• When a private action has side effects that affect other people in important ways, we have the problem of externalities
– By-product of a good or activity that affects someone not immediately involved in transaction
1

• Under certain conditions, inefficiency that would be caused by a negative externality will automatically be resolved by the parties themselves
– The outcome is the efficient outcome
• Achieves maximization of total net benefits possible in the situation
2

• What if building a theater would create
$100,000 of benefits for some but $70,000 worth of harm for others?
• Whether the theater will or will not be built depends entirely on whether it is the efficient or inefficient outcome
– Regardless of who holds the legal rights
– Negative externality is solved by market
– No government intervention is required, other than the initial assignment of legal rights
3

• The Coase Theorem—named after economist Ronald Coase
– States that private market will solve externality problem on its own, always arriving at the efficient outcome
• When side payments can be negotiated and arranged without cost
– While initial distribution of legal rights will determine allocation of gains and losses among the parties, it will not affect action taken
4

• Requires that side payments can be arranged without cost—or, in practice, that cost is so low relative to gains or losses at stake that it doesn’t matter
– This requirement is most likely to be satisfied when all of the following conditions are present
• Legal rights are clearly established
• Legal rights can be easily transferred
• The number of people involved is very small
• Unfortunately, many real world situations do not satisfy these conditions
• Biggest problem is applying Coase theorem to many real-world externalities is the third condition
– Often, a large number of people are involved
• When many people are involved, achieving efficiency with side payments is plagued by an often insoluble problem
– Free rider problem
5

• Occurs when efficient outcome requires a side payment but individual gainers —each obligated to pay a small share of the side payment —will not contribute
• If extensive enough—can shrink the side payment until it isn’t large enough to compensate losers and still leave gainers better off
• Stands in the way of many Pareto improvements
– One of the main reasons why we typically turn to government to deal with important externalities that affect many people
6

• A competitive market has many buyers and sellers
– When a negative externality affects a market, the private solution is unlikely to work
• A market with a negative externality associated with producing or consuming a good will produce more than the efficient quantity
– Creating a welfare loss
• Unfortunately, with so many people involved, it would take too much time and trouble for individual producers and consumers to arrange appropriate side payments and production cutbacks
– In any case, free rider problem would effectively destroy the arrangement
– Efficient outcome requires government intervention in the market
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2. The
Dollars
(a)
1. This market has a negative externality of $0.50 per unit.
C efficient quantity is here . . .
B
A
$1.00
MSC
$0.50
S
3. but the equilibrium quantity is here.
D
4. In equilibrium, the welfare loss is triangle ABC.
100 125
Millions of Gallons per Period
8

Dollars
$1.30
$1.00
$0.80
to the negative externality per unit,
6. shifts the supply curve upward . . .
B
S
After Tax
S
Before Tax
$0.50
A
7. and moves the equilibrium to the efficient quantity.
D
100 125
Millions of Gallons per Period
9

• Government could use a tax on producers to move gasoline market to point B
• Payment of the externality tax is shared between consumers and producers, as is the payment of any tax, and will depend on elasticities of supply and demand
– A tax on each unit of a good, equal to the external harm it causes, can correct a negative externality and bring market to an efficient output level
• Consider the logic of this result
– Tax cures the inefficiency because it forces market to internalize the externality
• To take account of the harm caused by gasoline
• Suggests that a tax on consumers of gasoline would work just as well as a tax on producers
• Taxes to correct negative externalities have been used in countries around the world
– In United States, however, taxes designed to correct negative externalities are less common
10

