Public goods and externalities

 In economics, a public good is a good that is
both non-excludable and non-rivalrous in that
individuals cannot be excluded from use or could
be enjoyed without paying for it, and where use
by one individual does not reduce availability to
others or the goods can be effectively consumed
simultaneously by more than one .
 The government provides various goods and
services such as roads, sidewalks, bridges, parks,
museums and libraries. The government may also
supply water and electricity, public health care,
transport systems, police protection and garbage
collection.

A public good has three characteristics: non-
divisibility, non-rivalry and non-exclusivity.
 Non-divisibility: this means that a good or
service is provided in totality e.g. the defense
which benefits everybody.
 Non-rivalry: this means that its consumption
does not involve competition, i.e. ne person can
increase consumption of the good without
reducing consumption by others e.g. roads.
 Non exclusivity : means that, it is difficult for
the supplier to exclude anyone who does not pay
for the commodity from enjoying.

 Pure public goods
 Congestible public goods
 Club goods

 Pure public goods, such as street lighting and
national defence, are indivisible (that is to
say, they cannot be divided into sealable
units) and therefore non rival in
consumption. For a given level of production
of public good, one person’s consumption
does not reduce the quantity available for
consumption by another person.

 For example the Rwandan Defence Force
protection to the inhabitants of Kigali does not
reduce the amount of protection available to the
inhabitants in Huye and Rubavu Districts or
elsewhere else.
 Non rivalry in consumption has two important
implications. First, the fact that one person’s
consumption does not reduce the quantity
available to other consumers implies that the
marginal cost (that is the cost of admitting an
additional user) is zero. From this follow the
second implication, namely that excluding
anyone from consuming a non rival good is
Pareto inefficient.

 In addition to being non rival in consumption,
pure public goods are also non excludable,
that is it impossible to exclude particular
individuals from consuming such goods. Put
differently, it is not possible to assign
specific property rights to public goods or to
enforce them.

 There are public goods where, after a point,
the enjoyment received by the consumer is
diminished by crowding or congestion. These
are called congestible public goods. For
Examples: roads and parks.

 Club goods is a subtype of public goods that
are excludable but non-rivalrous. These
goods are often provided by a natural
monopoly. An example of a club good is cable
TV. Your use of cable TV does not limit my
ability to also view television shows on cable;
as long as you live in an area where the
necessary cable is present, you can get cable
TV. However, it is excludable in that you
have to pay the monthly fee.

Public goods Private good
Property rights Non excludable Excludable
Consumption Non-rival Rival
Aggregate demand curve Vertical additional of
individual demand curve
Horizontal additional of
individual demand curves
Partial equilibrium
condition for optimum
provision
The sum of marginal
utilities equals marginal
costs
Marginal utility for each
consumer equals
marginal cost
[MUi=MU with i the
individual consumer].
Efficient pricing rule The sum of individual
prices equals marginal
cost
Price equals marginal
cost
[P=MC]

 When thinking about the various goods in
the economy, it is useful to group them
according to two characteristics:
 Is the good excludable?
 Is the good rival?

Four Types of Goods
 Private Goods
 Public Goods
 Common Resources
 Natural Monopolies

 Private Goods : Are both excludable and
rival.
 Public Goods : Are neither excludable nor
rival.
 Common Resources : Are rival but not
excludable.
 Natural Monopolies : Are excludable but not
rival

 A free-rider is a person who receives the
benefit of a good but avoids paying for it.

 Since people cannot be excluded from
enjoying the benefits of a public good,
individuals may withhold paying for the good
hoping that others will pay for it.
 The free-rider problem prevents private
markets from supplying public goods.

 The government can decide to provide the
public good if the total benefits exceed the
costs.
 The government can make everyone better
off by providing the public good and paying
for it with tax revenue.

 National Defense
 Basic Research
 Fighting Poverty

 Cost benefit analysis refers to a study that
compares the costs and benefits to society of
providing a public good.
 In order to decide whether to provide a
public good or not, the total benefits of all
those who use the good must be compared to
the costs of providing and maintaining the
public good.

 A cost-benefit analysis would be used to
estimate the total costs and benefits of the
project to society as a whole.
 It is difficult to do because of the absence of
prices needed to estimate social benefits and
resource costs.
 The value of life, the consumer’s time, and
aesthetics are difficult to assess.

