Public Goods & Externalities

Public goods are jointly consumed goods. If one person gets the good, everyone gets it. One person’s consumption of the good does not reduce the amount available for others to consume. (The good is “nonrival in consumption.”)Also, the good can not divided up into separate portions for different individuals. Once a public good has been provided to one person, there is no easy way to prevent others from consuming it as well. (The good is “nonexcludable.”)

What are Public Goods?

• national defense – everyone is protected by the same defense system

• Dams – everyone in the community is protected from flooding by the dam

Examples of Public Goods

There is an incentive to not reveal your true valuation, since if the good is provided, you are going to get the use of it anyway. But if everyone refuses to reveal their true value of the good and so refused to voluntarily pay what it is worth, the good will not be provided. Someone who enjoys the benefit of a good without paying for it is called a free rider.

The Free-Rider Problem of Public Goods

Efficient Provision of a Public Good

The social marginal benefit curve (MBS) is the demand curve for a public good.

It is derived by vertically summing the individual consumers’ marginal benefit curves.

The efficient level of a public good occurs where the social marginal benefit curve intersects the marginal cost curve: MBs = MC.

$

Q

MC

MBS

D1 = MB1

D2 = MB2

Q*

$500

$325

$175

If we vertically sum MB1 and MB2, we get the social marginal benefit curve (MBS) or society’s demand curve for the public good.Suppose the marginal cost of providing the good is MC ($500 in this example).Equating the MC and the MBS, we find the optimal level Q* of the public good.At that level, the marginal benefit to society is $500, and the marginal benefits to the two people are $175 and $325.

Suppose there are only two people.Their individual demand curves or marginal benefit curves for consumption of the public good are MB1 and MB2.

Externalities

Spillover effects or side effects of economic activities

External BenefitsExternal benefits – positive side effects of

economic activities

Examples: • my neighbor’s flower garden that

provides pleasure to other neighbors.• Immunization against a contagious

disease that reduces the likelihood that people who have not received the inoculation will get the disease.

External CostsExternal costs – negative side effects of

economic activities

Examples: • pollution• drunk drivers• litter bugs

social benefits = private benefits received by the decision-maker + any external benefits.

When there are no external benefits, private and social benefits are equal.

Social Benefits

social costs = private costs incurred by the decision-maker + any external costs.

When there are no external costs, private and social costs are equal.

Social Costs

What is the social cost of the project?social cost = private cost + external cost = 1500 + 500 = $2000.If the firm ignores the effects on the neighbors, will the firm undertake the project? Yes, because the private benefits (1800) exceed the private costs (1500). From the point of view of society, should the project be undertaken?Assuming there are no external benefits, social benefits = private benefits + ext. benefits = 1800 + 0 = $1800.Since the social costs were $2000, which is greater than the social benefits of $1800, the project should not be undertaken.

Example: Suppose a firm is considering a project that will cost $1500 and generate $1800 in revenue. The project would also produce $500 worth of aggravation for the neighbors.

An acceptable solution to an externality will be found if

• ownership of property is clearly defined,• the number of people involved is small,• the costs of bargaining are negligible.

Coase Theorem

These types of problems are unlikely to be resolved appropriately without government intervention.

In many situations, many people are affected

and the costs of bargaining are substantial.

External Benefits

In Microeconomics Principles, we found that when external benefits are ignored, too little is produced.In addition, when external benefits are ignored, we found that the level of demand is not as high as it should be, and therefore the price is lower than would be the case if the externalities were taken into consideration. If we subsidize goods with external benefits, we can raise the quantity produced to the socially optimal level.

External Benefits

Q

$ per unit

MBE

S = MC

D=MBP

Suppose that MBE is the marginal external benefit of a good.MBP is the marginal private benefit or demand curve for the good.The sum of MBE and MBP is the marginal social benefit MBS.

S=MC is the perfectly competitive supply curve and marginal cost of production.When the externality is ignored, the amount of the good produced is Q1, where the MBP equals the MC.However, the efficient amount from the viewpoint of society is Q2, where MBS equals MC.

Q2Q1

MBS

External Benefits

Q

$ per unit

S = MC

S' = MC'

D=MBP

Suppose a per unit subsidy of $A is provided.The new marginal cost is MC' = MC – A.When MC' is equated to MBP, the socially optimally amount of the good Q2 is produced.The price of the good paid by the consumer is lower (P2 instead of P1).The total price including the subsidy paid by the government, however, P2 +A is higher. Q2Q1

MBS

MBE

A

P1P2

P2+A

External Costs

In Microeconomics Principles, we found that when external costs are ignored, too much is produced.In addition, the price is lower than would be the case if those external costs were taken into consideration. If we tax goods with external costs, we can reduce the quantity produced to the socially optimal level.

External Costs

Q

$ per unit

Suppose that MCE is the marginal external cost of a good the production of which generates pollution.MCP is the marginal private cost of producing the good.The sum of MCE and MCP is the marginal social cost MCS.

D is the demand for the product.When the pollution is ignored, the amount of the good produced is Q1, where the D (or marginal private benefit) equals the MCP.

However, the efficient amount from the viewpoint of society is only Q2, where MCS equals D.

Q1Q2

MCE

MCS

MCP

D=MBP

External Costs

Q

$ per unit

MCE

MCP

Suppose a per unit pollution tax of $T is imposed.The new marginal private cost of producing the good is MCP' = MCP + T.When MCP' is equated to D = MBP, the socially optimally amount of the good Q2 is produced.The price of the good is also higher: P2 instead of P1. Q1Q2

MCP'T

MCS

P2

P1

D=MBP

Let’s focus on the cost of pollution reduction.

The production of some goods generates pollution.To reduce that pollution requires taking steps that

incur costs.One example would be the installation of filters on

smokestacks.Suppose the cost of pollution reduction is not the

same for all firms.What would be the impact of the government

imposing a per unit pollution tax on all firms?

Pollution Reduction

Pollution reduction Pollution

MCA

MCB

Suppose that the marginal cost of pollution reduction is MCA for firm A and B MCB for firm. Without a pollution tax, A produces PA=400 units of pollution and B produces PB=275 units of pollution.Notice in this graph that pollution is measured from the right and pollution reduction is measured from the left.

$ per unit $ per unit

PA = 400 PB = 275

Even with a tax, firms wouldn’t reduce pollution to zero.It costs more to get rid of all emissions than it does to clean up some of the emissions and pay the tax on the rest.Firms clean up to the point where the MC of cleaning up equals the MC of not cleaning up, that is of paying the tax on each of the remaining units of pollution.

A per unit pollution tax

Pollution reduction Pollution

MCA

MCB

So firm A will reduce its pollution by 250 units to PA' = 150.Firm B will reduce its pollution by 225 units to PB' = 50.This policy would reduce total pollution to 200 units, cleaning up all units that cost less than the tax to eliminate.The policy eliminates 475 units of pollution in the least costly way.

T

$ per unit $ per unit

PA=400 PB=275 PA' =150 PB' =50

Fixed Pollution Level

Pollution reduction Pollution

MCA

MCB

Suppose the government were instead to reduce pollution to 200 units by requiring each firm to cut back its pollution to 100 units.Firm A have to eliminate a lot of costly emissions, while firm B would not have to eliminate some less costly emissions.The extra cost to A would be the blue area.The reduction in cost to B would be the pink area.Clearly the extra cost to B is more than the savings to A.So a policy that required firms to cut back to the same pollution level is a more costly policy.

T

$ per unit $ per unit

PA=400 PB=275 PA' =150 PB' =50P0=100