Chapter Fifteen

Public Goods,
Externalities, and
Government
Behavior
 Public Goods

• Public Good – A good or service that has

two characteristics: non-rivalry in
consumption and non-excludability.

• Private Good – Has excludability or rivalry.

• Examples of Public Goods: National

defense, levees, clean air, etc.
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 Public Goods (cont’d)

Two Characteristics of Public Goods:

1) Non-rivalry in consumption - The
situation in which increased consumption
of a good by one person does not
decrease the amount available for
consumption by others. For example,
national defense is a good where your
consumption does not prohibit others
from consuming it, too.

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 Public Goods (cont’d)

2) Non-excludability – A situation in which

no one can be excluded from consuming
a good. For example, national defense
(again). If our houses are close to each
other and some of you are protected by
national defense, then I too, must be
defended.

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 Free riders

• Free rider problem – A problem arising in the

case of public goods because those who do not
contribute to the costs of providing the public
good cannot be excluded from the benefits of it.

• Again, going back to the national defense

example. No one would choose to pay for it if it
were a private good, because it is going to be
provided anyway, regardless of whether you pay
for it or not.

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 Avoiding Free-Rider Problems
• One way to avoid free rider problems is to
charge fees to all users. For example,
user fees have been common in
government services such as national
parks.

• User Fees – A fee charged for the use of a

good normally provided by the
government.

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 Cost – Benefit Analysis

• Decisions on which public good to produce

or how much to produce can be analyzed
using cost-benefit analysis.

• Cost-benefit analysis – An appraisal of a

project based on the expected costs and
benefits derived from it.

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 Cost – Benefit Analysis (cont’d)

• Contingent valuation – An estimation of the

willingness to pay for a project by asking the
consumers who may benefit from the project.
For example, people can be asked in surveys
how much they are willing to pay for having
more police patrolling an area.

• Economists do not believe that contingent

valuation is reliable, if people know they do not
have to pay for the good.

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 Externalities

• Externality – The situation in which the costs of

producing or the benefits of consuming a good
spill over onto those who are not producing or
consuming the good.

Two Types of Externalities

1) Positive externality
2) Negative externality

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 Externalities (cont’d)

• Negative Externality – the situation in

which the costs spill over onto someone
not involved in producing or consuming
the good.

• Positive Externality -the situation in which

the benefits spill over onto someone not
involved in producing or consuming the
good.

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 Negative Externality

• With negative externalities, the market

produces more of a good than the efficient
quantity because producers do not take
into account the cost to others when they
produce their goods.

• Examples: air pollution, loud music, traffic,

etc.

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 Negative Externality (cont’d)

• Marginal Private Cost – The marginal cost of

production as viewed by the private firm or
individual.

• Marginal Social Cost – The marginal cost of

production as viewed by society as a whole; the
sum of the firm’s marginal private cost and the
increase in external costs to society as more is
produced.

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 Negative Externality (cont’d)

• Marginal Social Cost = marginal private

cost + marginal external cost

• Figure 15.1 illustrates the relationship

between the marginal social cost and the
marginal private cost in a situation with
negative externality.

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 Negative Externality (cont’d)
Figure 15.1

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 Negative Externality (cont’d)

• From Figure 15.1: if producers produce

goods by taking into account the marginal
private costs, then the quantity produced
will exceed the socially efficient quantity.
At the quantity that the market produces,
the marginal social cost is larger than the
marginal benefit, and the economy
generates a deadweight loss equal to the
shaded triangle in Figure 15.1.

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 Positive Externalities

• Positive externality occurs when the activity of

one person makes another person better off by
either reducing costs or increasing benefits.

• Examples: Growing a nice garden in front of

your home makes you and your neighbors
happy; improving your hygiene makes it harder
for some diseases to spread to other
individuals.

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 Positive Externalities (cont’d)

• Marginal Private Benefit – The additional

benefit from consumption of a good as
viewed by a private individual.

• Marginal Social Benefit – The additional

benefit from consumption of a good from
the viewpoint of society as a whole.

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 Positive Externalities (cont’d)

• Figure 15.2 illustrates the relationship

between the marginal private benefit and
the marginal social benefit when positive
externality exists.

