GLS1e Chapter16

Externalities and
Public Goods 16
Chapter Outline
16.1 Externalities
16.2 Fixing Externalities

(Insert image of text cover)
16.3 Further Topics in Externalities
and Their Remedies
16.4 Public Goods
16.5 Conclusion
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/Syverson  1/e 16-1
Introduction 16
Pollution is a major fact of life around the world
• In the United States, there are areas (notably urban) struggling with air
quality issues, with the resulting health costs estimated at over $100 billion
per year
• Much pollution is due to coal-fired power plants operating both domestically
and abroad
Other forms of “pollution” are also common
• The noise of your neighbor’s party
• The person smoking a cigar next to you
• The mess in your neighbor’s lawn
Introduction 16
These outcomes are evidence of a market failure
• Markets are efficient when all transactions that positively benefit society take
place
• An efficient market takes all costs and benefits, both private and social, into
account
• Similarly, the smoker in the park is only concerned with his enjoyment, and
not the costs imposed on other people in the park
• An efficient market takes these additional costs into account
Asymmetric information is a source of market failure that we considered
in the last chapter. Here, we discuss two further sources
• Externalities
• Public goods
16.1 Externalities 16
Externalities – A cost or benefit that affects a third party not directly involved
in an economic transaction
Negative externality – A cost imposed on a third party not directly
involved in an economic transaction
• Example: Air pollution from coal-fired power plants
Positive externality – A benefit conferred on a third party not directly
involved in an economic transaction
• Example: A beekeeper’s bees not only produce honey, but can help
neighboring farmers by pollinating crops
Economic Inefficiencies from Externalities
In the presence of externalities, society’s benefit or cost from an
economic transaction is different from the private benefit or cost to those
who are party to the transaction
For example, a smoker’s private costs of smoking are (in part):
• The cost of purchasing cigarettes
• Smelly clothing, yellow teeth, etc.
• Private health costs
Societal costs are (in part):
• Second-hand smoke health effects
• Any smoker health costs that are borne by society
• The noxious smell imposed on nonsmokers
• External marginal cost – The cost imposed on a third party when an
additional unit of a good is produced or consumed
• External marginal benefit – The benefit conferred on a third party when
an additional unit of a good is produced or consumed
When there are no externalities, society’s costs and benefits align with
the costs and benefits of the private parties to a transaction
When there are externalities, the social costs and social benefits will
differ from the private costs and private benefits
• Social cost: The cost of an economic transaction to society, equal to the
private cost plus the external marginal cost
• Social benefit: The benefit of an economic transaction to society, equal to
the private benefit plus the external marginal benefit
Negative Externalities: Too Much of a Bad Thing
Negative externalities occur when a market transaction imposes an
external cost on society
Consider the example of a coal-fired power plant
• The power plant produces electricity, which is good, but in the process,
pollutants are released into the air: particulate matter, nitrogen oxides (NOx),
and sulfur dioxide (SO2)
• These pollutants both directly and indirectly impact human and
environmental health, leading to welfare losses
The costs of operating the plant are borne by the plant, but the health
effects are external costs, borne by society
Consider a competitive market for electricity
Figure 16.1 Negative Externalities in a Competitive
Electricity Market
A perfectly competitive electricity
Price Social marginal cost, maBecause the market
rket produces QMKT does not take
at market price
($/MWh) SMC = MCI + EMC external
PMKTmarginal
, where Scost
= MCinto
I =account
D.
Deadweight loss
when setting its quantity of output, it
from externality
Supply, S = MCI endsthis
At quantity, the
up producing industry
more imposes
electricity QMKT
external marginal cost EMC .
than is the socially optimal quantity Q*,
A resulting
SMC inthe
equals a deadweight
sum of MCIloss
andfrom
EMC.
P* overproduction equal to the shaded
B
PMKT triangle. at Q*< QMKT ,
Total surplus is maximized
where price P* equals SMC.
EMC
External marginal
cost, EMC
Demand, D
Q* QMKT Quantity of
electricity (MWh)
Negative Externalities: Too Much of a Bad Thing
The deadweight loss on the previous slide represents the social cost
associated with the competitive outcome in the presence of an
externality
• The magnitude of the deadweight loss depends on the size of the externality
• People buy electricity who otherwise wouldn’t if the price reflected the true
social cost
Leather Tanning figure it out
Suppose leather is sold in a perfectly competitive industry. The industry
short-run supply curve (marginal cost curve) is P = MC = 3Q, where Q
is measured in millions of hides per year. The inverse demand for
leather hides is given by P = 60 – 7Q.
Answer the following questions:
1. Find the equilibrium market price and quantity sold.
2. Suppose that leather tanning is a polluting activity that releases
chromium and other pollutants into local waterways. The external
marginal cost is estimated to be $4 for each hide produced.
Calculate the socially optimal level of output and price for the
leather tanning industry.
1. To find the competitive outcome, set the inverse demand and
supply curves equal to one another
3Q  60  7Q
10Q  60
Q  6 million hides
Using the supply curve to solve for the equilibrium price yields
P  3Q  $18
2. The social marginal cost is equal to the industry marginal cost plus
the external marginal cost:
SMC  MC  EMC  3Q  4
To find the social optimum, equate SMC with the inverse demand
3Q  4  60  7Q
10Q  56
Q  5.6
And the socially optimal price is:
P  3Q  4.00  16.8  4  $20.8
Positive Externalities: Not Enough of a Good Thing
Positive externalities exist when an economic activity has a spillover
