Public Goods - | Stanford Lagunita · PDF filePublic Goods Table 15-1 shows the range of goods...

Public GoodsTable 15-1 shows the range of goods and services produced by all lev-els of government in the United States: the federal government, the50 state governments, and more than 85,000 local governments(counties, cities, towns, and school districts). According to data fromthe U.S. Census Bureau, in terms of employment, the largest sector ofgovernment production in the United States is education at all levels,from elementary school to graduate school. Education is followed byhealth and hospital services, police, national defense, the postal service,corrections (prisons), and highways. (The figures for national defenseinclude only civilian workers; if Table 15-1 included those serving inthe armed forces, national defense would be second on the list.) Theother categories, ranging from the judicial and legal system (federal,state, and county courts) to parks and recreation, each are significantbut small relative to the total.

Observe also the types of goods and services that are not on thelist because they are produced by the private sector. Manufacturing,mining, retail trade, wholesale trade, hotel services, and motion pic-ture production are some of the items that are largely left to the pri-vate sector. Note also that for all the goods and services on the listin Table 15-1, the private sector provides at least some of the pro-duction. The private health care sector has 60 millions workers, for example, com-pared with 2 million in government health care. The private sector also is involved inmail delivery, education, garbage collection, and even fire protection (volunteer firedepartments).

Why is the government involved in the production of police services and educationservices but not in the production of automobiles? Why are education and health servicesprovided by both the private sector and the government sector, whereas judicial servicesand national defense services are provided only by the government? In more generalterms, why is it necessary for governments to produce any goods and services? The con-cept of a public good helps us answer the question.

Nonrivalry and NonexcludabilityA public good is a good or service that has two characteristics: nonrivalry in consump-tion and nonexcludability. Nonrivalry in consumption means that more consumptionof a good by one person does not imply less consumption of it by another person.Clean air and national defense are examples of goods with nonrivalry. For example, ifyou were to take a walk outside and bask in the warm sunshine and breathe more cleanair, you are not depriving another person of the opportunity to enjoy the sunshine orto breathe the clean air. Similarly, the sense of security that you get from a country’snational defense—the military personnel, the strategic alliances, the missile defensesystem—is not reduced by the fact that your neighbor enjoys the same benefits of anational defense system.

In contrast, for most goods, there is rivalry in consumption. For example, if you pur-chase a ripe apple from the supermarket and eat it, then no one else can consume thatapple. When you sit in the library and read this economics textbook, no one else can readthis particular copy of the textbook. But for a good with nonrivalry in consumption,everybody can consume more if they want to. The good has a collective aspect, and thetotal benefit is the sum of the benefits to every person.

Table 15-1Types of Goods andServices Produced byGovernment in the UnitedStates

Type of Good orService

Employment as aPercent of Total

Government

Education 46Health and hospitals 9Police protection 6National defense

(civilian)4

Postal service 4Corrections (prisons) 4Highways 3Judicial and legal 2Parks and recreation 2Fire protection 2All other 18

public gooda good or service that has twocharacteristics: nonrivalry inconsumption andnonexcludability.

nonrivalrythe situation in which increasedconsumption of a good by oneperson does not decrease theamount available for consumptionby others.

Public Goods 389

Nonexcludability means that one cannot exclude people from consuming thegood. For example, the supermarket will not let you eat the apple unless you pay for it.The library will not let you check out the copy of the textbook unless you have a validstudent ID card. These are excludable goods. On the other hand, no one can stop youfrom going outside, basking in the sunshine, and breathing clean air. The security pro-vided by national defense is available to you, and no one can prevent you from benefitingfrom that security. A good or service that has nonrivalry in consumption and nonexclud-ability is a public good. In contrast, a private good has excludability and rivalry.

Free Riders: A Difficulty for the Private SectorPeople can enjoy the consumption of a nonexcludable good or service without having topay for it. Furthermore, if that good is also a nonrival good, then its use by nonpayingconsumers does not reduce the ability of paying consumers to enjoy that good. Hence,instead of people clamoring to deny the use of a good to nonpaying consumers, youwould see previously paying consumers also turn into nonpaying consumers. Prettysoon, the only consumers of the nonrival, nonexcludable good will be nonpaying ones,and hence no one will have the incentive to provide that public good to the marketplace.We describe this situation as a free-rider problem associated with public goods: Peoplewho do not contribute to the costs of providing the good end up benefiting from thegood because they cannot be excluded.

To better understand this concept, imagine that you bought a huge bus for the pur-pose of transporting students around the college town and collecting a little money foryour service. But suppose the bus had a broken rear door that allowed people to get onand off without paying and without interfering with other people’s travel. In that situa-tion, you soon would find that all your riders would be nonpaying ones. If you couldnot fix the door or do something else to exclude the free riders, you would not be in thetransportation business long, because without fares, you would have losses.

National defense is like the huge bus with the broken rear door. You cannot excludepeople from enjoying it, even if they do not pay—for instance, if an enemy aircraft is

In the Wake of Hurricane Katrina

A Chinook helicopter drops sand bags to plug a canal levee break in the Gentilly neighborhood ofNew Orleans, Louisiana, on September 11, 2005. Levees are a public good, having characteristicsof both nonrivalry and nonexcludability.

nonexcludabilitythe situation in which no one canbe excluded from consuming agood.

free-rider problema problem arising in the case ofpublic goods because those whodo not contribute to the costs ofproviding the public good cannotbe excluded from the benefits ofthe good.

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390 Chapter 15 Public Goods, Externalities, and Government Behavior

intent on dropping bombs on a city, then shooting down that plane protects everyone’shouse, not just those of the people who paid for the antiaircraft missile. It is clear, then,that a private firm will have difficulty producing and selling national defense to the peo-ple of a country, because everyone will be hoping that someone else will pay for the anti-aircraft missile that protects his or her house. Given the free-rider problem, the publicgood would have to be provided by the government. For instance, the government willbe willing to provide national defense. Similar actions are taken with other public goodssuch as police protection, fire protection, and the judicial system. The government canbroadly fund its provision of these public goods by assessing taxes on households.

Certain types of information also have the features of a public good. Everyone canbenefit from information that a hurricane is on the way; there is no rivalry in consumingthis information. Excluding people from consuming that information also would be diffi-cult, because the most effective ways of notifying people quickly would involve radio andtelevision broadcasts that are accessible to all. The U.S. Weather Service therefore willcollect and distribute information about hurricanes and other adverse weather events.But you should keep in mind that not all information is nonexcludable. For example, ifyou want to analyze broad trends in the U.S. economy, you will find that much of theinformation you need is freely available through the Department of Commerce. If youwant to analyze detailed information about companies trading on the New York StockExchange, however, you will have to pay a fee to a company before you can gain accessto that information. We focus on the type of information that has a public good featureassociated with it.

