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Externalities and Public Goods


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externalities and public goods
Externalities and Public Goods
  • Setup: Perfectly competitive markets result in outputs and prices which are socially optimal in the sense of the maximizing surplus (Pareto Optimal). Another way to say this is that competition results in output levels for which marginal social benefit equals marginal social cost. (MSB = MSC)

Market failure

slide2
We saw that the presence of monopoly, for example, could justify government interference because monopolies don’t produce output levels where MSB = MSC.
  • But even competitive markets may fail under some circumstances.

Market failure

slide3
In what follows, we will examine the conditions under which competitive markets may fail to be optimal institutions to produce and distribute goods. This topic is known as “market failure.”

Market failure

reasons for market failure
REASONS FOR MARKET FAILURE
  • MONOPOLY POWER
  • EXTERNALITIES
  • PUBLIC GOODS
  • INFORMATION FAILURES

Market failure

externalities in more detail
EXTERNALITIES IN MORE DETAIL
  • An externality is a benefit or cost to third parties who are not directly involved in a transaction.
  • Externalities are sometimes called neighborhood effects.

Market failure

slide6
Externalities can be either beneficial or harmful, and can originate with either consumers or producers.
  • Here are some examples:

Hidden slides

Market failure

how externalities work
How Externalities Work
  • The existence of an externality creates a difference between either
  • a) the private and social cost of production, or
  • b) the private and social benefits from consumption.
  • The consequence is that even competitive markets will fail to reach a social optimum.

Market failure

slide8
Marginal external cost is the extra social cost (over and above the private cost) of producing one more unit of the good.
  • Marginal external benefit is the extra social benefit of consuming one more unit of a good.
  • The presence of external benefits and costs means there will be a difference between the private and social consequences of production.

Market failure

slide9
EXAMPLE 1:
  • Suppose the market in beer is perfectly competitive. But beer production creates terrible odors, and makes people who live downwind from breweries worse off.

Market failure

slide10
Here’s the situation for a typical beer producer:
  • MPC is the Marginal Private Cost of production. It’s the same as the firm’s supply curve, showing willingness to sell.
  • MPB is the Marginal Private Benefit. It's the demand curve for the good, showing willingness to pay.

$/Q

Supply = MPC

A competitive market will lead to Q*.

Demand = MPB

Q

Q*

Market failure

slide11

The existence of a harmful externality means there is a difference between the private and social costs of producing beer.

The difference between private and social cost is the marginal external cost (MEC)

Market failure

slide12

This distance is the pollution cost of one more unit of beer.

Marginal social cost

= MPC + MEC

$/Q

Supply = MPC

Demand = MPB

Q

Q*

Market failure

slide13

This area is the total pollution cost when Q* is produced.

Marginal social cost

= MPC + MEC

$/Q

Supply = MPC

Demand = MPB

Q

Q*

Market failure

slide14

The socially best output is Q(society).

Marginal social cost

= MPC + MEC

$/Q

Supply = MPC

Demand = MPB = MSB

Q

Q(society)

Q*

Market failure

slide15

This area is the total pollution cost when Q(society) is produced.

Marginal social cost

= MPC + MEC

$/Q

Supply = MPC

Demand = MPB

Q

Q(society)

Q*

Market failure

slide16
The conclusion is that when an externality is present, even a competitive beer market will not produce the best amount of beer.
  • In this example too much beer is produced from society’s point of view.

Market failure

slide17
EXAMPLE 2:
  • Prof. Brown is trying to decide how much schooling to buy for his daughter. He will buy years of schooling up to point where the last unit bought is just worth it to him. But schooling, especially at the elementary level, has positive externalities.

Market failure

slide18

Brown will choose years of schooling by equating MPB with MPC.

$/Q

MPC = MSC

MPB

Q

Q*

YEARS OF SCHOOLING

Market failure

slide19

This distance is the marginal external benefit.

$/Q

  • But the extra (external) benefits from schooling mean that Brown will buy too little schooling for his daughter if left to his own devices.

MPC = MSC

MSB=MPB+MEB

MPB

Q

Q*

Q(Society)

YEARS OF SCHOOLING

Market failure

slide20
EXAMPLE 3:
  • People decide whether or not to get vaccinated against diseases by comparing the private benefits with the private costs. But vaccinations carry important external benefits because when you are vaccinated people cannot get the illness from you.

Market failure

slide21

$/person

N’ is the private amount demanded. Society would want N* people vaccinated.

  • The horizontal axis here represents the number of people getting vaccinated. People will get vaccinated only if the benefit to them is at least as great as the cost.

