2. Previously
• Consumer surplus is the difference between
what a consumer is willing to pay and the price
actually paid for a good or service.
• Producer surplus is the difference between the
minimum price a producer is willing to accept
and the payments he actually receives from
selling a good.
• Excise taxes create deadweight loss and reduce
overall economic welfare.
3. Big Questions
1. What are externalities, and how do they affect
markets?
2. What are private goods and public goods?
3. What are the challenges of providing non-
excludable goods?
4. Externalities
• Internal costs
– The costs of an activity paid by an individual
engaging in the activity
• External costs
– The cost of an activity paid for by someone
else not directly involved in the activity
• Social costs
– Sum of internal and external costs
5. Third-Party Problem
• Externalities
–Occur when private cost (or benefit)
diverges from social cost (or benefit)
• Third-Party Problems
–People not directly involved in activity
experience positive or negative
externalities.
6. Third-Party Problem
• Negative externalities
– Costs experienced by third parties
– “Too much” of the good is consumed
and produced.
– Pollution, secondhand smoke
• Positive externalities
– Benefits experienced by third parties
– “Not enough” of the good is
consumed and produced.
– Education, vaccines
7. Correcting for Externalities
• Internalizing the externality
– The individual involved in the activity takes
account for social costs (or benefits).
• For negative externalities:
– Force individual to pay for external costs
– Tax production
– Regulate production
– Overall output is reduced, illustrated by a
leftward shift in supply.
9. Correcting for Externalities
• For positive externalities:
–Help individuals realize external benefits
–Finance and/or subsidize production
and consumption of the good
–Laws requiring consumption
• Vaccines
• Education
–Overall consumption is increased,
illustrated by a rightward shift in demand
11. Summary of Externalities
Negative Positive
Definition Costs borne by third parties.
Benefits received by third
parties.
Examples
Oil refining creates air pollution.
Traffic congestion causes all
motorists to spend more time on
the road waiting.
Airports create noise pollution.
Flu shots prevent the spread of
disease.
Education citizens are more
productive and make more
informed decisions for the
betterment of society.
Restored Historic buildings
enable people to enjoy the
beautiful architectural details.
Corrective
measures
Taxes, charges, or regulations
Subsidies or government
provision
12. Pecuniary Externalities
• Pecuniary externality
– Externality that operates through prices rather than
resources
– Example:
• Many people move to town and buy houses, which drives
housing prices upward.
• A third party who wants to buy a house later is hurt by the
higher price.
• However, this loss is exactly offset by the additional gain
received by house sellers.
– When considering all markets, there is no gain or loss
of efficiency. Some economists believe this should not
be called an externality.
13. Inframarginal Externalities
• Inframarginal externality
–Externality that exists, but consequence
of a marginal change in activity is
effectively zero
–We must examine total costs and
benefits rather than marginal effects.
–Example:
• One more person using bandwidth on the Internet
• One more person attending a concert or sporting
event
14. Inframarginal Externalities
• Think about going to the beach
– Plenty of sand
– Plenty of swimming room
• What if one more person shows up at the
beach?
– There won’t be any noticeable effect on you.
The marginal effect of one more person is
effectively zero.
– But what if we keep adding one person at a
time?
15.
16. Property Rights
• Externalities often arise because of a lack
of clearly defined property rights.
– Ask: Who owns the air? Can I pollute?
• Private property
– Provides exclusive right of ownership that
allows for the use and exchange of property
– Creates incentive to maintain, protect, and
conserve property, as well as listen to the
wishes of others
17. Private Property Incentives
1. Incentive to maintain
– Keep the vehicle safe and reliable
1. Incentive to protect
– Lock your doors
1. Incentive to conserve
– Extend vehicle life, drive less
1. Incentive to trade with others
– You can voluntarily trade for something better
in the market.
18. Coase Theorem
• Two adjacent farmers, no fences
– One raising cattle
– One growing wheat
• Scenario 1: The cattle rancher is
liable for damages the cows
cause.
• Options for cattle rancher
– Put up a fence
– Pay damages to wheat farmer
– Rancher will consider costs of both
to make choice.
19. Coase Theorem
• Scenario 2: The wheat farmer does not have a
legal right to cattle-free fields.
• Options for farmer
– Put up a fence
– Accept occasional cattle damage
• Result?
– If property rights are fully specified, either the cattle
rancher or wheat farmer will build a fence.
• Coase theorem
– If there are no barriers to negotiations, interested
parties will bargain to correct any externality.
20. Economics in King of Queens
• Coase theorem
• In this clip, a barking dog creates a
negative externality. See how the
parties involved work out a private
solution.
21. Private Goods
• Characteristics of certain consumption goods
• Excludable
– The good must be purchased before use.
• Rival
– The good cannot be enjoyed by more than one
person at the same time.
• Private goods
– Are both excludable and rival in consumption
– Most goods we purchase and consume are private
goods.
22. Public Goods
• Public goods
– Can be consumed by many
– Difficult to exclude non-payers
from consumption
– Examples:
• Public defense, public parks, public fireworks display
• Free-rider problem
– Someone has the ability to receive the benefit of a
good without paying for it.
– Examples:
• Eating (and not paying) at a free-will donation meal
• Letting a classmate do all the work in a group project!
23. Club Goods,
Common Resources
• Club goods
– Non-rival and excludable
– Examples:
• Satellite TV, gym membership
• Common resource goods
– Rival but non-excludable
– Examples:
• Fishing, hunting (specific animals
fished and hunted), public campsites
24. Four Types of Goods
Consumption
Rival Non-rival
Excludable
Yes
Private Goods
pizza, watches,
automobiles
Club Goods
satellite television,
education, country
clubs
No
Common Resource Goods
Alaskan king crab, sharing
a large popcorn at the
movies, congested roads,
charitable giving
Public Goods
street performers,
defense, Tsunami
warning systems
25. Cost-Benefit Analysis
• Cost-benefit analysis
– Process to determine whether the benefits of
providing a public good outweigh the costs
• Costs
– Known amount, easy to compute
• Benefits
– Difficult to quantify, different for all people
• Private goods
– Benefits and willingness to pay are expressed through
prices, easier to examine
26. Tragedy of the Commons
• Tragedy of the commons
– Occurs when a rival (but non-
excludable) good becomes
depleted or ruined
• Original example:
– Garret Hardin, Science
Magazine, 1968
– Cattle grazing
– Commons = shared area that all
cattle farmers get to use to let
cattle graze
27. Tragedy of the Commons
• The commons can be sustained indefinitely with
a capacity of around 100 cows.
• Suppose 100 farmers are each allowed to have
1 cow freely graze in the commons.
• One farmer thinks: What if I bring 2 cows?
• 100 cows? 101 cows? No difference!
• But suppose that ALL the farmers are thinking
the same thing?
• Can the commons support 200 cows?
28. Tragedy
• The commons get destroyed, even though
this was in nobody’s best interest.
29. Economics in South Park
• Tragedy of the commons: peeing in the
pool
• If one person pees in the pool, the effect
may be insignificant. But what if everyone
does it?
30. Common Property Incentives
• Incentive to neglect
– Good cannot be protected.
No political borders or ownership.
• Incentive to overuse
– Each individual wants to fish as
much as possible for higher profits.
If one conserves, others will
fish even more.
• Incentive to ignore others
– No one has the ability to define how many resources
can be used. I may still break the rules set even if
others follow them.
31. Solution to the Tragedy of the
Commons
• General proactive management is
needed.
– Taxes, regulations, or other ways to
internalize a negative externality
• King crab populations have done
much better than cod because:
1.Limited length of fishing season
2.Regulations on how much crab the
boats can harvest
3.Only adult males are harvested.
32. Cap and Trade
• Cap and trade
– A system of pollution “permits” that are traded on an
open market
– Purpose: reduce pollution
• Good in theory, but negative consequences?
– Agreements are difficult to negotiate; no international
consensus
– Countries with restrictions have higher costs than
others
– Often called “cap and tax”
33. Conclusion
• Inefficiencies occur because of poor
incentives
• Externalities
– Arise from the result of diverging social and
private costs (or benefits)
– Can be corrected by forcing economic agents
to internalize them
• Public goods present a special challenge
for a free-market economy.
34. Summary
• Internal costs are costs that are directly
borne by the decision-maker.
– Social costs = internal costs + external costs
• An externality exists whenever an internal
cost, or benefit, diverges from a social
cost, or benefit.
• Third Parties experience negative or
positive externalities from a market
activity.
35. Summary
• When a negative externality exists:
– Government can restore the social optimum by
discouraging economic activity that harms third
parties.
• When a positive externality exists:
– Government can restore the social optimum by
increasing economic activity that benefits third parties.
• An externality is internalized when decision-
makers take into account the external effects of
their actions.
36. Summary
• Private property
– Ensures that owners have an incentive to maintain,
protect, and conserve their property, and also to trade
it to others.
