Various types of goods

and externalities
 Externalities
An externality arises when a person engages
in an activity that influences the well-being
of a bystander, yet neither pays nor
receives compensation for that effect.
Negative externality if the impact on
bystander is adverse.
Positive externality if the impact on
bystander is beneficial
 Externalities
Negative externalities:
car-exhaust fumes, smoking, noisy late-
night parties, failing to get TB treatment
Positive externalities:
scientific research, maintaining historic
buildings, cleaning one’s surroundings,
replanting forests for the future
 Externalities
Buyers and sellers in a market pay attention
only to their own well-being in a market
situation and neglect the external effects
of their decisions regarding how much to
consume or produce.
As a result, the market equilibrium is not
efficient in the presence of externalities,
i.e., it does not maxmise society’s welfare.
Pollution as negative externality
Price Social cost

S (private cost)

Cost of
pollution

D (demand for cars)

QS QM Quantity
 Physics education as
positive externality
Price
Extra value to
S society

Social value

D (private value)

QM QS
Quantity
 Solutions to externalities
1. Private solutions
– moral codes and social sanctions can promote
positive externalities or minimise negative ones
(e.g., hiya, desire for approval by others)
– charity and philanthropy
– private business organization: integration of
activities with positive externalities
– buy-outs and compensation through private
bargaining
 Coase Theorem
(after Ronald Coase, 1960):
Private economic actors can solve the
problem of externalities among
themselves. Whatever the initial
distribution of rights, the interested parties
can always reach a bargain where
everyone is better off and the outcome is
efficient.
 Coase Theorem
Jay’s residence doubles as a workshop and his van is
always parked before his house on a narrow street.
This is not illegal. Eye lives across and has a hard
time backing out of the driveway in the morning
because of Jay’s van.
If the inconvenience of difficult backing out is worth
P200/month to Eye, and the trouble of finding
another parking spot is worth P150/month to Jay,
then Eye can buy out Jay’s right to park his van.
 Coase Theorem
The result is that the externality is removed. Society
gets an extra P50 in benefits per month.
Now suppose the trouble of finding another parking
spot is P300/month to Jay. Then he will not accept
Eye’s offer, and she has to live with the current
situation. But then this would also be the most
optimal solution.
Note: it will not matter who has the “right”, either way.
 Right is more valuable to Eye
Jay’s payoff Eye’s payoff Social gain or
loss

Jay’s rights – 150 + 150 = 0 200 – 150 = 50 50

Eye’s rights – 150 200 50

If rights are assigned to Jay, then Eye pays him 150 for
permission.
If the rights are given to Eye, then she does not have to
pay anything. Either way, the social gain is +50.
 Right is more valuable to Jay
Jay’s payoff Eye’s payoff Social gain or
loss

Jay’s rights 300 –200 100

Eye’s rights 300 – 200 = 100 200 – 200 = 0 100

If rights are assigned to Jay, then he does not have to do

anything. He gains 300 and Eye loses 200.
If the rights are given to Eye, then Jay can compensate
her for her loss. Either way, the social gain is 100.
 Coase Theorem
But the Coase Theorem does not always
work because of transactions costs,
costs i.e.,
costs of trying to reach agreement and
enforcing (following through on) a
bargain.
In the example, suppose for example, that Jay’s and
Eye’s schedules are so different they do not even have
a common time to meet to discuss the matter. Then
bargaining cannot even begin.
 Coase Theorem
Another example of transactions cost:
Many small fisherfolk are harmed by pollution by a mining
firm. The sum of the fishers’ losses is greater than the cost
of the mining firm installing an effective antipollution device.
The Coase Theorem says that if the right is assigned to the
firm, the fishers can pay it to install the antipollution device.
But because they are many and hard to organise, the fishers
cannot come up with a coherent offer. As a result, the
externality is unmitigated and society suffers a net loss.
 Coase Theorem
According to Coase himself, the existence of
transactions costs means government
intervention is necessary.
In particular, transactions costs make a wise
application of the law necessary.
In the previous example, it makes sense to
assign the rights to the fisherfolk. (What is
the general principle involved?)
 Solutions to externalities
2. Public policies towards externalities
– regulation and prohibition
 problem is the “one size fits all” nature
 same regulation affects industries differently
– taxes and subsidies
 tax is based on the amount of externality emitted,
rather than a common imposed limit
 allows private actors to calibrate their actions and
respond to the tax
 Solutions to externalities
Pigovian taxes and subsidies (unlike usual
ones) move the economy towards the
optimum rather than away from it.
The Pigovian tax (subsidy) reflects the extra
cost (value) to society of the production
activity or consumption and therefore
offsets the externality.
 Pigovian tax
Price Social cost

S (private cost)
T*
Pigovian tax

D (private value)

QS QM Quantity
Types of goods
 Markets and the type of goods

Markets are well-suited to supplying

private goods,
goods i.e., those which are
rival in use and exclusive.
 Rivalry (or subtractability)
 Does one person’s use of the good
diminish another’s enjoyment of it?
 e.g., shower vs. Olympic-size swimming
pool
– affected by the degree of congestion
– and rules of behaviour (institutions)
 Exclusion
 Can people be prevented from using
the good?
 e.g., soft-drink bottle vs. street-lighting
cable broadcast vs. radio broadcast
– technological: is it feasible to exclude others
or not? (e.g., a fence)
– institutional: what is the last resort when
technological barriers are breached? (e.g.,
trespassing as a crime)
 Ostrom’s typology
of goods

