Ch14

Externalities

• An externality is a cost or benefit
resulting from some activity or
transaction that is imposed or
bestowed upon parties outside the
activity or transaction. Sometimes
called spillovers or neighborhood
effects.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Externalities

• When external costs are not
considered in economic decisions, we
may engage in activities or produce
products are not “worth it.”

• When external benefits are not
considered, we may fail to do things
that are indeed “worth it.” The result is
an inefficient allocation of resources.


Marginal Social Cost and
Marginal-Cost Pricing

• Marginal social cost (MSC) is the
total cost to society of producing an
additional unit of a good or service.

• MSC is equal to the sum of the
marginal costs of producing the
product and the correctly measured
damage costs involved in the
process of production.


Marginal Social Cost and
Marginal-Cost Pricing

• At q*, marginal social cost exceeds the price paid by
consumers. Output is too high. Market price takes into
account only part of the full cost of producing the good.

Private Choices and External Effects

• Marginal private
cost (MPC) is the
amount that a
consumer pays to
consume an
additional unit of a
particular good.



• Marginal benefit
(MB) is the benefit
derived from each
successive hour of
music, or the
maximum amount
of money Harry is
willing to pay for
an additional hour
of music.



• Harry would play
the stereo until MB
= MPC, or eight
hours.
• However, this
result would be
socially inefficient
because Harry
does not consider
the cost imposed
on Jake.



• Marginal damage
cost (MDC) is the
additional harm
done by increasing
the level of an
externality-
producing activity
by one unit.



• Marginal social
cost (MSC) is the
total cost to society
of playing an
additional hour of
music.

• Playing the stereo beyond more than five hours is
inefficient because the benefits to Harry are less than the
social cost for every hour above five.

Internalizing Externalities

• A tax per unit equal to MDC is imposed on the firm.
The firm will weigh the tax, and thus the damage
costs, in its decisions.

The Coase Theorem

• Government need not be involved in
every case of externality.

• Private bargains and negotiations
are likely to lead to an efficient
solution in many social damage
cases without any government
involvement at all. This argument is
referred to as the Coase Theorem.


The Coase Theorem

• Three conditions must be satisfied for
Coase’s solution to work:
• Basic rights at issue must be assigned
and clearly understood.
• There are no impediments to bargaining.

• Only a few people can be involved.

• Bargaining will bring the contending
parties to the right solution regardless
of where rights are initially assigned.

Indirect and Direct Regulations

• Taxes, subsidies, legal rules, and
public auction are all methods of
indirect regulation designed to
induce firms and households to
weigh the social costs of their
actions against the benefits.

• Direct regulation includes legislation
that regulates activities that, for
example, are likely to harm the
environment.

Public Goods

• Public goods (social or collective
goods) are goods that are nonrival
in consumption and/or their benefits
are nonexcludable.

• Public goods have characteristics
that make it difficult for the private
sector to produce them profitably
(market failure).


The Characteristics of Public Goods

• A good is nonrival in consumption
when A’s consumption of it does not
interfere with B’s consumption of it.
The benefits of the good are
collective—they accrue to everyone.
• A good is nonexcludable if, once
produced, no one can be excluded
from enjoying its benefits. The good
cannot be withheld from those that
don’t pay for it.



• Because people can enjoy the
benefits of public goods whether
they pay for them or not, they are
usually unwilling to pay for them.
This is referred to as the free-rider
problem.



• The drop-in-the-bucket problem is
another problem intrinsic to public
goods: The good or service is
usually so costly that its provision
generally does not depend on
whether or not any single person
pays.



• Consumers acting in their own self-
interest have no incentive to
contribute voluntarily to the
production of public goods.

• Most people do not find room in their
budgets for many voluntary
payments. The economic incentive
is missing.


Public Provision of Public Goods

• Public provision does not imply
public production of public goods.

• Problems of public provision include
frequent dissatisfaction. Individuals
don’t get to choose the quantity they
want to buy—it is a collective
purchase. We are all dissatisfied!


Optimal Provision of Public Goods

• With private goods, consumers decide what quantity to
buy; market demand is the sum of those quantities at
each price.


Optimal Provision of Public Goods

• With public goods, there is only one
level of output, and consumers are
willing to pay different amounts for
each level.
• The market demand for a public
good is the vertical sum of the
amounts that individual households
are willing to pay for each potential
level of output.


Optimal Production of a Public Good

• Optimal production
of a public good
means producing as
long as society’s total
willingness to pay per
unit D(A+B) is greater than
the marginal cost of
producing the good.


Local Provision of Public Goods

• According to the Tiebout hypothesis,
an efficient mix of public goods is
produced when local land/housing
prices and taxes come to reflect
consumer preferences just as they do
in the market for private goods.


Imperfect Information and
Adverse Selection

• Most voluntary exchanges are
efficient, but in the presence of
imperfect information, not all
exchanges are efficient.

• Adverse selection can occur when
a buyer or seller enters into an
exchange with another party who
has more information.


Moral Hazard

• Moral hazard arises when one party
to a contract passes the cost of his
or her behavior on to the other party
to the contract.

• The moral hazard problem is an
information problem, in which
contracting parties cannot always
determine the future behavior of the
person with whom they are
contracting.

Market Solutions

• As with any other good, there is an
efficient quantity of information
production.

• Like consumers, profit-maximizing
firms will gather information as long
as the marginal benefits from
continued search are greater than
the marginal costs.


Government Solutions

• Information is nonrival in consumption.

• When information is very costly for
individuals to collect and disperse, it
may be cheaper for government to
produce it once for everybody.


Social Choice

• Social choice is the problem of
deciding what society wants. The
process of adding up individual
preferences to make a choice for
society as a whole.


The Impossibility Theorem

• The impossibility theorem is a
proposition demonstrated by
Kenneth Arrow showing that no
system of aggregating individual
preferences into social decisions will
always yield consistent, nonarbitrary
results.


The Impossibility Theorem

Preferences of Three Top University Officials
VP1 prefers A to B and B to C. VP2 prefers B to C and C to A. The dean
prefers C to A and A to B.
OPTION A OPTION B OPTION C
Hire more No change Reduce the size of the
faculty faculty
Ranking VP1 VP2

1 X X X
2 X X X
3 X X Dean X

• If A beast B, and B beats C, how can C beat A? The
results are inconsistent.

The Voting Paradox

• The voting paradox is a simple demonstration of how
majority-rule voting can lead to seemingly
contradictory and inconsistent results. A commonly
cited illustration of inconsistency described in the
impossibility theorem.
Results of Voting on University’s Plans: The Voting Paradox
VOTES OF:
Vote VP1 VP2 Dean Resulta
A versus B A B A A wins: A > B
B versus C B B C B wins: B > C
C versus A A C C C wins: C > A
a
A > B is read “A is preferred to B.”


Rent-Seeking Revisited

• There are reasons to believe that
government attempts to produce the
right goods and services in the right
quantities efficiently may fail.

• The existence of an “optimal” level of
public-goods production does not
guarantee that governments will
achieve it.


Ch14

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