Public goods and externalities:
examples and exercises
Lecture 12 – academic year 2014/15
Introduction to Economics
Fabio Landini
Example of the bridge:
two-ways table
Many
Ye
s
Tax
No
Excludable
Not Excludable
Rival
(PRIVATE GOOD)
Rival
(COLLECTIVE GOOD)
Excludable
Not Excludable
Not Rival
(NATURAL MONOPOLY)
Not Rival
(PUBLIC GOOD)
N. persons
Few
2
INTRO
The book says that both public good
entail externalities.
A) Are the externalities associated with public
goods positive or negative? Give an example.
B) Would the quantity of public good produced
thorough free market be higher or lower than
the efficient one?
3
INTRO
A) The externalities associated with public goods
are usually positive. Since the benefit that a person
receives from a public good does not affect the
benefit of other persons, the social value of public
good is higher than its private value. Example:
national defence, knowledge, …
B) Since public goods are not excludable, the
quantity produced by the free market is zero, and is
thus inferior to the efficient one.
4
Index of examples/exercises
• INTRO
• Ex. 12.1 (externalities and alcohol consumption)
• Ex. 12.2 (permit I)
• Ex. 12.3 (firms and R&D)
• Exercise on public good
• Ex. 12.4 (the Economist)
• Ex. 12.5 (permit II)
5
Ex.12.1
The higher alcohol consumption, the higher the
number of car accidents, and thus the higher the
risk of driving.
Are there externalities in the market for alcoholic
beverages?
6
Ex.12.1
Market for alcohol beverages
Price
Supply
(social cost)
B
A
C
Demand
Social value
Qo
Qm
Quantity
7
Ex.12.1
In because of the externalities due to the
increase in car accident, the social value
curve is below the demand curve. The
equilibrium in a free market is given by Qm,
whereas the socially efficient one is Qo.
8
Ex.12.2
Firm
A
B
Level of pollution
(units)
Cost to reduce
pollution (units)
110
30
50
10
In order to bring the level of global pollution to
80 units, the Government assigns to each firm 40
tradable permits to pollute one unit.
9
Ex.12.2
a) Who offer the permits in the market? How
many? Who purchases them? How many?
Explain the motivations behind buyer’s and
seller’s decision.
b) How much would the cost to reduce
pollution be if permits were not tradable?
10
Ex.12.2
a) Each permit is worth 10 for B and 30 for A
(=unitary cost to reduce pollution).
Since A’s cost are higher than B’s, A wishes to
maintain her level of pollution (she will keep
her 40 permits and is willing to buy 40 permits
more). Who sells this additional permits to A?
Firm B.
11
Ex.12.2
Therefore: A pollutes 80 units and reduce
pollution for 30 units (cost = 900). B sells her 40
permits e reduces pollution for 50 units (cost =
500).
Total cost for reducing pollution = 1.400 (900+500).
12
Ex.12.2
b) If the permits were not tradable, both firms
could pollute 40 units.
A must reduce pollution for 70 units (cost=2.100)
and B for 10 units (cost=100).
Total cost for reducing pollution= 2.200 (+800
with respect to the case with tradable permits).
13
Ex.12.3
People tend to argue that firms tend not not carry
out basic research (BR) at an efficient level.
Why is this so?
a) Which type of good is BR?
b) Which type of policy has been adopted by US?
c) It is generally believed the the adopted policy
increases the technological capabilities of firms with
respect to competitors. Is this argument coherent
with the adopted classification?
14
Ex.12.3
a) BR is a public good: it generates spillover that can
benefit many other social actors.
Firms do not take into account these externalities in
drafting their balance sheet; they consider only the
company’s expected future profits.
=> It follows that the amount of BR carried out by
private firms is below the social optimum.
15
Ex.12.3
b) In the US firms receive subsidies to carry out BR
through public institutions, e.g. NIH (National
Institute of Health) and NSF (National Science
Foundation).
c) Scientific knowledge spreads rapidly (especially
today) and it tends to be not excludable. Exclusion
can obtain if firms of other countries are not
allowed to access internally produced knowledge
(e.g. though patents).
16
Ex.12.3
The advantage of US firms is probably the one of
first mover.
However, ones research and knowledge spread,
the firms of other countries will be equally
competitive.
17
Exercise on public goods
100 inhabitants of a urban district are worried
about their SECURITY.
