Download Taxes and Welfare

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 don’t 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
slide 4
Externalities can be either beneficial or harmful,
and can originate with either consumers or
producers.
Here are some examples:
Hidden slides
Market failure
slide 5
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
slide 8
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
slide 9
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
slide 10
Here’s the situation for a typical beer producer:
MPC is the Marginal Private Cost of production. It’s the same as the
firm’s 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
Q
slide 11
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
slide 12
$/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
Q
slide 13
This area is the total
pollution cost when
Q* is produced.
$/Q
Marginal social cost
= MPC + MEC
Supply = MPC
Demand = MPB
Q*
Market failure
Q
slide 14
The socially best output is Q(society).
Marginal social cost
= MPC + MEC
$/Q
Supply = MPC
Demand = MPB = MSB
Q(society)
Market failure
Q*
Q
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)
Market failure
Q*
Q
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
society’s point of view.
Market failure
slide 17
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
slide 18
Brown will choose years of schooling
by equating MPB with MPC.
$/Q
MPC = MSC
MPB
Q
Q*
YEARS OF SCHOOLING
Market failure
slide 19
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
slide 20
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
slide 21
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
slide 22
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) Coase’s Theorem -- Assign property rights
6) Internalize the externality through mergers
Market failure
slide 23
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
slide 26
Examples of public goods:
Hidden slide
Market failure
slide 27
Some public goods can be excludable but not
rival:
1) Crossing a toll bridge when it isn’t 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
slide 29
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
slide 30
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
slide 31
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
slide 32