Topic 1

Externalities and Public Goods

Matthew H. Shapiro
ECON 251: Microeconomics 2

Singapore Management University

Outline

1. Preliminaries: Social Planner’s Problem

2. Externalities

3. Restoring Social Surplus under Externalities

4. Non-Private Goods

5. Wrapping Up

1
Main Questions

• What are externalities and public goods?

• How does optimal production under these conditions compare to

what the market delivers?

• How large is the cost of not correcting these issues?

• What mechanisms can correct for them?

2
Preliminaries: Social Planner’s
Problem
Recap: First Welfare Theorem

First Welfare Theorem

The perfectly competitive equilibrium allocation is Pareto optimal, if
there are no externalities

• All the pieces we will break over the semester are in red

• Obviously, we start by breaking the “no externalities” component

• The “three principles of efficiency” gave us some idea how the

perfectly competitive market yields Pareto optimality

• They can also help intuitively understand what “goes wrong”

• The “social planner’s problem” is another tool we will use

3
Introducing the “Social Planner’s Problem”

• The social planner is like a benevolent dictator who just wants to

maximize total surplus in the market

• By definition, this dictator’s plan maximizes welfare (when we can

measure it by surplus)
• What are the pieces of the surplus in the market?

1. Consumer surplus

2. Producer surplus (profits)

3. Government surplus? (e.g. tax revenue)

4. Anybody else affected positively or negatively by transactions

• We have so far lived in a world with only (1) and (2)

4
Introducing the Social Planner’s Problem

• For now let’s just consider a world with jut CS and PS

• As a dictator, the planner can just set quantity consumed and

produced without prices

• But, it does not not care about prices anyway. Why not?

• We will see this mathematically shortly

• Forewarning, you won’t be tested on this generic setting to follow;

it will help check answers for simpler settings

5
Social Planner’s Problem: Simple Setting

• Supply is summarized by C(q),

a total cost function
• Demand is linear and
summarized by P(q) = A − bq

• Consumer welfare is then

R
CS(q) = 0q P(x)dx − qP(q)
Rq
• 0 P(x)dx is their utility (all
the area under P(q))

• qP(q) is what they pay

• So we have “the CS triangle”

• Profits (producer surplus) are

π (q) = qP(q) − C(q)
6
Social Planner’s Problem: The Problem

• The planner wants to set q to maximize CS + PS

Z q
max CS(q) + π (q) = max P(x)dx − qP(q) + qP(q) − C(q)
q q 0
• Notice this simplifies and price terms drops out
Z q
max P(x)dx − C(q)
q 0
• This looks more doable once we replace that integral …
Z q
max (A − bx)dx − C(q)
q 0
• The following holds for any standard setting in class with CS plus
PS (so a good problem check)
 
 b 
max 
 Aq − q2 − C(q) 
q
| {z2 } | {z } 
Total Costs
Total Consumer Utility 7
Social Planner’s Problem Solution

• Solving the problem is easy now

 
b 2
max Aq − q − C(q)
q 2

• The first order condition is

0 = A − bq∗ − C′ (q∗ )

where C′ (q) is marginal cost

• Oh! A − bq∗ is just P(q∗ )!

• So we have P(q∗ ) = C′ (q∗ )!!!

• Why is this significant…

8
Social Planner’s Problem Recap

• The planner, to maximize surplus, would set a quantity so the

marginal benefit (WTP or P(·)) at q∗ is exactly marginal cost

• This is precisely principle 3

• It also shows why the competitive equilibrium maximizes surplus

even without the dictator

• Price acts as the mechanism to arrive at the same quantity

• We will revisit dear dictator as we introduce market imperfections

9
Externalities
Introduction to Externalities

• Consider the market for durian

• Key actors are clearly consumers / fanatics and suppliers

• Who else is affected by transactions in this market?