Avoiding Free-Rider ProblemsEven though we define public goods as being goods and services that are nonrival and nonex-cludable, few goods are completely nonexcludable. Sometimes the private sector is able to findways of making a good excludable to a degree sufficient to overcome the free-rider problem.A classic example used by economists to explore the nature of public goods is the lighthousethat warns ships of nearby rocks and prevents them from running aground. A lighthouse hasthe feature of nonrivalry. If one ship enjoys the benefit of the light and goes safely by, this doesnot mean that another ship cannot go by. Similarly, it is impossible to exclude ships fromusing the lighthouse because any ship can benefit from the light it projects.

Lighthouse services, however, are not always provided by the government. Earlylighthouses were built by associations of shippers, who charged fees to the ships innearby ports. This system worked well because the fees could be collected from mostshippers as they entered nearby ports. So even if not every ship that used the lighthouse’sservices could be charged individually for that service (for instance, a ship that did notcome into port but sailed by, using the lighthouse to gauge where land was, would notbe charged for lighthouse services), many of those who benefited from the good werecharged fees, thus alleviating the free-rider problem without government involvement.

Another example is over-the-air radio or television broadcasts. Such broadcasts haveboth characteristics of a public good. They are nonexcludable because anyone can tune into the broadcast, regardless of whether they have paid to see or hear that particular show.They are nonrival because the use of an antenna or an aerial to capture a television or radiosignal does not prevent anyone else from doing the same. Despite the public good charac-teristics of radio and television services, however, private firms always have provided the vastmajority of such services in the United States. They are able to do so by using advertisingto pay for the provision of the broadcast service, thus avoiding the free-rider problem.

Sometimes governments are able to charge people for the use of particular servicesthat have a certain amount of excludability. This charge is called a user fee. In recentyears, user fees have become more common in many government-provided services,

The Classic Lighthouse Example

How can the free-rider problem beavoided without governmentproviding the service?

user feea fee charged for the use of agood normally provided by thegovernment.

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Public Goods 391

including the national parks. The aim is to target the payments more closely to the usersof the goods and services.

Some public goods and services have closely associated supplements that are pro-vided privately. For instance, even though police services almost always are provided by alocal government, businesses and wealthier families in a town may choose to avail them-selves of security services provided by private firms to supplement the police services. Inthese cases, no free-rider problem arises because the private security service is excludable;it is targeted at a particular group, which will be charged for the use of that service.

Changes in Technology and ExcludabilityModern technology is constantly changing the degree to which certain goods are nonex-cludable. A good example is the changing public good features of television. Cable tele-vision and the ability to scramble signals for those who use satellites to obtain theirtelevision signals have reduced the problem of nonexcludability. If one does not pay acable television bill, the service can be turned off. If one does not pay the satellite fee,the signals can be scrambled so that reception is impossible. Thus, it is now common tosee cable television stations like HBO and Showtime delivering specialized programmingto small audiences that pay extra for the special service. Such broadcasts may have theluxury of being free of advertising because users can be charged directly for the services.

The Production of Goods by the GovernmentIf we look at the types of goods produced by government in Table 15-1, we see manypublic goods, such as national defense, police protection, and the judicial and legal sys-tem. Other goods in the list, however, do not have features of public goods. Postal deliv-ery, for example, is a service that has rivalry both in consumption and excludability. Ifyou do not put a stamp on your letter, it is not delivered, and a postal delivery worker’stime certainly has rivalry. In principle, education also is characterized by rivalry in con-sumption and excludability. For a given-size school, an additional student may reducethe education of other students, and it is technologically feasible to exclude a studentwho does not pay school fees or meet certain admissions criteria.

The mere production of a good by the government does not make that good a pub-lic good. In centrally planned economies, the government produces virtually everything,private goods as well as public goods. The economist’s definition of a public good is spe-cific and is useful for determining when the government should produce something andwhen it is better left to the market. If a good or service being produced by the govern-ment is not a public good, then it is important to find out the other reasons why thegovernment is involved in the production of that good or service.

Cost-Benefit AnalysisSuppose the government decides that a particular good or service is a public good andthat because of free-rider problems, the private sector will not get involved in the pro-duction of that good. Should the good be produced by the government? If so, howmuch of the good should be produced? Such decisions ultimately are made by votersand elected officials after much political debate. Economic analysis of the costs and bene-fits of providing the goods and services is critical if the participants in this debate are tomake informed decisions. Balancing the costs and benefits of providing a good or servicebefore making a decision is called cost-benefit analysis.

Marginal Cost and Marginal Benefit To determine the quantity of a govern-ment-provided service that should be produced, the marginal cost and marginal benefit

cost-benefit analysisan appraisal of a project based onthe costs and benefits derivedfrom it.


of the service should be considered. In the case of police services, for example, a decisionabout whether to increase the size of the police force should consider both the marginalbenefit to the people in the city—the reduction in the loss of life and property caused bycrime, the increased enjoyment from a secure environment, and safer schools—and themarginal cost—the increased payroll for the police. If the marginal benefit of having morepolice is greater than the marginal cost of providing more police, then the police forceshould be increased. The optimal size of the police force should be such that the marginalcost of providing more police is equal to the marginal benefit of having more police.

Measuring the costs of producing government-provided services is not difficult becausegovernment workers’ wages and materials used in production have explicit dollar values. Butmeasuring the benefits of government-provided services is much more difficult. How do wemeasure how much people value greater security in their community? How do we value areduction in violence at schools or a reduced murder rate? Public opinion polls in whichpeople are asked how much they would be willing to pay are a possibility. For example, peo-ple can be asked in surveys how much they would be willing to pay for more police in anarea. Such estimates of willingness to pay are called contingent valuations because theygive the value contingent on the public good’s existing and the person’s having to pay for it.Some economists think that contingent valuation is not reliable if people actually do nothave to pay for the good or service. People may not give a good estimate of their true will-ingness to pay.

Externalities: From theEnvironment to EducationWe have seen that the existence of public goods provides an economic rationale for gov-ernment involvement in the production of certain goods and services. Another rationale

R E V I E W• Public goods have two characteristics: nonrivalry,

which means that more consumption of the good byone person does not mean that less of the goodwould be available for someone else, and nonex-cludability, which means that it is not possible toexclude those who do not pay for the good fromconsuming the good.

• These two characteristics lead public goods to havea free-rider problem—people who do not pay for thegood can use it without interfering with the ability ofthose who paid for the good to use it. Instead ofobjecting to nonpayers’ use of the good, the payingcustomers will soon stop paying. This means thatprivate producers have little incentive to producethis good; thus, government production is frequentlynecessary.

