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Chapter 20
Externalities and Public Goods
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Externalities and inefficiency
Remedies for externalities: the private
sector
Remedies for externalities: the public
sector
Common property resources
Public goods
20-2
Externalities
 Competitive markets may not allocate resources
efficiently when the assumptions of the model are
violated
 Example: assumed that each consumer’s well-being
depends only on her own consumption
 An action creates an externality if it affects someone
with whom the decision-maker has not engaged in a
related market transaction
 Negative externality if it harms someone else
 Polluting causes health problems in a community, neglecting a
garden reduces neighbors’ home values
 Positive externality if it benefits someone else
 Pollution abatement reduces health effects on community,
carefully tended garden raises the value of surrounding homes
20-3
Negative Externalities and
Inefficiency
 Presence of a negative externality in a competitive
market will usually allocate economic resources
inefficiently
 An external cost is the economic harm that a negative
externality imposes on others
 Each firm produces up to the point at which its
marginal cost curve equals the market price
 But socially efficient level of production for any
particular firm equates marginal social cost and
marginal social benefit
 Marginal social cost = marginal cost to the producer + marginal
external cost
 Therefore the firm’s equilibrium production level is
socially excessive and inefficient
20-4
Negative Externalities and
Inefficiency
Similar result holds for the entire market
When firms ignore external costs, they are
willing to produce too much output at any given
price
The good is priced too cheaply in equilibrium
Because output is priced incorrectly, consumers
demand too much
The externality creates deadweight loss
Society’s loss equals the vertical distance between
the demand curve and the marginal social cost
curve
20-5
Figure 20.1: Negative Externality
in a Competitive Market
20-6
Positive Externalities and
Inefficiency
Competitive equilibria are inefficient when
either positive or negative externalities are
present
An external benefit is the economic gain that
a positive externality provides to others
Firm output will be inefficiently low from
society’s perspective
Like a negative externality, a positive
externality creates deadweight loss
20-7
Figure 20.2: Positive Externality in
a Competitive Market
20-8
Remedies for Externalities:
Private Sector
 Whenever the allocation of resources is inefficient it is
possible to arrange mutually beneficial trades
 Private parties thus have incentives to identify
inefficiencies and negotiate solutions
 When private negotiations fail to address market
failures associated with externalities, government
policies can potentially improve economic efficiency
 Policies that support markets (e.g., establishing clear property
rights)
 Quantity controls (e.g., emissions standards)
 Policies that correct private incentives (e.g., taxes, fees,
subsidies)
20-9
Property Rights and Negotiation
 Outcome of a negotiation depends on the parties’
property rights
 Party who holds the relevant property rights is in a
stronger bargaining position
 Usually emerges with a more favorable deal
 Assignment of property rights does not affect the level
of pollution but does affect profits
 Coase theorem: regardless of how property rights are
assigned, voluntary agreements will remedy
externalities
 If bargaining is frictionless
 Sometimes used as a justification for laissez faire
policies
 Coase did not believe that bargaining is frictionless
20-10
Limitations of Bargaining
 Every externality can be traced to missing markets
 Private negotiations lead to transactions that the
parties would have made if the required markets
weren’t missing
 Many factors that cause externalities also hinder
bargaining
 Bargaining can be impractical
 Difficult logistics, substantial time and effort
 Property rights may be ambiguous
 Limited information can lead to an impasse
 Contracts may be difficult to enforce
20-11
Quantity Controls
 Government can attempt to address an externality by
regulating the activity that produces it
 An emissions standard is a legal limit on the amount
of pollution that a person or company can produce
 When engaged in a particular activity
 Example: Aircraft noise abatement
 Setting a socially efficient abatement standard requires
information about abatement costs and benefits
 Private parties may have an incentive to exaggerate
their costs (or benefits)
 Government may have trouble learning the truth
 Can lead to an inefficient standard and deadweight loss
20-12
Policies that Correct
Private Incentives
 Some policies address externalities by forcing people
to internalize external costs and benefits
 Impose taxes or fees, provide subsidies, expose
decision-makers to legal liability
 Pigouvian taxation involves the use of taxes or fees
to remedy negative externalities
 A Pigouvian tax forces a decision-maker to internalize
the marginal external costs associated with her activity
 Weigh it against marginal benefit
 Make a socially efficient decision
 Ideal Pigouvian tax reproduces the price that the good
in question would command in an efficient competitive
equilibrium
20-13
Figure 20.5: Pigouvian Tax on Noise
 Airline produces noise
up to the point where
MCA equals the tax of
$10,000 per decibel
 Socially efficient
outcome is achieved,
with noise at 80
decibels
20-14
Liability Rules
 Another mechanism for addressing negative
externalities
 Under a liability rule a party who takes an action that
harms others must compensate the affected parties for
their losses
 Liability rules induce decision-makers to internalize all
external costs
 Lead to efficient choices
 In some cases, the government needs less information
to effectively use a liability rule than an emissions
standard or Pigouvian tax
 Liability rules raise other difficulties because of their
legal nature
20-15
Pitfalls for Policies that Correct
Private Incentives
 Liability rules and Pigouvian taxes both force decisionmakers to internalize harm caused to others
 But harms often have multiple causes
 In such cases efforts to correct private incentives can
lead to inefficiency
 Typical liability rule holds one source of external cost
accountable
 Inefficient if more than one group’s choices contribute to the
external costs
 Ideal rule would force all parties contributing to the
externality to bear a portion of the social costs
20-16
Consequences of Policy Errors
 Errors in setting a tax vs. a standard may have different
implications for efficiency
 This consideration can provide a reason for preferring one
approach over the other
 Which policy is better?