Exclusive Non-exclusive

Rival Private goods Common resource

Nonrival Toll goods Public goods

 Examples

Private goods haircut; plate of

cooked rice; book; pen

Public goods street lighting; natural park;

uncongested urban road

Toll or club goods phone connections; cable TV;

SLEX use; time-share condo

Common pool lake; crowded sidewalk

 Question
 the economic problem of (what, how, and
for whom) to produce consists of deciding
which institutions are to be assigned to
provide various types of goods
 think of: markets, the family, the
community, and the state
 Public goods
 Suppose it costs P100,000 for a town to
put up a fireworks display, while the value
to each person of watching it is P600. If
there are 500 residents, then the benefits
are greater than the cost (P300,000 is
greater than P100,000).
 Will this service be provided by the market?
(e.g., by selling tickets to the event)?
 Public goods
 A “free-rider” is a person who receives the
benefit of a good but avoids paying for it.
 Essentially an externality: no one will provide the
service because the total cost is less than the
private benefit, even if it is socially beneficial,
because other people will not pay for it but will
enjoy it if provided.
 Typical solution: government pays for the
service out of general taxes.
 Public goods
Other examples of public goods:
national defence
basic research in science
fire protection
street lighting
uncongested urban roads
 Public good problem
Price
S

Because of the free-rider

problem, the good is
not supplied privately.

A and B

A or B

QM QS Quantity
 Club goods
What happens if the “public good” becomes
exclusive, i.e., it is now possible to restrict
the enjoyment of the good?
The result is that the curve A and B
becomes effective, since the “free-rider”
problem is solved.
admission fees to a large swimming pool; to jazz
concerts; movies; cable TV; to high-speed
highways.
 Common resources
What happens if a public good becomes
rival?
Then it becomes a common-resource:
nonexclusive but rival.
Examples:
Congestion on urban roads and sidewalks
Pollution of previously pristine rivers and lakes
Deforestation and over-fishing in oceans
Disappearance of rare species in the wild
Overuse of a common resource
SS
Price precongestion

With congestion

SP

QS QM Quantity
 Common resources
Analysis of common-resource problems:
 an example is the “tragedy of the
commons”
 essentially boils down to a negative
externality of one’s action
 hence also susceptible to private or public
solutions of externalities
 Common resources
Solutions address the exclusion problem:
hence important to define property rights.
– state ownership: but typically ineffective,
because the state is not an effective owner,
especially in developing countries
– private-monopoly concession
– ownership by local community or association
(Examples abound in the forest-preservation
problem.)
 Assignment of provision
Private goods assigned to markets;
Public goods assigned to the state;
Club goods assigned to various types of
organizations charging fees or restricting
entry;
Common-pool resources assigned to
communities or managed by government.
Taxes and the tax
system
 Various kinds of taxes
1. Lump-sum taxes: levied on persons based
on their specific characteristics.
2. Commodity taxes: levied on specific
commodities
2.1 specific taxes: differ based on commodities
involved, e.g., alcohol and tobacco
2.2 value-added taxes: a uniform rate based on
the value-added content in a good (wages,
profits, rents)
2.3 tariffs: applicable only to imports
 Various kinds of taxes
3. Income taxes: levied on persons based
on their incomes they earn
4. Consumption taxes: levied on spending.
If a value-added tax covers all goods, then it is
equivalent to proportional tax on spending
5. Wealth and inheritance taxes: based on
what one owns.
 Efficiency
Taxing anything means less of it will be
produced and consumed. (Acceptable in
the case of goods with negative
externalities.)
But others can have disincentive effects:
Example: If income is taxed heavily, then
less effort will be forthcoming. (Less true
for wealth and inheritance taxes. Why?)
 Equity
Horizontal equity: people in approximately
the same situation should be taxed
approximately equally, e.g., an employee
earning P80,000 annually, and a self-
employed person earning the same
amount.
 Equity
Vertical equity: Wealthier people should pay
more in taxes.
(a) Benefits principle: people should pay
based on the benefits they receive from
government
(b) Ability-to-pay principle: people should
pay taxes according to how well they can
shoulder the burden.
 Progressive, regressive,
proportional taxation
Proportional taxation: proportion of income
paid as taxes is constant, as income
increases.
Regressive taxation: proportion of income
paid as taxes falls, as income increases.
Progressive taxation: proportion of income
paid as taxes increases, as income
increases.
 Progressive, regressive,
proportional taxation
Income Prog Reg Prop

120,000 12,000 12,000 12,000

(10%) (10%) (10%)
500,000 100,000 25,000 50,000
(20%) (5%) (10%)
1,000,000 300,000 33,000 100,000
(30%) (3%) (10%)
 Progressive, regressive,
proportional taxation
Algebraically, for Y2 > Y1:
T1/Y1 = T2/Y2 proportional
taxation
T1/Y1 > T2/Y2 regressive taxation
T1/Y1 < T2/Y2 progressive
taxation.
 Progressive, regressive,
proportional taxation
progressive
T (taxes paid)
proportional

regressive

Y (income)
 Further observations
 Income taxes discourage earnings (up to a
point) Also possible are expenditure or
consumption taxes, which discourage
consumption (VAT is a proportional tax).
 Two economic types of taxes : (a)
Pigouvian to address externalities; (b)
general taxation to finance public goods.
 Further observations
 Factors to consider in designing the
general tax system: (a) its disincentive
(efficiency) effects; (b) impact on equity;
(c) ease of collection.
 Sometimes one aspectmust be balanced
against another. E.g., income taxes can be
made progressive but are harder to collect
than sales taxes or VAT.
End