• If the goods are not completely nonexcludable, theprivate sector may be able to come up with ways to

charge at least some users of the good, enabling itto deal with the free-rider problem and producegoods in the market. Changes in technology alsocan help make previously nonexcludable goods andservices at least partially excludable. Sometimes,even the government may levy user fees on users ofsome public goods that the government provides.

• In deciding how much of a public good should beprovided, cost-benefit analysis can be used. Theoptimal quantity of the public good or service is thequantity at which the marginal benefit of the good orservice equals its marginal cost.

• Even though the marginal cost of providing a publicgood can be fairly easily calculated, the marginalbenefit is harder to calculate. Estimates of willing-ness to pay, known as contingent valuations, are asomewhat controversial measure of the marginalbenefit of a public good.

contingent valuationan estimation of the willingness topay for a project on the part ofconsumers who may benefit fromthe project.

Externalities: From the Environment to Education 393

for government involvement in production is a market failure known as an externality.An externality occurs when the costs of producing a good or the benefits from consum-ing a good spill over onto individuals who are not producing or consuming the good.The production of goods that cause pollution is the classic example of an externality. Forexample, when a coal-fired electric utility plant produces energy, it emits smoke thatcontains carbon dioxide, sulfur dioxide, and other pollutants into the air. These pollu-tants can make life miserable for people breathing the air and can cause serious healthconcerns. Similarly, people who smoke cigarettes pass on the health risks associated withsecondhand smoke to those in their vicinity and reduce the quality of life for people whohave negative reactions to the smell of cigarette smoke. These are examples of negativeexternalities because they have a negative effect—a cost—on the well-being of others.A positive externality occurs when a positive effect—a benefit—from producing orconsuming a good spills over onto others. For example, you might benefit if your neigh-bor plants a beautiful garden that is visible from your house or apartment. Similarly, ifyou decide to get a flu shot, then you not only are protected against the flu, but also willnot pass on the flu to others with whom you come into contact. We first will look at theeffects of negative externalities and then consider positive externalities.

Negative ExternalitiesIn the case of negative externalities, a competitive market produces a quantity thatexceeds the efficient amount of production. For example, companies may be too inclinedto use air-polluting fossil fuels to generate energy instead of using a nonpolluting sourceof energy like solar power. The reason is that producers do not take into account theexternal costs when they calculate their costs of production. If they did take these costsinto account, they would produce less.

Oil Spill: A Negative Externality

The BP oil spill that lasted three months beginning in April, 2010 is an example of a negative externality:The production of goods or services (oil for fuel) raises costs and/or reduces benefits to the livelihood ofpeople living in and around the Gulf of Mexico who work in the fishing and tourism industries.

externalitythe situation in which the costs ofproducing or the benefits ofconsuming a good spill over ontothose who are not producing orconsuming the good.

negative externalitythe situation in which costs spillover onto someone who is notinvolved in producing orconsuming the good.

positive externalitythe situation in which benefits spillover onto someone who is notinvolved in producing orconsuming the good.

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The reason why competitive markets are not efficient in the case of negative exter-nalities can be illustrated using the supply and demand curves. For example, consider anexample of a negative externality resulting from pollution caused by the production ofelectricity. This negative externality occurs because the production of electricity raisespollution costs to other firms and to individuals. The actual cost of producing electricpower is greater than the costs perceived by the electrical utility. In other words, becauseof the externality, the marginal cost as perceived by the private firm, which we now callthe marginal private cost, is less than the true marginal cost that is incurred by society,which we call the marginal social cost. Marginal social cost is the sum of the firm’smarginal private cost and the marginal external cost, that is, the increase in external coststo society as more is produced.

Marginal social cost ¼ marginal private cost þ marginal external cost

We illustrate this equation in Figure 15-1 by drawing a marginal private cost curvebelow the marginal social cost curve. We use the term marginal private cost to refer towhat we have thus far called marginal cost to distinguish it from marginal social cost.Recall that adding up all the marginal (private) cost curves for the firms in a market givesthe market supply curve, as labeled in the diagram.

Figure 15-1 also shows the marginal benefit to consumers from using the product,in this case, electrical energy. This is the market demand curve for electricity. Accordingto the supply and demand model, the interaction of firms and consumers in the marketwill result in a situation in which the marginal cost of production—the marginal privatecost—equals marginal benefit. This situation occurs at the market equilibrium, the pointat which the quantity supplied equals the quantity demanded. The resulting quantityproduced is indicated by point B in Figure 15-1.

At this amount of production, however, the marginal benefit of production is lessthan the marginal social cost of production. Marginal benefit equals marginal private cost

Figure 15-1

DOLLARS

Marginal private costas viewed by private firms(market supply curve)

Marginal social cost

Marginal benefit(market demand curve)

QUANTITY OF

ELECTRICITY

Marginal private cost isless than marginal socialcost by this amount.Deadweight

loss

Efficient quantity

A B

The market generatesthis quantity.

Illustration of a TypicalNegative ExternalityBecause production of the goodcreates costs external to thefirm, the marginal social cost isgreater than the marginal privatecost to the firm. Thus, theequilibrium quantity thatemerges from a competitivemarket is too large: Marginalbenefit is less than marginalsocial cost.

marginal private costthe marginal cost of production asviewed by the private firm orindividual.

marginal social costthe marginal cost of production asviewed by society as a whole.


but is less than marginal social cost. Only at point A in the figure is marginal benefitequal to marginal social cost. Thus, point A represents the efficient level of production.Because of the externality, too much is produced. Firms produce too much because theydo not incur the external costs.

Recall that we calculated how well off an economy is as a result of a particular out-come by adding up the values of consumer surplus and producer surplus. The sum ofconsumer and producer surplus is the area between the market supply curve and themarket demand curve over the range of output produced. Another way to think about itis as the difference between marginal benefit (demand) and marginal cost (supply) overthe range of output produced.

In the presence of a negative externality, how well off an economy is really shouldbe measured as the difference between marginal benefit and the marginal social cost ofproduction. For each additional unit that is produced above point A and below point B,the marginal benefit is less than the marginal social cost. Hence, the production of eachadditional unit is a net loss to society, and the overall deadweight loss from producing atthe market equilibrium quantity of B is indicated by the shaded triangle in Figure 15-1.

Positive ExternalitiesA positive externality occurs when the activity of one person makes another person bet-ter off, either by reducing costs or by increasing benefits. For example, an individualwho acquires additional education will obtain private benefits in the form of increasedearnings. But the education also benefits society. Going to school and learning to read,write, and think makes people better citizens who will be able to teach their kids how toread and write, who will be able to pass on knowledge about discoveries they make toothers, and who will be able to read about proper hygiene and health practices and thusreduce the burden on the public health system.

