Chapter 16

Externalities
and Public
Goods

2004 Thomson Learning/South-Western

 Defining Externalities

An externality is the effect of one partys

economic activities on another party that is not
taken into account by the price system.
Externalities can occur between any two
economic actors.
Externalities can be beneficial or harmful.

2
 Externalities between Firms

Consider two firms--one producing eyeglasses,

and another producing charcoal.
The production of charcoal is said to have an
external effect on the production of eyeglasses
if the output of eyeglasses depends not only on
the amount of inputs chosen by the eyeglass
firm but also on the level of production of
charcoal.

3
 Externalities between Firms

Suppose the eyeglass firm is near and

downwind from the charcoal company.
The amount of eyeglasses may depend upon
the amount of charcoal in the air which affects
the precision grinding wheels.
The level of eyeglass production is partially
determined by the amount of charcoal
produced, with more charcoal reducing the
amount of eyeglasses.
4
 Externalities between Firms

Oneof the most famous beneficial externalities

between firms involves one firm producing
honey and the other producing apples.
Bees feed on apple blossoms, which increases the
production of honey, and
Bees pollinate apple crops, which increases the
production of apples.

5
 Externalities
Firms can generate air, water, and other types
of pollution when producing products.
Alternatively, auto pollution, graffiti, and noise
are some externalities imposed by people on
firms.
When people do things that harm others, like
playing their radios loudly, or help, like
shoveling their sidewalk, they can impose
externalities on other people.
6
 Reciprocal Nature of Externalities

Indealing with externalities it is important to

recognize that both parties are needed for an
externality to exist.
If the eyeglass producer was not located near the
charcoal factory, there would be no externality.
If another person was not around, no one would be
bothered when someone plays their radio loudly.

7
 APPLICATION 16.1: Secondhand Smoke

Secondhand smoke (officially, environmental

tobacco smoke, or ETS), refers to the effects of
smokers consumption of cigarettes and other
tobacco products on third-party bystanders.
The harm of ETS is controversial, but the
Environmental Protection Agency estimates
approximately 2,200 deaths annually.

8
 APPLICATION 16.1: Reciprocal Nature
of the ETS Externality

Smokers potentially harm bystanders, but

limiting the rights of smokers impose
inconveniences as well.
One study suggests that workplace restrictions on
smoking results in a loss of approximately $20
billion per year in consumer surplus.
Suchestimates, like those of the harms of
ETS, are controversial.

9
 APPLICATION 16.1: Private Action and
Public Actions

Many private decisions have limited smoking in

the workplace and in public areas.
The Occupational Safety and Health
Administration has proposed banning all
workplace smoking.
Many question whether governmental action is
necessary given the private actions already
taken.
10
 Externalities and Allocational
Efficiency

Thepresence of externalities can cause a

market to operate inefficiently.
In the previous example an externality affected the
production of eyeglasses.
The firm producing charcoal did not take into
account the negative effect its production had on the
production of eyeglasses.

11
 Social Costs

Socialcosts are the costs of production that

include both input costs and costs of the
externalities that production may cause.
In the previous example, by not recognizing the
externality in its production, the charcoal firm
produced too much.
Society would be better-off by reallocating
resources away from charcoal production and
toward the production of other goods.

12
 A Graphical Demonstration

Assume the charcoal producer is a price taker

so that its demand curve is horizontal, as
shown in Figure 16.1.
The firm maximizes profits, given the prevailing
market price, by producing q* where price(P*) equals
marginal cost(MC).
Due to the externality, however, the social marginal
cost (MCS) exceeds MC.

13
 FIGURE 16.1: An Externality in Charcoal Production
Causes an Inefficient Allocation of Resources

Price, MCS
costs of
charcoal
MC

E
P*

0 q* Charcoal
14 per week
 A Graphical Demonstration
The cost of the externality is shown by the vertical
distance between MSC and MC.
At q* the social marginal cost exceeds what people
are willing to pay for the charcoal, P*.
Resources are misallocated and production should
be reduced to q where MSC equals P*.
The reduced total social costs (area ABq*q) exceed
the reduced total spending (area AEq*q).