• Humans with functioning noses within a kilo

• Potentially surrounding businesses

• If these other parties are affected but have no influence over the
goings-on of this market, this might raise an externality

• If the durian affects sales of the durian vendor’s other fruits,

does this impose an externality?

10
Externalities

Externality
A cost imposed on or benefit accrued by an actor not part of the
decision or transaction that led to that cost or benefit

From that definition is logically born two types of externalities

• Positive Externality: An externality in which the other parties

receive a benefit

• Negative Externality: An externality in which a cost is imposed on

other parties

• Aside: Markets with strategic play – one firm’s actions impact

another’s outcomes – feature externalities, though often not
talked about in those terms

11
Positive Externalities

Examples of positive externalities?

• Nice looking condo exterior

• Wearing perfume/cologne (in

moderation)

• Research

• Using a Mac

Outer Home Care Matters

12
Negative Externalities

Examples of negative externalities?

• Smoking

• Misnaming yourself on
Discord

• Driving cars

• Dirty production

13
Readings Discussion

13
Questions to Consider

Each group will be assigned one of the readings.

Please take clean notes as you discuss the following:

1. Who are the actors in this market?

2. What costs or benefits do these actors specifically not internalize

(or perhaps do not fully internalize)?

3. How does the proposed regulation help address this problem?

4. What issues arise from the proposed regulation either from its
execution or as a solution to the problem you identified in 2)?

14
The Social Cost of Externalities

14
Breaking the First Welfare Theorem (FWT)

• Somehow externalities will cause problems with the FWT

• I.e. the link between the competitive equilibrium outcome and

the outcome that maximizes surplus will break down

• We can use the principles of efficiency to understand the source

of the breakdown

• What principle of efficiency fails with an externality?

15
Breaking the First Welfare Theorem (FWT)

• The failure comes from Principle 3 (the marginal benefit of the last unit
consumed equals its marginal cost)

• Our recap definition neglected to note the principle requires marginal

social benefit (MSB) and marginal social cost (MSC) be equal
• MPB: marginal utility (read from inverse demand)
• MSB: MPB + any marginal external benefits (MEB), e.g. happiness
from looking at a Mac
• MPC: marginal supplier costs
• MSC: MPB + any marginal external costs (MEC), e.g. pollution

• Why might the competitive market equilibrium fail this principle?

• At this equilibrium we only have that marginal private benefit (MPB)

equals marginal private cost (MPC)
16
Taking Stock: Breaking the FWT

(1) The competitive equilibrium allocation satisfies MPB = MPC

(2) Efficiency requires MSB = MSC

• Without externalities MEC, MEB = 0, so MPB = MSB and

MPC = MSC

• Hence both (1) and (2) are satisfied in the competitive

equilibrium without externalities

• With externalities, MEC > 0 and/or MEB > 0 so there is now a

wedge between MSC and MSB in the competitive equilibrium

• Hence the competitive allocation will likely not be efficient

17
Modeling Generic Externalities: Setting

• We model this setting formally to measure the externality losses

• Let’s keep the setting from before
• Demand: P(q) = A − bq

• Supply: π (q) = qP(q) − cq, note c is marginal cost now

• Note: this is a firm with constant marginal costs

• We will introduce “external surplus” (ES(q)) and marginal

external surplus (MES(q) = ES′ (q))
• These are functions of total quantity sold q

• If the net external surplus is negative we can think of it like a

negative externality; if positive, a positive externality

• For now assume MES(q) is some constant τ

18
Modeling Generic Externalities: Competitive Equilibrium

• We can skip to the conclusion from recap lecture that p∗ = c

(equilibrium price equals marginal cost, or MPB = MPC)

• We can also find the equilibrium quantity q∗

P(q∗ ) = A − bq∗ = c
A−c
=⇒ q∗ =
b
• We will save looking at total surplus for numerical examples

