EXTERNALITIES AND GOVERNMENT

POLICY
» Externalities are costs or benefits of market transactions not reflected in prices.
֎ When an externality prevails, a third party (other than the buyers or sellers of an
item) is affected by its production or consumption. The benefits or costs of the
third party (either a household or a business) are not considered by either
buyers or sellers of an item whose production or use results in an externality.
» Market prices do not accurately reflect either all the marginal social benefit or all the
marginal social cost of traded items when an externality is involved.
֎ Negative externalities, also called external costs, are costs to third parties
other than the buyers or the sellers of an item not reflected in the market price.
֎ Positive externalities are benefits to third parties other than the buyers or the
sellers of a good or service not reflected in prices. Buyers and sellers of goods
that, when sold, result in positive externalities, do not consider the fact that each
unit produced provides benefits to others.
» Note: Effects of market exchanges on third parties are not externalities when those
effects are included in prices.
» Pecuniary externalities - the effects of increases (or decreases) in the price of a
good on existing consumers as a result of changes in the demand or supply of a
good.
» When an externality exists, the marginal costs or marginal benefits that market
participants base their decisions on diverge from the actual marginal social costs or
benefits. Externalities prevent competitive markets from achieving efficient
outcomes.

NEGATIVE EXTERNALITIES

» When a negative externality exists, the

price of a good or service does not
reflect the full marginal social cost of
resources allocated to its production.
» The marginal external cost (MEC)
is the extra cost to third parties
resulting from production of another
unit of a good or service.
 ֎ MEC is part of the marginal social of making a good available. However, it is not
reflected in the price of the good.
» (Refer to graph) The marginal cost that producers base their decisions on is the
marginal private cost (MPC) of producing goods. To obtain the marginal social cost,
the marginal external cost of output, MEC, must be added to the marginal private
costs, MPC:
MPC + MEC = MSC
» When a negative externality exists, the marginal private cost of a good falls short of
its marginal social cost of output.
» The competitive market equilibrium corresponds to point A, at which MPC = MSB
» Efficiency requires that the full marginal social cost of a good be considered in the
productive decision. The efficient equilibrium will be at point B rather than at point
A. At point B, the following condition is satisfied:
MSC = MPC + MEC = MSB
The marginal social cost of the good, including the marginal external cost, must be
equal to its marginal social benefit to attain efficiency
» When a negative externality exists, too much output is produced and sold in a
competitive market relative to the efficient amount.

POSITIVE EXTERNALITIES

» When a positive externality is

present, prices do not fully equal
the marginal social benefit of a
good or service.
» The marginal external benefit
(MEB), the benefit of additional
output accruing to parties other
than buyers or sellers of the good.
» The marginal benefit that
consumers base their decisions on
is the marginal private benefit
(MPB).
» (Refer to graph) The market
equilibrium occurs at point U.
֎ Market equilibrium corresponds to the equality of each person’s marginal private
benefit, MPB with the marginal social cost of providing the good.
֎ Assume that the marginal private cost to sellers accurately reflects its marginal
social cost. At the market equilibrium, point U, the actual marginal social benefit
exceeds the price each consumer uses whether to avail the good. This equals
the sum of the marginal private benefit received by consumers and the marginal
external benefit to others : MPB + MEB = MSB
» In general, when a positive externality exists, marginal private benefit will fall short
of marginal social benefit at each level of annual output.
» Less than the efficient output results from market interaction because the marginal
social benefit at the market equilibrium exceeds the marginal social cost.
» The efficient output of corresponds to point V. At that point, the marginal social
benefit of the good equals the marginal social cost incurred to produce them. The
marginal conditions for efficiency are met at that point because
MPB + MEB = MSB = MSC

INTERNALIZATION OF EXTERNALITIES

» Internalization of an externality occurs when the marginal private benefit or cost of

goods and services are adjusted so that the users consider the actual marginal social
benefit or cost of their decisions.
֎ In the case of a negative externality, the marginal external cost is added to
marginal private cost for internalization.
֎ For a positive externality, the marginal external benefit is added to marginal
private benefit to internalize the externality.
֎ Internalizing an externality results in changes in prices to reflect full marginal
social cost or benefit of a good.
» Internalization of externalities requires identification of the individuals involved and
measurement of the monetary value of the marginal external benefit or cost.
» A corrective tax (T) is designed to adjust the marginal private cost of a good or
service in such a way as to internalize the
externality.
֎ The tax must equal the marginal
external cost per unit of output to
achieve this objective.
֎ In effect, a corrective tax is exactly like
a charge for emitting wastes.
֎ It is designed to internalize a negative
externality by making sellers of the
product pay a fee equal to the
marginal external costs per unit of
output sold.
֎ To internalize the externality through the use of a corrective tax will result in
some groups receiving benefits at the expense of other groups bearing the costs.
In other words, the internalization of the externality also will result in income
redistributive effects, which, in turn, will influence the willingness of the
individuals involved to support the scheme.
» A corrective subsidy is a payment made by government to either buyers or sellers
of a good so that the price paid by consumers is reduced. The payment must equal
the marginal external benefit
of the good or service.

