Public goods and externalities

Public goods and externalities.

1. Public goods and Externalities

2. Meaning In economics, a  public  good is a good that is both non-excludable and non- rivalrous in that individuals cannot be excluded from use or could be enjoyed without paying for it, and where use by one individual does not reduce availability to others or the  goods can be effectively consumed simultaneously by more than one . The government provides various goods and services such as roads, sidewalks, bridges, parks, museums and libraries. The government may also supply water and electricity, public health care, transport systems, police protection and garbage collection.

3. Characteristics of public goods A public good has three characteristics: non-divisibility, non-rivalry and non-exclusivity. Non-divisibility : this means that a good or service is provided in totality e.g. the defense which benefits everybody. Non-rivalry: this means that its consumption does not involve competition, i.e. ne person can increase consumption of the good without reducing consumption by others e.g. roads. Non exclusivity : means that, it is difficult for the supplier to exclude anyone who does not pay for the commodity from enjoying.

4. Types of public goods Pure public goods Congestible public goods Club goods

5. Pure public goods Pure public goods, such as street lighting and national defence, are indivisible (that is to say, they cannot be divided into sealable units) and therefore non rival in consumption. For a given level of production of public good, one person’s consumption does not reduce the quantity available for consumption by another person.

6. Continue For example the Rwandan Defence Force protection to the inhabitants of Kigali does not reduce the amount of protection available to the inhabitants in Huye and Rubavu Districts or elsewhere else. Non rivalry in consumption has two important implications. First, the fact that one person’s consumption does not reduce the quantity available to other consumers implies that the marginal cost (that is the cost of admitting an additional user) is zero. From this follow the second implication, namely that excluding anyone from consuming a non rival good is Pareto inefficient.

7. Continue In addition to being non rival in consumption, pure public goods are also non excludable, that is it impossible to exclude particular individuals from consuming such goods. Put differently, it is not possible to assign specific property rights to public goods or to enforce them.

8. Congestible public goods There are public goods where, after a point, the enjoyment received by the consumer is diminished by crowding or congestion. These are called congestible public goods. For Examples: roads and parks.

9. Club goods Club goods is a subtype of public goods that are excludable but non- rivalrous . These goods are often provided by a natural monopoly. An example of a club good is cable TV. Your use of cable TV does not limit my ability to also view television shows on cable; as long as you live in an area where the necessary cable is present, you can get cable TV. However, it is excludable in that you have to pay the monthly fee.

10. Comparison of key characteristics of public and private goods Public goods Private good Property rights Non excludable Excludable Consumption Non-rival Rival Aggregate demand curve Vertical additional of individual demand curve Horizontal additional of individual demand curves Partial equilibrium condition for optimum provision The sum of marginal utilities equals marginal costs Marginal utility for each consumer equals marginal cost [ MUi =MU with i the individual consumer]. Efficient pricing rule The sum of individual prices equals marginal cost Price equals marginal cost [P=MC]

11. THE DIFFERENT KINDS OF GOODS When thinking about the various goods in the economy, it is useful to group them according to two characteristics: Is the good excludable? Is the good rival?

12. continue Four Types of Goods Private Goods Public Goods Common Resources Natural Monopolies

13. continue Private Goods : Are both excludable and rival. Public Goods : Are neither excludable nor rival. Common Resources : Are rival but not excludable. Natural Monopolies : Are excludable but not rival

14. Free rider A free-rider is a person who receives the benefit of a good but avoids paying for it.

15. The Problem of Free rider Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. The free-rider problem prevents private markets from supplying public goods.

16. Solving the Free-Rider Problem The government can decide to provide the public good if the total benefits exceed the costs. The government can make everyone better off by providing the public good and paying for it with tax revenue.

17. Some Important Public Goods National Defense Basic Research Fighting Poverty

18. Cost-Benefit Analysis Cost benefit analysis refers to a study that compares the costs and benefits to society of providing a public good. In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good.

19. continue A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole. It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. The value of life, the consumer’s time, and aesthetics are difficult to assess.

20. Common resources Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them. Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

21. Tragedy of the Commons The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. Common resources tend to be used excessively when individuals are not charged for their usage. • This is similar to a negative externality.