 Common resources, like public goods, are
not excludable. They are available free of
charge to anyone who wishes to use them.
 Common resources are rival goods because
one person’s use of the common resource
reduces other people’s use.

 The Tragedy of the Commons is a parable
that illustrates why common resources get
used more than is desirable from the
standpoint of society as a whole.
 Common resources tend to be used
excessively when individuals are not charged
for their usage. • This is similar to a negative
externality.

 Clean air and water
 Congested roads
 Fish, whales, and other wildlife

 The market fails to allocate resources
efficiently with the legal authority to control
it). when property rights are not well
established (i.e. some item of value does not
have an owner
 When the absence of property rights causes a
market failure, the government can
potentially solve the problem

 Goods differ in whether they are excludable
and whether they are rival.
 A good is excludable if it is possible to
prevent someone from using it.
 A good is rival if one person’s enjoyment of
the good prevents other people from
enjoying the same unit of the good.
 Public goods are neither rival nor excludable.

 Because people are not charged for their use
of public goods, they have an incentive to
free ride when the good is provided
privately.
 Governments provide public goods, making
quantity decisions based upon cost-benefit
analysis.

 Common resources are rival but not
excludable.
 Because people are not charged for their use
of common resources, they tend to use them
excessively.
 Governments tend to try to limit the use of
common resources.

 An externality is the cost or benefit that
affects a party who did not choose to incur
that cost or benefit.
 Externalities are a loss or gain in the welfare
of one party resulting from an activity of
another party, without there being any
compensation for the losing party.
Externalities are an important consideration
in cost-benefit analysis.

 Factors whose benefits (called external
economies) and costs (called external
diseconomies) are not reflected in the
market price of goods and services.
 Externalities are not usually fully reflected in
prices. Externalities are regarded as a form
of market failure.
 An externality is a positive or negative
consequence of an economic activity
experienced by unrelated third parties.

 Pollution emitted by a factory that spoils the
surrounding environment and affects the
health of nearby residents is an example of a
negative externality.
 The effect of a well-educated labor force on
the productivity of a company is an example
of a positive externality.

 Positive externality (also called "external
benefit" or "external economy" or "beneficial
externality") is the positive effect an activity
imposes on an unrelated third party. Such as
Public Goods.
 In other words positive externalities when the
actions of an individual producer or consumer
confer a positive benefit on another party free
of charge.
 For example, increased education of individuals
can lead to broader society benefits in the form
of greater economic productivity, a lower
unemployment rate, greater household mobility
and higher rates of political participation.
Positive externalities refer to the benefits.

 A beekeeper who keeps the bees for their honey.
A side effect or externality associated with such
activity is the pollination of surrounding crops by
the bees. The value generated by the pollination
may be more important than the value of the
harvested honey.
 The construction and operation of an airport.
This will benefit local businesses, because of the
increased accessibility.
 An industrial company providing first aid classes
for employees to increase on the job safety. This
may also save lives outside the factory.
 A foreign firm that demonstrates up-to-date
technologies to local firms and improves their
productivity.

 An individual who maintains an attractive
house may confer benefits to neighbors in
the form of increased market values for their
properties.
 An individual receiving a vaccination for a
communicable disease not only decreases the
likelihood of the individual's own infection,
but also decreases the likelihood of others
becoming infected through contact with the
individual.

 In an area that does not have a public fire
department, homeowners who purchase
private fire protection services provide a
positive externality to neighboring
properties, which are less at risk of the
protected neighbor's fire spreading to their
(unprotected) house.

 A negative externality (also called "external
cost" or "external diseconomy") is an
economic activity that imposes a negative
effect on an unrelated third party. It can
arise either during the production or the
consumption of a good or service.
 Many negative externalities are related to
the environmental consequences of
production and use.

 In other words negative externality is an
action of a product on consumers that
imposes a negative effect on a third party.
For example, Air pollution from burning fossil
fuels causes damages to crops, (historic)
buildings and public health.

 Air pollution from burning fossil fuels. This
activity causes damages to crops, (historic)
buildings and public health.
 Water pollution by industries that adds
effluent, which harms plants, animals, and
humans.
 Noise pollution during the production
process, which may be mentally and
psychologically disruptive.

 Negative effects of Industrial farm animal
production, including "the increase in the
pool of antibiotic-resistant bacteria because
of the overuse of antibiotics; air quality
problems; the contamination of rivers,
streams, and coastal waters with
concentrated animal waste; animal welfare
problems, mainly as a result of the extremely
close quarters in which the animals are
housed.

