Externalities and Public Goods

Setup: Perfectly competitive markets result in

outputs and prices which are socially optimal in
the sense of the maximizing surplus. Another way
to say this is that competition results in output
levels for which marginal social benefit equals
marginal social cost. (MSB = MSC)

Market failure

slide 1

We saw that the presence of monopoly, for example,

could justify government interference because
monopolies dont produce output levels where
MSB = MSC.
But even competitive markets may fail under some
circumstances.

Market failure

slide 2

In what follows, we will examine the conditions

under which competitive markets may fail to be
optimal institutions to produce and distribute
goods. This topic is known as market failure.

Market failure

slide 3

EXTERNALITIES
An externality is a benefit or cost to third parties
who are not directly involved in a transaction.
Externalities are sometimes called neighborhood
effects.

Market failure

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Externalities can be either beneficial or harmful,

and can originate with either consumers or
producers.
Here are some examples:

Hidden slides

Market failure

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How Externalities Work

The existence of an externality creates a difference
between either
a) the private and social cost of production, or
b) the private and social benefits from consumption.
The consequence is that even competitive markets
will fail to reach a social optimum.
Market failure

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Marginal external cost is the extra social cost

(over and above the private cost) of producing
one more unit of the good.
Marginal external benefit is the extra social
benefit of consuming one more unit of a good.
The presence of external benefits and costs means
there will be a difference between the private
and social consequences of production.

Market failure

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EXAMPLE 1:
Suppose the market in beer is perfectly competitive.
But beer production creates terrible odors, and
makes people who live downwind from breweries
worse off.

Market failure

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Heres the situation for a typical beer producer:

MPC is the Marginal Private Cost of production. Its the same as the
firms supply curve, showing willingness to sell.
MPB is the Marginal Private Benefit. It's the demand curve for the
good, showing willingness to pay.
$/Q
Supply = MPC

A competitive
market will lead
to Q*.

Demand = MPB
Q*

Market failure

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The existence of a harmful externality means there is a

difference between the private and social costs of
producing beer.
The difference between
private and social cost is
the marginal external cost
(MEC)

Market failure

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$/Q

This distance is the

pollution cost of
one more unit of
beer.

Marginal social cost

= MPC + MEC
Supply = MPC

Demand = MPB
Q*

Market failure

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This area is the total

pollution cost when
Q* is produced.
$/Q

Marginal social cost

= MPC + MEC
Supply = MPC

Demand = MPB
Q*

Market failure

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The socially best output is Q(society).

Marginal social cost
= MPC + MEC

$/Q

Supply = MPC

Demand = MPB = MSB

Q(society)

Q*

Market failure

slide 15

This area is the total

pollution cost when
Q(society) is
produced.
$/Q

Marginal social cost

= MPC + MEC
Supply = MPC

Demand = MPB
Q(society)

Q*

Market failure

slide 16

The conclusion is that when an externality is present,

even a competitive beer market will not produce
the best amount of beer.
In this example too much beer is produced from
societys point of view.

Market failure

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EXAMPLE 2:
Prof. Brown is trying to decide how much schooling
to buy for his daughter. He will buy years of
schooling up to point where the last unit bought is
just worth it to him. But schooling, especially at
the elementary level, has positive externalities.

Market failure

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Brown will choose years of schooling

by equating MPB with MPC.
$/Q

MPC = MSC

MPB

Q*
YEARS OF SCHOOLING

Market failure

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But the extra (external) benefits from schooling mean that Brown
will buy too little schooling for his daughter if left to his own
devices.

$/Q

This distance is the marginal

external benefit.
MPC = MSC

MSB=MPB+MEB
MPB
Q
Q* Q(Society)
YEARS OF SCHOOLING

Market failure

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EXAMPLE 3:
People decide whether or not to get vaccinated
against diseases by comparing the private benefits
with the private costs. But vaccinations carry
important external benefits because when you are
vaccinated people cannot get the illness from you.

Market failure

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The horizontal axis here represents the number of

people getting vaccinated. People will get
vaccinated only if the benefit to them is at least as
great as the cost.
$/person

N is the private amount demanded.

Society would want N* people
vaccinated.

MSC=MPC
MSB
MPB = DEMAND
N

N*

# of people

THE MARKET IN SMALLPOX VACCINATIONS

Market failure

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Solutions to externalities problems:

1) Economists generally favor taxes and
subsidies linked to the value of the externality
2) Direct regulation
3) Subsidize pollution control equipment
4) Sell or grant tradable pollution rights.
5) Coases Theorem -- Assign property rights
6) Internalize the externality through mergers

Market failure

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PUBLIC GOODS
A pure public good is a good or service that is
consumed in its entirety by everyone. When one
person consumes another unit of a public good we
all consume more.
The most common example is national defense.

Market failure

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Public goods have two special properties compared

to private consumption goods.
Nonrivalry: When one person consumes a unit of a
public good the amount available to be
consumed by everyone else is not diminished.
Nonexcludability: Once a public good is produced
it is difficult or impossible to exclude people
from consuming it.

Market failure

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Because public goods are nonrival and/or

nonexcludable, these goods will tend to be under
produced, or maybe not produced at all if left to
the private market.
Public goods are not the same as publicly provided
goods. Just because government provides a good
does not make it a public good.

Market failure

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Examples of public goods:

Hidden slide

Market failure

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Some public goods can be excludable but not

rival:
1) Crossing a toll bridge when it isnt crowded.
2) Scrambled on the air TV signals.
One way to explain nonrivalry in consumption is
by saying that the marginal cost of providing
the good to one more consumer is zero.

Market failure

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Some public goods may be nonexcludable but rival:

1) Air that is polluted by smoking.
2) The ocean is not excludable, but fishing is rival.
Production of public goods is sometimes said to suffer
from the free rider problem. This arises directly
from the nonexcludability property of public goods.

Market failure

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Public good summary:

If public goods are produced in private markets, they
will be under produced because social benefits
will exceed private benefits.

Market failure

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Solutions to the public goods problem:

1) Using technologies that provide for exclusion
(toll roads, cable TV)
2) Government ownership
3) Clubs or cooperatives

Market failure

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