Externalities and Public Goods in Economics

These are my notes and thoughts on externalities and public goods in economics.

An externality occurs when there is a spillover from one person’s actions to a bystander. If left alone, people will generally not account for how their actions affect other, whether positive or negative. They are called market failures because of the negative effects. 


There are important cases in which free markets fail to maximize social surplus. Three such cases are:

  1. Externalities
  2. Public goods
  3. Common pool resources

One common link among these three examples is that there is a difference between the private benefits and costs and the social benefits and costs. Government can play a role in improving market outcomes in such cases.


The market demand curve shows consumers’ willingness and ability to pay for electricity, and the market supply curve reflects producers’ marginal costs of generating it. It is at the equilibrium point where these two lines intersect that the invisible hand most efficiently allocates resources, the point at which social good is maxed.


The downward sloping demand curve meets the upward sloping supply curve. To determine the equilibrium price and equilibrium quantity of electricity.  


In economic terms, the power plant imposes an externality on the public as a by-product of producing electricity. An externality occurs when an economic activity has either a spillover cost to or a spillover benefit for a bystander. 


When there are negative externalities present, this market outcome is no longer efficient. This is because negative externalities impose an additional cost on society that is not explicitly recognized by the buyers and sellers in the market. To arrive at the efficient production level, we need to recognize both the firm's marginal cost and the marginal external costs of production. Together, they sum to the marginal social cost of production. 


Negative externalities lead to external costs of production that the private firm will not account for when making decisions. If we take the marginal external cost into account, a higher equilibrium price and a lower equilibrium quantity result.


Taking into account the extra costs imposed on society by the plant’s pollution, we can see that optimal quantity is less than market quantity because when a negative externality must be accounted for, a smaller quantity of electricity should be generated since it is now more costly to produce each unit. 


Deadweight loss is a decrease in social surplus that results from a market distortion.


Positive externalities occur when an economic activity has a spillover benefit that is not considered when people make their decisions. As with negative externalities, they are all around us. 


Pecuniary externalities exist when market transactions affect other people, but only through the market price. They act only through prices. Remember that negative and positive externalities lead to wrong equilibrium quantities. They do so because they create an external cost or external benefit that is not reflected in the market price. Pecuniary externalities don’t create these effects. Precisely because their impact is completely embodied in prices, the market price correctly reflects the society's wider impact of market transactions. 


When there are negative externalities present, free markets produce and consume too much. When there are positive externalities present, free markets produce and consume too little. 


When individuals or companies take into account the full costs and benefits of their actions because of some public or private incentive, economists say that they are internalizing the externalities. When the external effects of their actions are internalized, the general result is that the market equilibrium moves toward higher social well-being. 


The insight that negotiation leads to the socially efficient outcome regardless of who has the legal property right is called the Coase Theorem. The theorem’s implication is powerful, private bargaining will lead to an efficient allocation of resources. This means that the person who values the ownership the most will match his preferences. 


Governments respond to externalities in two main ways:

  1. Command control policies in which the government directly regulates the allocation of resources.
  2. Market based policies in which the government provides incentives for private organizations to internalize the externality.


Under command and control regulation, policymakers either directly restrict the level of production or mandate the use of certain technologies. However, this type of regulation action typically provides few incentives for producers to search for more cost effective ways to reduce pollution. 


A market based approach internalizes externalities by harnessing the power of market forces. The most prominent market based approaches to deal with externalities are corrective taxes and subsidies. 


A corrective or Pigoivian tax is designed to induce agents who produce negative externalities to reduce quantity toward the socially optimal level. 


As a social planner, you understand that you must internalize externalities. One solution is to tax each unit of production by the amount of the negative externality. Such a tax allows the externality to be internalized, resulting in a more efficient outcome. 


The same reasoning that holds for negative externalities also applies to positive externalities, the government can use corrective subsidies to internalize the externality. A corrective subsidy is designed to induce agents who produce positive externalities to increase quantity toward the socially optimal level.


