This document discusses public goods and externalities. It defines public goods as non-rival and non-excludable, and explains that their efficient provision requires the vertical summation of individual demand curves. It also describes the free-rider problem as an incentive for underprovision of public goods. Externalities are defined as activities that affect another's welfare outside of market mechanisms, like pollution. The efficient solution is for property rights to be assigned, allowing bargaining. Government can also intervene through taxes/subsidies or regulations.

1. Public
Economics
2013-­‐2014
Manon
Cuylits
Topic
4:
Externalities
and
public
goods
The
2
mains
problems
we
have
regarding
climate
change
are
public
goods
and
externalities.
1.
Public
goods
1.1.
Definition
A
good
is
called
“pure
public
good”
15
if
it
is
characterized
by
non-­‐rivalry
and
non-­‐
excludability
in
consumption.
The
2
criteria
are:
• Non-­‐rivalry:
once
it
has
been
provided,
the
additional
resource
cost
of
another
person
consuming
the
good
is
zero.
We
have
the
good,
we
can
consume
a
100%
and
someone
else
also
can,
with
the
same
good.
• Non-­‐excludability:
to
prevent
anyone
from
consuming
the
good
is
either
impossible
or
very
expensive
Example:
lighthouse,
national
defence,
education
è
Education:
• Rivalry:
there
can’t
be
300
students
in
a
room
for
20
students
• Excludability:
some
people
can
actually
be
excluded
So
education
can
be
a
public
good
to
some
extent.
Remarks:
• The
consumption
of
the
public
good
need
to
be
valued
equally
by
all
(although
everyone
consumes
the
same
quantity)
• Degree
of
publicness:
classification
as
a
public
good
depends
on
market
conditions
and
technology
è
from
few
public
goods
to
many
public
goods
=
degree
of
publicness
• Private
goods
are
not
necessarily
provided
exclusively
by
the
private
sector
è
ex:
house
and
services
(logements
sociaux)
is
a
private
good
provided
by
the
public
sector.
You
might
have
private
goods
provided
by
the
public
sector:
public
good
≠
public
sector
• Public
provision
of
a
good
does
not
necessarily
mean
public
production
of
that
good
(e.g.:
refuse
collection)
è
garbage
collection
=
thing
organized
by
public
authorities
but
it’s
often
the
case
that
it’s
made
by
private
companies,
though
it’s
public
money.

2. Public
Economics
2013-­‐2014
Manon
Cuylits
1.2.
Efficient
provision
of
public
goods
Public
goods:
16
Private
good:
horizontal
summation
of
individual
demand
curves
è
demand
for
A,
B,
etc.:
each
consumers
are
not
asking
the
same
things,
we
have
to
sum
for
each
level
of
the
price,
the
demand
for
each
consumer.
Property:
MRTD,F
=
MRSAD,F
=
MRSBD,F
Here
we
have
the
supply
and
demand
of
a
good
(food).
The
supply
comes
from
companies
while
the
demand
comes
from
consumers.
vertical
summation
of
individual
demand
curves.
è
Vertical
summation
because
if
a
public
good
is
provided,
it
means
everyone
can
consume
it.
Intuition:
firework
example
Fireworks
are
done
for
one
person
but
that’s
the
same
cost
if
it
is
done
for
more
people:
everyone
can
see
it,
it’s
difficult
to
forbid
people
to
watch
it.
è
We
decide
to
make
a
firework:
-­‐ How
much
will
it
cost?
-­‐ How
much
did
we
like
it?
-­‐ Should
we
have
a
firework
with
another
rocket?
An
additional
one?
• 19
rockets
–
5€/rocket
• Valuation
of
an
additional
rocket
(in
€)
Case
I
II
III
By
Alice
4
6
1
By
Bob
6
3
2
Provision?
Yes
Yes
No
What
if
we
had
1
additional
rocket?
♥ Alice
values
it
4
♥ Bob
values
it
6
♥ Total
valuation
=
4+6
=
10.
10
is
above
the
cost
(5€
per
rocket),
so
we
decide
that
we
should
have
an
additional
rocket.
What
about
2
additional
rockets?
The
total
valuation
=
6,
so
we
should
have
2
additional
rockets.
However,
3
additional
rockets
would
not
be
worth
it.
Indeed,
the
benefit
of
it
would
be
lower
than
its
price.
Thus:
provide
public
good
such
that
the
sum
of
each
person’s
marginal
valuation
on
the
last
unit
just
equals
the
marginal
cost.

