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Environmental Economics : Some Basic Concepts
1. Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being,
especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting
income distribution. associated with it. It analyzes social welfare, however measured, in terms of economic activities of
the individuals that comprise the theoretical society considered. As such, individuals, with associated economic activities,
are the basic units for aggregating to social welfare, whether of a group, a community, or a society, and there is no "social
welfare" apart from the "welfare" associated with its individual units.
Welfare economics typically takes individual preferences as given and stipulates a welfare improvement in Pareto
efficiency terms from social state A to social state B if at least one person prefers B and no one else opposes it. There is
no requirement of a unique quantitative measure of the welfare improvement implied by this. Another aspect of welfare
treats income/goods distribution, including equality, as a further dimension of welfare.
Social welfare refers to the overall welfare of society. With sufficiently strong assumptions, it can be specified as the
summation of the welfare of all the individuals in the society. Welfare may be measured either cardinally in terms of "utils"
or dollars, or measured ordinally in terms of Pareto efficiency. The cardinal method in "utils" is seldom used in pure theory
today because of aggregation problems that make the meaning of the method doubtful, except on widely challenged
underlying assumptions. In applied welfare economics, such as in cost-benefit analysis, money-value estimates are often
used, particularly where income-distribution effects are factored into the analysis or seem unlikely to undercut the
analysis.
Since the early 1980s economists have been interested in a number of new approaches and issues in welfare economics.
The capabilities approach to welfare argues that what people are free to do or be should also be included in welfare
assessments and the approach has been particularly influential in development policy circles where the emphasis on
multi-dimensionality and freedom has shaped the evolution of the Human Development Index.
Economists have also been interested in using life satisfaction to measure what Kahneman and colleagues call
experienced utility.
What follows, for the most part, therefore refers to a particular approach to welfare economics, possibly best referred to
as 'neo-classical' or 'traditional' welfare economics.
Other classifying terms or problems in welfare economics include externalities, equity, justice, inequality, and altruism.
Two approaches
There are two mainstream approaches to welfare economics: the early Neoclassical approach and the New welfare
economics approach.
The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou. It assumes that:
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Utility is cardinal, that is, scale-measurable by observation or judgment.
Preferences are exogenously given and stable.
Additional consumption provides smaller and smaller increases in utility (diminishing marginal utility).
All individuals have interpersonally comparable utility functions.
With these assumptions, it is possible to construct a social welfare function simply by summing all the individual utility
functions.
The New Welfare Economics approach is based on the work of Pareto, Hicks, and Kaldor. It explicitly recognizes the
differences between the efficiency aspect of the discipline and the distribution aspect and treats them differently.
Questions of efficiency are assessed with criteria such as Pareto efficiency and the Kaldor-Hicks compensation tests,
while questions of income distribution are covered in social welfare function specification. Further, efficiency dispenses
with cardinal measures of utility, replacing it with ordinal utility, which merely ranks commodity bundles, such as
represented by an indifference-curve map is adequate for this analysis.
Efficiency
Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most
utility from them.
Many economists use Pareto efficiency as their efficiency goal. According to this measure of social welfare, a situation is
optimal only if no individuals can be made better off without making someone else worse off.
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This ideal state of affairs can only come about if four criteria are met:
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The marginal rates of substitution in consumption are identical for all consumers. This occurs when no consumer can
be made better off without making others worse off.
The marginal rate of transformation in production is identical for all products. This occurs when it is impossible to
increase the production of any good without reducing the production of other goods.
The marginal resource cost is equal to the marginal revenue product for all production processes. This takes place
when marginal physical product of a factor must be the same for all firms producing a good.
The marginal rates of substitution in consumption are equal to the marginal rates of transformation in production,
such as where production processes must match consumer wants.
There are a number of conditions that, most economists agree, may lead to inefficiency. They include:
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Imperfect market structures, such as a monopoly, monopsony, oligopoly, oligopsony, and monopolistic competition.
Factor allocation inefficiencies in production theory basics.
Market failures and externalities; there is also social cost.
Imperfect Price discrimination and price skimming.
Asymmetric information, principal-agent problems.
Long run declining average costs in a natural monopoly.
Certain types of taxes and tariffs.
To determine whether an activity is moving the economy towards Pareto efficiency, two compensation tests have been
developed. Any change usually makes some people better off while making others worse off, so these tests ask what
would happen if the winners were to compensate the losers. Using the Kaldor criterion, an activity will contribute to Pareto
optimality if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are
prepared to accept. Under the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the
losers are prepared to offer to the gainers in order to prevent the change is less than the minimum amount the gainers
are prepared to accept as a bribe to forgo the change. The Hicks compensation test is from the losers' point of view, while
the Kaldor compensation test is from the gainers' point of view. If both conditions are satisfied, both gainers and losers
will agree that the proposed activity will move the economy toward Pareto optimality. This is referred to as Kaldor-Hicks
efficiency or the Scitovsky criterion.
Income distribution
There are many combinations of consumer utility, production mixes, and factor input combinations consistent with
efficiency. In fact, there are an infinity of consumer and production equilibria that yield Pareto optimal results. There are
as many optima as there are points on the aggregate production possibilities frontier. Hence, Pareto efficiency is a
necessary, but not a sufficient condition for social welfare. Each Pareto optimum corresponds to a different income
distribution in the economy. Some may involve great inequalities of income. So how do we decide which Pareto optimum
is most desirable? This decision is made, either tacitly or overtly, when we specify the social welfare function. This
function embodies value judgements about interpersonal utility. The social welfare function is a way of mathematically
stating the relative importance of the individuals that comprise society.
A utilitarian welfare function (also called a Benthamite welfare function) sums the utility of each individual in order to
obtain society's overall welfare. All people are treated the same, regardless of their initial level of utility. One extra unit of
utility for a starving person is not seen to be of any greater value than an extra unit of utility for a millionaire. At the other
extreme is the Max-Min, or Rawlsian John Rawls utility function (Stiglitz, 2000, p102). According to the Max-Min criterion,
welfare is maximized when the utility of those society members that have the least is the greatest. No economic activity
will increase social welfare unless it improves the position of the society member that is the worst off. Most economists
specify social welfare functions that are intermediate between these two extremes.