Another example of a good with a positive externality is research. Firms that engagein research get some of the benefits of that research through the products that they cansell—for instance, a new pharmaceutical to treat a particular disease. But the benefitsfrom the research expenditures often go well beyond the individual or the companyundertaking the research. The research spreads, and other people take advantage of it aswell. An example is military research into global positioning systems (GPS), which spilledover into the private sector and found its way into devices such as navigation systems forautomobiles.

Let us examine what happens when a positive externality raises social benefits above pri-vate benefits. To show how positive externalities affect the quantity produced in a competitivemarket, we need to look at the supply and demand curves. The externality makes the mar-ginal benefit as perceived by the consumer, which we now call the marginal private benefit,less than the true benefit to society, which we call the marginal social benefit. With a posi-tive externality, the marginal social benefit is greater than the marginal private benefit becausea marginal external benefit results from more consumption. That is,

Marginal social benefit ¼ marginal private benefit þ marginal external benefit

We illustrate this equation in Figure 15-2 by drawing a marginal private benefitcurve that lies below the marginal social benefit curve. We use the term marginal privatebenefit curve to refer to what we have thus far called marginal benefit or the marketdemand curve to distinguish it from marginal social benefit. Suppose that Figure 15-2refers to the market for education. The market equilibrium is the point at which the mar-ginal private benefit curve (the market demand curve) intersects the marginal cost curve(the market supply curve). The resulting quantity produced is indicated by point C inFigure 15-2.

marginal private benefitthe marginal benefit fromconsumption of a good as viewedby a private individual.

marginal social benefitthe marginal benefit fromconsumption of a good from theviewpoint of society as a whole.


At this amount of production, however, the marginal social benefit of productionexceeds the marginal cost of production. Only at point D in the figure is marginal socialbenefit equal to marginal cost. Thus, point D represents the efficient level of production.Because of the positive externality, too little is produced. Firms do not have the incentiveto produce more because they do not gain directly from the benefits that are spillingover onto others.

In the presence of a positive externality, the sum of consumer and producer surplusreally should be measured as the difference between the marginal social benefit and mar-ginal cost. You can see that each additional unit that is not produced above point C andbelow point D results in forgone net benefit to society because the marginal social benefitexceeds the marginal cost of production. By not increasing production from point C topoint D, we incur a deadweight loss that is indicated by the shaded triangle in Figure 15-2.

Externalities Spread across BordersExternalities are by no means limited in their geographic impact. Sulfur dioxide emis-sions from electrical utility plants are an externality with international effects. The sulfurdioxide travels high into the air and then is dispersed by winds across long distances.Rainfall then brings the sulfur dioxide back to Earth in the form of acid rain, which landson forests and lakes hundreds of miles away. In some cases, the acid rain occurs in coun-tries different from the country in which the sulfur dioxide was first emitted. In NorthAmerica, acid rain that results from burning fuel in the Midwest industrial centers mayfall in Canada or upstate New York.

Global warming is another example of an externality with international dimensions.When too much carbon dioxide accumulates in the Earth’s atmosphere, it prevents thesun’s warmth from escaping out of the atmosphere, causing a greenhouse effect. Global

Figure 15-2

The market generatesthis quantity.

Deadweightloss

Marginal cost(market supply curve)

Marginal social benefit

Marginal private benefit as viewed by consumers of goods(market demand curve)

Marginal social benefitis greater thanmarginal private benefitby this amount.

Efficient quantity

DOLLARS

QUANTITY OF

EDUCATION

C D

Illustration of a TypicalPositive ExternalityBecause consumption of thegood gives benefits to others,the marginal social benefit isgreater than the marginal privatebenefit. Hence, the equilibriumquantity that emerges from acompetitive market is too low.


warming is caused by the emission of carbon dioxide by firms and individuals but haseffects around the world.

The ease and prevalence of modern air travel also leads to negative spillover effectson other countries from a poor health care system in one country. For instance, ifpatients in one country fall victim to an infection like the avian flu but go untreated, theyvery easily can spread that disease to many other countries as the people they come intocontact with travel the world.

Remedies for ExternalitiesAs the previous section shows, competitive markets do not generate an efficient level ofproduction when externalities exist. What are some of the ways in which a society can al-leviate problems caused by these externalities? In some cases involving positive external-ities, the solution has been for the government to produce the good or service becausethe private sector will produce less than the socially efficient level of output. For instance,elementary education is provided by governments around the world with requirementsthat children attend school through a certain age. But in most cases in which external-ities are present, production is left to the private sector, and the government endeavorsto influence the quantity produced.

How can production in the private sector be influenced by government to lead to amore efficient level of production of goods and services in the economy? We will see that theanswer involves changing behavior so that the externalities are taken into account internallyby firms and consumers. In other words, the challenge is to internalize the externalities.

Four alternative ways can bring about a more efficient level of production in the caseof externalities. The first method we discuss, private remedies, does not require directgovernment intervention. The other three—command and control, taxes or subsidies,and tradable permits—do.

R E V I E W• Externalities occur when the benefits or costs of pro-

ducing and consuming spill over onto others. Thespillovers can be negative, as in the case of air pollu-tion, or positive, as in the case of vaccinations.

• Externalities are a cause of market failure. For goodswith negative externalities, more than the efficientamount is produced because the marginal socialcost exceeds the marginal private cost. Private firmsproduce until the marginal benefit equals the mar-ginal private cost, even though the optimal level islower—the point at which the marginal benefitequals the marginal social cost.

• For goods with positive externalities, less than theefficient amount is produced because the marginalsocial benefit exceeds the marginal private benefit.Private firms will produce only until the marginal pri-vate benefit equals the marginal cost, even though

the optimal level is higher—the point at which themarginal social benefit equals the marginal cost.

• Both positive and negative externalities result indeadweight loss. In the case of negative external-ities, this loss occurs because too many goods arebeing produced; these additional goods have a mar-ginal social cost that exceeds the marginal benefit.In the case of positive externalities, this loss occursbecause too few goods are being produced; the for-gone goods have a marginal social benefit thatexceeds the marginal cost.

• Externalities are not necessarily local in their impact.Air pollution and global warming are examples ofexternalities whose effects are not hemmed in byborders. Changes in technology also are increas-ingly making the impact of one country’s policy on,say, public health issues have a spillover effect onother countries.

internalizethe process of providingincentives so that externalities aretaken into account internally byfirms or consumers.


Private Remedies: Agreements betweenthe Affected PartiesIn some cases, through private remedies, people can eliminate externalities withoutgovernment assistance. A Nobel Prize winner in economics, Ronald Coase of the Uni-versity of Chicago, pointed out this possibility in a famous paper published in 1960.

Consider the following simple example. Suppose that the externality relates to theproduction of two products: health care and candy. Suppose that a hospital is built nextdoor to a large candy factory. Making candy requires noisy pounding and vibrating ma-chinery. Unfortunately, the walls of the new hospital are thin. The loud candy machinerycan be heard in the hospital. Thus, we might call this noise pollution an externality. Ithas a cost. It makes the hospital less effective; for example, it is difficult for the doctorsto hear their patients’ hearts through the stethoscopes.

What can be done? The city mayor could adopt a rule prohibiting loud noise near thehospital, but that would severely impinge on candy production in the city. Or, because thehospital was built after the candy factory, the mayor could say, ‘‘Too bad, doctors; candyis important too’’ and tell the hospital to relocate somewhere where the noise is not toogreat. Alternatively, it might be better for the candy workers and doctors to work this ex-ternality out on their own. The supervisor of the candy workers could negotiate with thedoctors. Perhaps the candy workers could agree to use the loud machines only at desig-nated hours during the afternoon, during which time the doctors would avoid schedulingprocedures that are sensitive to noise. Or perhaps the hospital would be willing to pay fora more insulated wall between the candy company and the hospital so that the noise isdampened, especially because that option would be cheaper than relocation. Or perhapsthe candy company will be willing to pay for newer, less noisy machinery because it is pref-erable to the risk of having to shut down because of the noise pollution.

Thus, it is possible to resolve the externality by negotiation between the two partiesaffected. The privately negotiated alternatives seem more efficient than the mayor’s rul-ings because the production of both candy and health care continues. Note that, in thesealternatives, both parties alter their behavior. For example, the doctors change theirscheduling of noise-sensitive procedures, and the candy factory limits loud noise to theafternoon. Thus, the parties find a solution in which the polluter does not make all theadjustments, as would be the case if the mayor adopted a ‘‘no loud noise’’ rule.

The Importance of Assigning Property Rights For a negotiation like thisto work, however, it is essential that property rights be well defined. Property rightsdetermine who has the right to pollute or infringe on whom. Who, for example, is beinginfringed on in the case of the noise pollution? Does the candy factory have the right touse loud machinery, or does the hospital have the right to peace and quiet? The mayor’sruling could establish who has the property right, but it is more likely that the casewould be taken to a court and the court would decide. After many such cases, precedentwould establish who has the property rights in future cases.

The property rights will determine who actually pays for the adjustment that rem-edies the externality. If the candy factory has the right, then the workers can demandsome compensation (perhaps free health care services) from the hospital for limiting theirnoise in the afternoon, or the candy company can demand that the hospital bear some ofthe cost of the new machinery. If the hospital has the right, then perhaps the hospitalstaff and patients can get compensated with free candy, or the hospital can ask the candycompany to pay for some of the cost of building a thicker wall. The Coase theoremstates that no matter who is assigned the property rights, the negotiations will lead to anefficient outcome as described in the candy–health care example. The assignment of theproperty rights determines who makes the compensation.

private remedya procedure that eliminates orinternalizes externalities withoutgovernment action other thandefining property rights.

property rightsrights over the use, sale, andproceeds from a good orresource. (Ch. 1)

Coase theoremthe idea that private negotiationsbetween people will lead to anefficient resolution of externalitiesregardless of who has theproperty rights as long as theproperty rights are defined.

Remedies for Externalities 399

Transaction Costs Even if property rights are well defined, for a private agree-ment like this to occur, transaction costs associated with the agreement must be smallcompared with the costs of the externality itself. Transaction costs are the time andeffort needed to reach an agreement. As Coase put it,

in order to carry out a market transaction, it is necessary to discover who it is that onewishes to deal with, to inform people that one wishes to deal and on what terms, to con-duct negotiations leading up to a bargain, to draw up the contract, to undertake theinspection needed to make sure that the terms of the contract are being observed, and soon. These operations are often extremely costly.1

Real-world negotiations are clearly time-consuming, requiring skilled and expensivelawyers in many cases. If these negotiation costs are large, then the private parties maynot be able to reach an agreement. If the negotiation in the health care–candy exampletook many years and had to be repeated many times, then it might be better to adopt asimple ‘‘no loud noise’’ rule or an ‘‘existing firms get precedence over new arrivals’’ rule.

The Free-Rider Problem Again Free-rider problems also can prevent a privateagreement from taking place. For example, a free-rider problem might occur if the hos-pital was very large, say, 400 doctors. Suppose that the candy workers have the right tonoise pollute, so that they require a payment in the form of health care. The hospitalwould need contributions from the doctors to provide the care. Thus, if each doctorworked in the hospital an extra day a year, this might be sufficient.

Any one of those 400 doctors, however, could refuse to work the extra day. Someof the doctors could say that they have other job opportunities that do not require themto work an extra day. In other words, doctors who did not pay could free-ride: Theycould work at the hospital and still benefit from the agreement. Because of this free-riderproblem, the hospital might find it hard to provide health care to the candy workers, anda private settlement might be impossible.

Thus, in the case in which the transaction costs are high or free-rider problems exist,a private remedy may not be feasible. Then the role of government comes into play,much as it did in the case of public goods, in which case the free-rider problem was sig-nificant. Again, as Coase put it, ‘‘Instead of instituting a legal system of rights which canbe modified by transactions on the market, the government may impose regulationswhich state what people must or must not do and which have to be obeyed.’’2

Command and Control RemediesWhen private remedies for externalities are not feasible, either because transaction costsare too high or because of free-rider problems, the government has a role for interven-tion. One form of government intervention to solve the problem of externalities isthe placement of restrictions or regulations on individuals or firms, often referred to ascommand and control. Firms that do not heed these restrictions and regulations arefined for their violations. Command and control methods are used widely by agenciessuch as the U.S. Environmental Protection Agency (EPA), which is responsible for fed-eral environmental policy in the United States. For example, in the United States, thecorporate average fleet efficiency (CAFE) standards require that the fleet of cars pro-duced by an automobile manufacturer each year achieve a stated number of miles pergallon on the average. Another example is a government requirement that electrical util-ities put ‘‘scrubbers’’ in their smokestacks to remove certain pollutants from the smoke

transaction coststhe costs of buying or selling in amarket, including search,bargaining, and writing contracts.

1 Ronald Coase, ‘‘The Problem of Social Cost,’’ Journal of Law and Economics 3 (October 1960): 15.2 Ronald Coase, ‘‘The Problem of Social Cost,’’ Journal of Law and Economics 3 (October 1960): 17.

command and controlthe regulations and restrictionsthat the government uses tocorrect market imperfections.


they emit. Through commands, the government controls what the private sector does.The government’s actions, in principle, make the externalities internal to the firm byrequiring that the firm act as if it was taking the external costs into account.

