Public Goods &
Externalities
What are Public Goods?
Public goods are jointly consumed goods. If one
person gets the good, everyone gets it. One
person’s consumption of the good does not reduce
the amount available for others to consume. (The
good is “nonrival in consumption.”)
Also, the good can not divided up into separate
portions for different individuals. Once a public
good has been provided to one person, there is no
easy way to prevent others from consuming it as
well. (The good is “nonexcludable.”)
Examples of Public Goods
• national defense – everyone is protected by the
same defense system
• Dams – everyone in the community is protected
from flooding by the dam
The Free-Rider Problem of Public Goods
There is an incentive to not reveal your true
valuation, since if the good is provided, you are
going to get the use of it anyway.
But if everyone refuses to reveal their true value
of the good and so refused to voluntarily pay
what it is worth, the good will not be provided.
Someone who enjoys the benefit of a good
without paying for it is called a free rider.
Efficient Provision of a Public Good
The social marginal benefit curve (MBS) is the
demand curve for a public good.
It is derived by vertically summing the individual
consumers’ marginal benefit curves.
The efficient level of a public good occurs where
the social marginal benefit curve intersects the
marginal cost curve:
MBs = MC.
Suppose there are only two people.
Their individual demand curves or
marginal benefit curves for
$
consumption of the public good are
MB1 and MB2.
MC
If we vertically sum MB1 and
$500
MB2, we get the social marginal
benefit curve (MBS) or society’s
MBS
demand curve for the public good. $325
Suppose the marginal cost of
D2 = MB2
providing the good is MC ($500 in $175
this example).
D1 = MB1
Equating the MC and the MBS, we
find the optimal level Q* of the
Q
Q*
public good.
At that level, the marginal benefit to society is $500, and the marginal
benefits to the two people are $175 and $325.
Externalities
Spillover effects or side effects
of economic activities
External Benefits
External benefits – positive side effects of
economic activities
Examples:
• my neighbor’s flower garden that
provides pleasure to other neighbors.
• Immunization against a contagious
disease that reduces the likelihood that
people who have not received the
inoculation will get the disease.
External Costs
External costs – negative side effects of
economic activities
Examples:
• pollution
• drunk drivers
• litter bugs
Social Benefits
social benefits = private benefits received by the
decision-maker + any external benefits.
When there are no external benefits, private and
social benefits are equal.
Social Costs
social costs = private costs incurred by the
decision-maker + any external costs.
When there are no external costs, private and
social costs are equal.
Example: Suppose a firm is considering a project that will
cost $1500 and generate $1800 in revenue. The project
would also produce $500 worth of aggravation for the
neighbors.
What is the social cost of the project?
social cost = private cost + external cost = 1500 + 500 = $2000.
If the firm ignores the effects on the neighbors, will the firm
undertake the project?
Yes, because the private benefits (1800) exceed the private costs
(1500).
From the point of view of society, should the project be undertaken?
Assuming there are no external benefits,
social benefits = private benefits + ext. benefits = 1800 + 0 = $1800.
Since the social costs were $2000, which is greater than the social
benefits of $1800, the project should not be undertaken.
Coase Theorem
An acceptable solution to an externality will be
found if
• ownership of property is clearly defined,
• the number of people involved is small,
• the costs of bargaining are negligible.
In many situations, many people are affected
and the costs of bargaining are substantial.
These types of problems are unlikely to be
resolved appropriately without government
intervention.
External Benefits
In Microeconomics Principles, we found that when
external benefits are ignored, too little is produced.
In addition, when external benefits are ignored, we
found that the level of demand is not as high as it
should be, and therefore the price is lower than
would be the case if the externalities were taken into
consideration.
If we subsidize goods with external benefits, we can
raise the quantity produced to the socially optimal
level.
Suppose that MBE is the marginal
external benefit of a good.
MBP is the marginal private
benefit or demand curve for the
good.
The sum of MBE and MBP is the
marginal social benefit MBS.
S=MC is the perfectly
competitive supply curve and
marginal cost of production.
When the externality is ignored,
the amount of the good produced
is Q1, where the MBP equals the
MC.