The social welfare function is typically translated into social indifference curves so that they can be used in the same
graphic space as the other functions that they interact with. A utilitarian social indifference curve is linear and downward
sloping to the right. The Max-Min social indifference curve takes the shape of two straight lines joined so as they form a
90 degree angle. A social indifference curve drawn from an intermediate social welfare function is a curve that slopes
downward to the right.
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The intermediate form of social indifference curve can be interpreted as showing that as inequality increases, a larger
improvement in the utility of relatively rich individuals is needed to compensate for the loss in utility of relatively poor
individuals.
A crude social welfare function can be constructed by measuring the subjective dollar value of goods and services
distributed to participants in the economy (see also consumer surplus).
A simplified seven-equation model
The basic welfare economics problem is to find the theoretical maximum of a social welfare function, subject to various
constraints such as the state of technology in production, available natural resources, national infrastructure, and
behavioural constraints such as consumer utility maximization and producer profit maximization. In the simplest possible
economy this can be done by simultaneously solving seven equations. This simple economy would have only two
consumers (consumer 1 and consumer 2), only two products (product X and product Y), and only two factors of
production going into these products (labour (L) and capital (K)). The model can be stated as:
maximize social welfare: W=f(U1 U2) subject to the following set of constraints:
K = Kx + Ky (The amount of capital used in the production of goods X and Y)
L = Lx + Ly (The amount of labour used in the production of goods X and Y)
X = X(Kx Lx) (The production function for product X)
Y = Y(Ky Ly) (The production function for product Y)
U1 = U1(X1 Y1) (The preferences of consumer 1)
U2 = U2(X2 Y2) (The preferences of consumer 2)
The solution to this problem yields a Pareto optimum. In a more realistic example of millions of consumers, millions of
products, and several factors of production, the math gets more complicated.
Also, finding a solution to an abstract function does not directly yield a policy recommendation! In other words, solving an
equation does not solve social problems. However, a model like the one above can be viewed as an argument that
solving a social problem (like achieving a Pareto-optimal distribution of wealth) is at least theoretically possible.
Efficiency between production and consumption
The relation between production and consumption in a simple seven equation model (2x2x2 model) can be shown
graphically. In the diagram below, the aggregate production possibility frontier, labeled PQ shows all the points of
efficiency in the production of goods X and Y. If the economy produces the mix of good X and Y shown at point A, then
the marginal rate of transformation (MRT), X for Y, is equal to 2.
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Point A defines the boundaries of an Edgeworth box diagram of consumption. That is, the same mix of products that are
produced at point A, can be consumed by the two consumers in this simple economy. The consumers' relative
preferences are shown by the indifference curves inside the Edgeworth box. At point B the marginal rate of substitution
(MRS) is equal to 2, while at point C the marginal rate of substitution is equal to 3. Only at point B is consumption in
balance with production (MRS=MRT). The curve 0BCA (often called the contract curve) inside the Edgeworth box defines
the locus of points of efficiency in consumption (MRS 1=MRS ²). As we move along the curve, we are changing the mix of
goods X and Y that individuals 1 and 2 choose to consume. The utility data associated with each point on this curve can
be used to create utility functions.
Social welfare maximization
Utility functions can be derived from the points on a contract curve. Numerous utility functions can be derived, one for
each point on the production possibility frontier (PQ in the diagram above). A social utility frontier (also called a grand
utility frontier) can be obtained from the outer envelope of all these utility functions. Each point on a social utility frontier
represents an efficient allocation of an economy's resources; that is, it is a Pareto optimum in factor allocation, in
production, in consumption, and in the interaction of production and consumption (supply and demand). In the diagram
below, the curve MN is a social utility frontier. Point D corresponds with point B from the earlier diagram. Point D is on the
social utility frontier because the marginal rate of substitution at point B is equal to the marginal rate of transformation at
point A. Point E corresponds with point C in the previous diagram, and lies inside the social utility frontier (indicating
inefficiency) because the MRS at point C is not equal to the MRT at point A.
Although all the points on the grand social utility frontier are Pareto efficient, only one point identifies where social welfare
is maximized. This is point Z where the social utility frontier MN is tangent to the highest possible social indifference curve
labelled SI.
Paretian Welfare Economics
Paretian welfare economics rests on the assumed value judgment that, if a particular change in the economy leaves at
least one individual better off and no individual worse off, social welfare may be said to have increased. (One individual
being better off than other individuals and not leaving other individuals worse off is possible in societies, where political
power is not related to economic power.) In this sense, an individualistic approach to social welfare is defined, with
concern extending to all individuals in society, and with an explicit rejection of any ‘organic’ concept of the State[3].
Criticisms
Some, such as economists in the tradition of the Austrian School, doubt whether a cardinal utility function, or cardinal
social welfare function, is of any value. The reason given is that it is difficult to aggregate the utilities of various people
that have differing marginal utility of money, such as the wealthy and the poor.
Also, the economists of the Austrian School question the relevance of pareto optimal allocation considering situations
where the framework of means and ends is not perfectly known, since neoclassical theory always assumes that the endsmeans framework is perfectly defined.
Some even question the value of ordinal utility functions. They have proposed other means of measuring well-being as an
alternative to price indices, "willingness to pay" functions, and other price oriented measures. [citation needed] These price
based measures are seen as promoting consumerism and productivism by many.[citation needed] It should be noted that it is
possible to do welfare economics without the use of prices, however this is not always done.
Value assumptions explicit in the social welfare function used and implicit in the efficiency criterion chosen make welfare
economics a highly normative and subjective field. This can make it controversial.
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Fundamental theorems of welfare economics
There are two fundamental theorems of welfare economics. The first states that any competitive
equilibrium or Walrasian equilibrium leads to a Pareto efficient allocation of resources. The second states the
converse, that any efficient allocation can be sustainable by a competitive equilibrium. Despite the apparent
symmetry of the two theorems, in fact the first theorem is much more general than the second, requiring far weaker
assumptions.
The first theorem is often taken to be an analytical confirmation of Adam Smith's "invisible hand" hypothesis,
namely that competitive markets tend toward the efficient allocation of resources. The theorem supports a case for
non-intervention in ideal conditions: let the markets do the work and the outcome will be Pareto efficient. However,
Pareto efficiency is not necessarily the same thing as desirability; it merely indicates that no one can be made
better off without someone being made worse off. There can be many possible Pareto efficient allocations of
resources and not all of them may be equally desirable by society.
