C H APTER
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14
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Externalities, Public Goods,
Imperfect Information,
and Social Choice
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Prepared by: Fernando Q uijano
and Yvonn Q uijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
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Karl Case, Ray Fair
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Market Failure
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• Market failure occurs
when resources are
misallocated or allocated
inefficiently.
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Externalities and
Environmental Economics
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
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Marginal Social Cost
and Marginal-Cost Pricing
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• Marginal social cost (MSC) is the
total cost to society of producing an
additional unit of a good or service.
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
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Marginal Social Cost
and Marginal-Cost Pricing
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• With an externality,
marginal social cost
(MSC) exceeds the
price paid by
consumers (P*).
Output is too high.
Market price takes
into account only part
of the full cost of
producing the good.
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Karl Case, Ray Fair
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Private Choices and External Effects
© 2004 Prentice Hall Business Publishing
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• Marginal private
cost (MPC) is the
amount that a
consumer pays to
consume an
additional unit of a
particular good.
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Private Choices and External Effects
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
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Private Choices and External Effects
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• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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Private Choices and External Effects
© 2004 Prentice Hall Business Publishing
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• Marginal damage
cost (MDC) is the
additional harm
done by increasing
the level of an
externalityproducing activity
by one unit.
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Private Choices and External Effects
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• Marginal social
cost (MSC) is the
total cost to society
of playing an
additional hour of
music.
Principles of Economics, 7/e
Karl Case, Ray Fair
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Internalizing Externalities
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•
Five approaches have been taken to
solving the problem of externalities:
1.
government-imposed taxes and subsidies,
2.
private bargaining and negotiation,
3.
legal rules and procedures,
4.
sale or auctioning of rights to impose
externalities, and
5.
direct government regulation.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Taxes and Subsidies
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• 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.
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Karl Case, Ray Fair
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C H A P T E R 14: Externalities,Public G oods,
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Bargaining and Negotiation
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• Government need not be involved in
every case of externality.
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Bargaining and Negotiation
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• Three conditions must be satisfied for
Coase’s solution to work:
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• Basic rights at issue must be assigned and
clearly understood.
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• There are no impediments to bargaining.
• Only a few people can be involved.
• Bargaining will bring the contending parties
to the right solution regardless of where
rights are initially assigned.
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Karl Case, Ray Fair
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Legal Rules and Procedures
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• An injunction is a court order
forbidding the continuation of
behavior that leads to damages.
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• Liability rules are laws that require
A to compensate B for damages
imposed.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Selling or Auctioning Pollution Rights
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• The right to dump in a river or pollute
the air or the ocean is a resource.
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• Under the Clean Air Act of 1990,
plants are issued tradable pollution
rights. These rights can be sold at
auction to those plants whose costs
of compliance are highest.
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Karl Case, Ray Fair
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Direct Regulation of Externalities
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Direct Regulation of Externalities
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• Direct regulation includes
legislation that regulates
activities that, for example, are
likely to harm the environment.
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C H A P T E R 14: Externalities,Public G oods,
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Public (Social) Goods
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• Public goods (social or collective
goods) are goods that are nonrival
in consumption and/or their benefits
are nonexcludable.
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• Public goods have characteristics
that make it difficult for the private
sector to produce them profitably
(market failure).
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
The Characteristics of Public Goods
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• A good is nonrival in
consumption when A’s
consumption of it does not
interfere with B’s consumption
of it. The benefits of the good
are collective—they accrue to
everyone.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
The Characteristics of Public Goods
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• A good is nonexcludable if,
once produced, no one can be
excluded from enjoying its
benefits. The good cannot be
withheld from those that don’t
pay for it.
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C H A P T E R 14: Externalities,Public G oods,
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The Characteristics of Public Goods
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
The Characteristics of Public Goods
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
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The Characteristics of Public Goods
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• Consumers acting in their own selfinterest have no incentive to
contribute voluntarily to the
production of public goods.
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• Most people do not find room in their
budgets for many voluntary
payments. The economic incentive
is missing.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Public Provision of Public Goods
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• Public provision does not imply
public production of public goods.
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• Problems of public provision include
frequent dissatisfaction. Individuals
don’t get to choose the quantity they
want to buy—it is a collective
purchase. We are all dissatisfied!