• Under a system of common property:
– The incentive structure causes destruction, neglect,
and overuse.
– Tragedy of the commons may occur.
• The Coase theorem
– If there are no barriers to negotiations, and property
rights are fully specified, interested parties will bargain
privately to correct externalities.
37. Summary
• A public good has two characteristics:
– It is non-excludable and non-rival in consumption.
– It creates the free-rider problem and results in the
underproduction of the good in the market.
• The line between each of the four types of goods
(private, club, common resource, and public) is
often hard to distinguish.
• Economists use cost-benefit analysis to
determine whether the benefits of providing one
type of good outweighs the costs.
38. Practice What You Know
Which of the following activities would most
likely create a negative externality?
a. eating a slice of pizza
b. smoking a cigarette
c. taking a nap
d. getting a college degree
39. Practice What You Know
Which of the following activities is most likely to
create a positive externality?
a. eating a slice of pizza
b. smoking a cigarette
c. taking a nap
d. getting a college degree
40. Practice What You Know
Membership at your local fitness facility is what
type of good?
a. private good
b. club good
c. common resource good
d. public good
41. Practice What You Know
Suppose good X creates a negative externality.
Which of the following would NOT be an
appropriate way to correct the negative
externality?
a. subsidize the production of good X
b. tax the production of good X
c. limit how much of good X can be produced
d. require the producers of good X to pay for
external costs that arise
42. Practice What You Know
Which of the following is an example of a
public good?
a. a free outdoor Christmas light display
b. a college football game
c. a parking spot with a parking meter
d. a college education
Notas del editor
Lecture notes:
This chapter will also deal with economic welfare. Specifically, we will study situations where certain costs or benefits are not internalized by the parties involved in trade. This can lead to an inefficient level of goods being traded.
Lecture notes:
Consider driving a car.
Internal costs: you pay for gas, wear and tear on vehicle.
External costs: you create pollution and road congestion.
Consider eating a garlic-filled Italian meal at a restaurant.
Internal costs: you pay for the meal; cost you time and money.
External costs: you may create unpleasantness to others later with bad garlic breath.
Lecture notes:
Third party = “other person” who is not involved directly in the activity, but suffers the cost of the activity. Pollution and secondhand smoke are examples.
Externalities: think “external.”
Lecture tips:
You can have the students experience a negative externality. If you bring a bottle of potent perfume or cologne to class, you can ask for a volunteer to spray a lot of it on themselves. The students sitting near the perfumed student will experience a negative externality.
If you’re willing to take a bigger risk (and assuming you won’t get in a lot of trouble), you could also think about smoking (or having a student smoke) in class. A negative externality will be created.
Generally, these are all examples of “market failures.” This occurs when individuals do not consider (internally) all of the costs or benefits of an activity.
With a negative externality, there are external costs (borne by others) that the individual engaging in the activity does not consider. Thus, social costs are understated, and too much of the activity is done.
With a positive externality, there are external benefits (borne by third parties) that the individual engaging in the activity does not consider. Thus, social benefits are understated, and too little of the activity is done.
Lecture notes:
Consider an oil refinery.
The oil refinery imposes a negative externality (pollution) on nearby residents. This can cause sickness, breathing problems, and dirty clothes.
When a negative externality exists, the government may be able to restore the social optimum by forcing externality—causing market participants to pay for the cost of their actions. In this case, there are three potential solutions. First, the refiner can be required to install pollution abatement equipment or to change production techniques to reduce emissions. A tax could be levied as a disincentive to produce. Finally, the government could require that the firm pay for any environmental damage it creates. Each of these solutions forces the firm to internalize the externality, meaning that the firm pays for the externality in some way.
Remember that the supply curve can be thought of as the MC (marginal cost) curve. A leftward shift means that we are internalizing high costs of production, and will want to produce less of the good.
Image: Animated Figure 7.1
Lecture notes:
Intuition: the new supply curve (shifted to the left) reflects ALL the costs (not just internal). Higher costs mean less production.
The figure illustrates the contrast between the market equilibrium and the social optimum in the case of an oil refinery. These costs are indicated on the graph by the supply curve, S internal, which represents how much the oil refiner will produce if it does not have to pay for the negative consequences of its activity. In this situation, the market equilibrium, Em, accounts only for the internal costs of production.
Suppose now the firm has to pay for pollution somehow (tax, pay for environment damages, or install abatement equipment). Abatement = act of reducing pollution.