15
 FIGURE 16.1: An Externality in Charcoal Production
Causes an Inefficient Allocation of Resources

Price, MCS
costs of
charcoal
B
MC

A E
P*

0 q q* Charcoal
16 per week
 Property Rights

Property rights are the legal specification of

who owns a good and the trades the owner is
allowed to make with it.
Common property is property that may be
used by anyone without cost.
Private property is property that is owned by
specific people who may prevent others from
using it.

17
 Costless Bargaining and
Competitive Markets

Considering the charcoal-eyeglass externality,

suppose property rights were defined so as to
give sole rights to use the air to one of the
firms.
The firms were then free to bargain over how the air
might be used.
Ifbargaining is costless the two parties might
arrive at q on their own.

18
 Ownership by the Polluting Firm

Ifthe charcoal firm owns the land, it must add

these ownership costs to its total costs.
The costs of polluting the air are what someone else
is willing to pay for this resource (clean air) in its
best alternative use.
The eyeglass company would be willing to pay the
an amount equal to the external cost the charcoal
company is imposing.

19
 Ownership by the Polluting Firm
The charcoal companys marginal cost will be MSC,
and it will produce q.
The charcoal company will sell the remaining air use
rights to the eyeglass maker for a fee of some
amount between AEC (the lost profits of producing
q rather than q*) and ABEC (the maximum amount
the eyeglass maker would be willing to pay to avoid
having the charcoal producer increase production to
q*.

20
 Ownership by the Injured Firm

Ifthe eyeglass maker owns the air, the

charcoal firm will offer a payment to use the
air associated with output level q.
The eyeglass owner will not sell rights to pollute
beyond this because the price that the charcoal
maker would be willing to pay (P* - MC) falls short
of the cost of this additional pollution (MCS - MC).
The socially optimal charcoal output, q, is
produced in this case as well.
21
 The Coase Theorem

The Coase theorem (first proposed by Ronal

Coase) states that, if bargaining is costless,
the social cost of an externality will be taken
into account by the parties, and the allocation
of resources will be the same no matter how
property rights are assigned.
In the previous example, q was produced
regardless of who owned the air.

22
 Distributional Effects

The assignment of property rights does affect

the distribution of the benefits.
If the charcoal maker receives the property rights,
the fees from the eyeglass producer will make it at
least as well off as if it produced q*.
If the eyeglass producer receives the property
rights, the fees from the charcoal producer will at
least cover the pollution damage.
Factors, such as equity may be important.
23
 The Role of Transactions Costs

The Coase theorem relies heavily on the

assumption of zero transactions costs.
If bargaining costs are high, the voluntary
exchange may break down so the efficient
outcome may not be realized.
This may be particularly true concerning
environmental externalities.

24
 APPLICATION 16.2: Property Rights in
NatureBees and Apples

In many locales contractual bargaining

between beekeepers and orchard owners
provide for renting bees for the pollination of
many crops.
Rents appear to accurately reflect the value of
honey that is yielded with higher rents for
clover growers because apple blossoms yield
less honey.

25
 APPLICATION 16.2: Property Rights in
NatureShellfish

Overfishing creates an externality since no

single fisher takes into account the fact that his
or her catch with reduce others catches.
Coastal situations allow property rights so
owners can consider harvesting practices.
One study suggests that oyster yields were higher in
Virginia because it made it easier to enforce
property rights.

26
 APPLICATION 16.2: Property Rights in
NatureElephants

In the past, ivory hunters have lead to a decline

of over 50 percent of the population in East
African countries.
Recently, villages received property rights to
elephants and sold limited numbers of
elephants for hunting.
Elephants populations in these areas are on
the rise.

