Chapter 3

Public goods and externalities

Learning outcomes

• Explain the effects of positive and negative externalities with the aid of supply and demand analysis

• Discuss the policy options to correct for externalities• Discuss the relative importance of property rights

and transaction costs in market-based approaches to dealing with the problem of externalities

• Discuss cap-and-trade programmes• Provide examples of global or regional public goods

and consider some of the relevant policy implications.

Learning outcomes (continued)

• Distinguish between private, public, mixed, and merit goods

• Derive the conditions for the optimal allocation of private, public, and mixed goods with the aid of supply and demand analysis

• Explain why competitive markets fail to provide public and mixed goods efficiently

• Explain the distinction between the financing of public goods and services and their physical production

• Explain the concept of an externality• Identify the main types of externalities.

Private goods and the benchmark model• Can all goods and services be supplied efficiently by

competitive markets?– Revealing consumer preferences– Production– Competition

• Characteristics of private goods:– Rivalry in consumption– Excludability.

Equilibrium of a private good

Pure public goods

• Non rivalry– Marginal cost of adding consumers is zero– Excluding consumers is Pareto-inefficient

• Non-excludablility.

Equilibrium of a pure public good

The difference between public and private goodsCharacteristic Public goods Private goods

Property rights Non-excludable Excludable

Consumption Non-rival Rival

Aggregate demand curve

Vertical addition of individual demand curves

Horizontal addition of individual demand curves

Partial equilibrium condition for optimum provision

The sum of marginal utilities equals marginal cost

Marginal utility of eachconsumer equals marginal cost

Efficient pricing rule The sum of individual prices equals marginal cost

Price equals marginal cost

Supplying public goods

• Free riding• Perfect price discrimination vs taxation• Production of public goods• Financing of public goods.

Mixed and merit goods

Mixed goods• Non-rival, excludable mixed goods and services• Rival, non-excludable mixed goods and servicesMerit goods• External benefits to buying or receiving goods and

services.

Externalities

• Positive externalities• Negative externalities• Technological actions• Pecuniary actions.

External cost and Pigouvian tax

External benefit and Pigouvian subsidy

Solutions to the externality problem

• Pigouvian taxes and subsidies• Regulation

– Command-and-control regulation– Bureaux of Standards– Regulatory measures

• Creation of markets– “Cap-and-trade” programme

• Property rights– Coase theorem– Transaction costs.

Global public and merit goods

• Joint responsibility/shared burden by neighbouring countries– Defence systems– Cross border road and rail networks– Air and water pollution– Carbon dioxide emissions

• Bilateral and multilateral agreements• Regional trade agreements• International agreements.

Thank you.