Externalities

Externalities and Public
Goods
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peped.org/economicinvestigations
Externalities, Public Goods, and Social Choice
market failure Occurs when resources are misallocated or allocated inefficiently.
Externalities
externality A cost or benefit imposed on, or enjoyed by an individual or a group that is

outside, or external to, the transaction.

Externalities and Environmental Economics
Marginal Social Cost and Marginal-Cost Pricing
marginal social cost (MSC) The total cost to society of producing an additional unit of a
good or service. MSC is equal to the sum of the marginal costs of producing the product
and measures the true cost – internal and external – of the process of production.

Marginal Social Cost and Marginal-Cost
Pricing
(£)
Profit-Maximizing Perfectly Competitive
Firms Will Produce Up to the Point That
Price Equals Marginal Cost (P = MC)
If we assume that the current price reflects

what consumers are willing to pay for a
product at the margin, firms that create
external costs without weighing them in
(£)
their decisions are likely to produce too
much. At q*, marginal social cost exceeds
the price paid by consumers.

Acid Rain and the Clean Air Act
Acid rain is an excellent example of an externality and of the issues and conflicts involved
in dealing with externalities.
The case of acid rain highlights the fact that efficiency analysis ignores the distribution of
gains and losses. To establish efficiency, we need only demonstrate that the total value of
the gains exceeds the total value of the losses.
But when UK acid rain lands on Sweden, the Swedish bear the cost. The costs are borne
unequally.

Other Externalities
Other examples of external effects are all around us. When people drive their cars into
the city at rush hour, they contribute to the congestion and impose costs (in the form of
lost time and posionous emissions) on others.
The most significant and hotly debated issue of externalities is global warming.

Some Examples of Positive Externalities
Externalities can also be positive benefits. When other people or firms engage in an
activity, there are benefits from that activity enjoyed by people outside of the immediate
activity. From an economics perspective, there are problems with positive externalities as
well.
The problem with positive externalities is that the individuals in charge have too little
incentive to engage in the activity because someone is providing it for nothing.

Private Choices and External Effects
Externalities in a Village
The marginal benefits to Harry exceed the marginal costs he must bear to play his stereo system for a period of up
to 8 hours. When the stereo is playing, a cost is being imposed on his next door neighbour, Jake. When we add the
costs borne by Harry to the damage costs imposed on Jake, we get the full cost of the stereo to the two-person
village made up of Harry and Jake. Playing the stereo more than 5 hours is inefficient because the benefits to Harry
are less than the social cost for every hour above 5. If Harry considers only his private costs, he will play the stereo
for too long a time from society’s point of view.
Private Choices and External Effects
marginal private cost (MPC) The amount that a consumer pays to consume an additional
unit of a particular good.
marginal damage cost (MDC) The additional harm (external cost) done by increasing the
level of an activity by 1 unit. If a pesticide pollutes the water in a river, MDC is the
additional cost imposed by the added pollution that results from increasing output by 1
unit of pesticide per period.

Internalising Externalities
Five approaches have been taken to solving the problem of externalities:
1. government imposed taxes and subsidies,

2. private bargaining and negotiation,
3. legal rules,
4. sale or auctioning of rights to impose externalities,
5. direct government regulation.
While each is best suited for a different set of circumstances, all five provide decision
makers with an incentive to weigh the external effects of their decisions. An example of
(4) is carbon permit trading.

Internalising Externalities – Taxes and Subsidies
(£)
Tax Imposed on a Firm Equal to Marginal Damage Cost
If a per-unit tax exactly equal to marginal damage costs is imposed on a firm, the firm will weigh the
tax, and thus the damage costs, in its decisions. At the new equilibrium price, P1, consumers will be
paying an amount sufficient to cover full resource costs as well as the cost of damage imposed. The
efficient level of output for the firm is q1.
Taxes and Subsidies
Measuring Damages:
The biggest problem with using taxes and subsidies is that damages must be estimated in
financial terms. Example: how do we cost the effects of acid rain on Swedish foresters?

Taxes and Subsidies
Reducing Damages to an Efficient Level:

Taxes also provide firms with an incentive to use the most efficient technology for dealing
with damage.
The Incentive to Take Care and to Avoid Harm:

You should understand that all externalities involve at least two parties and that it is not
always clear which party is “causing” the damage.

Bargaining and Negotiation
Coase theorem Under certain conditions, when externalities are present, private parties
can arrive at the efficient solution without government involvement.
Legal Rules and Procedures
injunction A court order forbidding the continuation of behavior that leads to damages.
liability rules Laws that require A to compensate B for damages imposed.

Selling or Auctioning Pollution Rights
TABLE 16.1 Permit Trading £

Firm A Firm A Firm A Firm B Firm B Firm B
Reduction of MC of reducing TC of reducing Reduction of MC of reducing TC of reducing
pollution by Firm A pollution for pollution for pollution by Firm B pollution for pollution for
(in units of pollution) Firm A Firm A (in units of pollution) Firm B Firm B
1 5 5 1 8 8
2 7 12 2 14 22
3 9 21 3 23 45
4 12 33 4 35 80
5 17 50 5 50 130

Direct Regulation of Externalities
The Debate Over Global Warming:

The Kyoto Protocol is an international treaty on global warming negotiated by the United
Nations in the 1997. It came into force after it was ratified by Russia in February 2005. A
total of 141 countries have ratified the agreement, which commits them to reduce their
emissions of carbon dioxide and five other greenhouse gases or to engage in emissions
trading. The United States refused to ratify the treaty.

