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Lecture 3
Public goods
Externalities
Congestion
Coase Theorem
Outline
• Market Failures
- Public Goods
- Externalities
- Congestion
• Demand for Public Goods
• Externalities
• Congestion
• Coase Theorem and Property Rights
• Analysis of Externalities and Efficiency
• Incentives and Revelation of Incremental Damage or
Gain
Examples of Public Goods –
Are They?
• Clean Air
• National Defense
•WI-FI – Wireless Internet
Figure 1 Four Types of Goods
Rival?
Yes
Yes
No
Private Goods
Natural Monopolies
• Ice-cream cones
• Clothing
• Congested toll roads
• Fire protection
• Cable TV
• Uncongested toll roads
Common Resources
Public Goods
• Fish in the ocean
• The environment
• Congested nontoll roads
• Tornado siren
• National defense
• Uncongested nontoll roads
Excludable?
No
Copyright © 2004 South-Western
Examples of Public Goods
• Visibility Conditions at Shenandoah
National Park
• Exxon Valdez Oil Spill to residents of
lower 48 states (public bad ?)
Getting Total or Market Demand for
a Private Good
• Add the individual demand curves
horizontally
• At each price add the quantity demanded
by all individuals who are willing to pay
that or more for some number of units of
the good
Total Demand for a Private
Good
Good
1
2
3
4
Person (WTPs)
#1
#2
1.00
0.50
0.75
0.25
0.50
0.10
0.25
0.05
Private Market Demand
Price
Q
1.00
1
0.75
2
0.50
4
0.25
6
0.10
7
0.05
8
Getting Total Demand for a Public
Good
• Add vertically individual demands (at each
quantity –since everyone gets the same amount
when there is no exclusion or no rilvary in
goods)
• This process means pick a quantity and add
each person who would be willing to pay a
positive amount his or her wtp for that amount of
the good
Total Demand for the Public
Good
Good
1
2
3
4
Person (WTPs)
#1
#2
1.00
0.50
0.75
0.25
0.50
0.10
0.25
0.05
Public Good
"Market" Demand
Price
Q
1.50
1
1.00
2
0.60
3
0.30
4
Efficiency Conditions
• Private Goods
Marginal Benefit = Incremental or Marginal Cost
MWTP = Marginal Benefit = Price = Marginal Cost
MWTP = Willingness to Pay for last unit
• Public Goods
MB = Sum of Marginal WTP = MC
(WTP = willingness to pay)
Why? Because everyone can enjoy resource
without detracting from anyone else.
Definition of Externality
Externality - an “unintended” by-product of some
individual or firm’s activities that creates
negative or positive effects for others
negative - air pollution, water pollution, noise
positive - education of general public (better
decisions in a democracy), honesty,
innovation
Externalities – Examples
• Air Pollution
• Water Pollution
• Odor
• Global Warming
Class Experiment
• Each sale of new entrant #2 cost seller #2 $0.05
• No one else was affected
• Was intervention required?
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Market Solution and Efficiency
Private Goods and Market (without externalities)
equilibrium
quantity demanded = quantity supplied
and
amount people will = amount it costs to
pay for last unit
provide last unit
Recall Experiment
price for last unit is marginal
price received for last unit
benefit to a person
is marginal cost
experienced by person
supplying it
Key to Efficiency Is:
marginal benefit = marginal cost at amount of good provided
Market Solution with Externalities
and Efficiency
Externality implies there is another cost (for negative
externalities) or another benefit (for positive
externalities) that is not counted by the market!
Label market counted benefits and costs - “private”
Label component not counted as “social”
Positive Externality - efficiency requirement
marginal private + marginal social = marginal private
benefits
benefits
costs
Negative Externality - efficiency requirement
marginal private + marginal social = marginal private
cost
cost
benefit
Congestion
• Mutual interdependence among users of a
common facility
- highway (I-40 or 440) at 4 am versus at 7:30
am, 5-6 pm, etc.
- Public beaches in season and on weekends
• “Impure” public good
- well-being depends on both individual’s use
of a resource and others’ “simultaneous” use
Congestion and Capacity –Step
one –who gets in ?
R
Benefit of capacity OB with zero pricing is
not OpAB; with equal access it is OpB.
Why Does this Work?
Random Rationing
consumer surplus at zero price
if all OR got in
1
OpR = Op ⋅ OR
2
But with capacity constraint, not all get in;
if each has equal chance
probability is
OB
OR
So actual benefit from use is
OpR ⋅
OB 1
= Op ⋅ OB
OR 2
or
OpB
Price
B
D1 (N)
A
E
F
D2 (N+K)
0
N
N+K
• Order each user from highest to lowest
• What are Expectations and how do they influence
management?
Total users
(quantity)
Coase Theorem
Assign property rights to source of externality and regardless of
who gets those rights externality will be “managed” efficiently.
Key Requirements
• no transactions costs
• damages are accessible and measurable
• “rights” not an important source of income
Example - Noise in Nashville
Incentives and Revelation of
Preferences
• Benefits of Consumption are available without paying
• Weakest Link to Best Shot
Island below
I
Q = Min (q1, q2, q3,…, qk)
II
Q = Max (q1, q2, q3,…, qk)
Sea Level
Missile Defense
for Island