Externalities 

and Public 
Goods
Sessions 19, 20
 In “An Inquiry into the Nature and Causes of the 
Wealth of Nations”, Adam Smith wrote thus in 1776:

• Does every individual necessarily labour to render the

annual revenue of the society as great as he can?
• Indeed, he neither intends to promote the public
interest, nor knows how much he is promoting it
• By his industry he intends only his own security; and
by directing that industry in such a manner as its
produce may be of the greatest value, he intends only
his own gain
 In “An Inquiry into the Nature and Causes of the 
Wealth of Nations”, Adam Smith wrote thus in 1776:

• And in this, he is led by an invisible hand to promote

an end which was no part of his intention
• By pursuing his own interest he frequently promotes
that of the society more effectually than when he
really intends to promote it
 The Fundamental Theorem of Welfare Economics

• If an economy satisfies the following properties:

– all goods are private goods and there is no externality
– all market participants have symmetric information about
the value of every trade (there might be symmetric
uncertainty),
– markets for all goods and services that consumers value
currently and in the future exist and are complete at all
points in time,
– and all markets are perfectly competitive,
 The Fundamental Theorem of Welfare Economics

• then the “general free-market equilibrium” is

efficient and Pareto optimal – i.e., there is no waste,
and no individual’s welfare can be improved without
reducing the welfare of some other individual(s)

• This is the formal statement of Adam Smith’s insight

into the “invisible hand” of laissez-faire
 The Import of the theorem

• The theorem delineates specific reasons why a free-

market equilibrium in any “real economy” will not be
efficient
- Every economy has public goods and externalities
- In many exchanges (credit, insurance, etc.), the different
parties have asymmetric information about the value of
trade
- All markets do not exist (mainly for the above reasons)
- All markets that exist are not perfectly competitive;
markets with large “entry costs” will have few firms
with market power
 The Import of the theorem

• These “market failures”, along with “issues of equity

and fairness”, (should) constitute the main economic
justifications for government intervention in markets

- be that the market for “rule of law” and “individual

safety”

- be that the market for an “essential commodity”…

 Quick Summary

• Markets may fail for various reasons to deliver the

socially optimal outcome:

• Externalities

• Public goods

• Imperfect competition

• Asymmetric information
 Externalities

• An externality is a non-priced side-effect (by-

product) of any activity by an individual or a
collective entity
• Negative
– Action by one party imposes a cost on another
party
• Positive
– Action by one party benefits another party

• In both cases, someone’s consumption or production

hurts or helps others outside a market
 External Cost

• Scenario

• Steel plant dumping waste in a river

• The entire steel market effluent can be reduced by
lowering output
• Marginal External Cost (MEC) is the cost imposed on
fishermen downstream for each level of production
• Marginal Social Cost (MSC) is MC plus MEC
 External Cost

When there are

negative
externalities, the
marginal social cost
MSC is higher than
the marginal cost
MC

The difference is the

marginal external
cost MEC
 External Cost

The industry
competitive output is
Q1 while the
efficient level is Q*

The shaded triangle

is the aggregate
social cost of
negative externality
 Externalities

• Positive Externalities and Inefficiency

• Externalities can also result in too little production, as

can be shown in an example of home repair and
landscaping.
External Benefits
 Public Goods and Externality

• Consider the following set of goods and services:

Electricity, Education, Digitized Music,
TV Signal, Road Infrastructure, Lighthouse
• These (and all) goods differ in their extent of rivalry
and excludability in consumption
• A good is fully non-rival if at any production level,
opportunity cost of providing it to an additional
consumer is zero
 Public Goods and Externality

• A good is fully non-excludable if it is impossible to

exclude a consumer from accessing the good once it
is provided
• A pure public good is fully non-rival and fully non-
excludable (national defense, absence of various
kinds of pollution)
• Many goods are predominantly non-rival but
excludable
(all digitized entertainment, national parks,
knowledge)
 Provision of Public Goods

• Market supply of a “pure public good” is highly

limited, as the free rider problem precludes the
possibility of charging a positive price to anyone who
consumes the good
• However, there are historical examples of groups of
agents solving the free-rider problem through mutual
agreements
– conditioning ‘port access’ on contributions for building a
lighthouse
– ‘open source’ software programmes
 Provision of Public Goods

• There are many examples of market supply of

“excludable non-rival goods” - digitized entertainment,
TV signals, etc.
• But market solutions (even if competitive) might provide
too little of a non-rival good than is socially efficient
• For a non-rival good, social efficiency requires the sum of
marginal utility of all consumers to equal the marginal
cost
• Providing legal basis for excludability (patents,
Intellectual Property regimes, toll roads) might be the
“best practical option” of encouraging private supply of
non-rival goods
 “Pure” and “impure” public goods