The use of command and control to reduce externalities has many disadvantages, espe-cially in the environmental area. The most significant disadvantage is that command andcontrol does not allow firms to find other, cheaper ways to reduce pollution. For example,under command and control, electrical utilities have to install a scrubber to remove pollu-tants; they do not have the incentive to discover a cheaper alternative technology thatmight be more effective at reducing pollution. Similarly, CAFE standards can lead to ineffi-cient production decisions—because firms have to produce smaller, more fuel-efficient carsthat they did not want to produce simply to offset the production of the less fuel-efficientSUVs—or to more gasoline consumption because people find that the per-mile cost ofdriving has fallen because of the higher fuel efficiency, and hence they drive more.

Taxes and SubsidiesBecause of the disadvantages associated with command and control, economists recom-mend alternative techniques to reduce the inefficiencies that result from externalities.The use of taxes and subsidies often is recommended by economists, with goods andservices that have negative externalities being taxed while goods and services that havepositive externalities are subsidized.

For example, consider the negative externalities that are imposed by drivers. When acity has many drivers, roads become congested, leading to traffic backups and delays.Each driver contributes to the congestion, imposing external costs on the other drivers.In 2003, a new tax, called a congestion charge, was imposed on vehicles that drive incentral London during the day. Drivers can pay £8 before they travel or £10 the day af-ter they travel; cameras mounted above the roads check vehicle registration numbers toensure that the taxes are paid. The idea was to internalize the externality of congestionin central London during rush hour by making drivers pay for the external congestioncosts through the tax. If the demand for days of driving in central London is downwardsloping, the tax will bring about a cutback in driving in central London, lower the exter-nal costs imposed on drivers by reducing congestion, and create government revenue. Infact, the evidence suggests that traffic in central London fell by one-third.

The way that taxes can be used to reduce negative externalities is illustrated graphicallyin Figure 15-3, which uses the same curves as Figure 15-1. Recall that the marginal socialcost of production is greater than the marginal private cost, as viewed from the privatefirm, because of the negative externality, resulting in the equilibrium quantity produced bythe market exceeding the efficient quantity. We know that taxes raise the marginal cost tothe individual firm. They thereby shift up the market supply curve. If the tax is chosen toexactly equal the difference between the marginal social cost and the marginal private cost,then the quantity produced by the market will decline from the inefficient quantity shownat point B to the efficient quantity shown at point A in Figure 15-3.

Many examples illustrate the use of taxes in part to reduce pollution. Gasoline taxesreduce gasoline consumption and thus pollution. In the United States, a federal tax islevied of $0.184 per gallon and a variety of state taxes are assessed averaging an addi-tional $0.236 per gallon. The big advantage of taxes or subsidies compared with com-mand and control is that the market is used. Instead of restricting the ratio of SUVs tosmall, fuel-efficient cars that a producer can manufacture, the government simply raisesthe relative cost of driving an SUV versus driving a subcompact car by increasing the gas-oline tax. If users of SUVs respond by switching over to smaller cars, then the car manu-facturer has an incentive to produce smaller cars that consumers actually want to buy, orto research more fuel-efficient SUV engines.

Big Brother Is Watching Your Car!

Closed circuit television camerasloom above traffic in central Londonto monitor the license plates of theestimated 250,000 cars entering thecity each day. Drivers pay a‘‘congestion charge’’ to drive incentral London, making it moreexpensive to drive in that area of thecity, with the ultimate goal ofreducing traffic backups.

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Next, we consider the use of subsidies for goods that have positive externalities.Recall that when a good has a positive externality, too little of it is produced in a com-petitive economy; a subsidy can be used to increase production and consumption of thegood. The Vaccines for Children (VFC) program provides free vaccines for children whoare poor and do not have access to health insurance. This program was implemented fol-lowing an outbreak of measles that killed hundreds of children in the late 1980s. Vacci-nations not only protect the child directly, but also produce a positive externality forothers who will no longer risk being infected by that child. Government intervention toeffectively drive the price of vaccinations to zero through the use of a subsidy will enablemore children to be vaccinated and allow parents to internalize the positive externality ofhaving their children vaccinated.

In Figure 15-4, which uses the same curves as Figure 15-2, we demonstrate how asubsidy can be used to encourage the production and consumption of a good with a posi-tive externality. In this case, a subsidy to the user will raise the demand for the good. If thesubsidy is chosen to be exactly the difference between the marginal private benefit and themarginal social benefit, then the quantity of the good that is produced and consumed willrise from the inefficient level (C) to the efficient level (D), as illustrated in Figure 15-4.

Another example of subsidizing positive externalities is the government’s funding ofresearch by providing grants to private firms and individuals. The National ScienceFoundation supports basic research, and the National Institutes of Health support medi-cal research. In supporting research with a limited budget, it is important for the govern-ment to place more emphasis on research that has large positive externalities. Many viewbasic research as having larger positive externalities than applied research. The ideas inbasic research, such as that on the structure of the atom, affect many parts of the econ-omy. Applied research, such as that on a new lightweight metal for a bike, has more lim-ited spillover effects, and the products developed through applied research usually can be

Figure 15-3

Marginal social cost equals marginal private cost viewed by private firms with tax

TaxMarginal private cost viewed by private firms without tax

Marginal benefit(market demand curve)

Quantity produceddecreases to lower,more efficient level.

Efficient quantity Inefficient quantity

DOLLARS

QUANTITY OF

ELECTRICITY

A B

Using Taxes in the Case ofa Negative ExternalityA tax equal to the differencebetween the marginal privatecost and the marginal social costin Figure 15-1 shifts the supplycurve up. This reduces theequilibrium quantity produced tothe lower, more efficient level.


The Tragedy of the Commons: Private or GovernmentRemedies?

Goods that exhibit both nonexcludability and rivalry aresaid to suffer from the tragedy of the commons, namedafter an article by Garrett Hardin in Science magazine in1968. According to Hardin:

The tragedy of the commons develops in this way.Picture a pasture open to all. It is to be expectedthat each herdsman will try to keep as many cattleas possible on the commons. . . . As a rationalbeing, each herdsman seeks to maximize his gain.Explicitly or implicitly, more or less consciously, heasks, ‘‘What is the utility to me of adding one moreanimal to my herd?’’ This utility has one negativeand one positive component.

1. The positive component is a function of the in-crement of one animal. Since the herdsmanreceives all the proceeds from the sale of theadditional animal, the positive utility is nearly þ1.