 Sleep deprivation due to a neighbor listening
to loud music late at night.
 Antibiotic resistance, caused by increased
usage of antibiotics. Individuals do not
consider this efficacy cost when making
usage decisions. Government policies
proposed to preserve future antibiotic
effectiveness include educational campaigns,
regulation and patents.
 Higher congestion costs and increased
accident risks when people use public roads.

 Private costs are those costs paid by the
firm producing the good.
 External costs are borne by someone not
involved in the transaction.
 Social costs include both the private costs
and any other external costs to society
arising from the production or consumption
of a good or service.
Social costs = private costs + external costs

 Private benefits are the benefits to people who
buy and consume a good.
 External benefits are the benefits to a third
party, someone who is not the buyer or the
seller.
 Social benefits is the total benefit to society
from producing or consuming a good and service.
Social benefit includes all the private benefits
plus any external benefits of production and
consumption. If a good has significant external
benefits, then the social benefit will be greater
than the private benefit.
Social benefits = private benefits + external benefits

 Marginal Private Benefit (MPB) is the benefit
which is derived by private individuals in the
consumption of a good or service.
 Marginal external benefits (MEB) : The per
unit change that accrues when the activities
of one group have a favorable effect on
another group.
For example, an economic thinker might be
interested in assessing the marginal external
benefit of having a more educated
population on the level of corporate business
profits.

 Marginal Social Benefit (MSB) The marginal
social benefit, is the total benefit to society,
from one extra unit of a good.
MSB = Marginal private benefit (MPB)
+
Marginal external benefit (MEB)

 Marginal Private Cost (MPC) is the cost of
producing, specifically marginal costs, which
are incurred by private individual while
producing a good or service.
 Marginal external cost (MEC) total incurred
cost change of some households or businesses
due to a unit change in other households’ or
businesses’ consumption or output.

 The 'Principle of Maximum Social Advantage' was
introduced by British economist Hugh Dalton.
 According to Hugh Dalton, "Public Finance" is
concerned with income & expenditure of public
authorities and with the adjustment of one with
the other.
 Taxation causes transfer of purchasing power
from tax payers to the public authorities, while
public expenditure results in transfers back from
the public authorities to some individuals,
therefore financial operations of the government
cause 'Sacrifice or Disutility' on one hand and
'Benefits or Utility' on the other.

 This results in changes in pattern of
production, consumption & distribution of
income and wealth. So it is important to
know whether those changes are socially
advantageous or not.
 If they are socially advantageous, then the
financial operations are justified otherwise
not.
 According to Hugh Dalton, "The best system
of public finance is that which secures the
maximum social advantage from the
operations which it conducts."

 The 'Principle of Maximum Social Advantage
(MSA)' is the fundamental principle of Public
Finance.
 The Principle of Maximum Social Advantage
states that public finance leads to economic
welfare when pubic expenditure & taxation
are carried out up to that point where the
benefits derived from the MU (Marginal
Utility) of expenditure is equal to (=) the
Marginal Disutility or the sacrifice imposed
by taxation.

Hugh Dalton explains the principle of
maximum social advantage with reference
to :-
 Marginal Social Sacrifice
 Marginal Social Benefits

 This principle is however based on the
following assumptions :-
 All taxes result in sacrifice and all public
expenditures lead to benefits.
 Public revenue consist of only taxes and no
other sources of income to the government.
 The government has no surplus or deficit
budget but only balanced budget.
 Public expenditure is subject to diminishing
marginal social benefit and taxes are subject
to increasing marginal social sacrifice.

 Marginal Social Sacrifice (MSS) refers to that
amount of social sacrifice undergone by
public due to the imposition of an additional
unit of tax.
 Every unit of tax imposed by the government
taxes result in loss of utility. Dalton says that
the additional burden (marginal sacrifice)
resulting from additional units of taxation
goes on increasing i.e. the total social
sacrifice increases at an increasing rate.

 This is because, when taxes are imposed, the
stock of money with the community
diminishes.
 As a result of diminishing stock of money, the
marginal utility of money goes on increasing.
Eventually every additional unit of taxation
creates greater amount of impact and
greater amount of sacrifice on the society.
That is why the marginal social sacrifice goes
on increasing.