22. Some Important Common Resources Clean air and water Congested roads Fish, whales, and other wildlife

23. THE IMPORTANCE OF PROPERTY RIGHTS The market fails to allocate resources efficiently with the legal authority to control it). when property rights are not well established (i.e. some item of value does not have an owner When the absence of property rights causes a market failure, the government can potentially solve the problem

24. Summary Goods differ in whether they are excludable and whether they are rival. A good is excludable if it is possible to prevent someone from using it. A good is rival if one person’s enjoyment of the good prevents other people from enjoying the same unit of the good. Public goods are neither rival nor excludable.

25. continue Because people are not charged for their use of public goods, they have an incentive to free ride when the good is provided privately. Governments provide public goods, making quantity decisions based upon cost-benefit analysis.

26. continue Common resources are rival but not excludable. Because people are not charged for their use of common resources, they tend to use them excessively. Governments tend to try to limit the use of common resources.

27. Externalities: meaning An externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit. Externalities are a loss or gain in the welfare of one party resulting from an activity of another party, without there being any compensation for the losing party. Externalities are an important consideration in cost-benefit analysis.

28. continue Factors whose benefits (called external economies) and costs (called external diseconomies) are not reflected in the market price of goods and services. Externalities are not usually fully reflected in prices. Externalities are regarded as a form of market failure. An externality is a positive or negative consequence of an economic activity experienced by unrelated third parties.

29. Examples of externalities Pollution emitted by a factory that spoils the surrounding environment and affects the health of nearby residents is an example of a negative externality. The effect of a well-educated labor force on the productivity of a company is an example of a positive externality.

30. Externalities or external effects can be either positive or negative Positive externality (also called "external benefit" or "external economy" or "beneficial externality") is the positive effect an activity imposes on an unrelated third party. Such as Public Goods. In other words positive externalities when the actions of an individual producer or consumer confer a positive benefit on another party free of charge. For example, increased education of individuals can lead to broader society benefits in the form of greater economic productivity, a lower unemployment rate, greater household mobility and higher rates of political participation. Positive externalities refer to the benefits.

31. Examples of positive production externalities include: A beekeeper who keeps the bees for their honey. A side effect or externality associated with such activity is the pollination of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey. The construction and operation of an airport. This will benefit local businesses, because of the increased accessibility. An industrial company providing first aid classes for employees to increase on the job safety. This may also save lives outside the factory. A foreign firm that demonstrates up-to-date technologies to local firms and improves their productivity.

32. Examples of positive consumption externalities include: An individual who maintains an attractive house may confer benefits to neighbors in the form of increased market values for their properties. An individual receiving a vaccination for a communicable disease not only decreases the likelihood of the individual's own infection, but also decreases the likelihood of others becoming infected through contact with the individual.

33. continue In an area that does not have a public fire department, homeowners who purchase private fire protection services provide a positive externality to neighboring properties, which are less at risk of the protected neighbor's fire spreading to their (unprotected) house.

34. negative externality A negative externality (also called "external cost" or "external diseconomy") is an economic activity that imposes a negative effect on an unrelated third party. It can arise either during the production or the consumption of a good or service. Many negative externalities are related to the environmental consequences of production and use.

35. continue In other words negative externality is an action of a product on consumers that imposes a negative effect on a third party. For example, Air pollution from burning fossil fuels causes damages to crops, (historic) buildings and public health.

36. Examples for negative production externalities include: Air pollution from burning fossil fuels. This activity causes damages to crops, (historic) buildings and public health. Water pollution by industries that adds effluent, which harms plants, animals, and humans. Noise pollution during the production process, which may be mentally and psychologically disruptive.

37. continue Negative effects of Industrial farm animal production, including "the increase in the pool of antibiotic-resistant bacteria because of the overuse of antibiotics; air quality problems; the contamination of rivers, streams, and coastal waters with concentrated animal waste; animal welfare problems, mainly as a result of the extremely close quarters in which the animals are housed.

38. Examples of negative consumption externalities include Sleep deprivation due to a neighbor listening to loud music late at night. Antibiotic resistance, caused by increased usage of antibiotics. Individuals do not consider this efficacy cost when making usage decisions. Government policies proposed to preserve future antibiotic effectiveness include educational campaigns, regulation and patents. Higher congestion costs and increased accident risks when people use public roads.