The ideal conditions of the theorems, however are an abstraction. For example, states that in the presence of either
imperfect information, or incomplete markets, markets are not Pareto efficient. Thus, in most real world economies,
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the degree of these variations from ideal conditions must factor into policy choices.
The second theorem states that out of all possible Pareto efficient outcomes one can achieve any particular one by
enacting a lump-sum wealth redistribution and then letting the market take over. This appears to make the case
that intervention has a legitimate place in policy – redistributions can allow us to select from all efficient outcomes
for one that has other desired features, such as distributional equity. The shortcoming is that for the theorem to
hold, the transfers have to be lump-sum and the government needs to have perfect information on individual
consumers' tastes as well as the production possibilities of firms. Additionally, an additional mathematical condition
is that preferences and production technologies have to be.
2. Transaction cost
The transaction cost approach to the theory of the firm was created by Ronald Coase. In economics and related
disciplines, a transaction cost is a cost incurred in making an economic exchange (restated: the cost of participating in a
market). It refers to the cost of providing for some good or service through the market rather than having it provided from
within the firm. For example, most people, when buying or selling a stock, must pay a commission to their broker; that
commission is a transaction cost of doing the stock deal. Or consider buying a banana from a store; to purchase the
banana, your costs will be not only the price of the banana itself, but also the energy and effort it requires to find out
which of the various banana products you prefer, where to get them and at what price, the cost of traveling from your
house to the store and back, the time waiting in line, and the effort of the paying itself; the costs above and beyond the
cost of the banana are the transaction costs. When rationally evaluating a potential transaction, it is important to consider
transaction costs that might prove significant.
A number of kinds of transaction cost have come to be known by particular names:
search costs (the costs of locating information about opportunities for exchange)
negotiation costs (costs of negotiating the terms of the exchange)
enforcement costs (costs of enforcing the contract)
Search and information costs are costs such as those incurred in determining that the required good is available on the
market, who has the lowest price, etc. Bargaining costs are the costs required to come to an acceptable agreement with
the other party to the transaction, drawing up an appropriate contract and so on. In game theory this is analyzed for
instance in the game of chicken. On asset markets and in market microstructure, the transaction cost is some function of
the distance between the bid and ask. Policing and enforcement costs are the costs of making sure the other party sticks
to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the
case.
In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to conduct
negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the
terms of the contract are being observed, and so on.
Coase contends that without taking into account transaction costs it is impossible to understand properly the working of
the economic system and have a sound basis for establishing economic policy.
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Coase observes that market prices govern the relationships between firms but within a firm decisions are made on a
basis different from maximizing profit subject market prices. Within the firm decisions are made on through
entrepreneurial coordination.
There are a great variety of arrangements in producing goods. In agriculture often most of the labor force works on a dayto-day basis. In other industries the labor force may be permanent, tied to the firm with long-term contracts. Repair
services in some firms may be supplied by an internal organization; in others it is provided by specialized firms from
outside. A firm is a system of long-term contracts that emerge when short-term contracts are unsatisfactory.
The unsuitability of short term contracts arises from the costs collecting information and the costs of negotiating contracts.
This leads to long term contracts in which the remuneration is specified for the contractee in return for obeying, within
limits, the direction of the entrepreneur.
Coase noted that there are inconveniences of market transactions, but if transactions are not governed by the price
system there has to be an organization. The object of a business organization is to reproduce the conditions of a
competitive market for the factors of production within the firm at a lower cost than the actual market. But if an
organization exists to reduce costs then why is there any market transactions at all? Coase gave two reasons:
1. the costs of organizing additional transactions rise with scale and are equated with the costs of additional market
transactions;
2. the organization of bigger firms may not reproduce the effects of market conditions.
In presenting the "Coase Theorem" Coase was arguing that in the absence of transaction costs many surprising results
hold. The Coase Theorem says that even in the presence of externalities (although he doesn't use that term) if there are
no transactions costs to creating private agreements the levels of productions of goods will be the same no matter which
party to an externality has legal right to compensation. This means that the intervention of the government in the case of
externality doesn't affect production if there are no transaction costs. Intervention of the government in such cases does
affect the distribution of income.
3. Property rights
A property right is the exclusive authority to determine how a resource is used, whether that resource is owned by
government or by individuals. All economic goods have a property rights attribute. This attribute has three broad
components
1. The right to use the good
2. The right to earn income from the good
3. The right to transfer the good to others
The concept of property rights as used by economists and legal scholars (see property rights) are related but distinct. The
distinction is largely seen in the economists' focus on the ability of an individual or collective to control the use of the
good. For example, a thief who has stolen a good would not be considered to have legal (de jure) property right to the
good, but would be considered to have economic (de facto) property right to the good.
Property Rights Regimes
Property rights to a good must be defined, their use must be monitored, and possession of rights must be enforced. The
costs of defining, monitoring, and enforcing property rights are termed transaction costs. Depending on the level of
transaction costs, various forms of property rights institutions will develop. Each institutional form can be described by the
distribution of rights. The following list is ordered from no property rights defined to all property rights being held by
individuals.
1.
2.
3.
4.
Open access
State property
Common property
Private property
Open-access property is property that is not owned by anyone. It is non-excludable (no one can exclude anyone else
from using it) and non-rival (one person's use of it does not prevent others from simultaneously using it). Open-access
property is not managed by anyone, and access to it is not controlled. There is no constraint on anyone using openaccess property (excluding people is either impossible or prohibitively costly). The tragedy of the commons is a
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misnomer. It should really be called the tragedy of open access. 'Open-access property may exist because ownership
has never been established, because the state has legislated it, or because no effective controls are in place, or feasible,
ie, the cost of exclusion outweighs the benefits. The state can sometimes effectively convert open access property into
private, common or public property by legislating to define rights and enforce them' . Examples of open-access property
are the atmosphere or ocean fisheries.
State property (also known as public property) is property that is owned by all, but its access and use is controlled by the
state. An example is a national park .
Common property is property that is owned by a group of individuals. Access, use, and exclusion are controlled by the
joint owners. True commons can break down, but, unlike open-access property, common property owners have greater
ability to manage conflicts through shared benefits and enforcement .
Private property is both excludable and rival. Private property access, use, exclusion, and management are controlled by
the private owner.
Property Rights and the Environment
Implicit or explicit property rights can be created by regulating the environment, either through prescriptive command and
control approaches (e.g. limits on input/output/discharge quantities, specified processes/equipment, audits) or by more
flexible market-based instruments (e.g. taxes, transferable permits or quotas) .