2. The negative component is a function of theadditional overgrazing created by one moreanimal. Since, however, the effects of over-grazing are shared by all the herdsmen, thenegative utility for any particular decisionmak-ing herdsman is only a fraction of �1.

Adding together the component partial util-ities, the rational herdsman concludes that the onlysensible course for him to pursue is to add anotheranimal to his herd. And another. . . . But this is theconclusion reached by each and every rationalherdsman sharing a commons. Therein is the trag-edy. Each man is locked into a system that com-pels him to increase his herd without limit—in aworld that is limited. Ruin is the destination towardwhich all men rush, each pursuing his own best in-terest in a society that believes in the freedom ofthe commons.

Because the pasture is nonexcludable, eachherder can graze his animals there. Because thepasture is rival, however, more consumption by the

animals of one herder means less for the animalsowned by other herders. A good example of thetragedy of the commons is fishing in the openocean. The benefit of catching one more fish isgreater than the cost, which is diffused across allfishing boats. Thus, the fish stocks begin todecrease as they have in the cod and halibut fish-eries in the United States. Governments have inter-vened in various ways to stop the overuse of thecommons: establishing fishing seasons, requiringlicenses, imposing catch quotas, and requiring thatfish with a certain size be thrown back.

But Elinor Ostrom, who won the Nobel Prize in eco-nomics in 2009 for her research on the commons prob-lem, found that such market failures can be resolved byindividuals working together, and that government inter-vention may not be needed. Indeed, her empirical studiesshow that individual arrangements frequently achievebetter results than government intervention. ‘‘When usersare genuinely engaged in decisions regarding rulesaffecting their use, the likelihood of them following therules and monitoring others is much greater than whenan authority simply imposes rules.’’

Elinor Ostrom receiving the 2009 Nobel Prize in EconomicSciences in Stockholm.

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sold by the creator for profit. In fact, the U.S. federal government does spend more tosubsidize basic research than applied research.

Emission Taxes A more direct way to use taxes to deal with pollution externalities isto tax the firm based on the amount of pollution emitted rather than on the quantity ofthe potentially polluting good that is produced or consumed. For example, an electricalutility could be charged fees depending on how many particles of sulfur dioxide it emits,rather than on how much electricity it produces. Such charges are called emission taxes.These taxes are much like those levied on the amount of the product sold, but they focusdirectly on the amount of pollution.

Emission taxes have an advantage over taxes on production in that the firm can usetechnology to change the amount of pollution associated with its production. Thus, ratherthan producing less electricity, the firm can reduce the amount of pollution associated witha given amount of electricity, if it can find a cheaper way to do so. Emission taxes have aneven greater advantage over command and control than a tax on the product has.

Why Is Command and Control Used More Than Taxes? Many peoplelike one feature of command and control: The total amount of pollution can be bettercontrolled than with a tax. This perceived advantage may explain why command andcontrol is used more than taxes. Suppose, for example, that a tax is used to equate mar-ginal social cost with marginal benefit, as in Figure 15-3. Now suppose that the privatecost of producing electricity suddenly reduces. The private marginal cost curve will shiftdown, and, with the tax unchanged, production (and pollution) will increase. A regula-tion that stipulates a certain quantity to produce would not have this problem. The totalamount of pollution would be fixed. Fortunately, in recent years, a new idea in pollutioncontrol has emerged that has both this advantage of command and control and the flexi-bility of the market. This new idea is tradable permits.

Figure 15-4

Marginal social benefit equals marginal private benefit plus subsidy

Marginal private benefitwithout subsidy

Subsidy

Inefficientquantity

Efficientquantity

Quantity producedincreases to higher,more efficient level.

DOLLARS

QUANTITY OF

EDUCATION

Marginal cost(market supply curve)

C D

Using Subsidies in the Caseof a Positive ExternalityA subsidy equal to the differencebetween the marginal socialbenefit and the marginal privatebenefit of education or researchshifts the demand curve up. Thisincreases the equilibriumquantity produced to the higher,more efficient level andeliminates the deadweight lossresulting from the externality.

emission taxa charge made to firms thatpollute the environment based onthe quantity of pollution that theyemit.


Tradable PermitsTradable permits use the market to help achieve the standards set by the government.The way these permits work is as follows. The government decides what limit it wants toimpose on the overall level of a particular pollutant. The government then issues a num-ber of permits specifying permissible amounts of pollution. The total amount of pollu-tion in the economy is equal to the total amount specified in the permits issued. If a firmplans to emit more pollutants than it has permits for, it will have to acquire additionalpermits from other firms. On the other hand, if a firm has more permits than the pollu-tants it plans to emit, it can sell its permits to another firm that wants them.

Firms now have an incentive to lower their emissions because they can sell thepermits if they do not use them. Firms that can lower their emissions cheaply willchoose to do so and benefit by selling their permits to other firms for which reducingthe pollution is more costly. Tradable permits not only allow the market system towork, but also give firms an incentive to find the least costly form of pollution control.Rather than forcing individual firms to limit the quantity of the pollutant that theycan release, tradable permits enable those firms that can reduce the emissions in themost cost-efficient manner to do the bulk of the emissions reduction. Firms that facea high cost of reducing pollution will cut back less on their pollution, but they willhave to internalize their pollution costs because of the need to buy permits. Thosefirms also will have an incentive to adopt technologies that eventually will emit fewerpollutants.

Tradable permits illustrate how important property rights are for resolving external-ities. The role of government in this case is to create a market by defining certain rightsto pollute and then allowing firms to buy and sell these rights. Once rights are assigned,the market can work and achieve efficiency.

Perhaps the best-known use of tradable permits in the United States has been toreduce emissions of sulfur dioxide. Tradable permits also can work in combating globalwarming. The amount of global warming depends on the total amount of carbon diox-ide emissions in the world’s atmosphere. It does not matter whether a firm in LosAngeles or in Shanghai emits the carbon dioxide. Tradable permits could control thetotal amount of pollution. The permits would let firms or individuals decide on the mostcost-effective way to reduce their total amount of pollution.

Balancing the Costs and Benefits ofReducing ExternalitiesAs with public goods, it is important to use cost-benefit analysis when considering how bestto intervene in the economy to fix problems caused by externalities. Clear benefits can accruefrom reducing pollution, but associated costs can result in the form of lower production, lostjobs, administrative expenses, and so on. These costs should be compared with the associatedbenefits on a case-by-case basis before deciding on the appropriate intervention method.