THE COASE THEOREM

» Externalities arise because the property rights of some resource users are not
considered in the marketplace by buyers or sellers of products.
» Transactions costs include the time, effort, and cash outlays involved in locating
someone to trade with, negotiating terms of trade, drawing contracts, and assuming
risks associated with the contracts.
֎ Transactions costs depend, in part, on property rights to use resources.
Government has the power to change property rights. By doing so, transactions
costs will be affected, as will the potential net gains realizable through market
exchanges. If a government lowers transactions costs, efficiency will be
improved in cases for which new gains from trading outweigh the costs involved
in establishing or modifying preexisting property rights.
» The Coase theorem states that governments, by merely establishing the rights to
use resources, can internalize externalities when transactions costs of bargaining are
zero.
֎ Once these property rights to resource use are established, the Coase theorem
holds that free exchange of established rights for cash payments among the
affected parties will achieve efficiency. This result holds irrespective of which of
the involved parties is granted the right.
» The kinds of externalities for which the Coase theorem is relevant are called small-
number externalities.
» The remarkable conclusion of the Coase theorem is that the efficient mix of output
will result simply as a consequence of the establishment of exchangeable property
rights. It makes no difference which party is assigned the right to use a resource.
Provided the transactions costs of exchanging the right are zero, the efficient mix of
 outputs among competing uses of the resource (in this case, land) will emerge. When
transactions costs of exchanging the right to resource use are low and the number of
parties involved is few, a government need do no more than assign property rights.
Bargaining among the interested parties will do the rest to achieve efficiency.
Answer the following:

1. Explain why externalities prevent the attainment of efficiency when goods are traded in
competitive markets.
2. Suppose a positive externality is associated with college enrollment. Assume that college
instruction is sold in a competitive market and that the marginal social cost of providing it
increases with enrollment. Show how a corrective subsidy to college students will increase
the market price of instruction. Show the net gain in well-being possible from the subsidy and
the amount of tax revenue required to finance its costs on your graph.
PUBLIC GOODS
» Goods with benefits that cannot be withheld from those who do not pay and are
shared by large groups of consumers are public goods.
» Public goods are non-rival in consumption, meaning that a given quantity of a
public good can be enjoyed by more than one consumer without decreasing the
amounts enjoyed by rival consumers.
» Goods that are rival in consumption are called private goods.
» It is also unfeasible to price units of a public good. This characteristic of public
goods, called non-exclusion, implies that it is too costly to develop a means of
excluding those who refuse to pay from enjoying the benefits of a given quantity of
a public good.
» A pure public good is non-rival in consumption for an entire population of
consumers, and its benefits have the characteristic of non-exclusion.
֎ A given quantity of a pure public good is consumed by all members of a
community as soon as it is produced for, or by, any one member.
» A pure private good is one that, after producers receive compensation for the full
opportunity costs of production, provides benefits only to the person who acquires
the good, and not to anyone else.
֎ A pure private good is rival in consumption, and its benefits are easily excluded
from those who choose not to pay its market price.
» Market exchange for pure private goods results in neither positive nor negative
externalities. A pure public good on the other hand results in widely consumed
external benefits to all people, even if made available only for one person.
» Pure public “bads” can also exist. These activities result in external costs affecting
a wide range of the population.
» The marginal cost of distributing a pure public
good to an additional consumer is zero for a
given amount of the public good.
֎ This follows from the non-rival
characteristic of pure public goods.
֎ (Refer to diagram A) The graph shows that
the marginal cost of allowing additional
people to consume certain amounts of a
pure public good falls to zero after the
good has been made available for any one
person. (Be careful not to confuse
distribution cost with production cost.)
֎ The marginal costs of accommodating an additional consumer will be zero for a
given quantity of a pure public good.
However, the marginal cost of
producing additional units of the
public good will be positive, as is
the case for all economic goods,
because increasing the quantity of a
pure public good requires
additional resources.
֎ This is illustrated in Figure B, where
we assume that the average cost of
a pure public good is constant

» Distinction between pure public goods and pure private goods:

֎ A pure public good is not divisible into units that can be apportioned among
consumers.
 A given quantity of a pure public good can only be shared rather than
enjoyed individually.
 Its benefits are collectively consumed by the entire population.
֎ A unit of a pure private good, on the other hand, can be enjoyed only by a single
consumer.
 The more units of a given amount available to be consumed by one person,
the less is available to rival consumers.