• We will compare q∗ to the surplus-maximizing (“optimal”) q

19
Modeling Generic Externalities: Social Planner Problem

• We can find the quantity that maximizes surplus by solving the

social planner’s problem

• It’s like before with one exception

• The planner wants to set q to maximize PS + CS + ES

max CS(q) + π (q) + ES(q)

q

• Everything simplifes similar to the non-externality case

 
 b 
max 
 Aq − q2 − cq + ES(q) 

q
| {z2 } |{z} | {z }
Total Costs External Surplus
Total Consumer Utility

20
Modeling Generic Externalities: Social Planner Problem

• Solving the problem as before

 
b 2
max Aq − q − cq + ES(q)
q 2
• The first order condition is
c +τ
0 = A − bq̃ − |{z}
| {z }
MPB MPC

remember τ is standing in for constant MES

• This shows why MSB = MSC is a condition for optimality
• Note if τ > 0, it is a benefit so MSB = A − bq + τ and MSC = c
• If τ < 0, MSB = A − bq and MSC = c + τ

• The surplus-maximizing quantity is thus

A−c+τ
q̃ =
b 21
Competitive and Optimal Quantity

• We can compare the competitive equilibrium q∗ and the optimal q̃

A−c+τ A−c
q̃ = ⪌ = q∗
b b
• If τ > 0 then q̃ > q∗ , and the opposite if τ < 0
• This matches up with some intuition
• If τ > 0, the external surplus is positive so society gains something
extra from the market
• The competitive market doesn’t account for this — who would pay
for the extra benefit? — so underproduces relative to optimum
• If τ < 0, the external surplus is negative
• In this case q∗ > q̃ so the market overproduces

• We will use numerical examples to look at the market’s cost to

total surplus, e.g. deadweight loss 22
Modeling Externalities: Negative Example

Matt’s Private Smokehouse

Matt has (likely illegally) started a Southern BBQ smokehouse in his
apartment, and it has started to get some attention by customers. It
is also starting to get some attention from his neighbors who dislike
suffocating in the smoke exhaust.

Demand for Matt’s BBQ is captured by P(q) = 100 − q. Matt produces

this meat at a constant marginal cost of c = 20. His neighbors
posted an angry letter on his door explaining that they face a
constant marginal external surplus of τ = −5. Find

1. The competitive equilibrium quantity and total surplus.

2. The optimal (surplus maximizing) quantity and associated total

surplus.
23
Negative Example: Solution

Matt’s Private Smokehouse

1 Importantly, the external surplus is irrelevant for the competitive
equilibrium.

1 The competitive equilibrium quantity is whatever sets P(q∗ ) = c

1 Hence we have
100 − q∗ = 20

1 Thus q∗ = 80

24
Negative Example: Solution

Matt’s Private Smokehouse

1 Total surplus is π (q∗ ) + CS(q∗ ) . . . PLUS τ q∗ , the externality

1 You should find π (q∗ ) = (P(q∗ ) − c)q∗ = 0

1 Consumer surplus can be found by the “triangle method”

CS(q∗ ) = .5 ∗ (100 − P(q∗ ))q∗ = .5 ∗ (100 − 20) ∗ 80 = 3200

1 The external surplus is τ ∗ q∗ = −5 ∗ 80 = −400

1 Hence total surplus is 0 + 3200 − 400 = 2800

25
Negative Example: Solution

Matt’s Private Smokehouse

2 To solve for the optimum (the planner’s problem), one can jump
ahead to finding the q where MSC = MSB

2 Just make sure to add the absolute value of MES to benefits side
if the external surplus is positive or to costs if negative