3. Public
Economics
2013-­‐2014
Manon
Cuylits
1.3.
The
free-­‐rider
problem
Incentive
to
avoid
paying
17
for
the
public
good
(let
the
others
pay
for
it,
still
enjoy
it).
When
everyone
does
so,
the
public
good
is
underprovided.
Sometimes,
public
goods
are
underprovided.
If
there’s
no
one
to
put
people
together
and
to
build
the
roads,
there
are
free-­‐riders4
benefiting
from
the
people
doing
something.
Ex:
should
we
build
a
swimming
pool?
:
ü How
much
do
we
value
it?
ü How
much
will
we
pay
to
have
it?
Some
people
will
answer:
“I’m
not
that
much
interested
in
having
a
swimming
pool”
while
they
actually
are
interested.
It’s
the
same
when
we
build
roads:
some
people
say
they
are
not
really
interested
but
they
will
use
roads
once
they
are
build
though.
2
contexts:
♥ Free-­‐riders
under
authority
(government):
possibility
to
hide
preferences
è
It’s
difficult,
even
if
there’s
a
government,
a
municipality,
etc.:
in
this
case
you
just
hide
your
preferences.
Free-­‐rider
just
hide
their
preferences
when
there’s
an
authority.
♥ Free-­‐riders
under
no
authority
(e.g.:
international/global
public
goods):
additional
problem:
lack
of
incentives
to
cooperate.
Thus,
how
to
enforce
the
efficient
level
of
the
public
good?
(See
topic
on
international
negotiations)
è
When
there’s
no
authority,
we
meet
other
kinds
of
free-­‐riding:
here
there’s
a
lack
of
incentive
to
cooperate,
it’s
not
like
in
the
1st
case
where
you
just
hide
your
preferences.
You
know
that
if
you
cooperate
with
the
others,
it
will
be
better
for
everyone,
but
if
you
have
an
incentive
to
not
cooperate,
and
you
don’t,
finally
it
will
be
worse
for
both
parts.
• Private
good:
no
incentive
to
misreveal
preferences
(valuation)
• Public
good:
incentive
to
hide
true
preferences
(valuation)
to
avoid
paying
for
the
provision
of
the
good
while
consuming
it
4
free
riders
=
passagers
clandestins
Public
good:
vertical
sum
on
individual
demand
curves.
Property:
MRTD,F
=
MRSAD,F
=
MRSBD,F
Satisfaction:
what
one
person
is
ready
to
pay
+
The
satisfaction
of
another
person.

