Externalities and Public Goods
Four Categories of Goods
 Goods differ on the basis of whether their
consumption is rival and excludable.

Rival – The situation that occurs when one person’s
consuming a unit of a good means no one else can consume it.


If you eat a hamburger, no one can eat the same unit of that
hamburger.
Excludable – The situation in which anyone who does not
pay for a good cannot consume it.

If you don’t pay for a hamburger, you could be excluded from
consuming it.
Four Categories of Goods
 1. Private Good – a good that is both rival and excludable.
 Food, clothing, personal electronics, cars, etc.
 The market is good at providing private goods
 2. Public Good – a good that is both nonrival and
nonexcludable.


National defense, court system, lighthouses, streetlights, flood-control
levees etc.
The market typically under-provides these goods or not at all since they
are nonexcludable. It is difficult for a firm to make a profit off of
providing them. People can consume these types of goods without
paying for them, which is known as free riding.


Free rider problem - Benefiting from a good without paying for it.
 The mandate in the ACA is supposed to help remedy the problem of
uncompensated expenses for health care.
The government provides public goods and partially resolves the free rider
through taxation.
Four Categories of Goods
 3. Quasi-Public Good / Club Good – a good that is
excludable, but not rival.

Cable TV, uncongested toll roads, uncongested beach that
required a fee, cinemas, etc.
 4. Common Property Resource – a good that is rival,
but nonexcludable.

International fish stocks, public pasture land, free water use,
hunting and trapping, etc.
Four Categories of Goods
Rival
Nonrival
Excludable
Nonexcludable
Private Goods:
Pizza
Tennis Rackets
Shoes
Quasi-Public Goods:
Cinemas
Uncongested Toll
Road
Internet
Common Resources:
International Fish
Stocks
Public Pasture Lands
Public Goods:
National Defense
Court System
Lighthouse
Demand for a Public Good
 The demand for a public good is similar to the
demand for a private good. It is the aggregation of
all individual demand curves (or marginal benefit
curves).
 The optimal quantity of a public good is where the
marginal social benefits equal the marginal social
costs.

This is also where consumer and producer surplus is
maximized.
Demand for a Public Good
 However, there is little to no incentive for an
individual to reveal their true preferences regarding
a public good since once it is supplied they cannot be
excluded from consuming it.
 In addition, public goods are often supplied to many
people and it is difficult and time consuming to
determine each individual’s marginal private benefit
curve.
Demand for a Public Good
 The government typically resorts to cost-benefit
analysis when supplying a public good or some sort
of political process.


Congress and the President do not use a formal cost – benefit
analysis to determine the optimal level of military spending.
Other times, public goods are left up to a referendum.
Common Resources and the Tragedy of the
Commons
 Common property resources are not owned by
anyone and therefore, everyone has access to it (i.e. it
is nonexcludable).
 Tragedy of the Commons – the tendency for a
common property resource to be overused,
potentially to the point where it is exhausted.
Common Resources and the Tragedy of the
Commons
 The Tragedy of the Commons is a 1968 essay by
Garret Hardin.
 Hardin hypothetically claimed that herders who
wanted to maximize their herd yields would expand
their herd size to a point that would lead to
overgrazing of public pastures lands and ultimately
rendering them useless.
 This has been criticized since public pasture lands
have been properly maintained, but the tragedy of
the commons does exist.
Common Resources and the Tragedy of the
Commons
 Haiti was once heavily forested. Today, about 80% of
the country’s forests have been cut down, primarily
to be burned to create charcoal for cooking and
heating. Heavy rains lead to devastating floods since
the mountains have no tree roots to hold the soil.
 Overfishing – salmon, sturgeon, whales, etc.
 Over appropriation of water.
 Pollution and environmental sinks.
Solutions to the Tragedy of the Commons
 1. Privatization along with clearly defined and
enforceable property rights. Individuals do not have
an incentive to over-exploit their own resources.
 2. Government intervention through regulations,
taxation, quotas, and permits.
Externalities
 Externality – a spillover benefit or cost onto someone
who is not directly involved in the production or
consumption process.

They impose external benefits and costs onto others
 Negative Externalities – Spillover costs

Air pollution from production, water contamination, animal
production, a cell phone ringing in class, people smoking by public
doorways, loud (and terrible) music at 2 a.m., too much drinking by
bar goers, eating unhealthy, crime, being distracted while driving.
 Positive Externalities – Spillover benefits

Education, immunization, looking your best, asking a question in
class, beekeepers, home improvements or gardens, research and
development, home ownership, fireworks, loud music that you like,
inspiring others with ideas and actions.
Externalities
 Externalities are a type of market failure since the
price mechanism does not take into accounts the full
marginal social costs and marginal social benefits
of production and consumption.
 Externalities are a divergence between the private
and social cost or benefits.


