Externalities and Public Goods

Chapter Summary

• Topic: Externalities and public goods
• Contrast with previous pro-market results
• Focus: Cases where unregulated markets do not maximize total surplus

Basic Premise

• Actions affect other people
• Example: Marginal costs of smoking (financial, health, second-hand smoke)

Concept of Externality

• Definition: Benefit or cost received by someone not directly involved in the production or consumption of a good
• Example: Second-hand smoke, rental scooters

Negative Externalities

• Positional Externalities: Dependence on relative performance
  • Examples: SUVs and crashes, steroid use in competitions, arms race
• Common Resource Problem: Use of a resource decreases its availability for others
  • Example: Overfishing
• Intergenerational Externalities: Affects future generations
  • Example: National debt, depletion of the ozone layer

Positive Externalities

• Benefits without consuming or selling the good
  • Examples: Bee pollination, LoJack for cars
• Fiscal Externalities: Taxes that benefit others
• Network Effects: Increases the usefulness of a product for others
• Thick Market Externalities: More buyers and sellers reduce transaction costs

Marginal Benefits and Costs

• Private Marginal Cost: Cost to the producer of an additional unit
• Private Marginal Benefit: Benefit to the consumer of an additional unit
• External Marginal Cost: Cost to others not involved in production/consumption
• External Marginal Benefit: Benefit to others not involved in production/consumption
• Social Marginal Cost: Sum of private and external marginal costs
• Social Marginal Benefit: Sum of private and external marginal benefits

Example

• Production of goods with negative and positive externalities
• How they affect supply and demand curves

Equilibrium and Externalities

• Negative Externalities: Shift the supply curve up/left
• Positive Externalities: Shift the demand curve up/right
• Results:
  • Goods with negative externalities are overproduced
  • Goods with positive externalities are underproduced

Solutions to Externalities

• Coase Theorem: Externality problems can be solved through private agreements if there are no negotiation costs
• Corrective Taxes and Subsidies: Align incentives with social costs/benefits
  • Example: Carbon tax, cigarette taxes
  • Corrective Subsidy: Incentivizes positive behaviors (example: vaccination)
• Social Norms: Act as corrective taxes (example: returning the shopping cart)
• Laws and Regulations: Restrict behaviors that generate negative externalities

Public Goods

• Non-Rival: Consumption by one person does not decrease availability for others
• Non-Excludable: Not easy to prevent consumption by non-payers
• Free Rider Problem: Difficulty for private companies to provide the good

Example of a Public Good

• Fireworks: Non-rival, non-excludable
• Solutions to the Free Rider Problem:
  • Government provision
  • Technologies to control access (tolls)