Having to pay the costs of imposing pollution on others reduces the amount of the pollution-causing activity. This result is seen in the shift of the supply curve to S social. The new supply curve reflects a combination of the internal and external costs of producing the good. Since each of the corrective measures requires the refiner to spend money to correct the externality, the willingness to sell the good declines, or shifts left. The result is a social optimum at a lower quantity, Qs, than at the market equilibrium, Qm. Here the trade-off is clear. We can reduce negative externalities by requiring producers to internalize the externality. However, internalizing the externality is not without cost. Since the supply curve shifts left, the quantity produced will be lower. In the real world, there is always a cost.
In addition, when there is an externality, the market equilibrium creates deadweight loss, as shown by the yellow triangle in the figure.
Lecture notes:
Generally, with positive externalities, we know that there are external benefits that individuals may not account for. Thus, we want to increase resource allocation to the activity.
Remember that the demand curve can be thought of as the MB (marginal benefit) curve. Shifting this curve to the right can be thought of as us realizing the extra benefits, so we want to engage in more of this activity.
Laws requiring consumption: everyone has to go to school until the age of 16. Some schools require vaccination records.
Image: Animated Figure 7.2
Lecture tip:
Use flu shots as an example of a behavior with a positive externality.
Easy intuition: the new demand curve (shifted to the right) reflects ALL the benefits rather than just internal benefits.
There is an incentive for people in high risk groups to get vaccinated for the sake of their own health. Looking at the figure, we capture this internal benefit in the demand curve labeled
D internal. However, the market equilibrium, Em, only accounts for the internal benefits of individuals getting vaccinated. In order to maximize the health benefits for everyone, public health officials need to find a way to encourage as many people as possible to get vaccinated. One way is through school vaccination laws. These laws require that all children entering school provide proof of vaccination against a variety of diseases. The overall effect of child vaccination laws are that more people get vaccinated early in life, which reduces the spread of contagious diseases. This creates a positive externality for society.
Government can also promote the social optimum by encouraging economic activity that helps third parties. For example, it can offer a subsidy, or price break, to encourage more people to get vaccinated. The subsidy acts as a consumption incentive. Since the subsidy allows the consumer to spend less money, the willingness to get the vaccine increases. More people are immunized, a result seen in a shift of the demand curve in the figure from D internal to D social. The new demand curve reflects the sum of the internal and social benefits of getting the vaccination. The subsidy encourages consumers to internalize the externality and, as a result, consumption moves from the market equilibrium, Qm, to a social optimum at a higher quantity, Qs.
Lecture tip:
Click through to reveal the table cells.
We have seen that markets do not handle externalities well. With a negative externality, the market produces too much of a good. But in the case of a positive externality, the market does not produce enough.
“Beyond the Book Slide”
Lecture notes:
Pecuniary = pertaining to money
“Beyond the Book Slide”
Lecture notes:
Inframarginal = below the margin, submarginal
“Beyond the Book Slide”
Lecture notes:
Photo of crowded beach.
If there are THIS MANY people at the beach, you’ll definitely notice.
Lecture notes:
We will discuss each of these incentives, one at a time, on the next slide.
Lecture tips:
In this slide, use a car as an example of a privately owned good.
Ask your students the question: What do you take better care of?
Public restroom or your own private bathroom?
Your own car or the public bus? (Do you wipe your feet before getting into both?)
Your own bike or equipment at the gym?
Just get the students to realize that when you privately own something, you have more incentives to take good care of the good!
Lecture notes:
Assume the cattle cause damage to the ground (no matter what farmer the ground belongs to). Without a fence, the cattle roam over both lands.
If the cost of the fence (building, maintenance) is more than the cost of the cattle damage, the rancher will not build a fence, and will just pay the farmer for damages. If the cattle destruction cost is greater, the rancher will build a fence to keep the cattle on his own land.
Either result will force the cattle farmer to internalize the entire costs of the cattle damage.
Lecture notes:
If the cost of the fence (building, maintenance) is more than the cost of the cattle damage, the farmer will not build a fence, and will just accept the damages to the wheat. If the cattle destruction cost is greater, the farmer will build a fence to keep the cattle out.
Building the fence will force the cattle rancher to internalize the externality.
Coase determined that whenever the size of the externality is large enough to justify the expense, the externality gets internalized. As long as the property rights are fully specified, either the cattle rancher or wheat farmer will build a fence. The fence keeps the cattle away from the wheat, removes the externality, and avoids the destruction of property.
Economics in the Media
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
Lecture notes:
Most goods we purchase and consume are private goods.