benefit enjoyed by third parties
• Marginal social benefit of an economic activity is higher than the private
marginal benefit (i.e., the demand curve)
The classic example of a positive externality is education
• Education is associated with private benefits (as seen in Chapter 15),
including higher lifetime earnings and many others
• Education is also associated with broader social benefits, such as an
increase in overall entrepreneurial activity, higher incomes, and a faster pace
of technological growth
We can examine positive externalities with a figure
Figure 16.2 Positive Externalities in the Market for College Degrees
The social demand for college degrees (SD)
equals the private marginal benefit curve D
Price plus the external marginal benefit EMB.
Deadweight loss Because the market does not take into account
($/degree) from externality thesocially
externaloptimal
marginal benefitofEMB , it ends up
The number college degrees,
S = MCI producing fewer
Q*, is found college
at point degrees
A, the QMKT than
intersection the
of the
socially optimal
marginal costquantity
curve S =Q*MC
, resulting
I and SD.
in a
deadweight loss equal to the shaded triangle.
EMB A In an unregulated market for college degrees,
P* production occurs at point B (QMKT , PMKT ),
B where D = S = MCI .
PMKT
Social demand,
SD = D + EMB
External marginal
D benefit, EMB
QMKT Q* Quantity of
college degrees
16.2 Fixing Externalities 16
Competitive markets with externalities produce more or less than that
which is socially efficient. There are a number of market interventions
available to governments and regulators that can help fix externalities
• Some work through their effect on prices (e.g., taxes)
• Some target the quantity produced and consumed
First, determine the size of the externality, and thus the amount by which
production must be changed to reach the socially efficient outcome
Example: The Efficient Level of Pollution
The goal is to determine the socially efficient level of pollution
• The level of emissions necessary to produce the efficient quantity of the good
tied to the externality
• The resulting level of production occurs where the marginal benefit of
production of a good (willingness to pay) is equal to the marginal cost
(private + external)
• This also implies that the marginal costs of pollution (health costs, etc.) are
equivalent to the marginal benefits of pollution (increased production of
goods and/or services)
Figure 16.4 The Efficient Level of Pollution
The efficient level of pollution
Price Marginal cost (POLL*, PPOLL * ) occurs where the
($/unit) of pollution, MCP marginal cost of pollution (MCP )
equals the marginal benefit or
marginal abatement cost of
pollution (MBP = MAC).
*
PPOLL
Marginal benefit of
pollution, MBP = marginal
abatement cost, MAC
POLL* Quantity of
pollution
The Efficient Level of Pollution
 Why does the marginal cost of pollution curve (MCP) slope
upward?
• At low levels of pollution, the damage associated with an additional unit of
pollution is relatively low
• At higher levels of pollution, health effects become more severe, and
additional units of pollution are more costly to society
 Why does the marginal benefit of pollution curve (MBP) slope
downward?
• High levels of pollution are associated with high levels of production, and
therefore lower market prices. As pollution is reduced, so is production, and
the forgone consumer and producer surplus is an opportunity cost
• As pollution is reduced, the cost of reducing pollution even further increases
because easy pollution-reduction methods are exhausted
The Efficient Level of Pollution
Marginal abatement cost – The cost of reducing emissions by one unit,
including technological costs and forgone production
The previous figure is very similar to the supply and demand figures we
have been using throughout this class
• MBP is demand for pollution; MCP is the marginal societal cost, or supply
• This represents a hypothetical market for pollution, with a resulting optimal
price and quantity placed on pollution
• Since this market doesn’t exist in the real world, what can be done to induce
private parties to produce/consume at the socially efficient level?
Using Prices to Fix Externalities
Consider changing the price of goods that are produced in the presence
of externalities, so that the social and private benefits/costs align
• For a negative externality, tax production or consumption
• For a positive externality, subsidize production or consumption
In the presence of negative externalities, economists often advocate for
the use of a Pigouvian tax
• A tax that equals the external marginal cost imposed by an externality
• Pigouvian taxes are designed to fix market failures and, therefore, improve
societal welfare (rather than distorting markets like other taxes)
Consider the power plant example
Figure 16.5 A Pigouvian Tax Corrects for a Negative
Externality
Price SMC = MCI + T
($/MWh) In an unregulated market, a power
S = MCI company overproduces quantity QMKT
Now, theatpower
price Pcompany produces at
MKT (point B).
point A, where SMC intersects demand
A D, and supplies the socially efficient
P* B A Pigouvian tax T equal to the external
PMKT quantity Q* MWh at price P*.
marginal cost EMC shifts up the supply
curve S from marginal cost = MCI to
the social marginal cost curve SMC.
EMC = T
EMC = Tax, T
D
Q* QMKT Quantity of
electricity (MWh)
Using Prices to Fix Externalities
Similarly, in the presence of positive externalities, economists often
advocate for the use of a Pigouvian subsidy
• A subsidy that equals the external marginal benefit imposed by an externality
Consider the education example
Figure 16.6 A Pigouvian Subsidy Corrects for a Positive
Externality
In an unregulated market, colleges
under
Now, theproduce QMKT , college
quantityproduces
college market where
Price EMB = Sub
S = MCI degrees,
supply S intersects P,MKT
at priceSD and(point B). the
supplies
($/degree)
socially efficient quantity Q*, college
A Pigouvian subsidy Sub equal to
degrees, at price P* (point A).
A external marginal benefit EMB shifts
P* demand D out to social demand SD.
B
PMKT
SD = D + EMB = D + Sub
EMB = Subsidy, Sub

