PUBLIC FINANCE

Lecture no.5
Chapter 3: Public goods and externalities
Associate Professor Ph.D Ramona MARA
Finance Department
Chapter 3: Public goods and externalities
1. The concept of “market
failure”
2. What is a public good?
3. Externalities
Key concepts
Market Public
failure goods

Externaliti
Free rider
es
1. The concept of “market failure”
Definiton
Market failure
is the economic situation defined by an
inefficient distribution of goods and
services in the free market.
Furthermore, the individual incentives for
rational behavior do not lead to rational
outcomes for the group. Put another way, each
individual makes the correct decision for
him/herself, but those prove to be the wrong
decisions for the group.
1. The concept of “market failure”
Private markets, if certain conditions are met, will allocate
goods and services among individuals efficiently.

If private markets were able to provide efficient outcomes and

if the distribution of income was socially acceptable, then there
would be little or no scope for government. In many cases,
however, conditions for private market efficiency are violated.

For example, if many people can enjoy the same good at the
same time (non-rival, non-excludable consumption), then
private markets may supply too little of that good. National
defense is one example of non-rival consumption, or of a
public good.
1. The concept of “market failure”
The public sector is the part of economic and administrative
life that deals with the delivery of public goods and services at
different government levels:
 national,
 regional or
 local/municipal.

Examples of public sector activity range from delivering

 social security,
 administering urban planning and
 organizing national defenses.
1. The concept of “market failure”
The organization of the public sector (public ownership) can
take several forms, including:
 Direct administration funded through taxation; the
delivering organization generally has no specific requirement
to meet commercial success criteria, and production decisions
are determined by government.
 Publicly owned corporations (in some contexts, especially
manufacturing, "state-owned enterprises"); which differ from
direct administration in that they have greater commercial
freedoms and are expected to operate according to commercial
criteria, and production decisions are not generally taken by
government (although goals may be set for them by
government).
1. The concept of “market failure”
 1. The concept of “market failure”
During market failures the government usually responds to varying
degrees. Possible government responses include:
legislation – enacting specific laws. For example, banning smoking
in restaurants, or making high school attendance mandatory.
direct provision of merit and public goods – governments
control the supply of goods that have positive externalities. For
example, by supplying high amounts of education, parks, or
libraries.
taxation – placing taxes on certain goods to discourage use and
internalize external costs. For example, placing a ‘sin-tax’ on
tobacco products, and subsequently increasing the cost of tobacco
consumption.
subsidies – reducing the price of a good based on the public benefit
that is gained. For example, lowering college tuition because society
benefits from more educated workers. Subsidies are most
appropriate to encourage behavior that has positive externalities.
extension of property rights – creates privatization for certain
non-private goods like lakes, rivers, and beaches to create a market
for pollution. Then, individuals get fined for polluting certain areas.
advertising – encourages or discourages consumption.
2. What is a public good

 https://www.youtube.com/watch?v=aTbJETkImHc

https://www.youtube.com/watch?v=hA2z-X31IvI&t=66s

A public good is a good that is non-rivaled and non-excludable. This

means, respectively, that consumption of the good by one individual
does not reduce availability of the good for consumption by others;
and that no one can be effectively excluded from using the good.[1]

In the real world, there may be no such thing as an absolutely non-
rivaled and non-excludable good; but economists think that some
goods approximate the concept closely enough for the analysis to be
economically useful.

[1] Hal R. Varian, Microeconomic Analysis Mas-Colell, Whinston &

Green, Microeconomic Theory
 2. What is a public good
In economics, a public good is one that cannot or
will not be produced for individual profit, since it
is difficult to get people to pay for its large
beneficial externalities. A public good is defined as
an economic good which possesses two properties:
It is
non-rivalrous, meaning that its benefits do not
exhibit scarcity from an individual point of view;
once it has been produced, each person can
benefit from it without diminishing anyone
else's enjoyment.
non-excludable , meaning that once it has been
created, it is impossible to prevent people
from gaining access to the good.
Public goods are "pure" when they possess these
properties absolutely.

A public good would be for society as a whole (the

public), while a "collective good" is merely for a
2. What is a public good
Excludable Non-excludable
(non-
excluderea)
Rivalness Private goods Common goods /
food, clothing, (Common-pool
toys, furniture, resources)
cars water, fish, hunting
game

Non- Club goods Public goods

rivalness cable television national defense,
(non- free-to-air
rivalitate television, Public
a lighting
consumu
 2. What is a public good
For example, if one individual eats a cake, there is no cake left for
anyone else, and it is possible to exclude others from consuming the
cake; it is a rivaled and excludable private good.

Conversely, breathing air neither significantly reduces the amount of

air available to others, nor can people be effectively excluded from
using the air. This makes it a public good, but one that is economically
trivial, as air is a free good. A less trivial example is the exchange of
MP3 music files on the internet: the use of these files by any one
person does not restrict the use by anyone else and there is little
effective control over the exchange of these music files.

