EC 201 Chapter 10: Externalities and Public Goods

Positive Externalities: Thick market externalities

- A "thick market" has many buyers and sellers, reducing search costs - When you search hard for a job, it makes it easier for firms to find workers, leading them to create more jobs - When you shop on Facebook Marketplace, that leads sellers to put things on Facebook Marketplace instead of throwing them away

Nonrival:

- A good for which one person's use doesn't subtract from another's - A good where consumption by one person does not diminish the amount available for someone else

Free-rider problem: Possible solutions

- A simple solution to the underprovision of public goods is for the government to purchase public goods for everyone to use, paid for from tax revenues - develop technologies to control access

Solving externality problems: Private bargaining

- Coase Theorem: If bargaining is costless, then externality problems can be solved by private bargains - Side payments: If someone else's actions harm you, you can pay them to do something else instead - Strategic investments

Solving externality problems: Corrective taxes and subsidies that change the price

- Corrective tax: A tax designed to induce people to take account of the negative externalities they cause - Corrective subsidy: A subsidy designed to induce people to take account of the positive externalities they cause - Negative externalities: Corrective tax equal to the external cost - Positive externalities: Corrective subsidy equal to the external benefit Overall: Corrective taxes and subsidies fix distortions caused by market failures

Implications of Positive Externalities:

- Shifts social demand curve to the right - Markets yield too few positive externalities - Leads to underproduction

Implications of Negative Externalities:

- Shifts social supply curve to the left - Leads to overproduction

Externality:

- The benefit or cost received by someone not directly involved in production or consumption of a good - A side effect of an activity that affects bystanders whose interests aren't taken into account.

Private Marginal Cost:

- The cost to the producer of an additional unit - The extra cost paid by the seller from one extra unit.

Marginal External Benefit:

- The extra external benefit accruing to bystanders from one extra unit - The benefit of an additional unit of good that is imposed on people other than the direct consumer

Negative externalities: Positional externalities - Depend on relative performance

- Your SUV makes it more likely that if we crash, it will be fatal for me - Your decision to take steroids hurts my chance of winning - Arms race: Your weapons investments undermine my military supremacy

Negative externalities: Intergenerational externalities

- Your overfishing leaves none for the next generation - Over-spending by baby-boomers leaves a debt for your generation - Your depletion of ozone leaves a hole for the next generation

Rival good:

A good for which your use of it comes at someone else's expense

Club goods:

A good that is excludable, but nonrival in consumption

Common resources:

A good that is rival and also nonexcludable

Solving externality problems: Cap and Trade

A quantity regulation implemented by allocating a fixed number of permits, which can then be traded. - Change the quantity of the harmful activity directly, through a quantity regulation - a cap and trade system is like a corrective tax

Marginal Social Benefit:

All marginal benefits, no matter who gets them Marginal social benefit = Marginal private benefit + marginal external benefit

Marginal Social Cost:

All marginal costs, no matter who pays them Marginal social cost = Marginal private cost + marginal external cost

Positive externalities:

An activity whose side effects benefit bystanders

Negative externalities:

An activity whose side effects harm bystanders

Solving externality problems: Laws, Rules, and Regulations

Many of our laws exist to help solve problems caused by negative externalities - Noise restrictions - Speed limits - Environmental standards Rules can solve positional externalities: - campaign spending limits - arms treaties Company rules also target externalities

Problem with positive externalities:

Marginal private benefits understate marginal social benefits

Problem with negative externalities:

Marginal private costs understate marginal social costs

Socially optimal outcome occurs at the quantity where:

Marginal social benefit = Marginal social cost

Negative externalities: Common resource problem - The more I take, the less is left for you

Overfishing: Your fishing leaves none for me

Rational Rule for Society:

Produce more of an item if its marginal social benefit is greater than (or equal to) the marginal social cost

3 step recipe to analyze externalities:

Step one: Predict the equilibrium outcome to forecast what you think will happen Step two: Assess what externalities are involved Step three: Find the socially optimal outcome that is in society's best interest, and then compare this to the equilibrium forecast from the first step

Private Marginal Benefit:

The benefit to the consumer from an additional unit

External Marginal Cost:

The extra external cost imposed on bystanders from one extra unit

Solving externality problems: overall

The key is to "internalize the externality": - Make the actions of buyers and sellers reflect everyone who benefits from the good and everyone who is harmed by the good

Socially optimal outcome:

The outcome that is most efficient for society as a whole, including the interests of buyers, sellers, and bystanders

Tragedy of the commons:

The tendency to overconsume a common resource

Challenge with private bargaining

When bargaining is costly, externality problems persist

Free-rider problem:

When someone can enjoy the benefits of a good without bearing the costs - With nonrival goods, free riders enjoy positive externalities without hurting others - When goods or services are rival and it's easy to exclude those who don't pay, there's no free-rider problem

Nonexcludable:

When someone cannot be easily excluded from using something, even if they didn't pay for it

Positive Externalities: Network effects

When you buy an iPhone, you increase the market for iPhone apps, leading more to be developed, benefiting other iPhone owner

Positive Externalities: Fiscal externalities

Your success leads you to pay higher taxes, benefiting

Positive externalities drive a wedge between the ______ curve and marginal ____ benefits

demand; social

A price change is not an ___________

externality

For goods with negative externalities, we want quantity to be _______ For good with positive externalities, we want quantity to be _______

lower; higher

Externalities are important because they lead to ________ _________, producing inefficient outcomes

market failure

Each unit of a good produced with negative externalities has both marginal _______ costs and marginal _______ costs

private; external

Public goods:

public goods are goods that are both nonrival and nonexcludable - subject to the free-rider problem - fireworks are a public good

Negative externalities drive a wedge between the _____ curve and the marginal ______ ______ curve

supply; social cost