Public (Social) Goods
Income Distribution as a Public Good?
Note that some economists have argued for redistribution of income on grounds that it
generates public benefits.
If we accept the idea that redistributing income generates a public good, private
endeavours may fail to do what we want them to do, and government involvement may be
called for.

Public Provision of Public Goods
All societies, past and present, have had to face the problem of providing public goods.
When members of society get together to form a government, they do so to provide
themselves with goods and services that will not be provided if they act separately.
This forms part of Social Contract Theory – a theory of Government originating with Jean-
Jacques Rousseau in the C18th.

Optimal Provision of Public Goods
Economist Paul Samuelson demonstrated that there exists an optimal, or a most efficient,
level of output for every public good.
Samuelson’s Theory
An efficient economy produces what people want. Private producers, whether perfect
competitors or monopolists, are constrained by the market demand for their products. If
they cannot sell their products for more than it costs to produce them, they will be out of
business. Because private goods permit exclusion, firms can withhold their products until
households pay. Buying a product at a posted price reveals that it is “worth” at least that
amount to you and to everyone who buys it.

Optimal Provision of Public Goods - Samuelson’s Theory
(£)
With Private Goods, Consumers Decide What Quantity to Buy; Market Demand Is the Sum of Those
Quantities at Each Price:
At a price of £3, A buys 2 units and B buys 9 for a total of 11. At a price of £1, A buys 9 units and B
buys 13 for a total of 22. We all buy the quantity of each private good that we want. Market demand
is the horizontal sum of all individual demand curves.

Optimal Provision of Public Goods -
(£)
With Public Goods, There Is Only One Level of

Output and Consumers Are Willing to Pay
Different Amounts for Each Level
(£)
A is willing to pay £6 per unit for X1 units of the
public good. B is willing to pay only £3 for X1 units.
Society—in this case A and B—is willing to pay a
total of £9 for X1 units of the good. Because only
one level of output can be chosen for a public good,
(£)
we must add A’s contribution to B’s to determine
market demand. This means adding demand curves
vertically.

Optimal Provision of Public Goods -
Optimal Production of a Public Good
Optimal production of a public good means

producing as long as society’s total willingness
to pay per unit (DA+B) is greater than the
(£)
marginal cost of producing the good.

Optimal Provision of Public Goods
optimal level of provision for public goods The level at which society’s total willingness to
pay per unit is equal to the marginal cost of producing the good.
The Problems of Optimal Provision
One major problem exists. To produce the optimal amount of each public good, the
government must know something that it cannot possibly know— everyone’s preferences.

Social Choice
Government Inefficiency: Theory of Public Choice
Looking at the public sector from the standpoint of the behaviour of public officials and the
potential for inefficient choices and bureaucratic waste rather than in terms of its potential
for improving the allocation of resources has become quite popular. This is the viewpoint
of what is called the public choice field in economics that builds heavily on the work of
Nobel laureate James Buchanan.

Social Choice
Rent-Seeking Revisited
A monopolist would be willing to pay to prevent competition from eroding its economic
profits. Many—if not all—industries lobby for favourable treatment, softer regulation, or
antitrust exemption. This we call rent-seeking.
Theory may suggest that unregulated markets fail to produce an efficient allocation of
resources. This should not lead you to the conclusion that government involvement
necessarily leads to efficiency. There are reasons to believe that government attempts to
produce the right goods and services in the right quantities efficiently may fail.

Government and the Market
There is no question that government must be involved in both the provision of public
goods and the control of externalities.
The question is not whether we need government involvement. The question is how much
and what kind of government involvement we should have.

Key Terms
• externality
• free-rider problem
• marginal damage cost (MDC)
• marginal private cost (MPC)
• marginal social cost (MSC)
• market failure
• mixed goods
• non-excludable
• non-rival in consumption
• optimal level of provision for public goods
• public goods (social or collective goods)
• social choice


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Externalities and Public

Copyright © 2015 Active Education

externality A cost or benefit imposed on, or enjoyed by an individual or a group that is

Copyright © 2015 Active Education

Copyright © 2015 Active Education

If we assume that the current price reflects

Copyright © 2015 Active Education

Acid Rain and the Clean Air Act

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Some Examples of Positive Externalities

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Five approaches have been taken to solving the problem of externalities:

1. government imposed taxes and subsidies,

Copyright © 2015 Active Education

Tax Imposed on a Firm Equal to Marginal Damage Cost

Taxes and Subsidies

Copyright © 2015 Active Education

Taxes and Subsidies

Reducing Damages to an Efficient Level:

The Incentive to Take Care and to Avoid Harm:

Copyright © 2015 Active Education

Bargaining and Negotiation

Legal Rules and Procedures

liability rules Laws that require A to compensate B for damages imposed.

Copyright © 2015 Active Education

Selling or Auctioning Pollution Rights

TABLE 16.1 Permit Trading £

Copyright © 2015 Active Education

Direct Regulation of Externalities

The Debate Over Global Warming:

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Copyright © 2015 Active Education

With Public Goods, There Is Only One Level of

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Optimal Production of a Public Good

Optimal production of a public good means

Copyright © 2015 Active Education

The Problems of Optimal Provision

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Copyright © 2015 Active Education

Copyright © 2015 Active Education

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