Chapter 5:

Public Goods and

Externalities
 OBJECTIVES
• IN THIS CHAPTER YOU WILL LEARN:

• How public goods are distinguished from private

goods.
• The method for determining the optimal quantity
of a public good.
• About externalities (spillover costs and benefits)
and the methods to remedy them.
• The difference between the benefits-received
and ability-to-pay principles of taxation.
• The differences between proportional,
progressive, and regressive taxes.
 Market Failure
• In some cases certain goods and services
might not be produced at all.
• In other cases certain goods and services
might be over- or under-produced compared
to what would be best for the society.
• These situations represent a market failure
to achieve the outcome that is best for the
society.
• Whenever there is a market failure, there
might be a role for a government to intervene
in the economy.
LO: 5-1

5-3
 Market Failure
• Two common cases in which market failures
arise are:
– Production of public goods (and
services)
– Production of goods and services that
involve externalities
Market failure is the inability of a market to
produce a desirable product or produce it in the
“right” amount.
LO: 5-1

5-4
 Private Goods vs. Public Goods
• Private goods are
– Rival: if one person
consumes a private good,
another cannot
– Excludable: only those who
pay for goods enjoy their
benefits
– Bought and consumed by
people individually
– Produced and allocated
efficiently by competitive
markets
LO: 5-1
• Public goods are
– Non-rival: one person’s
consumption of a public good
does not preclude others from
consuming it too
– Non-excludable: there is no
efficient way to prevent people
from enjoying a public good
without paying
– Subject to a free-rider problem
– non-payers can enjoy
benefits of a public good
– Not produced or under-
produced by competitive
markets
5-5
 Private Goods vs. Public
Goods: Examples
• Private goods • Public goods
– A pair of shoes – National defense
– A cup of coffee – Roads
– A car – Parks
– A house – Street lighting
– A haircut – Environmental protection
– A circus show
Because of the free-rider problem, government
provides public goods and finances them through
taxes.
LO: 5-1

5-6
 Market Demand for Public Goods
and Optimal Quantity
• Market demand for a private good is a horizontal sum
of individual demands: quantities demanded at each
price are added up.
• Market demand for a public good is a vertical sum of
individual demands: individuals’ willingness to pay (per
unit) for each given quantity of a public good are added
up.
• Optimal quantity of a public good is where the marginal
benefit of this good (market demand) is equal to the
marginal cost of producing it (supply).

LO: 5-2

5-7
 Demand for Public Goods: An
Example with Two Individuals
(1) (2) (3) (4)
Quantity Adams’ Benson’s Collective
Of Public Willingness Willingness Willingness
Good To Pay (Price) To Pay (Price) To Pay (Price)

1 $4 + $5 = $9
2 3 + 4 = 7
3 2 + 3 = 5
4 1 + 2 = 3
5 0 + 1 = 1

LO: 5-2
Graphically…
5-8
 P
Collective Demand $9 S Optimal
$7(per item) 7
Quantity
for 2 Items 5
Collective
$3 (per item) 3 Willingness
for 4 Items DC To Pay
1

Connect the Dots 0 1 2 3 4 5 Q

Collective Demand and Supply
P
Benson’s Demand $6
5
$4 (per item) 4
for 2 Items 3
2 D2
$2 (per item) 1
0 1 2 3 4 5 Q
for 4 Items Benson
P
Adams’ Demand $6
$3 (per item) 5
4
for 2 Items 3
2
$1 (per item) 1 D1
0
for 4 Items 1 2 3 4 5 Q
Adams
LO: 5-2

5-9
 Externalities: Positive and
Negative
• An externality occurs when some of the costs or the
benefits of a good are passed on to or “spill over to”
someone other than the immediate buyer or seller.
• Externalities are benefits or costs that accrue to some
third party that is external to the market transaction.
• Externalities can be positive or negative.
Negative externalities are Positive externalities are
spillover production or spillover production or
consumption costs imposed consumption benefits
on third parties without conferred on third parties
compensation to them. without compensation from
them.
LO: 5-2

5-10
 Externalities: Equilibrium Output
vs. Optimal Output
• With negative • With positive
externalities, the externalities, the market
producers’ supply curve demand curve is below
is below (to the right of) (to the left of) the full-
the full-cost supply
curve, therefore benefit demand curve,
therefore
– equilibrium output is
greater than optimal, – equilibrium output is
i.e. overallocation of less than optimal, i.e.
resources. underallocation of
resources.
LO: 5-3
Graphically…
5-11
Externalities: Equilibrium Output
vs. Optimal Output
P P
Negative
Externalities
St St
Positive
S Externalities

Dt

D D
Overallocation Underallocation
0 Qo Qe Q 0 Qe Qo Q

Negative Positive
Externalities Externalities

Examples: pollution from Examples: inventions,

factories, traffic jams. front yard landscaping.
LO: 5-3

5-12
 Ways to Resolve Externalities
Problem
• Individual bargaining: When property rights are clearly
established, externality problems can be resolved through
private negotiations (Coase Theorem).
• Liability rules and lawsuits: The perpetrator of the harmful
externality is forced to pay damages to those injured.
• Government intervention:
– Direct control through legislation;
– Specific taxes to bring producers’ supply curve closer to the full-
cost supply curve;
– Subsidies and government provision for goods and services
with positive externalities.
• Market-based approach: Government can create a market
for externality rights.
LO: 5-3

5-13
 Taxation: Apportioning the Tax
Burden
• To finance government provision of public goods and
subsidies and government provision in case of positive
externalities, government is levying taxes on
households and businesses.
• How is this tax burden distributed?
– Benefits-received principle: People who receive the benefit
from government-provided goods and services should pay the
taxes required to finance them.
– Ability-to-pay principle: People who have greater income
should pay a greater proportion of it as taxes than those who
have less income.

The tax burden is the total cost of taxes imposed on

society.
LO: 5-4

5-14
 Progressive, Proportional, and
Regressive Taxes
• A progressive tax: average tax rate increases as
the taxpayer’s income increases.
• A regressive tax: average tax rate decreases as
the taxpayer’s income increases.
• A proportional tax: average tax rate remains
constant as the taxpayer’s income increases.

Average tax rate is the total tax paid divided by total

taxable income, as a percentage.
Marginal tax rate is the tax rate paid on each additional
dollar of income.
LO: 5-5

5-15
 Tax Progressivity in the U.S.
• The majority view of economists is as follows:
– The Federal tax system is progressive.
– The state and local tax structures are largely
regressive. A general sales tax and property
taxes are regressive with respect to income.
– The overall U.S. tax system is slightly progressive.

Government’s Role: A Qualification

In addition to correcting externalities and providing public
goods, government also sets the rules and regulations for
the economy, redistributes income when desirable, and
takes macroeconomic actions to stabilize the economy.
LO: 5-5

5-16
 TAKE HOME QUIZ
• GLOBAL WARMING—THE EPA'S VIEW
• Go to www.epa.gov and select Climate Change.
• What are the major greenhouse gases?
• How much greenhouse gas does the United States
emit per person?
• What is the trend of emissions on a per-person basis?
• What is the trend of emissions per dollar of GDP in
the United States?
• Use your own analysis to explain how total emissions
can rise even though emissions per dollar of GDP
substantially decline.
• Which of the two is more relevant for climate
change?