4. Public
Economics
2013-­‐2014
Manon
Cuylits
è
18
Firework
example:
Valuation
statement
Alice
4
1
Bob
6
2
Total
10
3
Provision
Yes
No
2.
Externalities
2.1.
Definition
and
analysis
Externality
=
an
activity
of
one
entity
that
affects
the
welfare
of
another
entity
in
a
way
that
is
outside
the
market
mechanism.
Examples:
• Emissions
of
pollutants
due
to
road
traffic
are
responsible
for
health
problems
è
externality:
efficiency
is
affected
• The
presence
of
European
Institutions
in
Brussels
is
responsible
for
an
increase
in
the
price
of
housing
thus
increasing
the
welfare
of
property
owners
è
not
an
externality:
efficiency
is
not
necessarily
affected;
however,
equity
is
affected
by
a
change
in
distribution
of
real
income
The
lake
or
river
example5
• Nobody
owns
the
lake
o Alice
uses
to
fish
and
swim
in
the
lake
o Bob
operates
a
factory
that
discharges
pollutants
in
the
lake
• Thus
Bob’s
activities
make
Alice
worse
off:
externality
• Water
is
scarce
resource
but
it
has
no
price
• Consequently,
Bob
uses
the
water
as
an
input
with
zero-­‐price,
that
is
in
inefficiently
large
quantities.
• Other
inputs:
price
reflects
the
value
of
their
alternative
uses;
Bob
has
to
pay
the
price,
otherwise
the
owners
of
those
inputs
sell
them
to
others
people.
An
externality
is
the
consequence
of
the
lack
of
property
right:
• If
Alice
owns
the
lake,
she
could
charge
Bob
for
polluting
the
lake;
Bob
would
then
account
for
the
price
of
this
input
in
his
production
decisions
• If
Bob
owns
the
lake,
he
could
charge
Alice
for
fishing
in
the
lake;
Bob
knows
he
can
ask
her
a
higher
price
when
he
discharge
less
pollutants
Thus,
as
long
as
someone
owns
the
resource,
its
price
reflects
the
value
for
alternative
uses.
5
Manque
notes
jusqu’à
la
fin
du
chapitre

5. Public
Economics
2013-­‐2014
Manon
Cuylits
Other
remarks:
19
• Externalities
can
be
produced
by
consumers
as
well
as
by
firms
From…
To…
Example
Consumer
Consumer
Ex:
smoking
Consumer
Firm
Ex:
Forests
Firm
Consumer
Ex:
Lake
Firm
Firm
Ex:
Industrial
areas
• Externalities
can
be
positive
or
negative
o Ex:
positive:
vaccination
o Ex:
negative:
pollution
• Public
goods
can
be
viewed
as
a
special
kind
of
externality:
externality
with
effects
on
every
person
in
the
economy
• Ex:
greenhouse
gas
emissions
Graphical
analysis
–
Lake
example

6. Public
Economics
2013-­‐2014
Manon
Cuylits
Notes:
20
• MB
is
‘horizontal’
if
Bob
sells
the
output
on
a
competitive
market
(price-­‐taker)
• Implicit
assumption
in
graphical
analysis:
fixed
amount
of
pollution
per
unit
of
output
2.2.
Private
response
to
externalities
Bargaining
• Provided
that
transaction
costs
are
negligible,
an
efficient
solution
to
an
externality
problem
is
achieved
as
long
as
someone
is
assigned
property
rights,
independant
of
who
is
assigned
those
rights
(Coase
Theorem)
• Thus,
only
when
few
parties
are
involved
and
the
sources
of
the
externality
are
well
defined
• Graphical
analysis:
lake
example
Mergers
(firms)
• ‘Internalisation’
of
the
externality
by
combining
the
involved
parties
(only
one
decision
maker;
takes
into
account
the
impact
of
one
activity
on
another)
Note:
social
conventions
as
a
form
of
merger
(individuals)
2.3.
Public
response
to
externalities
• Establishing
property
rights:
See
bargaining
• Taxes
and
subsidies:
Government
sets
the
price
(‘pigouvian’
taxation)
• Tradable
permits
(or
cap-­‐and-­‐trade)
Government
sets
the
quantity
• Regulations:
Technology
standards,
performance
standards
(non-­‐tradable
permits),
...
è
This
will
be
analyzed
in
topic
6

7. Public
Economics
2013-­‐2014
Manon
Cuylits
Setting
the
price
(tax-­‐subsidy):
Pigouvian
taxation
Tax
t*
on
output
Q
is
equal
to
marginal
damage
at
the
efficient
level
(Q*)
Subsidy
Subsidy
s*
on
non-­‐produced
output
is
equal
to
marginal
damage
at
the
efficient
level
(Q*)
Remark
on
subsidy
21
• Reduction
in
output
must
be
measured
w.r.t.
a
baseline
• Above
example:
baseline
=
Q1
• Any
other
baseline
(to
the
right
of
Q*)
could
be
used
• Difficulties
with
baselines:
possible
incentive
for
firms
to
overproduce
if
future
baseline
depends
on
current
output
(Note:
link
with
discussion
on
allocation
of
tradable
permits)

