Externalities, Public Goods, Imperfect Information, and Social Choice
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.
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 is an inefficient allocation of resources.
Marginal Social Cost andMarginal-Cost Pricing Marginal social cost (MSC) is the total cost to society of producing an additional unit of a good or service. 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.
The Coase Theorem Government need not be involved in every case of externality. 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.
The Coase Theorem Three 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. Bargaining will bring the contending parties to the right solution regardless of where rights are initially assigned.
Indirect and Direct Regulations 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. Direct regulation includes legislation that regulates activities that, for example, are likely to harm the environment.
Public Goods Public goods (social or collective goods) are goods that are nonrival in consumption and/or their benefits are nonexcludable. Public goods have characteristics that make it difficult for the private sector to produce them profitably (market failure).
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.
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.
The Characteristics of Public Goods 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.
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.
Public Provision of Public Goods Public provision does not imply public production of public goods. 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!
Local Provision of Public Goods 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.
Imperfect Information andAdverse Selection Most voluntary exchanges are efficient, but in the presence of imperfect information, not all exchanges are efficient. Adverse selection can occur when a buyer or seller enters into an exchange with another party who has more information.
Moral Hazard 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. 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.
Market Solutions As with any other good, there is an efficient quantity of information production. Like consumers, profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs.
Government Solutions Information is nonrival in consumption. When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody.
Social Choice 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.
The Impossibility Theorem 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.
Rent-Seeking Revisited There are reasons to believe that government attempts to produce the right goods and services in the right quantities efficiently may fail. The existence of an “optimal” level of public-goods production does not guarantee that governments will achieve it.