copyright 2002, pearson education canada1 externalities, public goods, imperfect information, and...

Copyright 2002, Pearson Education Canada1

Externalities, Public Goods, Imperfect Information, and Social Choice

Chapter 16


Externality

An externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside the activity or transaction.

Also called spillovers or neighborhood effects.

The classic example of an externality is pollution.


Marginal Social Cost (MSC)

The marginal social cost is the total cost to society of producing an additional unit of a good or service.

MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production


A Profit Maximizing Firm and an Externality (Figure 16.2b)

If firms were forced to account for the full cost of their production then P**, q** would be the equilibrium and S’ the new supply curve.


Marginal Private Cost (MPC)

The marginal private cost is the amount that a consumer pays to consume an additional unit of a particular good.


Marginal Damage Cost (MDC)

Marginal damage cost is the additional harm done by increasing the level of an externality-producing activity by one unit.

If producing product X pollutes the water in a river, MDC is the additional cost imposed by the added pollution that results from increasing output by one unit of X per period.


Externalities in University Residence (Figure 16.3)

Harry enjoys marginal benefits of listening to his stereo higher than his marginal costs.

Costs are also imposed on Jake - an externality.

The full cost to this society of two individuals are substantially higher than Harry’s MPC.

The efficient level of stereo time is 5 hours and not 8 hours.


Internalizing Externalities

Government-imposed taxes and subsidiesPrivate bargaining and negotiationLegal rules and proceduresThe sale or auctioning of rights to impose

externalitiesDirect government regulation


Tax Imposed on a Firm Equal to Marginal Damage Cost (Figure 16.4)

If a per unit tax exactly equal to marginal damage costs is imposed on a firm, the firm will weigh the tax, and thus

the damage costs in its decisions and produce the efficient output.


Coase Theorem

Coase Theorem states that under certain conditions, when externalities are present, private parties can arrive at the efficient solution without government involvement.


Public (Social) Goods

Public goods are those goods or services that bestow collective benefits on members of society.

Such goods are nonrival in consumption and their benefits are nonexcludable.


Characteristics of Public Goods

Nonrival in consumption: One person’s enjoyment of the benefits of a public good does not interfere with another’s consumption of it.

Nonexcludable: Once a good is produced, no one can be excluded from enjoying its benefits.


Intrinsic Problems of Public Goods

Free-rider problem: Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them.

Drop-in-the-bucket problem: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays.


Market Demand For Public Goods (Figure 16.6)

Person A is willing to pay $6 per X units of the public good and Person B is willing to pay $3.

The market demand for the public good is $9 per X units of the good.

Demand curves are vertically added to obtain the demand for public goods.


Optimal Provision of a Public Good (Figure 16.7)

Optimal production or provision of a public good means producing as long as society’s total willingness to pay per unit (DA+B) is greater than the marginal cost of producing the good.


Optimal Level of Provision for Public Goods (Samuelson)

The level at which resources are drawn from the production of other goods and services only to the extent that people want the public good and are willing to pay for it. At this level, society’s willingness to pay per unit is equal to the marginal cost of producing the good.


Tiebout Hypothesis

An efficient mix of public goods is produced when local land / housing prices and taxes come to reflect consumer preferences just as they do in the market for private goods.


Imperfect Information

Imperfect information refers to the absence of full information that can cause households and firms to make mistakes.


Adverse Selection

Adverse selection can occur when a buyer or seller enters into an exchange with another party who has more information.


Moral Hazard

A moral hazard arises when one party to a contract passes the cost of his or her behaviour on to the other party to the contract.


Market Solutions to Imperfect Information

Like consumers, profit maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs of engaging in it.


Social Choice

Social choice refers to the problem of deciding what society wants; the process of adding up individual preferences to make a choice for society as a whole.


Arrow’s Impossibility Theorem

From a proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent arbitrary results.


Voting Paradox

A simple demonstration of how majority- rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem.


Logrolling

Logrolling occurs when elected representatives trade votes, agreeing to help each other get certain pieces of legislation passed.


Governmental Failure in the Efficient Allocation of Resources

Measurement of social costs and benefits is difficult and imprecise.

There is no reliable measure of citizens’ preferences.

Governments are not subject to the discipline of the market.

Elected and appointed officials may not act selflessly for the good of society.


Review Terms & Concepts

adverse selection Coase Theorem drop-in-the-bucket

problem externality free-rider problem impossibility theorem injunction

liability rules logrolling marginal damage cost

(MDC) marginal private cost

(MPC) marginal social cost (MSC) market failure moral hazard


Review Terms & Concepts(continued)

nonexcludable nonrival in

consumption optimal level of

provision of public goods

public goods

social choice Tiebout hypothesis voting paradox

copyright 2002, pearson education canada1 externalities, public goods, imperfect information, and...

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