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
Expected effects of global warming:
x Rising se levels
x Changes in amount and pattern of world precipitation
x Increase in subtropical deserts
x Retreat of glaciers, permafrost, sea ice
x Increased frequency of extreme weather events
x Species extinctions
x Changes in agricultural yield patterns
Intergovernmental Panel on Climate Change estimate of the average social cost of carbon dioxide emissions = $12 per ton of carbon
dioxide, with estimates ranging up to $95 per ton.
To stabilize at a concentration of carbon dioxide that will result in global temperatures 2.0 – 2.4 degrees above pre-industrial average
requires emissions to be reduced by 50 – 85% compared to 2000 levels, by 2050.
Carbon prices of $5 – $65 per ton in 2030 and higher levels in 2050 will be needed for stabilization of carbon dioxide emissions (at a
higher level) by 2100.
What can be done?
GHG emissions are evidence of massive and important failure of markets to allocate resources appropriately.
Polluters (i.e., you and me, business and agriculture) do not pay for the use of a key resource—the atmosphere. Free resources will be
overused (used even though the marginal benefit of using more is not greater than the marginal cost of all of us of a degraded
We need a model that helps us to calculate the “optimum amount of pollution reduction” (i.e., abatement), and we need to design policy in
order to give correct amount of pollution abatement.
Focus attention on Marginal Cost of Abatement (MCA), which is a function of the level of pollution (of GHG). This is the marginal cost
of cleaning up pollution. Also focus on the Marginal Benefits of Abatement (MBA)—the marginal benefit of reducing GHG [which
reflects the Marginal Social Cost (MSC) of pollution (of not abating)].
Two industries: electricity production (from burning oil), and computer production
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) . N when there is only a small number of producers (oligopoly) or only one producer (monopoly) N when a good (or service) has substantial external costs (external costs are ones that producers ignore in their decisions e. g. , pollution) N when a good (or service) has substantial external benefits (external benefits are ones that consume ignore in their decisions to consume e. g. , education) N when a good is a public good: i. e. , (1) it is collectively consumed, and (2) consumers cannot be excluded from consuming the good. In all these cases, markets fail to work well, governments may need to correct what markets would naturally do!