Externalities, Public Goods, Imperfect Information, and Social Choice

1. Externalities, Public Goods, Imperfect Information, and Social Choice Chapter 16 Copyright 2002, Pearson Education Canada

2. Externality • 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. • Also called spillovers or neighborhood effects. • The classic example of an externality is pollution. Copyright 2002, Pearson Education Canada

3. Marginal Social Cost (MSC) • The marginal social cost 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 Copyright 2002, Pearson Education Canada

4. A Profit Maximizing Firm and an Externality (Figure 16.2b) If firms were forced to account for the full cost of their production then P**, q** would be the equilibrium and S’ the new supply curve. Copyright 2002, Pearson Education Canada

5. Marginal Private Cost (MPC) • The marginal private cost is the amount that a consumer pays to consume an additional unit of a particular good. Copyright 2002, Pearson Education Canada

6. Marginal Damage Cost (MDC) • Marginal damage cost is the additional harm done by increasing the level of an externality-producing activity by one unit. • If producing product X pollutes the water in a river, MDC is the additional cost imposed by the added pollution that results from increasing output by one unit of X per period. Copyright 2002, Pearson Education Canada

7. Externalities in University Residence (Figure 16.3) • Harry enjoys marginal benefits of listening to his stereo higher than his marginal costs. • Costs are also imposed on Jake - an externality. • The full cost to this society of two individuals are substantially higher than Harry’s MPC. • The efficient level of stereo time is 5 hours and not 8 hours. Copyright 2002, Pearson Education Canada

8. Internalizing Externalities • Government-imposed taxes and subsidies • Private bargaining and negotiation • Legal rules and procedures • The sale or auctioning of rights to impose externalities • Direct government regulation Copyright 2002, Pearson Education Canada

9. Tax Imposed on a Firm Equal to Marginal Damage Cost (Figure 16.4) If a per unit tax exactly equal to marginal damage costs is imposed on a firm, the firm will weigh the tax, and thus the damage costs in its decisions and produce the efficient output. Copyright 2002, Pearson Education Canada

10. Coase Theorem • Coase Theorem states that under certain conditions, when externalities are present, private parties can arrive at the efficient solution without government involvement. Copyright 2002, Pearson Education Canada

11. Public (Social) Goods • Public goods are those goods or services that bestow collective benefits on members of society. • Such goods are nonrival in consumption and their benefits are nonexcludable. Copyright 2002, Pearson Education Canada

12. Characteristics of Public Goods • Nonrival in consumption: One person’s enjoyment of the benefits of a public good does not interfere with another’s consumption of it. • Nonexcludable: Once a good is produced, no one can be excluded from enjoying its benefits. Copyright 2002, Pearson Education Canada

13. Intrinsic Problems of Public Goods • Free-rider problem: Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them. • Drop-in-the-bucket problem: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays. Copyright 2002, Pearson Education Canada

14. Market Demand For Public Goods (Figure 16.6) • Person A is willing to pay $6 per X units of the public good and Person B is willing to pay $3. • The market demand for the public good is $9 per X units of the good. • Demand curves are vertically added to obtain the demand for public goods. Copyright 2002, Pearson Education Canada

15. Optimal Provision of a Public Good (Figure 16.7) • Optimal production or provision of a public good means producing as long as society’s total willingness to pay per unit (DA+B) is greater than the marginal cost of producing the good. Copyright 2002, Pearson Education Canada

16. Optimal Level of Provision for Public Goods (Samuelson) • The level at which resources are drawn from the production of other goods and services only to the extent that people want the public good and are willing to pay for it. At this level, society’s willingness to pay per unit is equal to the marginal cost of producing the good. Copyright 2002, Pearson Education Canada

17. 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. Copyright 2002, Pearson Education Canada

18. Imperfect Information • Imperfect information refers to the absence of full information that can cause households and firms to make mistakes. Copyright 2002, Pearson Education Canada

19. Adverse Selection • Adverse selection can occur when a buyer or seller enters into an exchange with another party who has more information. Copyright 2002, Pearson Education Canada

20. Moral Hazard • A moral hazard arises when one party to a contract passes the cost of his or her behaviour on to the other party to the contract. Copyright 2002, Pearson Education Canada

21. Market Solutions to Imperfect Information • Like consumers, profit maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs of engaging in it. Copyright 2002, Pearson Education Canada

22. Social Choice • Social choice refers to the problem of deciding what society wants; the process of adding up individual preferences to make a choice for society as a whole. Copyright 2002, Pearson Education Canada

23. Arrow’s Impossibility Theorem • From a proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent arbitrary results. Copyright 2002, Pearson Education Canada

24. Voting Paradox • A simple demonstration of how majority- rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem. Copyright 2002, Pearson Education Canada

25. Logrolling • Logrolling occurs when elected representatives trade votes, agreeing to help each other get certain pieces of legislation passed. Copyright 2002, Pearson Education Canada

26. Governmental Failure in the Efficient Allocation of Resources • Measurement of social costs and benefits is difficult and imprecise. • There is no reliable measure of citizens’ preferences. • Governments are not subject to the discipline of the market. • Elected and appointed officials may not act selflessly for the good of society. Copyright 2002, Pearson Education Canada

27. adverse selection Coase Theorem drop-in-the-bucket problem externality free-rider problem impossibility theorem injunction liability rules logrolling marginal damage cost (MDC) marginal private cost (MPC) marginal social cost (MSC) market failure moral hazard Review Terms & Concepts Copyright 2002, Pearson Education Canada

28. nonexcludable nonrival in consumption optimal level of provision of public goods public goods social choice Tiebout hypothesis voting paradox Review Terms & Concepts(continued) Copyright 2002, Pearson Education Canada