L06
Chapter 5 – Externalities and Public Goods
The Club
Anti Theft Device
 Assume you car is parked and has the
club in place.

◦ Does this have an effect on the chance that
other cars are stolen? Why?
Externalities

Def: A benefit or cost that affects someone
who is not directly involved in the production
or consumption of a good.
 Example:
◦ Sweaty gym clothes
◦ Positive Externality
 Purchase of Subway Sandwich
 Only two parties benefit, you and Subway  No
Externality
 Purchase of college education
 You AND society benefits
 Less Crime, better health, more informed voters
etc…
Positive Externalities

Def: Benefits to third parties other than
buyers or sellers not reflected in prices

Examples: Identify the primary parties and the third
parties



Fire prevention mechanisms for your apartment
Nice Landscaping
Education
Externalities
◦ Negative Externality
 Producers of electricity
 Pay to get the coal, build the plant, pay the
workers etc
 Is that the only cost of electricity consumption
and production?
 What other costs are there?
 ____________________________________
____________________________________
 Example: Coal Ash spill in Tennessee
 December 27, 2008 – 5.4 million cubic yards
 Thought question: Is the optimal level of pollution
zero?
Negative Externality

Def: costs to third parties other than the
buyers and sellers of an item not reflected
in the market price
◦ Examples – Identify the primary parties and
the third parties





Construction on an empty lot next to your house
Commercial aircraft flying over a neighborhood
Driving
Smoking
Others?
Effects of Externalities

Previous Lecture  Markets maximize surplus
◦ Only true in a market without externalities
◦ With externalities, Surplus is reduced
◦ Externalities are a source of Deadweight loss

Private Cost: The cost borne by the producer of the
good or service
◦ Trucks, workers, coal

Social Cost = Private cost + any external costs
◦ Trucks, workers, coal + Asthma, pollution etc..

Private benefit: The benefit received by the consumer
of a good
◦ Higher wage

Social benefit = Private Benefit + any external benefit
◦ Higher wage + lower crime for all of society
Externalities and Inefficiency
•What will happen to this graph
once we take into account the
extra costs borne by society?
•_______________________
________________________
•When we take into account all
MC and all MB, then we are at
the efficient equilibrium
•Q2 is efficient because at that point
MB = MC for society as a whole.
•Q1 is inefficient, Why?
•______________________
_______________________
_______________________
•In other words, society could
save resources by reducing
output.
•Producing at Q1 causes deadweight
loss because marginal costs are
greater than the marginal benefits.
Key Point: In a market with a negative externality,
too much will be produced at the market
equilibrium
Market
Equilibrium
Externalities and Inefficiency
•What happens in this graph when we
taken into account the extra benefits
society gets from people getting
educated?
•___________________________
____________________________
__________________________
•When we take into account all MC
and MB, then we are at the efficient
equilibrium
•Q2 is efficient because at that point
MB = MC for society as a whole.
•Q1 is inefficient, Why?
•________________________
________________________
___________.
•In other words, society could be
better off by producing more
education.
•Producing at Q1 causes deadweight
loss because marginal benefits are
greater than marginal cost.
•Key Point: When there is a positive
externality, the market equilibrium is
below the efficient equilibrium
•The market produces too little of
the good
Cause of Externalities

Lack of Property rights
◦ Def: The rights individuals or businesses have to the
exclusive use of their property including the right to
sell it.
Car vs Air
 Externalities result from incomplete property
rights
 Musical Example of Property Rights


And the sign said anybody caught trespassing would be shot on sight
So I jumped on the fence and yelled at the house, Hey! what gives you the right
To put up a fence to keep me out or to keep mother nature in
If God was here, he'd tell you to your face, man you're some kinda sinner
How to get regain the surplus that
was lost due to externalities

Two general methods
1. Solutions that do not involve the
government

Private solutions
2. Solutions that do involve the government
Private Solutions to Externalities

The Coase Theorem If negotiations are
possible, then bargaining will result in the
efficient solution to the problem of
externalities.
◦ No outside party, like the government is
required to make the decision.
 Laws are required, but the government’s decision is
not.