27
 Externalities with High
Transactions Costs

When transactions costs are high, externalities

may cause real losses in economic welfare.
The fundamental problem is that, with high
transactions costs, economic actors face no
pressure to recognize the third-party effects
they have.
All solutions to externality problems in these
cases must therefore find some way to get the
actors to internalize the third-party effects
they cause.
28
 Legal Redress

The operation of the law may sometimes provide

a way for taking externalities into account.
If the charcoal producer in Figure 16.1 can be
sued for the harm it does to eyeglass makers,
payment of damages will increase the costs
associated with charcoal production.
Hence, the charcoal MC curve will shift upward
to MCS and an efficient allocation of resources
will be achieved.
29
 Taxation
A Pigovian tax (first proposed by A. C.
Pigou) is a tax or subsidy on an externality
that brings about an equality of private and
social marginal costs.
Figure 16.2 is similar to Figure 16.1, except
that an excise tax of amount t is shown that
reduces the net price to P* - t.
This causes the firm to produce the socially
optimal level of output, q.
30
 FIGURE 16.2: Taxation Solution to the
Externality Problem
Price, MCS
costs of
charcoal
B
MC

A E
P*

P* - t
C

0 q q* Charcoal
31 per week
 Regulation of Externalities

An alternative to taxation is regulation.

The horizontal axis in Figure 16.3 shows
percentage reductions in pollution that would
exist without regulation.
The curve MB shows the marginal benefit by
reducing pollution by one unit.
The shape comes from the assumption of
diminishing returns.

32
 FIGURE 16.3: Optimal Pollution
Abatement

Marginal MC
benefit,
cost

f*

MB

0 R* 100 Reduction
33 in emission
 Regulation of Externalities
The curve MC reflects the marginal costs in
reducing environmental emissions including
foregone profits and the costs of antipollution
equipment.
The positive slope reflects the assumption of
increasing marginal costs.
R*is the optimal level of pollution where the
marginal benefits equal marginal costs.

34
 Fees, Permits, and Direct Controls

Threegeneral ways to reduce emissions to R*

through environmental policy.
A Pigovian-type effluent fee for each percent of
pollution not reduced.
Governmental regulators could issue permits to
produce emission levels.
Direct controls of the amount of pollution allowed.

35
 Fees

An effluent fee,f*in Figure 16.3, is charged

for each percent that pollution is not reduced.
For reductions less than R*, the fee exceeds
marginal cost, so firms will choose abatement.
Reductions greater than R* would not be
profitable.
Thefirm is free to choose its method to
reduce pollution.

36
 FIGURE 16.3: Optimal Pollution
Abatement
Marginal MC
benefit,
cost

f*

MB

0 RL R* RH 100 Reduction
37
in emission
 Permits

Government issued permits would allow firms

to produce (100 - R*) percent of their
unregulated emission levels.
As shown in Figure 16.3, freely traded permits
would sell for a price of f*.
A competitive market will ensure that the
optimal level of emissions reductions will be
attained at minimal social cost.

38
 Direct Controls

Governments can tell firms the level of

emissions they would be allowed, and, in many
cases, are accompanied by specification of the
precise mechanism by which R* is to be
achieved.
This is a common approach in the U.S.
Specification of the mechanism of reduction may
reduce the cost-minimization incentive.

39
 APPLICATION 16.3: Regulating Power
Plant Emissions

Many electric power plants burn coal for fuel.

This generates some byproducts including
sulfuric acid which is associated with the
creation of acid rain which harms lakes and
forests.
Acid rain is found in the eastern U.S. and Canada
as well as Europe, Russia, and China.

40
 APPLICATION 16.3: Regulation of
Production Technology

The U.S. has used a command-and-control

(CAC) approach.
Air quality standards are defined by law and
plants are required to install specific
equipment; with most requiring scrubbers that
clean exhaust fumes in their stacks.
Studies suggest that these costs exceed
minimum costs by a factor of two.