It has been proposed that clearly defining and assigning property rights would resolve environmental problems by
internalizing externalities and relying on incentives of private owners to conserve resources for the future. However, this
assumes that it is possible to internalize all environmental benefits, that owners will have perfect information, that scale
economies are manageable, transaction costs are bearable, and that legal frameworks operate efficiently. Strengthening
markets and creating and strengthening property rights could reduce, but not eliminate, such problems.
4. Externality
in economics, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices, incurred
by a party who did not agree to the action causing the cost or benefit. A benefit in this case is called a positive
externality or external benefit, while a cost is called a negative externality or external cost.
In these cases in a competitive market, prices do not reflect the full costs or benefits of producing or consuming a
product or service, producers and consumers may either not bear all of the costs or not reap all of the benefits of
the economic activity, and too much or too little of the good will be produced or consumed in terms of overall costs
and benefits to society. For example, manufacturing that causes air pollution imposes costs on the whole society,
while fire-proofing a home improves the fire safety of neighbors. If there exist external costs such as pollution, the
good will be overproduced by a competitive market, as the producer does not take into account the external costs
when producing the good. If there are external benefits, such as in areas of education or public safety, too little of
the good would be produced by private markets as producers and buyers do not take into account the external
benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and
costs for all parties involved.
External costs and benefits
Implications
Standard economic theory states that any voluntary exchange is mutually beneficial to both parties involved in the
trade. This is because either the buyer or the seller would refuse the trade, if it won't benefit both. However, an
exchange can cause additional effects on third parties. From the perspective of those affected, these effects may
be negative (pollution from a factory), or positive (honey bees that pollinate the garden). Welfare economics has
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shown that the existence of externalities results in outcomes that are not socially optimal. Those who suffer from
external costs do so involuntarily, while those who enjoy external benefits do so at no cost.
A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the
negative externality in the case of air pollution will see it as lowered utility: either subjective displeasure or
potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on
their lungs, violating their property rights. Thus, an external cost may pose an ethical orpolitical problem.
Alternatively, it might be seen as a case of poorly defined property rights, as with, for example, pollution of bodies
of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries
and/or legal traditions).
On the other hand, a positive externality would increase the utility of third parties at no cost to them. Since
collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will
be produced than would be optimal for society as a whole. Goods with positive externalities include education
(believed to increase societal productivity and well-being; but controversial, as these benefits may be internalized),
public health initiatives (which may reduce the health risks and costs for third parties for such things as
transmittable diseases) and law enforcement. Positive externalities are often associated with the free rider problem.
For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others
around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one
individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.
There are a number of potential means of improving overall social utility when externalities are involved. The
market-driven approach to correcting externalities is to "internalize" third party costs and benefits, for example, by
requiring a polluter to repair any damage caused. But, in many cases internalizing costs or benefits is not feasible,
especially if the true monetary values cannot be determined.
The monetary values of externalities are difficult to quantify, as they may reflect the ethical views and preferences
of the entire population. It may not be clear whose preferences are most important, interests may conflict, the value
of externalities may be difficult to determine, and all parties involved may try to influence the policy responses to
their own benefit. An example is the externalities of the smoking of tobacco, which can cost or benefit society
depending on the situation. Because it may not be feasible to monetize the costs and benefits, another method is
needed to either impose solutions or aggregate the choices of society, when externalities are significant. This may
be through some form of representative democracy or other means. Political economy is, in broad terms, the study
of the means and results of aggregating those choices and benefits that are not limited to purely private
transactions.
Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to externalities as
"neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized.
Private and social costs: Social costs are the spillover costs to society (society pays off the costs), while private
costs are the costs given to the individual firms or producer.
Examples
Negative
A negative externality is an action of a product on consumers that imposes a negative side effect on a third party;
(aka- Social Cost). Many negative externalities (also called "external costs" or "external diseconomies") are
related to the environmental consequences of production and use. The article on environmental economics also
addresses externalities and how they may be addressed in the context of environmental issues.
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Systemic risk describes the risks to the overall economy arising from the risks which the banking system takes.
That the private costs of banking failure may be smaller than the social costs justifies banking regulations,
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although regulations could create a moral hazard.
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Anthropogenic climate change is attributed to greenhouse gas emissions from burning oil, gas, and coal.
The Stern Review on the Economics Of Climate Change says "Climate change presents a unique challenge for
economics: it is the greatest example of market failure we have ever seen."
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Water pollution by industries that adds poisons to the water, which harm plants, animals, and humans.
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Industrial farm animal production, on the rise in the 20th century, resulted in farms that were easier to run, with
fewer and often less-highly-skilled employees, and a greater output of uniform animal products. However, the
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externalities with these farms include "contributing to the increase in the pool of antibiotic-resistant bacteria
because of the overuse of antibiotics; air quality problems; the contamination of rivers, streams, and coastal
waters with concentrated animal waste; animal welfare problems, mainly as a result of the extremely close
quarters in which the animals are housed."
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The harvesting by one fishing company in the ocean depletes the stock of available fish for the other
companies and overfishing may be the result. This is an example of a common property resource, sometimes
referred to as the Tragedy of the commons.
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When car owners use roads, they impose congestion costs on all other users.
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A business may purposely underfund one part of their business, such as their pension funds, in order to push
the costs onto someone else, creating an externality. Here, the "cost" is that of providing minimum social
welfare or retirement income; economists more frequently attribute this problem to the category of moral
hazards.
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Consumption by one consumer causes prices to rise and therefore makes other consumers worse off, perhaps
by reducing their consumption. These effects are sometimes called "pecuniary externalities" and are
distinguished from "real externalities" or "technological externalities". Pecuniary externalities appear to be
externalities, but occur within the market mechanism and are not a source of market failure or inefficiency.
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The consumption of alcohol by bar-goers in some cases leads to drinking and driving accidents which injure or
kill pedestrians and other drivers.
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Commonized costs of declining health and vitality caused by smoking and/or alcohol abuse. Here, the "cost" is
that of providing minimum social welfare. Economists more frequently attribute this problem to the category
of moral hazards, the prospect that a party insulated from risk may behave differently from the way they would
if they were fully exposed to the risk. For example, an individual with insurance against automobile theft may be
less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne
by the insurance company.
