1. Market Inefficiencies: Externalities and Public Goods7
Market Inefficiencies: Externalities and Public Goods

2. Market Failure Market Failure Sources Asymmetric Information
When the free market may not provide economically efficient (ideal) outcome
Sources
Too little competition
Monopoly/Cartels
Too little output/total surplus (deadweight loss)
Goods produced at too high a cost
Asymmetric Information
Financial Markets (insider trading – Facebook IPO)
Externalities (positive and negative)

3. Externalities Externality Negative externality Positive externality
The uncompensated impact of one person’s actions on the well-being of a bystander
Negative externality
Impact on the bystander is adverse (cost)
Positive externality
Impact on the bystander is beneficial (benefit)
Decision maker - fails to account for externalities
Government: develop market incentives/signals to correct market failure

4. Previously
Consumer surplus is the difference between what a consumer is willing to pay (maximum) and the price actually paid for a good or service.
Producer surplus is the difference between the minimum price a producer is willing to accept and the payments he actually receives from selling a good.
Lecture notes:
This chapter will also deal with economic welfare. Specifically, we will study situations where certain costs or benefits are not internalized by the parties involved in trade. This can lead to an inefficient level of goods being traded.

5. Big Questions What are externalities, and how do they affect markets?
What are private goods and public goods?
What are the challenges of providing non-excludable goods?

6. Negative Externalities
Internal costs (private market costs)
The costs of an activity paid by an individual engaging in the activity (market participant)
External costs (cost of the externality)
The cost of an activity paid for by someone else not directly involved in the activity (not involved in the market exchange)
Social costs (SMC)
Sum of internal and external costs
Lecture notes:
Consider driving a car.
Internal costs: you pay for gas, wear and tear on vehicle.
External costs: you create pollution and road congestion.
Consider eating a garlic-filled Italian meal at a restaurant.
Internal costs: you pay for the meal; cost you time and money.
External costs: you may create unpleasantness to others later with bad garlic breath.

7. Third-Party Problem Externalities Third-Party Problems
Occur when private cost (or benefit) diverges from social cost (or benefit)
Third-Party Problems
People not directly involved in activity experience positive or negative externalities.
Free rider – when positive externality
Lecture notes:
Third party = “other person” who is not involved directly in the activity, but suffers the cost of the activity. Pollution and secondhand smoke are examples.
Externalities: think “external.”

8. Third-Party Problem Negative externalities Positive externalities
Costs experienced by third parties
“Too much” of the good is consumed and produced. (don’t have to pay all of the costs)
Pollution, secondhand smoke
Positive externalities
Benefits experienced by third parties
(someone else pays for the good)
“Not enough” of the good is consumed and produced.
Education, vaccines
Lecture tips:
You can have the students experience a negative externality. If you bring a bottle of potent perfume or cologne to class, you can ask for a volunteer to spray a lot of it on themselves. The students sitting near the perfumed student will experience a negative externality.
If you’re willing to take a bigger risk (and assuming you won’t get in a lot of trouble), you could also think about smoking (or having a student smoke) in class. A negative externality will be created.
Generally, these are all examples of “market failures.” This occurs when individuals do not consider (internally) all of the costs or benefits of an activity.
With a negative externality, there are external costs (borne by others) that the individual engaging in the activity does not consider. Thus, social costs are understated, and too much of the activity is done.
With a positive externality, there are external benefits (borne by third parties) that the individual engaging in the activity does not consider. Thus, social benefits are understated, and too little of the activity is done.

9. Externalities and Market Inefficiency
Negative externalities
Pollution
Cost to society (of producing electricity from coal)
Larger than the cost to the electric utilities
Social cost - supply
Private costs of the producers
Plus the costs to those bystanders affected adversely by the negative externality
Social cost curve – above the supply curve

10. Pollution and the social optimum2
Pollution and the social optimum
Price of
Electricity
Social cost (private cost
and external cost)
External
Cost
Supply
(private cost)
Demand
(private value)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Megawattsof Electricity
In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET.