8. Public
Economics
2013-­‐2014
Manon
Cuylits
Setting
the
quantity
(permits)
Permits
Q
equal
to
the
efficient
level
of
production
(Q*)
3.
Climate
change
as
a
market
failure
3.1.
Introduction
Human-­‐induced
climate
change
is
an
22
externality
• Activities
involve
the
emission
of
greenhouse
gases
• As
GHGs
accumulate
in
the
atmosphere,
temperatures
increase,
and
the
climatic
changes
that
result
impose
costs
(and
some
benefits)
on
society.
• Full
costs
of
GHG
emissions,
in
terms
of
climate
change,
are
not
borne
by
the
emitter
è
no
economic
incentive
to
reduce
emissions
• Emitters
do
not
have
to
compensate
those
who
lose
out
because
of
climate
change
(no
‘correction’
through
any
institution
or
market
unless
policies
are
implemented)
• Thus
human-­‐induced
climate
change
is
an
externality
Climate
is
a
public
good
The
climate
is
a
public
good:
• Those
who
fail
to
pay
for
it
cannot
be
excluded
from
enjoying
its
benefits
• One
person’s
enjoyment
of
the
climate
does
not
diminish
the
capacity
of
others
to
enjoy
it
Underproviding
of
public
goods
by
the
markets
in
the
absence
of
public
policy
because
limited
or
no
returns
to
private
investors
for
doing
so.
In
other
words,
“in
this case,
markets for relevant goods and services (energy, land use, innovation, etc) do not reflect the
consequences of different consumption and investment choices for the climate” (Stern,
2006)
Thus,
climate
change
is
an
example
of
market
failure
involving
externalities
and
public
goods.

9. Public
Economics
2013-­‐2014
Manon
Cuylits
Special
features
of
the
externality
Special
features
that
together
distinguish
it
from
other
externalities
(Stern,
2006):
23
• It
is
global
in
its
causes
and
consequences
• The
impacts
of
climate
change
are
long-­‐term
and
persistent
• Uncertainties
and
risks
in
the
economic
impacts
are
pervasive
• There
is
a
serious
risk
of
major,
irreversible
change
with
non-­‐marginal
economic
effects
So,
basic
theory
of
externalities
and
public
goods
is
a
good
starting
point
but
one
has
to
go
much
deeper
into
the
analysis.
è
The
following
slides
show
how
these
special
features
affect
the
overall
framework/approach
for
the
economic
analysis
of
climate
change;
these
are
a
starting
point
for
deeper
analyses
provided
in
topics
5
to
12
Optimal
level
of
emissions
in
a
given
period
This
analysis
is
thus
similar
to
the
“Lake”
example
(section
2)
3.2.
Dynamics
and
uncertainty
However,
it
is
not
so
simple...
• Computation
of
SCC
curve
must
be
based
on
assumptions
over
the
whole
pathway
(future
periods);
let
us
assume
that
it
is
computed
on
the
optimal
pathway,
that
is
knowing
future
MACs
...
• Also,
MAC
curve
lowers
with
technological
progress;
let
us
assume
this
is
anticipated
and
included
in
the
computation
of
the
optimal
pathway
...