N. Guards
24h
Tot. Cost
(Euro)
Individual benefit for
each inhabitant
(Euro)
0
0
0
1
150
10
2
300
16
18
Exercise on public goods
Questions:
a)Is the surveillance service a public good for
inhabitants? Why?
b)If one inhabitant decided to the pay the
surveillance service by her own, how many
guards would she hire?
c)If 50 inhabitants made an agreement in which
all pay one share of the cost of surveillance, how
many guards would they hire?
19
Exercise on public goods
a) The surveillance service is a public good
because, once produced, it is
NOT EXCLUDABLE
and
NOT RIVAL
20
Exercise on public goods
b) If one inhabitant took the initiative to pay by
her own the surveillance service, she would not
hire ANY guards.
In fact the marginal benefit of hiring one guard
(10 Euro) would be much higher than the
marginal cost(150 Euro)
21
Exercise on public goods
c) If 50 inhabitants made an agreement in which
all pay one share of the cost of surveillance, then
they can decide to hire 2 guards:
Cost = 300/50 = 6 Euro each
Benefit= 16 Euro
22
Ex.12.5
The Economist , 19/03/1994: “in the last decade,
world’s fishing areas have been exploited near to
their depletion”. Then, analysis of the problem and
possible solutions, both private and public:
a) “Fishers cannot be blamed for over-exploitation,
somehow, they behave rationally ad they have
always done”. In which sense is over-exploitation
rational from the fishers’ point of view?
23
Ex.12.5
b) “A community, tighten by common obligations
and interests, is able to self-manage a common
resource”. Explain.
24
Ex.12.5
c) “Until 1976 most part of the world’s fishing areas
were open to everybody, making it impossible to
apply any policy for preservation. Since then,
international law has extended the national
jurisdiction from 12 to 200 miles form the coast”.
Explain how this agreement can contribute to
(partially) solve the problem.
25
Ex.12.5
d) Several governments encourage fishing by giving
aids to fishers. Explain in which way these incentives
favoured over-exploitation.
e) “Only if fishers will be granted an exclusive right
on a specific fishing area management as efficient
as the one of a farmer on her own land will obtain”.
Find argument in support of this statement.
f) Are there other policy interventions that could be
implemented in order to reduce over-exploitation of
world’s fishing areas?
26
Ex.12.5
a) “Fishers cannot be blamed for overexploitation, somehow, they behave rationally ad
they have always done”. In which sense is overexploitation rational from the fishers’ point of
view??
a) Over-exploitation is rationale for fishers because
they are using a collective resource, thus they do
not pay the costs associated with the reduction of
fishes available to others
In free market, the quantity of fish that is sold
exceeds the socially efficient quantity .
27
Ex.12.5
b) “A community, tighten by common obligations
and interests, is able to self-manage a common
resource”. Explain.
b) One possible solution to the problem could
derive from regulating the quantity of fish that can
be caught, e.g., imposing a tax or auctioning
some permits to fish.
Problem: MANY nations have access to oceans.
This would require some forms of international
cooperation, which is difficult to implement in
because of the large dimension of the sea.
28
Ex.12.5
c) “Until 1976 most part of the world’s fishing areas
were open to everybody, making it impossible to
apply any policy for preservation. Since then,
international law has extended the national
jurisdiction from 12 to 200 miles form the coast”.
Explain how this agreement can contribute to
(partially) solve the problem.
c) The recognition of property rights to individual
nations could be a viable solution, given that each
nation would then have a higher incentive to find
a solution. Each nation could introduce a tax or
create permits, ensuring monitoring over an area
of smaller size.
29
Ex.12.5
d) Several governments encourage fishing by
giving aids to fishers. Explain in which way these
incentives favoured over-exploitation.
d) So long as governmental authorities, such as the
Coast Guard in US, protect fishers and help them
when they need so, fishers will never pay the total
cost of their fishing (private plus social cost) and
will thus catch as much fish as they can.
30
Ex.12.5
e) “Only if fishers will be granted an exclusive right
on a specific fishing area management as efficient
as the one of a farmer on her own land will obtain”.
Find argument in support of this statement.
e) If fishers owned a specific fishing area, they
would not over-exploit it because they would
necessarily pay the cost. This is an example in which
property rights help preventing over-exploitation of
a collective resource.
31
Ex.12.5
f) Are there other policy interventions that could be
implemented in order to reduce over-exploitation of
world’s fishing areas?
f) The alternatives include: fishing regulation, tax on
fishers, auctioning of fishing permits or taxation of
fish that is sold; in general all these interventions
would help reducing the quantity of fish that is
exchanged in equilibrium bringing it closer to the
efficient quantity.
32