39. Basic concepts Private costs are those costs paid by the firm producing the good. External costs are borne by someone not involved in the transaction. Social costs include both the private costs and any other external costs to society arising from the production or consumption of a good or service. Social costs = private costs + external costs

40. continue Private benefits are the benefits to people who buy and consume a good. External benefits are the benefits to a third party, someone who is not the buyer or the seller. Social benefits is the total benefit to society from producing or consuming a good and service. Social benefit includes all the private benefits plus any external benefits of production and consumption. If a good has significant external benefits, then the social benefit will be greater than the private benefit. Social benefits = private benefits + external benefits

41. continue Marginal Private Benefit (MPB) is the benefit which is derived by private individuals in the consumption of a good or service. Marginal external benefits (MEB) : The per unit change that accrues when the activities of one group have a favorable effect on another group. For example, an economic thinker might be interested in assessing the marginal external benefit of having a more educated population on the level of corporate business profits.

42. Continue Marginal Social Benefit (MSB) The marginal social benefit, is the total benefit to society, from one extra unit of a good. MSB = Marginal private benefit (MPB) + Marginal external benefit (MEB)

43. continue Marginal Private Cost (MPC) is the cost of producing, specifically marginal costs, which are incurred by private individual while producing a good or service. Marginal external cost (MEC) total incurred cost change of some households or businesses due to a unit change in other households’ or businesses’ consumption or output.

44. Principle of maximum social advantage The 'Principle of Maximum Social Advantage' was introduced by British economist Hugh Dalton . According to Hugh Dalton, "Public Finance" is concerned with income & expenditure of public authorities and with the adjustment of one with the other . Taxation causes transfer of purchasing power from tax payers to the public authorities, while public expenditure results in transfers back from the public authorities to some individuals, therefore financial operations of the government cause 'Sacrifice or Disutility' on one hand and 'Benefits or Utility' on the other.

45. continue This results in changes in pattern of production, consumption & distribution of income and wealth. So it is important to know whether those changes are socially advantageous or not . If they are socially advantageous, then the financial operations are justified otherwise not . According to Hugh Dalton, " The best system of public finance is that which secures the maximum social advantage from the operations which it conducts. "

46. continue The 'Principle of Maximum Social Advantage (MSA)' is the fundamental principle of Public Finance . The Principle of Maximum Social Advantage states that public finance leads to economic welfare when pubic expenditure & taxation are carried out up to that point where the benefits derived from the MU (Marginal Utility) of expenditure is equal to (=) the Marginal Disutility or the sacrifice imposed by taxation.

47. continue Hugh Dalton explains the principle of maximum social advantage with reference to :- Marginal Social Sacrifice Marginal Social Benefits

48. continue This principle is however based on the following assumptions :- All taxes result in sacrifice and all public expenditures lead to benefits. Public revenue consist of only taxes and no other sources of income to the government. The government has no surplus or deficit budget but only balanced budget. Public expenditure is subject to diminishing marginal social benefit and taxes are subject to increasing marginal social sacrifice.

49. 1. Marginal Social Sacrifice Marginal Social Sacrifice (MSS) refers to that amount of social sacrifice undergone by public due to the imposition of an additional unit of tax . Every unit of tax imposed by the government taxes result in loss of utility. Dalton says that the additional burden (marginal sacrifice) resulting from additional units of taxation goes on increasing i.e. the total social sacrifice increases at an increasing rate.

50. continue This is because, when taxes are imposed, the stock of money with the community diminishes. As a result of diminishing stock of money, the marginal utility of money goes on increasing. Eventually every additional unit of taxation creates greater amount of impact and greater amount of sacrifice on the society. That is why the marginal social sacrifice goes on increasing.

51. Graph of MSS

52. Explanation of graph The above diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards from left to right. This indicates that with each additional unit of taxation, the level of sacrifice also increases. When the unit of taxation was OM 1 , the marginal social sacrifice was OS 1 , and with the increase in taxation at OM 2 , the marginal social sacrifice rises to OS 2 .