2 An alternative is to solve the planner’s problem directly

Z q
max (100 − x)dx − 20q − 5q = max[100q − q2 /2 − 25q]
q 0 q

note I’ve already simplified this a bit by cancelling out the

transfer from consumers to firms

26
Negative Example: Solution

Matt’s Private Smokehouse

2 The first-order condition of that problem is

0 = 100 − q̃ − 25

so q̃, the social optimum, is 75

2 Notice this is lower than the equilibrium quantity 80, which we

would predict since the externality is negative

2 Find total surplus by plugging q̃ back into the planner’s problem

2 Total surplus is 2812.5, higher than in the competitive equilibrium

2 The difference in the two surpluses (2812.5 − 2800 = 12.5) is the

deadweight loss
27
Negative Example: Graphical Illustration

Figure 1: Market Outcome, - Externality

• The dotted area is the total
negative externality accrued
from consuming q∗
• If consumption were q̃

• CS would be smaller;

• But costs would be lower

• Plus the loss from the ES

recovered would outweigh
the CS loss

28
Modeling Externalities: Positive Example

Matt’s Gallery of Old Macs

Matt has collected generations of old Macs to start a public gallery.
Even though paying visitors are few, some research suggests there is
an extra benefit to society by exposing people to Macs.
The number of visitors willing to enter the gallery at ticket price p is
captured by D(p) = 50 − 1/2p. Every visitor brings in some dust that
must has to clean at a constant cost of c = 10 per visitor. The
societal benefits accrued from more visits diminishes with more
visitors so MES(q) = 20 − .4q. Find

1. The competitive equilibrium quantity and total surplus.

2. The optimal (surplus maximizing) quantity and associated total

surplus.

29
Positive Example: Solution

Matt’s Gallery of Old Macs

• This problem is similar to the previous one except that
MES(q) > 0 for relevant q and not constant

1 Find the competitive equilibrium quantity by finding q∗ so

P(q∗ ) = c

1 Note that demand was given, not inverse demand so first find
P(q) = 100 − 2q

1 Hence we have
100 − 2q∗ = 10

1 Thus q∗ = 45

30
Positive Example: Solution

Matt’s Gallery of Old Macs

1 Profit is still 0 π (q∗ ) = (P(q∗ ) − c)q∗ = 0

1 Consumer surplus can also be found by the “integral method”

Z q∗
∗
CS(q ) = (100 − 2x)dx − q∗ P(q∗ ) = 100q∗ − (q∗ )2 − 10q∗ = 2025
0
R q∗
1 The external surplus is 0 (20 − 25 x)dx = 20q∗ − 15 (q∗ )2 = 495

1 Note this requires integration (or a geometric area method)

because MES is not constant

1 Hence total surplus is 0 + 2025 + 495 = 2520

31
Positive Example: Solution

Matt’s Gallery of Old Macs

2 To solve for the planner’s problem, this time I jump ahead to
finding the q where MSC = MSB

2 Because MES > 0, I need to count it on the benefit side

2 MSC(q) is just the marginal cost of production ($10)

2 MSB(q) is P(q) (private benefit) plus MES(q)

2 Hence the socially optimal q̃ solves

10 = 100 − 2q̃ + 20 − .4q̃

2 So q̃ ≈ 45.83

2 Note this is higher than the market equilibrium quantity

32
Positive Example: Solution

Matt’s Gallery of Old Macs

2 We didn’t write the planner’s problem this time, but we still need
to calculate total surplus

2 Check that you can find its components

2 Consumer utility (without payment): ≈ 2482.6

2 Private production costs: ≈ −458.3

2 External surplus: ≈ 496.53

2 Total surplus is their sum or 2520.83, (barely) higher than in the

competitive equilibrium

2 The difference in the two surpluses (2520.83 − 2520 = 0.83) is the

HUGE deadweight loss
33
Positive Example: Graphical Illustration

Figure 2: Market Outcome, + Externality

• The dotted area is the extra

positive externality accrued
from consuming q∗
• If consumption were q̃

• Costs would be higher;

• But CS would be larger

• Plut the gain from the extra

ES would outweigh it

34
Final Note: Deadweight Loss

• Regardless of whether the externality is positive or negative, we

see that the competitive market fails to maximize total surplus
Deadweight Loss
The difference between what the total surplus the market delivers
and the optimal surplus

