Chapter 20

EXTERNALITIES AND
PUBLIC GOODS

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. c

 " ternality
G An externality occurs whenever the
activities of one economic agent affect
the activities of another economic agent
in ways that are not reflected in market
transactions
± chemical manufacturers releasing toxic
fumes
± noise from airplanes
± motorists littering roadways
m
 Ãnterfirm " ternalities
G Consider two firms, one producing good
0 and the other producing good
G The production of 0 will have an external
effect on the production of if the output
of depends not only on the level of
inputs chosen by the firm but on the level
at which 0 is produced


(, 0·

-
 6eneficial " ternalities
G The relationship between the two firms
can be beneficial
± two firms, one producing honey and the
other producing apples

]
 " ternalities in Utility
G Externalities can also occur if the
activities of an economic agent directly
affect an individual¶s utility
± externalities can decrease or increase
utility
G It is also possible for someone¶s utility to
be dependent on the utility of another
utility =  (01,«,0 
·
î
 
lic Goods " ternalities
G Public goods are nonexclusive
± once they are produced, they provide
benefits to an entire group
± it is impossible to restrict these benefits to
the specific groups of individuals who pay
for them

§
" ternalities and Allocative
Ãnefficiency
G Externalities lead to inefficient
allocations of resources because
market prices do not accurately reflect
the additional costs imposed on or the
benefits provided to third parties
G We can show this by using a general
equilibrium model with only one
individual
Õ
" ternalities and Allocative
Ãnefficiency
G Suppose that the individual¶s utility
function is given by
utility = (0, ·
where 0 and  are the levels of 0 and
consumed
G The individual has initial stocks of 0* and
*
± can consume them or use them in

production
" ternalities and Allocative
Ãnefficiency
G Assume that good 0 is produced using
only good according to
0 = ( ·
G Assume that the output of good
depends on both the amount of 0 used in
the production process and the amount
of 0 produced
 = (0,0·
›
 " ternalities and Allocative
Ãnefficiency
G or example, could be produced
downriver from 0 and thus firm must
cope with any pollution that production of
0 creates
G This implies that 1 > 0 and 2 < 0

c
" ternalities and Allocative
Ãnefficiency
G The quantities of each good in this
economy are constrained by the initial
stocks available and by the additional
production that takes place
0

0 
0

0*



 
0

*

cc
inding the "fficient Allocation
G The economic problem is to maximize
utility subject to the four constraints
listed earlier
G The Lagrangian for this problem is
¬ = (0, · + 1[( · - 0] + 2[ (00· - ] +
-(0

0  0  0*· + ]( 

    *·

cm
inding the "fficient Allocation
G The six first-order conditions are
0¬X00 
1 + - = 0
0¬X0  
2 + ] = 0
0¬X00 
2 1 + - = 0
0¬X0  
1 + ] = 0
0¬X00 
1 + 2 2 - - = 0
0¬X0  
2 - ] = 0 c-
inding the "fficient Allocation
G Taking the ratio of the first two, we find
o

X = -X]
G The third and sixth equation also imply
that
o

-X] = 2 1X2 = 1
G Optimality in production requires that
the individual¶s o in consumption
equals the marginal productivity of 0 in
the production of c]
inding the "fficient Allocation
G To achieve efficiency in 0 production,
we must also consider the externality
this production poses to
G Combining the last three equations
gives
o

-X] = (-1 + 2 2·X] = -1X] + 2 2X]

o

1X - 2

cî
inding the "fficient Allocation
G This equation requires the individual¶s
o to equal  X0 obtained through 0
production
± 1X represents the reciprocal of the
marginal productivity of in 0 production
± 2 represents the negative impact that
added 0 production has on output
G allows us to consider the externality from 0

production
c§
 Ãnefficiency of the
Competitive Allocation
G Reliance on competitive pricing will result
in an inefficient allocation of resources
G A utility-maximizing individual will opt for
o

0X
and the profit-maximizing producer of
would choose 0
input according to
0 = 1
cÕ
 Ãnefficiency of the
Competitive Allocation
G But the producer of 0 would choose
input so that

0
0X = 1X
G This means that the producer of 0 would
disregard the externality that its
production poses for and will
overproduce 0 c
 rod ction " ternalities
G Suppose that two newsprint producers
are located along a river

