PUBLIC GOODS, EXTERNALITIES, AND INFORMATION ASYMMETRIES

LECTURE NOTES

Public Goods
A. Private goods are produced and sold in competitive markets, and have two characteristics:
1. Rivalry in consumption – when one person buys and consumes a good, it is not available to others.
2. Excludability – Sellers can restrict the benefits to those who pay for the good.
B. Market demand for private goods is found by horizontally summing the individual demand schedules.
C. Private markets allocate goods and resources efficiently – those willing to pay obtain goods get them. Sellers
produce goods to satisfy consumer wants, and consumer buying behavior tells them whether to produce more or
less of any particular good.
D. Unlike private goods, public goods are those goods that are nonrival and nonexcludable.
E. Public goods suffer from the free-rider problem, where a consumer can enjoy the benefit of the good without
having to pay for the benefit.
Art for Art’s Sake
F. The demand for public goods differs from the market demand for private goods.
1. It is a “phantom” demand since the consumers will not be making individual purchases.
2. To find the collective demand schedule for a public good, we add the prices people collectively are willing to
pay for the last unit of the public good at each quantity demanded
3. A collective demand curve is the vertical sum of the individual demand curves for the public who want that
good.
4. Recall that the market demand for a private good was a horizontal summation of the individual demand
curves.
G. The supply curve for any good is its marginal cost curve. As with private goods, the law of diminishing returns
applies to the supplying of public goods.
H. The optimal quantity of a public good can be determined by comparing the collective demand curve with the
supply (marginal cost) curve to determine their point of intersection or by looking at the demand and supply
(marginal cost) schedules to see at what price and quantity marginal benefit equals marginal cost.
I. Cost-benefit analysis is a technique for decision making in the public sector.
1. The concept involves comparing the benefit of providing incremental units of public goods with the costs of
providing these additional units. Note that the comparison is a marginal one, i.e., the comparison is made
between the costs and benefits of additional amounts of a public good or service.
2. This is the concept in determining the scope of a national highway construction project. Four possible phases
of projects are considered, with costs and benefits compared. By comparing the marginal costs and benefits
as one moves from the least expensive phase to the most expensive phase.
3. The rule for this decisionmaking technique is to use the marginal benefit = marginal cost rule; if the marginal
cost exceeds the marginal benefit, that part of the project should not be included.
4. The problem with this technique is the difficulty in measuring costs and benefits. Benefits are particularly
difficult to estimate, because there are many related aspects that are not easily calculated. Nevertheless, the
method is widely used.
Externalities revisited
A. An overallocation of resources occurs when negative externalities are present and an underallocation of resources
occurs when positive externalities are present.
1. Negative externalities occur when producers are able to shift some of their costs onto the community.
2. Positive externalities occur when the benefits of a good are received by others in the community although
they did not pay for them. These benefits are not reflected in the individual demand curve.
B. One approach to reducing the externality or misallocation problem is the market approach of individual
bargaining.
1. The Coase theorem, named after Nobel prizewinning economist Ronald Coase, suggests that government is
not needed to remedy external costs and benefits when property rights are clearly defined, the number of
people involved is small, and bargaining costs are negligible.
2. Government’s role should be to encourage bargaining wherever possible, rather than to get involved in direct
restrictions or subsidies.
3. The extended example in the text looks at the owner of a forest who wants to contract with a logging
company to clearcut his land. The land surrounds a lake with a nationally known resort, which depends on
the beauty of the forest for its success. Should the state or government intervene?
a. The Coase theorem would assign property rights over the issue and let both parties negotiate a solution.
Since the forest owner has the right over the trees, the resort should negotiate to reduce the logging
impact because it has economic incentive to do so. The resort owner should be willing to pay the forest
owner to avoid or minimize the external cost.
b. The Coase theorem argues that it doesn’t matter which party is assigned the property rights. If the resort
owner had been assigned the right to prevent logging, the forest owner would have to negotiate and pay
the resort owner for the right to cut the forest. Both parties would have an economic incentive to
eliminate the externality in this situation also. In the unlikely event that this was the case, the resort
owner’s property would have been much more valuable in the first place, because it included the rights
over the logging permission.
4. Limitations exist with the Coase theorem, because many problems involving externalities affect many people
and bargaining is too costly and inefficient to accomplish solutions effectively.
C. A second approach is by the assignment of liability through lawsuits. If one property owner damages another, a
private lawsuit may settle the dispute by assessing damage liability on the violator. Once again, however, this
solution is limited to cases in which the damaged parties can afford to initiate the suit, or in the case of many
people, can organize to sue.
D. A third approach is to apply direct government controls or taxes to reduce negative externalities, or to provide
subsidies or government provision where positive externalities exist.
1. Direct controls place limits on the amount of the offensive activity that can occur. Clean air and water
legislation are examples. The effect is to force the offenders to incur costs associated with pollution control.
This should shift the product supply curve leftward and reduce the equilibrium quantity. Therefore, it should
reduce the resource allocation in a socially optimal way.
2. Specific taxes can be levied on polluters. The tax payment will increase costs to the producer, shifting the
product supply curve leftward, and reducing resource allocation to this type of production as desired.
3. Subsidies and government provision suggest three options.
a. Buyers may be subsidized. For example, new parents may be given coupons to receive inoculations at
reduced prices for their children. This would increase the number of vaccinations and eliminate the
underallocation of resources
b. Producers could be subsidized so that producers’ costs are reduced, thus shifting the supply curve
rightward, increasing equilibrium output, and eliminating the underallocation.
c. The government could provide the product as a public good where spillover benefits are extremely large.