However, the efficient amount
from the viewpoint of society is
Q2, where MBS equals MC.
External Benefits
$ per unit
MBS
S = MC
MBE
D=MBP
Q1 Q2
Q
External Benefits
Suppose a per unit subsidy of $A
$ per unit
is provided.
The new marginal cost is
MBS
MC' = MC – A.
When MC' is equated to MBP,
the socially optimally amount of P2+A
P1
the good Q2 is produced.
P2
The price of the good paid by the
consumer is lower (P2 instead of
P1).
MBE
The total price including the
subsidy paid by the government,
however, P2 +A is higher.
Q1 Q2
S = MC
A
S' = MC'
D=MBP
Q
External Costs
In Microeconomics Principles, we found that when
external costs are ignored, too much is produced.
In addition, the price is lower than would be the
case if those external costs were taken into
consideration.
If we tax goods with external costs, we can reduce
the quantity produced to the socially optimal level.
Suppose that MCE is the marginal
external cost of a good the
production of which generates
pollution.
MCP is the marginal private cost
of producing the good.
The sum of MCE and MCP is the
marginal social cost MCS.
D is the demand for the product.
When the pollution is ignored, the
amount of the good produced is
Q1, where the D (or marginal
private benefit) equals the MCP.
However, the efficient amount
from the viewpoint of society is
only Q2, where MCS equals D.
External Costs
$ per unit
MCS
MCP
MCE
D=MBP
Q2
Q1
Q
External Costs
Suppose a per unit pollution tax
of $T is imposed.
The new marginal private cost
of producing the good is
MCP' = MCP + T.
When MCP' is equated to
D = MBP, the socially optimally
amount of the good Q2 is
produced.
The price of the good is also
higher: P2 instead of P1.
$ per unit
MCS
MCP'
T
P2
MCP
P1
MCE
D=MBP
Q2
Q1
Q
Let’s focus on the cost of pollution reduction.
The production of some goods generates pollution.
To reduce that pollution requires taking steps that
incur costs.
One example would be the installation of filters on
smokestacks.
Suppose the cost of pollution reduction is not the
same for all firms.
What would be the impact of the government
imposing a per unit pollution tax on all firms?
Pollution Reduction
Suppose that the marginal
cost of pollution reduction
is MCA for firm A and B
MCB for firm.
Without a pollution tax, A
produces PA=400 units of
pollution and B produces
PB=275 units of pollution.
Notice in this graph that
pollution is measured
from the right and
pollution reduction is
measured from the left.
$ per unit
MCA $ per unit
MCB
PA = 400
PB = 275
Pollution
reduction
Pollution
Even with a tax, firms wouldn’t reduce pollution
to zero.
It costs more to get rid of all emissions than it
does to clean up some of the emissions and pay
the tax on the rest.
Firms clean up to the point where the MC of
cleaning up equals the MC of not cleaning up,
that is of paying the tax on each of the remaining
units of pollution.
So firm A will reduce its
pollution by 250 units to
PA' = 150.
Firm B will reduce its
pollution by 225 units to
PB' = 50.
This policy would reduce
total pollution to 200
units, cleaning up all units
that cost less than the tax
to eliminate.
The policy eliminates 475
units of pollution in the
least costly way.
A per unit pollution tax
$ per unit
MCA $ per unit
MCB
T
PA=400
PB=275
Pollution
reduction
PA' =150
PB' =50
Pollution
Suppose the government were
instead to reduce pollution to
200 units by requiring each
firm to cut back its pollution to
100 units.
Firm A have to eliminate a lot
of costly emissions, while firm
B would not have to eliminate
some less costly emissions.
The extra cost to A would be
the blue area.
The reduction in cost to B
would be the pink area.
Clearly the extra cost to B is
more than the savings to A.
So a policy that required firms
to cut back to the same
pollution level is a more costly
policy.
Fixed Pollution Level
$ per unit
MCA $ per unit
MCB
T
PA=400
PB=275
Pollution
reduction
PA' =150 PB' =50
P0=100
Pollution