Chapter 9: Externalities and Public Goods – Microeconomics Study Notes

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Externalities and Public Goods

Introduction

This chapter explores situations where free markets fail to maximize social surplus, focusing on externalities, public goods, and common pool resources. These cases are characterized by a divergence between private and social benefits or costs, often requiring government intervention or private solutions to achieve efficiency.

Externalities

Definition and Types

Externality: An externality occurs when an economic activity imposes a spillover cost or benefit on bystanders not directly involved in the transaction.
Negative Externality: An activity that imposes a spillover cost (e.g., pollution).
Positive Externality: An activity that confers a spillover benefit (e.g., education).

Key equations:

(Marginal Social Cost = Marginal Private Cost + Marginal External Cost)
(Marginal Social Benefit = Marginal Private Benefit + Marginal External Benefit)

Market equilibrium occurs where , but the efficient outcome is where .

Negative Externalities

Firms or consumers impose costs on others (e.g., pollution from factories or household waste).
Market produces too much of the good ().
Results in deadweight loss (DWL) due to overproduction.

Market for Electricity: Market Equilibrium Socially Optimal Quantity and Price of Electricity Deadweight Loss Due to a Negative Externality

Positive Externalities

Activities confer benefits on others (e.g., education increases societal welfare).
Market produces too little of the good ().
Results in deadweight loss due to underproduction.

Market Equilibrium for Education Deadweight Loss of a Positive Externality

Pecuniary Externalities

Market exchanges affect others only through price changes (e.g., increased demand raises prices for others).
Do not cause inefficiency—just transfer surplus between buyers and sellers.

Summary Table: Market Outcomes with Externalities

Type	Market Outcome	Efficient Outcome	Correction
Negative Externality	Overproduction		Pigouvian Tax
Positive Externality	Underproduction		Pigouvian Subsidy

Private Solutions to Externalities

Bargaining and the Coase Theorem

Private parties can negotiate to internalize externalities if transaction costs are low, property rights are clear, and the number of parties is small.
Coase Theorem: Private bargaining leads to efficient outcomes without government intervention, provided the above conditions hold.

Profits Per Day Table: Bargaining Example

Limitations of Private Solutions

High transaction costs
Unclear property rights
Too many parties involved

Social norms and ethics (e.g., recycling) can also help internalize externalities.

Government Solutions to Externalities

Command-and-Control Policies

Direct regulation of resource allocation (e.g., emission limits, required technology).
Example: Mandating catalytic converters on cars.

Socially Optimal Quantity and Price of Electricity (Command-and-Control)

Market-Based Policies

Use incentives (taxes or subsidies) to internalize externalities.
Pigouvian Tax: Tax equal to the marginal external cost (MEC) to reduce negative externalities.
Pigouvian Subsidy: Subsidy equal to the marginal external benefit (MEB) to encourage positive externalities.

Effect of a Pigouvian Tax

Application: Negative Consumption Externalities

Example: "Pay as You Throw"—households pay for waste disposal to reduce overconsumption.

Evidence-Based Example: Earthquakes in Oklahoma

Fracking wastewater injections caused earthquakes (negative externality).
Command-and-control: Limiting injections reduced earthquakes.
Market-based: A tax on injections could also internalize the externality.

Public Goods

Definitions and Characteristics

Rival Good: Only one person can consume at a time (e.g., food).
Nonrival Good: More than one person can consume simultaneously (e.g., national defense).
Excludable Good: Must be paid for to consume (e.g., cable TV).
Nonexcludable Good: Can be consumed without payment (e.g., air, public parks).

Classification of Goods

	Excludable	Nonexcludable
Rival	Private Goods (food, clothes)	Common Pool Resources (fish, forests)
Nonrival	Club Goods (cable TV, Wi-Fi)	Public Goods (national defense)

The Free Rider Problem

Occurs when individuals do not pay for nonexcludable goods, leading to underproduction.
Solution: Government provision funded by mandatory taxes.

Determining the Efficient Quantity of Public Goods

For private goods: Market demand is the horizontal sum of individual demands.
For public goods: Market demand is the vertical sum of individual marginal benefits at each quantity.
Efficient provision: Sum of marginal benefits equals marginal cost.

Private Provision and Its Limitations

Charity and donations can provide public goods but are often insufficient, variable, and may not target the most critical needs.

Common Pool Resource Goods

Definition and Issues

Rival but nonexcludable (e.g., fish in the ocean, forests).
Subject to overuse—known as the tragedy of the commons.

Solutions to the Tragedy of the Commons

Private ownership (with government-defined property rights)
Government regulation (e.g., fishing limits)
Tax on use (e.g., congestion charges for road use)

Summary Table: Types of Goods

Type	Rival?	Excludable?	Examples
Private Good	Yes	Yes	Food, clothing
Club Good	No	Yes	Cable TV, Wi-Fi
Common Pool Resource	Yes	No	Fish, forests
Public Good	No	No	National defense

Key Takeaways

Markets fail to maximize social surplus in the presence of externalities, public goods, and common pool resources.
Private and government solutions can help internalize externalities and provide efficient outcomes.
Understanding the characteristics of different types of goods is essential for designing effective policies.