53. Marginal Social Benefit (MSB) While imposition of tax puts burden on the people, public expenditure confers benefits. The benefit conferred on the society, by an additional unit of public expenditure is known as Marginal Social Benefit (MSB ). as the marginal utility from a commodity to a consumer declines as more and more units of the commodity are made available to him, the social benefit from each additional unit of public expenditure declines as more and more units of public expenditure are spent.

54. continue In the beginning, the units of public expenditure are spent on the most essential social activities. Subsequent doses of public expenditure are spent on less and less important social activities. As a result, the curve of marginal social benefits slopes downward from left to right as shown in figure below.

55. Graph of msb

56. continue In the above diagram, the marginal social benefit (MSB) curve slopes downward from left to right. This indicates that the social benefit derived out of public expenditure is reducing at a diminishing rate. When the public expenditure was OM 1 , the marginal social benefit was OB 1 , and when the public expenditure is OM 2 , the marginal social benefit is reduced at OB 2 .

57. The Point of Maximum Social Advantage Social advantage is maximized at the point where marginal social sacrifice cuts the marginal social benefits curve. This is at the point P. At this point, the marginal disutility or social sacrifice is equal to the marginal utility or social benefit. Beyond this point, the marginal disutility or social sacrifice will be higher, and the marginal utility or social benefit will be lower.

58. Graph of Maximum Social Advantage Maximum Social Advantage

59. continue At point P social advantage is maximum. Now consider Point P 1 . At this point marginal social benefit is P 1 Q 1 . This is greater than marginal social sacrifice S 1 Q 1 . Since the marginal social sacrifice is lower than the marginal social benefit, it makes more sense to increase the level of taxation and public expenditure. This is due to the reason that additional unit of revenue raised and spent by the government leads to increase in the net social advantage. This situation of increasing taxation and public expenditure continues, as long as the levels of taxation and expenditure are towards the left of the point P.

60. continue At point P, the level of taxation and public expenditure moves up to OQ. At this point, the marginal utility or social benefit becomes equal to marginal disutility or social sacrifice. Therefore at this point, the maximum social advantage is achieved.

61. continue At point P 2 , the marginal social sacrifice S 2 Q 2  is greater than marginal social benefit P 2 Q 2 . Therefore, beyond the point P, any further increase in the level of taxation and public expenditure may bring down the social advantage. This is because; each subsequent unit of additional taxation will increase the marginal disutility or social sacrifice, which will be more than marginal utility or social benefit. This shows that maximum social advantage is attained only at point P & this is the point where marginal social benefit of public expenditure is equal to the marginal social sacrifice of taxation.

62. conclusion Maximum Social Advantage is achieved at the point where the marginal social benefit of public expenditure and the marginal social sacrifice of taxation are equated, i.e. where MSB = MSS. This shows that to obtain maximum social advantage, the public expenditure should be carried up to the point where the marginal social benefit of the last rupee or dollar spent becomes equal to the marginal social sacrifice of the last unit of rupee or dollar taxed.

63. continue Externalities can originate on either the supply side or the demand side of the market and it is possible to distinguish between the following categories: Negative Production Externality Positive Consumption Externality

64. Negative Production Externality In a negative production externality, the producer does not face the entire cost of production. For example, an oil refinery generates air pollution in its production of oil. The presence of air pollution makes the community around the oil refinery worse off due to diminished health or due to diminished ability to view a clear blue sky, etc

65. Graph of Negative Production Externality

66. Explanation of graph The firm will only take into account their own private costs and thus will produce where private benefits = private costs. This is equivalent as saying where supply equals demand. The oil refinery would produce at Point A where (Quantity = Q 1 ; Price = P 1 ). However, there are social costs (the air pollution) to the production of oil, which the oil refinery ignores.

67. continue The social cost curve must be higher (to the left) of the private cost curve. At the original level of production, social costs are higher than social benefits and thus this quantity is not efficient and we have market failure. The reason for market failure is that the market participants do not factor in the full social costs of their harmful economic activities. There is a divergence between social costs and private costs which is the negative externality.

68. continue Note that there is no externality on the consumption side, so private benefit = social benefit (the demand curve will be the same). When externalities exist, economic efficiency will only occur when social benefit is equal to social cost. In this case, economic efficiency will be at Point B. The shaded area is the area in which social costs exceeded social benefit that results from overproduction. This is the deadweight loss.

