NH

1. Microeconomics
Module 11: Public Goods and Externalities

2. Why It Matters: Public Goods and Externalities
• Decisions made by firms and individuals in
markets often have a spillover on other people
whether good or bad
• Goods can be public or private
• A good is not private because it was provided by a
private business and vice versa
• Private/public is a description of how the goods are
consumed

3. Externalities
• When a market doesn’t operate efficiently it is called market failure
• The effect of a market exchange on a third party who is outside or ”external” to the
exchange is called an externality
• Example: an outdoor country music concert happens a half-mile away from your home and you can
hear the music from your backyard
• Because externalities that occur in market transactions affect other parties beyond those
involved, are sometimes called spillovers
• Externalities can be negative or positive
• If you hate country music then the listening to it would be a negative externality and vice
versa if you love country music it would be a positive externality

4. Positive Externalities in Public Health Programs
• The standard of living in the last several centuries has changed because
people are living longer
• The rise in life expectancy seems to stem from three primary factors:
1. Systems for providing clean water and disposing for human waste helped
to prevent the transmission of many diseases
2. Changes in public behavior (washing hands, precautions with tobacco and
smoking)
3. Medicine advancements (immunizations, penicillin, antibiotics)
• These advances in public health have all been closely linked to positive
externalities and public goods

5. The Definition of a Public Good
• Public goods have two defining characteristics:
1. Nonexcludable, meaning that it is costly or impossible to exclude someone from using the
good
• If Larry buys a private good like a slice of pizza, he excludes others, Like Lorna, from eating pizza
2. Nonrivalrous, meaning that when one person uses the public good, another can also use it
• National defense is a public good that does not rival any other consumers
• A number of government services are examples of public goods
• Positive externalities and public goods are closely related concepts
• Police protection or public health funding have positive externalities
• Not all goods and services with positive externalities are public goods, however

6. Common Resources and the “Tragedy of the
Commons”
• Goods that are nonexcludable and rivalrous are called common resources
• For example, in the Caribbean the queen conch is a common resource, they easily found in the
wild and therefore tend to be overharvested
• Ecologist Garret Hardin called it the “Tragedy of the Commons” when he addressed the
overharvesting common resources in a 1968 article in the magazine Science
• To address the issue of overharvesting conch, economists typically advocate simple devices
like fishing licenses, harvest limits, and shorter fishing seasons
• The United States banned harvesting conch in1986

7. Free Riders
• When individuals make decisions about buying a public good, a free rider problem
can arise
• Free rider: people who have an incentive to let others pay for the public good and
then to “free ride” on the purchases of others
Table 1. Contributing to a Public Good as a Prisoner’s Dilemma
– Samuel (S) Contribute Samuel (S) Do Not Contribute
Rachel (R) Contribute
R pays $4, receives $6, net
gain +$2
S pays $4, receives $6, net
gain +$2
R pays $4, receives $3, net
gain –$1
S pays $0, receives $3, net
gain +$3
Rachel (R) Do Not Contribute
R pays $0, receives $3, net
gain +$3
S pays $4, receives $3, net
gain –$1
R pays $0, receives $0
S pays $0, receives $0

8. The Role of Government in Paying for Public Goods
• The key insight in paying for public goods is to find a way of assuring that
everyone will make a contribution and to prevent free riders
• Government spending and taxes are not the only way to provide public
goods
• Some public goods will also have a mixture of public provision at no
charge along with fees for some purposes
• Examples: radio, city parks

9. Marginal Private Benefits
• Individual demand reflects the marginal
benefits a consumer receives from some
product
• When we sum all individual demands, we
get the market demand
• Market demand captures the marginal
private benefits (MPB) of the product,
since it measures the benefits received by
the consumers who purchase the product

10. Positive Externalities and Private Benefits
• Market competition can provide an incentive for discovering new technology
• Gregory Lee, CEO of Samsung said, “Relentless pursuit of new innovation is the key
principle of our business and enables consumers to discover a world of possibilities
with technology.”
• An innovative firm knows that it will usually have a temporary edge over its
competitors and thus an ability to earn above-normal profits before competitors can
catch up
• In some cases, competition can discourage new technology
• Such inventors such as Eli Whitney, Thomas Edison, and Gordon Gould found that
their inventions less profitable then they expected

11. The Positive Externalities of New Technology
• When a firm invests in new
technology, the private benefits, or
profits, that the firm receives are only
a portion of the overall social benefits
• The social benefits of an innovation
take into account the value of all the
positive externalities of the new idea
or product
• Positive externalities are beneficial
spillovers to a third party, or parties

12. Why Invest in Human Capital?
• An investment in anything usually requires a certain upfront cost with an uncertain
future benefit
• Using education as an example, once the numbers are crunched, does the
investment pay off for the student?
• Almost universally, economists say that the answer is a clear “Yes”
Table 2. Usual Weekly Earnings of Wage and Salary Workers, Fourth Quarter 2016
– Less than a High School Degree High School Degree, No College Bachelor’s Degree
Median Weekly Earnings (full-time
workers over the age of 25) $519 $698 $1,270

13. Negative Externalities: Pollution
• A negative externality exists when the cost to society of a economic agent’s
action is greater than the cost to the agent
• The problem of pollution arises for every economy in the world
• Every country needs to strike some balance between production and
environmental quality
• Traditionally, policies for environmental protection have focused on
governmental limits on how much of each pollutant can be emitted
• Economists have suggested a range of more flexible, market-oriented
policies that reduce pollution at a lower cost

