Module 8

Public goods and externalities

Previous assumption was that firms pay for all cost incurred and consumers pay for
all goods consumed. In many cases this is not so. When the cost that firms actually
do pay differs from total production costs and when some households can consume
goods without paying for them , a competitive market economy will tend to not
allocate resources efficiently.

8.2 Private Goods and Public Goods

Private g consumed by 1 individual or household. 2 imp characteristics
Excludability once you own it no one else
can
Rivalry once owned there is less for others
Public good - consumed by everyone and no one is excluded eg national defense
Some goods are neither e.g. motorway anyone can use it and as many ppl can use
it. However beyond capacity ( i.e. max traffic) each additional car reduced service
for other consumers.
Free rider problem someone who consumes goods without having to pay for it.ie
cost of public good not shared equally. If individuals actually allowed an option they
would not contribute since once public good is provided there is zero extra benefit
to incentive them to pay.
One of principal activities of gov is to make expenditure on behalf of individuals that
would not be produced in a market economy. Not all people consume these and due
to diff tax schemes not all people pay. But in most cases they are free to use.
Gov still apply efficiency criteria in spending due to scare resources. Optimum
provisions is when marginal social cost of production = marginal social benefit
To provide best economic efficient for each good the marginal social benefits per its
marginal cost is same for all goods. Some benefits are entirely indivisible among
citizens eg national defense but some may provide different private and social
benefits. Eg health system takes care of sick people but in doing so prevent healthy
people getting sick and overall less sick days so higher output at social level ie more
social benefit.
Marginal cost are also considered for all gov expenditures . Eg when increasing
number of students posts the society is paying for resources but also loosing output
that would have occurred had students been working instead.
Optimum level of provision only when

Benefits are calculated based on both total individual benefits and also total social
benefit ( social output).

How are public goods financed;

Flat rate scheme since equal benefits all citizens pay the same amount. (argument
also overrides individuals preferences towards good). This means that poorer ppl
with lower income pay a higher percentage of their income for this good.
Equal proportions scheme everyone pays equal proportions of their income ie
richer ppl pay much more but same proportionally.
Brackets of progressively higher income levels diff income levels pay diff amount
and proportions.
Therefore while economic criteria can settle issue of optimal level of goods provision
they cannot settle question re goods financing this is a question of equity rather
than efficiency.
Eg motorway makes economic sense but who should pay, specific users, motorist as
a group or end users ie consumers ie households?

8.3 Externalities : Positive and Negative

Every economic activity involves costs and benefits. In making the decision the
individual/firm will consider the private costs and benefits ie what they will
pay and benefit.
For many economic activities private costs and benefits equal social costs and
benefits. Ie other individual who are not involved will benefit nor pay anything. Eg. If
a student buys a notebook no one else paid or benefitted since private. Since the
student is part of the society the social benefits society gains and cost involved
equal what that student gained and paid.
External benefits or positive externalities individual not involved still benefit ( eg
neighbors nice garden)
External costa or negative externalities individuals no involved still pay. ( eg
pollution - cleaning)
To maximize utility benefits/cost incur to other individuals are usually ignored.
However in reality since for economic efficiency the marginal condition must hold.

MC is the marginal cost of society to produce the goods while MU is the benefit. If
social and private benefits/cost are equal there is balance. But if private and social
benefits are different then economic efficacy will not prevail.
If externalities are not taken in consideration then marginal equivalency will not
occur. Eg a polluting firm will benefit more than society since society will pay for
clearing.

ration will be lower than equivalency since MU is befit of firm but MC is cost
for firm and also society.

8.4 Externalities, Collective Action and Economic

Efficiency
With externalities there is inefficient allocation of resources due to divergence
between private and social costs/benefits. There needs collective action/gov to
interfere in market.
Eg if firm is causing increase social cost it should pay for marginal costs. So total
MR=total MC
Collective action is needed to equate MU/MC for all goods. Tax if social costs are
more than private firm cost and subsidy of social benefits are more than private/firm
benefits because of lower marginal costs.
Or finally in completive equilibrium at PS but externalities were not considered.
Firms are taxed per unit due to pollution. S curve shifts left since MC cost rise full
amount of tax. Q would and price . The resources allocation would be balanced
now since producers and consumers are taking full social costs into account via
higher costs and prices.
If firm was providing external benefits that were not considered a subsidy will
reduce marginal cots curve shifts S curve to right Q will and price will . The
subsidy will reflect the external benefits derived.
If the firm that produced the external costs/benefits were to include the bearers of
those cost/benefits the full costs /benefits will be taken into account and the
externalities are internalized. eg the free loader become share payer etc.
Counteracting negative externalities such as pollution requires resources that some
firms or poor countries do not have. Resources that could have been spent
otherwise. Extra benefit from getting rid of it might not be worth extra cost.
Externalities are forced to be taken in considering in case of property rights. Eg
construction workers that has to consider the damage done to adjacent buildings.

Coases theorem - finding the optimal solution for balancing externalities

Profit maximizing rancher will produce at N max profit that exclude externalities
At N marginal cost of cattle is less than marginal societal cost of carp damage at N.
Agreement to produce at N1 and rancher pays farmer the difference YY1. Rancher
also accepts loss of XX1.
N1 is optimal since account for marginal social cost ( externalities). This is
represented by P.
Problem when no one has property rights like air or there is a high transaction cost
as well as great complication in getting all parties involved.
8.5 The problems of collective decision Making

Voting paradox Eg Even though A is preferred to be it can happen that if C is

added B becomes favored. Or else if the 2 bigger parties having parliament seats
48% the smallest party will be yield power disproportionately more than has 4%
votes.