Externalities and Public Goods
Lecture 7 – academic year 2013/14
Introduction to Economics
Fabio Landini
Where we are…
• Lecture 1 : Demand and supply model
• Lecture 2: Elasticity and its application
• Lecture 4: Demand, Supply and economic
policy
• Lecture 5: Demand, Supply and economic
efficiency
• Lecture 5: Surplus of consumers and producer
What do we do today?
• The “external” effects of economic
activities
• How do we internalize externalities?
• The different typologies of economic
goods: private goods, public goods,
common resources and natural
monopolies
3
The KYOTO Protocol – since 1997
• The Kyoto Protocol, signed in December 1997 at the
UNFCCC COP3 (Conference Of Parties), represents
the executive instruments of the Framework
Convention
• The countries that are subject to the emission
constraint are 39 and they include the European
countries (including the East countries), Japan,
Russia, United States, Canada, Australia and New
Zealand
4
The KYOTO Protocol – since 1997
The European Directive 2003/87/CE “Emissions
Trading” regulate the exchange of quotas for the
emission of greenhouse gas. The final aim is to
establish an European market for the emission quotas.
During the first three years (2005-2007), the emissions
of large combustion plants, such as oil refineries,
plants for the production of ferrous metal, mineral
goods (concrete, lime, etc.) and the plants for the
production of paper and cartboard
5
Market efficiency: A brief recap
In a perfectly competitive market with no externalities
the total welfare of the economic system is measured
as the sum of consumer surplus and producer surplus.
“The invisible hand” (of the market) maximize the total
benefit of society
Markets are usually good instruments to organize the
economic activity
Sometimes, however: “markets fail”
6
Externalities: definition and effects
When the transaction between a buyer and a seller has
an effect on a third party, the effect on the latter is
called externality.
Whenever they do not take into account the “third
party”, the equilibrium prices and quantities are not
efficient.
Therefore the externalities cause an inefficient
allocation of resources, i.e. market failure.
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The effects of externalities
on society
In the presence of externalities:
•Social welfare is not measured only by the welfare of
consumers and producers, but also by the welfare of the
third party (involuntary participant to the market).
•The externalities can be negative or positive
•However, ALL externalities are sources of market
inefficiencies in the sense that the quantity exchanged ≠
optimal quantity.
8
Negative externalities
Costs on other individuals (consumers or
producers) that are not directly involved in
the market exchange.
Example: smoke of cigarettes, cars’ exhaust
gas
9
Positive externalities
Direct benefits obtained by individuals
(consumers or producers) not directly
involved in the market exchange.
Example: Vaccines, restoration of a piece of
Art, investment in new technologies.
10
Externalities and market inefficiency
• Negative externalities in production
Qmarket > Qoptimum (socially desirable quantity)
social costs > private costs
• Positive externalities in production
Qmarket < Qoptimum
social costs < private costs
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Externalities and market inefficiency
• Negative externalities in consumption
Qmarket > Qoptimum (socially desirable quantity)
Social benefit < private benefit
• Positive externalities in consumption
Qmarket < Qoptimum
Social benefit > private benefit
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Negative externalities in production
Price of
aluminium
Cost of
pollution
Social cost
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
aluminium
13
Positive externalities in production
Price of
Robot
Value of
technological
diffusion
Supply (private cost)
Social cost
Equilibrium
Optimum
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity
of Robot14
Negative externalities in consumption
Price of
alcoholic
drinks
Supply (private cost)
Equilibrium
Optimum
Demand
(private value)
Social value
0
QOPTIMUM QMARKET
Quantity of
alcoholic drinks
15
Positive externalities in consumption
Price of
education
Supply (private cost)
Optimum
Equilibrium
Social value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
education
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How to obtain Qoptimum?
1. Government intervention
Government can internalize the externalities by
taxing the goods that causes negative
externalities and by subsidizing those with
positive externalities.
“To internalize an externality” means to alter
market incentive with subsidies and taxes, so as
to induce individuals to take adequately into
account the external effects of their actions.
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Obtaining optimal production
If the externality is negative: internalization
through a tax – the tax reduces the quantity that
is exchanged in equilibrium until the social
optimum obtains
If the externality is positive: internalization
through a subsidy – the subsidy increase the
quantity that is exchanged in equilibrium until
the social optimum obtains
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How to obtain Qoptimum?
2. Private solution
Public intervention is not always either necessary or
efficacious to deal with externalities.
Example of private solutions:
•Ethical codes and social sanctions.
•NGOs (in the “no-profit” sector).
•Integration of different types of activities.
•System of contracts (Coase’s theorem).
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Externalities and public goods
A case in which externalities are of particular
relevance is when we deal with specific types of
economic goods, called public goods and
common resources
Example: knowledge (technological spillover),
environment (pollution)
What are public goods and common resources?