A private good is both excludable and rival in consumption. For instance, a slice of pizza is excludable because it must be purchased before you can eat it. Also, a slice of pizza is rival; only one person can eat it. These two characteristics: excludability and rivalry, allow the market to work efficiently in the absence of externalities. Consider a pizza business. The pizzeria bakes pizza pies because it knows it can sell them to consumers. Likewise, consumers are willing to buy pizza because it is a food they enjoy. Since the producer is able to charge a price and the consumer to acquire a rival good, this sets the stage for mutual gains from trade.
Lecture tip:
Other free-rider example: not putting money in a collection plate!
Lecture notes:
Club goods:
You can be excluded if you don’t pay. However, they are non-rival. Just because I get a membership to the YMCA doesn’t exclude you from getting one.
Common resources:
You can’t be excluded from the public campsite, but they are rival campsites. If I set up my tent at campsite 1A, you can’t also set up camp there. There are a limited number of campsites, as well as deer to hunt.
Technicality: hunting and fishing sometimes requires licensing and fees, and that could sometimes exclude.
Lecture tip;
Click through to remove the white rectangles to reveal the table one cell at a time.
2x2 grid here.
Are goods excludable? (yes or no)
Is consumption rival or non-rival?
Lecture notes:
Realize that all economic decisions by consumers, firms, and governments involve a cost-benefit analysis. Are the benefits greater than the costs? If so, it is a good action to perform.
The difficulty with public goods (which are often provided by the government) is that the costs are clear, but the benefits are often not. How do we measure the benefits of a park, bike trail, campground, or fireworks display? Some people may really enjoy these goods, while other people may not care.
Private goods are easier to examine with respect to costs and benefits. The value of the good is the price people are willing to pay. Thus, if people purchase the good, we know the benefits are greater than the costs.
Lecture notes:
The commons is an area maintained by the public government. It can sustain a limited amount of cattle; it needs to sustain itself over time.
Lecture tip:
The pictures are set on a timer. The slide will slowly fill up with cows. Each additional cow may not make a noticeable difference, but soon you will begin to notice all the cows!
The slide will fill up after 50 seconds.
Lecture notes:
Here is the tragedy:
Everyone did what they thought was in their own best interest: bring a second cow. I get twice as much free feeding, and the costs are minimal (to me and society). However, if EVERYONE does this, all those “small” costs add up to a “big” cost! The commons dies, which is bad for everyone.
Economics in the Media
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
Lecture notes:
The common property incentives are almost the opposite of the private property incentives!!
Use cod fishing industry as an example.
No borders on the ocean. If there’s no fish here, you’ll fish somewhere else.
You will fish as much as you can. More fishing is more profit.
Even if others are following the rules set in place, it’s still in my best interest to try and fish more to get a bigger haul. (Everyone is thinking the same thing.)
Lecture notes:
In addition, there has to be a way to enforce the laws, as well as stating clear punishments for rule breakers.
Lecture notes:
Pollution is a negative externality—a byproduct of manufacturing various goods.
Difficulty: if the United States places tougher pollution standards on firms and other countries don’t, we are putting ourselves at a disadvantage. Other countries will produce cheaper products. Thus, cap and trade may only work successfully if the system (and trading market) was international. This would be very difficult to negotiate and organize.
Thus, it is often called “cap and tax” since it seems to tax producers.
Lecture notes:
One solution is to encourage businesses to internalize externalities. This can be done through taxes and regulations that force producers to account for the negative externalities that they create. Similarly, subsidies can spur the additional production of activities that generate positive externalities. However, not all externalities require active management from the government. Many externalities are too small to matter, and do not justify the costs associated with government regulation or taxation.
Clicker Question
Correct answer: B
Secondhand smoke is a classic example of a negative externality. Third parties who are not smoking experience a cost.
Clicker Question
Correct answer: D
If you are more educated, other people around may be likely to experience external benefits. You may be more productive, less likely to be unemployed, and may be more politically involved.
Clicker Question
Correct answer: B
It’s excludable (you have to pay to be a member), but non-rival. Just because one person is a member doesn’t mean you can’t join as well.
Clicker Question
Correct answer: A
Subsidizing would result in MORE of good X being produced. We want less of the good to be made since it creates the negative externality.
Clicker Question
Correct answer: A
For (A) to be correct, note that the word “free” is explicitly included. Imagine a display, outdoors, that anyone can freely see and enjoy.
The parking spot is not free, and is rivalrous. College education is not free (at least in the U.S.)