D
QMKT Q* Quantity of
college degrees
Returning to our example of leather tanning, suppose the government
imposes a tax of $4.00 on every hide of leather sold. The industry short-
run supply curve (marginal cost curve) is P = MC = 3Q, where Q is
measured in millions of hides per year. The inverse demand for leather
hides is given by P = 60 – 7Q (remember, the externality was equal to $4
per hide)
Answer the following question:
How many leather hides would be sold, what price would buyers pay,
and what price would sellers receive (net of the tax)?
To solve this problem, we use the method from Chapter 3, where the
price paid by buyers, PB, is equal to the price received by sellers, PS,
plus the tax, T. Therefore, PB = PB + 4. The inverse demand and supply
curves are given by P S  3Q
P B  60  7Q
To equate the two inverse demand curves, however, requires us to
rewrite the supply curve in terms of PB
P B  P S  4  3Q  4
Solving for the equilibrium quantity,
3Q  4  60  7Q
10Q  56
Q  5 .6
And the prices paid by buyers and sellers are:
P B  3Q  4  $20.8
P S  3Q  $16.8
Quantity Mechanisms to Fix Externalities
Quantity-based interventions have the same goal as taxes or subsidies:
to move a market with externalities toward the efficient outcome
Quota – A regulation mandating that the production or consumption of a
certain quantity of a good or externality be limited (negative externality)
or required (positive externality)
Figure 16.7 The Effects of a Quota on a Market with a
Negative Externality
In an unregulated market, a power
Price company overproduces quantity QMKT at
MCI (with quota) SMC price PMKT (point B).
($/MWh)
S = MCI When the government enacts a quota
A limiting production to Q*, the private
P* marginal cost curve MCI becomes vertical
B at Q*, intersecting the social marginal cost
PMKT
SMC at the socially optimal quantity Q*
and price P* (point A).
EMC
D
Quota = Q* QMKT Quantity of

electricity (MWh)
Application 16
“Rationalization” in Fisheries
Historically, fishing effort was managed using tools such as total
allowable catch (TAC) limits and limited entry (LE)
In the British Columbia, Canada, (B.C.) halibut fishery, these two
regulations effectively limited catch but had other consequences
• In response to the LE (limited to 435 vessels), in the 1980s
vessel owners invested in alternative forms of capital (e.g.,
better electronics, larger crews)
• In response to the TAC, fishermen fished as fast as they could,
as soon as the season opened (in 1982, 60-day season; in
1990, a 6-day season) Photos courtesy of NOAA Fisheries
• This “derby fishing” was very dangerous. Fishermen would go

out in horrible weather, and sinkings and deaths increased
• Further, the short seasons made it difficult to enforce the TAC;
TAC was exceeded by 10% in 1990
Citation: Casey, K, C. Dewees, J. Wilen, and B. Turris, 1995. The Effects of Individual Transferable Harvest Quotas
in the British Columbia Halibut Fishery, Marine Resource Economics 10(5).
Application 16
In response, the B.C. government decided to implement an
individual vessel quota system (IVQ)
• Vessels given a yearly share of the TAC and the right to fish at
any point in an 8-month season (until the TAC is reached)
• At first, IVQs were not tradable, but they were leasable; trading
was allowed after two-year trial period
• Enforcement self-funded (tax of C$0.09/pound)
Many benefits:
• Firms focus on lowering costs rather than racing to fish
Photos courtesy of NOAA Fisheries
• Longer season made fishing safer, reduced idle capital