In sum, externalities potentially drive a wedge between social benefits and costs and private benefits and costs. This wedge creates a distortion and deadweight loss if the quantity levels of the free market equilibrium diverge from those of the social optimum. Corrective taxes and subsidies can cause agents to internalize their externalities. 


Public goods:

  1. No one can prevent others from consumption
  2. One person’s consumption doesn’t prevent another person’s consumption


Private goods are excludable, meaning that people can be kept from consuming them if they have not paid for them. Public goods are non-excludable, meaning that once such goods are produced, it is not possible to exclude people from using them.


Private goods are rival in consumption, meaning that they cannot be consumed by more than one person at a time. Public goods are non rival in consumption, meaning that one person’s consumption does not preclude consumption by others. 


To summarize, we can say that private goods are excludable and rival in consumption and public goods are non excludable and nonrival in consumption. 


Ordinary private goods are both highly excludable and highly rival in consumption. 

Goods that are highly excludable but nonrival in consumption are called club goods or artificially scarce goods. 

Common pool resource goods are nonexcludable but rival in consumption.

Public goods are nonrival and nonexcludable in nature. 


What makes public goods different from private goods is precisely their nonrival and nonexcludable nature. 


Public goods need to be valued on the marginal benefit that a single unit of the good provides to society. For this reason, market demand curves for public goods are added along the vertical axis, producing a total willingness to pay for each unit of the public good. 


Private provision of public goods refers to any situation in which private citizens make contributions to the production or maintenance of a public good. This usually happens through donations of time and money. 


Common pool resource goods are nonexcludable so anyone can consume as much as they can. However, they are rival goods. 


Tragedy of the commons occurs when a common resource is used too much. 


The three major examples of when the invisible hand fails are externalities, public goods, and common pool resources. In each case, free markets typically do not maximize social surplus.


Externalities can occur in many shapes and sizes. They can be either positive or negative and can occur in consumption or production. The solution to externalities can come is meant by the tragedy of the commons through private or public means. The key to each is internalizing the externality. In doing so, we can align private and social incentives to maximize overall well-being.


Public goods, which can be provided publicly or privately, are nonrival in consumption and are nonexcludable. This means that once they are provided, no one can be excluded, and all agents can consume them at the same time.


Common pool resource goods are not excludable but are rival. This leads to an important negative externality that one person imposes on all others. Once the bluegil is taken out of the stream, no one else can catch it. Therefore, solutions to common pool resource problems mirror solutions to externalities.


A key link between externalities, public goods, and common pool resources is that there is a difference between the private benefit and costs and the social benefits and costs. 


Which of the following is not an externality?

  1. Jordan has lung cancer from smoking cigarettes


Consider the private market for these pesticides shown in the graph on the right. It shows the equilibrium level of pesticides that will be produced in the private, unregulated market for these pesticides. This outcome:

  1. Is not socially efficient

In the graph, how would you account for the pesticides effect on honeybees?

  1. Draw line that has lower price and quantity, so shifted left. Draw new equilibrium point lower on supply curve.

This outcome:

  1. Is socially efficient


You have just been appointed as the county commissioner of hazard county. After your first day of work, you realize that many people talked to you about externalities all day. Based on your conversations today and your economic experience, you conclude that when externalities are present:

  1. The free market outcome is not efficient

Furthermore, you conclude that when there are negative externalities present, markets:

  1. Produce too much

When there are positive externalities, markets:

  1. Produce too little 


The coase theorem states that:

  1. Private bargaining will result in an efficient allocation of resources

The coase theorem will breakdown when:

  1. There are a large number of agents
  2. When property rights are not clearly defined
  3. Transaction costs are too high

Jones and Smith live in the same building. HJones loves to play his opera recordings so loudly that Smith can hear them. Smith hates opera. Jones receives 100 worth of benefits from his music and Smith suffers 60 worth of damages. From an efficiency perspective, Jones:

  1. Should be allowed to play his opera music

Suppose the building does not have any rules about noise. Jones and Smith can bargain at zero cost. According to the coase theorem:

  1. Jones will pay 0 to Smith to compensate for the negative externality

According to the coase theorem:

  1. Jones will pay 60 to Smith to compensate for the negative externality


There is a road between the suburbs and downtown. The road is congested at rush hour. If 169 people use the road at rush hour, the trip takes 36 minutes. If one additional person enters the road, everyone has to slow down and the trip now takes 37 minutes. People value their time at 6 per hour or .10 per minute. For simplicity, Ignore all of the costs of using the road other than the cost of time. The total social cost of 169 people using the road art rush hour is:

  1. 169*36*.10 = 608.40

The marginal social cost of one additional person is:

  1. New social cost - original social cost
  2. New social cost = 170*37*.10 = 629
  3. Original social cost = 169*36*.10 = 608.40
  4. Marginal social cost = 629-608.40 = 20.6

The efficient toll on this one additional person is:

  1. 169 * (37 min - 36 min) * .10 = 16.9

The toll at noon should be:

  1. 0


A three person city is considering a fireworks display. Anne is willing to pay 50 to see the fireworks, Bob is willing to pay 15, and Charlie is willing to pay 15. The cost of the fireworks is 60. In terms of efficiency, the fireworks display:

  1. Should be offered

Who will provide the display on their own?

  1. No one

Who will vote in favor of the display?

  1. One person


You are the Hazard county commissioner. Dwight’s neighbors bring a complaint before you that Dwight’s hog farm is creating a terrible odor, and they are demanding government action.

You respond to the neighbor’s complaints by putting a tax on DSwight’s hog production.

Taxing Dwight’s hog production is an example of:

  1. Pigouvian taxation

Using the graph to the right, answer the following questions.

Before the tax goes into effect, Dwight will produce 5 thousand hogs and will sell them for a price of:

  1.  5 per pound.

The efficient tax is:

  1. 2.36 per pound

After the tax goes into effect, Dwight will produce:

  1. 3.79 thousand hogs and sell them for a price of 6.21 per pound

As a result of the tax:

  1. Supply decreases, price increases, and the negative externality decreases


Classify the following goods and services as private goods, common pool resources, club goods, or public goods.

  1. Health insurance is a private good
  2. Radio spectrum is a common pool resource
  3. A video on youtube is a public good
  4. A mosquito control program in a city is a public good
  5. A library’s collection of ebooks is a club good


Three roommates share an apartment. It is really cold outside and they are considering turning up the thermostat in the as[artment by 1,2,3 or 4 degrees. Their individual marginal benefits from making it warmer in the apartment are as follows:

1 10 8 6

2 8 6 4

3 6 4 2

4 4 2 0

They know that each time they raise the temperature in the apartment by 1 degree, their heating bill goes up by 10.

To maximize social benefit, they should raise the temperature by:

  1. 3 degrees


You are the county commissioner of Hazard County. Recently a severe wave of storms swept across Hazard County, spawning several tornadoes and creating a wide path of mayhem. The citizens of Hazard County are demanding that you do something to protect them.

You decide to install some early warning tornado sirens. However, there is no money left in the county budget, so you ask each citizen to donate some money to build the system. Many citizens donate money to help build the warning system, However, Ms Nancy is wealthy. Decides she is not going to donate.

The early warning sirens are an example of a:

  1. Public good

Nancy represents a:

  1. Free rider

Public goods are:

  1. Low in rivalry and low in excludable

What approach would be the least effective way to deal with free riders:

  1. Exclude citizens from benefiting from the good or service


Assume that only three citizens are willing to donate to build the sirens. Their demand curves for tornado sirens are below.

  1. Draw a demand curve from y=1- to x=5 then draw equilibrium point where it crosses the supply curve