11. Externalities and Market Inefficiency
Negative externalities (Costs not taken into account)
Optimum quantity produced
Maximize total welfare
Smaller than market equilibrium quantity
Government – correct market failure
Internalizing the externality
Altering incentives so that people take account of the external effects of their actions
E.g.: tax producers
Shift supply upward – by the size of the tax
Tax – value of negative externality

12. Correcting for Negative Externalities
Image: Animated Figure 7.1
Lecture notes:
Intuition: the new supply curve (shifted to the left) reflects ALL the costs (not just internal). Higher costs mean less production.
The figure illustrates the contrast between the market equilibrium and the social optimum in the case of an oil refinery. These costs are indicated on the graph by the supply curve, S internal, which represents how much the oil refiner will produce if it does not have to pay for the negative consequences of its activity. In this situation, the market equilibrium, Em, accounts only for the internal costs of production.
Suppose now the firm has to pay for pollution somehow (tax, pay for environment damages, or install abatement equipment). Abatement = act of reducing pollution.
Having to pay the costs of imposing pollution on others reduces the amount of the pollution-causing activity. This result is seen in the shift of the supply curve to S social. The new supply curve reflects a combination of the internal and external costs of producing the good. Since each of the corrective measures requires the refiner to spend money to correct the externality, the willingness to sell the good declines, or shifts left. The result is a social optimum at a lower quantity, Qs, than at the market equilibrium, Qm. Here the trade-off is clear. We can reduce negative externalities by requiring producers to internalize the externality. However, internalizing the externality is not without cost. Since the supply curve shifts left, the quantity produced will be lower. In the real world, there is always a cost.
In addition, when there is an externality, the market equilibrium creates deadweight loss, as shown by the yellow triangle in the figure.

13. Correcting for Externalities
For positive externalities:
Help individuals realize external benefits
Finance and/or subsidize production and consumption of the good
Laws requiring consumption
Vaccines
Education
Overall consumption is increased, illustrated by a rightward shift in demand
Lecture notes:
Generally, with positive externalities, we know that there are external benefits that individuals may not account for. Thus, we want to increase resource allocation to the activity.
Remember that the demand curve can be thought of as the MB (marginal benefit) curve. Shifting this curve to the right can be thought of as us realizing the extra benefits, so we want to engage in more of this activity.
Laws requiring consumption: everyone has to go to school until the age of 16. Some schools require vaccination records.

14. Correcting for Positive Externalities
Image: Animated Figure 7.2
Lecture tip:
Use flu shots as an example of a behavior with a positive externality.
Easy intuition: the new demand curve (shifted to the right) reflects ALL the benefits rather than just internal benefits.
There is an incentive for people in high risk groups to get vaccinated for the sake of their own health. Looking at the figure, we capture this internal benefit in the demand curve labeled
D internal. However, the market equilibrium, Em, only accounts for the internal benefits of individuals getting vaccinated. In order to maximize the health benefits for everyone, public health officials need to find a way to encourage as many people as possible to get vaccinated. One way is through school vaccination laws. These laws require that all children entering school provide proof of vaccination against a variety of diseases. The overall effect of child vaccination laws are that more people get vaccinated early in life, which reduces the spread of contagious diseases. This creates a positive externality for society.
Government can also promote the social optimum by encouraging economic activity that helps third parties. For example, it can offer a subsidy, or price break, to encourage more people to get vaccinated. The subsidy acts as a consumption incentive. Since the subsidy allows the consumer to spend less money, the willingness to get the vaccine increases. More people are immunized, a result seen in a shift of the demand curve in the figure from D internal to D social. The new demand curve reflects the sum of the internal and social benefits of getting the vaccination. The subsidy encourages consumers to internalize the externality and, as a result, consumption moves from the market equilibrium, Qm, to a social optimum at a higher quantity, Qs.