• Longer season also increased fish prices, as more fish were
able to be sold to fresh markets, rather than frozen
• Fishermen felt more secure in their investments; profits grew
Citation: Casey, K., C. Dewees, J. Wilen, and B.Turris, 1995. The Effects of Individual Transferable Harvest Quotas
Application 16
Also some problems
• Vessel owners were primary beneficiaries. Reported crew
shares declined (crew are often paid a percentage of revenue;
now, quota was viewed as a valuable asset and worthy of its
own share)
• Focus on cost savings reduced fishing employment in
communities with few outside options
• Is it fair to permanently bequest access rights to a public asset
to private citizens?
Photos courtesy of NOAA Fisheries
Citation: Casey, K., C. Dewees, J. Wilen, and B. Turris, 1995. The Effects of Individual Transferable Harvest Quotas
Price-Based versus Quantity-Based Interventions with Uncertainty
With perfect information, price and quantity instruments are equally
effective in controlling externalities
Without perfect information, there are significant informational problems
facing regulators
• The costs of controlling externalities (marginal abatement costs) are often
difficult to ascertain ex ante
• The benefits of controlling externalities (marginal pollution costs) are similarly
difficult to estimate (in the case of pollution, valuing changes to human
health, ecosystems, etc.)
When there is uncertainty in marginal abatement costs, price and
quantity mechanisms are not equivalent
The equivalence between price and quantity instruments breaks down
under uncertainty because of a simple difference between the two
• Price instruments fix the price of pollution (e.g., a pollution tax imposes a
fixed cost on polluters for each unit emitted)
• Quantity instruments fix the quantity of pollution
Consider the case when marginal abatement costs turn out to be larger
than expected
• Under a pollution permit system, firms are forced to abate a fixed amount of
pollution
• Under a pollution tax system, firms will abate less pollution (they will limit
pollution until the additional cost of reducing one more unit of pollution is
equal to the tax, and then they will simply pay the tax)
 What happens to the outcomes under taxes and permits when
the marginal benefits of reducing pollution (MCP) are greater
than expected?
• Nothing! Polluting firms operating under a pollution tax system will only
change their pollution control efforts in response to a change in the private
costs of pollution control (marginal abatement costs)
• The benefits of reducing pollution are in the form of reduced external costs.
As these costs are not borne by polluting firms, the choice of how much
pollution to emit is not affected
• Benefit uncertainty does not alter the equivalence between price and quantity
interventions
 When are price-based interventions preferable to quantity-based
interventions, and vice-versa?
When the marginal abatement cost (MAC) and marginal pollution cost
(MCP) curves are linear, two factors determine the relative superiority of
on intervention of the other
• The slope of the MAC curve
• The slope of the MCP curve
Figure 16.8 When Quantity Mechanisms Are Preferable to
Price Mechanisms
Government officials initially believe
Price MCP abatement costs to be MACe .
($/unit)
Deadweight loss from Deadweight loss
quantity mandate from Pigouvian tax
If government regulators incorrectly estimate
Because MAC is flat relative to MCP, the
farmers’ marginal abatement costs (MACe <
quantity-based intervention is preferable to
MAC), the quantity-based intervention would
A Y the price mechanism, as seen by comparing
reduce pollution to POLLB < POLL*, while the
T* the resulting deadweight losses from the two
X Pigouvian tax would increase pollution to
T C interventions (X < Y).
B POLLC > POLL*.
MBP = MAC
MBPe = MACe
POLLB POLL* POLLC Quantity of fertilizer

runoff (ppm)
Figure 16.9 When Price Mechanisms Are Preferable to
Quantity Mechanisms
Price Deadweight loss from
($/unit) quantity mandate Government officials initially believe
MCP abatement costs to be MACe .
X A Deadweight loss
T* Y
from Pigouvian tax
T B C
If government
Because MAC isregulators incorrectly
steep relative to the
estimate farmers’ marginal abatement
marginal cost of pollution MCP, the price costs
(MACe < MAC
mechanism ), the quantity-based
is preferable to the quantity
intervention would reduce pollution
mechanism, as seen by comparing to
the
MBP = MAC POLLB <deadweight
POLL*, whilelosses
the Pigouvian
resulting from the tax
two
would increase pollution to POLL
interventions (X < Y). C > POLL* .
MBPe = MACe
POLLB POLL* POLLC Quantity of fertilizer

