EC2066 MICROECONOMICS

TOPIC 12: EXTERNALITIES AND PUBLIC GOODS

Learning Outcomes

By the end of this chapter, and having completed the Essential readings and activities, you should
be able to:

 Define positive and negative externalities, and explain how and why the presence of
externalities creates inefficient outcomes

 Compute the socially efficient outcome, and the outcome in the presence of
externalities, and compare the two for standard problems

 Show (both in theory and in exercises) how taxation, regulation, property rights and
licensing can overcome market failure in the presence of externalities

 Define and give examples of public goods

 Explain why competitive markets with public goods may not operate efficiently.

Essential Reading

 Morgan, Katz and Rosen [MKR], Microeconomics, Chapter 18.

 Perloff, J.M., Microeconomics: theory and applications with calculus. Chapter ?
 Pindyck and Rubenfeld (PR) chapter

1. Preface
 In the previous chapter on General Equilibrium, we learnt about Pareto efficiency,
production efficiency and consumption efficiency.

 In this chapter, we are going to learn about the main factors of market incompleteness
or even market failure. These factors are externalities and public good.

2. Externalities
 According to the subject guide, there is an externality if the actions of an agent
(consumer or firm) affect directly the welfare of another agent in a way that is not
captured by a price effect. This situation arises when there are goods that are non-
excludable.

 Non-excludability implies that it is impossible to exclude other individuals from consuming

the good when one individual is consuming this good. Other individuals will either benefit
or suffer from it.

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 In the chapter on General Equilibrium, we assumed that all goods are private goods
which are strictly for private consumption only and hence excludable. For example,
buying a cup of coffee in the canteen. In this chapter we are dealing with a non-excludable
good.

 For example, you are watching Running Man in the lab and you cannot stop the lady
sitting behind you from watching it (benefit). Meanwhile, you do not use a headset and
the loud voice disturbs the nerd who is also sitting beside you (suffering).

 The consumption of a non-excludable good triggers externality. There are two types of
externalities: negative externalities (detrimental) and positive externalities (beneficial).
With regards to the above example, there are positive externalities for the lady because
she enjoys the show, but there are negative externalities to the nerd because he suffers
from it.

3. Negative Externalities
 Negative externalities happen if the action that the agent exerts decreases other agent’s
welfare (reduces consumers’ utility or generates an extra cost for other firms).

 For example, consider a steel plant located at the upstream that pump out its waste into
the river. Then, it causes negative externalities to the fishermen downstream, as the
toxic waste pollutes the river and reduces the number of fish available to the fishermen.
Under such circumstance, we said that it is the steel producer affects the fishermen. It
also causes negative externalities to the public who enjoys swimming in the river too.
Therefore, the producer also affects the consumers.

 We can use a supply and demand diagram for the steel market to show that under
perfect competition, steel plants produce excessive pollution because each firm’s private
cost is lesser than the social cost. Graphically,

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225

172.5

141 DW
120

15

Q
84 105 225

Assuming steel market demand, 225

Firms’ private marginal cost (marginal cost), 15
Firms’ pollution marginal cost (externalities),
Social marginal cost is the sum of two, 15

Firms will not factor the pollution into its cost consideration. It will produce at the
competitive equilibrium where → 225 15

At the competitive market equilibrium, 105, 120

The social optimum happens where → 225 15

At the social optimal point, 84, 141
The deadweight loss, 2,756.25

 The steel plant over produce at 105 because the social optimum point happens at
84

4. Negative Externalities and Monopoly

 Earlier, we assume that the steel plant is engaged in perfect competition. Now, let us
assume that the steel plant is a monopolist.

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225
DW

165
155
120
105

15
MR D
Q
60 70 84 225

Assuming steel market demand, 225

Marginal revenue of steel market demand, M 225 2
Firms’ private cost (marginal cost), 15
Firms’ pollution cost (externalities),
Social marginal cost, 15

Firms will produce at the monopolistic equilibrium where → 225 2

15
At the monopolistic market equilibrium, 70, 155
Suppose the monopolist takes the pollution cost into consideration, it will produce at
→ 225 2 15 , or, 60, 165

The deadweight loss when the monopolist produces at 60, 475

The deadweight loss when the monopolist produces at 70, 245

 Notice that the DW loss due to negative externalities is smaller under monopoly than
perfect competition.

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5. Positive Externalities
 Contrasted against negative externalities, positive externalities happen if the action that
the agent exerts increases another agent’s welfare (increases consumer utility or
generates an extra benefit for other firms).

 For example, consider the effect of Christiano Ronaldo joining Real Madrid a few years
ago, which boosted the sales of merchandise at the club (like football jerseys with CR7
printed behind). Since Adidas was the shirt sponsor of Real Madrid, the increase in the
sales of football jerseys benefited Adidas too.

P
MC

225

195
157.5 DW
120

15
MPB MSB
Q
105 142.5 225

Notice that the market demand is also the marginal private benefit from consuming
the good. That is, the benefit from an additional unit of a good or service that the
consumer of that good or service receives.

Assuming CR7 jersey demand or marginal private benefit is, 225

Seeing someone wearing a CR7 jersey, fans of Christiano Ronaldo will also be happy.
This gives rise to Marginal External Benefit of consuming CR7 jerseys, i.e., the benefit
from an additional unit of the CR7 jersey that people other than the consumer enjoys.

Defining marginal social benefit (MSB) as the marginal benefit enjoyed by the entire
society, both by the consumer and by everyone else (MSB = MPB + Marginal External
Benefit).

