1. Chapter 9 THE ECONOMICS OF GOVERNANCE

2. Externalities and Public Goods
Markets organize the supply of many of the goods and services we consume, and our ability to pay them is a key determinant of our well-being.
There are some goods and services that we wish to consume that cannot be efficiently supplied through markets.
Public Good: A public good is a good that is not rival, that is, my consuming it does not reduce the amount available for you; it is also not excludable, that is, if I am consuming it I cannot prevent you from consuming it too.
Examples of public goods: national defense, street lighting, and road networks.

3. Externality: An externality occurs when one person’s action affects the welfare of another in ways that the first need not take into account. An externality therefore arises in a market when a producer’s seller’s or buyer’s actions influence the welfare of others in ways not reflected in market prices.
A good example of such a negative externality is water pollution. Pollution is an externality because firms do not have to pay for its costs to others.
A Rationale for Government Intervention: Governments have two basic methods to force output and pollution down. They can impose a tax that internalizes the externality, that is, it increases firms’ costs to include the full costs of their output including the social cost.
Figure 9.3 (page 252) shows how taxes in general affect competitive markets. The market equilibrium without a tax is at A with price P and output Q. Imposing a tax t per unit of output shifts the supply curve upwards, because each firm’s costs are increased by the tax. That is, before they take their profit on each unit, they must pay the tax, which therfore experience as a cost.

4. Figure 9.4 (page 253) shows the use of a specific tax to force down output of the polluting industry to the optimum level.
The tax rate is the vertical distance between the supply curves S and S + t, equal to the distance BC. The market equilibrium without the tax is at A, with price Pp and output Qp.
The tax shifts the firm’s supply curve to S + t, and the market equilibrium to B with price Ps and quantity Qs.
As Figure 9.4 shows, the tax is at precisely the level to force output down to the market optimum level Qs.