Transcript Externalities and Public Goods

Externalities and Public
Goods
From free-riding to the
Coase theorem
Externalities and Public Goods

Up until now we have made several implicit
assumptions when analysing “agents”
1. Agents are independent : their welfare
depends only on their own consumption /
production decisions



But maybe people’s satisfaction/welfare depends
indirectly on what other people decide?
Does this influence the market outcome? How?
How can these effects be taken into account?
Externalities and Public Goods
2. The characteristics of goods are “well
behaved”



Goods and services are always clearly defined,
dividable into measurable units and
exchangeable on a specified market
But what about goods or services that can’t be
divided, valued (priced), or exchanged on a
market?
What does economics have to say about these
kinds of goods?
Externalities and Public Goods
Public goods and free riding
Externalities and inefficiency
The Coase theorem
Public goods and free riding

Goods can be classified according to two
fundamental, intrinsic properties :


Rivalry : Two agents cannot simultaneously
benefit from the consumption of a given unit of a
good
Exclusion (through price): an agent can only
dispose of a given unit of a good once he has
paid its price. This concept is closely linked to
the existence of property rights.
Public goods and free riding
Typology of
goods
Rival?
Exclusion Possible?
Yes
Private Good
Yes Car, medical
drugs
No
Club Good
Pay per view
TV, Patents
No
Impure Public good
Congested road
14th July Fireworks
Public Good
Public lights
Defence
Public goods and free riding
A “pure” public good satisfies three conditions:
1. Impossibility of exclusion (possibility of
freeriding)

One cannot restrict the use of the good to
specific agents (i.e. To those who pay)

Examples:

Public lighting? Defence? Fireworks display?
Motorway? Lighthouse? Rule of Law?
Public goods and free riding
A “pure” public good satisfies three conditions:
2. Non-congestion (Non-rivalry)

The satisfaction obtained from the good
does not depend on the number of users

Examples:

Public lighting? Defence? Fireworks display?
Motorway? Lighthouse? Rule of Law?
Public goods and free riding
A “pure” public good satisfies three conditions:
3. Compulsory consumption

The agent cannot decide not to consume
the good (has no choice in the matter)

Examples:

Public lighting? Defence? Fireworks display?
Motorway? Lighthouse? Rule of Law?
Public goods and free riding

As a result, for public goods, the
coordination of agents cannot happen on
the market




Everybody is a consumer whether they want it or
not.
A supplier of the public good cannot exclude
people who refuse to pay the good (free riders)
This supplier has not way of recuperating his
costs
There is a market failure on public goods:
they will not be provided on a free market
Public goods and free riding

The central aspect of this was shown by
Ronald Coase

Free-riding and externalities occur when
property rights are either:
 Not defined: who owns light of a lighthouse or
the security provided by a police force?
 Not enforceable: there is a lack of institutions
to enforce the property rights (example: “free”
internet downloads)

As a result, there is no market to extract
compensation from freeriders
Externalities and Public Goods
Public goods and free riding
Externalities and inefficiency
The Coase theorem
Externalities and inefficiency

An externality is a possible cause of market
failures.


External economies, external effects,
externalities



It corresponds to the direct (non-market) impact of
an agents decision on another agent’s welfare
In production (the bees and orchard example)
In consumption (internet or telephone)
This impact can be negative or positive


Negative : leads to over-investment
Positive : leads to under-investment
Externalities and inefficiency

Definition of a negative externality

The Marginal social cost (msC) is larger that the
marginal private cost (mpC)
msC > mpC

In other words, I do not bear all the costs of
my production/consumption decisions,

Some costs “leak” out and are borne by other
agents
Externalities and inefficiency
C
The polluter pays principle
internalises the externality by
making the polluter carry the
negative externality
msC
mpC
p*
Marginal external cost
q*
q1
q
Externalities and inefficiency

Example of negative production externalities



The effect of oil spills on local fishermen
My neighbour's trees shading my garden from
the sun
Examples of negative consumption
externalities


Smokers in restaurants
Neighbours playing techno very loudly at 3am!
Externalities and inefficiency

What policies can be used to remove the
inefficiency ?



Regulation (emission standards, smoking bans)
Taxation (problem: what is the optimal level of
taxes what is the size of the externality?)
Importantly, in terms of policy there is an
optimal level of pollution !!

It is not socially desirable to reduce it to zero.
Externalities and inefficiency

Definition of a positive externality

The Marginal social benefit (msB) is larger that
the marginal private benefit (mpB)
msB > mpB

In other words, I do not reap all the benefits
of my production/consumption decisions,

some benefits “leak” out and benefit other
agents
Externalities and inefficiency
B
Example : intellectual property rights attempt
to increase the marginal private benefit by
capturing the externality
p*
Marginal external benefit
msB
mpB
q1
q*
q
Externalities and inefficiency

Example of positive production externalities



The classical bees/orchard example
Technological innovations (spillovers)
Examples of positive consumption
externalities




Network goods (internet, telephone)
Homeownership
Education
Vaccination
Externalities and inefficiency

What policies can be used to remove the
inefficiency ?




Subsidies (tax deductions on mortgages, public
network infrastructure investment)
Intellectual property rights (IPR)
Regulations
As for the optimal level of pollution, there is
an optimal level of intellectual protection!

It is not socially desirable to reduce IPR to zero
Externalities and Public Goods
Public goods and free riding
Externalities and inefficiency
The Coase theorem
The Coase theorem


Named after Ronald Coase (Nobel 1991)
No state intervention is required to correct
externalities if:



There are defined property rights (remember
what was said above)
There are no transaction costs between agents
In this ideal case, all the state has to do is
define some property rights, and the market
will internalise the externality
The Coase theorem

Coase’s initial work: Radio stations

Initially, no frequency bands are defined: radio
stations can interfere
 Negative production externality

The state needs to create frequency bands
 enforceable property rights

Interactions between agents produce :
 The allocation of these bands between the various radio
stations
 The compensation of externalities is carried out by
transactions between stations
The Coase theorem

In real life, however, transaction costs exist

Asymmetric/imperfect information about the
externality
 Proving the existence of an externality can take a
lot of time and effort (see Erin Brockovich vs Pacific
Gas),

Asymmetric relations between agents
 Imagine a litigation between a big chemical
consortium and a local association on pollution.
 What is the likelihood of the association making its
case with no external help ?
The Coase theorem

In that case, a 2nd role appears for the state:
Reduce transactions costs between agents



Encourage the creation of consumers rights
associations (increase coordination between agents)
Create environmental watchdogs with a monitoring
mission (reduces the information asymmetries)
Reinforce legal / mediation /dispute resolution
institutions (reduces the transaction costs)
The Coase theorem

This decentralised approach to reducing
externalities is becoming increasingly
popular



In theory it is cheaper: Taxes on pollution do provide
an income, but monitoring costs are usually higher
In theory it is also more efficient: The state doesn’t
need to figure out what the size of the externality is,
which is a problem with taxation or regulation
Recent example: the market for Carbon dioxide