Here, the marginal social benefit is, 300

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Firms’ private cost (marginal cost), 15

Firms produces at the competitive equilibrium where → 225 15

At the competitive market equilibrium, 105, 120

When firms produce 105, the corresponding price under MSB is 195.
The social optimum happens where → 300 15
At the social optimal point, 142.5, 157.5
The deadweight loss is thus, 1406.25

 Real Madrid under-produces the CR7 jersey at 105 because the social optimum
happens at 142.5

6. How to Overcome Externalities

Mergers

 In the case of negative externalities, the root of the problem is that the firm produces
according to its private marginal cost instead of social cost. In the case of positive
externalities, the problem is caused by the firm producing according to its private
marginal benefit instead of social marginal benefit.

 Merger is a good solution to the externality problem as it internalises the problem by

combining the involved parties and aligning their interests.

 For example, in the positive externalities case, if Real Madrid and Adidas merge, then
their combined interest will be the social marginal benefit. Therefore, Real Madrid will
produce at the social optimum level to maximise their combined profit.

 In the case of the steel plant and fishermen, suppose the two merge, the steel plant will
consider the suffering of fishermen when it pollutes. Knowing that pollution will increase
the fishermen’s cost, the steel plant might reduce production if it operates in a
competitive environment.

Taxes

 In the case of negative externalities with perfect competition, it is possible to force the
steel plant to produce at the social optimum level of output by imposing a per unit tax on
it.

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225

172.5

141
120

15

Q
84 105 225

At the social optimum level of output, the steel plant produces at → 141
15 84 , which implies 42.

Emissions standards

 The government can also set emission standards to limit the waste pollution from the
steel plant. In order to fulfil the emission standards, the steel plant needs to reduce its
production output and thus, the corresponding water pollution.

Coase Theorem

 Another core issue of externalities lie in the lack of ownership of the resources, which
leads to inefficiency.

 According to Coase Theorem, if property rights exist, if only a small number of parties
are involved, and transactions costs are low (or zero), then private transactions are
efficient.

 Coase Theorem implies that, regardless to whom the property right is given (the polluter
or the victim), as long as a property right is granted, an efficient level of pollution results.

 Using the steel plant example, if the fishermen are assigned the ownership of the river,
then the fishermen have the right to demand compensation from the steel plant polluting
the river and affecting their livelihood. Therefore, the steel plant has to either cut down
production or install environmentally-friendly machinery/processes.

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 If the steel plant is assigned the ownership of the river, then when the fishermen
complain, the steel plant will point out that it has the right to pollute the river. So, the
fishermen might have to install a water purification plant to clean up the polluted river.
After cleaning the river, the efficient level of pollution will result.

 As long as the ownership of the resources is assigned to either party, the problem of
externalities might be solved, depending which party bear the cost. Whether the steel
plant install the environmentally-friendly machinery or if the fishermen build a water plant.

 However, there are some special cases where negative externalities cannot be solved
although there is ownership of the resources. For example, when there are too many
steel plants upstream, it is very hard to identify which plant pollutes more and which
plant needs to install environmentally-friendly machinery. Or when there are too many
fishermen downstream, and none of them are willing to bear the cost of building the
water plant, which will benefit everyone else.

7. Public Good

 Public good is a product that one individual can consume without reducing its availability
to another individual and from which no one is excluded.

 Public goods give positive externalities such as the water purification plant in the above
example. The water purification plant will benefit every fisherman downstream of the
river, whether or not they contribute to the building of the water plant. Other examples
are public defence, public parks, street lights and the police force.

 The characteristics that differentiate a public good from a private good are:

- Non-excludable: Once the good has been produced, everyone in the market cannot
be excluded from using and benefiting from the good.

- Non-rivalry: the extra consumption of the public good by one extra person doesn’t
reduce the benefits of the rest who consumes that particular public good.

 The table below demonstrates the possible characteristic of a public good with different
kinds of combination of non-excludability and non-rivalry.

Exclusion Non-Exclusion
Rivalry Private good like chocolate Open access common property
like fishery, hunting
Non-rivalry Private good with exclusion Public good without exclusion like
like cable TV national defence, clean air.

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8. Free Riding and Public Goods

 Normally, under the presence of free-riding and private consumption, the provision of
public goods are likely to be under-produced. Free-riding happens when one who does
not pay for the public good manages to still enjoy the benefit of that good.

 Consider the following case: Ted and Doraemon are roommates and they love anime
very much. However, there is no TV in their room. Thus, the TV is a public good to them.

- If Ted buys the TV, his utility is -5 but Doraemon’s utility is +20. This is because
poor Ted needs to pay for the TV and Doraemon can free-ride (watch free TV).
- If both share the cost of the TV, both end up with a utility of +10.
- If both do not buy the TV, both end up with a utility of zero.

 The following table shows all the possible scenarios:

Doraemon
Buy Don’t buy
Buy 10, 10 -5, 20
Ted
Don’t buy 20, -5 0, 0

 The dominant strategy for both Ted and Doraemon is not to buy the TV. Thus, free-riding
prevents the public good (TV), from being provided.

9. Market for public goods (using a past year question 2014 ZA Q7)

 There are 3 consumers of a public good. The demand function of the consumers are as
follows:

Consumer 1: 60
Consumer 2: 100
Consumer 3: 140

Where Q is the quantity of public good and is the price consumer is willing to pay, ∈
1,2,3 . The public good can be produced at a constant marginal cost of 180, and there
are no fixed costs.

 In order to find the efficient level of production of the public good, we need to obtain the
social demand curve for the public good which is the vertical sum of the demand curves
of each consumer.

The social demand curve is 300 3

At social optimum equilibrium, → 300 3 180 → 40

 Under private provision, each consumer provide the good at , ∈ 1,2,3 . But
since 180, none of the consumers will purchase the public good. That will be the
outcome for this example.

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 Graphically, this is shown below.

P
300

180 MC

140
DS
100
60

D1 D2 D3
Q
40

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