15. Inframarginal Externalities
Inframarginal externality
Externality that exists, but consequence of a marginal change in activity is effectively zero
We must examine total costs and benefits rather than marginal effects.
Example:
One more person using bandwidth on the Internet
One more person attending a concert or sporting event
“Beyond the Book Slide”
Lecture notes:
Inframarginal = below the margin, submarginal

16. Property Rights
Externalities often arise because of a lack of clearly defined property rights.
Ask: Who owns the air? Can I pollute?
Private property
Provides exclusive right of ownership that allows for the use and exchange of property
Creates incentive to maintain, protect, and conserve property, as well as listen to the wishes of others
Lecture notes:
We will discuss each of these incentives, one at a time, on the next slide.

17. Private Property Incentives
Incentive to maintain
Keep the vehicle safe and reliable
Incentive to protect
Lock your doors
Incentive to conserve
Extend vehicle life, drive less
Incentive to trade with others
You can voluntarily trade for something better in the market.
Lecture tips:
In this slide, use a car as an example of a privately owned good.
Ask your students the question: What do you take better care of?
Public restroom or your own private bathroom?
Your own car or the public bus? (Do you wipe your feet before getting into both?)
Your own bike or equipment at the gym?
Just get the students to realize that when you privately own something, you have more incentives to take good care of the good!

18. Coase Theorem Two adjacent farmers, no fences
One raising cattle
One growing wheat
Scenario 1: The cattle rancher is liable for damages the cows cause.
Options for cattle rancher
Put up a fence
Pay damages to wheat farmer
Rancher will consider costs of both to make choice.
Lecture notes:
Assume the cattle cause damage to the ground (no matter what farmer the ground belongs to). Without a fence, the cattle roam over both lands.
If the cost of the fence (building, maintenance) is more than the cost of the cattle damage, the rancher will not build a fence, and will just pay the farmer for damages. If the cattle destruction cost is greater, the rancher will build a fence to keep the cattle on his own land.
Either result will force the cattle farmer to internalize the entire costs of the cattle damage.

19. Coase Theorem
Scenario 2: The wheat farmer does not have a legal right to cattle-free fields.
Options for farmer
Put up a fence
Accept occasional cattle damage
Result?
If property rights are fully specified, either the cattle rancher or wheat farmer will build a fence.
Coase theorem
If there are no barriers to negotiations, interested parties will bargain to correct any externality.
Lecture notes:
If the cost of the fence (building, maintenance) is more than the cost of the cattle damage, the farmer will not build a fence, and will just accept the damages to the wheat. If the cattle destruction cost is greater, the farmer will build a fence to keep the cattle out.
Building the fence will force the cattle rancher to internalize the externality.
Coase determined that whenever the size of the externality is large enough to justify the expense, the externality gets internalized. As long as the property rights are fully specified, either the cattle rancher or wheat farmer will build a fence. The fence keeps the cattle away from the wheat, removes the externality, and avoids the destruction of property.

20. Private Goods Characteristics of certain consumption goods Excludable
The good must be purchased before use.
Rival
The good cannot be enjoyed by more than one person at the same time.
Private goods
Are both excludable and rival in consumption
Most goods we purchase and consume are private goods.
Lecture notes:
Most goods we purchase and consume are private goods.
A private good is both excludable and rival in consumption. For instance, a slice of pizza is excludable because it must be purchased before you can eat it. Also, a slice of pizza is rival; only one person can eat it. These two characteristics: excludability and rivalry, allow the market to work efficiently in the absence of externalities. Consider a pizza business. The pizzeria bakes pizza pies because it knows it can sell them to consumers. Likewise, consumers are willing to buy pizza because it is a food they enjoy. Since the producer is able to charge a price and the consumer to acquire a rival good, this sets the stage for mutual gains from trade.

21. Public Goods Public goods Free-rider problem Can be consumed by many
Difficult to exclude non-payers from consumption
Examples:
Public defense, public parks, public fireworks display
Free-rider problem
Someone has the ability to receive the benefit of a good without paying for it.
Eating (and not paying) at a free-will donation meal
Letting a classmate do all the work in a group project!
Lecture tip:
Other free-rider example: not putting money in a collection plate!