14. The Economics of Pollution
• Over the past 50 years population in the U.S. has increased by one-third
and the U.S. economy has doubled.
• Despite the gradual reduction in emissions from fossil fuels, many
important environmental issues remain
• There are still high levels of air and water pollution
• Other issues include:
• Hazardous waste disposal
• Destruction of wetlands and other wildlife habitat
• Impact on human health from pollution

15. Pollution as a Negative Externality
• Pollution is a negative externality
• The social costs include the
private costs of the production
incurred by the company and the
external costs of pollution that
are passed on to society
• In a market with no antipollution
restrictions, firms can dispose of
certain wastes absolutely free

16. Regulating Pollution
• In the 60s and 70s the U.S. began passing laws comprehensive environmental laws
specifying how much pollution could be emitted out of a smokestack or a drainpipe
• This law also imposed penalties if that limit was exceeded
• Some laws required the installation of certain equipment
• These laws fall under the category of effluent standards
• Effluent standards require that firms increase their costs by installing anti-pollution equipment
• Firms are thus required to take the social costs of pollution into account

17. Command-and-Control Regulation
• Command-and-control regulations have been highly successful in protecting and cleaning
up the U.S. environment
• Some examples of command-and-control regulation is the creation of the Environmental
Protection Agency (EPA) and the Clean Air Act
• Three difficulties with command-and-control environmental regulation:
1. Once the regulation is satisfied, polluters have zero incentive to do better
2. It is inflexible
• For some firms it is easy to meet the pollution standard or reduce it, and others find it very difficult
3. The regulations are written by legislators and the EPA, so they are subject to compromises in the
political process

18. Benefits and Costs of Clean Air and Water
• The benefits of a cleaner environment can be
divided into four areas:
1. People may stay healthier and live longer
2. Certain industries that rely on clean air and water
(farming, fishing, tourism) may benefit
3. Property values may be higher
4. People may simply enjoy a cleaner environment
• It’s difficult to put a monetary value for a clean
environment
• The value of clean air for someone with asthma is worth
more than someone who doesn’t have asthma

19. Ecotourism: Making Environmentalism Pay
• Ecotourism can mean several different things
• Ecotourism needs careful management
• The combination of eager tourists and local entrepreneurs can destroy what visitors
come to see
• Even though there are many negative opinions about ecotourism, sometimes it’s
better than low-income people in poor countries damaging their local environment in
order to survive

20. Marginal Benefits and Marginal Costs
• When the quantity of environmental
protection is so low that pollution is
extensive, there are usually a lot of
relatively cheap ways to reduce
pollution
• The marginal benefits from these ways
are quite high
• As environmental protection
increases, the cheap, easy ways to
reduce pollution decrease

21. Intellectual Property Rights
• There are a number of government policies that increase incentive to innovate:
• Guaranteeing intellectual property rights
• Government assistance with costs of R&D
• Cooperative research ventures between universities and companies
• Intellectual property rights include patents which give the inventor the exclusive legal
right to make, use, or sell the invention for a limited time

22. Problems with Patents
• Patents are not perfect, for example:
• Countries that already have patents have shown in economic studies that inventors only
receive a small portion of the profits of their inventions
• Patents on technology become irrelevant due to technology advancing so quickly
• Not every new idea can be protected with a patent or a copyright
• Patents occasionally cover too much or be granted too easily
• The 21 year time period for a patent is somewhat arbitrary

23. Patents Filed and Granted, 1981-2012

24. Effluent Changes
• An effluent (or pollution) charge is a tax
imposed on the quantity of pollution that a
firm emits
• Under an effluent charge system, firms are
allowed to pollute, as long as they pay the
charge for every unit of pollution
• A pollution charge gives a profit-maximizing
firm an incentive to figure out ways to
reduce its emissions
• A pollution charge gives a profit-maximizing
firm an incentive to figure out ways to reduce its
emissions

25. Marketable Permits
– Firm Alpha Firm Beta Firm Gamma Firm Delta
Current emissions—
permits distributed free
for this amount
200 tons 400 tons 600 tons 0 tons
How much pollution will
these permits allow in
one year?
100 tons 200 tons 300 tons 0 tons
Actual emissions one
year in the future
150 tons 200 tons 200 tons 50 tons
Buyer or seller of
marketable permit?
Buys
permits for
50 tons
Doesn’t buy or
sell permits
Sells permits for
100 tons
Buys permits for
50 tons
Table 1. How Marketable Permits Work

26. Quick Review
• What are externalities and market failure?
• How do markets not always allocate goods efficiently, due to externalities?
• What are some characteristics of public goods?
• What are some common resources and the tragedy of the commons?
• What is the free rider problem?
• What are positive externalities, including new technology?
• How are private and social benefits different?
• How do they cause market failure?
• What are negative externalities and examples of negative externalities?
• How do the differences between private costs and social costs cause market failure?

27. More Quick Review
• What is command-and-control regulation?
• What are the benefits and costs of environmental protection?
• How do you apply marginal analysis to illustrate the marginal costs and marginal
benefits of reducing pollution?
• What are some ways that some U.S. government policies encourage innovation?
• How can pollution charges or marketable permits impact firm decisions?
• What is the significance of marketable permits and property rights?
• Which government and market policies are most appropriate for various situations?