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The cost of storing nuclear waste from nuclear plants for more than 1,000 years (over 100,000 for some
types of nuclear waste) is included in the cost of the electricity the plant produces, in the form of a fee paid to
the government and held in the Nuclear Waste Fund. Conversely, the costs of managing the long term risks of
disposal of chemicals, which may remain permanently hazardous, is not commonly internalized in prices. The
USEPA regulates chemicals for periods ranging from 100 years to a maximum of 10,000 years, without respect
to potential long-term hazard.
Positive
Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit goods)
include:
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A beekeeper keeps the bees for their honey. A side effect or externality associated with his activity is
the pollination of surrounding crops by the bees. The value generated by the pollination may be more important
than the value of the harvested honey.
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An individual planting an attractive garden in front of his or her house may provide benefits to others living in
the area, and even financial benefits in the form of increased property values for all property owners.

An individual buying a product that is interconnected in a network (e.g., a video cellphone) will increase the
usefulness of such phones to other people who have a video cellphone. When each new user of a product
increases the value of the same product owned by others, the phenomenon is called a network externality or
a network effect. Network externalities often have "tipping points" where, suddenly, the product reaches general
acceptance and near-universal usage, a phenomenon which can be seen in the near universal take-up of
cellphones in some Scandinavian countries.
9

Knowledge spillover of inventions and information - once an invention (or most other forms of practical
information) is discovered or made more easily accessible, others benefit by exploiting the invention or
information. Copyright and intellectual property law are mechanisms to allow the inventor or creator to benefit
from a temporary, state-protected monopoly in return for "sharing" the information through publication or other
means.

Sometimes the better part of a benefit from a good comes from having the option to buy something rather than
actually having to buy it. A private fire department that only charged people that had a fire, would arguably
provide a positive externality at the expense of an unlucky few. Some form of insurance could be a solution in
such cases, as long as people can accurately evaluate the benefit they have from the option.

A family member buying a movie or game will provide a positive externality to the rest of the family, who can
then watch the movie or play the game.

An organization that purchases a large screen and projector will give benefits to those who may use the screen
for various purposes.
Home ownership creates a positive externality in that homeowners are more likely than renters to become
actively involved in the local community. For this reason, in the US interest paid on a home mortgage is
[9]
an available deduction from the income tax.


Education creates a positive externality because more educated people are less likely to engage in violent
crime, which makes everyone in the community, even people who are not well educated, better off.
As noted, externalities (or proposed solutions to externalities) may also imply political conflicts, rancorous lawsuits,
and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle.
Similarly, if too many positive externalities fall outside the participants in a transaction, there will be too little
incentive on parties to participate in activities that lead to the positive externalities.
Supply and demand diagram
The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the
externality can be monetized and valued in terms of money. An extra supply or demand curve is added, as in the
diagrams below. One of the curves is theprivate cost that consumers pay as individuals for additional quantities of
the good, which in competitive markets, is the marginal private cost. The other curve is the true cost that society as
a whole pays for production and consumption of increased production the good, or the marginal social cost.
Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect
the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals
and is reflected as effective demand in the market.
External costs
The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be
selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire).
The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the
cost of air pollution and water pollution. This is represented by the vertical distance between the two supply curves.
It is assumed that there are no external benefits, so that social benefit equals individual benefit.
10
Supply & Demand with external costs
If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead
of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should
equal the marginal social cost, that is that production should be increased only as long as the marginal social
benefit exceeds the marginal social cost. The result is that a free market is inefficient since at the quantity Qp, the
social benefit is less than the social cost, so society as a whole would be better off if the goods
between Qp andQs had not been produced. The problem is that people are buying and consumingtoo much steel.
This discussion implies that negative externalities (such as pollution) is more thanmerely an ethical problem. The
problem is one of the disjuncture between marginal private and social costs that is not solved by the free market. It
is a problem of societal communication and coordination to balance costs and benefits. This also implies that
pollution is not something solved by competitive markets. Somecollective solution is needed, such as a court
system to allow parties affected by the pollution to be compensated, government intervention banning or
discouraging pollution, or economic incentives such as green taxes.
External benefits
The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying
smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the
vaccination is less than the marginal social or public benefit by the amount of the external benefit (for example,
society as a whole is increasingly protected from smallpox by each vaccination, including those who refuse to
participate). This marginal external benefit of getting a smallpox shot is represented by the vertical distance
between the two demand curves. Assume there are no external costs, so that social cost equals individual cost.
Supply & Demand with external benefits
If consumers only take into account their own private benefits from getting vaccinations, the market will end up at
price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect
the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be
increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered
market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so society as a
whole would be better off if more goods had been produced. The problem is that people are buying too
few vaccinations.
The issue of external benefits is related to that of public goods, which are goods where it is difficult if not impossible
to exclude people from benefits. The production of a public good has beneficial externalities for all, or almost all, of
the public. As with external costs, there is a problem here of societal communication and coordination to balance
benefits and costs. This also implies that vaccination is not something solved by competitive markets. The
government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If
the government does this, the good is called a merit good.
Possible solutions
There are at least four general types of solutions to the problem of externalities:

Criminalization: As with prostitution, addictive drugs, commercial fraud, and many types of environmental and
public health laws.
11



Civil Tort law: For example, class action by smokers, various product liability suits.
Government provision: As with lighthouses, education, and national defense.
Pigovian taxes or subsidies intended to redress economic injustices or imbalances.
A Pigovian tax is a tax imposed that is equal in value to the negative externality. The result is that the market
outcome would be reduced to the efficient amount. A side effect is that revenue is raised for the government,
reducing the amount of distortionary taxes that the government must impose elsewhere. Economists prefer
Pigovian taxes and subsidies as being the least intrusive and most efficient method to resolve externalities.
However, the most common type of solution is tacit agreement through the political process. Governments are
elected to represent citizens and to strike political compromises between various interests. Normally governments
pass laws and regulations to address pollution and other types of environmental harm. These laws and regulations
can take the form of "command and control" regulation (such as setting standards, targets, or process
requirements), or environmental pricing reform (such as eco-taxes or other pigouvian taxes, tradable pollution
permits or the creation of markets for ecological services). The second type of resolution is a purely private
agreement between the parties involved.
Government intervention may not always be needed. Traditional ways of life may have evolved as ways to deal
with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs
and benefits in an amicable way. Externalities can sometimes be resolved by agreement between the parties
involved. This resolution may even come about because of the threat of government action.