runoff (ppm)
A Market-Oriented Approach to Reducing Externalities: Tradable
Permits Markets
Using price or quantity interventions involves a lot of effort
• Firms may differ dramatically in their abatement costs
• Often, pollution control regulations require a fixed aggregate emissions
reduction; taxes have difficulty with this
In response to these challenges, many regulatory agencies issue
tradable permits to control pollution
• A government-issued permit that allows a firm to emit a certain amount of
pollution during production and that can be traded to other firms
• In theory, they are effective in achieving allocative efficiency: marginal
abatement costs equalized across firms
Firms’ Costs of Reducing Emissions
Suppose there are two firms producing electricity, Acme and Best
• Without regulation, each firm would emit 40 tons of pollutant, for a total of 80
• The regulator has come to the conclusion that 50 tons is the socially optimal
aggregate level of emissions
• Any scheme of emissions reduction across the two firms that adds to 30 tons
will work to achieve this reduction
• However, all schemes are not equal, particularly if costs differ
Consider the following
• Acme is older and less efficient at reducing pollution. Marginal abatement
costs are (cost per ton cut)
MACA = 2eA
• Best is newer and more efficient at reducing pollution. Marginal abatement
costs are (cost per ton cut)
MACB = eB
• Notice that each firm’s MAC increases as they cut more; each additional unit
of pollution reduction costs more than the last
 Why does it cost more to reduce additional pollution?
• At first, firms are able to take advantage of relatively low cost technologies
• As those low-cost methods are exhausted, removing additional pollution
becomes more expensive
The lowest-cost way for society to achieve the 30-ton emissions cut is to
split the cut across the two firms in a way that equalizes the two firms’
marginal abatement costs
• If, at any allocation of pollution cuts, Best has a lower MAC than Acme, the
standard could be met at a lower cost by shifting cuts to Best from Acme
The efficient allocation of cuts occurs where
MACA = MACB ® 2eA = eB
How do we solve for the efficient allocation? We know that the total pollution
reduction must be equal to 30
eA + eB = 30
Using this equation and the one above, solve the first for eB, and then substitute
into the second
eB = 2eA ® eA + ( 2eA ) = 30 ® eA =10
And solving for Best’s emission reductions
eB = 20
The cost-minimizing allocation of reduction is for Acme to cut 10 tons and Best
to cut 20. This makes sense; Best is a more efficient pollution abater
 Why do we need tradable permits? Can’t the regulator assign
emissions reductions to firms efficiently?
• In reality it is difficult for regulators to ascertain firms’ costs of reducing
pollution
• Often, firms do not have a perfect understanding of the costs involved with
reducing pollution
• There is the problem of moral hazard: firms have an incentive to overstate
costs to regulators, hoping to reduce their financial liability
Tradable permits solve this problem
• High-cost firms purchase permits from low-cost firms until there are no
mutually beneficial trades remaining
• The “market clearing” price for permits will be equal to MAC for each firm
• This is exactly how markets for any other good or service work
Noise Pollution figure it out
Global Package Service (GPS) and Mail & Parcel Service (MAPS) are
cargo airlines using a small regional airport. Their jets inflict noise pollution
on a nearby town. At current production levels, GPS creates 600 decibel-
hours (dbh) of noise each day, while MAPS creates 750 dbh. Government
regulators would like to lower the total noise pollution to 1,000 dbh. GPS
faces a total abatement cost of TACG = 20dG + 2dG2 and a marginal
abatement cost of MACG = 20 + 4dG, where dG is the number of dbh abated
by GPS. MAPS planes are older, so its TAC and MAC are greater: TACM =
40dM + 3dM2 and MACM = 40 + 6dM.
1. Suppose regulators implement a quantity regulation and divide the 1,000 dbh
limit equally. How many dbh will each firm have to cut?
2. How much will this cut in jet noise cost each firm? What is the total cost of
reducing the noise pollution to its optimal level?
3. Suppose regulators create 1,000 1-dbh permits and divide them equally, allowing
trading. How many dbh will each firm cut? What is the price of a permit?
4. What is the total cost of reducing the noise pollution to 1,000 dbh with tradable
permits? How does this compare with question 2?
1. If regulators require each firm to cut its noise pollution to 500 dbh, GPS
will have to cut 100 dbh (= 600 – 500) and MAPS will have to cut 250
dbh (= 750 – 500)
2. The cost of this plan is equal to the sum of each firm’s total abatement
cost
TACG = 20dG + 2dG2 = 20(100)+ 2(100)2 = $22, 000
TAC M  40d M  3d M2  40(250)  3(250) 2  $197,500
Total Cost = TACG +TACM = $22, 000 + $197, 500 = $219, 500
3. Under a system of tradable permits, GPS and MAPS will split the
reduction in noise pollution in the most efficient way. This occurs when
their marginal abatement costs are equalized
MACG = MACM ® 20 + 4dG = 40 + 6dM
Remembering that dG + dM = 350, we can solve for the efficient
allocation of emission reductions
dG + dM = 350 ® dG = 350 - d M
20 + 4dG = 40 + 6dM
20 + 4 ( 350 - dM ) = 40 + 6d M
10dM = 1, 380 ® dM = 138dbh
dG = 350 - dM = 350 -138 = 212dbh
The price of a permit is equal to each firm’s MAC. Using GPS:
Price = MACG = 20 + 4dG = 20 + 4 ( 212) = $868
4. The total cost of abatement is equal to the sum of the abatement costs
of the two firms
TACG = 20dG + 2dG2 = 20(212)+ 2(212)2 = $94,128

