will exceed private benefits.

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Solutions to the public goods problem: 1) Using technologies that provide for exclusion (toll roads, cable TV) 2) Government ownership 3) Clubs or cooperatives

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