 Depends on the slopes of the marginal social cost (MSC) and
marginal cost of abatement (MCA) curves
 Standard is superior when the MCA curve is relatively
flat and the MSC curve is relatively steep
 Tax is superior when the MCA curve is relatively steep
and the MSC curve is relatively flat
20-17
Figure 20.8: Consequences of
Policy Errors
20-18
Minimizing Total Cost
of Abatement
 External costs of pollution may depend on the total
emission of many parties
 In so, an emissions tax guarantees that reduction in the
overall level of pollution will be achieved at the lowest
possible cost
 Emissions standard does not guarantee this
 Each firm will pollute up to the point at which the
marginal cost of abatement equals the tax rate
 Firms produce different amounts of pollution but will
share the same marginal cost of abatement
 Any change in firms’ emissions that leaves total
pollution unchanged will increase overall abatement
costs
20-19
Figure 20.9: Emissions Tax
20-20
Tradable Emissions Permits
 A tradable emissions permit entitles a firm to generate a
specified amount of a given pollutant
 Transferable, one firm can sell it to another
 Total emissions are limited by the number of permits the
government issues
 Enables the government to reduce the level of pollution to any desired
target
 Can achieve any given reduction in total emissions at the lowest
possible abatement cost
 Competitive market for permits may emerge
 Each firm will generate pollution up to the point at which marginal
cost of abatement equals the market price of a permit
 Note that the market does not set the level of pollution
20-21
Common Property Resources
 A common property resource is a resource that more than one
person is free to use without payment
 Examples: Lakes, air, oceans
 Generally, each person’s use of a common property resource
reduces its value to others
 Creates a negative externality
 Consider a large lake, the only source of fish for nearby towns,
where anyone can become a fisherman free of charge
 The marginal social cost of fishing exceeds the marginal private
cost
 Each fisherman fails to account for the fact that his decision to catch
fish reduces the fish population and raises the cost of fishing for
future fishermen
 Competitive level of fishing is socially excessive
 Remedies for market failures associated with common property
resources are the same as for negative externalities
20-22
Figure 20.13: Common Property
Resources and Overfishing
MSC
Price per pound of fish ($)
2000
1500
Dmarket
Smarket
1000
MEC
500
Qefficient
Qequilib
Fish (pounds)
20-23
Public Goods: Basics
 A public good is nonrival and nonexcludable
 A good is nonrival if more than one person can
consume it at the same time without affecting its value
to others
 Marginal cost of providing it is zero
 A good is nonexcludable if there is no way to prevent
a person from consuming it
 Examples of public goods: national defense,
construction of lighthouses
 Governments often provide public goods
 Not all goods provided by a government are public goods
20-24
Efficient Provision of Public Goods
 Socially efficient level of production is where marginal
social cost equals marginal social benefit
 Whether good is private or public
 To determine the marginal social benefit of a public
good, add up the gains to all affected individuals
 Important difference from process for private good
 Sum individual curves vertically for a public good
 Example: security patrols on a city block
 Three stores would receive marginal benefit of $7.50, $45, and
$40 from the first hour of patrolling
 Marginal social benefit is the vertical sum, $92.50, for a
quantity of one hour
20-25
Figure 20.14: Provision of a
Public Good
20-26
Public Goods and Market Failure
 If someone decides to contribute to a public good,
other people will benefit
 The contribution creates a positive externality
 Competitive markets produce too little output when
positive externalities are present
 If provision of a public good is left entirely to the
independent actions of private parties, the level of
production will be inefficiently low
 Market failure associated with public goods is due to
free riding
 A free rider contributes little or nothing to a public
good while benefiting from others’ contributions
20-27
Public Policy Toward Public Goods
 Governments address the market failures associated with public
goods in a variety of ways:
 Provide some public goods (national defense)
 Contribute to non-profit organizations that provide them (public radio
and television)
 Subsidize private contributions to many public goods (environmental
protection)
 Subsidization often takes the form of tax deductibility for
contributions to charitable causes that support public goods
 These are variants of the methods used to address externalities
 Efficient public provision of a public good need not entail public
production
 Market failure of public goods related to demand, not production
 Governments often rely on the private sector to produce public goods
 Example: U.S. obtains military equipment from private defense
contractors
20-28
Gathering Reliable Information
 To provide a public good efficiently, the government must have
information about individual preferences
 Cannot simply ask; answers will depend on who consumers expect to
foot the bill for the public good
 A Groves mechanism is a way to set the level of a public good
that induces everyone to report their preferences correctly
 Produces a socially efficient outcome
 Ask each citizen to report the total benefit he would receive from
the public good
 Calculate teach individual’s marginal benefit as though he told the
truth
 Each consumer’s contribution toward the public good is based on
the quantity of public good that would be optimal with and without
his reported benefits
 Consumer will be worse off if he exaggerates or understates his
benefits than if he tells the truth
 Groves mechanism gives consumers a strong incentive to tell the
truth
20-29
Figure 20.15: The Groves Mechanism
20-30
Public Decision-Making
 The field of political economy examines the economic
consequences of public sector decision-making
 Example: determine whether public intervention is
justified
 Weigh the consequences of a market failure against the likely
consequences of a government failure
 When markets fail, the public sector may be able to
improve the allocation of resources, in principle
 Do democratic mechanisms promote socially efficient
government decision-making?
 Assume a policy is overturned if more than 50% of voters
prefer an alternative
20-31
Median Voter Theorem
Median voter theorem: if voters have singlepeaked preferences, a majority of them prefer
the median ideal policy to all others
A voter’s preferences are single-peaked if her
net benefit from an activity increases with the
activity’s level until her ideal is reached
Declines thereafter
Median voter is the voter who has the median
ideal policy among all voters
Majority rule leads to the selection of the
median ideal policy
20-32
Figure 20.16: Majority Rule and
the Level of a Public Good
20-33