10. Public
Economics
2013-­‐2014
Manon
Cuylits
How
the
path
for
the
social
cost
of
carbon
drives
the
extent
of
abatement
24
• So,
a
good
understanding
of
the
dynamics
is
key
• This
also
illustrates
the
role
of
uncertainty:
when
technological
progress
is
more
important
than
expected,
this
leads
to
a
revision
of
the
optimal
path
(with
more
abatement),
and
consequently
a
revision
of
the
SCC
curve
(downward
because
of
a
lower
stock
of
GHGs)
3.3.
Standard
welfare
economics
and
ethics
Climate
change
impacts
mostly
poor
countries
and
poor
people
in
any
country.
Thus
ethical
dimension
is
key
The
welfare
economics
framework
allows
for
the
inclusion
of
many
dimensions
(☺)
• Can
include
goods
appearing
at
different
dates
and
in
different
circumstances.
Thus
the
theory
covers
time
and
uncertainty.
• To
the
extent
that
individuals
value
the
environment,
that
too
is
part
of
the
analysis.
(Many
goods
or
services,
including
education,
health
and
the
environment,
perform
a
dual
role:
individuals
directly
value
them
and
they
are
inputs
into
the
use
or
acquisition
of
other
consumption
goods.)
• The
list
of
goods
or
services
should
include
not
only
consumption
(usually
monetary
or
the
equivalent),
but
also
education,
health
and
the
environment
(cfr.
cross-­‐country
comparisons
of
living
standards,
such
as,
for
example,
in
the
World
Development
Indicators
of
the
World
Bank,
the
Human
Development
Report
of
the
UNDP,
and
the
Millennium
Development
Goals
(MDGs)).
…
But:
(L)
• The
ethical
framework
of
standard
welfare
economics
looks
first
only
at
the
consequences
of
actions
(an
approach
often
described
as
‘consequentialism’)
and
then
assesses
consequences
in
terms
of
impacts
on
‘utility’
(an
approach
often
described
as
‘welfarism’).
• This
standard
welfare-­‐economic
approach
has
no
room,
for
example,
for
ethical
dimensions
concerning
the
processes
by
which
outcomes
are
reached.
Some
different
notions
of
ethics,
including
those
based
on
concepts
of
rights,
justice
and
freedoms,
do
consider
process.
Others,
such
as
sustainability
and
stewardship,
emphasise
particular
aspects
of
the
consequences
of
decisions
for
others
and
for
the
future.

11. Public
Economics
2013-­‐2014
Manon
Cuylits
Nevertheless...
25
• The
consequences
on
which
most
of
these
notions
would
focus
for
each
generation
often
have
strong
similarities:
above
all,
with
respect
to
the
attention
they
pay
to
consumption,
education,
health
and
the
environment.
• And
all
the
perspectives
would
take
into
account
the
distribution
of
outcomes
within
and
across
generations,
together
with
the
risks
involved
in
different
actions,
now
and
over
time.
So,
from
an
ethical
perspective,
how
policy-­‐makers
aggregate
over
consequences
(i)
within
generations,
(ii)
over
time,
and
(iii)
according
to
risk
will
be
crucial
to
policy
design
and
choice:
• Aggregation
requires
being
quantitative
in
comparing
consequences
of
different
kinds
and
for
different
people.
• In
arriving
at
decisions,
it
is
not,
however,
always
necessary
to
derive
a
single
number
that
gives
full
quantitative
content
and
appropriate
weight
to
all
the
dimensions
and
elements
involved.
• The
standard
welfare-­‐economics
framework
has
a
single
criterion,
and
implicitly,
a
single
governmental
decision-­‐maker.
It
can
be
useful
in
providing
a
benchmark
for
what
a
‘good’
global
policy
would
look
like.
But
the
global
nature
of
climate
change
implies
that
the
simple
economic
theory
with
one
jurisdiction,
one
decision-­‐maker,
and
one
social
welfare
function
cannot
be
taken
literally.
Instead,
it
is
necessary
to
model
how
different
players
or
countries
will
interact
and
to
ask
ethical
questions
about
how
people
in
one
country
or
region
should
react
to
the
impacts
of
their
actions
on
those
in
another.
• This
raises
questions
of
how
the
welfare
of
people
with
very
different
standards
of
living
should
be
assessed
and
combined
in
forming
judgments
on
policy.
Aggregation
within
generations
• Aggregation
across
education,
health,
income
and
environment
raises
profound
difficulties,
particularly
when
comparisons
are
made
across
individuals.
• A
‘numeraire’
is
necessary:
the
most
common
way
of
expressing
an
aggregate
measure
of
wellbeing
is
in
terms
of
real
income
• Nevertheless,
there
are
significant
difficulties
inherent
in
the
valuation
of
health
and
the
environment,
many
of
which
are
magnified
across
countries
where
major
differences
in
income
affect
individuals’
willingness
and
ability
to
pay
for
them.
è
More
on
this
in
topic
#10
Aggregation
over
time
(across
generations)
• Long
term
effects
of
GHGs
emitted
today,
thus
need
to
aggregate
across
generations.
The
ethical
decisions
on,
and
approaches
to,
this
issue
have
major
consequences
for
the
assessment
of
policy.
è
See
the
discussion
on
discounting,
topic
#8