• A tax is not only way to correct a negative externality
– Government can also use regulation to move a market closer to the efficient point
• In last two decades, U.S. government has relied increasingly on an innovative technique to reduce several types of pollution
– Tradable permits
• License that allows a company to release a unit of pollution into the environment over some period of time
– Firms can trade their permits in an organized market
• Left to itself, a market with a negative externality will produce too much output
– Taxes, regulation, and tradable permits are examples of government intervention to decrease output toward efficient level
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• What about the case of a positive externality?
– By-product of an activity or a service benefits other parties, rather than harms them
• A market with a positive externality associated with producing or consuming a good will produce less than the efficient quantity, creating a welfare loss
• A subsidy on each unit of a good, equal to the external benefits it creates, can correct a positive externality and bring the market to an efficient output level
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(a) of $30,000 per college degree.
Dollars
2. The equilibrium quantity is here . . .
S
$30,000
B
3. but the efficient quantity is here.
$100,000 A
C
MSB
D
800,000 1,000,000
4. In equilibrium, the welfare loss is triangle ABC.
Number of
Degrees per Year
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5. A subsidy per unit for consumers equal
Dollars
6. shifts the demand curve upward . . .
$30,000
B market to the efficient quantity
$114,000
$100,000
$84,000
A
800,000 1,000,000
D
After Subsidy
D
Before Subsidy
Number of
Degrees per Year
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• Pure private good
– One that is both rivalrous and excludable
– In absence of any significant market failure, private firms will provide these goods at close to efficient levels
• When a good is nonexcludable, people have an incentive to become free riders
– To let others pay for the good, so they can enjoy it without paying
• When a good is nonexcludable, private sector will generally be unable to provide it
– In most cases, if we want such a good, government must provide it
• When a good or service is nonrivalrous, market cannot provide it efficiently
– Rather, to achieve economic efficiency, good or service would have to be provided free of charge
• Pure public good
– One that is both nonrivalrous and nonexcludable
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Pure Private Good
More Excludable
More Rival More Nonrival
Mixed Good
• food, clothing, housing
• sold-out movie
• crowded highway
• newspaper
• software
• movie with empty seats
• uncrowded highway
• cable television
• downloaded music file
• crowded city streets
• fish in international waters
More Nonexcludable
Mixed Good
• urban park
• police and fire protection
• national defense, legal system
Pure Public Good
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• Goods that appear in upper right and lower left corners of Figure 13 can be called mixed goods
– Share features of both public and private goods
• These goods are becoming increasingly important in our society
– Are responsible for some growing tension and controversy
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• Goods near lower left hand corner are excludable but nonrivalrous
– Includes most information products
– Software is an essentially nonrivalrous good, but an excludable one
• Neither pure public nor pure private
– Digital music files are another example of this type of mixed good
• Currently, music remains somewhat excludable
– It is against the law to make copyrighted music available online
– Many people—either because of respect for the law, fear of getting caught, lack of technical expertise, or scarce time —still prefer to buy their music from a store or online shipping service
– Music industry is desperately looking for ways to achieve greater excludability
• Has not yet found a good solution
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• Tragedy of commons occurs when rivalrous but nonexcludable goods are overuse to detriment of all
• An economy with well-functioning, perfectly competitive markets tends to be economically efficient
– Many types of government involvement are needed to ensure that markets function well and to deal with market failures
• Cases of government involvement are not without controversy
– Debates about public education, Social Security, international trade, and immigration center on questions of proper role for government
• Some of the disagreement is over government’s role in bringing about a more fair economy
– Also debate about the government’s role in bringing about economic efficiency
19

• Information problems
– While government may be able to move us closer to efficiency, it can also fall short or overshoot based on inaccurate information
• Incentive problems for government
– Government officials are agents of the general public, and are supposed to serve public interest
• However, they can be influenced by lobbies for special interest groups
• In order for government to have the funds it needs to support markets and do other things, it must raise revenue through taxes
• Inherent problem with provision of public goods that almost guarantees dissatisfaction about them
• Other important roles for government besides fostering efficiency
– Equity, fairness, justice, and more
• Anyone studying role of government in the economies is struck by one glaring fact
– Most economic activity is carried out among private individuals
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• Almost everyone in United States has been caught in a traffic jam in some large town or city at some point in their lives
• Problem in most cities is getting worse
– Consider London, for example
• Traffic congestion has worsened dramatically in recent decades, especially in the historic inner city
• Traffic is an externality problem
– When you decide to take your car onto a city street, your decision is based on the costs and benefits to you
• Traffic can be viewed as a mixed good
– Can the government solve the problem?
• Some cities, such as New York, do charge tolls for cars that enter via bridges or tunnels
– But entry tolls are problematic, and are rarely set high enough to solve the problem
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• A bigger problem
– Political damage to any elected representative who would propose a fee high enough to be efficient for a good that has traditionally been free
• All of this conventional political wisdom may have changed in early 2003
– In early 2003, Ken Livingstone, the Mayor of London, decided to take a chance
• His administration established a 5£ (about $8) per day user fee on any automobile that appeared in the 8 square mile boundary of London’s inner city
• On the first day the fee applied, traffic dropped about 25%
– 60,000 fewer cars entered the area than on a normal day
– Officials in New York, Paris, Los Angeles, and other large cities around the world have been studying London’s success
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