22. Club Goods, Common Resources
Non-rival and excludable
Examples:
Satellite TV, gym membership
Common resource goods
Rival but non-excludable
Fishing, hunting (specific animals fished and hunted), public campsites
Lecture notes:
Club goods:
You can be excluded if you don’t pay. However, they are non-rival. Just because I get a membership to the YMCA doesn’t exclude you from getting one.
Common resources:
You can’t be excluded from the public campsite, but they are rival campsites. If I set up my tent at campsite 1A, you can’t also set up camp there. There are a limited number of campsites, as well as deer to hunt.
Technicality: hunting and fishing sometimes requires licensing and fees, and that could sometimes exclude.

23. Cost-Benefit Analysis
Process to determine whether the benefits of providing a public good outweigh the costs
Costs
Known amount, easy to compute
Benefits
Difficult to quantify, different for all people
Private goods
Benefits and willingness to pay are expressed through prices, easier to examine
Lecture notes:
Realize that all economic decisions by consumers, firms, and governments involve a cost-benefit analysis. Are the benefits greater than the costs? If so, it is a good action to perform.
The difficulty with public goods (which are often provided by the government) is that the costs are clear, but the benefits are often not. How do we measure the benefits of a park, bike trail, campground, or fireworks display? Some people may really enjoy these goods, while other people may not care.
Private goods are easier to examine with respect to costs and benefits. The value of the good is the price people are willing to pay. Thus, if people purchase the good, we know the benefits are greater than the costs.

24. Tragedy of the Commons Tragedy of the commons Original example:
Occurs when a rival (but non-excludable) good becomes depleted or ruined
Original example:
Garret Hardin, Science Magazine, 1968
Cattle grazing
Commons = shared area that all cattle farmers get to use to let cattle graze
Lecture notes:
The commons is an area maintained by the public government. It can sustain a limited amount of cattle; it needs to sustain itself over time.

25. Tragedy of the Commons
The commons can be sustained indefinitely with a capacity of around 100 cows.
Suppose 100 farmers are each allowed to have 1 cow freely graze in the commons.
One farmer thinks: What if I bring 2 cows?
100 cows? 101 cows? No difference!
But suppose that ALL the farmers are thinking the same thing?
Can the commons support 200 cows?
Lecture tip:
The pictures are set on a timer. The slide will slowly fill up with cows. Each additional cow may not make a noticeable difference, but soon you will begin to notice all the cows!
The slide will fill up after 50 seconds.

26. Tragedy
The commons get destroyed, even though this was in nobody’s best interest.
Lecture notes:
Here is the tragedy:
Everyone did what they thought was in their own best interest: bring a second cow. I get twice as much free feeding, and the costs are minimal (to me and society). However, if EVERYONE does this, all those “small” costs add up to a “big” cost! The commons dies, which is bad for everyone.

27. Common Property Incentives
Incentive to neglect
Good cannot be protected. No political borders or ownership.
Incentive to overuse
Each individual wants to fish as much as possible for higher profits. If one conserves, others will fish even more.
Incentive to ignore others
No one has the ability to define how many resources can be used. I may still break the rules set even if others follow them.
Lecture notes:
The common property incentives are almost the opposite of the private property incentives!!
Use cod fishing industry as an example.
No borders on the ocean. If there’s no fish here, you’ll fish somewhere else.
You will fish as much as you can. More fishing is more profit.
Even if others are following the rules set in place, it’s still in my best interest to try and fish more to get a bigger haul. (Everyone is thinking the same thing.)

28. Solution to the Tragedy of the Commons
General proactive management is needed.
Taxes, regulations, or other ways to internalize a negative externality
King crab populations have done much better than cod because:
Limited length of fishing season
Regulations on how much crab the boats can harvest
Only adult males are harvested.
Lecture notes:
In addition, there has to be a way to enforce the laws, as well as stating clear punishments for rule breakers.