• This is surplus that could exist but does not

• There is some benefit to market participation that is tossed away

• Correcting externalities is an important theoretical and empirical

task

• Ideally we can redistribute that potential surplus to market

participants or others
35
Restoring Social Surplus under
Externalities
Internalizing Externalities

• To recap: the market “imperfection” caused by externalities is the

difference between social and private surplus

• One way to correct the imperfection is to force actors in the

market to internalize the externality

• That is, they consider the external surplus in their decision(s)

• What are some examples of markets with externalities and
mechanisms to internalize them?
• Pollution: emissions taxes

• Education: low-interest loans, student grants

• Bathing: social stigmas

• Vehicle wear and tear on roads: gasoline taxes (in the US)
36
Pigouvian Intervention

Pigouvian Interventions
Taxes or subsidies imposed on behavior / transactions with
externalities. The goal is typically to target the socially optimal level.

• If MES < 0 (neg. externality), obviously a tax should be imposed

• Remember the competitive market will, without intervention,

yield a quantity where MPC(q) = MPB(q)

• A tax T per unit should be set so q satisfies MSC(q) = MSB(q)

• Easy case: if MES is constant, then T should be the size of MES

• The actors internalize the external cost by having the tax per unit
(of the same size) imposed on them

• The logic follows for positive externalities as well, but with a

37
subsidy S instead
Not-So-Pop Quiz

37
Exercise: Pigouvian Subsidy Part 2

Econ Major Night Door Charges

A local club wants to buck the trend of “Ladies’ Nights” with a special “Econ
Majors’ Night.” The market for these fine folk has settled on a door charge
of around $5. This club understands that there is positive externality from
hanging with econ majors. Their research finds the following:

• Econ majors’ demand: P(q) = 200 − q, where q is number of people

• The marginal external surplus to other club goers MES(q) = 20 − .1q
(diminishing social returns to hanging with economists)

Assume the club’s costs are a constant $5 per customer. Answer the
following:

• Assume the club only cares about maximizing total surplus for now
(playing the good social planner). What subsidy (reduction in price to
consumers) would they set to maximize surplus?
38
Solution: Pigouvian Subsidy Part 2

Econ Major Night Door Charges

• We are already half way to answering the question

• In the in-class quiz, we already found the optimal number of

econ majors and we know the price

• Suppose the optimal level is q̃

• Set the subsidy S so D(P − S) = q̃, i.e. lower price enough so the
majors’ demand is at the right level (around .45 in this case)

• Notice the effect of the subsidy is to shift the inverse demand

curve right (at any P, demand is higher because of the subsidy)

39
Solving for the Pigouvian Subsidy

• Because price is fixed by constant marginal cost, this question

was quite easy
• If it were not, the process would need a slight adjustment

• Find q̃ where MSC(q) = MSB(q)

• The size of the subsidy should be equal to MES(q̃)

• That is we — the government ? — throws in an extra benefit exactly

equal to the part not internalized by the players in the market

• The same logic applies for a negative externality and the size of
the tax (except tax raises price) to maximize surplus

• Note: In imperfectly competitive environments, the effect of the

subsidy would change the firm’s behavior too

40
Welfare with a Subsidy / Tax

1/2 All the standards components — CS and PS — remain

1/2 Just remember that the subsidy / tax means the price firms get
and consumers pay is different by the subsidy / tax

3 We also have to include the the ES, if there is an externality

4 Finally, we have to account for the tax or subsidy
• Tax revenues are a positive transfer to (typically) gov’t

• Subsidy costs are a negative

• If you calculated everything correctly, this surplus should the

social planner’s maximum as well

• Remember the goal of all of this was to implement the planner’s

optimum with a tax or subsidy
41
Welfare Exmaple: Pigouvian Subsidy Part 2

Econ Major Night Door Charges

• Back in the night club, we can test our calculation of welfare
when q̃ ≈ 195.45 as we found
R 195.45
• CS: 0 (200 − q)dq − (4.55 ∗ 195.45) ≈ 19100.35 benefit