69. continue Society would be better off if the economy was at Point B rather than at Point A. As long as the firm has the ability to compensate the damaged parties fully and still have profits left over, then pollution is “worth it” to society. It would be inefficient for the oil refinery to stop polluting.

70. conclusion In conclusion as far as the supply side is concerned; the productive activities of producer can have either: A negative external effect on other producers or consumers, in which case the marginal external cost (MEC)>0 and the marginal social cost ( MSC) is greater than the marginal private cost ( MPC); or A positive external effect, in which case MEC<0 and MPC>MSC.

71. Positive Consumption Externality A positive production externality occurs when a third party gains as a result of production.  Positive production externalities occur in many situations, most notably with the construction and operation of infrastructure projects, such as a new airport, or motorway. Education and Health. Research and development  which leads to new technology is also a potential by-product of production, which other firms can benefit from.

72. Example of Positive Consumption Externality Examples of this could include the consumption of vaccinations. When I consume a vaccine I decrease the chance of me passing on diseases to the wider population, therefore third parties are less likely to get ill. Goods like these with positive externalities are called merit goods.

73. Graph of Positive Consumption Externality

74. Explanation of graph In the case of a positive externality of consumption the marginal social benefit (MSB) of consuming a good and the marginal private benefit of consuming a good (MPB) will be different, as private benefit does not consider third party benefits. We can show this on a price-quantity diagram: MSB will be further right than MPB and market failure will occur, with the welfare loss shown as the shaded triangle. Within our vaccine example the welfare loss would be the increased likelihood of people in society getting a disease.

75. continue This is the case, because at every price, society would benefit more from flu shots. There is no externality on the production side, therefore the social and private costs are the same. We know that the market equilibrium is where the private costs = private benefits at Point A. Point A cannot be efficient since at that quantity the social benefits exceed the social costs.

76. Continue Economic efficiency will only be reached when social costs = social benefits at Point B. The shaded area is the positive externality that is realized as we produced the good. The deadweight loss is the shaded area between Q1 and Q2 . It is the loss to society by not producing enough of the good.

77. continue In conclusion on the demand side, the consumption activities of an individual consumer can have either: A positive external effect on the consumers or producers, in which case the marginal external benefit (MEB) > O and the marginal social benefit (MSB)> marginal private benefit (MPB); or A negative external effect, in which case MEB<0 and MPB>MSB.

78. Possible solutions to the externality problem Regulation Pigouvian taxes and subsidies Property rights Creation of markets

79. 1. Regulation The option of regulation is particularly relevant to the case of negative production externalities such as pollution. It involves telling each polluter to reduce pollution to a certain level or else face legal sanction.

80. 2. Pigouvian taxes and subsidies Pigouvian tax is a special tax that is often levied on companies that pollute the environment or create excess social costs, called negative externalities, through business practices. In a true market economy, a Pigovian tax is the most efficient and effective way to correct negative externalities. A type of a Pigovian tax is a "sin tax", which is a special tax on tobacco products and alcohol.

81. continue Pigovian tax is applicable only because market economies often fail to provide a proper incentive to reduce negative externalities. For example, a coal-powered plant may be polluting a nearby river by disposing its harmful byproducts in the river instead of shipping the byproducts to a special facility. A sufficient Pigovian tax would punish this firm economically when it chooses to dispose of the harmful byproducts in the river, creating an incentive to use more environmentally friendly methods of disposal.

82. 3. Property rights Property rights represent the legal specification of who owns what goods, broadly defined, including the rights and obligations attendant upon such ownership. The problem of externalities thus boils down to disputes over the use of resources.

83. 4. Creation of markets A fourth approach, also developed in the context of the context of pollution problem, consists in the creation of a market in which the government would sell legal permits giving owners the rights to pollute. The government would first establish the overall quantity of pollutant which it considers to be efficient level and then sell a limit number of individual permits to the highest bidders. The price of these permits should ideally clear the market, in which case the actual amount of pollution will equal the level determined by government.

84. continue Producers who are unwilling to pay the market determined effluent fee would have to reduce their own output or shift to cleaner technologies. The market creation approach also assumes that government possesses perfect knowledge about the sources of pollution appropriate with efficient level of output.