Externalities and Public Goods

Lecture 7 – academic year 2013/14Introduction to Economics

Fabio Landini

Where we are…

• Lecture 1 : Demand and supply model• Lecture 2: Elasticity and its application• Lecture 4: Demand, Supply and economic

policy• Lecture 5: Demand, Supply and economic

efficiency• Lecture 5: Surplus of consumers and producer

What do we do today?

• The “external” effects of economic activities

• How do we internalize externalities?• The different typologies of economic

goods: private goods, public goods, common resources and natural monopolies

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The KYOTO Protocol – since 1997

• The Kyoto Protocol, signed in December 1997 at the UNFCCC COP3 (Conference Of Parties), represents the executive instruments of the Framework Convention

• The countries that are subject to the emission constraint are 39 and they include the European countries (including the East countries), Japan, Russia, United States, Canada, Australia and New Zealand

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The European Directive 2003/87/CE “Emissions Trading” regulate the exchange of quotas for the emission of greenhouse gas. The final aim is to establish an European market for the emission quotas.

During the first three years (2005-2007), the emissions of large combustion plants, such as oil refineries, plants for the production of ferrous metal, mineral goods (concrete, lime, etc.) and the plants for the production of paper and cartboard

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The KYOTO Protocol – since 1997

Market efficiency: A brief recap

In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus.

“The invisible hand” (of the market) maximize the total benefit of society

Markets are usually good instruments to organize the economic activity

Sometimes, however: “markets fail”

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Externalities: definition and effects

When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality.

Whenever they do not take into account the “third party”, the equilibrium prices and quantities are not efficient.

Therefore the externalities cause an inefficient allocation of resources, i.e. market failure.

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The effects of externalities on society

In the presence of externalities:•Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market).•The externalities can be negative or positive•However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged ≠ optimal quantity.

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Negative externalities

Costs on other individuals (consumers or producers) that are not directly involved in the market exchange.

Example: smoke of cigarettes, cars’ exhaust gas

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Positive externalities

Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange.

Example: Vaccines, restoration of a piece of Art, investment in new technologies.

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Externalities and market inefficiency

• Negative externalities in productionQmarket > Qoptimum (socially desirable quantity)

social costs > private costs

• Positive externalities in productionQmarket < Qoptimum

social costs < private costs

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• Negative externalities in consumptionQmarket > Qoptimum (socially desirable quantity)

Social benefit < private benefit

• Positive externalities in consumption

Qmarket < Qoptimum

Social benefit > private benefit

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Externalities and market inefficiency

Negative externalities in production

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EquilibriumEquilibrium

00

Price of Price of aluminiumaluminium

QQMARKETMARKET

DemandDemand(private value)(private value)

SupplySupply(private cost)(private cost)

Social costSocial costCost of Cost of pollutionpollution

QQOPTIMUMOPTIMUM

OptimumOptimum

Quantity of Quantity of aluminiumaluminium

Positive externalities in production

14QuantityQuantity

of Robotof Robot00

Price of Price of RobotRobot

QQOPTIMUMOPTIMUM

DemandDemand(private value)(private value)

Supply (private cost)Supply (private cost)

QQMARKETMARKET

Value of Value of technological technological

diffusiondiffusion

EquilibriumEquilibrium

Social costSocial cost

OptimumOptimum

Negative externalities in consumption

15Quantity of Quantity of alcoholic drinksalcoholic drinks

00

Price of Price of alcoholic alcoholic

drinksdrinks

DemandDemand(private value)(private value)

Supply (private cost)Supply (private cost)

QQMARKETMARKET

EquilibriumEquilibrium

QQOPTIMUMOPTIMUM

OptimumOptimum

Social valueSocial value

Positive externalities in consumption

16Quantity ofQuantity ofeducationeducation

00

Price of Price of educationeducation

DemandDemand(private value)(private value)

Supply (private cost)Supply (private cost)

QQMARKETMARKET

EquilibriumEquilibrium

QQOPTIMUMOPTIMUM

OptimumOptimum

Social valueSocial value

How to obtain Qoptimum?1. Government intervention

Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities.

“To internalize an externality” means to alter market incentive with subsidies and taxes, so as to induce individuals to take adequately into account the external effects of their actions.

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Obtaining optimal production

If the externality is negative: internalization through a tax – the tax reduces the quantity that is exchanged in equilibrium until the social optimum obtains

If the externality is positive: internalization through a subsidy – the subsidy increase the quantity that is exchanged in equilibrium until the social optimum obtains

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Public intervention is not always either necessary or efficacious to deal with externalities.

Example of private solutions:•Ethical codes and social sanctions.•NGOs (in the “no-profit” sector).•Integration of different types of activities.•System of contracts (Coase’s theorem).

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How to obtain Qoptimum?2. Private solution

Externalities and public goods

A case in which externalities are of particular relevance is when we deal with specific types of economic goods, called public goods and common resources

Example: knowledge (technological spillover), environment (pollution)

What are public goods and common resources?

