BM1709

EXTERNALITIES AND PUBLIC GOODS

Externalities

Externality – This is the uncompensated income of one person’s actions on the well-being of a bystander.
It arises when a person engages in an activity that influences the well-being of a bystander but neither
pays nor receives compensation for that effect. If the impact on the bystander is adverse, it is called a
negative externality. Examples of these are pollution and noise. If it is beneficial, it is called a positive
externality.

Negative Externalities:
• When a paint factory dumps waste into a river, the people who live by the river and use it bear
the cost of pollution. The paint factory does not consider the cost of pollution when it comes to
the quantity of paint to produce.
• There are different types of costs related to externalities:
o Private costs are costs that is borne by the producer of a good or service. Marginal cost is
the cost of producing an additional unit of a good or service.
o The marginal private cost is the cost of producing an additional unit of good or service
that is borne by the producer of that good and service.
o An external cost is a cost of producing a good or service that is NOT borne by the
producer, but by other people. A marginal external cost is the cost of producing an
additional unit of a good or service that falls on people other than the producer.
o The marginal social cost is the marginal cost incurred by the entire society, and is the sum
of marginal private cost and marginal external cost.
• Negative externalities impose an additional cost on society that is not explicitly recognized by the
buyers and sellers in the market. When computing efficient outcome, economists must adjust the
supply curve to take account of the negative externalities or external costs. To arrive at efficient
production level, we need to recognize both the firm’s marginal costs and the marginal external
cost. Together, they make up the marginal social cost of production.

Managing Negative Externalities

• Establish property rights
o Property rights are legally established titles to the ownership, use, and disposal of factors
of production and goods and services that are enforceable in the courts. Establishing
property rights where they do not currently exist can confront producers with the costs
of their actions and provide them with an incentive to allocate resources efficiently.
o The Coase Theorem is a proposition that if property rights exist and the costs of enforcing
them are low, then the market outcome is efficient and it does not matter who has the
property rights (whether the polluter or the victim).
• Mandate clean technology – The governments of most countries regulate what may be dumped
into rivers and emitted into the atmosphere. In the Philippines, there are several laws that help
regulate pollution:

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o RA 9003, Ecological Solid Waste Management Act of 2000 – The firm must have a
systematic, comprehensive, and ecological solid waste management program that shall
ensure the protection of public health and environment. The law ensures proper
segregation, collection, storage, treatment, and disposal of solid waste.
o RA 9275 Philippine Clean Water Act of 2004 – This law aims to protect the country’s
water bodies from pollution from land-based sources, such as industries and commercial
establishments, agriculture, and household activities.
o RA 8749 Philippine Clean Air Act of 1999 – The law aims to achieve and maintain clean
air that meets the National Air Quality guideline values for criteria pollutants, while
minimizing the possible associated impacts to the economy.
o RA 6969 Toxic Substances, Hazardous and Nuclear Waste Control Act of 1990 – This law
aims to regulate, restrict or prohibit the importation, manufacture, processing, sale,
distribution, use and disposal of chemical substances and mixtures that present
unreasonable risk to human health. It also prohibits the entry, even in transit, of
hazardous and nuclear wastes and their disposal into the Philippine territorial limits.

• Tax pollution – Governments can use taxes as an incentive for producers to reduce the pollution
they create. Taxes used this way are called Pigovian taxes. By setting the tax equal to the marginal
external cost, firms would be made to behave in the same way as they would if they bore the cost
of externality directly.

Positive Externalities
• A private benefit is a benefit that the consumer of a good or service receives. The marginal private
benefit is the benefit from an additional unit of good or service that the consumer of that good
or service receives.
• An external benefit is a benefit from a good or service that someone other than the consumer
receives. A marginal external benefit is the benefit from an additional unit of a good or service
that people other than the consumer enjoy.
• Marginal social benefit is the benefit enjoyed by society – by the consumers of a good or service
and by everyone else who benefits from it.

