© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 14 Prepared by: Fernando Quijano and Yvonn Quijano Externalities, Public Goods, Imperfect Information, and Social Choice

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Externalities An externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside the activity or transaction. Sometimes called spillovers or neighborhood effects.An externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside the activity or transaction. Sometimes called spillovers or neighborhood effects.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Externalities When external costs are not considered in economic decisions, we may engage in activities or produce products are not worth it.When external costs are not considered in economic decisions, we may engage in activities or produce products are not worth it. When external benefits are not considered, we may fail to do things that are indeed worth it. The result is an inefficient allocation of resources.When external benefits are not considered, we may fail to do things that are indeed worth it. The result is an inefficient allocation of resources.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Marginal Social Cost and Marginal-Cost Pricing Marginal social cost (MSC) is the total cost to society of producing an additional unit of a good or service.Marginal social cost (MSC) is the total cost to society of producing an additional unit of a good or service. MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production.MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Marginal Social Cost and Marginal-Cost Pricing At q*, marginal social cost exceeds the price paid by consumers. Output is too high. Market price takes into account only part of the full cost of producing the good.At q*, marginal social cost exceeds the price paid by consumers. Output is too high. Market price takes into account only part of the full cost of producing the good.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Private Choices and External Effects Marginal private cost (MPC) is the amount that a consumer pays to consume an additional unit of a particular good.Marginal private cost (MPC) is the amount that a consumer pays to consume an additional unit of a particular good.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Private Choices and External Effects Marginal benefit (MB) is the benefit derived from each successive hour of music, or the maximum amount of money Harry is willing to pay for an additional hour of music.Marginal benefit (MB) is the benefit derived from each successive hour of music, or the maximum amount of money Harry is willing to pay for an additional hour of music.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Private Choices and External Effects Harry would play the stereo until MB = MPC, or eight hours.Harry would play the stereo until MB = MPC, or eight hours. However, this result would be socially inefficient because Harry does not consider the cost imposed on Jake.However, this result would be socially inefficient because Harry does not consider the cost imposed on Jake.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Private Choices and External Effects Marginal damage cost (MDC) is the additional harm done by increasing the level of an externality- producing activity by one unit.Marginal damage cost (MDC) is the additional harm done by increasing the level of an externality- producing activity by one unit.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Private Choices and External Effects Marginal social cost (MSC) is the total cost to society of playing an additional hour of music.Marginal social cost (MSC) is the total cost to society of playing an additional hour of music. Playing the stereo beyond more than five hours is inefficient because the benefits to Harry are less than the social cost for every hour above five.Playing the stereo beyond more than five hours is inefficient because the benefits to Harry are less than the social cost for every hour above five.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Internalizing Externalities A tax per unit equal to MDC is imposed on the firm. The firm will weigh the tax, and thus the damage costs, in its decisions.A tax per unit equal to MDC is imposed on the firm. The firm will weigh the tax, and thus the damage costs, in its decisions.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Coase Theorem Government need not be involved in every case of externality.Government need not be involved in every case of externality. Private bargains and negotiations are likely to lead to an efficient solution in many social damage cases without any government involvement at all. This argument is referred to as the Coase Theorem.Private bargains and negotiations are likely to lead to an efficient solution in many social damage cases without any government involvement at all. This argument is referred to as the Coase Theorem.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Coase Theorem Three conditions must be satisfied for Coases solution to work:Three conditions must be satisfied for Coases solution to work: Basic rights at issue must be assigned and clearly understood. Basic rights at issue must be assigned and clearly understood. There are no impediments to bargaining. There are no impediments to bargaining. Only a few people can be involved. Only a few people can be involved. Bargaining will bring the contending parties to the right solution regardless of where rights are initially assigned.Bargaining will bring the contending parties to the right solution regardless of where rights are initially assigned.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Indirect and Direct Regulations Taxes, subsidies, legal rules, and public auction are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against the benefits.Taxes, subsidies, legal rules, and public auction are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against the benefits. Direct regulation includes legislation that regulates activities that, for example, are likely to harm the environment.Direct regulation includes legislation that regulates activities that, for example, are likely to harm the environment.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Public Goods Public goods (social or collective goods) are goods that are nonrival in consumption and/or their benefits are nonexcludable.Public goods (social or collective goods) are goods that are nonrival in consumption and/or their benefits are nonexcludable. Public goods have characteristics that make it difficult for the private sector to produce them profitably (market failure).Public goods have characteristics that make it difficult for the private sector to produce them profitably (market failure).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Characteristics of Public Goods A good is nonrival in consumption when As consumption of it does not interfere with Bs consumption of it. The benefits of the good are collectivethey accrue to everyone.A good is nonrival in consumption when As consumption of it does not interfere with Bs consumption of it. The benefits of the good are collectivethey accrue to everyone. A good is nonexcludable if, once produced, no one can be excluded from enjoying its benefits. The good cannot be withheld from those that dont pay for it.A good is nonexcludable if, once produced, no one can be excluded from enjoying its benefits. The good cannot be withheld from those that dont pay for it.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Characteristics of Public Goods Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them. This is referred to as the free-rider problem.Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them. This is referred to as the free-rider problem.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Characteristics of Public Goods The drop-in-the-bucket problem is another problem intrinsic to public goods: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays.The drop-in-the-bucket problem is another problem intrinsic to public goods: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Characteristics of Public Goods Consumers acting in their own self- interest have no incentive to contribute voluntarily to the production of public goods.Consumers acting in their own self- interest have no incentive to contribute voluntarily to the production of public goods. Most people do not find room in their budgets for many voluntary payments. The economic incentive is missing.Most people do not find room in their budgets for many voluntary payments. The economic incentive is missing.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Public Provision of Public Goods Public provision does not imply public production of public goods.Public provision does not imply public production of public goods. Problems of public provision include frequent dissatisfaction. Individuals dont get to choose the quantity they want to buyit is a collective purchase. We are all dissatisfied!Problems of public provision include frequent dissatisfaction. Individuals dont get to choose the quantity they want to buyit is a collective purchase. We are all dissatisfied!

