Externalities, Public Goods, Imperfect Information, and...

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & Yvonn Quijano

15 Chapter

Externalities, Public Goods,

Imperfect Information,

and Social Choice

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© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 35

Chapter Outline

15 Externalities, Public Goods,

Imperfect Information,

and Social Choice Externalities and Environmental Economics

Marginal Social Cost and Marginal-Cost

Pricing

Private Choices and External Effects

Internalizing Externalities

Public (Social) Goods

The Characteristics of Public Goods

Mixed Goods

Income Distribution as a Public Good?

Public Provision of Public Goods

Optimal Provision of Public Goods

Local Provision of Public Goods: Tiebout

Hypothesis

Imperfect Information

Adverse Selection: Asymmetric Information

Moral Hazard

Market Solutions

Government Solutions

Social Choice

The Voting Paradox

Government Inefficiency: Theory of Public

Choice

Rent-Seeking Revisited

Government and the Market

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EXTERNALITIES, PUBLIC GOODS, IMPERFECT

INFORMATION, AND SOCIAL CHOICE

market failure Occurs when resources are

misallocated or allocated inefficiently.

The existence of externalities, public goods,

and imperfect information are examples of

market failure.

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EXTERNALITIES AND ENVIRONMENTAL

ECONOMICS

externality A cost or benefit resulting from

some activity or transaction that is imposed

or bestowed on parties outside the activity

or transaction. Sometimes called spillovers

or neighborhood effects.

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ECONOMICS

marginal social cost (MSC) The total cost

to society of producing an additional unit of

a good or service. MSC is equal to the sum

of the marginal costs of producing the

product and the correctly measured damage

costs involved in the process of production.

MARGINAL SOCIAL COST AND MARGINAL-COST

PRICING

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ECONOMICS

FIGURE 15.1 Profit-Maximizing Perfectly Competitive Firms Will Produce

Up to the Point That Price Equals Marginal Cost (P = MC)

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ECONOMICS

Acid Rain and the Clean Air Act

Acid rain is an excellent example of an externality

and of the issues and conflicts in dealing with

externalities.

The case of acid rain highlights the fact that

efficiency analysis ignores the distribution of gains

and losses. That is, to establish efficiency we need

only to demonstrate that the total value of the gains

exceeds the total value of the losses.

Other Externalities

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ECONOMICS

PRIVATE CHOICES AND EXTERNAL EFFECTS

FIGURE 15.2 Externalities in a College Dormitory

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ECONOMICS

marginal damage cost (MDC) The

additional harm done by increasing the level

of an externality-producing activity by one

unit. If producing product X pollutes the

water in a river, MDC is the additional cost

imposed by the added pollution that results

from increasing output by one unit of X per

period.

When economic decisions ignore external costs, whether those costs are borne by one

person or by society, those decisions are likely to be inefficient.

marginal private cost (MPC) The amount

that a consumer pays to consume an

additional unit of a particular good.

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ECONOMICS

INTERNALIZING EXTERNALITIES

Five approaches have been taken to solving

the problem of externalities: (1) government-imposed taxes and subsidies,

(2) private bargaining and negotiation,

(3) legal rules and procedures,

(4) sale or auctioning of rights to impose

externalities, and

(5) direct government regulation.

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ECONOMICS

Taxes and Subsidies

FIGURE 15.3 Tax Imposed on a Firm Equal to Marginal Damage Cost

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ECONOMICS

Bargaining and Negotiation

Coase theorem Under certain conditions,

when externalities are present, private

parties can arrive at the efficient solution

without government involvement.

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ECONOMICS

Legal Rules and Procedures

injunction A court order forbidding the

continuation of behavior that leads to

damages.

liability rules Laws that require A to

compensate B for damages imposed.

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ECONOMICS

Selling or Auctioning Pollution Rights

Singapore is known for its many

laws designed to reduce negative

externalities. Littering, chewing

gum in public, eating on a subway

car, failing to flush a toilet, and

vandalizing public property are all

considered serious offenses that

are punishable by imprisonment,

fines, and/or public chastisement.

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ECONOMICS

Direct Regulation of Externalities

Taxes, subsidies, legal rules, and public auction

are all methods of indirect regulation designed

to induce firms and households to weigh the

social costs of their actions against their

benefits.

Direct regulation of externalities takes place at

the federal, state, and local level.

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PUBLIC (SOCIAL) GOODS

public goods (social or collective goods)

Goods that are nonrival in consumption

and/or their benefits are nonexcludable.

In an unregulated market economy with no government to see that they are produced,

public goods would at best be produced in insufficient quantity and at worst not produced

at all.

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nonrival in consumption A characteristic

of public goods: One person’s enjoyment of

the benefits of a public good does not

interfere with another’s consumption of it.

THE CHARACTERISTICS OF PUBLIC GOODS

nonexcludable A characteristic of most

public goods: Once a good is produced,

no one can be excluded from enjoying its

benefits.

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free-rider problem A problem intrinsic to

public goods: Because people can enjoy

the benefits of public goods whether they

pay for them or not, they are usually

unwilling to pay for them.

drop-in-the-bucket problem A problem

intrinsic to public goods: The good or

service is usually so costly that its provision

generally does not depend on whether or

not any single person pays.

Consumers acting in their own self-interest have no incentive to contribute voluntarily to the

production of public goods. Some will feel a moral responsibility or social pressure to

contribute, and those people indeed may do so. Nevertheless, the economic incentive is

missing, and most people do not find room in their budgets for many voluntary payments.