Obtaining Positive Externalities

• Public provision – This is the production of a good or service by a public authority that receives
most of its revenue from the government. Educational services provided by the public
universities, colleges and schools are examples of public provision. Public provision cannot lower
the cost of production, so marginal cost is the same as before. Marginal private benefit, marginal
external benefit, and marginal social benefit are also the same as before.
• Private subsidies – This is a payment by the government to a producer to cover part of the costs
of production. By giving producers a subsidy, the government can induce private suppliers into
providing the product.
• Vouchers – These are tokens that the government provides to households, which they can use to
buy specified goods or services. The government would provide each student with a voucher.
Students would choose the school to attend and pay the tuition with money plus a voucher.

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Schools would exchange the vouchers they receive for money from the government. If the
government set the value of a voucher equal to the marginal external benefit of a year of college
at the efficient quantity, the outcome would be efficient. Vouchers provide public financial
resources to the consumer rather than the producer. Economists generally believe that vouchers
offer a more efficient outcome than public provision and subsidies because they combine the
benefits of competition among private schools with the injection of the public funds needed to
achieve an efficient level of output. Also, students and their parents can monitor school
performance more effectively than the government can.

Public Goods

Characteristics of Goods
• Excludability/nonexcludability – a good, or service, is excludable if it is possible to prevent
someone from enjoying its benefits. People must pay to consume them. A good or service is
nonexcludable if it is impossible, or extremely costly, to prevent someone from benefitting from
it. Examples are police services, fish in the Pacific Ocean, or a concert in TV.
• Rival/nonrival goods – A good or service is rival if the use of one person decreases the quantity
available for someone else. For example, a truck can’t deliver things to two (2) places at the same
time. A good or service is nonrival if its use by one person does not decrease the quantity available
for someone else. The services of the city police and the TV concert are nonrival.

Fourfold Classification
• Private goods – A good or service that is both rival and excludable. It can be consumed by only
one person at a time, and only by the person who has bought it or owns it. For example, a burger
is an example of a private good. One person’s consumption of burger decreases the chances of
other people consuming a burger (rival), and everyone except the person who bought the burger
is excluded from consuming it.
• Public goods – A good or service that is both nonrival and nonexcludable is a public good: It can
be consumed simultaneously by everyone, and no one can be excluded from enjoying its benefits.
The system of law and order provided by the courts and the body of laws is an example.
• Common resources – A resource that is rival and nonexcludable is a common resource. A unit of
it can only be used once, but no one can be prevented from using what is available. Ocean fish
are an example of common resources. A fish taken by one person is not available for anyone else,
and they are nonexcludable because it is difficult to prevent people from catching them.
• Natural monopoly good/club goods – A good that is nonrival but excludable is a good produced
by a natural monopoly. A natural monopoly is a firm that can produce at a lower cost than two or
more firms can. Examples are the internet, cable television, a bridge, or a tunnel. One more user
doesn’t decrease the enjoyment of the other users, and people can be excluded with user codes,
scramblers, and tollgates. Club goods are also known as natural monopoly.

Marginal Benefit from a Public Good

• For a private good, the marginal benefit curve is the demand curve. Everyone pays the same
market price for a private good, and each person chooses the quantity to buy at that price. In
contrast, for a public good, everyone consumes the same quantity, but each person puts a