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Optimal Provision of Public Goods
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• With private goods, consumers decide
what quantity to buy; market demand is the
sum of those quantities at each price.
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C H A P T E R 14: Externalities,Public G oods,
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Optimal Provision of Public Goods
© 2004 Prentice Hall Business Publishing
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
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Optimal Production of a Public Good
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• The optimal level of
provision for public
goods 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Local Provision of Public Goods
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
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Imperfect Information
and Adverse Selection
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• Most voluntary exchanges are
efficient, but in the presence of
imperfect information, not all
exchanges are efficient.
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• Adverse selection can occur when
a buyer or seller enters into an
exchange with another party who
has more information.
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C H A P T E R 14: Externalities,Public G oods,
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Moral Hazard
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
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Moral Hazard
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Market Solutions
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• As with any other good, there is an
efficient quantity of information
production.
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• Like consumers, profit-maximizing
firms will gather information as long
as the marginal benefits from
continued search are greater than
the marginal costs.
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C H A P T E R 14: Externalities,Public G oods,
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Government Solutions
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• Information is nonrival in consumption.
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• When information is very costly for
individuals to collect and disperse, it
may be cheaper for government to
produce it once for everybody.
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C H A P T E R 14: Externalities,Public G oods,
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Social Choice
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
The Impossibility Theorem
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• 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.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
The Impossibility Theorem
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Preferences of Three Top University Officials
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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
Hire more faculty
No change
Ranking
OPTION C
Reduce the size of the faculty
VP2
VP1
1
X
X
X
2
X
X
X
3
X
X
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X
Dean
• If A beats B, and B beats C, how can C
beat A? The results are inconsistent.
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Principles of Economics, 7/e
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C H A P T E R 14: Externalities,Public G oods,
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The Voting Paradox
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• 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.
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Results of Voting on University’s Plans: The Voting Paradox
VOTES OF:
Vote
VP1
VP2
Dean
Result a
A versus B
A
B
A
B versus C
B
B
C
B wins: B > C
C versus A
A
C
C
C wins: C > A
aA
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A wins: A > B
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> B is read “A is preferred to B.”
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
The Voting Paradox
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• Logrolling occurs when
congressional representatives
trade votes, agreeing to help
each other get certain pieces
of legislation passed.
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C H A P T E R 14: Externalities,Public G oods,
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Government Inefficiency:
Theory of Public Choice
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• Government officials are assumed to
maximize their own utility, not the
social good.
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• To understand the way government
functions, we need to look less at the
preferences of individual members of
society and more at the incentive
structures that exist around public
officials.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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Im perfectInform ation,and SocialChoice
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Government Inefficiency:
Theory of Public Choice
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• Like voters, public officials suffer
from a lack of incentive to become
fully informed and to make tough
choices.
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• This is the viewpoint of what is called
the public choice field in economics
that builds heavily on the work of
Nobel Laureate James Buchanan.
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C H A P T E R 14: Externalities,Public G oods,
Im perfectInform ation,and SocialChoice
Rent Seeking Revisited
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• There are reasons to believe that
government attempts to produce the
right goods and services in the right
quantities efficiently may fail.
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• The existence of an “optimal” level of
public-goods production does not
guarantee that governments will
achieve it.
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C H A P T E R 14: Externalities,Public G oods,
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Government and the Market
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•
Governments can fail to produce an
efficient allocation of resources for a
number of reasons:
1.
Measurement of social damages and benefits
is difficult and imprecise.
2.
There is no precise mechanism for determining
citizens’ preferences for public goods.
3.
Government agencies are not subject to the
discipline of the market.
4.
It is naïve to expect elected and appointed
officials to act selflessly for the good of society.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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Review Terms and Concepts
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adverse selection
logrolling
nonrival in consumption
Coase theorem
marginal damage
cost (MDC
(MDC))
optimal level of provision
for public goods
marginal private cost
(MPC)
MPC)
public goods (social or
collective goods)
marginal social cost
(MSC)
MSC)
social choice
market failure
voting paradox
dropdrop-inin-thethe-bucket
problem
externality
freefree-rider problem
impossibility theorem
injunction
liability rules
© 2004 Prentice Hall Business Publishing
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Tiebout hypothesis
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moral hazard
nonexcludable
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