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 Positive Externalities (cont’d)
Figure 15.2

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 Positive Externalities (cont’d)

• With positive externality, as illustrated in

Figure 15.2, the marginal social benefit is
higher than the marginal private benefit, so
the socially efficient production quantity of
the good with a positive externality is
higher than what the market produces. At
the quantity that the market produces, the
social marginal benefit is larger than the
marginal cost, so increasing production
would have increased society’s surplus.
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 Positive Externalities (cont’d)

• Producing at a quantity below the socially

efficient quantity results in a deadweight
loss. The deadweight loss is the shaded
triangle illustrated in Figure 15.2.

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 Remedies for Externalities (cont’d)

• Internalizing the externality – the process of

providing incentives so that the externalities
are taken into account internally by firms or
consumers.

Four ways to internalize an externality:

1) Private remedies
2) Command and control
3) Taxes and subsidies
4) Tradable permits
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 Private Remedies

• Private remedy – A procedure that

eliminates or internalizes externalities
without government intervention other than
defining property rights.

• Property rights – Rights over the sale, use,

and proceeds from a good or a resource.

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 Private Remedies (cont’d)

• By assigning property rights, we define

who has the right to use the resource, and
who has the right to pollute or infringe on
whom. As we shall see with the Coase
Theorem, who we assign rights to does
change the efficient outcome.

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 Private Remedies (cont’d)

• Coase Theorem – The idea that private

negotiations between people will lead to an
efficient resolution of externalities regardless of
who has the property rights as long as property
rights are defined (and the transaction costs are
low).

• Transaction Costs – The costs of buying or

selling in a market, including search, bargaining,
and writing contracts.

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 Private Remedies (cont’d)

Coase Theorem, an example:

• Suppose a firm producing chemicals

is polluting a lake that Bob likes to
swim in. The benefit Bob gets from
swimming is $500 while the benefit
that the firm gets from polluting is the
$1000 profit that it makes. The cost
of cleaning the lake, so Bob can swim
in it, is $200.

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 Private Remedies (cont’d)

• Suppose Bob owns the right to pollute. He

can demand the firm to either stop
polluting, pay the cost of cleaning, or pay
Bob the $500 in lost benefits. Since the
cost of cleaning is least expensive, the
firm will choose to pollute and keep
cleaning the lake. Bob will continue
swimming.

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 Private Remedies (cont’d)

• If the firm owns the property rights, Bob

can approach the firm and pay them to
stop producing or he can pay for the
cleaning of the lake so that he can swim.
Bob can also choose to not swim and lose
the $500 in benefits from swimming.
Since the cost of cleaning is least
expensive, Bob will choose to pay for
cleaning the lake so that he can swim.
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 Private Remedies (cont’d)

• Notice that in the example, assigning Bob or the

firm the right to the lake does not change the
end solution, i.e., the firm pollutes, Bob swims,
and the lake is cleaned.

• Transaction costs must be low for the solution to

be the same. Imagine if in the same example,
the cost of getting lawyers is $600, then Bob
may not want to make a deal with the firm, since
the transaction cost is larger than his benefit of
swimming.
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 Private Remedies (cont’d)

• Free rider problems also complicate the

analysis. Suppose there are 200 swimmers, and
the property rights belong to the firm. In order to
swim, swimmers must pay $1 each in order to
pay for their share of the $200 clean-up cost.

• If one swimmer refuses to pay, others will have

to end up paying that swimmer’s share of the
clean-up costs and the swimmer who did not pay
gets a free ride.

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 Command and Control

• Command and Control – The regulations and

restrictions that the government uses to correct
market imperfections.

• One example where the government takes

command and control is in crab fishing. The
Department of Fish and Game wants to
minimize the negative effects of taking too many
crabs; it places restrictions on the quantity of
crabs that firms can catch and then closes for
the season.
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 Command and Control (cont’d)

• One disadvantage of the command and

control method is that it does not allow
firms to find a cheaper alternative to
reducing the externality.

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 Taxes and Subsidies
• Goods that produce negative externalities are taxed in
order to raise the producer’s marginal private cost equal
to the marginal social costs. The tax is aimed at
encouraging the producer of the negative externality to
decrease the quantity produced.