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different private value on that quantity. To find the equivalent of a demand curve for a public
good, add the amount that each person is willing to pay for the public good.
• For a public good, each person’s marginal benefit diminishes as the quantity of the good
decreases. People are less willing to pay for more of a public good (for example, street lights).
• Because everyone shares in the benefits of a public good, the marginal private benefits of
everyone in the society are added together to get the public good’s marginal benefit. The marginal
benefit from a public good is called the marginal social benefit. Graphically, it is shown by a
marginal social benefit curve (MSB).
• The marginal cost of a public good is determined in exactly the same way as that of a private good.
The principle of increasing marginal cost applies to the marginal cost of a public good. So, the
marginal cost curve of a public good slopes upward. A public good does not create an externality,
so the marginal cost is also the marginal social cost.
• People’s preferences and demands for public goods are conceptually no different from their
preferences and demands for private goods. The Samuelson Musgrave Theory states that once
we know how much society is willing to pay for a public good, we need only compare that amount
to the cost of its production. As long as society is willing to pay more than the marginal cost of
production, the good should be produced. If a person is willing to pay P600 per unit of public good
and another person is willing to pay P300 per unit, society is willing to pay P900. We have arrived
at the optimal level of provision for public goods. At the optimal level, society’s total willingness
to pay per unit is equal to the marginal cost of producing the good.
• To determine the efficient quantity, we find the quantity at which marginal social benefit equals
marginal social cost. If marginal social benefit exceeds marginal social cost, resources can be used
more efficiently by increasing the quantity of the public good. If marginal social cost exceeds
marginal social benefit, resources can be used more efficiently by decreasing the quantity of the
public good. If marginal social benefit equals marginal social cost, resources are being used
efficiently.
• One major problem exists, however. To produce the optimal amount of each public good, the
government must know something that it cannot possibly know—everyone’s preferences.
Because exclusion is impossible, nothing forces households to reveal their preferences.
Furthermore, if we ask individuals directly about their willingness to pay, people would most likely
not be honest about the amount they’re willing to pay. They would want to pay as low as possible,
which is different from what they are willing to pay. Furthermore, they know that they cannot be
excluded from enjoying the benefits of the good and that their payment is not likely to have an
appreciable influence on the level of output finally produced.

Issues with Public Goods

• Free-rider problem – A free rider is a person who enjoys the benefits from a good or service
without paying for it. Because everyone consumes the same quantity of goods, no one can be
excluded from enjoying its benefits, and no one has an incentive to pay for it. Everyone has an
incentive to free ride. The free-rider problem is that the private market, left on its own, would
provide too small quantity of a public good. To produce efficient quantity, government action is
required.
• Drop in the bucket problem – This is another issue associated with the provision of public goods.
This states that the public good or service is usually so costly that its provision normally does not
depend on whether any single person pays.

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Common Resources
• In most parts of the world, the open sea, beyond territorial limits around individual countries, is
currently common area, available and open to all to fish, subject to a handful of international
fishing rules. The sea has no owner.
• Economists refer to areas like the fishing grounds as common resources. Common resources, like
public goods, are nonexcludeable. One cannot keep someone from setting out a fishing line in
open sea. But, in contrast to public goods, the consumption of a common resource by one person
has an effect on the availability of that resource to others. If a person catches too many fish, the
population will suffer and there will be none left for future generations.
Tragedy of the Commons
• Economists have worried for a long time about the management of commons. The central
concern is the overuse of resources.
• If a common resource is shared by many, and technology is well developed, overuse is more likely.
In modern times, overfishing of the sea is a problem that worries many policy makers.
• As with externalities, there are several policy instruments we can use to control overuse of a
commons. Standards are common; there are in most areas times of the year one cannot fish and
limits on the size of fish that can be landed. Taxes are also common, typically levied by limiting
and charging for fishing licenses. For some commons problems, a solution is found by privatizing
the resource, as England did in the enclosure movement. If a common area is turned into a private
resource, the owner will have incentives for using that resource efficiently.

References
Bade, R., & Parkin, M. (2015). Foundations of microeconomics, Seventh edition. Upper Saddle River:
Pearson Education Inc.

Case, K. E., Fair, R. C., & Oster , S. E. (2017). Principles of microeconomics, Twelfth edition. Harlow:
Pearson Education Limited.

Major environmental laws. (n.d.). Retrieved from Environmental compliance assistance center :
http://ecac.emb.gov.ph/?page_id=43, https://aboutphilippines.ph/files/Philippine-Laws-on-
Environmental-Pollution.pdf

Mankiw, N. G. (2015). Principles of microeconomics. Stamford : Cengage Learning.

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