TACM = 40dM + 3dM2 = 40(138)+ 3(138)2 = $62, 652
Total Cost = TACG +TACM = $156, 780
This is significantly less than the $219,500 cost of the uniform standard
and Their Remedies 16
The Tragedy of the Commons – a common resource is used more
intensively than it would be if it were privately owned
• Another pervasive form of a negative externality
• A common resource is an economic good that all individuals can access
freely and whose value to the individual consumer decreases as others use it
• Many lake, river, coastal, and ocean fisheries, public forests, reservoirs,
aquifers, and other sources of water, the atmosphere
• Public airways, public bathrooms
• Key characteristic: nonexcludability – consumers cannot be prevented
from consuming the good once it is available
The Tragedy of the Commons
Nonexcludability means that users have little private incentive to protect
the resource for others, since they do not realize the full cost of overuse
Consider the case of a lake fishery owned by a single person
• Subject to a few assumptions about the price of fish, the cost of fishing, and
the biological growth of fish, the owner will treat the fishery like an asset
• He will recognize that removing a fish to sell today comes with three costs:
the cost of catching the fish, the opportunity cost of not being able to catch
the fish in the future, and any lost reproduction or natural growth that would
have occurred
• Since the resource is treated like an asset, it will earn a “resource rent,” just
as labor and capital each earn a rent (wage and interest, respectively)
The Tragedy of the Commons
Now, consider the case of a lake fishery with no exclusions on who can
go fishing there
• Individual fishermen will only consider their private cost of fishing when
determining how much to fish
• They cannot capture the benefits of leaving a fish in the lake (the option to
catch it, or its offspring, in the future)
• Fisheries with “open access” will experience “rent dissipation,” whereby any
positive economic profit experienced in the fishery is driven to zero by new
entrants and/or greater fishing pressure
• Open-access fisheries have also experienced severe biological over-
exploitation, with some historically important fisheries collapsing
• So, private property rights have been used in fisheries to help manage the
problem of nonexcludability
The Coase Theorem: Free Markets Fixing Externalities on Their
Own
Under certain circumstances, it may be possible to reach the efficient
market outcome through private negotiation.
The Coase Theorem: costless negotiation among market participants
will lead to the efficient market outcome, regardless of who holds legal
property rights
• It does not matter who has a property right
• If outcomes can be monitored and individuals can costlessly coordinate and
negotiate, parties should be able to reach the efficient outcome
• Coordination is often very difficult, particularly when there are many
participants and information problems exist
Coasian Solutions to Externalities figure it out
Green Acres Fertilizer Company is located near Barney’s Dry Cleaning
Service. Green Acres’ production process emits noxious odors that are
absorbed by the clothing that Barney is cleaning. The result is that Barney
has lost many customers over time. Barney estimates that the odors cost
his business $10,000 per year. Green Acres can eliminate its odors by
altering its production process at a cost of $12,000 per year.