12. Public
Economics
2013-­‐2014
Manon
Cuylits
3.4.
Risk
and
uncertainty
26
• There
are
large
risks
and
uncertainties
around
costs
and
benefits
of
climate
change
• Extension
of
the
social
welfare
framework:
standard
expected
utility
theory;
thus
aggregation
over
possible
‘states
of
the
world’
(probabilities
used
to
weight
those
states)
• Difficulty:
how
to
build
those
probabilities
(distribution
functions)?
‘subjective’
probability
approach,
i.e.
a
pragmatic
response
to
the
fact
that
many
of
the
‘true’
uncertainties
around
climate-­‐change
policy
cannot
themselves
be
observed
and
quantified
precisely,
as
they
can
be
in
many
engineering
problems,
for
example.
• Risk
aversion,
derived
from
decreasing
marginal
utility,
can
be
introduced.
It
is
linked
to
the
‘precautionary
principle’.
è
More
on
this
in
Topic
#9
3.5.
Non-­‐marginal
impacts
Without
climate
change
mitigation,
impacts
on
the
overall
economy
could
be
very
large
(non-­‐marginal)

13. Public
Economics
2013-­‐2014
Manon
Cuylits
Appendix:
a
mechanism
to
reveal
preferences
27
• Ask
demand
curve
(valuation)
• A
Pareto
efficient
level
of
public
good
will
be
provided
on
the
basis
of
all
demand
curves
• Contribution
will
be
based
on
valuation
of
the
other
people
An
increase
of
1
unit
of
the
public
good
raises
tax
bill
of
one
person
by
the
marginal
cost
of
that
unit,
minus
the
value
that
everyone
else
puts
on
that
unit
• Then
every
person
has
the
incentive
(is
better
off)
by
telling
the
truth
!
Proof
(see
Rosen
and
Gayer,
ch.
4)
2
persons:
Alice
and
Bob
MRTrd:
additional
cost
of
public
good
(r)
ΔTA:
change
in
Alice
tax
bill
after
increase
1
unit
Ø Best
for
Alice:
public
good
provided
up
to
ΔTA
=
MRSArd
i.e.
marginal
benefit
from
additional
unit
equals
what
she
has
to
pay
for
that
unit
(i.e.
tax
bill)
Ø According
to
rule
ΔTA
=
MRTrd
-­‐
MRSBrd
Ø Thus,
with
such
a
rule,
if
she
says
the
truth:
MRTrd
-­‐
MRSBrd
=
MRSArd
which
corresponds
to
efficient
level
computed
by
gvt
Ø Same
for
Bob;
thus
both
have
incentives
to
tell
truth.
Limit
Implementation
is
difficult/costly
• when
many
people
are
involved
• because
demand
schedule
(not
unique
number)
is
required
• because
people
might
not
understand
the
scheme
Suggested
readings
• Rosen
and
Gayer
(2010),
ch.4,
pp
54-­‐72
• Rosen
and
Gayer
(2010),
ch.5,
pp.
73-­‐104
• Stern
(2006),
pp
23-­‐40