G The upstream firm has a production

function of the form
0 = 2,00000.5

c›
 rod ction " ternalities
G The downstream firm has a similar
production function but its output may
be affected by chemicals that firm 0

pours in the river
= 2,000 0.5(0
 0 0 ·" (for 0 > 00·
= 2,000 0.5 (for 0
p 00·
where 00 represents the river¶s natural
capacity for pollutants
m
 rod ction " ternalities
G Assuming that newsprint sells for $1 per
foot and workers earn $50 per day, firm
0 will maximize profits by setting this
wage equal to the labor¶s marginal
product
0
50
1,000 0´0 5
0

G 0* = ]00
G If " = 0 (no externalities·,  * = ]00 mc
 rod ction " ternalities
G When firm 0 does have a negative
externality (" < 0·, its profit-maximizing
decision will be unaffected (0* = ]00
and 0 = ]0,000·
G But the marginal product of labor will be
lower in firm because of the externality

mm
 rod ction " ternalities
G If " = -0.1 and 00 = - ,000, firm will
maximize profits by

’ ´0 ´0
0  ,000 ’ 40,000 ´ - ,000)

’
î
’´
î

G Because of the externality,  * =
and

output will be ,
2-
m-
 rod ction " ternalities
G Suppose that these two firms merge
and the manager must now decide how
to allocate the combined workforce
G If one worker is transferred from 0 to ,
output of 0 becomes
0

2,000(-·0.5 = -,50
and output of becomes


2,000( ·0.5(1,50·-0.1 = ,

m]
 rod ction " ternalities
G Total output increased with no change
in total labor input
G The earlier market-based allocation
was inefficient because firm 0 did not
take into account the effect of its hiring
decisions on firm

mî
 rod ction " ternalities
G If firm 0 was to hire one more worker, its
own output would rise to
0 = 2,000(]01·0.5 = ]0,050
± the private marginal value product of the
]01st worker is equal to the wage
G But, increasing the output of 0 causes
the output of to fall (by about 21 units·
G The social marginal value product of the
additional worker is only $2 m§
 Úol tions to the
" ternality ro
lem
G The output of the externality-producing
activity is too high under a market-
determined equilibrium
G Incentive-based solutions to the
externality problem originated with
Pigou, who suggested that the most
direct solution would be to tax the
externality-creating entity
mÕ
 Úol tions to the
" ternality ro
lem
Price o

oarket equilibrium
will occur at |1, 01


o

If there are external
costs in the
production of 0,
c social marginal costs
are represented by
o



uantity of 0
0c
m
 Úol tions to the
" ternality ro
lem
Price o

A tax equal to these
additional marginal


o
costs will reduce
output to the socially
optimal level (02·
2

0 The price paid for the

good (|2· now
reflects all costs


uantity of 0
02
m›
A igo vian Ta on Newsprint
G A suitably chosen tax on firm 0 can
cause it to reduce its hiring to a level at
which the externality vanishes
G Because the river can handle pollutants
with an output of 0 = - ,000, we might
consider a tax that encourages the firm
to produce at that level

-
A igo vian Ta on Newsprint
G Output of 0 will be - ,000 if 0 = -1
G Thus, we can calculate Y from the labor
demand condition
(1 - Y·o  = (1 - Y·1,000(-1·-0.5 = 50
Y

0.05
G Therefore, a 5 percent tax on the price
firm 0 receives would eliminate the
externality
-c
 Ta ation in the General
"
ili
ri m Model
G The optimal Pigouvian tax in our
general equilibrium model is to set
Y = -| 2
± the per-unit tax on 0 should reflect the
marginal harm that 0 does in reducing
output, valued at the price of good

-m
 Ta ation in the General
"
ili
ri m Model
G With the optimal tax, firm 0 now faces a
net price of (|0  Y· and will choose
input according to
| 
(|0  Y·
G The resulting allocation of resources will
achieve
o

|0X| = (1X · + YX| = (1X · - 2
--
 Ta ation in the General
"
ili
ri m Model
G The Pigouvian tax scheme requires that
regulators have enough information to
set the tax properly
± in this case, they would need to know firm
¶s production function

-]
 oll tion Rights
G An innovation that would mitigate the
informational requirements involved with
Pigouvian taxation is the creation of a
market for ³pollution rights´
G Suppose that firm 0 must purchase from
firm the rights to pollute the river they
share
± 0¶s choice to purchase these rights is
identical to its output choice
-î
 oll tion Rights
G The net revenue that 0 receives per unit
is given by |0 - , where  is the payment
the firm must make to firm
for each
unit of 0 it produces
G irm must decide how many rights to
sell firm 0 by choosing 0 output to
maximize its profits
P = | (0,0o· + 0o
-§
 oll tion Rights
G The first-order condition for a maximum
is
0P X00 = | 2