An example would be administering free vaccines to all children in India to end smallpox.
E. A fourth corrective approach is the development of markets for externality rights. This is the latest policy
innovation for dealing with pollution abatement.
1. A pollutioncontrol agency decides the acceptable amount of pollution in a particular region and creates rights
that firms can purchase to allow them to pollute. Each right will allow a certain amount of pollution. The
total supply of rights is perfectly inelastic
2. The demand for rights should be downward sloping. At high prices, polluters will either stop polluting or
pollute less by acquiring pollutionabatement equipment, which is more attractive when the rights are more
expensive.
3. With the given supply of rights, and a demand for rights, an equilibrium price will be established for each
right to pollute.
 4. There are several advantages to this system.
a. It reduces society’s costs because pollution rights can be bought and sold. Some firms will find it cheaper
to buy the rights than to acquire abatement equipment; other firms can sell their rights because they may
be able to reduce pollution at a lower cost; in both situations, the firms reduce their cost below what the
cost would have been under direct controls.
b. Conservation groups as well as producers can buy rights. If conservation groups are unhappy with the
existing amount of pollution, they can acquire pollution rights and hold them.
c. The revenue from the sale of pollution rights could be used to improve the environment.
d. The rising cost of pollution rights should lead to improved pollution-control techniques.
e. A market for air pollution rights has emerged and is expanding.
F. Society’s optimal amount of externality reduction is not necessarily total elimination.
1. The cost of reducing spillover costs increases with each additional unit of reduction. The benefit received
from each additional unit of reduction decreases due to diminishing marginal utility.
2. In general, the marginal benefit of reducing pollution should equal the marginal cost. At this point, society
has found its optimal amount of pollution abatement
3. In reality it is difficult to measure benefits as well as costs, but this analysis demonstrates that some degree of
pollution may be socially efficient.
H. Global warming and Climate Change
1. The global warming problem is an example of how cost-benefit analysis can be used to establish policies that
will deal with a global environmental problem.
2. Scientific evidence suggests that carbon dioxide and other gas emissions are creating a greenhouse effect.
3. It is predicted that all regions of the world will experience climatic changes.
4. Industrially advanced countries agreed in the Kyoto Protocol of 1997 to reduce their gas emissions 6 to 8
percent below 1990 levels by 2012. The U.S. was the only major nation not to ratify the agreement. Few
nations are expected to actually meet the goals.
5. In setting policies and goals, the costs and benefits of the reduction in gas emissions must be considered.
Information failures are another form of market failure.
A. Information is often asymmetric – buyers and sellers don’t have the same information about the good, service or
resource being sold, and the cost of obtaining better information is often prohibitive.
B. Inadequate information about sellers—two examples:
1. Assume that the gasoline market exists in an absurd situation in which there is no system of weights and
measures established by law. In such a world, the station could advertise highoctane gas that was actually
lowoctane gas; pumps could register more gallons than were actually being pumped. Without government
regulation, one could imagine some incentive for some stations to cheat in such ways. Government
intervenes in such markets to prevent such cases of market failure. This provides reliable information to
buyers and also helps sellers through enforcement of fair sales practices.
2. Licensing of surgeons is another example in which the consumer would find it difficult to gather information
about a physician’s expertise without government licensing standards. Such rules set minimum standards for
competence. There will still be physicians of varying abilities, but the consumer can be confident that basic
standards were met.
C. Inadequate information about buyers may lead to potential problems for sellers.
1. The moral hazard problem occurs when there is a tendency of one party to a contract to alter his/her behavior
in ways that are costly to the other party. Examples include the driver who behaves more recklessly after
obtaining insurance; guaranteed contracts for athletes, which may reduce their performance; unemployment
compensation insurance, which may discourage incentives to work.
2. The adverse selection problem arises when information known by the first party to a contract is unknown to
the second and, as a result, the second party incurs major costs. Examples include those in poor health who
take out health insurance, the person planning an arson attempt who takes out fire insurance, and the person
whose marriage is failing who takes out the book’s hypothetical “divorce” insurance. In areas where
insurance is traditionally underprovided, the government has provided insurance or subsidized insurance.
“Lemons” (used-car sales).
 3. Workplace safety becomes a problem if workers do not know particular occupations or workplaces are less
safe than others. Without accurate information about employers (buyers), workers will not demand higher
wages for less-safe jobs. This is a market failure involving information about buyers (employers) where the
government has intervened.
a. Government can directly provide information to workers.
b. Policies can mandate that firms provide information.
c. Standards of workplace safety can be set.
4. Qualification: There are private methods of overcoming lack of information problems.
a. Product warranties overcome lack of information about the seller or product.
b. Franchising helps set uniform standards, so that most McDonalds or Holiday Inns have similar quality.
c. Firms have specialized in providing information to buyers and sellers; consumer reports, travel guides,
and credit-checking agencies are some examples.
Lojack: A Case of Positive Externalities
A. Lojack is a device that can be installed in a car. If activated by police, it gives the police the car’s precise
location.
B. Not only has this device resulted in benefits to the owners of the cars who have installed the device by increasing
the retrieval rate from 60 percent to 95 percent, it has provide an external benefit to other car owners.
C. Police have been able to intercept cars while the thieves are still driving them. Police have been able to trace the
cars with the device to “chop shops.”
D. Some states have mandated a reduction in insurance premiums for car owners who have installed the device in
order to encourage an increase in sales of the device.
E. Ayres and Leavitt contend that the current levels of insurance discounts are too small to correct for the
underallocation of the product that results from the positive externalities created by Lojack.