Ronald Coase argued that if all parties involved can easily organize payments so as to pay each other for their
actions, then an efficient outcome can be reached without government intervention. Some take this argument
further, and make the political claim that government should restrict its role to facilitating bargaining among the
affected groups or individuals and to enforcing any contracts that result. This result, often known as the Coase
Theorem, requires that



Property rights be well defined
People act rationally
Transaction costs be minimal
If all of these conditions apply, the private parties can bargain to solve the problem of externalities.
This theorem would not apply to the steel industry case discussed above. For example, with a steel factory that
trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one
person to negotiate with the producer, and there are large transaction costs. Hence the most common approach
may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for
the regulation and enforcement with taxes. The case of the vaccinations would also not satisfy the requirements of
the Coase Theorem. Since the potential external beneficiaries of vaccination are the people themselves, the people
would have to self-organize to pay each other to be vaccinated. But such an organization that involves the entire
populace would be indistinguishable from government action.
In some cases, the Coase theorem is relevant. For example, if a logger is planning to clear-cut a forest in a way
that has a negative impact on a nearby resort, the resort-owner and the logger could, in theory, get together to
agree to a deal. For example, the resort-owner could pay the logger not to clear-cut – or could buy the forest. The
most problematic situation, from Coase's perspective, occurs when the forest literally does not belong to anyone;
the question of "who" owns the forest is not important, as any specific owner will have an interest in coming to an
agreement with the resort owner (if such an agreement is mutually beneficial).
5. Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not
efficient. That is, there exists another outcome where market participants' overall gains from the new outcome outweigh
their losses (even if some participants lose under the new arrangement). Market failures can be viewed as scenarios
where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the
societal point-of-view. The first known use of the term by economists was in 1958, but the concept has been traced back
to the Victorian philosopher Henry Sidgwick.
Market failures are often associated with information, non-competitive markets, externalities, or public goods. The
existence of a market failure is often used as a justification for government intervention in a
particular market. Economists, especially microeconomists, are often concerned with the causes of market failure, and
possible means to correct such a failure when it occurs. Such analysis plays an important role in many types of public
policy decisions and studies. However, some types of government policy interventions, such as taxes, subsidies, bailouts,
wage and price controls, and regulations, including attempts to correct market failure, may also lead to an inefficient
12
allocation of resources, (sometimes called government failures). Thus, there is sometimes a choice between imperfect
outcomes, i.e. imperfect market outcomes with or without government interventions. But either way, if a market failure
exists the outcome is not pareto efficient. Mainstream neoclassical and Keynesian economists believe that it may be
possible for a government to improve the inefficient market outcome, while several heterodox schools of thought disagree
with this.
Causes
According to mainstream economic analysis, a market failure (relative to Pareto efficiency) can occur for three main
reasons.


First, agents in a market can gain market power, allowing them to block other mutually beneficial gains from
trades from occurring. This can lead to inefficiency due to imperfect competition, which can take many different
forms, such as monopolies, monopsonies, cartels, or monopolistic competition, if the agent does not implement
perfect price discrimination. In a monopoly, the market equilibrium will no longer be Pareto optimal. [11] The monopoly
will use its market power to restrict output below the quantity at which the Marginal social benefit (MSB) is equal to
the Marginal social cost (MSC) of the last unit produced, so as to keep prices and profits high.[11] An issue for this
analysis is whether a situation of market power or monopoly is likely to persist if unaddressed by policy, or whether
competitive or technological change will undermine it over time.
Second, the actions of agents can have externalities,[which are innate to the methods of production, or other
conditions important to the market.[For example, when a firm is producing steel, it absorbs labor, capital and other
inputs, it must pay for these in the appropriate markets, and these costs will be reflected in the market price for steel.
If the firm also pollutes the atmosphere when it makes steel, however, and if it is not forced to pay for the use of this
resource, then this cost will be borne not by the firm but by society. Hence, the market price for steel will fail to
incorporate the full opportunity cost to society of producing. In this case, the market equilibrium in the steel industry
will not be optimal. More steel will be produced than would occur were the firm to have to pay for all of its costs of
production. Consequently, the MSC of the last unit produced will exceed its MSB. Finally, some markets can fail due
to the nature of certain goods, or the nature of their exchange. For instance, goods can display the attributes of public
goods or common-pool resources, while markets may have significant transaction costs, agency problems, or
informational asymmetry. In general, all of these situations can produce inefficiency, and a resulting market failure. A
related issue can be the inability of a seller to exclude non-buyers from using a product anyway, as in the
development of inventions that may spread freely once revealed. This can cause underinvestment, such as where a
researcher cannot capture enough of the benefits from success to make the research effort worthwhile.
More fundamentally, the underlying cause of market failure is often a problem of property rights. As Hugh Gravelle and
Ray Rees put it,
A market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in
particular ways for particular amounts of time. [...] Markets are institutions which organize the exchange of control of
commodities, where the nature of the control is defined by the property rights attached to the commodities.
As a result, agents' control over the uses of their commodities can be imperfect, because the system of rights which
defines that control is incomplete. Typically, this falls into two generalized rights – excludability and transferability.
Excludability deals with the ability of agents to control who uses their commodity, and for how long – and the related costs
associated with doing so. Transferability reflects the right of agents to transfer the rights of use from one agent to another,
for instance by selling or leasing a commodity, and the costs associated with doing so. If a given system of rights does
not fully guarantee these at minimal (or no) cost, then the resulting distribution can be inefficient. Considerations such as
these form an important part of the work of institutional economics. Nonetheless, views still differ on whether something
displaying these attributes is meaningful without the information provided by the market price system.
Traffic congestion is an example of market failure, since driving can impose hidden costs on other drivers and society.
Solutions for this include public transportation, congestion pricing, toll roads and toll bridges, and other ways of making
the driver include the social cost in the decision to drive. Other common examples of market failure include environmental
problems such as pollution or overexploitation of natural resources.
6. Public good
In economics, a public good is a good that is non-rivalrous and non-excludable. Non-rivalry means that
consumption of the good by one individual does not reduce availability of the good for consumption by others; and
[1]
non-excludability that no one can be effectively excluded from using the good. In the real world, there may be no
such thing as an absolutely non-rivaled and non-excludable good; but economists think that some goods
approximate the concept closely enough for the analysis to be economically useful.