29. Cap and Trade Cap and trade Good in theory, but negative consequences?
A system of pollution “permits” that are traded on an open market
Purpose: reduce pollution
Good in theory, but negative consequences?
Agreements are difficult to negotiate; no international consensus
Countries with restrictions have higher costs than others
Often called “cap and tax”
Lecture notes:
Pollution is a negative externality—a byproduct of manufacturing various goods.
Difficulty: if the United States places tougher pollution standards on firms and other countries don’t, we are putting ourselves at a disadvantage. Other countries will produce cheaper products. Thus, cap and trade may only work successfully if the system (and trading market) was international. This would be very difficult to negotiate and organize.
Thus, it is often called “cap and tax” since it seems to tax producers.

30. Conclusion Inefficiencies occur because of poor incentives
Externalities
Arise from the result of diverging social and private costs (or benefits)
Can be corrected by forcing economic agents to internalize them
Public goods present a special challenge for a free-market economy.
Lecture notes:
One solution is to encourage businesses to internalize externalities. This can be done through taxes and regulations that force producers to account for the negative externalities that they create. Similarly, subsidies can spur the additional production of activities that generate positive externalities. However, not all externalities require active management from the government. Many externalities are too small to matter, and do not justify the costs associated with government regulation or taxation.

31. Summary
Internal costs are costs that are directly borne by the decision-maker.
Social costs = internal costs + external costs
An externality exists whenever an internal cost, or benefit, diverges from a social cost, or benefit.
Third Parties experience negative or positive externalities from a market activity.

32. Summary When a negative externality exists:
Government can restore the social optimum by discouraging economic activity that harms third parties.
When a positive externality exists:
Government can restore the social optimum by increasing economic activity that benefits third parties.
An externality is internalized when decision-makers take into account the external effects of their actions.

33. Summary Private property Under a system of common property:
Ensures that owners have an incentive to maintain, protect, and conserve their property, and also to trade it to others.
Under a system of common property:
The incentive structure causes destruction, neglect, and overuse.
Tragedy of the commons may occur.
The Coase theorem
If there are no barriers to negotiations, and property rights are fully specified, interested parties will bargain privately to correct externalities.

34. Summary A public good has two characteristics:
It is non-excludable and non-rival in consumption.
It creates the free-rider problem and results in the underproduction of the good in the market.
The line between each of the four types of goods (private, club, common resource, and public) is often hard to distinguish.
Economists use cost-benefit analysis to determine whether the benefits of providing one type of good outweighs the costs.

35. Practice What You Know
Which of the following activities would most likely create a negative externality?
eating a slice of pizza
smoking a cigarette
taking a nap
getting a college degree
Clicker Question
Correct answer: B
Secondhand smoke is a classic example of a negative externality. Third parties who are not smoking experience a cost.

36. Practice What You Know
Which of the following activities is most likely to create a positive externality?
eating a slice of pizza
smoking a cigarette
taking a nap
getting a college degree
Clicker Question
Correct answer: D
If you are more educated, other people around may be likely to experience external benefits. You may be more productive, less likely to be unemployed, and may be more politically involved.

37. Practice What You Know
Membership at your local fitness facility is what type of good?
private good
club good
common resource good
public good
Clicker Question
Correct answer: B
It’s excludable (you have to pay to be a member), but non-rival. Just because one person is a member doesn’t mean you can’t join as well.

38. Practice What You Know
Suppose good X creates a negative externality. Which of the following would NOT be an appropriate way to correct the negative externality?
subsidize the production of good X
tax the production of good X
limit how much of good X can be produced
require the producers of good X to pay for external costs that arise
Clicker Question
Correct answer: A
Subsidizing would result in MORE of good X being produced. We want less of the good to be made since it creates the negative externality.

39. Practice What You Know
Which of the following is an example of a public good?
a free outdoor Christmas light display
a college football game
a parking spot with a parking meter
a college education
Clicker Question
Correct answer: A
For (A) to be correct, note that the word “free” is explicitly included. Imagine a display, outdoors, that anyone can freely see and enjoy.
The parking spot is not free, and is rivalrous. College education is not free (at least in the U.S.)