Public Goods and Externalities

Public goods and externalities: two more “market failures”

• another market failure (discussed in the previous lecture) is due to “monopoly power”

• these three market failures plus income distribution are the main rationales for government intervention in a market economy

Public Goods

• Two Key properties

• non-rivalry in consumption– if I consume more, others do not need to

consume less

• non-excludability– you cannot prevent people from consuming the

good– free rider problem

National Defense

F172

Fire Protection

Police

Lighthouse?

How much of a public good should be produced?

• Mimic the market: – produce up to the point where marginal benefit

equals marginal cost

• examples: – number of police on the street– size of national defense force

Cost-Benefit Analysis

• when the choice is to produce or not produce

• Because benefits come in the future they must be discounted

Numerical Example: Should PAPD buy a new computer?

Time Costs Benefits

This year $1,000 0

Next year 0 $500

Two yearsfrom now

0 $600

Present Discounted Value of Benefits

• PDV = 500/(1+i) + 600/(1+i)2

• if i = .05 then

• PDV = 500/(1.05) + 600/(1.05)2 = 476 + 544 = 1020– thus the PAPD should make the investment in

the computer

Higher discount rates mean that fewer projects will meet cost-benefit test. Thus

discounting enters political debate.

i PDV

.04 1035

.05 1020

.06 1005

.07 991

Externalities

• Definition: When the costs of producing or the benefits of consuming spill over to other people.

• Negative externalities

• Positive externalities

A Negative Externality: Pollution

Positive Externalities

• Education

• Innovative ideas

• Research

The Economic Impact of Negative Externalities

15_01

DOLLARS

Marginal private cost as viewed by private firms (market supply curve)

Marginal social cost

Marginal benefit (market demand curve)

QUANTITY OF ELECTRICITY

Marginal private cost is less than marginal social cost by this amount.Deadweight

loss

Efficient quantity

A B

The market generates this quantity.

The Economic Impact of Positive Externalities

15_02

The market generates this quantity.

Deadweight loss

Marginal cost (market supply curve)

Marginal social benefit

Marginal private benefit as viewed by consumers of goods (market demand curve)

Marginal social benefit is greater than marginal private benefit by this amount.

Efficient quantity

DOLLARS

QUANTITY OF EDUCATION

C D

What are the possible remedies for externalities?

• Private Remedies Let the individuals work it out themselves– Need to define property rights– But transaction costs and free rider problem

might prevent the private remedy

Command and control

• A common form of “social regulation” used by EPA– scrubbers– CAFÉ standards

• Usually not very flexible or efficient

Using Taxes or subsidies

• make them feel the pain or the gain

• more flexible than command and control

• but can’t be sure about the total amount

The Tax Remedy for a Negative Externality

15_03

Marginal social cost equals marginal private cost viewed by private firms with tax

TaxMarginal private cost viewed by private firms without tax

Marginal benefit (market demand curve)

Quantity produced decreases to lower, more efficient level.

Efficient quantity Inefficient quantity

DOLLARS

QUANTITY OF ELECTRICITY

A B

The Subsidy Remedy for a Positive Externality

15_04

Marginal social benefit

equals marginal private

benefit plus subsidy

Marginal private benefit

without subsidy

Subsidy

Inefficient quantity

Efficient quantity

Quantity produced increases to higher, more efficient level.

DOLLARS

QUANTITY OF EDUCATION

Marginal cost

(market supply curve)

C D

Why don’t you draw it by hand?

Tradable Permits

• Examples– SO2 (acid rain)

– CO 2 (global warming)

• Permit allows each firm to emit a certain amount of pollutants

• Total number of permits issued equals emission limit for the region each year

• Firms that are better at reducing emissions sell permits to firms that are worse at it.

End of Lecture