
Capitalism is associated with limited
government, but government is necessary for
three reasons:




Establish and maintain legal system to protect property
rights.
Promote equity in the distribution of income and wealth.
Correct inefficiencies that arise from markets
(externalities, public goods, and monopoly power).
Public Finance/Choice is the area of economics
that studies the public sector.

Incentives are different in markets versus political
sphere– in capitalism preference are revealed with
purchases versus votes.
 Efficiency
in competitive markets occurs
where MB=MC. Where MB= private (max.)
willingness to pay and MC= private (min.)
willingness to sell.
 More correctly, society will see the
outcome as efficiency where marginal
social benefits = marginal social costs.
 Externalities drive a wedge between
private and social benefits and private
and social costs.
Price of
Aluminum
Supply
(private cost)
Equilibrium MB=MC
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Externalities are benefits (costs) received
(borne) by neither the seller or the buyer but by
third parties.
 Private benefits + external benefits = social
benefits
 Private costs + external costs = social costs
 Since external benefits and costs are not
perceived by buyers and sellers they are not
captured in markets.
 Therefore, markets may fail to allocate
resources inefficiently.

Marginal social costs are greater than marginal
private costs.
 Pollution is a cost that may not be borne by
sellers, but it is a cost nonetheless to society.
 Private markets will overproduce (devote too
many resources) to the production of goods with
negative externalities.
 External costs and the supply curve.
 Missing the extra costs, markets generate an
outcome where MSC > MSB, signal that
decreasing output will increase net social
benefits.
 Is zero pollution efficient?

Price of
Aluminum
Social
Cost =MSC
Cost of
pollution
Supply
(private cost)
=MPC
MSC
MSC
Optimum
Equilibrium
MSB
MSB
Demand
(private value)
MPB=MPB
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
 Marginal
social benefits are greater than
marginal private benefits.
 Education is a benefit not only to the
individual but to society in general.
 Private markets will underproduce
(devote too few resources) to the
production of goods with positive
externalities.
 External benefits and the demand curve.
 Missing the extra benefits, markets
generate outcomes where MSB > MSC, a
signal that increasing production will
increase net social benefits.
Price of
Education
Supply
(private cost)
MSB
The market does too little MSB>MSC
MSC
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
Copyright © 2004 South-Western
Efficiency versus who ought to modify their
behavior?
 Moral and Ethical Codes
 Non-governmental organizations or Charities
 Integrating certain activities (bee keepers and
fruit growers)
 Contract between parties
 Coase Theorem – if negotiation costs are zero,
private parties can resolve the problem of
externalities.




An optimal compensatory payment (bribe) = one that
makes both parties better off.
Initial distribution of rights does not affect the efficient
outcome, but it does determine who will pay whom.
Example of heating the apartment in Santiago
 Government

Regulation





policies
Limits to pollution
Specific technology requirements
Government production
Regulation and least cost solutions
Taxes and Subsidies

Who should pay the tax or receive the subsidy?



Tax /subsidy incidence is the same
External costs, supply (demand) and the optimal tax.
External benefits, demand (supply) and the optimal
subsidy.

Tradeable Pollution Permits


The higher costs of avoiding pollution, i.e. the higher
the benefits from polluting, the more a firm is willing
to pay.
Criticism of Economic Solutions to Pollution


To live is to pollute
Natural carrying capacity
Externalities are “invisible” to buyers and sellers
in markets. In some cases, government action
may be needed to make them visible and ensure
they are included in economic decision-making.
 The efficient allocation of resources occurs
where:

MSB=MSC
 Certain
kinds of goods or services are
underproduced in markets because the
market does not contain sufficient
incentives to produce them in efficient
amounts.
 Certain kinds of resources are overused
because they are owned collectively or
people cannot prevent them from being
used.
 Exclusion
or non-exclusion– can
individuals be excluded from consuming
the good or the resource. (e.g.
hamburger, houses, physical examination
versus fireworks, national defense, and
the ocean outside of territorial waters)?
 Rival or non-rival – does one person’s use
of the good or resource affect another
persons use. (e.g. hamburger versus
lighthouse, uncongested versus congested
highway)
Rival?
Yes
Yes
No
Private Goods
Natural Monopolies
• Ice-cream cones
• Clothing
• Congested toll roads
• Fire protection
• Cable TV
• Uncongested toll roads
Common Resources
Public Goods
• Fish in the ocean
• The environment
• Congested nontoll roads
• Tornado siren
• National defense
• Uncongested nontoll roads
Excludable?
No
Copyright © 2004 South-Western
 Private
Good – excludable and rival
(hamburger)
 Public Good – not excludable and nonrival (lighthouse, warning siren)
 Common Resource – rival but not
excludable (ocean, old days pasture land)
 Natural Monopoly – excludable but nonrival (protecting another house – MC is
small)
Examples are fireworks, national defense, basic
research, alleviating poverty)
 Free-rider problem – another example of
revealed preference. If people cannot be
excluded, they have no little incentive to pay for
the good or service).
 Free-riders make it difficult for private providers
to provide the optimal amount of a public good.
 Voluntary exchange does not work efficiently and
efficiency may be provided by government
coercion.

 The
government must perform costbenefit analysis to decide if it is
worthwhile to provide the good and
determine how much should be produced
(valuing a life).



Stoplights
Highways – public or private, uncongested or
congested
Taxes are then imposed to provide for
the good.
 Boston
Commons – overuse of a rival
resource where individuals were not
purposively not excluded.
 Ocean Fishing
 Bison versus Cattle – the importance of
property rights
 Pricing in national parks
 Efficiency
and the market system
 Market failures
 Government failures