1 ECON CHAPTER 16: EXTERNALITIES, PUBLIC GOODS AND SOCIAL
CHOICE
Lecture Oct. 12
Market failure: resources are misallocated or allocated inefficiently
Externality: exists when actions or decisions of one person/group impose a cost or
bestow benefit on 2nd or 3rd parties
spillover or neighborhood effects
Ie. Environmental economics
Marginal Social Cost and Marginal-Cost Pricing
Marginal Social Cost: Total cost to society to produce additional unit of good or service
MSC=sum of marginal costs of producing product and measured damage costs in
process of production
If a firm allowed to dump wastewater and does not have to pay for resulting
damage, it produces exactly the same level of output (q*) as before and price (P*)
reflects only costs that firm actually pays to produce its product
At equilibrium, q*, marginal social costs are considerably greater than price
(full value to consumers of a unit of product at the margin)
With externalities:
Examples of negative externalities: Acid rain often requires govt to get involved cap
and trade program to control emissions
Global warming
Marginal costs increase to MSC with increase of External Cost however q* and Q*
remain at same level
Examples of positive externalities:
-vaccinations
Private Choices and External Effects:
MB: marginal benefits, downward sloping curve (demand curve=MWTP)
benefits are maximum amount of money he would be willing to pay
diminishing marginal utility
Marginal Private Cost (MPC): amount consumer pays to consume an additional unit of
particular good
Marginal Damage Cost (MDC): additional harm done by increasing level of
externality-producing activity by 1 unit. If producing product X pollutes the water in
river, MDC is the additional cost imposed by added pollution that results from increasing
output by 1 unit of X per period.
MPC+MDC=MSC
Social optimum: occurs where MSB=MSC
Internalizing Externalities:
Private Bargaining and Negotiation
o Coase theorem: under certain conditions, when externalities are present,
private parties can arrive at the efficient solution without govt
involvement
o Example: When Harry plays his game 8 hours a day, the value of last
hour of play is only $0.05. However, Jake would pay more than $0.25
for an hour of relief. As Harry cuts back on play, the value of
marginal hour of play goes up and marginal damage to Jake of
listening begins to fall. For hours of play in excess of 5, Jakes
incremental damage exceeds Harrys incremental value of playing.
Five hours is the efficient playing time as more or fewer hours reduce
total benefits to Harry and Jake.
Legal Rules and Procedures
o Injunction: court order forbidding continuation of behavior that leads to
damages
o Liability rules: Laws that require A to compensate B for damages
imposed
Taxes and Subsidies
o Tax should be exactly equal to marginal damage costs
o Tax=MDC
o MC=MSC
o Efficient level of output is q1 where P=MC
Selling or Auctioning of Pollution Rights
o Cap and trade: in firms best interest to cut back below permit levels of
pollution and sell unused permits to firms with higher abatement costs
o Pollution (p.339): abatement As firm tries to reduce pollution, doing so
becomes more difficult and MCs of reducing pollution rise.
Firm A: $5 for first unit, 7 for second, 9 for third. By third, it will
have costs 21
Firm B: Reducing pollution by 3 units costs 45
Therefore: firm B would be willing to pay up to 23 to buy permit
allowing continuation of pollution up to a level of 3
LECTURE OCT. 17: PUBLIC GOODS
Public goods (social, collective): goods that are nonrival in consumption and/or benefits
are nonexcludable
Nonrival in consumption: One persons enjoyment of benefits of public good does not
interfere with anothers consumption of it
Goods can sometimes generate collective benefits and be rival in consumption ie.
Crowding at pool
Nonexcludable: characteristic of most public goods: once produced, no one can be
excluded from enjoyment
Free-rider problem: Problem intrinsic to public goods: people can enjoy benefits
whether or not they pay, they are usually unwilling to pay
Drop-in the bucket: Good or service so costly that provision does not depend on
whether any single person pays
Optimal Provision of Public Goods:
Samuelson-Musgrave Theory: Buying a product at posted price reveals it is worth at
least that amount to you (and everyone who buys it)
Market demand: sum of quantities that each household decides to buy (x-axis) at each
price.
Example: Assume society consists of 2 people, A and B. At price of 1, A demands 9 units
and B demands 13. Market demand at price of 1 is 22 units. If price rose to 3, A would
drop to 2 units and B would drop to 9 thus MD would=11 units.
To arrive at market demand for public goods, do not sum quantities instead add the
amounts that individual households are willing to pay for each potential level of
output
With public goods, only one level of output and
consumers are willing to pay different amounts for each
level: add demand curves vertically
**At Optimal level of provision for public goods: societys
total WTP per unit is equal to the MC of producing the good
MSWTP=MC
**producing as long as societys TWTP per unit (Da+b) is greater than MC of producing
the good
Local Provision of Public Goods: Tiebout Hypothesis: An efficient mix of public
goods is produced when local land/housing prices and taxes come to reflect consumer
preferences just as they do in market for private goods
Social choice: problem of deciding what society wants. Process of adding up individual
preferences to make choice for society as a whole
Voting Paradox: A simple demonstration of how majority-rule voting can lead to
seemingly contradictory and inconsistent results. A commonly cited illustration of the
kind of inconsistency described in the impossibility theorem
Impossibility theorem: proposition showing that no system of aggregating
individual preferences into social decisions will always yield consistent,
nonarbitrary results
Preferences of 3 Top University Officials (p. 346):
o VP1 prefers A to B and B to C
o VP2 prefers B to C and C to A
o The dean prefers C to A and A to B
Logrolling: occurs when congressional reps trade votes to pass legislation