ECON8069 Chap.6 Externalities and Public Goods
Externalities and Public Goods
Market failure appears when private prices omit values that matter for social surplus. A negative externality places part of the cost on bystanders, so social marginal cost exceeds private marginal cost and the market produces too much. Public goods create another divergence because everyone consumes the same non-rival quantity and exclusion is difficult.
The chapter adds willingness to pay vertically and explains free-rider under-provision.
Identify the omitted party
An externality affects someone outside the buyer-seller transaction. The welfare account therefore gains an external term that is negative for harm and positive for benefit.
Ordinary competitive effects on rivals work through the price mechanism and should not automatically be relabelled as bystander costs.
Recompute the social margin
With negative production harm, social marginal cost equals private marginal cost plus marginal external cost. The private market stops where benefit equals private cost, while efficiency stops earlier where benefit equals social cost.
Positive external benefits reverse the direction and can make private quantity too low.
Evaluate the corrective route
A corrective tax can place a constant marginal harm into the producer's private calculation. Property rights and bargaining can also internalise an effect when rights are clear and enforcement is timely.
Detection, attribution, information control, delay and legal cost can prevent a formal right from changing the expected private payoff.
Aggregate public benefits correctly
Public goods are non-rival and non-excludable. Because everyone consumes the same quantity, willingness to pay is added vertically at each quantity before comparison with marginal cost.
Non-excludability encourages free riding, so collectible private revenue can remain below summed social benefit and provision falls short.
What this chapter covers
- 01
Bystanders and the externality boundary
- 02
Social surplus with an external term
- 03
Private versus social marginal cost
- 04
Property rights and corrective taxes
- 05
Non-excludability and non-rivalry
- 06
Vertical summation and free riding
Worked example · free
Comparing market and efficient quantities
- 2Private equilibrium solves 60 - Q = 12 + Q, giving quantity 24.
- 3Social marginal cost is 24 + Q, so efficiency solves 60 - Q = 24 + Q and gives quantity 18.
- 2A $12 per-unit tax internalises the constant marginal harm in this simplified model.
Key terms
- Externality
- A transaction's effect on a bystander who is neither buyer nor seller.
- Corrective Tax
- A per-unit charge designed to place marginal external cost into a private decision.
- Public Good
- A good that is non-excludable and non-rival in consumption.
- Free Rider
- A beneficiary who has an incentive to avoid paying for a non-excludable good.
Externalities and Public Goods FAQ
What makes an effect an externality?
The affected party stands outside the buyer-seller transaction whose private surplus is being measured. A competitor harmed through ordinary price competition is not automatically a bystander externality because the effect works through the market mechanism.
Why can property rights fail to solve pollution?
A right must be detected, attributed, enforced and bargained over at tolerable cost. When information is controlled by the polluter or harm appears after a long delay, expected private liability may remain too small to internalise the damage.
Why are public-good demands added vertically?
Everyone consumes the same quantity because the good is non-rival. At each shared quantity, individual willingness to pay is summed to obtain social willingness to pay. Private goods instead add separate quantities at a common price.
Does identifying an externality prove a policy will help?
No. The divergence identifies a potential gain from internalising the omitted effect, but implementation also requires information, enforcement and administrative resources. Compare those costs and the policy's targeting accuracy before claiming that intervention improves the social outcome.
Exam move
Identify the omitted party before choosing a diagram or policy. For an externality, write private marginal cost, external cost and social marginal cost on separate lines. For a public good, state non-excludability and non-rivalry, then add willingness to pay vertically at a common quantity. End by naming the incentive gap that makes private provision diverge from the social calculation.
Rework each externality example in the positive direction and verify that the efficient quantity moves to the right rather than left. For property-rights questions, list detection, attribution, enforcement and delay before deciding that bargaining internalises the harm. For public goods, build a vertical sum from two individual schedules and compare it with marginal cost at the shared quantity.
Do not add quantities across people when consumption is non-rival. Create a policy comparison grid with information needs, enforcement cost, targeting precision and distributional effect as columns. Use it to explain why identifying a divergence does not by itself prove that any proposed tax, subsidy, rule or bargaining arrangement improves the outcome.
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