• In a mall with TWENTY shops, the shops can avail

of a ‘pure public security system’ S that will give
each a benefit of 100
• But if S is “privately provided” at a price of 500, no
shop will individually buy it in a free-market
equilibrium
• Alternatively, consider the availability of a ‘quasi-
private security system’ X at a price of 81
 “Pure” and “impure” public goods

• If a shop buys X it gets a benefit of 100; while if it does

not buy X it gets a benefit of 5N when N of its neighbours
buy X
• In a free-market equilibrium, exactly FOUR shops will
buy X
• The shops which buy X will achieve a ‘net benefit’ of 19,
while the shops that do not buy X will achieve a ‘net
benefit’ of 20
• This market outcome is Pareto-dominated by the outcome
where all shops “contribute” 25 and buy S
• Are there “mechanisms” to achieve the Pareto-optimal
outcome?
 Externality & Inefficiency

• Consider the following actions and their side effects:

- A hotel beautifies the local park, but plays loud music at
night
- A firm builds a manufacturing plant in a depressed rural
community, but discharges effluents into the local lake
• An externality is a non-priced side-effect (by-product) of
any activity by an individual or a collective entity
• If side-effect is beneficial to well-being of other
consumers and/or producers, it is a positive externality (a
pure public good)
 Externality & Inefficiency

• If side-effect is detrimental to others’ well being, it is

a negative externality (a pure public bad)

• In a free-market equilibrium, there will be “too little”

/ “too much” private incentive to engage in actions
that create “positive”/“negative” externalities
 Negative Externality: Example

• Two students A and B, living in adjacent hostel

rooms, derive conflicting benefits from listening to
loud music

• UA = {[200D – D2] + coffee}, and UB = {[10,000 –

100D] + coffee},

where D = decibel level of the music, and coffee

costs Re.1/cup
 Negative Externality: Example

• Most likely outcome: A will play music at decibel

level 100 and B will suffer in silence

• How this problem can be resolved?

• Efficient outcome: A plays music at decibel level 50

(the outcome maximizes the sum of utilities of A and
B)
 Policy interventions

• Quantity ceilings: Announce a noise-limit of 50

decibels
• Pigouvian taxes (proposed by British economist
Arthur Pigou):
Require A to buy B 100 cups of coffee for every
decibel played
• Solving positive externality problems will require
“quantity floors” / “Pigouvian subsidies”
• Are there other “mechanisms” to solve externality
problems?
 A Permit Mechanism to correct externalities

• Distribute 100 “decibel permits” in any manner

between the two students, with provision that (i) they
can trade permits between them, and (ii) holding D
permits allows one to play maximum of D decibels
• In a free-trade equilibrium, A and B will each hold 50
permits (and A will “use” his permits) irrespective of
the initial permit allocation
• Because ‘marginal value’ of Dth permit is (200 – 2D)
for A and (100) for B
 A Permit Mechanism to correct externalities

• This result is a manifestation of the Coase Theorem

which states that under perfect information, free-
bargaining leads to efficient outcomes as long as initial
property rights are clearly defined (irrespective of how
equal or unequal the rights distribution is)
• A similar logic underlies the ‘emissions permit markets’:
• The idea is to achieve a limit on the aggregate emissions
level by different firms reducing their individual
emissions by different amounts according to their
privately known abatement costs
 “Public” Provision of Goods

• Reconsider the following set of goods and services:

Electricity, Education, Digitized Music,
TV Signal, Road Infrastructure, Lighthouse
• Some ‘private goods’ are publicly provided, while many
non-rival (but excludable) goods are privately provided
• There is large variation in the set of goods that are
publicly provided (i.e., provided by local, state, or
national govt.)
 “Public” Provision of Goods
• ‘Social welfare’ justifications for public provision of a
good:
a. ‘Public’ nature of the good and/or its positive externalities
b. Ethical requirement that the good should not be traded on
price
c. Fairness requirement that all should have access to the
good
d. ‘Natural monopoly’ cost structure in the production of the
good
• In many real-world scenarios, some of these reasons co-
exist with conflicting ‘efficiency and incentive’ reasons for
private provision
 Co‐existence of Public and Private Provision

• Deterioration of the “quality” of public provision

provides profitable space for private providers to enter –
education, health-care, public safety, electricity and water
supply etc.
• On the one hand, this can be a good thing as it can
supplement public provision and reduce “congestion
costs”
• But the phenomenon of the more affluent citizens “opting
out” of the “public system” can have serious negative
consequences
 Co‐existence of Public and Private Provision

• First, private supply may be inefficient precisely due to

‘public’ nature of the good, or its positive externalities, or
its natural monopoly cost structure
• Second, withdrawal of “citizens with voice” from the
public system can lead to further deterioration of the
quality of public supply
• Third, the introduction of private provision might itself
introduce “new” negative externalities into the system