PROVISION OF PRIVATE GOODS AND PUBLIC GOODS

» Congestible public goods are those for which crowding or congestion reduces the
benefits to existing consumers when more consumers are accommodated.
֎ The marginal cost of accommodating an additional consumer is not zero after the
point of congestion is reached.
» Price-excludable public goods are those with benefits that can be priced. Private
clubs are often set up to share facilities, such as tennis courts, swimming pools, and
dining areas for small groups.
֎ Membership rights, which are sold in the market, are sometimes negotiable and
can be sold by their holders to others. By joining clubs and paying dues,
members share in the cost of facilities and services that they otherwise would be
unable to afford. Dues and limits on the number of members are determined by
collective agreement of existing members. The dues ration the facilities of the
club to avoid the effects of congestion. Other price-excludable public goods
include such public facilities as schools and hospitals. These goods can be priced,
but their provision results in positive externalities.
EFFICIENT OUTPUT OF A PURE PUBLIC GOOD

» Efficiency requires that all economic activities be undertaken up to the point that their
marginal social benefit is equated with their marginal social cost. This principle holds for
pure public goods as well.
» Suppose a person were to attempt to produce or purchase a pure public good for her own
use.
֎ By making a unit of the public good available in the community, this person will
generate benefits not only for herself but also for every other member of the community
in which she resides.
֎ The marginal social benefit of this good will be more than the extra benefit to its
purchaser.
֎ Additional benefits will accrue to each and every other person who will simultaneously
enjoy each unit made available.
֎ Summing up these benefits to all people in the community gives the marginal social
benefit for each extra unit of output produced.
֎ The marginal social benefit of any given amount of a pure public good is the sum of the
individual marginal benefits received by all consumers.
֎ The efficient quantity per time period of a pure public good corresponds to the point at
which output is increased so that the sum of the marginal benefits of consumers equals
the marginal social cost of the good. The efficiency conditions for a pure public good are
MSB = ΣMB = MSC
» Market sale of a pure public good for individual purchase would generate wide-ranging
positive externalities, because a purchaser of the good would consider only his marginal
benefit in deciding how much to buy.
֎ The marginal external benefit would be the sum of the marginal benefits to all other
consumers. When individual buyers do not take the marginal external benefit into
account, sale of the good to individuals in a market is likely to result in less than the
efficient annual quantity. A pure private good has no external benefits of additional
production. In evaluating the benefit of extra production, it is necessary to count only
the benefit received by the individual who actually purchases and consumes the extra
output. The efficiency conditions for a pure public good can also be written as

֎ The production of a pure public good

generates external benefits that are positively valued by all members of a community.
» Efficiency requires that the production of pure public goods be undertaken to the point
where the sum of the marginal private benefits is exactly equal to the marginal social cost
of production.
֎ Market supply of public goods for individual purchase is likely to be inefficient.
  This result from the positive externalities associated with market provision of such
goods.
» People often attempt to consume the benefits of others’ purchases of pure public goods
while bearing no costs themselves. These people try to become free riders.
֎ A free rider is a person who seeks to enjoy the benefits of a public good without
contributing anything to the cost of financing the amount made available. The free-rider
problem stems from the incentive people have to enjoy the external benefits financed by
others, with no cost to themselves. Free riding can be a reasonable strategy for any one
individual, provided that no penalty exists and that only a few individuals choose the
strategy.
» Ideally, an efficient output of a pure public good could be achieved if each person
contributed an amount equal to the marginal benefits received per unit of a public good.
This is known as the Lindahl equilibrium.
֎ The voluntary contribution per unit of the public good of each member of the
community equals her marginal benefit of the public good at the efficient level of
output. These equilibrium contributions per unit of the public good are sometimes called
Lindahl prices.
֎ However, problems in inducing households to reveal their true preferences for public
goods resulting from free-rider effects make this solution difficult to implement.
» In actuality, many goods and services fall between the extremes of pure public goods and
pure private goods. In evaluating the alternatives of government and market supply for
intermediate cases, the external benefits of the good and the efficiency of alternative
methods of exclusion have to be considered.