LECTURE 3: PUBLIC GOODS AND

EXTERNALITIES

ECONOMICS 3D
ECO3DB3
MR JUGAL MAHABIR AND MR FRANK BANNOR
02 AUGUST 2022
 LEARNING OUTCOMES
• Distinguish between private, public, mixed and merit
goods
• Derive the conditions for optimal allocation of private
and public goods
• Explain why competitive markets fail to provide public
and mixed goods efficiently
• Distinguish between financing and production of public
goods and services
• Explain and identify the main types of externalities
• Explain the effects of positive and negative externalities
• Discuss policy options to correct for externalities

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 PRIVATE GOODS AND
COMPETITIVE MARKETS
• Competitive markets cannot supply all goods and
services efficiently
– Consumer should reveal preferences
– Signals guide decisions of producers
– Competition ensures production at minimum costs
• Mechanisms for demand revelation exists for private
goods
• Private goods
– Rivalry in consumption
– Excludability

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 EQUILIBRIUM OF A
PRIVATE GOOD

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 PURE PUBLIC GOOD
• Characteristics of a Pure Public Good
– Non-rival in consumption
• Marginal cost of adding consumers is zero
• Excluding consumers is pareto-inefficient
– Non-excludable
• Impossible to assign or enforce property rights
• Cost of excluding someone from using the good is very high
• Criteria is quite stringent
– Unlikely to have pure public goods in real world
• Technology is improving to ability to exclude

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 PURE PUBLIC GOOD
• Characteristics of a Pure Public Good
– Non-rival in consumption
• Marginal cost of adding consumers is zero
• Excluding consumers is pareto-inefficient
– Non-excludable
• Impossible to assign or enforce property rights
• Cost of excluding someone from using the good is very high
• Criteria is quite stringent
– Unlikely to have pure public goods in real world
• Technology is improving to ability to exclude

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 EQUILIBRIUM OF A
PURE PUBLIC GOOD

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 MARKET FOR PUBLIC GOODS
• Public goods are indivisible
• Non-excludability of public goods ensures that the quantity
supplied is available to all consumers
– Consumers are quantity takes
• Market demand is derived by adding the quasi-demand
curves vertically
– The prices they are willing to pay and not what they demand
• Consumers are price adjusters
– Price in this case indicates the value they place on the public good
• Lindahl price
– Each consumer pays a different price per unit of the
public good based on the respective tax share
– Equilibrium is achieved when consumers agree on their
respective tax shares
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 MARKET FOR PUBLIC GOODS
• Efficient allocation differs for public good
• Area below the demand curve is the sum of marginal
utilities
• Equilibrium is the sum of marginal utilities equal to
the marginal cost
– Sum of individual prices equal to marginal cost
– PxB+J = MCx = MUxB + MUxJ

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CHARACTERISTICS OF PRIVATE
AND PURE PUBLIC GOODS

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 SUPPLYING PUBLIC GOOD
• Efficient pricing by competitive markets is impossible as
equilibrium price cannot be determined
• Non-excludability creates incentive for free-riding
• Government provision of public goods improves on the
inefficient outcomes of markets
– Can use coercive powers to force payment
• Optimal provision requires price discrimination
– Cannot be determined as consumer preferences are not
revealed
• Public goods funded through a mandatory “tax price”
• Government production of public goods is not essential
but the funding of such goods is essential
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 MIXED GOODS
• Mixed goods and services
– Non-rival but excludable
• Club goods
– Rival but non-excludable
• Common pool resources
• Excludability of mixed goods is influenced by
technology
– Navigational aids
• Should the public or private sector supply these
goods?

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 MERIT GOODS
• Merit goods and services
– Excludable
– Supplied by public sector (national budget)
• Individual consumption of such goods has external
benefits to society
– Education
– Health care
• Paternalistic approach of government
– Seatbelt regulations

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 EXTERNALITIES
• External effects of consumption and production
• Positive externality
– The actions of an individual consumer or producer that
confers a benefit on another party free of charge
• Negative externality
– The actions of an individual consumer or producer that
imposes a cost on another party without compensation to
said party
• Technological vs pecuniary externalities

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 CLASSIFICATION OF
EXTERNALITIES
• Externalities drive a wedge between private benefits and
costs and social benefits and costs
• Market without externalities
– MPB = MSB
– MPC = MSC
• Negative production externality
– MEC>0 therefore MSC>MPC
• Positive production externality
– MEC<0 therefore MPC>MSC
• Negative consumption externality
– MEB<0 therefore MPB>MSB
• Positive consumption externality
– MEB>0 therefore MSB>MPB
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 EXTERNAL COSTS AND A
PIGOUVIAN TAX

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EXTERNAL BENEFITS AND A
PIGOUVIAN SUBSIDY

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 REGULATION AND EXTERNALITIES
• Direct regulation
• Restricting the quantities of “harmful” goods and
services
– “Bads”
• Command and control regulations
• Effectiveness is influenced by information
constraints
– Can government determine the socially optimal output
levels?

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 REGULATION AND EXTERNALITIES
• Creation of regulated markets
• Incentive-based options – cap and trade
programmes
– Tradeable pollution permits
– Subject to information constraints
– Is the level of pollution corresponding with the optimal
level of output?
– Cost and environmentally effective alternative to
command and control regulation
• Support for alternative markets and technologies

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 PROPERTY RIGHTS AND
EXTERNALITIES
• Coase
– Problems of externalities due to disputes about
ownership of resources
• Coase theorem
• Market incentives will generate mutually beneficial
exchange of property rights through which
externalities can be fully internalised, provided that
property rights are well defined and enforceable and
transaction costs are negligible
– Important role of transaction costs

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 GLOBAL PUBLIC AND
MERIT GOODS
• Joint responsibility of neighbouring countries for
providing and sharing the burden of cross-border
public and merit goods
– Defence systems
– Cross-border road and rail networks
– Air and water pollution
– Carbon-dioxide emissions
• Importance of bilateral and multilateral agreements
• Roles of regional and global institutions

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QUESTIONS, COMMENTS AND
REFLECTIONS?

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