 The above diagram indicates that the
Marginal Social Sacrifice (MSS) curve rises
upwards from left to right. This indicates
that with each additional unit of taxation,
the level of sacrifice also increases. When
the unit of taxation was OM1, the marginal
social sacrifice was OS1, and with the
increase in taxation at OM2, the marginal
social sacrifice rises to OS2.

 While imposition of tax puts burden on the
people, public expenditure confers benefits.
The benefit conferred on the society, by an
additional unit of public expenditure is
known as Marginal Social Benefit (MSB).
 as the marginal utility from a commodity to a
consumer declines as more and more units of
the commodity are made available to him,
the social benefit from each additional unit
of public expenditure declines as more and
more units of public expenditure are spent.

 In the beginning, the units of public
expenditure are spent on the most essential
social activities. Subsequent doses of public
expenditure are spent on less and less
important social activities. As a result, the
curve of marginal social benefits slopes
downward from left to right as shown in
figure below.

 In the above diagram, the marginal social
benefit (MSB) curve slopes downward from
left to right. This indicates that the social
benefit derived out of public expenditure is
reducing at a diminishing rate. When the
public expenditure was OM1, the marginal
social benefit was OB1, and when the public
expenditure is OM2, the marginal social
benefit is reduced at OB2.

 Social advantage is maximized at the point
where marginal social sacrifice cuts the
marginal social benefits curve.
 This is at the point P. At this point, the
marginal disutility or social sacrifice is equal
to the marginal utility or social benefit.
Beyond this point, the marginal disutility or
social sacrifice will be higher, and the
marginal utility or social benefit will be
lower.

 At point P social advantage is maximum. Now
consider Point P1. At this point marginal social
benefit is P1Q1. This is greater than marginal
social sacrifice S1Q1. Since the marginal social
sacrifice is lower than the marginal social
benefit, it makes more sense to increase the
level of taxation and public expenditure. This is
due to the reason that additional unit of revenue
raised and spent by the government leads to
increase in the net social advantage. This
situation of increasing taxation and public
expenditure continues, as long as the levels of
taxation and expenditure are towards the left of
the point P.

 At point P, the level of taxation and public
expenditure moves up to OQ. At this point,
the marginal utility or social benefit becomes
equal to marginal disutility or social
sacrifice. Therefore at this point, the
maximum social advantage is achieved.

 At point P2, the marginal social sacrifice S2Q2 is
greater than marginal social benefit P2Q2.
Therefore, beyond the point P, any further
increase in the level of taxation and public
expenditure may bring down the social
advantage.
 This is because; each subsequent unit of
additional taxation will increase the marginal
disutility or social sacrifice, which will be more
than marginal utility or social benefit. This
shows that maximum social advantage is
attained only at point P & this is the point where
marginal social benefit of public expenditure is
equal to the marginal social sacrifice of
taxation.

 Maximum Social Advantage is achieved at the
point where the marginal social benefit of
public expenditure and the marginal social
sacrifice of taxation are equated, i.e. where
MSB = MSS.
 This shows that to obtain maximum social
advantage, the public expenditure should be
carried up to the point where the marginal
social benefit of the last rupee or dollar
spent becomes equal to the marginal social
sacrifice of the last unit of rupee or dollar
taxed.

 Externalities can originate on either the
supply side or the demand side of the market
and it is possible to distinguish between the
following categories:
 Negative Production Externality
 Positive Consumption Externality

 In a negative production externality, the
producer does not face the entire cost of
production. For example, an oil refinery
generates air pollution in its production of
oil. The presence of air pollution makes the
community around the oil refinery worse off
due to diminished health or due to
diminished ability to view a clear blue sky,
etc

 The firm will only take into account their
own private costs and thus will produce
where private benefits = private costs. This is
equivalent as saying where supply equals
demand.
 The oil refinery would produce at Point A
where (Quantity = Q1 ; Price = P1 ). However,
there are social costs (the air pollution) to
the production of oil, which the oil refinery
ignores.

 The social cost curve must be higher (to the
left) of the private cost curve. At the
original level of production, social costs are
higher than social benefits and thus this
quantity is not efficient and we have market
failure.
 The reason for market failure is that the
market participants do not factor in the full
social costs of their harmful economic
activities. There is a divergence between
social costs and private costs which is the
negative externality.

 Note that there is no externality on the
consumption side, so private benefit = social
benefit (the demand curve will be the same).
 When externalities exist, economic
efficiency will only occur when social benefit
is equal to social cost. In this case, economic
efficiency will be at Point B.
 The shaded area is the area in which social
costs exceeded social benefit that results
from overproduction. This is the deadweight
loss.

