Chapter 11 Externalities and Public Goods The role of Government

1. Chapter 11 Externalities and Public Goods The role of Government

2. Externalities and Public Goods • Externalities: Take different forms • E.g. External costs of production, pollution • Steel Factory S(K,L), output increases in K and L: S(+,+) • But S(K,L) = S+DW Fishery F(L,DW)=F Fishery F(+, -)

3. Externalities and Public Goods • Externalities • External costs of production • Steel Factory F(K,L) = S + DW • Fishery F(L,DW) So Steel Production Up, DW up Fish down What happens if the steel factory does not take this into account?

4. Externalities and Public Goods So Steel Production Up, DW up Fish down What happens if the steel factory does not take this into account? Selling Steel at price PS ‘Selling’ pollution at price 0 (doesn’t have to pay to get rid of it) We get too much steel and too little fish

5. We know that firms hire workers and capital according to the rules: If steel producer had to clean up the dirty water

6. Saw before firms hire workers untill So the real (social) cost of producing is wage plus the clean up cost of the extra pollution

7. So for Capital and labour

8. THE CASE FOR GOVERNMENT INTERVENTION • So we say MC of steel is less than the MSC (marginal social cost) of steel: (W=) MC<MSC (=W+”cleanup cost”)

9. External costs in production MC = S Costs and benefits P D O Q1 Quantity

10. External costs in production MSC MC = S Costs and benefits P D External cost O Q1 Quantity

11. External costs in production MSC MC = S Costs and benefits P D O Q2 Q1 Social optimum Quantity

12. THE CASE FOR GOVERNMENT INTERVENTION • Externalities • External costs of productionMSC > MC • External benefits of productionMSC < MC • Training

13. External benefits in production MC = S Costs and benefits P D O Q1 Quantity

14. External benefits in production MC = S MSC External benefit Costs and benefits P D O Q1 Quantity

15. External benefits in production MC = S MSC Costs and benefits P D O Q2 Q1 Social optimum Quantity

16. THE CASE FOR GOVERNMENT INTERVENTION • Externalities • External costs of productionMSC > MC • External benefits of productionMSC < MC

17. PUBLIC GOODS • Goods which are ‘non-rival’ and ‘non- exclusive’ • Non-rival/Exclusive - my consumption does not preclude yours, but you can be prevented from consuming by the producer. e.g. Concert • Non-exclusive/Rival – cannot prevent you from consuming, but your consumption (in principle) precludes mine e.g.drinking water from a public lake

18. PUBLIC GOODS • Non-rival and non-exclusive: Cannot prevent access (for practical purposes) and consumption of one doesn’t preclude consumption by someone else. • street lighting: A Public Good

19. Public Goods Dr. Jeckyl O Q1 Quantity Marginal benefit from Street lignts Mr. Hyde O Q1 Quantity

20. Public Goods Dr. Jeckyl O Q1 Quantity Marginal benefit from Streetlignts Maureen Hyde O Q1 Quantity

21. Pricing at marginal costs is not socially optimal – even if it is possible (see next slide). MC P1 Dr. Jeckyl MC O Q1 MC P2 Marginal benefit from Street lignts Mr. Hyde P1 O QS Q1 Q1 Quantity

22. Who pays ? • The firm might sell to “the first person” – charging at the marginal cost and using this person’s demand function. • This won’t work. First of all, it is not likely that anyone will actually pay (why not just wait for someone else to pay ?) • Moreover, as shown on the previous slide, this would not be socially optimal.