ECX5953 Economics
Externalities, Public Goods and Common Resources
Week 4 of ECX5953 Economics at Monash University is the market-failure chapter of the microeconomics block: it shows why the competitive quantity stops being efficient once a trade spills costs or benefits onto a third party. You will learn to diagnose negative and positive externalities, prescribe the right Pigouvian tax or subsidy, sort goods by rivalry and excludability, and reason about the free-rider problem, the tragedy of the commons, and cost-benefit analysis for public goods. Because it is Week-4 micro, it is examinable in the mid-semester test (Weeks 1-6) and can also appear in the final examination.
What this chapter covers
- 01Externality = the uncompensated impact of one person's action on a bystander; internalising means altering incentives to account for it
- 02Negative externality: SMC = PMC + external cost lies above supply, so the market over-produces (Qm > Q*)
- 03Positive externality: SMB lies above demand, so the market under-produces (Qm < Q*)
- 04Corrective (Pigouvian) tax = external cost fixes a negative externality; a subsidy = external benefit fixes a positive one
- 05Deadweight loss triangle between social and private curves; a corrective tax removes it and raises revenue
- 06Other remedies: tradable pollution permits, command-and-control regulation, and the Coase theorem (private bargaining)
- 07Goods taxonomy on two axes (rival? excludable?): private, club, common resource, public good
- 08Public goods are non-rival and non-excludable -> free-rider problem -> market under-provision
- 09Common resources are rival and non-excludable -> tragedy of the commons (over-use)
- 10Cost-benefit analysis: provide a public good if summed (vertical) valuations exceed total cost
Pigouvian tax on a polluting factory
- +1Market equilibrium (D = private cost). Set 100 - Q = 20 + Q, so 80 = 2Q, giving Qm = 40 and Pm = 100 - 40 = $60.
- +1Social marginal cost. SMC = private cost + external cost = (20 + Q) + 16 = 36 + Q.
- +1Social optimum (D = SMC). Set 100 - Q = 36 + Q, so 64 = 2Q, giving Q* = 32 (its value on demand is 100 - 32 = $68).
- +1Diagnose and price the tax. Qm = 40 > Q* = 32, so the market over-produces; the corrective (Pigouvian) tax = the external cost = $16 per unit, which lifts private cost onto SMC and moves the market to Q* = 32.
- +1Deadweight loss removed. Triangle base = 40 - 32 = 8; height = external-cost gap at Qm = $16. DWL = 1/2 x 8 x 16 = $64 (thousand).
- +1Tax revenue. tax x Q* = 16 x 32 = $512 (thousand). The corrective tax raises welfare and revenue.
Key terms
- Externality
- The uncompensated impact of one person's action on the well-being of a bystander. Negative if the spillover is a cost (pollution), positive if it is a benefit (research). It drives a wedge between private and social costs or benefits, so the market quantity is inefficient.
- Negative externality
- A spillover cost on third parties, making social marginal cost exceed private marginal cost (SMC > PMC). The market over-produces (Qm > Q*); the fix is a corrective tax equal to the external cost.
- Positive externality
- A spillover benefit to third parties, making social marginal benefit exceed private benefit (SMB > MPB). The market under-produces (Qm < Q*); the fix is a subsidy equal to the external benefit.
- Pigouvian (corrective) tax
- A per-unit tax set equal to the marginal external cost. It lifts the firm's private cost onto the social-cost curve, moving output to the efficient level Q*, removing the deadweight loss and raising revenue.
- Public good
- A good that is non-rival (one person's use does not diminish another's) and non-excludable (no one can be shut out), e.g. national defence. It is under-provided by the market because of free-riding; valuations are summed vertically for cost-benefit.
- Common resource
- A good that is rival but non-excludable, e.g. ocean fish. Each user ignores the cost imposed on others, so it is over-used - the tragedy of the commons.
- Free-rider problem
- Because a public good is non-excludable, individuals can enjoy it without paying, so private suppliers cannot cover costs and the good is under-provided even when its total benefit exceeds its cost.
- Coase theorem
- If property rights are clearly assigned and transaction costs are low, private bargaining between the parties reaches the efficient allocation regardless of who holds the rights; it breaks down when many parties or high bargaining costs are involved.
Externalities, Public Goods and Common Resources FAQ
Do I tax or subsidise an externality?
Match the instrument to the sign. A negative externality (a spillover cost, like pollution) means the market over-produces, so you tax it - a Pigouvian tax equal to the external cost. A positive externality (a spillover benefit, like education) means the market under-produces, so you subsidise it - a subsidy equal to the external benefit. Reversing these loses the instrument marks.
Why does the market under-provide public goods?
A public good is non-excludable, so people can enjoy it without paying - the free-rider problem. Private suppliers cannot charge free riders, so they will not supply, and the good is under-provided even when a cost-benefit analysis (summing everyone's valuation vertically) shows total benefit exceeds cost. Government can then provide it and fund it from tax revenue.
Can AI help me with externalities and public goods in ECX5953?
Yes - Sia can explain the ideas step by step: why a Pigouvian tax equals the external cost, how to add public-good valuations vertically, or why a common resource is over-used. Use it to build understanding and check your reasoning, not to obtain exam answers - Sia is a study aid and does not sit the exam for you or promise any grade.
Exam move
Master one diagram first: private supply and demand, then the social curve sitting above it (SMC above supply for a negative externality, SMB above demand for a positive one). Label Qm and Q*, shade the deadweight-loss triangle, and write the instrument as 'tax = external cost' or 'subsidy = external benefit'. Drill the direction pairs until they are automatic - negative/over-produce/tax and positive/under-produce/subsidise - because a reversed sign fails the whole answer. For public goods and common resources, memorise the rivalry-by-excludability grid and remember that public-good valuations add vertically. Since this is Week-4 microeconomics, it falls inside the mid-semester test (45 MCQs, 90 minutes, Weeks 1-6) at two minutes per mark, and can be revisited in the final examination; confirm the final exam's date, duration and open- or closed-book status on Moodle.
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