Externalities and Public Goods Managerial Economics ECON 511 Lecture 6 Externalities and Public Goods Professor Changqi Wu 1

Topics for Today Externality and Its Solutions Public Goods Externality and public goods 2

1. Externalities Negative externality Positive externality Action taken by one party imposes a cost on another party Positive externality Action taken by one party benefits another party Externality and public goods 4

An Example Scenario Steel plant dumping waste in a river The entire steel market effluent can be reduced by lowering output Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. Marginal Social Cost (MSC) is MC plus MEC. Externality and public goods 5

External Costs P1 q1 Q1 MSC MSCI MEC MECI q* P* Q* MC S = MCI D P1 When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. MEC MECI The differences is the marginal external cost MEC. q* P* Q* The industry competitive output is Q1 while the efficient level is Q*. The profit maximizing firm produces at q1 while the efficient output level is q*. Price Price MC S = MCI D P1 Aggregate social cost of negative externality Firm output Industry output 16

Negative Externality Negative externality: the social marginal cost is higher than the individual marginal cost. Negative externality encourages inefficient firms to remain in the industry and creates excessive production in the long run. Externality and public goods 17

Positive Externality Positive externality: the social marginal benefit is larger than the individual marginal benefit Positive externality then results in too little production. Externality and public goods

External Benefits Value MSB D P1 MC P* MEB Effort Level q* q1 When there are positive externalities (the benefits of R&D spillovers to others), marginal social benefits MSB are higher than marginal benefits D. q* P* A self-interested firm invests q1 in innovative effort. The efficient level of effort q* is higher. The higher cost P1 discourages innovation . D MC P1 q1 Is research and development discouraged by positive externalities? Effort Level Externality and public goods 25

Consequences of Externalities Over provision of goods or services when a negative externality exists over-production happens when the production produces pollution Under provision of goods or services when a positive externality is present spillover of research and development(R&D) leads to under-investment in R&D Externality and public goods

2. Solutions to Externalities Solution 1: government solution taxation or subsidization Solution 2: internalization Disneyland solution research joint ventures Solution 3: creation of a market by clarifying property rights the fable of the bees Externality and public goods

2.1. Government Solution Taxation or subsidization to restore the optimal level of output In controlling emissions, fees used to solve the externality problem In education, governments provide loans and subsidies to students Externality and public goods

Business Application Rental differences at shopping centers. Anchor stores attract traffic into the shopping centers and specialty stores benefit. Real estate managers should tax specialties stores and subsidies anchor stores. Externality and public goods

2.2. Internalization Solution If both the steel mill and fishing pond are owned by the same company, the externality problem will be resolved. Disneyland owns large amount of land and develops hotels in the vicinity of its theme parks. Externality and public goods

2.3. Property Rights Solution Legal rules describing what people or firms can do with their property Economic efficiency can be achieved when property rights are well specified. Externality and public goods 81

Coase Theorem When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified. Externality and public goods

Coase Theorem Illustrated Benefit/cost MC to fishermen MB to factory Level of Emissions Externality and public goods 38

3. Public Goods Government sometimes replaces private firms as the producer of goods and services. Question When should government replace firms as the producer of goods and services? Externality and public goods 100

Public Good Characteristics Nonrivalry For any given level of production the marginal cost of providing it to an additional consumer is zero. Nonexclusivity People cannot be excluded from consuming the good. Externality and public goods 101

Public Goods High Externality: crowded street Pure private goods: hamburgers NC TFT Marginal cost to society of additional usage Pure public goods: street lights, police protection Club goods: swimming pool, cable TV Low Difficult Exclusion Easy Externality and public goods 23 23 23 23

Efficient Public Good Provision Benefits (dollars) D1 D2 D When a good is nonrival, the social marginal benefit of consumption (D) , is determined by vertically summing the individual demand curves for the good. $7.00 $5.50 Marginal Cost $1.50 Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50. $4.00 Output 1 2 3 4 5 6 7 8 9 10 Externality and public goods 105

Free Riders There is no way to provide some goods and services without benefiting everyone. Households do not have the incentive to pay what the item is worth to them. Free riders understate the value of a good or service to them so that they can enjoy the benefit without paying for it. Externality and public goods

Public Goods and Market Failure How much police protection did you consume last week? How much were you willing to pay for that service? Externality and public goods

Solutions to Public Goods Public provision of public goods government provides police services Commercial provision of public goods lighthouse Externality and public goods

The Key Learning Points Externalities and public goods lead to economic inefficiencies. These inefficiencies can be mitigated by government interventions and private initiatives. A firm can take advantages of externality to improve its market positions. Externality and public goods