41
 APPLICATION 16.3: Emission Charges

A moreefficient alternative would be to impose

a Pigouvian tax on emissions.
Firms could choose any technology that gives
emission reductions at a marginal cost that is less
than or equal to the tax.
Studies suggest this is considerable more cost
effective, but will decrease the demand for eastern
U.S. coal (with employment losses), which is not
politically popular.

42
 APPLICATION 16.3: Emissions Trading

TheClean Air Act amendments of 1990 allow

power plants who reduce their pollution levels
below specified standards to sell credits to
other firms.
This allows other firms to subsidize the reductions
of emissions by those firms who can achieve low
pollution with the least cost.
This has achieved savings of approximately 50
percent over regular CAC approaches.
43
 An Example: Global Warming

Existing models of the earths atmosphere are

not adequate to explain how carbon emissions
may raise global temperatures.
Evaluating the costs to restrict carbon
emissions involve much uncertainty.
Estimates from general equilibrium models
range from welfare gains to costs as great as
10 percent of GDP.

44
 Attributes of Public Goods

Nonexclusive goods are goods that provide

benefits that no one can be excluded from
enjoying.
National defense is an example since, once an
army or navy is set up, everyone in the country
receives protection whether they pay or not.
Alternatively, a hamburger is exclusive since,
someone can be excluded from consuming if they
do not pay for it.
45
 Attributes of Public Goods

Nonrival
goods are goods that additional
consumers may use at zero marginal cost.
For example, one more person crossing an already
existing bridge during an off-peak period requires no
additional resources and does not reduce
consumption of anything else.

46
 Public Goods

Public goods provide nonexclusive benefits to

everyone in a group and that can be provided
to one more user at zero marginal cost.
Table 16.1 presents a cross-classification of
goods by their possibilities for exclusion and
rivalry.

47
 TABLE 16.1: Types of Public and
Private Goods

Exclusive
Yes No
Hot dogs, automobiles, Fishing grounds, public
Yes
houses grazing land, clean air
Bridges, swimming National defense,
Rival pools, scrambled mosquito control, justice
No
satellite television
signals

48
 Public Goods and Market Failure

In buying a public good, any one person will

not be able to appropriate all the benefits the
good offers.
Since others can not be excluded they can use
the good at zero marginal cost, societys
benefits from the public good exceed the
benefits to the single buyer.

49
 Public Goods and Market Failure
However, the buyer will not take societies
benefits into consideration.
As a result, private markets will tend to
underallocate resources to public goods.
Figure 16.4 shows a situation two people
have a demand for a public good. The total
demand for the public good is the vertical
sum of each persons demand curve.

50
 FIGURE 16.4: Derivation of the Demand
for a Public Good

Willingness
to pay
Total demand

Demand by
person 2

Demand by
person 1


Quantity of
[
, ] Denotes equal distances
51 public good
per week
 Public Goods and Market Failure

Each point on the total demand curve shows

what persons 1 and 2, together, are willing to
pay for a particular level of the public good.
Because each individuals demand curve is
below the total demand curve, no single buyer
is willing to pay what the good is worth to
society.

52
 Voluntary Solutions for Public
Goods

Sincepublic goods cannot be traded efficiently

in competitive markets, one approach deals
with whether an efficient allocation might come
out voluntarily.
Would people agree to be taxed in exchange for the
benefits the public good provides?
Onesolution was proposed by Erik Lindahl in
1919.

53
 The Lindahl Equilibrium

InFigure 16.5, the curve labeled SS shows

one persons (Smith) demand for a particular
public good.
The vertical axis measures the share of the public
goods cost that Smith must pay.
The negative slope of SS indicates that, at a higher
tax price for the public good, Smiths quantity
demanded is smaller.

