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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