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MIXED GOODS

mixed goods Goods that have

characteristics that are part public and part

private.

INCOME DISTRIBUTION AS A PUBLIC GOOD?

If we accept the idea that redistributing income generates a public good, private endeavors

may fail to do what we want them to do, and government involvement may be called for.

PUBLIC PROVISION OF PUBLIC GOODS

When members of society get together to form a

government, they do so to provide themselves with goods

and services that will not be provided if they act separately.

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OPTIMAL PROVISION OF PUBLIC GOODS

Samuelson’s Theory

FIGURE 15.4 With Private Goods, Consumers Decide What Quantity to Buy;

Market Demand Is the Sum of Those Quantities at Each Price

The price mechanism forces people to reveal what they want, and it forces firms to produce

only what people are willing to pay for, but it works this way only because exclusion

is possible.

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FIGURE 15.5 With Public Goods,

There Is Only One

Level of Output, and

Consumers Are

Willing to Pay

Different Amounts

for Each Level

For private goods, market demand is the

horizontal sum of individual demand

curves—we add the different quantities that

households consume (as measured on the

horizontal axis). For public goods, market

demand is the vertical sum of individual

demand curves—we add the different

amounts that households are willing to pay

to obtain each level of output (as measured

on the vertical axis).

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FIGURE 15.6 Optimal Production of a Public Good

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optimal level of provision for public

goods The level at which resources are

drawn from the production of other goods

and services only to the extent that people

want the public good and are willing to pay

for it. At this level, society’s willingness to

pay per unit is equal to the marginal cost of

producing the good.

At the optimal level, society’s total willingness to pay per unit is equal to the marginal cost of

producing the good.

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The Problems of Optimal Provision

To produce the optimal amount of each public

good, the government must know something

that it cannot possibly know—everyone’s

preferences.

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Tiebout hypothesis An efficient mix of

public goods is produced when local

land/housing prices and taxes come to

reflect consumer preferences just as they

do in the market for private goods.

LOCAL PROVISION OF PUBLIC GOODS:

TIEBOUT HYPOTHESIS

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IMPERFECT INFORMATION

adverse selection Can occur when a

buyer or seller enters into an exchange

with another party who has more

information.

ADVERSE SELECTION: ASYMMETRIC

INFORMATION

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moral hazard Arises when one party to

a contract passes the cost of its

behavior on to the other party to the

contract.

MORAL HAZARD

It is impossible to know everything about behavior and intentions. If a contract absolves one

party of the consequences of its action, and people act in their own self-interest, the result is

inefficient.

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MARKET SOLUTIONS

Like consumers, profit-maximizing firms will gather information as long as the marginal

benefits from continued search are greater than the marginal costs.

GOVERNMENT SOLUTIONS

Information is essentially a public good and is

nonrival in consumption.

When information is very costly for individuals to

collect and disperse, it may be cheaper for

government to produce it once for everybody.

There is an efficient quantity of information

production.

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SOCIAL CHOICE

social choice The problem of deciding

what society wants. The process of

adding up individual preferences to

make a choice for society as a whole.

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SOCIAL CHOICE

THE VOTING PARADOX

impossibility theorem A proposition

demonstrated by Kenneth Arrow

showing that no system of aggregating

individual preferences into social

decisions will always yield consistent,

nonarbitrary results.

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SOCIAL CHOICE

FIGURE 15.7 Preferences of Three Top University Officials

TABLE 15.1 Results of Voting on University’s Plans: The Voting Paradox

VOTES OF:

Vote VP1 VP2 Dean Result a

A versus B A B A A wins: A > B

B versus C B B C B wins: B > C

C versus A A C C C wins: C > A

aA > B is read “A is preferred to B.”

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SOCIAL CHOICE

voting paradox A simple demonstration

of how majority-rule voting can lead to

seemingly contradictory and inconsistent

results. A commonly cited illustration of

the kind of inconsistency described in the

impossibility theorem.

logrolling Occurs when congressional

representatives trade votes, agreeing to

help each other get certain pieces of

legislation passed.

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SOCIAL CHOICE

GOVERNMENT INEFFICIENCY: THEORY OF

PUBLIC CHOICE

To understand the way government functions,

we need to look less at the preferences of

individual members of society and more at the

incentive structures that exist around public

officials.

RENT-SEEKING REVISITED

Theory may suggest that unregulated markets fail to produce an efficient allocation of

resources. This should not lead you to the conclusion that government involvement

necessarily leads to efficiency. There are reasons to believe that government attempts to

produce the right goods and services in the right quantities efficiently may fail.

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GOVERNMENT AND THE MARKET

GOVERNMENT INEFFICIENCY: THEORY OF

PUBLIC CHOICE

There is no question that government must be

involved in both the provision of public goods

and the control of externalities.

The question is not whether we need

government involvement. The question is how

much and what kind of government involvement

we should have.

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adverse selection

Coase theorem

drop-in-the-bucket problem

externality

free-rider problem

impossibility theorem

injunction

liability rules

logrolling

marginal damage cost

(MDC)

marginal private cost (MPC)

marginal social cost (MSC)

REVIEW TERMS AND CONCEPTS

market failure

mixed good

moral hazard

nonexcludable

nonrival in consumption

optimal level of provision for

public goods

public goods (social or

collective goods)

social choice

Tiebout hypothesis

voting paradox

Externalities, Public Goods, Imperfect Information, and...

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