• Goods that produce positive externalities are subsidized

in order to increase the marginal private benefits of the
producer to equal the marginal social benefits.
Subsidies aim to encourage the producer of the positive
externality to increase the quantity produced.

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 Taxes and Subsidies (cont’d)

• Figure 15.3 illustrates how a tax will result

in an efficient quantity produced. The tax
that will shift the marginal private cost
(faced by the producer) equal to the
marginal social cost, will result in an
efficient quantity. The deadweight loss will
be eliminated.

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 Taxes and Subsidies (cont’d)
Figure 15.3

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 Taxes and Subsidies (cont’d)

• Figure 15.4 illustrates how a subsidy will

result in an efficient quantity produced.
The subsidy that will shift the marginal
private benefit (faced by the consumer)
equal to the marginal social benefit, will
result in an efficient quantity. The
deadweight loss will be eliminated.

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 Taxes and Subsidies (cont’d)
Figure 15.4

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 Emission Taxes

• Emission Taxes – A charge to firms that

pollute the environment based on the
quantity of the pollution they emit.

• One advantage of imposing emission

taxes is that it encourages the taxed firm
to find ways to lower its tax payments by
finding ways to lower the emissions that it
emits.

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 Tradable Permits

• Tradable permit – A governmentally

granted license to pollute that can be
bought and sold.

• One advantage of tradable permits is that

they give firms incentive to find the least
costly form of pollution control.

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 Models of Government Behavior

• Government Failure – The situation where

the government fails to improve on the
market or even makes things worse.

• Public Choice Models – Models of

government behavior that assume that
those in government take actions that
maximize their own well-being, such as
getting reelected.

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 Economic Policy Decisions
Through Voting
• Median Voter Theorem – A theorem
stating that the median or middle of
political preferences will be reflected in
government decisions. The preferences of
the voters on the extremes will not matter.

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 Economic Policy Decisions
Through Voting (cont’d)
• One interesting result from the Median Voter
Theorem is that the political parties will have a
convergence of opinions, i.e., they will gravitate
towards the opinion of the median voter.

• Convergence of positions – The concentration of

the stances of political parties around the
citizens’ opinions.

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 Economic Policy Decisions
Through Voting (cont’d)
• Voting paradox – A situation where voting
patterns will not consistently reflect
citizens’ preferences because of multiple
issues on which people vote.

• Table 15.3 illustrates how preferences

generate a voting paradox.

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 Economic Policy Decisions
Through Voting (cont’d)

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 Economic Policy Decisions
Through Voting (cont’d)

• From Table 15.3, we can see that issue A will

win against issue B, and issue B will win against
issue C, but issue A will not win against issue C.

• This example shows that an instability exists in

the possible outcomes in the vote. This is
because the results from voting can change
simply by changing how issues are paired up.

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 Economic Policy Decisions
Through Voting (cont’d)

• Arrow Impossibility Theorem – A theorem

that states that no democratic voting
scheme can avoid a voting paradox.

• Voting paradoxes can be a source of

government failure.

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 Special Interest Groups

• Another source of government failure is the

presence of special interest groups. Special
interest groups lobby for policies that benefit a
particular group, even though these policies may
not be the best for society.

• From the point of economics, lobbying may also

be wasteful because of the time and resources
that lobbying uses.

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 Incentive Problems in Government

• Another source for government failure is

that there are no incentives for the
government to be efficient. In contrast, a
firm has higher profits as an incentive for
trying to be efficient.

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 Key Terms

• Public good
• Non-rivalry
• Nonexcludability
• Free-rider problem
• User-fee
• Cost-benefit analysis
• Contingent valuation
• Externality

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 Key Terms (cont’d)

• Positive and negative externality

• Marginal private cost
• Marginal social cost
• Marginal private benefit
• Marginal social benefit
• Internalizing an externality
• Private remedy
• Coase Theorem

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 Key Terms (cont’d)

• Transaction cost
• Command and control
• Emission tax
• Tradable permit
• Public choice models
• Median voter theorem
• Convergence of positions
• Voting paradox
• Arrow Impossibility theorem

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