 Society would be better off if the economy
was at Point B rather than at Point A.
 As long as the firm has the ability to
compensate the damaged parties fully and
still have profits left over, then pollution is
“worth it” to society. It would be inefficient
for the oil refinery to stop polluting.

 In conclusion as far as the supply side is
concerned; the productive activities of
producer can have either:
 A negative external effect on other
producers or consumers, in which case the
marginal external cost (MEC)>0 and the
marginal social cost ( MSC) is greater than
the marginal private cost ( MPC); or
 A positive external effect, in which case
MEC<0 and MPC>MSC.

 A positive production externality occurs
when a third party gains as a result of
production.
 Positive production externalities occur in
many situations, most notably with the
construction and operation of infrastructure
projects, such as a new airport, or motorway.
Education and Health.
 Research and development which leads to
new technology is also a potential by-product
of production, which other firms can benefit
from.

 Examples of this could include the
consumption of vaccinations.
 When I consume a vaccine I decrease the
chance of me passing on diseases to the
wider population, therefore third parties are
less likely to get ill.
 Goods like these with positive externalities
are called merit goods.

 In the case of a positive externality of
consumption the marginal social benefit
(MSB) of consuming a good and the marginal
private benefit of consuming a good (MPB)
will be different, as private benefit does not
consider third party benefits.
 We can show this on a price-quantity
diagram: MSB will be further right than MPB
and market failure will occur, with the
welfare loss shown as the shaded triangle.
Within our vaccine example the welfare loss
would be the increased likelihood of people
in society getting a disease.

 This is the case, because at every price,
society would benefit more from flu shots.
There is no externality on the production
side, therefore the social and private costs
are the same.
 We know that the market equilibrium is
where the private costs = private benefits at
Point A.
 Point A cannot be efficient since at that
quantity the social benefits exceed the social
costs.

 Economic efficiency will only be reached
when social costs = social benefits at Point B.
 The shaded area is the positive externality
that is realized as we produced the good.
The deadweight loss is the shaded area
between Q1 and Q2 . It is the loss to society
by not producing enough of the good.

 In conclusion on the demand side, the
consumption activities of an individual
consumer can have either: A positive
external effect on the consumers or
producers, in which case the marginal
external benefit (MEB) > O and the marginal
social benefit (MSB)> marginal private
benefit (MPB); or A negative external effect,
in which case MEB<0 and MPB>MSB.

1. Regulation
2. Pigouvian taxes and subsidies
3. Property rights
4. Creation of markets

 The option of regulation is particularly
relevant to the case of negative production
externalities such as pollution. It involves
telling each polluter to reduce pollution to a
certain level or else face legal sanction.

 Pigouvian tax is a special tax that is often
levied on companies that pollute the
environment or create excess social costs,
called negative externalities, through
business practices.
 In a true market economy, a Pigovian tax is
the most efficient and effective way to
correct negative externalities. A type of a
Pigovian tax is a "sin tax", which is a special
tax on tobacco products and alcohol.

 Pigovian tax is applicable only because market
economies often fail to provide a proper
incentive to reduce negative externalities. For
example, a coal-powered plant may be polluting
a nearby river by disposing its harmful
byproducts in the river instead of shipping the
byproducts to a special facility.
 A sufficient Pigovian tax would punish this firm
economically when it chooses to dispose of the
harmful byproducts in the river, creating an
incentive to use more environmentally friendly
methods of disposal.

 Property rights represent the legal
specification of who owns what goods,
broadly defined, including the rights and
obligations attendant upon such ownership.
 The problem of externalities thus boils down
to disputes over the use of resources.

 A fourth approach, also developed in the context
of the context of pollution problem, consists in
the creation of a market in which the
government would sell legal permits giving
owners the rights to pollute.
 The government would first establish the overall
quantity of pollutant which it considers to be
efficient level and then sell a limit number of
individual permits to the highest bidders.
 The price of these permits should ideally clear
the market, in which case the actual amount of
pollution will equal the level determined by
government.

 Producers who are unwilling to pay the
market determined effluent fee would have
to reduce their own output or shift to
cleaner technologies.
 The market creation approach also assumes
that government possesses perfect
knowledge about the sources of pollution
appropriate with efficient level of output.

Public goods and externalities

Public goods and externalities

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