Microeconomics

Second Edition, Global Edition

EC 101.03

Chapter 9
Externalities and
Public Goods

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Learning Objective

9.1 Externalities
9.2 Private Solutions to Externalities
9.3 Government Solutions to Externalities
9.4 Public Goods
9.5 Common Pool Resource Goods

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Key Ideas (1 of 2)

1. There are important cases in which free

markets fail to maximize social surplus.

2. This chapter discusses three such cases:

externalities, public goods, and common
pool resources.

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Key Ideas (2 of 2)

3. One common link among these three examples

is that there is a difference between the private
benefits and costs and the social benefits and
costs.
4. Government can play a role in improving market
outcomes in such cases.

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Externalities and Public Goods (1 of 2)

Evidence-Based Economics Example:

How can the Queen

of England lower her
commute time to
Wembley Stadium?

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Externalities and Public Goods (2 of 2)

Why aren’t cows extinct?

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Externalities A “Broken” Invisible Hand:
Negative Externalities (1of 6)

We Make Sweaters, Inc.

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Externalities A “Broken” Invisible Hand:
Negative Externalities (2 of 6)

Free yarn?

Free workers?
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Externalities A “Broken” Invisible Hand:
Negative Externalities (3 of 6)

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 Externalities A “Broken” Invisible Hand:
Negative Externalities (4 of 6)
Exhibit 9.2 The Socially Optimal Quantity and Price of Electricity

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Externalities A “Broken” Invisible Hand:
Negative Externalities (5 of 6)
Exhibit 9.3 Deadweight Loss Due to a Negative Externality

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Externalities A “Broken” Invisible Hand:
Negative Externalities (6 of 6)

Negative externality

An economic activity that has a negative

spillover effect

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Externalities A “Broken” Invisible Hand:
Negative Externalities (1 of 4 )

Positive externality

An economic activity that has a positive spillover

effect

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Externalities A “Broken” Invisible Hand:
Negative Externalities (2 of 4 )

Social benefits of education:

• Higher individual wages = more tax revenues
• Less reliance on social programs
• Decreased crime
• More innovation
• Better functioning society

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Externalities A “Broken” Invisible Hand:
Negative Externalities (3 of 4 )

Exhibit 9.4 The Market Equilibrium for Education

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Externalities A “Broken” Invisible Hand:
Negative Externalities (4 of 4 )

Exhibit 9.5 Deadweight Loss of a Positive Externality

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Externalities Pecuniary Externalities

Pecuniary externality

When a market exchange affects other people

through market prices

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Externalities

How can we address inefficient outcomes?

• Private solutions
• Government solutions

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Private Solutions to Externalities Private
Solution: Bargaining (1 of 2)

Can Fred and Anne come to an agreement?

Profits Per Day

Without Filter With Filter
Fred $130 $100
Anne $90

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Private Solutions to Externalities Private
Solution: Bargaining (2 of 2)

Range of terms: greater than $30 and less than

$50

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Private Solutions to Externalities The
Coase Theorem (1 of 2)

Coase Theorem

States that private bargaining will result in an

efficient allocation of resources

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Private Solutions to Externalities The
Coase Theorem (2 of 2)

Will the Coase Theorem hold if:

• The beach-goers (instead of the brewery) try to

come to an agreement with Fred?

Why or why not?

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Private Solutions to Externalities Private
Solution: Doing the Right Thing
Why do you recycle?

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Government Solutions to Externalities

What if private solutions do not work?

Government solutions:
• Command-and-control—direct regulation
• Market-based policies—provide incentives

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 Government Solutions to Externalities
Government Regulation: Command- and-
Control Policies (1 of 2)
Exhibit 9.2 The Socially Optimal Quantity and Price of Electricity

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Government Solutions to Externalities
Government Regulation: Command- and-
Control Policies (2 of 2)

Would you put a catalytic converter on your car if it

were optional?

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Government Solutions to Externalities
Corrective Taxes (1 of 3)
Exhibit 9.8 Effect of a Pigouvian Tax

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Government Solutions to Externalities
Corrective Taxes (2 of 3)

Pigouvian tax

The tax necessary to incentivize a firm to

produce the socially optimal level of output

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Government Solutions to Externalities
Corrective Taxes (3 of 3)
Pigouvian taxes also work on individuals

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Government Solutions to Externalities
Corrective Subsidies (1 of 2)
Exhibit 9.9 Effect of a Pigouvian Subsidy on the Education
Market

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Government Solutions to Externalities
Corrective Subsidies (2 of 2)

Pigouvian subsidy

The subsidy necessary to make aneconomic

agent increase consumption to the socially
optimal level

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Externalities and Public Goods (1 of 3)

Evidence-Based Economics Example:

What can the

government do to
lower the number of
earthquakes
in Oklahoma?

