ECB1101 · Introductory Microeconomics
Externalities and Public Goods
The competitive market maximises total surplus only when the buyer's willingness to pay and the seller's willingness to sell are the whole story. They are not when a transaction spills a cost or benefit onto a bystander — an externality. A negative externality (pollution) means social cost exceeds private cost, so the market over-produces; a positive externality (vaccination, fire extinguishers) means social value exceeds private value, so the market under-produces. The fix is a corrective (Pigouvian) policy sized at the per-unit external effect e: a tax = e for a negative externality, a subsidy = e for a positive one, which moves the market to the efficient Q*. Some goods escape price altogether: sort every good on excludability and rivalry. The non-excludable column is where markets fail — a public good (non-rival) is under-provided through free-riding, a common resource (rival) is over-used through the tragedy of the commons.
What this chapter covers
- 017.1 An externality is a spillover onto a bystander
- 027.2 Negative externality — social cost above private cost
- 037.3 Positive externality — social value above private value
- 047.4 The corrective (Pigouvian) tax or subsidy = e
- 05Worked: fire extinguishers (subsidy = $10)
- 067.6 The rival × excludable 2×2 grid of goods
- 07Public goods (free-riding) vs common resources (commons)
Worked example: a positive externality and the corrective subsidy
- +2(a) Protecting neighbours is a benefit to bystanders, so this is a positive externality. The social-value curve (WTP + e) lies $10 above demand, and the market under-produces — buyers ignore the $10 they hand their neighbours.
- +1(b) The market trades at Q_market where WTP = WTS (demand meets supply); the efficient Q* is where Social value = WTS, further right. So Q* > Q_market.
- +2(c) Set a corrective subsidy = e = $10 per extinguisher; it lifts the demand buyers face up to the social-value curve, raising output to Q*.
Key terms
- Externality
- A cost or benefit of a transaction that falls on someone who is neither buyer nor seller — a spillover the decision-maker ignores. Negative externalities (e > 0 on costs) cause over-production; positive ones (e > 0 on benefits) cause under-production.
- External effect (e)
- The per-unit cost or benefit a transaction imposes on bystanders, in Monash notation. Social cost = WTS + e (negative externality); social value = WTP + e (positive externality). If e = 0, private and social coincide and the market is efficient.
- Corrective (Pigouvian) tax or subsidy
- A policy sized at the external effect e that makes the decision-maker internalise the spillover. A tax = e (per-unit external cost) cuts a negative externality's output to Q*; a subsidy = e (per-unit external benefit) raises a positive externality's output to Q*.
- Public good
- A good that is non-rival (one person's use doesn't reduce another's) and non-excludable (you can't stop non-payers). Because no one can be charged, the market under-provides it through the free-rider problem; government typically provides it, financed by taxation.
- Common resource
- A good that is rival (one person's use depletes the stock) but non-excludable (anyone may use it). Each extra user depletes it for the rest — the tragedy of the commons — so the market over-uses it. The remedy is usually to restore excludability (fees, quotas, rights).
Externalities and Public Goods FAQ
How do I read Q_market and Q_optimum off an externality diagram?
Q_market always comes from the PRIVATE curves — where willingness to pay (demand) meets willingness to sell (supply), WTP = WTS — because buyers and sellers ignore the spillover. Q_optimum uses the SOCIAL curve on whichever side the externality lands: for a negative externality, social cost (WTS + e) sits above supply, so Q* is where WTP = social cost; for a positive externality, social value (WTP + e) sits above demand, so Q* is where social value = WTS. The wedge between Q_market and Q_optimum is the welfare loss.
How big should the corrective tax or subsidy be?
Exactly the per-unit external effect e — the vertical gap between the social and private curve. You do not need a welfare table: state 'tax = e' for a negative externality (cut output) or 'subsidy = e' for a positive one (raise output). A $10 external benefit calls for a $10 subsidy, which makes buyers act as if each unit were worth WTP + 10, so they buy where social value = WTS, exactly Q*.
What's the difference between a public good and a common resource?
Both sit in the non-excludable column, so neither is rationed by price — that's the shared root cause. The difference is rivalry. A public good is non-rival (national defence, a lighthouse), so the failure is under-provision through free-riding, and government usually provides it. A common resource is rival (fish stocks, congested roads), so the failure is over-use through the tragedy of the commons, and the remedy is usually to restore excludability with a fee or quota. Watch for a good that changes box: free airport Wi-Fi is a public good when uncrowded but becomes a common resource once congestion makes it rival.
What happens if I get the policy sign wrong?
It's an instant zero on that part. A negative externality needs a TAX (to cut output back toward Q*); a positive externality needs a SUBSIDY (to raise output up to Q*). Taxing a positive externality makes the under-provision worse, not better. So always identify the sign of the externality first — which side the spillover lands and whether it's a cost or a benefit — then match the policy: external cost to tax, external benefit to subsidy.
Exam move
Run the Week 7 exam move: (1) identify the failure — externality (which side, which sign?), public good, or common resource; (2) for an externality, draw the social curve a distance e from the private one, above supply for an external cost, above demand for an external benefit; (3) read Q_market off the private curves (WTP = WTS) and Q_optimum off the social curve, and the wedge between them is the welfare loss; (4) prescribe the fix — corrective tax = e for a negative externality, corrective subsidy = e for a positive one; (5) for non-excludable goods, classify on the 2×2 grid and name the symptom (public good → under-provision → government provision; common resource → over-use → restore excludability). Section C wants a fully labelled, hand-drawn graph with the shift arrow and both quantities marked.