For example, if one individual visits a doctor there is one less doctor's visit for everyone else, and it is possible to
exclude others from visiting the doctor. This makes doctor visits a rivaled and excludable private good. Conversely,
breathing air does not significantly reduce the amount of air available to others, and people cannot be effectively
13
excluded from using the air. This makes air a public good, albeit one that is economically trivial, since air is a free
good. A less straight-forward example is the exchange of MP3 music files on the internet: the use of these files by
any one person does not restrict the use by anyone else and there is little effective control over the exchange of
these music files and photo files.
Non-rivalness and non-excludability may cause problems for the production of such goods. Specifically, some
economists have argued that they may lead to instances of market failure, where uncoordinated markets driven by
parties working in their own self interest are unable to provide these goods in desired quantities. These issues are
known as public goods problems, and there is a good deal of debate and literature on how to measure their
significance to an economy, and to identify the best remedies. These debates can become important to political
arguments about the role of markets in the economy. More technically, public goods problems are related to the
broader issue ofexternalities.
Graphically, non-rivalry means that if each of several individuals has a demand curve for a public good, then the
individual demand curves are summed vertically to get the aggregate demand curve for the public good . This is in
contrast to the procedure for deriving the aggregate demand for a private good, where individual demands are
summed horizontally.
Terminology, and types of public goods
Excludable
Non-excludable
Rivalrous
Private
food,
clothing,
personal electronics
goods
cars,
Non-rivalrous
Club
cinemas, private
satellite television
goods
parks,
Common goods (Common-pool
resources)
fish stocks, timber, coal, national
health service
Public
goods
free-to-air television, air, national
defense
Paul A. Samuelson is usually credited as the first economist to develop the theory of public goods. In his classic
[2]
1954 paper The Pure Theory of Public Expenditure, he defined a public good, or as he called it in the paper a
"collective consumption good", as follows:
...[goods] which all enjoy in common in the sense that each individual's consumption of such a good leads to no
subtractions from any other individual's consumption of that good...
This is the property that has become known as Non-rivalry. In addition a pure public good exhibits a second
property called Non-excludability: that is, it is impossible to exclude any individuals from consuming the good.
The opposite of a public good is a private good, which does not possess these properties. A loaf of bread, for
example, is a private good: its owner can exclude others from using it, and once it has been consumed, it cannot be
used again.
A good which is rivalrous but non-excludable is sometimes called a common pool resource. Such goods raise
similar issues to public goods: the mirror to the public goods problem for this case is sometimes called the tragedy
of the commons. For example, it is so difficult to enforce restrictions on deep sea fishing that the world's fish stocks
can be seen as a non-excludable resource, but one which is finite and diminishing.
The definition of non-excludability states that it is impossible to exclude individuals from consumption. Technology
now allows radio or TV broadcasts to be encrypted such that persons without a special decoder are excluded from
the broadcast; however, an unencrypted Many forms of information have characteristics of public goods. For
example, a poem can be read by many people without reducing the consumption of that good by others; in this
sense, it is non-rivalrous. Similarly, the information in most patents can be used by any party without reducing
consumption of that good by others. Creative works may be excludable in some circumstances, however: the
individual who wrote the poem may decline to share it with others by not publishing it. Copyrights and patents both
encourage and inhibit the creation of such non-rival goods by providing temporary monopolies, or, in the
terminology of public goods, providing a legal mechanism to enforce excludability for a limited period of time. For
public goods, the "lost revenue" of the producer of the good is not part of the definition: a public good is a good
whose consumption does not reduce any other's consumption of that good.
14
The economic concept of public goods should not be confused with the expression "the public good", which is
usually an application of a collective ethical notion of "the good" in political decision-making. Another common
confusion is that public goods are goods provided by thepublic sector. Although it is often the case
that Government is involved in producing public goods, this is not necessarily the case. Public goods may
be naturally available. They may be produced by private individuals and firms, by non-state collective action, or
they may not be produced at all.
The theoretical concept of public goods does not distinguish with regard to the geographical region in which a good
may be produced or consumed. However, some theorists (such as Inge Kaul) use the term global public good to
mean a public good which is non-rival and non-excludable throughout the whole world, as opposed to a public good
[3]
which exists in just one national area. Knowledge has been held to be an example of a global public good.
Collective good
Collective goods (or social goods) of a sovereign nation are defined public goods that could be delivered
as private goods, but are usually delivered by the government for various reasons, including social policy, and
finances from public funds like taxes.
Note: Some writers have used the term public good to refer only to non-excludable pure public goods. They may
then call excludable public goods club goods.
Examples
Common examples of public goods of a sovereign nation include: defense and law enforcement (including the
system of property rights), public fireworks, lighthouses, clean air and other environmental goods, and information
goods, such as some software development,authorship, and invention. Some goods (such as orphan drugs) require
special governmental incentives to be produced, but can't be classified as public goods since they don't fulfill the
above requirements (Non-excludable and non-rivalrous.)
The provision of a lighthouse has often been used as the standard example of a public good, since it is difficult to
exclude ships from using its services. No ship's use detracts from that of others, but since most of the benefit of a
lighthouse accrues to ships using particular ports, lighthouse maintenance fees can often profitably be bundled with
port fees (Ronald Coase, The Lighthouse in Economics 1974). This has been sufficient to fund actual lighthouses.
Technological progress can create new public goods. The most simple examples are street lights, which are
relatively recent inventions (by historical standards). One person's enjoyment of them does not detract from other
persons' enjoyment, and it currently would be prohibitively expensive to charge individuals separately for the
amount of light they presumably use. On the other hand, a public good's status may change over time.
Technological progress can significantly impact excludability of traditional public goods: encryption
allows broadcasters to sell individual access to their programming. The costs for electronic road pricing have fallen
dramatically, paving the way for detailed billing based on actual use.
There is some question as to whether defense is a public good. Murray Rothbard argues, "'national defense' is
surely not an absolute good with only one unit of supply. It consists of specific resources committed in certain
definite and concrete ways—and these resources are necessarily scarce. A ring of defense bases around New
[5]
York, for example, cuts down the amount possibly available around San Francisco." Jeffrey Rogers Hummel and
Don Lavoie note, "Americans in Alaska and Hawaii could very easily be excluded from the U.S. government's
defense perimeter, and doing so might enhance the military value of at least conventional U.S. forces to Americans
in the other forty-eight states. But, in general, an additional ICBM in the U.S. arsenal can simultaneously protect
everyone within the country without diminishing its services."
