Chapter 4Efficiency: Public Goods

and Externalities

Chapter outline

The rationale for government production of goods and services.

1.Public Goods, Private Goods, and Goods with Externalities

NonrivalryNonexcludabilityFree Riding and Public GoodsSome Qualifications

Free-riding and the Street Lights (A True Story)Identifying Public GoodsPublic Goods Versus Private GoodsDemand, Price, and Level of OutputWho Pays for Public Goods?Local Public Goods, Club Goods, and Congestible Goods

Externalities

Positive Externalities

Negative Externalities

Creative Solutions

Property Rights and the Coase Theorem

Tax Incentives and Vouchers

The Garbage Dilemma

Shifting the Demand Curve

Other Providers

1. Public Goods, Private Goods, and

Goods with Externalities Public goods have two characteristics:

nonrivalry and nonexcludability

①nonrivalry A good that is nonrival in consumption

can be consumed by any number of people simultaneously ,without diminishing the amount available to be consumed by others.

②nonexcludability

This term describes the inability to keep people ,specifically nonpayers,from consuming the good or service.

It is the problem of excluding nonpayers rather than nonrivalry that is often the determining factor in calling for public production.

Exclusion technique:innovations in technology and high fine.

2.Identifying Public Goods All public goods can be classified according to

the degree of rivalry and excludability into four classes.low rivalry,low excludability goods are public goods;high rivalry,high excludability goods are private goods;low rivalry,high excludability goods are local public goods or club goods;high rivalry,low excludability goods are those that create positive or negative externalities.

Figure 4-1 Classifying Goods and services by Rivalry and Excludability

①Public goods versus private goods

②Demand,price,and level of output

For public goods,demand is added vertically rather than horizontally to determine the optimum quantity.

Figure 4-2Market Demand and Optimal Output for Private Goods

Figure 4-3 Demand,Supply,and Equilibrium in the Market for a Public Good

③Who pays for public goods?

First of all,there is the challenge of determining A’s and B’s valuations of the public goods so that each can be charged the appropriate price. for government the first challenge is to measure or estimate difference in demand from different individuals groups within the population.

The second problem of getting to the optimal quantity when it is not possible to exclude nonpayers or free riders. The second challenge is to devise ways of collecting revenue that approximate those Lindahl price for different segments of the population.

When each person pays the price that reflects his marginal benefit,he is being charged Lindahl price.

Some public goods lend themselves more easily than others to such a strategy.

Optimality requires not only that total marginal benefit be equal to marginal cost ,but also that the marginal tax price paid by each citizen be equal to the marginal benefit received.

④local public goods,club goods,and congestible goods

A local public goods or a lub good is shared by members of a group or community on the basis of shared membership.free riding is avoided because the good is excludable.

Congestible goods are a special case of local public goods in which the marginal cost is very low up to a capacity point at which the marginal cost of additional users begins to rises sharply.

Figure4- 4 Supply,Demand,and Price for a congestible Good

There are at least five reasons why the producer should be charging a peak-period fee:

Ⅰ.The fee rations a scarce good among users.

Ⅱ.Revenue collected relative to the cost of collecting it rises sharply.

Ⅲ.Additional users are imposing significant costs on others in terms of congestion and delay.

Ⅳ.In the absence of fee,marginal benefit is equal to the zero price.

Ⅴ.The price for congestion and noncongestion times offers an incentive for other substitutions.

3.Externalities Consumption (production) externalities occur when a

second person is affected by consumption (production) of a good or service,either positively or negatively.①Positive externalities

Goods that create positive externalities or marginal social benefits to someone other than the buyer will be underproduced by the market in the absence of intervention.

To determine the optimal quantity and price,private demand and marginal social benefits are added vertically.

Figure 4-5 Optimal Output for a Good with Positive Externalities

The fact that there are external benefits does not necessarily mean underproduction will occur.

How to fill in the ab gap?

Among the common methods of addressing positive externalities are public production or public subsidies of private production.

Public subsidies for private production are a little more successful.

②negative externalities

Goods that create negative externalities or marginal social costs to someone other than the producer or consumer will be overproduced by the market in absence of intervention.

To determined the optimal quantity and price ,marginal social costs are added vertically to the supply or marginal private cost curve.

Possible forms of intervention include taxes,fees,fines,charges and regulations.

③creative solutions

Ⅰ.Assignment of property rights (the Coase theorem)

Coase theorem says that ,where small numbers of participants are involved ,property rights can assigned to one of the parties for a contested resource,and subsequent negotiations will result in the socially optimal use of the resource.

The coase theorem applies only to cases where there are relatively few affected parties.Otherwise there will be a potential for free riding.

Ⅱ.Tax incentives and vouchers

Ⅲ.Shifting the demand curve

Ⅳ.Marketable emission permits

Ⅴ.other providers

True-false questions

If false, change the statement to make it true.

1.A pure public good is both nonrival and nonexcludable.

2.According to the Coase theorem, the outcome of a dispute will be different depending on which party is assigned the property rights.

3.Lindahl prices are intended to ensure that everyone pays the same price for public goods.

4.The property of nonrivalry refers to the difficulty of keeping someone else from consuming something I have paid for and he/she has not.

5.If a good has positive externalities, in the absence of intervention, private decisions would result in consuming too much at too low a price.

Answers:1. T 2. F (It should be the same, barring any questions of income distribution.) 3. F (Lindahl prices attempt to charge people different prices that reflect their different marginal benefits.) F (The easiest correction is to change nonrivalry to nonexcludability. Alternatively, nonrivalry should be correctly defined as “my consumption does not diminish the amount available to you” or similar language.) F (Correction is either to change positive to negative or change too much to too little and too low to too high.)