1. If Green Acres has the right to emit the odors, what will the socially
optimal outcome be? How will it be reached? Will any money change
hands?
2. If Barney has the right to odor-free air, what will the socially optimal
outcome be? How will it be reached? Will any money change hands?
Coasian Solutions to Externalities Figure it out
1. The socially optimal outcome will occur when Green Acres emits the
odor. The cost of eliminating the emissions ($12,000 per year) is greater
than the external cost of the odor ($10,000 per year). If Green Acres
has the right to emit the odors, it will continue to do so. Barney does not
value clean air enough to purchase that right from Green Acres, so no
money will change hands.
2. The socially optimal outcome will still be for Green Acres to emit the
odor. The optimal outcome is determined by the relative values that
Green Acres and Barney place on the resource (air). Because Green
Acres values the air more than Barney does, it should use the resource
and emit the odor. However, because Barney has a right to odor-free
air, Green Acres will have to purchase the right to emit odors from him.
Assuming that this can be done costlessly, Green Acres will have pay
Barney between $10,000 and $12,000 for that right.
The Coase Theorem and Tradable Permits Markets
The Coase theorem has been used to help inform the design of
government regulations for controlling externalities
• Consider the concept of tradable permits for pollution control discussed
previously
 How should a regulatory agency distribute the rights to pollute? Should
they be given away for free? Allocated by sector? Auctioned to the
highest bidder?
• The Coase theorem suggests it does not matter who is endowed with the
rights, or how they are distributed
• So long as there is monitoring and the ability to coordinate participants in a
way that facilitates negotiation, the outcomes should be the same no matter
the initial allocation
• This is one reason why markets for tradable permits receive attention in the
literature; markets act to make coordination easier
Application 16
Fishing Quota Markets
 While tradable permits and other market-based solutions
sound good in theory, will they work in the real world?
• The benefit of tradable permits is that they allow efficiency
gains by allocating production to the most efficient firms
• In the case of fisheries, this means that more efficient fishing
operations should be purchasing quota from less efficient
operations, thereby lowering the cost of catching a given Photo courtesy of: www.munz.org.nz
amount of fish
Newell et al. (2005) examined the “rationalization” experience
(privatization of fishing rights) in New Zealand
• In 1986, N.Z. established an “individually transferrable quota”
(ITQ) system for its previously open-access fisheries
• It covered 28 species, expanding to 45 in 2000, with quota
being traded in over 275 markets; as of mid-1990s, 85% of
catches came from ITQ-managed fisheries
Citation: Newell, R.G., J. N. Sanchirico, and S. Kerr, 2005. Fishing Quota Markets. Journal of Environmental Economics and Management 49(3) 437–462.
Application 16
Fishing Quota Markets
The authors found that at the onset of the ITQ system, there was
significant price dispersion and few quota transactions
• Characteristic of thin markets: low volume, high price variability
• As time went on, however, price dispersion declined
• While the amount of quota permanently transferred between
parties actually fell over time, leasing activity increased
Photo courtesy of: www.munz.org.nz
dramatically, with almost half of total quota being leased to third
parties by 2000
• Implies quota owners view their quota as a valuable asset that
may grow in value over time
Newell et al. contend that this is a sign that ITQ systems can be
effective in both controlling fishing effort and improving the
economic performance (efficiency) of fisheries
Citation: Newell, R.G., J. N. Sanchirico, and S. Kerr, S. Fishing Quota Markets. Journal of Environmental Economics and Management 49(3) 437–462.
16.4 Public Goods 16
There is another type of good for which markets can fail to deliver the
socially optimal level of output: public goods
• A good that benefits the individual consumer even as others consume it
• These goods (e.g., national defense, a fireworks display, or clean air) remain
just as valuable to the consumer, even as other people consume them
Similar to positive externalities
• Provide positive external benefits to everyone, regardless of who purchases
them; public goods, however, differ in a fundamental way
• Public goods are nonrival: Defining property of a public good that describes
how one individual’s consumption of the good does not diminish another
consumer’s enjoyment of the same good
Using the definitions of excludability and rivalry, we can construct a table
characterizing four types of goods
The Optimal Level of Public Goods
Market efficiency requires that a good is produced until the marginal
benefits of production are equal to the marginal costs
• Since public goods are nonrival, the marginal benefit of a given level of
provision is the vertical sum of all individuals’ marginal benefit curves
• Total marginal benefit is defined as
MBT = å MBi
where the i subscript indicates each individual
• The cost side is the same as with any other good
Figure 16.10 Efficiency in the Market for a Public Good
Marginal benefit, MC
marginal cost
Total marginal benefit,
MBT = MB1 + MB2
The two consumers of a public good
have marginal benefit curves, MB1
If the two consumers
and privately bought
MB2 , respectively.
the good, each would consume below
MB2 thethe
At optimal level
efficient at quantities
point, Q1 and
both consumers
A
Q2 , where
consume MBof1 the
Q*Pub MB2 each
andpublic good,
where their intersect MC. benefit
total marginal
curve MBT intersects the marginal
cost curve MC.
MB1
Q1 *
Q2 QPub Quantity of
public good
The Optimal Level of Public Goods
There are two reasons why markets will underprovide public goods
The first is illustrated by the figure on the previous slide
• If individuals are able to purchase the goods themselves, they will purchase
only up until the point at which private marginal benefit equals marginal cost
• The efficient level occurs when the total marginal benefits equal marginal
cost
A second problem results from the nonexcludability of public goods
• This is called the free-rider problem: A source of inefficiency resulting from
individuals consuming a public good or service without paying for it
• Why take on any private costs, when you can simply benefit from its
provision without paying anything (e.g., NPR)
Public Goods figure it out
Dale and Casey are neighbors in a rural area. They are considering the
joint installation of a large fountain near their joint property line so that each
can enjoy its beauty and also improve the value of his property. Dale’s
marginal benefit from the fountain is MBD = 70 – Q, where Q measures the
diameter of the fountain (in feet). Casey’s marginal benefit from the fountain
can be represented as MBC = 40 – 2Q. Assume that the marginal cost of
producing the fountain is constant and equal to $80 per foot (in diameter).
1. Find an equation to represent the total marginal benefit of the fountain.
2. What is the socially optimal size of the fountain?
3. Would you expect Dale and Casey to build the optimally sized fountain?
Explain.
Public Goods figure it out
1. The total marginal benefit is the vertical summation of Dale’s and Casey’s
individual marginal benefit curves:
MBT = MBD + MBC = 70 -Q + 40 - 2Q =110 -3Q

