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Chapter 11 Externalities and Public Goods The role of Government Externalities and Public Goods • Externalities: Take different forms – E.g. External costs of production, pollution – Steel Factory S(K,L), output increases in K and L: S(+,+) – But S(K,L) = S+DW Fishery F(L,DW)=F Fishery F(+, -) Externalities and Public Goods • Externalities – External costs of production – Steel Factory F(K,L) = S + DW – Fishery F(L,DW) So Steel Production Up, DW up Fish down What happens if the steel factory does not take this into account? Externalities and Public Goods So Steel Production Up, DW up Fish down What happens if the steel factory does not take this into account? Selling Steel at price PS ‘Selling’ pollution at price 0 (doesn’t have to pay to get rid of it) We get too much steel and too little fish We know that firms hire workers and capital according to the rules: dQ MRPL PS W MC L dL If steel producer had to clean up the dirty water dQ MRPL (PS PDW ) W dL dQ dQ PS W PDW dL dL Saw before firms hire workers untill dQ dQ MRPL PS W PDW dL dL So the real (social) cost of producing is wage plus the clean up cost of the extra pollution So for Capital and labour dQ dQ MRPL P W PDW dL dL dQ dQ MRPK PS r PDW dK dK THE CASE FOR GOVERNMENT INTERVENTION • So we say MC of steel is less than the MSC (marginal social cost) of steel: (W=) MC<MSC (=W+”cleanup cost”) External costs in production Costs and benefits MC = S P D O Q1 Quantity External costs in production Costs and benefits MSC P MC = S D External cost O Q1 Quantity External costs in production Costs and benefits MSC P MC = S D O Q2 Social optimum Quantity Q1 THE CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC Training External benefits in production Costs and benefits MC = S P O D Q1 Quantity External benefits in production Costs and benefits MC = S MSC External benefit P O D Q1 Quantity External benefits in production Costs and benefits MC = S MSC P O D Q1 Quantity Q2 Social optimum THE CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC PUBLIC GOODS • Goods which are ‘non-rival’ and ‘nonexclusive’ • Non-rival/Exclusive - my consumption does not preclude yours, but you can be prevented from consuming by the producer. e.g. Concert • Non-exclusive/Rival – cannot prevent you from consuming, but your consumption (in principle) precludes mine e.g. drinking water from a public lake PUBLIC GOODS • Non-rival and non-exclusive: Cannot prevent access (for practical purposes) and consumption of one doesn’t preclude consumption by someone else. –street lighting: A Public Good Public Goods Marginal benefit from Street lignts Dr. Jeckyl O Q1 Quantity Mr. Hyde O Q1 Quantity Public Goods Marginal benefit from Streetlignts Dr. Jeckyl O Q1 Quantity Maureen Hyde O Q1 Quantity Pricing at marginal costs is not socially optimal – even if it is possible (see next slide). MC Marginal benefit from Street lignts P1 Dr. Jeckyl MC O Q1 P2 Mr. Hyde P1 O MC Q1 Quantity Q1 QS Who pays ? • The firm might sell to “the first person” – charging at the marginal cost and using this person’s demand function. • This won’t work. First of all, it is not likely that anyone will actually pay (why not just wait for someone else to pay ?) • Moreover, as shown on the previous slide, this would not be socially optimal.