Non-rivalness and non-excludability may cause problems for the

production of such goods. Specifically, some economists have argued
that they may lead to instances of market failure, where uncoordinated
markets are unable to provide these goods in desired quantities.
These spanner issues are known as public goods problems, and there
is a good deal of debate and literature on how significant they are, and
on what their solutions might be. These debates can become important
to political arguments about the role of markets in the economy.
2. What is a public good
Paul A. Samuelson is usually credited as the
first economist to develop the theory of public
goods.
In his classic 1954 paper The Pure Theory of
Public Expenditure,[2] he defined a public
good, or as he called it in the paper a
"collective consumption good", as follows:
...[goods] which all enjoy in common in the
sense that each individual's consumption of
such a good leads to no subtractions from any
other individual's consumption of that good...
[2] Paul A. Samuelson (1954). "The Pure Theory of Public Expenditure". Review of
Economics and Statistics 36 (4): 387–389.
2. What is a public good
Competitive markets (with voluntary provision)
 either fail to provide any amount of public goods,
 or fail to provide efficient quantities of public
goods.
 The main reason is that non rivalry in
consumption and free-riding behaviour of
individuals, that can benefit without paying or
contributing.
In a private market for an homogeneous good,
consumers adjust quantities to the market price.
In public goods, there are no markets,
consumers consume the same quantity (even
valuing differently the public good) and tax
prices are different.
The Free-Rider Problem
A free-rider is a person who receives the
benefit of a good but avoids paying for it.
Since people cannot be excluded from
enjoying the benefits of a public good,
individuals may withhold paying for the good
hoping that others will pay for it.
The free-rider problem prevents private
markets from supplying public goods.
Forms of production and provision of goods
Production:
 Entity responsible for the production and/or maintenance of
that good.
Provision:
 The means by which citizens gain access to that good.
Public provision/production
 Public provision/production is funded by the budget of a public
entity (government or local authority), essentially through taxes.
 Users do not pay a price for its use (funding is indirect, through
taxes).
Private provision/production (*)
 Private provision/production is funded through a price, fees
and charges that should reflect the marginal or average cost of
production.
 Users pay for the provided good or rendered service (the user
pays principle).
 (*) The entity that produces and provides the good can be
either public or private
3. Externalities
Definition
 There is an externality whenever the action of an
individual meaningfully affects the well-being of
other individuals, and this effect is not transmitted
through a pricing system.
Externalities can be:
 Positive/negative,
 Consumption/production,
 Few/many agents.
External marginal cost (benefit):
A negative (positive) externality generates a
marginal external cost (benefit) that is the
additional cost (benefit) of producing one
additional unit of that good, imposed on all affected
economic agents.
Exercise No 1Homework for 1.Nov
Justify why these activities are negative
externalities and mention the causes of these
externalities:
1. Air pollution
2. Acid rain
3. Water pollution
4. Passive smoking:
Mention solutions for reducing these externalities
through taxation.
Identify which are production/consumption
externalities.
Examples for negative production
externalities

include:
Air pollution from burning fossil fuels. This activity causes
damages to crops, (historic) buildings and public health.

 Acid rain is a classic negative production externality

 Water pollution by industries that adds effluent, which harms

plants, animals, and humans.

 Noise pollution during the production process, which may be

mentally and psychologically disruptive.

 Negative effects of industrial farm animal production, including

"the increase in the pool of antibiotic-resistant bacteria because of
the overuse of antibiotics; air quality problems; the contamination
of rivers, streams, and coastal waters with concentrated animal
waste; animal welfare problems, mainly as a result of the
extremely close quarters in which the animals are housed.“

 The depletion of the stock of fish in the ocean due to overfishing.

Examples of negative consumption externalities include:
 Noise pollution: Sleep deprivation due to a neighbor listening
to loud music late at night.

 Antibiotic resistance, caused by increased usage of antibiotics.

Individuals do not consider this efficacy cost when making
usage decisions. Government policies proposed to preserve
future antibiotic effectiveness include educational campaigns.

 Passive smoking: Shared costs of declining health and vitality

caused by smoking and/or alcohol abuse. Here, the "cost" is
that of providing minimum social welfare.

 Traffic congestion: When more people use public roads, road
users experience (congestion costs) such as more waiting in
traffic and longer trip times. Increased road users also
increase the likelihood of road accidents.
Examples of positive production externalities include:

The construction and operation of an airport.

This will benefit local businesses, because of
the increased accessibility.
A foreign firm that demonstrates up-to-date
technologies to local firms and improves their
productivity
Examples of positive consumption externalities include:

Driving an electric vehicle charged by

electricity from a renewable source,
reducing greenhouse gas emissions and
improving local air quality and public health.
Increased education of individuals, as this
can lead to broader society benefits in the
form of greater economic productivity, a
lower unemployment rate.
3. Externalities
To address a negative externality: a Pigouvian
tax is levied: It is a per unit tax (by unity of
production) that equals the marginal external
cost at an efficient level of output
To address a positive externality: a Pigouvian
subsidy is given: it is a per unit subsidy (by
unity of production) that equals the marginal
external benefit at an efficient level of output:
Types of intervention
Optional readings
Donath Liliana, et all., Public Finance
Handbook, 2012, Mirton, Timisoara (FSEGA
Library) Pages: 4-16
Zai P.V, et all, Economics and Public Finance,
2013, Tritonic, Bucuresti (FSEGA Library)
Pages: 7-125 (these pages include also the
materials for previously lectures 1-4)