2. The socially optimal size of the fountain occurs where MBT equals the marginal
cost of producing the fountain:
MBT = MC ®110 - 3Q = 80
30 = 3Q ® Q =10
The socially optimal diameter for the fountain is 10 feet.
3. Dale will not be willing to build a fountain that is 10 feet in diameter because his
private marginal benefit is less than the marginal cost
MBD = 70 -Q = 70 -10 = 60 < MC (80)
Casey also will be unwilling to build a 10-foot fountain because his private marginal
benefit from a 10-foot fountain is lower than the marginal cost:
MBC = 40 - 2Q = 40 - 20 = 20 < MC (80)
Therefore, the optimally sized fountain will not be built.
Solving the Free-Rider Problem
The most common way that the free-rider problem is dealt with is
through government action
• Governments have the ability to tax citizens, and those powers are often
used to provide public goods such as national defense, air traffic control,
weather forecasting services, etc.
There are other potential solutions
• Groups of private citizens can form to provide public goods (e.g.,
homeowners associations for condo buildings)
• It is not always the case that people will succumb to the free-rider problem.
Private motivations are often more complicated than assumed by the
economic theory of rational agents
Application 16
The “Al Gore Effect”: Voluntary Provision of Public
Goods
The global climate regulatory system is a public good
• Nonexcludable
• Nonrival
However, by contributing to the greenhouse effect, our carbon-
based global economy is degrading the ability of our atmosphere
to regulate global temperatures
Without a global climate agreement in place, some advocates
have called for more effective outreach to the public
• Induce people to make more climate-friendly consumption
decisions
• Encourage the purchase of “carbon offsets” to reduce individual
carbon footprints
Citation: Jacobsen, G.D. 2011. The Al Gore Effect: An Inconvenient Truth and Voluntary Carbon Offsets. Journal of Environmental Economics and Management 61(1):
67–78.
Application 16
The “Al Gore Effect”: Voluntary Provision of Public
Goods
Jacobsen (2011) investigated whether the release of Al Gore’s film
An Inconvenient Truth in 2006 corresponded with an increase in
the purchase of carbon offsets
• Examined households in zip codes within a 10-mile radius of
theaters
The main finding: households near theaters that screened An
Inconvenient Truth were more likely to purchase offsets
• In the two months following the film’s release, households
within the radius experienced a 50% relative increase in carbon
offset purchases, compared to households outside the radius
• During other times, purchasing patterns did not differ
• However, purchases were one time; there was no discernible
difference the following year
Citation: Jacobsen, G.D. 2011. The Al Gore Effect: An Inconvenient Truth and Voluntary Carbon Offsets” Journal of Environmental Economics and Management 61(1):
67–78.
16.5 Conclusion 16
In this chapter, we delved into the issues that develop when markets are
missing or otherwise incomplete
• Externalities occur when costs and/or benefits are not completely captured
by those making production and consumption decisions
• Nonexcludable, common-pool goods suffer from overuse and/or
underinvestment
• Public goods are underprovided by private agents due to free riding and the
misalignment of private and total marginal benefits
In the final chapter, we examine situations in which economic actors
(consumers and producers) may not appear to be the rational, utility-
and profit-maximizing agents we have modeled throughout this text

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Externalities and

16.2 Fixing Externalities

16.4 Public Goods

EMB = Subsidy, Sub

Quota = Q* QMKT Quantity of

• This “derby fishing” was very dangerous. Fishermen would go

• Longer season made fishing safer, reduced idle capital

POLLB POLL* POLLC Quantity of fertilizer

POLLB POLL* POLLC Quantity of fertilizer

TACG = 20dG + 2dG2 = 20(212)+ 2(212)2 = $94,128

Answer the following questions:

MBT = MBD + MBC = 70 -Q + 40 - 2Q =110 -3Q

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