Lecture 6

1. Managerial Economics ECON 511 Lecture 6 Externalities and Public Goods Professor Changqi Wu

2. Topics for Today • Externality and Its Solutions • Public Goods Externality and public goods

3. 1. Externalities • Negative externality • Action taken by one party imposes a cost on another party • Positive externality • Action taken by one party benefits another party Externality and public goods

4. An Example • Scenario • Steel plant dumping waste in a river • The entire steel market effluent can be reduced by lowering output • Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. • Marginal Social Cost (MSC) is MC plus MEC. Externality and public goods

5. The differences is the marginal external cost MEC. The profit maximizing firm produces at q1 while the efficient output level is q*. When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. MSC MSCI MC S = MCI The industry competitive output is Q1 while the efficient level is Q*. Aggregate social cost of negative externality P* P1 P1 MECI MEC D q* q1 Q* Q1 External Costs Price Price Industry output Firm output

6. Negative Externality • Negative externality: the social marginal cost is higher than the individual marginal cost. • Negative externality encourages inefficient firms to remain in the industry and creates excessive production in the long run. Externality and public goods

7. Positive Externality • Positive externality: the social marginal benefit is larger than the individual marginal benefit • Positive externality then results in too little production. Externality and public goods

8. When there are positive externalities (the benefits of R&D spillovers to others), marginal social benefits MSB are higher than marginal benefits D. MSB A self-interested firm invests q1 in innovative effort. The efficient level of effort q* is higher. The higher cost P1 discourages innovation . D P1 MC P* MEB q1 q* External Benefits Value Is research and development discouraged by positive externalities? Effort Level Externality and public goods

9. Consequences of Externalities • Over provision of goods or services when a negative externality exists • over-production happens when the production produces pollution • Under provision of goods or services when a positive externality is present • spillover of research and development(R&D) leads to under-investment in R&D Externality and public goods

10. 2. Solutions to Externalities • Solution 1: government solution • taxation or subsidization • Solution 2: internalization • Disneyland solution • research joint ventures • Solution 3: creation of a market by clarifying property rights • the fable of the bees Externality and public goods

11. 2.1. Government Solution • Taxation or subsidization to restore the optimal level of output • In controlling emissions, fees used to solve the externality problem • In education, governments provide loans and subsidies to students Externality and public goods

12. Business Application • Rental differences at shopping centers. • Anchor stores attract traffic into the shopping centers and specialty stores benefit. • Real estate managers should tax specialties stores and subsidies anchor stores. Externality and public goods

13. 2.2. Internalization Solution • If both the steel mill and fishing pond are owned by the same company, the externality problem will be resolved. • Disneyland owns large amount of land and develops hotels in the vicinity of its theme parks. Externality and public goods

14. 2.3. Property Rights Solution • Property Rights • Legal rules describing what people or firms can do with their property • Economic efficiency can be achieved when property rights are well specified. Externality and public goods

15. Coase Theorem • When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified. Externality and public goods

16. MC to fishermen MB to factory Coase Theorem Illustrated Benefit/cost Level of Emissions Externality and public goods

17. 3. Public Goods • Government sometimes replaces private firms as the producer of goods and services. • Question • When should government replace firms as the producer of goods and services? Externality and public goods

18. Public Good Characteristics • Nonrivalry • For any given level of production the marginal cost of providing it to an additional consumer is zero. • Nonexclusivity • People cannot be excluded from consuming the good. Externality and public goods

19. Public Goods High Externality: crowded street Pure private goods: hamburgers NC TFT Marginal cost to society of additional usage Pure public goods: street lights, police protection Club goods: swimming pool, cable TV Low Difficult Easy Exclusion Externality and public goods

20. When a good is nonrival, the social marginal benefit of consumption (D) , is determined by vertically summing the individual demand curves for the good. Marginal Cost D2 Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50. D $1.50 D1 Efficient Public Good Provision Benefits (dollars) $7.00 $5.50 $4.00 Output 0 1 2 3 4 5 6 7 8 9 10 Externality and public goods

21. Free Riders • There is no way to provide some goods and services without benefiting everyone. • Households do not have the incentive to pay what the item is worth to them. • Free riders understate the value of a good or service to them so that they can enjoy the benefit without paying for it. Externality and public goods

22. Public Goods and Market Failure • How much police protection did you consume last week? • How much were you willing to pay for that service? Externality and public goods

23. Solutions to Public Goods • Public provision of public goods • government provides police services • Commercial provision of public goods • lighthouse Externality and public goods

24. The Key Learning Points • Externalities and public goods lead to economic inefficiencies. • These inefficiencies can be mitigated by government interventions and private initiatives. • A firm can take advantages of externality to improve its market positions. Externality and public goods