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

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

3. 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

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

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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

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

17. 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

18. 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

19. 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

20. 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
$ $4.00 or $5.50.
$4.00
Output 1 2 3 4 5 6 7 8 9 10
Externality and public goods
105

21. 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

22. 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

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

24. 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