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Chapter 15:
Externalities, Public Goods and
Social Choice
Market failure
Occurs when resources are misallocated or
allocated inefficiently. In addition to the
market failures
(imperfect markets: monopoly,
oligopoly, and monopolistic competition)
discussed earlier, externalities,
public or social costs, and imperfect
information will be discussed next.
Market failure (cont.)
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Governments increase efficiency by promoting
competition, limiting externalities like pollution, and
providing public goods.
Governments promote equity by using tax and expenditure
programs to redistribute income toward particular groups.
Government foster macroeconomic stability and growth –
reducing unemployment and inflation while encouraging
economic growth – through fiscal policy (i.e. taxing and
spending) and monetary regulation (i.e. interest rates and
credit conditions).
Externalities and Environmental Economics
Externality
A cost or benefit imposed or bestowed on an individual or a
group that is outside, or external to, the transaction.
Externalities are sometimes called spillovers or
neighbourhood effects. Inefficient decisions result when
decision makers fail to consider social costs and benefits.
Examples include air, water, land, sight and sound pollution
(including acid rain); traffic congestion; automobile
accidents; abandoned housing; nuclear accidents; and
second-hand smoke.
Externalities and Environmental Economics (cont.)
Marginal Social Cost and Marginal-Cost Pricing
Marginal social cost (MSC) the total cost to
society of producing an additional unit of a good
or service. MSC is equal to the sum of the
marginal costs of producing the product and the
correctly measured damage costs involved in the
process of production.
Acid Rain and the Clean Air Act
Other Externalities
Externalities and Environmental Economics (cont.)
Externalities and Environmental Economics (cont.)
Internalizing Externalities
(1) Government imposed taxes and subsidies,
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Measuring Damages
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Reducing Damages to an Efficient Level
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The Incentive to Take Care and to Avoid Harm
(2) Private bargaining and negotiation,
(3) Legal rules and procedures
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Injunction A court order forbidding the continuation of
behaviour that leads to damages.
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Liability rules Laws that require A to compensate B for
damages imposed.
(4) sale or auctioning of rights to impose externalities
(5) direct government regulation
Public (Social) Goods
public goods (social or collective goods) Goods that are no
rival in consumption and/or their benefits are no excludable.
In an unregulated market economy with no government to see
that they are produced, public goods would at best be
produced in insufficient quantity and at worst not produced at
all.
The Characteristics of Public Goods
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No rival in consumption
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No excludable
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Drop-in-the-bucket problem
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Free-rider problem
Public (Social) Goods (cont.)
Income Distribution as a Public Good?
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Public Provision of Public Goods
Because private provision of public goods is generally
insufficient, the government must step in to encourage
the production of public goods. By casting sufficient
amounts of money in certain directions, it causes
resources to flow there. All levels of government – city,
state, and federal – collect taxes to pay for their
spending.
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Public (Social) Goods (cont.)
Optimal Provision of Public Goods
Economist Paul Samuelson demonstrated that there exists an optimal, or a most efficient, level
of output for every public good.
Samuelson’s Theory
An efficient economy produces what people want. Private producers, whether perfect
competitors or monopolists, are constrained by the market demand for their products. If they
cannot sell their products for more than it costs to produce them, they will be out of business.
Because private goods permit exclusion, firms can withhold their products until households pay.
Buying a product at a posted price reveals that it is “worth” at least that amount to you and to
everyone who buys it.
Optimal level of provision for public goods The level at which society’s total willingness to pay
per unit is equal to the marginal cost of producing the good.
The Problems of Optimal Provision
One major problem exists. To produce the optimal amount of each public good, the government
must know something that it cannot possibly know— everyone’s preferences.
Mixed Goods
Mixed goods that are part public goods and part private goods. Education is a key example.
Imperfect Information
Adverse Selection: Asymmetric Information
Moral Hazard
It is impossible to know everything about behaviour and
intentions. If a contract absolves one party of the
consequences of its action, and people act in their own selfinterest, the result is inefficient.
Market Solutions
Like consumers, profit-maximizing firms will gather
information as long as the marginal benefits from continued
search are greater than the marginal costs.
Social Choice
social choice
The problem of deciding what society wants. The process of adding up individual preferences to
make a choice for society as a whole.
The Voting Paradox
The most common social decision-making mechanism is majority rule – but it is not perfect.
Impossibility theorem A proposition demonstrated by Kenneth Arrow showing that no system of
aggregating individual preferences into social decisions will always yield consistent, no arbitrary
results.
Voting paradox A simple demonstration of how majority-rule voting can lead to seemingly
contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency
described in the impossibility theorem.
Logrolling A problem of majority-rule voting. Occurs when congressional representatives trade
votes, agreeing to help each other get certain pieces of legislation passed.
Social Choice (cont.)
Government Inefficiency: Theory of Public Choice
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Rent-Seeking Revisited
Theory may suggest that unregulated markets fail to produce
an efficient allocation of resources. This should not lead you
to the conclusion that government involvement necessarily
leads to efficiency. There are reasons to believe that
government attempts to produce the right goods and services
in the right quantities efficiently may fail.
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Government and the Market
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