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Ch. 14: More Market Failures: Externalities,
Public Goods and Imperfect Information
14.1
An externality is an external cost or benefit resulting from some activity or
transaction that is imposed or bestowed upon parties outside the activity or
transaction (“bystander”). Sometimes called spillovers or neighborhood
effects.
• When external costs are not considered in economic decisions, we may
engage in activities or produce products are not “worth it.”
• When external benefits are not considered, we may fail to do things that
are indeed “worth it.”
The result of an externality is an inefficient allocation of resources
 P  MC
Market Failure (when a market fails to allocate resources efficiently P=MC)
Buyers and sellers neglect the external effects of their actions when deciding how
much to demand or supply market equilibrium is inefficient. (The equilibrium
fails to maximize the total benefit to society as a whole.)
Production vs. Consumption Externalities
Externalities in Production:
Negative: classic example is pollution
Positive: beekeeper and the orchard
Externalities in Consumption:
Negative: drunk driving
Positive: vaccinations, education
14.2
Negative Externalities:
Marginal Social Cost and Marginal-Cost Pricing
14.3
Marginal social cost (MSC) is the total cost to society of producing an additional
unit of a good or service.
• When there is no external cost, there is no difference between MC and
MSC
• When there is an external cost, MSC is equal to the sum of the marginal
cost of producing the product (MC) + the correctly measured marginal
damage costs involved in the process of production.
MSC = MC + marginal damage costs
Example: Suppose a firm that produces widgets also produces pollution as a byproduct that is dumped into the local river.
Negative Externalities:
Marginal Social Cost and Marginal-Cost Pricing
14.4
At q*, marginal social cost exceeds the price paid by consumers. Output is
too high. Market price takes into account only part of the full cost of
producing the good.
Negative Externalities:
Marginal Social Cost and Marginal-Cost Pricing
14.5
Inefficiency arises because P ≠ MSC. Too much of the good is
being produced because we find that P < MSC. This happens
because the firm ignores the damage costs.
How can we improve the situation?
One method is to impose a tax equal to the marginal damage
cost
What does this achieve? It internalizes the externality
Issues:
• It may be difficult to measure these damage costs
• It will not eliminate the externality; we didn’t advocate zero
pollution levels.
Internalizing Externalities
A tax per unit equal to MDC is imposed on the firm. The firm will
weigh the tax, and thus the damage costs, in its decisions.
14.6
Positive Externalities
14.7
In the case of positive externalities, we again have a market failure
in that the free market will produce an inefficient allocation of
resources.
Marginal private benefit is less than marginal social benefit  not
enough is produced (market failure)
Solutions?
Want to increase the production/consumption of these “positiveexternality” producing activities through subsidies
Ex: education, vaccinations
The Coase Theorem
14.8
• Government need not be involved in every case of externality.
• Private bargains and negotiations are likely to lead to an efficient
solution in many social damage cases without any government
involvement at all. This argument is referred to as the Coase
Theorem.
Three conditions must be satisfied for Coase’s solution to work:
• Basic rights at issue must be assigned and clearly understood.
• There are no impediments to bargaining.
• Only a few people can be involved.
 Bargaining will bring the contending parties to the right
solution regardless of where rights are initially assigned.
Indirect and Direct Regulations
14.9
When the conditions behind the Coase Theorem don’t hold,
we often need government intervention to improve the
situation
• Taxes, subsidies, legal rules, and public auction are all
methods of indirect regulation designed to induce firms
and households to weigh the social costs of their actions
against the benefits.
• Direct regulation includes legislation that regulates
activities that, for example, are likely to harm the
environment.
Public Goods
14.10
Public goods (social or collective goods) are goods that are
nonrival in consumption and/or their benefits are nonexcludable.
Characteristics of a Public Good:
• A good is nonrival in consumption when A’s consumption of it
does not interfere with B’s consumption of it. The benefits of the
good are collective—they accrue to everyone.
• A good is nonexcludable if, once produced, no one can be
excluded from enjoying its benefits. The good cannot be
withheld from those that don’t pay for it.
 These characteristics make it difficult for the private sector to
produce them profitably  market failure
Why the Market Fails
14.11
• Because people can enjoy the benefits of public goods whether they pay for
them or not, they are usually unwilling to pay for them. This is referred to
as the free-rider problem.
• The drop-in-the-bucket problem: The good or service is usually so costly
that its provision generally does not depend on whether or not any single
person pays.
Consumers acting in their own self-interest have no incentive to contribute
voluntarily to the production of public goods.
Solution: public provision
• Public provision does not imply public production of public goods.
• Problems of public provision include frequent dissatisfaction. Individuals
don’t get to choose the quantity they want to buy—it is a collective
purchase. We are all dissatisfied!
Remember the Provision of Private Goods
With private goods, consumers decide what quantity to buy; market
demand is the sum of those quantities at each price.
14.12
Optimal Provision of Public Goods
14.13
• With public goods, there is only one level of
output, and consumers are willing to pay
different amounts for each level.
• The market demand for a public good is the
vertical sum of the amounts that individual
households are willing to pay for each potential
level of output.
• Optimal production of a public good
difficult to figure out what these demand
curves look like 
•
Dictator
•
Representative Government
•
Vote
Local Provision of Public Goods
14.14
• According to the Tiebout hypothesis, an efficient mix of public
goods is produced when local land/housing prices and taxes
come to reflect consumer preferences just as they do in the
market for private goods.
• The diagram on the previous slide is difficult to identify
realistically because people won’t/can’t express their
preferences. However, they do vote with their feet.
• Local communities with low crime and good schools attract
people who value these public goods the highest. In turn, they
agree to the high taxes these services necessitate.
Imperfect Information
14.15
Remember that complete and perfect information was necessary for
markets (through voluntary exchanges) to achieve the efficient
allocation of resources.
Most voluntary exchanges are efficient, but in the presence of
imperfect information, not all exchanges are efficient.
Adverse selection can occur when a buyer or seller enters into an
exchange with another party who has more information.
Examples:
the market for “lemons”
the market for insurance
Imperfect Information
14.16
Moral hazard arises when one party to a contract passes the cost
of his or her behavior on to the other party to the contract.
The moral hazard problem is an information problem, in
which contracting parties cannot always determine the future
behavior of the person with whom they are contracting.
Examples: insurance and 1) risky behavior 2) excessive
consumption of medical care
Solutions to Imperfect Information
14.17
Market Solutions:
As with any other good, there is an efficient quantity of information
production. (will the market achieve this?)
• Utility-maximizing Consumers and profit-maximizing firms will gather
information as long as the marginal benefits from continued search are greater
than the marginal costs.
• The World Wide Web has (to some extent) made information gathering less
costly  we are acquiring more of it.
Government Solutions
Information is nonrival in consumption (somewhat like a public good)
When information is very costly for individuals to collect and disperse, it may
be cheaper for government to produce it once for everybody.
Examples:
Federal Trade Commission
Consumer Product Safety Commission
Food and Drug Administration