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Externalities and Public Goods (2 of 3)

Exhibit 9.6 The Number of Earthquakes in Oklahoma

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Externalities and Public Goods (3 of 3)

Exhibit 9.7 Results of the March 2015 Command-and-

Control Regulation in Kansas

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Public Goods (1 of 9)
So far, we have only been talking
about private goods

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Public Goods (2 of 9)

How many people can eat this apple?

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Public Goods (3 of 9)

Private
Rival good
Private
Goods that only one person
can consume at a time
Nonrival goods Public

Goods that more than one

Public
person at a time can
consume

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Public Goods (4 of 9)

Can you eat this apple without paying for it?

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Public Goods (5 of 9)

Private

Excludable goods Private

Must be paid for in

order to consume them
Public
Non excludable goods
Can be consumed, Public
even if they are not
paid for

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Public Goods (6 of 9)

Exhibit 9.10 Four Types of Goods

Excludability
High Low
High Ordinary private goods Common pool resource goods
(e.g., clothes, food, (e.g., fish, water, natural forests,
Rivalry furniture) food at a picnic)
Club goods (e.g., cable Public goods (e.g., national
Low TV, pay-per-view TV, defense, early warning systems,
Wi-Fi, music downloads) earth protection programs)

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Public Goods (7 of 9)
Exhibit 9.10 Four Types of Goods
Nonexcludable =
Can be consumed
without paying for Rival, Excludable Goods
Excludable = Rival = We have talked a lot about
Must be paid for One person at a time these
Rival = (or think about it this way: The market provides these,
One person at a time does my consumption of the right? If you don’t pay you
product limit others ability to don’t get them
consume? If yes, then rival) Market has incentive to
provide these goods
Excludable =
Must be paid for
Nonexcludable =
Nonrival =
Can be consumed without
More than one paying for
person at a time Nonrival =
More than one
person at a time
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Public Goods (8 of 9)

How much are you willing to pay for national

defense?

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Public Goods (9 of 9)
BOMB
HERE
FIRST

What if you didn’t

contribute?

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Public Goods Government Provision of
Public Goods (1 of 6)

Free rider problem

When an individual does not pay for a good
because it is non-excludable
Solution
The government makes paying for it
mandatory

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Public Goods Government Provision of
Public Goods (2 of 6)

What’s the “right” amount of a public good?

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Public Goods Government Provision of
Public Goods (3 of 6)
Exhibit 9.11 Constructing a Market Demand Curve for a
Private Good

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Public Goods Government Provision of
Public Goods (4 of 6)
Exhibit 9.12 Constructing a Market Demand Curve for a
Public Good

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 Public Goods Government Provision of
Public Goods (5 of 6)
Exhibit 9.10 Constructing a Market Demand Curve for a Public
Good

Why? Because we can

With a public good, what both consume the good!

we want to know is how

much value is placed on The Market Quantity is
NOT = 16 as in the
each unit, not how many private market

units people will consume.

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Public Goods Government Provision of
Public Goods (6 of 6)

Exhibit 9.13 The Equilibrium Point for Providing a Public

Good

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Public Goods Private Provision of Public
Goods (1 of 3)

Did you pay for

Cookie Monster’s
salary?

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Public Goods Private Provision of Public
Goods (2 of 3)
Exhibit 9.14 Total Giving in the United States Over Time

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Public Goods Private Provision of Public
Goods (3 of 3)

What’s wrong with charity?

• Money may not go to the areas of most critical

need
• Too variable
• When economy is in downturn (needed the
most), giving decreases

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Common Pool Resource Goods (1 of 2)

Why would people who fish be in favor of limits on how

many fish they can catch?

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Common Pool Resource Goods (2 of 2)

Tragedy of the commons

When common pool resources are

overused

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Externalities and Public Goods (1 of 4)
Why aren’t cows extinct?

Buffalo were common pool Cows were

resources private property

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Externalities and Public Goods (2 of 4)

Solutions to tragedy of the commons:

• Private ownership (defined by the government)

• Government regulation (fishing limits, for
example)
• Tax on use

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Externalities and Public Goods (3 of 4)

Evidence-Based Economics Example:

How can the Queen of

England lower her
commute time to
Wembley Stadium?

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Externalities and Public Goods (4 of 4)

Exhibit 9.16 Results of the Congestion Charge

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