The free rider problem
Public goods provide a very important example of market failure, in which market-like behavior of individual gainseeking does not produce efficient results. The production of public goods results in positive externalities which are
not remunerated. If private organizations don't reap all the benefits of a public good which they have produced, their
incentives to produce it voluntarily might be insufficient. Consumers can take advantage of public goods without
contributing sufficiently to their creation. This is called the free rider problem, or occasionally, the "easy rider
problem" (because consumer's contributions will be small but non-zero).
The free rider problem depends on a conception of the human being as homo economicus: purely rational and also
purely selfish—extremely individualistic, considering only those benefits and costs that directly affect him or her.
Public goods give such a person an incentive to be a free rider.
15
For example, consider national defense, a standard example of a pure public good. Suppose homo
economicus thinks about exerting some extra effort to defend the nation. The benefits to the individual of this effort
would be very low, since the benefits would be distributed among all of the millions of other people in the country.
There is also a very high possibility that he or she could get injured or killed during the course of his or her military
service.
On the other hand, the free rider knows that he or she cannot be excluded from the benefits of national defense,
regardless of whether he or she contributes to it. There is also no way that these benefits can be split up and
distributed as individual parcels to people. The free rider would not voluntarily exert any extra effort, unless there is
some inherent pleasure or material reward for doing so (for example, money paid by the government, as with an allvolunteer army or mercenaries).
In the case of information goods, an inventor of a new product may benefit all of society, but hardly anyone is
willing to pay for the invention if they can benefit from it for free.
Efficient production levels of public goods
Imagine that someone came to your door and asked you to pay twenty euros towards the cost of powering the
street lamp out in the street for another year. The collector argues that the street lamp provides you with light to
help you see at night when you are driving or walking home.
A public good is provided efficiently at the level where the combined marginal rate of substitution of all individuals is
equal to the marginal rate of transformation. (The marginal rate of substitution is the rate at which an individual is
willing to exchange a private good for a public good, the marginal rate of transformation is the quantity of a private
good which the society has to give up in order to produce one unit of a public good).
When should a public good be provided? To illustrate the basic principle, consider a community composed of just
two consumers. The government is considering whether or not to provide a park. Arthur is prepared to pay up to
£200 for use of the park, while Julia is willing to pay up to £100. The total value to the two individuals of having the
park is £300. If it can be produced for £225, there is a £75 gain on its production since it provides services that the
community values at £300 at a cost of only £225.
Regardless of the method of providing public goods, the efficient level of such provision is still being subjected to
economic analysis. For instance, the Samuelson condition calculates the efficient level of public goods production
to be where the ratio of the marginal social cost of public and private goods production equals the ratio of
the marginal social benefit of public and private goods production.
"If the amount of a public good can be varied continuously, the optimal quantity to produce is that quantity for which
the marginal cost of the last unit is just equal to the sum of the prices that all consumers would be willing to pay for
that unit." This equilibrium guarantees that the last unit of the public good costs as much to produce as the value
that it gives to all of its consumers.
7. Social cost
Social cost, in economics, is generally defined in opposition to "private cost". In economics, theorists model
individual decision-making as measurement of costs and benefits. Rational choice theory often assumes that
individuals consider only the costs they themselves bear when making decisions, not the costs that may be borne
by others.
In most cases, the costs carried by the individuals involved are the only economically meaningful costs. The choice
to purchase a glass oflemonade at a lemonade stand has little consequence for anyone other than the seller or the
buyer. The costs involved in this economic activity are the costs of the lemons and the sugar and the water that are
ingredients to the lemonade, the opportunity cost of the labour to combine them into lemonade, as well as any
transaction costs, such as walking to the stand.
Implications
If there is a negative externality, then social costs will be greater than private costs. Environmental pollution is an
example of a social cost that is seldom borne completely by the polluter, thereby creating a negative externality. If
there is a positive externality, then one will have higher social benefits than private benefits. For example, when a
supplier of educational services indirectly benefits society as a whole but only receives payment for the direct
benefit received by the recipient of the education: the benefit to society of an educated populace is a positive
externality. In either case, economists refer to this as market failure because resources will be allocated
inefficiently. In the case of negative externalities, private agents will engage in too much of the activity; in the case
of positive externalites, they will engage in too little. (The marginal rate of transformation in production will not be
16
equal to the marginal rate of substitution in consumption due to the effect of the externality and as a result Pareto
optimality will not occur—see welfare economics for an explanation.)
Theory
The ideas of social cost, externalities, and market failure are often used as an argument
for government intervention in the form of regulations. Libertarians who believe in a free market respond that the
existence of market failure should not lead to government intervention. They prefer to rely on tradition, community
pressure, and dollar voting.
Negative externalities (external costs) lead to an over-production of those goods that have a high social cost. For
example, the logging of trees for timber may result in society losing a recreation area, shade, beauty, good quality
soil to grow crops on, and air quality but this loss is usually not quantified and included in the price of the timber that
is made from the trees. As a result, individual entities in the marketplace have no incentive to factor in these
externalities. More of this activity is performed than would be if its cost had a true accounting.
This can be illustrated with a diagram. Profit-maximizing organizations will set output at Qp where marginal private
costs (MPC) is equal to marginal revenue (MR). (This diagram assumes perfect competition, under which price (P)
equals MR.) This will yield a profit shown by the triangular area 0,C,F.
But if externalities are present, the attainment of social optimality requires that the full social costs must be
considered. The socially optimum level of output is Qs where marginal social costs (MSC) is equal to marginal
revenue (MR). The amount of output, Qp minus Qs, indicates the excess output due to the externality. Profits will
decrease also, from0,C,F to 0,A,F. It is clearly profitable for the firm to pollute, since "internalizing the externality"
hurts profits. The amount of the externality will decrease from C,D to B,A.
Because the marginal social cost curve (MSC) is above the marginal private cost curve (MPC), this diagram
illustrates the case of a negative externality. If the marginal social cost curve was below the marginal private cost
curve, it would be a positive externality and social optimality would require a greater output than Qp rather than a
reduction of output.
Institutional ecological economists in the tradition of Karl William Kapp provide a different definition of social costs,
i.e. that share of the total costs of production that is not born by producers but is shifted to 3rd parties, future
generations or society at large.
17