15.2 Public goods and externalities

Public goods and externalities are key concepts in economics that challenge traditional market dynamics. These phenomena often lead to market failures, where the invisible hand fails to allocate resources efficiently.

Governments and policymakers must intervene to address these issues. Solutions like Pigouvian taxes, cap-and-trade systems, and Coasian bargaining aim to align private incentives with social welfare, ensuring optimal resource allocation and maximizing societal benefits.

Public Goods

Non-Excludability and Non-Rivalry

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• Non-excludability prevents individuals from being excluded from consuming a good or service
  • Once provided, everyone can access and benefit from it (national defense, public parks)
• Non-rivalry means one person's consumption does not reduce the amount available for others
  • Additional consumers do not impose extra costs on the supplier (lighthouse, street lights)
• These characteristics make it difficult for private firms to provide public goods profitably
  • Lack of incentive to invest in and maintain such goods

Free-Rider Problem and Tragedy of the Commons

• Free-rider problem arises when individuals benefit from a good without contributing to its provision
  • Rational consumers have an incentive to free ride on others' contributions (public radio, fireworks display)
• Tragedy of the commons occurs when a shared resource is overused or depleted due to individual self-interest
  • Each user has an incentive to maximize their own consumption (overfishing, overgrazing)
• Both issues lead to underinvestment in public goods and overexploitation of common resources
  • Market failure results as the socially optimal level of provision is not achieved

Externalities

Positive and Negative Externalities

• Positive externalities generate benefits for third parties not involved in the transaction
  • Spillover effects that are not accounted for in market prices (education, vaccinations)
• Negative externalities impose costs on third parties not involved in the transaction
  • External costs that are not reflected in market prices (pollution, congestion)
• In both cases, the market equilibrium diverges from the socially optimal level of production or consumption

Social Optimum

• The social optimum is the level of production or consumption that maximizes total social welfare
  • Considers both private and external costs and benefits
• In the presence of positive externalities, the market underproduces relative to the social optimum
  • Marginal social benefit exceeds marginal private benefit (research and development, beekeeping)
• With negative externalities, the market overproduces relative to the social optimum
  • Marginal social cost exceeds marginal private cost (factory emissions, noise pollution)
• Achieving the social optimum requires internalizing the externalities through policy interventions

Solutions to Externalities

Coase Theorem

• The Coase theorem suggests that private parties can negotiate efficient outcomes in the presence of externalities
  • Property rights are clearly defined and transaction costs are low
• Parties can bargain to reach a mutually beneficial agreement that internalizes the externality
  • Regardless of the initial allocation of property rights (land use disputes, water rights)
• In practice, high transaction costs and asymmetric information often hinder Coasian bargaining

Pigouvian Tax and Cap and Trade

• A Pigouvian tax is a tax imposed on activities that generate negative externalities
  • Set equal to the marginal external cost at the socially optimal level of output (carbon tax, congestion pricing)
• Cap and trade is a market-based approach to controlling negative externalities
  • A total limit (cap) is set on the level of the externality-generating activity
  • Tradable permits are allocated to firms, which can buy or sell them (emissions trading, fishing quotas)
• Both policies aim to internalize the external costs and incentivize firms to reduce their externality-generating activities
  • Achieve the socially optimal level of production or consumption