• Notice how the price paid is 5 less the subsidy we found .45

• PS: 0 as costs are 5 as is the price it gets

R 195.45
• ES: 0 (20 − .1q)dq ≈ 1998.96 benefit

• Total Subsidy: An additional S ∗ q = .45 ∗ 195.45 ≈ 87.95 cost

• TS here is CS + PS + ES − subsidy = 21011.36

• This is slightly higher than the unregulated market’s TS if you

calculate that
42
Command and Control

• Pigouvian taxes are not the only “market correction” options

• A more extreme option is to set the number of transactions

• For (-) externalities, the government might use quotas

• Binding quotas, e.g. if quota q̄ < q∗ , the market quantity,
introduce their own welfare problems
• Binding quotas can introduce supply rationing issues

• The WTP of consumers at q̄ will be higher than marginal cost

=⇒ The market could produce more than the government allows it

• E.g. 2 units to be produced, 2 firms have costs below P(q̄) but only
one could with costs below P(q∗ )

• If the less efficient firm produces this violates principal 2

43
Command and Control

• What are potential positives of command and control

interventions?
• The incentive to innovate around the regulation is high (perhaps
more than a tax would be)
• If negative externalities are huge, e.g. nuclear radiation or
hexavalent chromium, this system is easier to guarantee safe limits
• Pigouvian taxes requires understanding how markets will respond
to the price intervention

• What are some examples?

• Vehicle pollution: emissions standards
• Local fishing: number of catches allowed
• Are there markets with positive externalities with this type of
intervention?
44
Cap and Trade

• Somewhere in between these interventions is cap and trade

• The intervention has three distinct components
1 Set a quota (similar to command and control)

2 Assign quota rights to different participants

3 Allow participants to trade for those quota rights

• The secondary market ensures principles 1/2 are satisfied, why?

• See supplemental notes for more details

• An auction is a common means to assign initial quota rights

• What are some examples?
• Vehicle congestion: COE (in Singapore)

• Sulfur dioxide: US SO2 trading market (see book case study) 45

Cap and Trade

• The SO2 trading market was highly successful

• Cap and trade comes with its own pros and cons
- Initial allocation of permits

+ No need to have a knowledge of the market; the trading provides

the correction

+ Potential market-like solution to deal with pitfalls of command

and control when needed
46
- Overcorrection if MES is small relative to market value
Non-Government Intervention

• Because the unregulated market introduced the surplus loss, our

interventions have required some government or third party

• It’s possible the private market could address externalities

• Back to the durian market, how could I get vendors to internalize
the cost imposed on me by the smell?

• One option is to create a market for air free gasoline smells

• If I get control, I charge the vendors for the right to pollute my air

47
Coase Theorem

• The issue with the vendors in the original market was unclear
rights over durian-free air

• The Coase theorem states how property rights can address the
original efficiency loss
Coase Theorem
In the absence of transaction costs and clear assignment of
property rights, bargaining over the use of the property will lead to
an efficient outcome

• Note: You will see an application in your homework

• Other than in the durian market, what are other externalities that
could be captured through the assignment of property rights?

48
Issues with Coasian Solutions

• Assigning property rights: the initial owner has a distributive

advantage in negotations
• Holdout problems: a common example is redeveloping property
in condos

• If all owners want to sell, one person can override the will others

• Legal requirements often make thresholds lower to prevent this

• Transaction Costs: the theory requires no transaction costs, in

reality what are among the many bargaining frictions?

• What other issues does reality present for the theorem?

49
Which Intervention is Best?

49
Non-Private Goods
Rivalry and Excludability

Access to and usage of goods are characterized along two dimensions

• Rivalry: a good is rivalrous if one person’s consumption

precludes another person enjoying the same product

• Excludability: a good is excludable if people can be stopped from

consuming it

• We will shortly see how this relates to externalities

What are examples of nonrivalrous goods? Non-excludable?