0
 = -| 2
G The equilibrium solution is identical to
that for the Pigouvian tax
± from firm 0¶s point of view, it makes no
difference whether it pays the fee to the
government or to firm -Õ
 The Coase Theorem
G The key feature of the pollution rights
equilibrium is that the rights are well-
defined and tradable with zero
transactions costs
G The initial assignment of rights is
irrelevant
± subsequent trading will always achieve the
same, efficient equilibrium
-
 The Coase Theorem
G Suppose that firm 0 is initially given 0
rights to produce (and to pollute·
± it can choose to use these for its own
production or it may sell some to firm
G Profits for firm 0 are given by
P0 = |00

(0  0· = (|0  ·0 + 0
P0 = (|0  ·( · + 0

-›
 The Coase Theorem
G Profits for firm are given by
P = | (0,0o· - (0  0·
G Profit maximization in this case will lead
to precisely the same solution as in the
case where firm was assigned the
rights

]
 The Coase Theorem
G The independence of initial rights
assignment is usually referred to as the
Coase Theorem
± in the absence of impediments to making
bargains, all mutually beneficial
transactions will be completed
± if transactions costs are involved or if
information is asymmetric, initial rights
assignments will matter
]c
 Attri
tes of 
lic Goods
G A good is exclusive if it is relatively easy
to exclude individuals from benefiting
from the good once it is produced
G A good is nonexclusive if it is
impossible, or very costly, to exclude
individuals from benefiting from the
good

]m
 Attri
tes of 
lic Goods
G A good is nonrival if consumption of
additional units of the good involves
zero social marginal costs of production

]-
 Attri
tes of 
lic Goods
G Some examples of these types of goods
include:

Excl si e
U

H t s, Fis i
U
c rs, r s,
s s cl ir
i l ti l
ri s,
f s ,
s i i
s it
ls
c tr l
V
]]
 
lic Good
G A good is a pure public good if, once
produced, no one can be excluded from
benefiting from its availability and if the
good is nonrival -- the marginal cost of
an additional consumer is zero

]î
 
lic Goods and
Reso rce Allocation
G We will use a simple general equilibrium
model with two individuals (• and ·
G There are only two goods
± good is an ordinary private good
G each person begins with an allocation ( • and
·

± good 0 is a public good that is produced

using
0

( •

 ·
]§
 
lic Goods and
Reso rce Allocation
G Resulting utilities for these individuals are
•[0,( • 
•·]

 [0,(  ·]


G The level of 0 enters identically into each

person¶s utility curve
± it is nonexclusive and nonrival
G each person¶s consumption is unrelated to what
he contributes to production
G each consumes the total amount produced ]Õ
 
lic Goods and
Reso rce Allocation
G The necessary conditions for efficient
resource allocation consist of choosing
the levels of • and  that maximize
one person¶s (•¶s· utility for any given
level of the other¶s ( ¶s· utility
G The Lagrangian expression is
¬ = •(0, •  •· + [ (0,   · -
]
 

]
 
lic Goods and
Reso rce Allocation
G The first-order conditions for a maximum
are
0¬X0 • 
1•
 2•

1 

0


0¬X0  
1•
 2

1 

0
G Comparing the two equations, we find
2 
2•

]›
 
lic Goods and
Reso rce Allocation
G We can now derive the optimality
condition for the production of 0
G rom the initial first-order condition we
know that
1•X2•

1 X2 = 1X
o •

o 
1X
G The o must reflect all consumers
because all will get the same benefits î
 ail re of a
Competitive Market
G Production of 0 and in competitive
markets will fail to achieve this allocation
± with perfectly competitive prices |0 and | ,
each individual will equate his o to |0X|
± the producer will also set 1X equal to |0X|
to maximize profits
± the price ratio |0X| will be too low
G it would provide too little incentive to produce 0
îc
 ail re of a
Competitive Market
G or public goods, the value of producing
one more unit is the sum of each
consumer¶s valuation of that output
± individual demand curves should be added
vertically rather than horizontally
G Thus, the usual market demand curve
will not reflect the full marginal valuation

îm
 Ãnefficiency of a
Nash "
ili
ri m
G Suppose that individual • is thinking
about contributing • of his initial

endowment to the production of 0
G The utility maximization problem for • is
then
choose • to maximize •[(•

 ·, •   •]