54
 FIGURE 16.5: Lindahl Equilibrium in the
Demand for a Public Good

Share of cost 100

paid by Smith

0
Quantity of
55 public good
 The Lindahl Equilibrium

The second individuals (Jones) public good

demand curve is derived similarly, but the
proportion paid by Jones is shown on the right
axis.
The right axis is reverse scale so that moving up the
axis results in a lower tax paid by Jones.
Given this convention, Joness demand curve (JJ)
has a positive slope.

56
 FIGURE 16.5: Lindahl Equilibrium in the
Demand for a Public Good

Share of cost Share of cost

paid by Smith 100 0 paid by Jones
J

J
S

0 100
Quantity of
57 public good
 The Lindahl Equilibrium

Thetwo demand curves intersect at C with an

output level OE of the public good.
At this output level Smith is willing to pay 60 percent
of the goods cost whereas Jones willingly pays 40
percent.
At outputs below OE, the two people combines are
willing to pay more than 100 percent of the cost of
the public good.

58
 FIGURE 16.5: Lindahl Equilibrium in the
Demand for a Public Good

Share of cost Share of cost

paid by Smith 100 J
0 paid by Jones

C
60 40

J
S

0 100
E Quantity of
59 public good
 The Lindahl Equilibrium
For output levels greater than OE, people are not
willing to pay the total cost of the good.
Output level OE is a Lindahl equilibrium
which is a balance between peoples demand
for public goods and the tax shares that each
must pay for them.
The tax shares are pseudo prices, and the
outcome can be shown to be efficient.

60
 Revealing the Demand for Public
Goods: The Free Rider Problem

The voting patterns of people generally do not

provide enough information to permit Lindahls
tax share to be computed.
Alternatively, governments might ask people
how much they are willing to pay for a
particular package of public goods.
It is likely that this poll would prove to be extremely
inaccurate because of free riders.

61
 The Free Rider Problem

People may feel that they should understate

their true preferences to reduce their tax
liability with the hope that others will be willing
to bear the burden of paying the taxes for the
public good.
A free rider is a consumer of a nonexclusive
good who does not pay for it in the hope that
other consumers will.

62
 APPLICATION 16.4: Why is There So
Much Fund-Raising Public
Broadcasting?
The public radio and television broadcasting
corporations in the U.S. were intended to be
supported primarily by listeners and viewers
through voluntary contributions.
Since users can not be excluded from using
what is on the air and costs do not increase if
another user tunes in, broad-casting appears
to be a pure public good.

63
 APPLICATION 16.4: Why is There So
Much Fund-Raising Public
Broadcasting?
However, thriving commercial markets suggest
that broadcasting may not be underproduced.
Viewed as a mechanism for delivering
advertising messages, broadcasting is both
exclusive (advertisers must pay) and rival (only
one advertiser can use a time slot).

64
 APPLICATION 16.4: Why is There So
Much Fund-Raising Public
Broadcasting?
An alternative justification is that certain types
of broadcasting will be unattractive to
advertisers (for example, cultural) and will be
underprovided in private markets.
However, the free rider problem tends to
undermine voluntary support.
Fewer than 10 percent of the viewers of public
television make voluntary contributions.

65
 APPLICATION 16.4: Why is There So
Much Fund-Raising Public
Broadcasting?
Public broadcasting has had to turn to
advertising.
Cable television stations, such as The Learning
Channel, today provide programming that is
indistinguishable from public broadcasting.
Voluntary support of public is declining and its
long-run viability is in doubt.

66
 Local Public Goods

Since individuals are relatively free to move

from one locality to another, the public goods
problem may be more tractable on the local
level.
Voting with ones fee provides a mechanism for
revealing demand for public goods.
People who want high-quality schools or strong
police protection can choose to live in high tax
areas.
67
 Direct Voting and Resource
Allocation

In some situations, people vote directly on

policy questions.
While majority rule is a common criteria, many
cases require even greater amounts (even 100
percent in Quaker meetings) to win in a voting
situation.
However, for what follows, majority rule is assumed.