50
Rival Goods
Rivalrous
• Macbooks

• Pie

• Prof’s attention

• Clean air

Non-rivalrous
• National defense

• Civil alarm

• Large parks

• Your data
51
Excludable Goods

Excludable
• Most food

• Parks

• SupremeTM merchandise

Non-excludable
• Air

• Roads (mostly)

• International water fish stocks

52
Summary

• The combination of these characteristics yield a common

taxonomy for goods, listed in the table below

• We typically deal with private goods

• Club goods are occasionally called “artificially scarce”

• Common pool resources and public goods both feature

interesting economics related to externalities

Rival Non-rival
Excludable Private Goods Club Goods
Non-Excludable Common Pool Resources Public Goods

53
Common Pool Resources

Common Pool Resources

Goods or resources that are non-excludable yet rivalrous. See also
common property

• Specific examples include

• Roads (rivalrous from congestion)

• Fisheries (rivalrous from overfishing)

• Congestion and overfishing are two examples of negative

externalities born from markets with common pool resources

54
Common Pool Resources and Maximizing Welfare

• The FWT underlies strong normative support for the “free market”

• The story follows that everyone acting in their own best interest
can still generate the highest surplus for society

• Ignoring distributive issues we know have a set of circumstances

where this story would not hold

• A vivid example is the tragedy of the commmons related to

common pool resources

55
Tragedy of the Commons

Description

• Everyone uses the resource as needed

• The impact of that usage on the availability of that resource for

everyone else is a negative externality

• The negative externality suggests people tend to overuse the

resource relative to the optimum

Solutions

• As these goods are non-excludable, it is hard to curb overusage

• Innovations that allow pricing of these resources help, e.g. ERP

system in Singapore, fishing article you read

56
Public Goods

Public Goods
Goods or resources that are non-excludable and non-rivalrous

• Because goods are non-rivalrous, the challenges are different

than with common pool resources

• E.g. Me being protected by the military does not (mostly)

diminish other citizens’ protection
• Two key sets of questions emerge:
• What level of the public good is optimal to provide?

• How do we pay for it?

• Similar questions were asked when correcting externalities, also

a situation when the market cannot provide the good optimally
57
Optimal Provision of Public Goods

• Although the product in question is public, the intuition of

efficient provision is unchanged

• The social planner will provide the good where the MSB = MSC
• The difference is in how to measure MSB

• Suppose 1 unit of defense is provided, what is the MSB?

• I accrue some marginal utility

• Everyone gains something from this unit provided, unlike with

private goods, and that benefit must be added up

58
Optimal Provision of Public Goods

• Suppose we have N people in our country with inverse demands

Pi (q) = Ai − bi q
where i is for the ith person

• q is this public good, hence the same for everyone

• The MSB is the sum of these inverse demands

N
MSB(q) = ∑ max{Pi (q), 0}
i=1
where “max” ensures no marginal benefit falls below 0

• If MSC(q) is the cost of providing q units, the social planner will

set an optimal q̃ to satisfy
MSC(q̃) = MSB(q̃)
59
• To actually solve this, we can look at a two-person case
Exercise

Matt’s Radio Broadcast Econ Lessons

Matt has decided to take some econ lessons to the public airwaves.
Doing so is not costless to him, however. Every hour of a lesson he
provides costs him $40. Meanwhile he has identified two (D:)
potential consumers of the show with marginal benefits over the
consumption of the show summarized by

