Chapter 18: Externalities and Public Goods – Microeconomics Study Notes

Chapter 18: Externalities and Public Goods

Introduction

This chapter examines externalities—the effects of production and consumption activities not directly reflected in market prices—and public goods, which benefit all consumers but are often underprovided or not provided at all by the market. The presence of externalities and public goods can lead to market inefficiency, requiring government intervention or alternative solutions.

18.1 Externalities

Definition and Types

• Externality: An action by a producer or consumer that affects other producers or consumers, but is not accounted for in the market price.

• Externalities can be negative (imposing costs) or positive (providing benefits).

Negative Externalities and Inefficiency

• Marginal external cost (MEC): The increase in cost imposed externally as output increases by one unit.

• Marginal social cost (MSC): The sum of the marginal cost of production (MC) and the marginal external cost (MEC).

When negative externalities exist, MSC > MC, leading to overproduction and inefficiency.

Positive Externalities and Inefficiency

• Marginal external benefit (MEB): The increased benefit to other parties as output increases by one unit.

• Marginal social benefit (MSB): The sum of the marginal private benefit and the marginal external benefit.

With positive externalities, MSB > marginal private benefit, resulting in underproduction relative to the socially optimal level.

Key Equations

• $MSC = MC + MEC$

• $MSB = MB + MEB$

Example: Sulfur Dioxide Emissions

• Most sulfur dioxide emissions in the U.S. come from burning fossil fuels for electricity.

• Efficient reduction equates the marginal abatement cost to the marginal external cost.

18.2 Ways of Correcting Market Failure

Efficient Level of Emissions

• The efficient level is where $MEC = MCA$ (marginal external cost equals marginal cost of abatement).

• Without abatement, firms maximize profit at a higher emission level.

Policy Tools

• Emissions Standard: Legal limit on the amount of pollutants a firm can emit.

• Emissions Fee: Charge levied on each unit of a firm's emissions.

• Tradable Emissions Permits: Marketable permits specifying the maximum emissions allowed; can be bought and sold.

Comparing Standards and Fees

• Both can achieve the same reduction in emissions.

• Fees allow firms with lower abatement costs to reduce more emissions, increasing cost-effectiveness.

• Standards may be preferable when the marginal external cost curve is steep.

Recycling

• Low disposal costs lead to overuse of virgin materials and underuse of recycled materials.

• Efficient recycling equates the marginal social cost of disposal to the marginal cost of recycling.

Refundable Deposits

• Encourage recycling by increasing the supply of recycled materials and reducing disposal.

18.3 Stock Externalities

Definition

• Stock externality: Accumulated result of actions by producers or consumers, affecting others over time (e.g., greenhouse gases).

Stock Buildup and Its Impact

• With ongoing emissions, the stock accumulates, but some fraction dissipates each year.

• General formula for stock after N years:

$S_N = E[1 + (1 - d) + (1 - d)^2 + cdots + (1 - d)^{N-1}]$

As N becomes large, stock approaches long-run equilibrium $E/d$.

Net Present Value (NPV) of Emissions Policy

• NPV is the present discounted value of annual net benefits:

$NPV = \frac{-1.5 + 1.98}{1 + R} + \frac{-1.5 + 2.96}{(1 + R)^2} + \frac{-1.5 + 4.337}{(1 + R)^3}$

Discount Rate

• Social rate of discount: Opportunity cost to society of receiving a benefit in the future rather than the present.

• Depends on expected real economic growth, risk aversion, and time preference.

18.4 Externalities and Property Rights

Property Rights

• Property rights: Legal rules stating what people or firms may do with their property.

• Clear property rights can internalize externalities, leading to efficient resource allocation.

Bargaining and Economic Efficiency

• When property rights are well-defined, parties can negotiate to reach efficient outcomes (Coase Theorem).

Legal Solutions

• Damages or lawsuits can be used to internalize external costs.

Example: The Coase Theorem at Work

• Cooperative agreements between parties (e.g., New York City and New Jersey) can resolve externality issues efficiently.

18.5 Common Property Resources

Definition and Issues

• Common property resource: Resource to which anyone has access (e.g., fisheries).

• Overuse can occur because individuals do not account for the cost imposed on others.

Management Solutions

• Government regulation (e.g., catch limits) can help prevent overexploitation.

18.6 Public Goods

Definition

• Public good: Nonexclusive and nonrival; marginal cost of provision to an additional consumer is zero, and people cannot be excluded from consumption.

• Nonrival good: Marginal cost of provision to an additional consumer is zero.

• Nonexclusive good: People cannot be excluded from consumption.

Efficiency and Public Goods

• Efficient provision occurs when the sum of individual marginal benefits equals the marginal cost of provision.

$\sum MB_i = MC$

Market Failure and Public Goods

• Markets may underprovide public goods because individuals have little incentive to pay for them (free rider problem).

Example: The Demand for Clean Air

• Clean air is a public good; individual demand curves are summed to determine total willingness to pay.

Tables

Table: Buildup in the Stock Pollutant

Year	E	S	Damage ($ Billion)	Cost of E = 0 ($ Billion)	Net Benefit ($ Billion)
2010	100	100	0.100	1.5	-1.400
2011	100	198	0.198	1.5	-1.302
2012	100	296	0.296	1.5	-1.204
2013	100	433	0.337	1.5	-1.163
...	...	5000	5.000	1.5	-3.500

Table: Recycling Rates of Selected Products for U.S., 2013

Product	Recycling Rate (%)
Aluminum	50.7
Paper	74.2
Glass Containers	31.1
Other	...

Summary

• Externalities and public goods are key sources of market failure in microeconomics.

• Government intervention or market-based solutions (fees, permits, property rights) can improve efficiency.

• Understanding the nature of externalities and public goods is essential for designing effective policies.