68
 TABLE 16.3: Preferences That Produce
the Paradox of Voting

Voter Order of Preferences

Smith A B C
Jones B C A
Fudd C A B

69
 The Paradox of Voting

Majority-rule voting systems may not arrive at

an equilibrium but instead may cycle among
alternative options.
This paradox is illustrated in Table 16.3.
Suppose there are three voters (Smith, Jones, and
Fudd) choosing among three policy options
regarding spending on a particular public good (A =
low, B = medium, and C = high).

70
 The Paradox of Voting
Preferences of the three voters are indicated by the
order listed in the table.
For example, Smith prefers A to B and B to C.
In a vote between A and B option A would win.
Similarly, a vote between A and C would result in
option C winning.
But, a vote between C and B would find B (which
lost to A above, and A lost to C) winning.

71
 Single-Peaked Preferences and the
Median Voter Theorem

Equilibrium voting outcomes can always occur

in cases where the issue being voted upon is
one-dimensional and where voters
preferences are single-peaked.
In Figure 16.6, the preferences that give rise to
the paradox of voting are shown by assigning
hypothetical utility levels to A, B, and C.

72
 Single-Peaked Preferences and the
Median Voter Theorem

The preferences of Smith and Jones are

single-peaked--as levels of public goods
expenditures rise, there is only one local utility
maximizing choice (A for Smith, B for Jones.
Fudd has two local peaks (A and C).
If Fudds preferences were represented by the
dashed line, option B would defeat both A and C.

73
 FIGURE 16.6: Single-Peaked Preferences and
the Median Voter Theorem

Utility

Fudd
Fudd (alternate)
Jones

Smith

A B C Quantity of
public good

74
 Single-Peaked Preferences and the
Median Voter Theorem

B wins because it is the choice of the median

voter whose preferences for a public good
represent the middle point of all voters
preferences for the good.
The median voter result applies to any number of
voters.
If choices are one-dimensional and preferences are
single-peaked, majority rule will select the median
voters choice.
75
 APPLICATION 16.5: Referenda on
Public Spending

CaliforniasProposition 13, passed in 1977,

required that property in California be taxed at
a maximum rate of 1 percent of the 1975 fair
market value.
It also imposed sharp limits on tax increases in
future years.
Local property tax revenues declined by nearly 60
percent between fiscal 1978 and 1979.

76
 APPLICATION 16.5: Referenda on
Public Spending

One explanation for the passage of this law

was a demand for changing the sources of
local tax revenues.
Citizens were largely content with existing levels of
local services but wanted state tax sources
(income and sales, primarily) to take over a larger
share of the burden.

77
 APPLICATION 16.5: Referenda on Public
Spending--Californias Proposition 13

Alternatively,voters may have wished for a

decline in local government size.
Both hypotheses have empirical support.
California voters did raise other state taxes, but
spending is significantly lower than before the
initiative.

78
 APPLICATION 16.5: Referenda on Public
Spending--Massachusetts and Michigan

In Massachusetts, the 1980 passage of

Proposition 2, similar to Proposition 13, was
fueled by a preference for greater efficiency
in government.
The Michigan Headler Amendment, which
proposed to limit state taxes, also appeared to
stem from preferences for more efficiency.

79
 APPLICATION 16.5: Referenda on Public
Spending --Home Rule in Illinois

Home Rule, which eliminates state-level

restrictions on spending, was adopted by
communities in Illinois.
More heterogeneous groups appeared to want to
limit local spending.
More homogeneous groups wanted to forsake the
spending restrictions.
The homogeneous groups have similar interests
with respect to government size and functions.

80
 Representative Government and
Bureaucracies

In a representative government, individuals

vote for directly for candidates, not policies.
This raises the issue of whether or not
representatives will actually vote the way their
constituents want and present the possibility
for rent-seeking behavior where firms or
individuals influence government policy to
increase their own welfare.

81