A Brief Discussion of Public Goods and Externalities: Selected Topics
from Chapter 15
Public Goods
We’ve seen that public goods work differently than private goods in the market – public
goods have nonrivalry in consumption and nonexcludability.1 These differences lead to
the free-rider problem, something often studied in economics.
The free rider problem pops up when someone can consume a good even if they didn’t
pay for it. Classic examples include national defense, roads, police protection, etc. Take
roads for example. I can drive on them regardless of if I helped pay for their construction
or not. No one can force me over to the side of the road, ask to see proof I paid for the use
of F Street, and punish me if I didn’t.
The free rider problem means that private companies have big problems in producing
public goods. What company would want to get into the business of building roads if they
knew it would be hard to charge people to use them? Instead, public goods are often
produced by the government, and funded through things like taxation.2 How much of the
good to produce is often decided by doing cost-benefit analysis.3
Externalities
Externalities pop up whenever the benefit or cost of consuming a good affects people that
aren’t actually consuming it. They come in two forms: positive and negative externalities.
1. Positive – example = education: You’re all in college because you want to get an
education, probably so you can get good jobs, live happy lives, etc. But you
getting an education doesn’t just benefit you, it benefits society as well. Some of
you may go on to invent handy products, or come up with important ideas, which
everyone else will gain from. So even people that aren’t paying for your education
will get some positive benefit from it.
2. Negative – example = pollution: Pollution is the classic negative externality. If I
own a coal mining company, my excavation of coal has costs that I have to pay.
But it also results in costs for everyone else, despite the fact that they aren’t
producing coal. The rest of society has to deal with the added pollution resulting
from my production.
1
Recall that nonrivalry in consumption implies that one person consuming the good doesn’t prevent
another person from consuming the good, while nonexcludability implies people can’t be excluded from
consumption of the good.
2
As you textbook says, it is important to note that just because the gov’t produces something doesn’t
necessarily mean it is a public good.
3
In my past life as a private sector worker, this is a lot of what I did for a living. For example, one project I
worked on was endangered species preservation. My company was asked to figure out how much money it
would cost to protect the species, and then figure out some sort of financial measure of the gain society
would have from keeping that species around.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005
Negative externalities are always
oversupplied in the market. In other words,
there is more production of goods that have
negative externalities than is considered
socially efficient. This happens because the
marginal private cost of production is less
than the marginal social cost of production.
P
MSC
MPC
A
Here, MPC stands for marginal private cost,
MSP is marginal social cost, and MB is
marginal benefit. The superscript E on the
quantity indicates the socially efficient
level of production of the good with the
negative externality.
MB
QE
Q
Q
To bring this back to our example, consider the mining company again. If I’m the CEO,
and I’m trying to decide how much coal to mine, I’m going to compare my marginal
benefit to my marginal private cost of production, and produce until those two are equal,
which is point Q on the graph. But I’m not considering the additional costs to society. If I
were, I would equate marginal social cost to marginal benefit, and only produce QE. The
triangle marked A is the deadweight social loss that results form the externality.
Positive externalities, on the other hand, are always undersupplied by the market. This is
because the marginal private benefit is lower than the marginal social benefit.
Take our education example. If someone was
trying to decide if they wanted to go on to
college, they would weigh the cost of doing
so again their personal benefit. People will
attend college as long as their marginal
private benefit is greater than or equal to
marginal cost. But if the market were working
efficiently, they would decide to attend as
long as marginal social benefit was at greater
than or equal to marginal cost. This results in
an undersupply of goods with positive
externalities, and the deadweight social loss is
the triangle marked B.
P
MC
B
MSB
MPB
Q
Q
E
Q
Dealing With Externalities
There are a variety of ways to deal with externalities. These include:
1. Assigning property rights – Suppose there is a firm that pollutes a nearby river as
a result of production, and that same river is used for recreational swimming.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005
Then the swimmers suffer the negative externality of production (their recreation
source is now polluted). If we assign “property rights” to one of the parties, this
could help solve the problem. For example, we could give the swimmers the
rights to the river, and make the firms pay the swimmers to allow them to pollute.
Or we could give the property rights to the firm, and have the swimmers pay them
NOT to pollute. The Coase theorem says that regardless of who gets the rights,
the end result will be an efficient outcome.
a. Drawback – There are a variety of costs associated with property right
negotiations, including the time and money required to reach agreements.
2. Command/Control – The government might place a limit on the amount of
pollution firms are allowed to produce in an attempt to solve the market
inefficiency.
a. Drawback – The major complaint is that this method doesn’t allow firms
to find more efficient ways of doing things, but instead requires them to
handle things in a specific way. It’s also tough to monitor some negative
externality levels, such as pounds of sulfur dioxide produced.
3. Taxation/Subsidies – The government can tax things that create negative
externalities, and subsidize those things that create positive externalities. Take our
negative externality example. If the
government taxes coal production, then
P
MC
the marginal private cost of production
will increase (shifting of MPC curve
Subsidy
upward). If they are taxed the correct
amount, the marginal private cost will
equal the marginal social cost, and we’ll
have an efficient market outcome. For
our education example, if the
MSB
government subsidizes students, it raises
their marginal private benefit (shifting
MPB
the MPB curve upward). If the subsidy
amount is correct, then MPB = MSB,
QE
Q
and we have an efficient market outcome,
as shown in the graph.
a. Drawback – The actual amount of the externality produced isn’t
necessarily controllable under taxation and subsidization. If the
government is aiming for a specific limit of air pollution, they’re better off
using a command/control method.
4. Permits – Firms can buy and sell permits from each other for the right to pollute.
This creates incentive to find efficient ways of production so you can sell
unneeded permits.
a. Drawback – Many of the costs associated with assigning property rights
exist here as well, since permits are very similar to property right
assignment.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005