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An externality is an unintended consequence of a choice
that falls on someone other than the decision-maker.
Externalities may be positive or negative
Externalities may arise in consumption or production
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Production Externalities
Production externalities drive a wedge between the
marginal private cost (MC) that is borne by the producer,
and the marginal social cost (MSC) that is the total cost
to society.
MSC = MC + marginal external cost
The marginal external cost is the cost of producing one
more unit of a good or service that falls on people other
than the producer.
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Negative Production Externalities
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Negative Production Externalities:
Pollution
Production and Pollution: How Much?
In the market for a good with an externality that is
unregulated, the amount of pollution created depends on
the equilibrium quantity of the good produced.
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Negative Externalities: Pollution
Figure 16.2 shows the
equilibrium in an
unregulated market with
an external cost.
The quantity produced is
where marginal private
cost equals marginal
social benefit.
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Negative Externalities: Pollution
At the market equilibrium,
MSB is less than MSC,
so the market produces
an inefficient quantity.
At the efficient quantity,
marginal social cost equals
marginal social benefit.
With no regulation, the
market overproduces and
creates a deadweight loss.
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Consumption Externalities
Consumption externalities drive a wedge between the
marginal private benefit (MB) that is borne by the
producer, and the marginal social benefit (MSB) that is
the total cost to society.
MSB = MB + marginal external benefit
The marginal external benefit is the benefit from
consuming one more unit of a good or service that falls on
people other than the consumer.
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Positive Consumption Externalities:
Knowledge
The marginal external
benefit is the vertical distance
between the MB and MSB
curves.
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Positive Externalities: Knowledge
A private market will
underproduce an item
that generates an
external benefit
and creates a
deadweight loss.
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Externalities and property rights
Property Rights
Property rights are legally established titles to the
ownership, use, and disposal of factors of production and
goods and services that are enforceable in the courts.
One way to look at the market failure that arises in the
presence of externalities is that it comes about because of
the absence of property rights.
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Externalities and property rights
The Coase Theorem
The Coase theorem is a proposition that if property rights
exist, only a small number of parties are involved, and
transactions costs (defined below) are low, then private
transactions are efficient.
There are no externalities because all parties take into
account the externalities involved. The outcome is
independent of who has the property rights.
To see this, take the example of “the barking dog”.
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Barking dog example
D owns a dog that barks
J is bothered by the dog barking
What is the efficient allocation?
Depends on value of benefit to D of keeping dog compared
to cost to J of barking.
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Benefit to D from owning dog:
$500
Cost to J of barking dog:
-$800
Total surplus if D keeps dog :
-$300
Total surplus if D gets rid of the dog : $ 0
Efficient outcome: J pays D to get rid of the dog
Scenario 1 Suppose D owns the “property right” to let the
dog bark. J can offer to pay him to get rid of the dog.
She will offer P<$800; he will accept P>500. So he gets
rid of the dog - outcome is efficient.
Scenario 2 Suppose J owns the “property right” to quiet. D
can offer to pay her not to complain about the dog. D
will offer P<500; J will accept P>500. No deal. She
complains, the dog is removed. The outcome is efficient.
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This example illustrates the Coase theorem:
(1) if property rights exist, only a small number of parties
are involved, and transactions costs (defined below) are
low, then private transactions are efficient; and
(2) the outcome is independent of who has the property
rights.
Easy to see (2) in our example. In both scenarios, the dog
is not allowed to bark. Does not depend on who has
property right.
However, the distribution of surplus depends on the
property right. When D has the property right, J gets
less surplus and D gets more surplus (J pays D to get rid
of dog).
© 2010 Pearson Education Canada
This example illustrates the Coase theorem:
(1) if property rights exist, only a small number of parties
are involved, and transactions costs (defined below) are
low, then private transactions are efficient; and
(2) the outcome is independent of who has the property
rights.
What about the first proposition?
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The Coase solution works only if transaction costs are low.
Transactions costs are the cost of conducting a
transaction.
In our example, the transactions cost would involve
negotiating a price between J and D.
When a large number of people are involved in an
externality and transactions costs are high, the Coase
solution of establishing property rights doesn’t work and
governments try to deal with the externality.
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Negative Externalities: Pollution
Government Actions in the Face of External Costs
There are three main methods that the government uses
to cope with external costs:

Taxes

Emission charges

Marketable permits
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Negative Externalities: Pollution
Taxes
The government can set a tax equal to marginal external
cost.
The effect of such a tax is to make marginal private cost
plus the tax equal to marginal social cost,
MC + tax = MSC.
This tax is called Pigovian tax, in honor of the British
economist Arthur Pigou, who first proposed dealing with
externalities in this fashion.
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Negative Externalities: Pollution
A pollution tax equal to
the marginal external cost
can achieve an efficient
outcome because
MSC = MSB.
The government collects a
tax revenue.
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Negative Externalities: Pollution
Marketable Permits
Each firm is assigned a permitted amount of pollution per
period and firms trade permits.
The market price of a permit confronts polluters with the
marginal social cost of their actions and leads to an
efficient outcome.
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Positive Externalities: Knowledge
Government Action in the Face of External Benefits
Four devices that the government can use to achieve a
more efficient allocation of resources in the presence of
external benefits are

Public provision

Private subsidies

Vouchers

Patents and copyrights
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Positive Externalities: Knowledge
Public Provision
Under public provision,
a public authority that
receives payment from
the government produces
the good or service.
Figure 16.7(a) shows how
public provision can
achieve an efficient
outcome.
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Positive Externalities: Knowledge
Private Subsidies
A subsidy is a payment by the government to private
producers.
If the government pays the producer an amount equal to
the marginal external benefit for each unit produced, the
quantity produced is efficient.
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Positive Externalities: Knowledge
Figure 16.7(b) shows
how a subsidy can
achieve an efficient
outcome.
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Positive Externalities: Knowledge
Vouchers
A voucher is a token that
the government provides
to households, which they
can use to buy specified
goods or services.
Figure 16.8 shows how
vouchers can achieve a
more efficient outcome.
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Positive Externalities: Knowledge
Patents and Copyrights
Intellectual property rights give the creator of knowledge
the property right to the use of that knowledge.
The legal device for establishing an intellectual property
right is the patent or a copyright.
A patent or copyright is a government-sanctioned
exclusive right given to an inventor of a good, service or
productive process to use to produce, use and sell the
invention for a given number of years.
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Classifying Goods and Resources
What is the essential difference between:

A city police department and Brinks security

Fish in the Atlantic Ocean and fish in a fish farm

A live concert and a concert on television
These and all goods and services can be classified
according to whether they are excludable or
nonexcludable and rival or nonrival.
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Classifying Goods and Resources
Excludable
A good is excludable if only the people who pay for it are
able to enjoy its benefits.
Brinks’s security services, Cooke Aquaculture’s fish, and a
U2 concert are examples.
Nonexcludable
A good is nonexcludable if everyone can benefit from it
regardless of whether they pay for it.
The services of the Calgary police, fish in the Atlantic
Ocean, and a concert on network television are examples.
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Classifying Goods and Resources
Rival
A good is rival if one person’s use of it decreases the
quantity available for someone else.
A Brinks’s truck can’t deliver cash to two banks at the
same time. A fish can be consumed only once.
Nonrival
A good is nonrival if one person’s use of it does not
decrease the quantity available for someone else.
The services of the Calgary police and a concert on
network television are nonrival.
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Classifying Goods and Resources
A Four-Fold Classification
Private Goods
A private good is both rival and excludable.
A can of Coke and a fish on Cooke’s Aquaculture farm are
examples of private goods.
Public goods
A public good is both nonrival and nonexcludable. A
public good can be consumed simultaneously by
everyone, and no one can be excluded from its benefits.
National defence is the best example of a public good.
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Classifying Goods and Resources
Common Resources
A common resource is rival and nonexcludable.
A unit of a common resource can be used only once, but
no one can be prevented from using what is available.
Ocean fish are a common resource.
They are rival because a fish taken by one person isn’t
available for anyone else.
They are nonexcludable because it is difficult to prevent
people from catching them.
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Classifying Goods and Resources
Natural Monopolies (don’t focus on this)
In a natural monopoly, economies of scale exist over the
entire range of output for which there is a demand.
A special case of natural monopoly arises when the good
or service can be produced at zero marginal cost. Such a
good is nonrival. If it is also excludable, it is produced by a
natural monopoly.
The Internet and cable television are examples.
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Classifying Goods and Resources
Figure 17.1
shows this fourfold classification
of goods and
services.
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Public Goods
The Free-Rider Problem
A free rider enjoys the benefits of a good or service without
paying for it.
Because no one can be excluded from the benefits is a
public good, everyone has an incentive to free ride.
Public goods create a free-rider problem—the absence of
an incentive for people to pay for what they consume.
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Public Goods
The value of a private good is the maximum amount that a
person is willing to pay for one more unit of it.
The value of a public good is the maximum amount that all
the people are willing to pay for one more unit of it.
To calculate the value placed on a public good, we use the
concepts of total benefit and marginal benefit.
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Public Goods
Marginal Social Benefit of a Public Good
Total benefit is the dollar value that a person places on a
given quantity of a good.
The greater the quantity of a good, the larger is a person’s
total benefit.
Marginal benefit is the increase in total benefit that results
from a one-unit increase in the quantity of a good.
The marginal benefit of a public good diminishes with the
quantity of the good provided.
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Public Goods
Figure 17.2 shows that the
marginal social benefit of a
public good is the sum of
marginal benefits of
everyone at each quantity
of the good provided.
Part (a) shows Lisa’s
marginal benefit.
Part (b) shows Max’s
marginal benefit.
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Public Goods
The economy’s marginal
social benefit of a public
good is the sum of the
marginal benefits of all
individuals at each quantity
of the good provided.
The economy’s marginal
social benefit curve for a
public good is the vertical
sum of all individual
marginal benefit curves.
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Public Goods
The marginal social benefit
curve for a public good
contrasts with the demand
curve for a private good,
which is the horizontal sum
of the individual demand
curves at each price.
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Public Goods
The Marginal Social Cost of a Public Good
The marginal social cost of a public good is determined
in the same way as that of a private good.
The Efficient Quantity of a Public Good
The efficient quantity of a public good is the quantity that
at which marginal social benefit equals marginal social
cost.
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Public Goods
Figure 17.3 illustrates
the efficient quantity of
a public good.
With fewer than
2 satellites,
MSB exceeds MSC.
Resources a can be
used more efficiently by
increasing the quantity.
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Public Goods
With more than
2 satellites,
MSC exceeds MSB.
Resources can be used
more efficiently if fewer
satellites are provided.
So the quantity at which
MSB = MSC, resources
are used efficiently.
Private production would
produce 0 satellites.
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Public Goods
Efficient Public Provision
Because the government can tax all the consumers of the
public good and force everyone to pay for its provision,
public provision overcomes the free-rider problem.
If two political parties compete, each is driven to propose
the efficient quantity of a public good.
A party that proposes either too much or too little can be
beaten by one that proposes the efficient amount because
more people vote for an increase in net benefit.
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Common Resources
The Tragedy of the Commons
The tragedy of the commons is the absence of
incentives to prevent the overuse and depletion of a
commonly owned resource.
Examples include the Atlantic Ocean cod stocks, South
Pacific whales, and the quality of the earth’s atmosphere.
The traditional example from which the term derives is the
common grazing land surrounding middle-age villages.
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Common Resources
Sustainable Production
Sustainable production is the rate of production that
can be maintained indefinitely.
This production rate depends on the existing stock of
fish and the number of boats that go fishing.
For a given fish stock, as more boats go fishing, the
quantity of fish caught increases.
But with too many boats fishing, the quantity of fish
caught decreases.
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Common Resources
Table 17.1 illustrates the
number of boats and the
quantity if fish caught.
As the number of fishing
boats increases, the
quantity of fish caught
increases to some
maximum.
Overfishing occurs when
the maximum sustainable
catch decreases.
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Common Resources
Table 17.1 also shows the
average and marginal
catch depends on the
number of boats that go
fishing.
As the number of fishing
boats increases:

The average quantity of
fish caught decreases.

The marginal catch
decreases.
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Common Resources
Figure 17.6 illustrates the
sustainable production of
fish.
As the number of fishing
boats increases, the
quantity of fish caught
increases to some
maximum.
Overfishing occurs when
the maximum sustainable
catch decreases.
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Common Resources
An Overfishing Equilibrium
Figure 17.7 shows why
overfishing occurs.
Marginal private benefit, MB,
is the average catch per
boat.
Marginal private benefit
decreases as the number of
boats increases.
The marginal cost per boat
is MC (assumed constant).
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Common Resources
The Efficient Use of the Commons
The quantity of fish caught by each boat decreases as the
number of boats increases.
But no one has an incentive to take this fact into account
when deciding whether to fish.
The efficient use of a common resource requires marginal
social cost to equal marginal social benefit.
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Common Resources
Marginal Social Benefit
Marginal social benefit is the increase in the total fish
catch that results from an additional boat.
Marginal social benefit equals the marginal catch of a
boat, not the average catch per boat.
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Common Resources
Efficient Use
Figure 17.8 shows the
marginal private benefit
curve, MB, and the marginal
social benefit curve, MSB.
With no external costs, the
marginal social cost MSC
equals marginal cost MC.
Resources are used
efficiently when
MSB equals MSC.
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Common Resources
Achieving an Efficient Outcome
It is harder to achieve an efficient use of a common
resource than to define the conditions under which it
occurs.
Three methods that might be used are

Property rights

Production quotas

Individual transferable quotas (ITQs)
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Common Resources
Property Rights
By assigning property rights, common property becomes
private property.
When someone owns a resource, the owner is
confronted with the full consequences of her/his actions
in using that resources.
The social benefits become the private benefits.
But assigning property rights is not always feasible.
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Common Resources
Production Quotas
By setting a production
quota at the efficient
quantity, a common
resource might remain in
common use but be used
efficiently.
Figure 17.9 shows this
situation.
It is hard to make a
production quota work.
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Common Resources
Individual Transferable Quotas
An individual transferable quota (ITQ) is a production
limit that is assigned to an individual who is free to
transfer (sell) the quota to someone else.
A market in ITQs emerges.
If the efficient quantity of ITQs is assigned, the market
price of an ITQ confronts resource users with a marginal
cost of MC + price of ITQ.
With MC + price of ITQ equal to MSB, the quantity
produced is efficient.
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Common Resources
Figure 17.10 shows the
situation with an efficient
number of ITQs.
The market price of an
ITQ increases the
marginal cost to
MC0 + price of ITQ.
Users of the resource
make MB equal
MC0 + price of ITQ, and
the outcome is efficient.
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Common Resources
Public Choice and Political Equilibrium
It is easy for economists to agree that ITQs make it
possible to achieve an efficient use of a common
resource.
It is difficult to get the political marketplace to deliver that
outcome.
In 1996, Congress killed an attempt to use ITQs in the
Gulf of Mexico and the Northern Pacific Ocean.
Self-interest and capture of the political process
sometimes beats the social interest.
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