Lecture 13

Externalities, public goods, common-property resources

The Theory of Externalities

• Does government intervention always lead to inefficiency?

• No! In case of externalities, public goods, etc. government intervention can actually increase economic efficiency.

• Externality: a positive or negative side effect of an economic transaction that affect those not directly involved in this transaction

• Examples: pollution, smoking, planting flowers, education, consuming solar panels for electricity production, etc.

Negative externality

Market failure: Situations in which unregulated markets fail to produce the socially efficient outcome

Negative externality & Tax

Positive externality

Goods other than private goods

• So far, we analyzed the markets for private goods which are– excludable: owners of the good can prevent others

from consuming it or enjoying its benefits – rival: a unit of that good can be consumed only by

one person at a time• But there are other types of goods as well: public goods,

common-property resources, club goods… • For these goods, we usually have market failure, i.e.,

markets cannot provide them efficiently.

Classification of Different Types of Goods

Public goods

• Non-excludable and non-rival• Examples: National defense, clean air • Private markets fail to provide the efficient level of public

goods (market failure!)• Even though many people value the benefits of public goods,

private markets often fail to provide any public goods at all• In private markets, the ability to change a price acts as a way

to exclude non-buyers and thus make a profit.• But for public goods: anyone can enjoy the benefits of a

public good without paying and each additional user does not affect the amount or quality of the good available to others

Public goods: Free-riders

• Therefore, free-riding problem:

No one has an incentive to pay because he/she could receive essentially the same level of benefits without paying.

• Thus, the equilibrium quantity of public goods in a market setting is normally zero: no company would want to produce something for which no one is willing to pay!

• Therefore, a market failure!

Public goods• If public goods cannot be provided by the market mechanism,

then who will provide it?

– Voluntary donations? Probably not sufficient for an efficient provision of the public goods (because of free-riders)

– In democracies, decisions regarding the provision of public goods (and also for the provision of environmental public goods, such as national parks) are commonly decided in the political arena. Some kind of social deliberation is necessary:

• Either, through elected officials • Or, through direct voting, local town meetings, etc.

Common-property resources

• Available to everyone, but one person’s use diminishes other people’s use (rival)

• Overuse is often a problem! (overfishing, overgrazing, etc.):Garrett Hardin (1968) has called this problem the «Tragedy of the Commons»

Common-property resources

• But tragedy of the commons is essentially about open-access resources to which everyone has access without any limitation or regulation

• Open-access resources are usually confused with common-property resources; but common-property resources are not necessarily open-access resources.

• The use of common-property resources may be regulated by customs, traditional rules, social norms of communities! (Elinor Ostrom, Nobel Prize in Economics, 2009)

Common-property resources• Elinor Ostrom argued:

– Many societies have worked out institutional arrangements that operate with the same result as government regulations but that depend on social norms and customs instead of laws.

– In many parts of the world, such systems have been sustainably managed for generations, sometimes even for centuries!