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Optimal Provision of Public Goods With private goods, consumers decide what quantity to buy; market demand is the sum of those quantities at each price.With private goods, consumers decide what quantity to buy; market demand is the sum of those quantities at each price.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Optimal Provision of Public Goods With public goods, there is only one level of output, and consumers are willing to pay different amounts for each level.With public goods, there is only one level of output, and consumers are willing to pay different amounts for each level. The market demand for a public good is the vertical sum of the amounts that individual households are willing to pay for each potential level of output.The market demand for a public good is the vertical sum of the amounts that individual households are willing to pay for each potential level of output.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Optimal Production of a Public Good Optimal production of a public good means producing as long as societys total willingness to pay per unit D (A+B) is greater than the marginal cost of producing the good.Optimal production of a public good means producing as long as societys total willingness to pay per unit D (A+B) is greater than the marginal cost of producing the good.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Local Provision of Public Goods According to the 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 the market for private goods.According to the 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 the market for private goods.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Imperfect Information and Adverse Selection Most voluntary exchanges are efficient, but in the presence of imperfect information, not all exchanges are efficient.Most voluntary exchanges are efficient, but in the presence of imperfect information, not all exchanges are efficient. Adverse selection can occur when a buyer or seller enters into an exchange with another party who has more information.Adverse selection can occur when a buyer or seller enters into an exchange with another party who has more information.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Moral Hazard Moral hazard arises when one party to a contract passes the cost of his or her behavior on to the other party to the contract.Moral hazard arises when one party to a contract passes the cost of his or her behavior on to the other party to the contract. The moral hazard problem is an information problem, in which contracting parties cannot always determine the future behavior of the person with whom they are contracting.The moral hazard problem is an information problem, in which contracting parties cannot always determine the future behavior of the person with whom they are contracting.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Market Solutions As with any other good, there is an efficient quantity of information production.As with any other good, there is an efficient quantity of information production. Like consumers, profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs.Like consumers, profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Government Solutions Information is nonrival in consumption.Information is nonrival in consumption. When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody.When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Social Choice Social choice is the problem of deciding what society wants. The process of adding up individual preferences to make a choice for society as a whole.Social choice is the problem of deciding what society wants. The process of adding up individual preferences to make a choice for society as a whole.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Impossibility Theorem The impossibility theorem is a proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent, nonarbitrary results.The impossibility theorem is a proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent, nonarbitrary results.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Impossibility Theorem Preferences of Three Top University Officials VP1 prefers A to B and B to C. VP2 prefers B to C and C to A. The dean prefers C to A and A to B. OPTION A OPTION B OPTION C Hire more faculty No change Reduce the size of the faculty Ranking 1XXX 2XXX 3XXX If A beast B, and B beats C, how can C beat A? The results are inconsistent. VP1 VP2 Dean

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Voting Paradox The voting paradox is a simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of inconsistency described in the impossibility theorem.The voting paradox is a simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of inconsistency described in the impossibility theorem. Results of Voting on Universitys Plans: The Voting Paradox VOTES OF: VoteVP1VP2Dean Result a A versus B ABA A wins: A > B B versus C BBC B wins: B > C C versus A ACC C wins: C > A a A > B is read A is preferred to B.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Rent-Seeking Revisited There are reasons to believe that government attempts to produce the right goods and services in the right quantities efficiently may fail.There are reasons to believe that government attempts to produce the right goods and services in the right quantities efficiently may fail. The existence of an optimal level of public-goods production does not guarantee that governments will achieve it.The existence of an optimal level of public-goods production does not guarantee that governments will achieve it.