Private costs or benefits are borne by the decision maker;
either the buyer or seller
External costs or benefits are the values lost to (or gained by)
outside parties who are not represented by the market supply
and demand
Social Costs or Benefits
 Social costs or benefits are the sum of all the costs or
all the benefits to all members of society; includes
both private and external costs.
 To summarize:


Social costs = private costs + external costs
Social benefits = private benefits + external benefits
Example: Positive Externality
 Education is a positive externality.
 The private benefits of education are:

Earning more money, having more opportunities, increasing your
utility from becoming more worldly, fixing a problem in your life,
help you to achieve your dreams, etc.
 However, are these the only benefits of education?
 The external benefits of educations are:

Education leads to higher incomes and more taxes being paid in
which others benefits from, less (property) crime, better voting
decisions which affect many, economic growth and increased
opportunities for others.
 Notice that individuals who pay for their education do not get
compensated for these spillover effects.
Example: Negative Externality
 Pollution from production (steel firm, paper mill,
industrial farming) is a negative externality.

The private costs are:


What the firm pays for their factors of productions.
The external costs are:

Bad odors, increases in respiratory and cardiovascular diseases,
water contamination, increase in resilience of bacteria to
antibiotics, dirtier homes, cars, and clothes.
 Notice that the firm does not pay for these external costs, unless
government or legal action takes places.
Externalities and Market Failure
 Externalities are a type of market failure since the
price mechanism does not take into accounts the full
marginal social costs and marginal social benefits
of production and consumption. Therefore, the
market price is not the efficient price and we have
deadweight loss.


With negative externalities, the market over-allocates
resources towards that activity.
With positives externalities, the market, under-allocates
resources towards that activity.
What causes Externalities and Market Failures?
 Externalities and their coinciding market failures are
the result from incomplete property rights or from
the difficulty of enforcing property rights in certain
situations.

For example, when you buy a college education, other people
may benefit from it. You have no property rights that enable
you to prevent others from benefiting or to charge them for the
benefits they receive.
Correcting for Externalities.
 1. Tax away negative externalities or subsidize away
positive externalities. This is also known as a
Pigouvian Tax or Pigovian Subsidy.

For example, if the marginal external cost of a negative
externality (e.g. smoking) is $1, then a $1 per-unit tax would
lead to the right outcome.

The individual (or firm) would be internalizing their external
costs.
 A key problem with the Pigouvian tax (and subsidy)
is that it is difficult to estimate and like all taxes, it
may promote gray and black activity
Correcting for Externalities.
 2. Quotas—For example, set a maximum quota for

pollution or set a minimum amount of rest for
airline pilots.
3. Tradable permits—are quotas for pollution that
can be traded on the market.

Advantages over quotas are that tradable permits tend to
promote efficient exchange, give the incentive to promote
pollution abatement technology, and environmental groups
can even buy the ‘right to pollute’ permits.
Correcting for Externalities.
 4. Regulation and mandates.


Technology mandates such as catalytic convertors for automobiles and scrubbers
for smokestacks.
Mandate that children must be provided an education up to a certain level or age.
Mandatory vaccinations for children enrolling in public schools.
 5. Criminalization.

Prostitution, addictive drugs, commercial fraud, and many types of
environmental and public health laws.
 6. Government provision.

As with lighthouses, education, and national defense (i.e. goods that
provide positive externalities).
 7. Do nothing.

The cost of correcting the externality may exceed the benefit.
Coase Theorem
 Coase Theorem—in absence of transaction costs,
individuals may be able to solve the problem of
externalities without government involvement
through negotiation.

A major problem with the Coase Theorem is the assumption of
zero transaction costs; that it costs absolutely nothing to strike
a deal--no time, no effort, no lawyers, and not even a paper
and pen on which to write it up the deal.

Even if transactions are low, then the Coase Theorem could be
applied, but transactions costs are not typically low for significant
externalities, such as pollution.
To Summarize:
 There are four types of goods based on whether their
consumption is rival and excludable.
 Externalities – spillover benefits or costs.
 Public Goods and Externalities are a type of market
failure.


The market underprovides public goods since they are
nonexcludable.
As for externalities, there is a divergence between the market
price and efficient price due to external benefits and costs.
DWL results when prices are not efficient.

The market over-allocate resources with negative externalities and
under-allocates resources with positive externalities.