For example, the EPA introduced a new rule for stricter standards on the amount ofsulfur allowed in diesel fuel in 2000. Environmentalists saw a clear benefit from thesenew standards because they were concerned that diesel exhaust was causing acceleratedcancer rates. On the other hand, trucking companies that use diesel fuel saw a clear costbecause the effect of the stricter standards was to raise the price of the fuel needed torun their trucks. The EPA estimated that the new, stricter standards would prevent8,300 deaths and 360,000 asthma attacks, while increasing the price of diesel fuel by$0.04 to $0.05 per gallon. The oil industry reported that implementation of the stricterstandards would cost $8 billion. Policy makers would have to do a cost-benefit analysisto determine whether the additional benefits coming from a stricter standard on sulfurjustified the additional costs.

tradable permita governmentally granted licenseto pollute that can be bought andsold.


As the following two examples illustrate, policy makers sometimes rule that the ben-efits justify the costs, whereas at other times they conclude that the costs outweigh thebenefits. The first example was the regulation of carbon dioxide emissions, a policy thatPresident George W. Bush had advocated during his 2000 campaign for the presidency.In 2001, President Bush changed his mind about regulating carbon dioxide emissions. Astudy by the Energy Department showed that this regulation would result in nearly aquadrupling of the cost of producing electricity from coal, causing large price increasesfor both electricity and natural gas. President Bush stated that the impact on utility pricesmade the cost of regulating carbon dioxide emissions too high.

The second example relates to stricter standards on the level of arsenic allowed indrinking water that President Clinton imposed shortly before leaving office. In March2001, the EPA rescinded the new, stricter standard and debated its merits. Scientificstudies showed that higher levels of arsenic in drinking water lead to higher risks of fatalcancer, heart disease, and diabetes. The cost of the stricter standard for arsenic in drink-ing water was estimated at billions of dollars because arsenic is a by-product in mining, isused as a wood preservative for lumber, and occurs naturally in water in some areas. Af-ter examining the evidence, the Bush administration decided to impose the stricterstandard, convinced that the health benefits were worth the cost.

Some people object to the use of cost-benefit analysis for deciding whether environ-mental regulations should be implemented. They argue that environmental regulationscan benefit rather than cost the economy, because requiring individuals to reduce pollu-tion creates a demand for pollution-reducing devices and creates jobs in the pollution-reducing industry. But unless the pollution-reducing equipment is creating a benefit tosociety greater than the benefits of other goods, shifting more resources to pollutionabatement will not be an efficient allocation of society’s resources.

In recent years, there has been significant concern about rising pollution levels inother parts of the world, especially in very fast-growing economies like China, India, andBrazil. As more factories start producing goods and services, more forests are cleared tomeet the space needs of expanding cities, more power generation is needed to meet thedemands of newly electrified homes, and more vehicles enter the streets as people spendtheir rising incomes, air- and water-pollution problems in these countries become magni-fied. This poses a dilemma for policy makers because asking these countries to cut backon their rates of economic growth to reduce pollution clearly does not seem like a feasi-ble plan. In fact, many people argue that the surest way to reduce pollution around theworld is to ensure that the less-developed economies of the world increase their level ofincome. This will give them more resources to spend on pollution control.

Environmental economists and policy makers will continue to study these vexingcost-benefit analyses of how to reduce pollution at both local and global levels. Whatyou have learned in this chapter about externalities, public goods, taxes, regulations,tradable permits, and private remedies will play an important role in their deliberations.

R E V I E W• There are four basic ways to improve the efficiency

of markets in the presence of externalities: privateremedies, command and control, taxes andsubsidies, and tradable permits. In each of theseapproaches, the goal is to get firms to internalize the

externality—to change their behavior to take intoaccount the impact their actions have on others.

• Private remedies do not require direct governmentintervention. The affected parties can negotiateamong themselves and efficiently resolve the


Models of Government BehaviorThe previous two sections outlined what government should do to correct market failurecaused by public goods and externalities. Regardless of the reason that market failureoccurs, the outcome is similar: Production may be too little or too much, and producersurplus plus consumer surplus is not maximized, resulting in deadweight loss. The roleof government is to intervene in the economy to reduce this deadweight loss.

Using economics to explain the role of government in this way is considered a nor-mative analysis of government policy. Normative economics is the study of what shouldbe done. But another way to look at government policy falls into the area of positive eco-nomics and looks at what governments actually do rather than what they should do.

One of the reasons for studying what governments actually do is that governmentssometimes fail because the normative recommendations are ignored or poorly imple-mented. Government failure occurs when the government intervention fails to improveon the market or even makes things worse. One objective of positive analysis of govern-ment is to understand why success occurs in some situations and failure results in others.

Public Choice ModelsPeople run the government. Government behavior depends on the actions of voters,members of political parties, elected politicians, civil servants, and political appointees fromjudges to cabinet officials. The work of government also depends on the large number ofpeople who lobby and who participate in grassroots campaigns, from letter writing toe-mail messages to political protests. What motivates the behavior of all these people?

The motivations of politicians and government workers are complex and varied. Manypeople enter politics for genuine patriotic reasons and are motivated by a desire to improvethe well-being of people in their city, state, or country, or even the world. Their motiva-tions may be deeper than watching out for their own best interests, narrowly defined.

For example, Alexander Hamilton, the first secretary of the U.S. Department ofTreasury, worked hard to put the newly formed country on a firm economic foundationby having the federal government assume the debts of the states after the Revolutionary

externalities. The Coase theorem states that as longas property rights are defined clearly, parties will cometo an agreement. This approach also requires thattransaction costs not be too high and that free-riderproblems associated with the settlement be minimized.

• Command and control refers to direct rules andregulations imposed by the government to limitmarket imperfections. Examples include theimposition of fuel-efficiency standards on automanufacturers and requirements that coal-burningutilities install scrubbers.

• Taxes and subsidies are considered by economiststo be superior to command and control techniquesbecause they use the market to internalize theexternality. Taxes of an appropriate magnitude canhelp reduce the output of goods with negativeexternalities to the socially efficient level. Similarly,

subsidies at an appropriate level can help increasethe consumption and production of goods withpositive externalities to the socially efficient level.

• Tradable permits are a method of internalizingexternalities that economists typically favor. Thegovernment can set strict limits on the production ofa negative externality, such as a pollutant, by issuinga limited number of permits. By allowing the permitsto be traded, however, the reduction in the pollutantcan be done efficiently by allowing firms that areable to reduce it at the lowest cost to do the bulk ofthe reductions. Firms also have incentives to comeup with new ways to reduce the externality becausethey can sell their permits to less efficient producers.

• Regardless of which method is used to eliminatethe impact of an externality, policy makers still have todo a cost-benefit analysis of the proposed intervention.

government failurethe situation in which thegovernment fails to improve onthe market or even makes thingsworse. (Ch. 1)

Models of Government Behavior 407

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