Chapter 15
Externalities, Public
Goods, Imperfect
Information, and Social
Choice
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Externalities
• 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.
• Inefficient decisions result when decision makers fail
to consider social costs and benefits.
• E.g.- air, water, land pollution- e.g. of cost
• Externalities are part of study of environmental
economics
• As societies become more urbanized, study of
externalities become more important
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Externalities
• When external costs are not considered in
economic decisions, we may engage in activities
or produce products are not “worth it.”
• When external benefits are not considered, we
may fail to do things that are indeed “worth it.”
• The result in either of the case above is an
inefficient allocation of resources.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Marginal Social Cost and
Marginal-Cost Pricing
• Marginal social cost (MSC) is the total cost to
society of producing an additional unit of a good
or service.
MSC =
Marginal costs of producing the product
+
Correctly measured damage costs involved in the
process of production.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Marginal Social Cost and
Marginal-Cost Pricing
• At q*, marginal social cost exceeds the price paid by consumers.
Market price takes into account only part of the full cost of
producing the good.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Private Choices and External Effects
• Harry likes loud
music, Jake
likes silence.
• Marginal private
cost (MPC) is
the amount that
a consumer
pays to
consume an
additional unit
of a particular
good.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Private Choices and External Effects
• 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Private Choices and External Effects
• Harry would play
the stereo until
MB = MPC, or 8
hours.
• However, this
result would be
socially inefficient
because Harry
does not consider
the cost imposed
on Jake.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Private Choices and External Effects
• Marginal damage
cost (MDC) is the
additional harm
done by increasing
the level of an
externalityproducing activity
by one unit.
• Here, It is
measured in terms
of how much Jake
will be willing to
pay every hour to
avoid music.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Private Choices and External Effects
• Marginal social
cost (MSC) is the
total cost to
society of playing
an additional
hour of music.
• Playing the stereo beyond more than 5 hours is inefficient
for the society because the MSC borne by the society
exceeds the Marginal Benefit of Harry, i.e., MSC>Harry’s
MB
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Internalizing Externalities: Weighing decision
makers external costs and benefits of their decision
• In certain cases, externalities are internalized through bargaining
and negotiation without government involvement
• In others, government involvement becomes a must
5 approaches to solving the problem of externality include:
1.Government imposed Taxes and subsidies
2. Private bargaining and negotiation
3. Legal rules and procedures
4. Sale or auctioning of rights to impose externality
5. Direct government regulation
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
1.Taxes and subsidies
• A tax per unit exactly equal to Marginal Damage Cost
is imposed on the firm. The firm will weigh the tax,
and thus the damage costs, in its decisions.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Other implications of Taxes
• Measuring damages: the biggest problem
• Taxing externality producing activity may not
eliminate damages
• Reducing damages to an efficient level-taxes also
gives incentives to firms to use the most efficient
technology
• Incentive to take care and avoid harm-solution can be
to stop the externality generating activity
• Subsidizing external benefits- just as ignoring social
costs leads to inefficient decisions, so too can
ignoring benefits!!!!!
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
2. Bargaining and negotiation
• 1960, Ronald Coase argued that private bargains and
negotiations are likely to lead to an efficient solution in
many social damage cases, without any government
involvement- Coase Theorem
• 3 conditions must be satisfied for Coase’s solution to
work:
• Basic rights at issue must be assigned and clearly understood.
• There are no impediments to bargaining.
• Only a few people can be involved.; one partly should not be very
large
• Bargaining will bring the contending parties to the right
solution regardless of where rights are initially assigned
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
3. Legal Rules and Procedures
• When rights are established by law, some
mechanism to protect that right is also inbuilt in
that law
• Injunction is a court order forbidding the
continuation of behavior that leads to damages
• Liability rules : Laws that require A to compensate
B for damages imposed
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
4. Selling or auctioning pollution rights
• Not all externality generating activities should be
banned
• Hence selling or auctioning of these rights have
emerged
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
5. Direct Regulation of Externalities
• Many externalities are too important to be
regulated indirectly
• Direct regulation of externalities takes place at the
central, state and local level through the enactment
of various acts
• Government imposes criminal penalties and
sanctions for violating such acts
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Public / Social Goods
• Public goods (social or collective goods) are
goods that are nonrival in consumption and
their benefits are nonexcludable.
• Public goods have characteristics that make it
difficult for the private sector to produce them
profitably , i.e.,
in an unregulated market with no government
to see that they are produced, public goods
would at best be produced in insufficient
quantity and at worst not produced at all!!!!!
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Characteristics of Public Goods
• 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.
• 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.
• Goods are either public or private by virtue of their
characteristic and not by virtue that the are
produced by public sector
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Public goods……..
• The real problem with public goods is that
private producers may simply not have any
incentive to produce them or to produce the right
amount
• For a private profit making firm to produce a
good and make a profit, it must be able to
withhold that good from those who do not pay for
it.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Characteristics of Public Goods
• 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 with
public goods, i.e., people get a free ride.
e.g.- paying for police protection
• 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.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Characteristics of Public Goods
• Consumers acting in their own self-interest
have no incentive to contribute voluntarily to
the production of public goods.
• Most people do not find room in their budgets
for many voluntary payments. The economic
incentive is missing.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair