1. Copyright 2002, Pearson Education Canada1 Externalities, Public Goods, Imperfect Information, and Social Choice Chapter 16

2. Copyright 2002, Pearson Education Canada2 Externality zAn externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside the activity or transaction. zAlso called spillovers or neighborhood effects. zThe classic example of an externality is pollution.

3. Copyright 2002, Pearson Education Canada3 Marginal Social Cost (MSC) zThe marginal social cost is the total cost to society of producing an additional unit of a good or service. zMSC 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

4. Copyright 2002, Pearson Education Canada4 A Profit Maximizing Firm and an Externality (Figure 16.2b) If firms were forced to account for the full cost of their production then P**, q** would be the equilibrium and S’ the new supply curve.

5. Copyright 2002, Pearson Education Canada5 Marginal Private Cost (MPC) zThe marginal private cost is the amount that a consumer pays to consume an additional unit of a particular good.

6. Copyright 2002, Pearson Education Canada6 Marginal Damage Cost (MDC) zMarginal damage cost is the additional harm done by increasing the level of an externality- producing activity by one unit. zIf producing product X pollutes the water in a river, MDC is the additional cost imposed by the added pollution that results from increasing output by one unit of X per period.

7. Copyright 2002, Pearson Education Canada7 Externalities in University Residence (Figure 16.3) zHarry enjoys marginal benefits of listening to his stereo higher than his marginal costs. zCosts are also imposed on Jake - an externality. zThe full cost to this society of two individuals are substantially higher than Harry’s MPC. zThe efficient level of stereo time is 5 hours and not 8 hours.

8. Copyright 2002, Pearson Education Canada8 Internalizing Externalities zGovernment-imposed taxes and subsidies zPrivate bargaining and negotiation zLegal rules and procedures zThe sale or auctioning of rights to impose externalities zDirect government regulation

9. Copyright 2002, Pearson Education Canada9 Tax Imposed on a Firm Equal to Marginal Damage Cost (Figure 16.4) If a per unit tax exactly equal to marginal damage costs is imposed on a firm, the firm will weigh the tax, and thus the damage costs in its decisions and produce the efficient output.

10. Copyright 2002, Pearson Education Canada10 Coase Theorem zCoase Theorem states that under certain conditions, when externalities are present, private parties can arrive at the efficient solution without government involvement.

11. Copyright 2002, Pearson Education Canada11 Public (Social) Goods zPublic goods are those goods or services that bestow collective benefits on members of society. zSuch goods are nonrival in consumption and their benefits are nonexcludable.

12. Copyright 2002, Pearson Education Canada12 Characteristics of Public Goods zNonrival in consumption: One person’s enjoyment of the benefits of a public good does not interfere with another’s consumption of it. zNonexcludable: Once a good is produced, no one can be excluded from enjoying its benefits.

13. Copyright 2002, Pearson Education Canada13 Intrinsic Problems of Public Goods zFree-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. zDrop-in-the-bucket problem: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays.

14. Copyright 2002, Pearson Education Canada14 Market Demand For Public Goods (Figure 16.6) zPerson A is willing to pay $6 per X units of the public good and Person B is willing to pay $3. zThe market demand for the public good is $9 per X units of the good. zDemand curves are vertically added to obtain the demand for public goods.

15. Copyright 2002, Pearson Education Canada15 Optimal Provision of a Public Good (Figure 16.7) zOptimal production or provision of a public good means producing as long as society’s total willingness to pay per unit (D A+B) is greater than the marginal cost of producing the good.

16. Copyright 2002, Pearson Education Canada16 Optimal Level of Provision for Public Goods (Samuelson) zThe level at which resources are drawn from the production of other goods and services only to the extent that people want the public good and are willing to pay for it. At this level, society’s willingness to pay per unit is equal to the marginal cost of producing the good.

17. Copyright 2002, Pearson Education Canada17 Tiebout Hypothesis zAn 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.

18. Copyright 2002, Pearson Education Canada18 Imperfect Information zImperfect information refers to the absence of full information that can cause households and firms to make mistakes.

19. Copyright 2002, Pearson Education Canada19 Adverse Selection zAdverse selection can occur when a buyer or seller enters into an exchange with another party who has more information.

20. Copyright 2002, Pearson Education Canada20 Moral Hazard zA moral hazard arises when one party to a contract passes the cost of his or her behaviour on to the other party to the contract.

21. Copyright 2002, Pearson Education Canada21 Market Solutions to Imperfect Information zLike consumers, profit maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs of engaging in it.

22. Copyright 2002, Pearson Education Canada22 Social Choice zSocial choice refers to the problem of deciding what society wants; the process of adding up individual preferences to make a choice for society as a whole.

23. Copyright 2002, Pearson Education Canada23 Arrow’s Impossibility Theorem zFrom a proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent arbitrary results.

24. Copyright 2002, Pearson Education Canada24 Voting Paradox zA 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.

25. Copyright 2002, Pearson Education Canada25 Logrolling zLogrolling occurs when elected representatives trade votes, agreeing to help each other get certain pieces of legislation passed.

26. Copyright 2002, Pearson Education Canada26 Governmental Failure in the Efficient Allocation of Resources zMeasurement of social costs and benefits is difficult and imprecise. zThere is no reliable measure of citizens’ preferences. zGovernments are not subject to the discipline of the market. zElected and appointed officials may not act selflessly for the good of society.

27. Copyright 2002, Pearson Education Canada27 Review Terms & Concepts zadverse selection zCoase Theorem zdrop-in-the-bucket problem zexternality zfree-rider problem zimpossibility theorem zinjunction zliability rules zlogrolling zmarginal damage cost (MDC) zmarginal private cost (MPC) zmarginal social cost (MSC) zmarket failure zmoral hazard

28. Copyright 2002, Pearson Education Canada28 Review Terms & Concepts (continued) znonexcludable znonrival in consumption zoptimal level of provision of public goods zpublic goods zsocial choice zTiebout hypothesis zvoting paradox