Example
Example of Private Solutions to
Property Rights
You like to BBQ, your
neighbor hates BBQ
smoke
 You are good friends
 What can you do to solve
this problem?
 What if you have the legal
right to BBQ?
 What if your neighbor has
the legal right to clean air?

Example of Private Solutions to Externality
•Assume negotiations are possible
•BBQers have the right to BBQ.
•BBQs can be compensated (given money) to reduce their level
of BBQing
•Any compensation (money) that the neighbor gives to the
BBQer must be subtracted from the neighbor’s total value.
•Neighbors have the right to smoke free air
•Neighbors can be compensated (given money) for the
smokiness of the air.
•Any compensation (money) that the BBQer gives to the neighbor
must be subtracted from the BBQer’s total value.
Smoke From
BBQ
0
1
2
3
BBQer’s Total
Value
$0
$30
$50
$60
Neighbor’s Total
Value
$35
$30
$20
$0
Total Value
$35
$60
$70
$60
How to regain Surplus lost from
Externalities: Government Solutions
•What do we know of
that will move us from
S1 to S2?
•_______
•A tax forces
producers to take into
account the external
costs
•A tax in the case of
externality eliminates
the dead weight lost.
•That is because the
tax helps to equate
society’s MC to
society’s MB
This is where society is best off
S2 Marginal
Social Cost
DWL
This is where the market settles
How to Regain Surplus Lost from
Externalities
This is where society is best off
•What Do we know
of that will move us
from D1 to D2?
•__________
•A subsidy helps us
to take into account
the external benefits
of our actions
•A subsidy in this
case eliminates the
deadweight loss
•That is because the
subsidy helps to
equate society’s MB
to society’s MC
DWL
D2 Marginal
Social
benefit
This is where the market settles
Public Goods

What we are going to do
◦
◦
◦
◦
Definitions
Examples
Graphs
Rivalry – If someone consumes a good, then
no one else can
◦ Excludability – If you don’t pay, you don’t get
the good.
◦ Private Goods: Goods that are rival and
Excludable
 Result in no Externalities
Public Goods

Public Good
◦ you can’t stop people from consuming it
(nonexcludable)
◦ Your consumption doesn’t affect other’s
consumption (nonrivalrous)
Public goods are associated with
externalities because no one has a
property right to a public good.
 Public goods lead to free riding

 Benefiting from a good without paying for it.
Public Goods

Examples of Rivalry
◦ Is Satellite TV rivalrous?
 ___________________
◦ Is it Satellite TV excludable?
 ___________________
◦ Is it a public good then?
 ______________________________________
_______________
Public Goods

Example of Excludability
◦ Is fishing international waters excludable?
 _________________________________
 Think Whale Wars
◦ Is it rivalrous?
 _________________________________
◦ Is it a public good?
 _________________________________
Public Good Examples

National Defense
◦ Rivalrous? Excludable?
◦ ______________________
______________________
____________________

Fireworks show
◦ Rivalrous? Excludable?
◦ ______________________
______________________
_____________________
Market Demand for a Purely Private
good.




Private good – Think Horizontal
Each Individual chooses how much they want at each
price
Demand for a purely Private good is the horizontal
summation of the individual demand curves.
Adding Quantities
Demand for Pure Public Goods





Public Good – Think
Vertical
All consumers must
consume the same
quantity of the good
Demand for public good
is the maximum
individuals are willing to
pay for the amount of the
good that is available
Demand for public good
is the vertical summation.
Adding Prices
Example
Solving the Public
Good problem

Elephants in Central Africa
◦
◦
◦
◦
Lots of Killing despite government efforts
Why?
_______________________
Assign property right to tribes
 Tribes sell permits to hunt elephants
 Have incentive to maintain health of herd
 Elephant Population increased 400% in 10 years