î-
 Ãnefficiency of a
Nash "
ili
ri m
G The first-order condition for a maximum
is
1•
 2• = 0
1•X2• = o • = 1X
G Because a similar argument can be
applied to , the efficiency condition will
fail to be achieved
± each person considers only his own benefit
î]
 The Roommates¶ Dilemma
G Suppose two roommates with identical
preferences derive utility from the number
of paintings hung on their walls (0· and the
number of granola bars they eat ( · with a
utility function of
(0, · = 01X- 
2X- (for =1,2·
G Assume each roommate has $-00 to
spend and that |0 = $100 and | = $0.20
îî
 The Roommates¶ Dilemma
G We know from our earlier analysis of
Cobb-Douglas utility functions that if each
individual lived alone, he would spend 1X-
of his income on paintings (0
= 1· and 2X-
on granola bars (
= 1,000·
G When the roommates live together, each
must consider what the other will do
± if each assumed the other would buy
paintings, 0 = 0 and utility = 0
î§
 The Roommates¶ Dilemma
G If person 1 believes that person 2 will
not buy any paintings, he could choose
to purchase one and receive utility of
1(0, 1· = 11X-(1,000·2X- = 100
while person 2¶s utility will be
2(0, 2· = 11X-(1,500·2X- = 1-1
G Person 2 has gained from his free-riding
position
îÕ
 The Roommates¶ Dilemma
G We can show that this solution is
inefficient by calculating each person¶s
o
 /  
o  Ë Ë
 /  

G At the allocations described,

o 1 = 1,000X2 = 500
o 2 = 1,500X2 =
50
î
 The Roommates¶ Dilemma
G Since o 1 + o 2 = 1,250, the
roommates would be willing to sacrifice
1,250 granola bars to have one additional
painting
± an additional painting would only cost them
500 granola bars
± too few paintings are bought

î›
 The Roommates¶ Dilemma
G To calculate the efficient level of 0, we
must set the sum of each person¶s o
equal to the price ratio
’ ’ ’ ’

  Ë Ë Ë Ë

’

G This means that

1 + 2 = 1,0000
§
 The Roommates¶ Dilemma
G Substituting into the budget constraint,
we get
0.20( 1 + 2· + 1000 = 00
0=2
1 + 2 = 2,000
G The allocation of the cost of the
paintings depends on how each
roommate plays the strategic financing
game §c
 ¬indahl ricing of

lic Goods
G Swedish economist E. Lindahl
suggested that individuals might be
willing to be taxed for public goods if they
knew that others were being taxed
± Lindahl assumed that each individual would
be presented by the government with the
proportion of a public good¶s cost he was
expected to pay and then reply with the
level of public good he would prefer
§m
 ¬indahl ricing of

lic Goods
G Suppose that individual • would be
quoted a specific percentage ("•· and
asked the level of a public good (0· he
would want given the knowledge that this
fraction of total cost would have to be
paid
G The person would choose the level of 0
which maximizes
utility = •[0, •- "•
-1(0·] §-
 ¬indahl ricing of

lic Goods
G The first-order condition is given by
1• - "•2 (1X·=0
o • = "•X
G aced by the same choice, individual
would opt for the level of 0 which satisfies
o = " X

§]
 ¬indahl ricing of

lic Goods
G An equilibrium would occur when
"•
" = 1
± the level of public goods expenditure
favored by the two individuals precisely
generates enough tax contributions to pay
for it
o •

o 
("•

" ·X = 1X

§î
 Úhortcomings of the
¬indahl Úol tion
G The incentive to be a free rider is very
strong
± this makes it difficult to envision how the
information necessary to compute
equilibrium Lindahl shares might be
computed
G individuals have a clear incentive to understate
their true preferences

§§
Ãmportant oints to Note:
G Externalities may cause a
misallocation of resources because of
a divergence between private and
social marginal cost
± traditional solutions to this divergence
includes mergers among the affected
parties and adoption of suitable
Pigouvian taxes or subsidies

§Õ
Ãmportant oints to Note:
G If transactions costs are small, private
bargaining among the parties
affected by an externality may bring
social and private costs into line
± the proof that resources will be
efficiently allocated under such
circumstances is sometimes called the
Coase theorem

§
Ãmportant oints to Note:
G Public goods provide benefits to
individuals on a nonexclusive basis -
no one can be prevented from
consuming such goods
± such goods are usually nonrival in that
the marginal cost of serving another
user is zero

§›
Ãmportant oints to Note:
G Private markets will tend to
underallocate resources to public
goods because no single buyer can
appropriate all of the benefits that
such goods provide

Õ
Ãmportant oints to Note:
G A Lindahl optimal tax-sharing scheme
can result in an efficient allocation of
resources to the production of public
goods
± computation of these tax shares
requires substantial information that
individuals have incentives to hide

Õc