1. P1 (q) = 100 − q
2. P2 (q) = 200 − q

Find the following

1. The optimal level of q

2. The total surplus if that q is provided

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Solution

Matt’s Radio Broadcast Econ Lessons

1 Keep in mind the goal is to set MSC(q) = MSB(q)

1 The only cost is Matt’s private marginal cost so MSC(q) = 40

1 To get MSB(q) we need to add the marginal benefit curves

(inverse demand functions) of the two problems

1 Adding P1 (q) to P2 (q) creates a “kinky inverse demand”

1 It arises because we do not the “negative” parts of the inverse

demand curve

IMPORTANT: This is NOT the same problem as summing over

demand functions. See math review notes if it is unclear why the
sum of demand is not the same as the sum of inverse demand.
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Solution

Matt’s Radio Broadcast Econ Lessons

1 Call the sum of the inverse demands PA (q) (also MSB(q))

1 PA (q) = max{0, P1 (q)} + max{0, P2 (q)}

1 This generates a piecewise function


 if q > 200
0

MSB(q) = PA (q) = 200 − q if 200 ≥ q > 100



300 − 2q if 100 ≥ q ≥ 0

1 The bounds are found by figuring out where the smaller inverse
demand curve hits 0

1 Here P1 (q) = 100 − q is smaller and hits 0 at q = 100

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Solution

Matt’s Radio Broadcast Econ Lessons

1 With MSB(q) in hand, we need to check where it intersects
MSC(q) for both of the segments

1 One solution will violate the constraints; the other is the right
answer

1 Solution for q ∈ (100, 200]

200 − q = 40 =⇒ q = 160

1 Solution for q < 100

300 − 2q = 40 =⇒ q = 130

1 The second one violates the constraint, so the right solution is

the first, i.e. q̃ = 160 63
Solution

Matt’s Radio Broadcast Econ Lessons

Figure 3: MSC, MSB Graphically • Notice that cost crosses twice

• The red line is the MB Curve

• The dotted areas are where

the pieces of our curve extend
beyond bounds

• There is only one place where

the MB Curve intersects MC,
q = 160

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Solution

Matt’s Radio Broadcast Econ Lessons

2 To calculate total surplus we simply need to add up the CS of the
two consumers and subtract Matt’s costs
2 Note that the “triangle” method to calculate CS will not work as
the quantity is not determined by a price
2 Either use the integral method (as I will here) or add up the
shapes under the inverse demand curves up to the q̃
2 The tricky part is here is to remember not to let P(q) < 0, which
P1 (q) would for q > 100
R 160 R 100
2 CS1 (q = 160) = 0 max{0, 100 − x}dx = 0 (100 − x)dx = 5000
R 160
2 CS2 (q = 160) = 0 max{0, 200 − x}dx = 19200
2 Costs are 40 ∗ q̃ = 6400
2 So total surplus is 5000 + 19200 − 6400 = 17800 65
The Free Rider Problem

• Now that an optimum is found, the next issue is actually

providing it

• Would these listeners pay to have the radio station?

• I might wonder whether the other person will pay

• Since I cannot be excluded and the other person’s consumption

does not hurt my own, why bother paying if he will?

• With two of us, we might coordinate

• With many more people, this coordination becomes difficult

• People who benefit from the provision of public goods without

paying for them are free riders

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The Free Rider Problem

• Private provision of public goods is difficult because of free riders

• The problem increases as each individual’s benefit is small but

aggregate gains are large (think defense)

• One solution is for the government to provide these goods and

charge a tax to everyone

• An elegant solution beyond the scope of this class is the

Groves-Clark tax to figure out the optimal tax to charge people
who will benefit from the project

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Wrapping Up
Review

Externalities
• Behavior or transactions that affect other parties are externalities

• Markets with externalities may not be Pareto efficient when the

costs/benefits are not internalized by its actors

• These externalities also commonly arise with non-private goods,

such as common pool resources

Welfare Implications
• Because externalities can create deadweight losses, correction is
valuable to redistribute that lost surplus

• We covered many forms of correction, including Pigouvian taxes /

subsidies and quota & trade programs
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Preview

• Begin our study of markets with imperfect competition structures

• Monopoly

• Monopsony

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