MSC=MPC

MSB

MPB = DEMAND

# of people

N’

N*

THE MARKET IN SMALLPOX VACCINATIONS

Market failure

slide22
Solutions to externalities problems:
  • 1) Economists generally favor taxes and subsidies linked to the value of the externality
  • 2) Direct regulation
  • 3) Subsidize pollution control equipment
  • 4) Sell or grant tradable pollution rights.
  • 5) Coase’s Theorem -- Assign property rights
  • 6) Internalize the externality through mergers

Market failure

slide23

PUBLIC GOODS IN MORE DETAIL

  • A pure public good is a good or service that is consumed in its entirety by everyone. When one person consumes another unit of a public good we all consume more.
  • The most common example is national defense.

Market failure

slide24
Public goods have two special properties compared to private consumption goods.
  • Nonrivalry: When one person consumes a unit of a public good the amount available to be consumed by everyone else is not diminished.
  • Nonexcludability: Once a public good is produced it is difficult or impossible to exclude people from consuming it.

Market failure

slide25
Because public goods are nonrival and/or nonexcludable, these goods will tend to be under produced, or maybe not produced at all if left to the private market.
  • Public goods are not the same as publicly provided goods. Just because government provides a good does not make it a public good.

Market failure

slide26
Examples of public goods:

Hidden slide

Market failure

slide27
Some public goods can be excludable but not rival:
  • 1) Crossing a toll bridge when it isn’t crowded.
  • 2) Scrambled on the air TV signals.
  • One way to explain nonrivalry in consumption is by saying that the marginal cost of providing the good to one more consumer is zero.

Market failure

slide28
Some public goods may be nonexcludable but rival:
  • 1) Air that is polluted by smoking.
  • 2) The ocean is not excludable, but fishing is rival.
    • Production of public goods is sometimes said to suffer from the “free rider problem.” This arises directly from the nonexcludability property of public goods.

Market failure

slide29
Public good summary:
  • If public goods are produced in private markets, they will be under produced because social benefits will exceed private benefits.

Market failure

slide30
Solutions to the public goods problem:
  • 1) Using technologies that provide for exclusion (toll roads, cable TV)
  • 2) Government ownership
  • 3) Clubs or cooperatives

Market failure

information failures in more detail
INFORMATION FAILURES IN MORE DETAIL
  • Information failures occur when one party to a transaction lacks information on product quality, or cannot monitor the behavior of a person with whom they have a contract.
  • Note that information failures result from asymmetric or lopsided information about products or actions, not just the absence of information.

Market failure

slide32
The usual way to deal with uncertainty or lack of perfect information is to buy insurance of some sort.
  • Examples: Health insurance
  • Fire and theft insurance

Market failure

slide33
Adverse selection occurs when one party to a contract has better information than the other party. Adverse selection is sometimes called the problem of hidden characteristics.
  • Examples: Health insurance.
  • Life insurance.
  • Used cars.
  • Used computers.

Market failure

slide34
When there is adverse selection, insurance markets will fail to provide the socially best amount of insurance at fair rates.
  • People who would be willing to pay fair prices for health insurance may find themselves unable to do so.

Market failure

slide35
In the case of asymmetric information in markets for used cars or used computers the consequence is that only bad ones (lemons) will be traded. People willing to pay a fair price for a good used car or computer will be unable to find one.

Market failure

slide36
Solutions to the problem of adverse selection.
  • Many of the solutions employ what economists call signaling.
  • 1) Market search
  • 2) Consumer Reports Magazine
  • 3) Reputation
  • 4) Standardization (McD’s, Holiday Inn)
  • 5) Warranties and guarantees
  • 6) Physical exams for life insurance
  • 7) Pooling through groups for health insurance

Market failure

slide37
Some governmental solutions:
  • Licensing of occupations
  • National health care
  • “Lemons” laws

Market failure

slide38
Moral hazard occurs when it is difficult or impossible to monitor the actions of a person with whom you have a contract. It is sometimes referred to as the problem of hidden actions, or the failure to take care.

Market failure

slide39
Examples of moral hazard:
  • 1) Getting an employee to do your bidding (the problem of shirking).
  • 2) You buy fire insurance and stop replacing the batteries in the smoke detectors.
  • 3) You sign an apartment lease that includes heat, and you leave the door open all winter.
  • 4) You buy life insurance and then commit suicide.
  • 5) You can’t buy “human capital payoff” insurance.

Market failure

slide40
Solutions to the problem of moral hazard.
  • Generally, the problem can be solved by creating appropriate incentives.
  • 1) Worker commissions based on performance.
  • 2) Copayments and deductibles in insurance contracts.
  • 3) Leases that provide incentives for good care of the premises.

Market failure