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Lecture 9: Externalities and Public goodsCharit Tingsabadh

M.Sc. Programme in Environmental and natural resource economics

Semester 1/2005

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outline

• Concepts• Specification• Empirics

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concept

• Externality: By-products of consumptions and production may benefit or harm other people

• Definition:when a person’s well-being or a firm’s capability is directly affected by the actions of other consumers of firms rather than indirectly through changes in prices.

• Examples: any suggestion?

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Externalities: examples• Supply side: a wedge between private cost and social cost (can be +

or - )• Example:

– Polluting factory causes fish deaths in river– Building a road allows other people to travel more conveniently– Coal-burning power station emits SO2 which causes acid rain

• Demand side: wedge between (marginal) private benefit and (marginal) social benefit

• (+ or - )• Example:

– vaccination reduces health risk for all, not only the individual taking the jab;

– Network: the more people have telephone, the more benefit to each subscriber

– Forest conservation improves water supply and reduces greenhouse gas concentration

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More generally..

Private good Common pool/open access

Club good Public good

rivalry

high

low

excludabilityhigh low

Externality arises from low excludability

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Effect on the market:supply side• Negative externality raises social cost over private cost

price

quantity

D

D

M Private Cost

M Social cost

Result: price too low, too much is demanded and produced

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Effect on the market:demand side• Positive externality raises social benefit cost over private benefit

price

quantity

D

D

Cost

M Social benefit

Result: price too low, too little is demanded and produced

M private benefit

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conclusion

• Because of externalities• Market (private) prices do not reflect social prices• Wrong (inefficient) resource allocation• Would improve if external cost(benefit) can be

internalised.• Internalisation through property rights-give

ownership, but of what ? And to whom?• Institutional economics to the rescue..

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Public Good

• Extreme case of low rivalry and low excludability

• Pure public good: • no rivalry-if available to one consumer, is

avaliable to all consumers• No excludability-cannot exclude anybody

from consumption• So, if one consumes, all consume.

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Graphing public good

• Demand side:• Individual demand, normal downward

sloping demand curve• Market demand, vertical summation of

individual demand curves, because same amount is consumed. Samuelson condition.

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Market for public good

Total demand

D2

D1

S

Price

quantity

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Description of market• Total demand is vertical sum of individual demand• Supply is shared in same quantity• Cost is more than individual benefit• Will there be market supply?• If one pays for supply, all others will have it also,• So wait for the “public” spirited person, free riding

by others• If not, no supply.• Clear case of market failure!!!!

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Correcting for externalities

• Pigouvian tax– How to set the tax rate?

• Property rights allocation (Coase theorem)– Whose rights-who pays?

• Rule-based control– To reduce transaction cost

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The Commons

• Commons: high rivalry, low excludability• Example: public park, roads, fishing• Capacity limits to use • Over-capacity use results in congestion• Demand-side management vs. supply

expansion• Fees, quota, controlling access, etc.

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Chapter 18

Externalities, Commons, and Public Goods

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Figure 18.1 Welfare Effects of Pollution in a Competitive Market

Table 18.1

Industrial CO2

Emissions, 1998

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Figure 18.2 Taxes to Control Pollution

Figure 18.3 Cost-

Benefit Analysis

of Pollution

Application (Page 634) Emissions

Standards for Ozone

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Figure 18.4 Monopoly, Competition, and Social Optimum

with Polution

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Table 18.2 Property Rights and Bargaining

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Table 18.2a Property Rights and Bargaining

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Table 18.2b Property Rights and Bargaining

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Table 18.2c Property Rights and Bargaining

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Table 18.3 Rivalry and Exclusion

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Figure 18.5 Inadequate Provision of a Public Good

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Table 18.4 Private Payments for a Public

Good

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Table 18.5 Voting on $300 Traffic Signals

Cross-Chapter Analysis (Page 657)Emissions Fees Versus Standards

Under Uncertainty