Externalities and Public Goods
When markets work well, they work very well…
Competitive markets (usually) allocate resources to deliver maximum Gain to Society!
At competitive equilibrium, P = MC or the marginal benefit of additional output = marginal cost of additional output
But markets sometimes do not work well (i.e., markets fail)…
x when there is only a small number of producers (oligopoly) or only one producer (monopoly)
x when a good (or service) has substantial external costs (external costs are ones that producers ignore in their decisions—e.g.,
x when a good (or service) has substantial external benefits (external benefits are ones that consume ignore in their decisions to
x when a good is a public good: i.e., (1) it is collectively consumed, and (2) consumers cannot be “excluded” from consuming the good
x In all these cases, markets fail to work well, governments may need to correct what markets would naturally do!
x Side note: Another form of “failure” that governments address is income distribution: governments redistribute income from rich to
poor, or provide services for “needy” individuals. However this is an equity rather than an efficiency issue
Positive and Negative Externalities (also called external benefits and external costs)
Goods or services that affect others (not just the direct consumer and producer)
x beautiful garden
x raising bees
x raising well-educated children
x pollution (e.g., greenhouse gas emissions)
x second-hand smoke
x noisy activities
When there are external effects (i.e., externalities), markets do not receive the right signals about all the benefits and all the costs, and
therefore make the wrong decisions. Consumers and producers do not face the correct incentives. They will consume and/or produce too
much or too little of the good.
When small numbers of people are affected, private negotiations can solve the problem. When large numbers of people are affected, this
is a form of market failure.
A first look at the problem:
However, this approach assumes production and pollution are inseparably linked.
Better to develop a model that focuses on pollution reduction (abatement) itself.
First, some background about GHG’s as an introduction to discussing the Marginal Cost of Abatement and the Marginal Benefit of
Greenhouse Gas Emissions (GHG emissions)
x The earth’s surface temperature has risen by a little less than 1 degree Celsius in the 20th century. Mostly (3/4) due to increasing
burning of fossil fuels. Also deforestation and agricultural practices.
x Projected average temperature rise over the 21st century ranges from 1.1 – 6.4 degrees Celsius (U.N. Intergovernmental Panel on
x Important GHG’s: carbon dioxide, methane, nitrous oxide, ozone