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Typologies of economic goods
The goods available in our economy can be
distinguished along two dimensions:
Excludability
and
Rivalry
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Typologies of economic goods
Excludability
An individual can be prevented from using a good (e.g.
laws usually recognize the private property of a good)
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Typologies of economic goods
Rivalry
The consumption of a good by an individual prevents
the simultaneous consumption of the same good by
other individuals
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Example of a public good: A bridge
A bridge connects two shores of a river
Given a certain dimension of the bridge, if the n. of
people using the bridge increases (congestion):
consumption rivalry
If there is a fee for the bridge (those who don’t pay
cannot use it): consumption excludability
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Example of the bridge
Free access
Many
Rivalrous
N. people
Few
Non-rivalrous
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Example of the bridge
Fee
yes
Given
number of
people
Excludable
No
Nonexcludable
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Example of the
bridge: two-ways
table
Yes
Fee
No
Excludable
Non-excludable
Rivalrous
Rivalrous
Excludable
Non-excludable
Non-rivalrous
Non-rivalrous
Many
N. people
Few
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Example of the
bridge: two-ways
table
Many
N. people
Few
Yes
Fee
No
Excludable
Non-excludable
Rivalrous
(PRIVATE GOODS)
Rivalrous
(COMMONS)
Excludabe
Non-excludable
Non-rivalrous
(NATURAL
MONOPOLY)
Non-rivalrous
(PUBLIC GOODS)
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Four types of economic goods (1)
Private goods
• Both excludable and rivalrous
Example: ice-cream, CDs, etc.
Public goods
• Neither excludable nor rivalrous
Example: national defence, scientific
knowledge
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Four types of economic goods (1)
Commons
• Rivalrous, but non-excludable
Example: sea fishes
Natural monopoly
• Excludable, but non-rivalrous
Example: drinkable water
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Public goods and externalities
Non-excludable goods  all can benefit without
paying the price, p = 0
Access to the good cannot be limited; private value
= 0, social value > 0
But: production costs > 0 (scarce resources)
Who is it going to produce the good, if not paid?
Therefore: positive externalities of a public good
(autonomously, market produces too few).
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The problem of free riding
A free rider is a person who can enjoy the
benefit of a good without paying the price
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In order to build the bridge, a voluntary
contribution equal to 10 is requested…..
The bridge The bridge is
is built
not built
I contribute
(I pay 10)
I do not contribute
(I don’t pay)
90
- 10
100
0
It is convenient for me NOT to pay!!!
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The problem of free riding
Since public goods are non-excludable, each individual
can refuse to pay the good, hoping that other people
will pay in his/her place.
If everybody reasons the same, the good is not
produced.
IMPORTANT: the presence of free riding makes it
impossible to rely on the market to supply public goods.
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Solution of the free riding problem
If the benefits > costs (social value > 0), public
authorities can produce the good by relying on taxes.
Example: fireworks by Moena’s Municipality
– 500 inhabitants; value for each inhabitant =10 €; cost of
fireworks = 1000 €.
– Fireworks tax for each inhabitant = 2€, it covers the costs.
– Consumer surplus = 8€ (= 10€ - 2€).
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The need for a State to produces public goods,
whose cost is financed via taxes, represents the
main economic justification for the existence of
taxation (and thus for the fight against tax
evasion): that is the “minimum State”.
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Common resources
Common resources are non-excludable
They are freely available for anybody to exploit
But they are rival: the consumption of the good
by one individual reduces the possibility for
other individual to consume
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Examples of common resources
• Air and clean water
• Congested streets
• Fishes, whale and other wild species
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The tragedy of the commons
When an individual, by using a resource,
diminishes the availability of the resource for
others we encounter the tragedy of the
commons.
Common resources tend to be over-exploited
This generates a negative externality.
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The tragedy of the commons
The public administration can:
• Impose a tax on usage;
• Regulate the use of the resource;
• Transform the common resource in a private
good (by defining and enforcing individual
property rights on the resource.
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The importance of property rights
When the absence of property rights is the cause of
market failures, public intervention can potentially
solve the problem in 3 ways
1) By defining property rights, which enable the
market to operate efficiently;
2) By regulating individual behaviour;
3) By producing a good that the market does not
supply.
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Conclusion
When the transaction between consumer and
producer has effects on a third party, there is an
externality.
Negative (positive) externalities imply that the
quantity exchanged in the market equilibrium is
superior (inferior) to the social optimum.
The solution to the problem of externalities can
be pursued both by private parties and public
intervention
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Conclusion
Economic goods differ in terms of excludability
and rivalry.
The market can function when goods are private
i.e. both excludable and rivalrous.
Public goods are neither excludable nor
rivalrous, hence the market does not function
well.
In because of free riding, it is the public sector
who is responsible to supply public goods.
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Conclusion
Collective resources are rivalrous but not
excludable.
Since individuals do not pay for the use of the
resource, there is a tendency toward overexploitation.
Public administration may limit the use of
common resources via access regulation and
taxes
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