Chapter 3 Public Goods and Externalities Learning outcomes • Distinguish between private, public, mixed and merit goods • Derive the conditions for the optimal allocation of private, public and mixed goods with the aid of supply and demand analysis • Explain why competitive markets fail to provide public and mixed goods efficiently • Explain the distinction between the financing of public goods and services, and their physical production • Explain the concept of an externality • Identify the main types of externalities • Explain the effects of positive and negative externalities with the aid of supply and demand analysis • Discuss the policy options to correct for externalities Learning outcomes (continued) • Discuss the relative importance of property rights and transaction costs in market-based approaches to dealing with the problem of externalities • Discuss cap-and-trade programmes • Provide examples of global or regional public goods and consider some of the relevant policy implications Private goods and the benchmark model • Not all goods and services can be supplied efficiently by competitive markets • Efficient production under competitive conditions: • Consumer should reveal preferences (demand) • Signals guide decisions of producers • Competition ensures production at minimum cost • Mechanisms for demand revelation exist for private goods • Characteristics of private goods: • Rivalry in consumption • Excludability Equilibrium of a private good Pure public goods • Characteristics of pure public goods: • Non-rival in consumption • Marginal cost of adding consumers is zero • Excluding consumers is Pareto-inefficient • Non-excludable • Impossible to assign or enforce property rights • The stringency of the criteria for pure public goods • Non-excludability: Technological and cost factors Equilibrium of a pure public good Comparison of characteristics of private and pure public goods Supplying public goods • Efficient pricing by competitive markets impossible • Impossible to determine an equilibrium price for private provision of a pure public good • Non-excludability creates incentives for "free-riding" • Government provision improves on the inefficient outcomes of markets • Optimal provision requires price discrimination • Prevented by lack of knowledge of individuals' (non-revealed) preferences • Hence: Financing by means of mandatory "tax price" • The distinction between public financing and public production of pure public goods Mixed and merit goods • Mixed goods and services: • Non-rival, excludable mixed goods and services • Rival, non-excludable mixed goods and services • Public or private supply? An open question • The role of technology • Merit goods and services: • Excludable, but supplied via the national budget because of their meritorious nature • The external benefits to buying or receiving merit goods and services Externalities • Positive externality: The actions of an individual producer or consumer confer a benefit on another party free of charge • Negative externality: The actions of an individual producer or consumer impose a cost on the other party for which he or she is not compensated • The distinction between technological and pecuniary externalities • Pecuniary externalities: A net effect on society or not? • A classification of externalities: • Negative production externality: MEC > 0; MSC > MPC • Positive production externality: MEC < 0; MPC > MSC • Positive consumption externality: MEB > 0; MSB > MPB • Negative consumption externality: MEB < 0; MPB > MSB Solutions to externality problems • Pigouvian taxes and subsidies • Direct regulation • Creation of and support for markets • Property rights (the Coase theorem) External costs and a Pigouvian tax External benefits and a Pigouvian subsidy Regulation and externalities • Direct regulation • Command-and-control regulation • Information constraints • Bureaux of Standards • Regulatory measures • Creation of regulated markets • An incentive-based option: Cap-and-trade programmes • Information constraints • Support for alternative markets • Example: Energy markets Property rights and externalities • Coase: Problems of externalities boils down to disputes about ownership of resources • Coase theorem: Market incentives will generate a mutually beneficial exchange of property rights through which externalities can be fully internalised, provided that property rights are well defined and enforceable, and transaction costs are negligible • The role of transaction costs Global public and merit goods • Joint responsibility by neighbouring countries for providing and sharing the burden of cross-border public and merit goods • Examples: • Defence systems • Cross-border road and rail networks • Air and water pollution • Carbon dioxide emissions • Bilateral and multilateral agreements • Regional trade agreements • International agreements Allocative efficiency • Allocative efficiency: A situation in which the limited resources of a country are allocated in accordance with the wishes of its consumers • Outcome: Optimal mix of commodities • Result of the interaction between the activities of consumers and producers • Requires simultaneous concurrence of three conditions: • Pareto optimality in production • Pareto optimality in consumption • Simultaneous equilibrium for consumers and producers (“top-level Pareto equilibrium”) Summary • Public goods and externalities reflect the incompleteness of markets • These market failures provide a rationale for complementary government actions aimed at improving the allocation of resource. • Pure public goods: Characteristics of non-rivalry and non-excludability prevent efficient pricing by competitive markets and enforcement of payment of the price • Mixed goods contain both private and public good characteristics, and are usually provided by a combination of the private and public sectors • Externalities: Positive or negative external effects not reflected in prices • Possible solutions: Pigouvian taxes and subsidies, regulation, creation of and support for markets; property rights (Coasian solution) • Cross-border public goods and external effects require international cooperation