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Typologies of economic goods

The goods available in our economy can be distinguished along two dimensions:

Excludabilityand

Rivalry

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ExcludabilityAn individual can be prevented from using a good (e.g. laws usually recognize the private property of a good)

Typologies of economic goods

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RivalryThe consumption of a good by an individual prevents the simultaneous consumption of the same good by other individuals

Typologies of economic goods

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A bridge connects two shores of a river

Given a certain dimension of the bridge, if the n. of people using the bridge increases (congestion): consumption rivalry

If there is a fee for the bridge (those who don’t pay cannot use it): consumption excludability

Example of a public good: A bridge

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Rivalrous

Non-rivalrous

N. people

Many

Few

Free accessExample of the bridge

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ExcludableNon-

excludable

Fee

yes No

Given number of people

Example of the bridge

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Excludable

Rivalrous

Non-excludable

Rivalrous

Excludable

Non-rivalrous

Non-excludable

Non-rivalrous

Yes No

N. people

Many

Few

Example of the bridge: two-ways table

Fee

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Excludable

Rivalrous

(PRIVATE GOODS)

Non-excludable

Rivalrous

(COMMONS)

Excludabe

Non-rivalrous

(NATURAL MONOPOLY)

Non-excludable

Non-rivalrous

(PUBLIC GOODS)

Yes No

N. people

Many

Few

Example of the bridge: two-ways table

Fee

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Four types of economic goods (1)

Private goods•Both excludable and rivalrousExample: ice-cream, CDs, etc.

Public goods•Neither excludable nor rivalrousExample: national defence, scientific knowledge

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Commons•Rivalrous, but non-excludableExample: sea fishes

Natural monopoly•Excludable, but non-rivalrousExample: drinkable water

Four types of economic goods (1)

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Public goods and externalities

Non-excludable goods all can benefit without paying the price, p = 0

Access to the good cannot be limited; private value = 0, social value > 0

But: production costs > 0 (scarce resources)

Who is it going to produce the good, if not paid?

Therefore: positive externalities of a public good (autonomously, market produces too few).

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The problem of free riding

A free rider is a person who can enjoy the benefit of a good without paying the price

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The bridge is built

The bridge is not built

I contribute(I pay 10) 90 - 10

I do not contribute(I don’t pay) 100 0

In order to build the bridge, a voluntary In order to build the bridge, a voluntary contribution equal to 10 is requested…..contribution equal to 10 is requested…..

It is convenient for me It is convenient for me NOTNOT to pay!!! to pay!!!

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The problem of free riding

Since public goods are non-excludable, each individual can refuse to pay the good, hoping that other people will pay in his/her place.

If everybody reasons the same, the good is not produced.

IMPORTANT: the presence of free riding makes it impossible to rely on the market to supply public goods.

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Solution of the free riding problemIf the benefits > costs (social value > 0), public authorities can produce the good by relying on taxes.

Example: fireworks by Moena’s Municipality – 500 inhabitants; value for each inhabitant =10 €; cost of

fireworks = 1000 €.

– Fireworks tax for each inhabitant = 2€, it covers the costs.

– Consumer surplus = 8€ (= 10€ - 2€).

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The need for a State to produces public goods, whose cost is financed via taxes, represents the main economic justification for the existence of taxation (and thus for the fight against tax evasion): that is the “minimum State”.

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Common resources

Common resources are non-excludable

They are freely available for anybody to exploit

But they are rival: the consumption of the good by one individual reduces the possibility for other individual to consume

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Examples of common resources

• Air and clean water• Congested streets • Fishes, whale and other wild species

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The tragedy of the commons

When an individual, by using a resource, diminishes the availability of the resource for others we encounter the tragedy of the commons.

Common resources tend to be over-exploited

This generates a negative externality.

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The public administration can:• Impose a tax on usage;• Regulate the use of the resource; • Transform the common resource in a private

good (by defining and enforcing individual property rights on the resource.

The tragedy of the commons

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The importance of property rights

When the absence of property rights is the cause of market failures, public intervention can potentially

solve the problem in 3 ways

1) By defining property rights, which enable the market to operate efficiently;

2) By regulating individual behaviour;3) By producing a good that the market does not

supply.

Conclusion

When the transaction between consumer and producer has effects on a third party, there is an externality.

Negative (positive) externalities imply that the quantity exchanged in the market equilibrium is superior (inferior) to the social optimum.

The solution to the problem of externalities can be pursued both by private parties and public intervention

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Economic goods differ in terms of excludability and rivalry.

The market can function when goods are private i.e. both excludable and rivalrous.

Public goods are neither excludable nor rivalrous, hence the market does not function well.

In because of free riding, it is the public sector who is responsible to supply public goods.

Conclusion

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Conclusion

Collective resources are rivalrous but not excludable.

Since individuals do not pay for the use of the resource, there is a tendency toward over-exploitation.

Public administration may limit the use of common resources via access regulation and taxes