MGEA02H3 Chap.10 Externalities and Public Goods
Externalities and Public Goods
External costs
An externality is an effect on third parties that the market price ignores. With pollution, marginal social cost is private marginal cost plus marginal external cost, MEC = dTEC/dQ.
The efficient output is where demand meets marginal social cost; the market overproduces, and a corrective tax equal to MEC at the efficient output removes the deadweight loss with no excess burden.
Public goods
A public good is non-rival and non-excludable, so the community’s marginal benefit is the vertical sum of individual marginal benefits, and the efficient quantity is where that sum meets marginal cost.
No individual buys alone, and a private market cannot charge for it. Pollution targets can be shared between firms with a tax or tradable permits.
What the answer keys reward
The keys state the efficient condition in words, demand equals marginal social cost, and set the corrective tax as the gap between buyers’ price and supply at the efficient quantity.
They count the gain to society including external cost and tax revenue, and they explain that the corrective tax has no excess burden because it moves output to the optimum. Public-good items sum marginal benefits vertically and set the sum equal to marginal cost.
How this topic connects to later chapters
This chapter reuses three earlier tools.
The competitive equilibrium of chapter 7 is the market outcome that overproduces, the tax wedge of chapter 4 becomes the corrective instrument, and the prisoners’ dilemma of chapter 9 explains why individuals do not fund public goods on their own. Recent finals in the folder have repeatedly set a ten-mark short answer on exactly this combination.
What this chapter covers
- 01
Marginal external and marginal social cost
- 02
Overproduction and deadweight loss
- 03
The corrective tax and its excess burden
- 04
Public goods and vertical summation
- 05
The free-rider problem
- 06
Abatement taxes and tradable permits
Worked example · free
Overproduction and the corrective tax
- 2MEC = 0.5Q, so marginal social cost is 30 + Q.
- 2The market solves 180 − Q = 30 + 0.5Q: 100 units at $80.
- 2The optimum solves 180 − Q = 30 + Q: 75 units at $105.
- 2The tax is MEC at 75 units, $37.50, removing a $625 deadweight loss.
Key terms
- Externality
- An externality is a cost or benefit of an activity that falls on people outside the transaction.
- Marginal Social Cost
- Marginal social cost is private marginal cost plus marginal external cost.
- Pigouvian Tax
- A Pigouvian tax is a per-unit tax equal to marginal external cost at the efficient output.
- Public Good
- A public good is non-rival and non-excludable, so one person’s use does not reduce another’s.
- Free Rider
- A free rider benefits from a good without paying for it, which stops private markets from supplying public goods.
- Tradable Permits
- Tradable permits fix the total quantity of pollution and let firms trade the right to emit.
- Marginal External Cost
- Marginal external cost is the extra damage to third parties from one more unit, dTEC/dQ.
Externalities and Public Goods FAQ
Does a negative externality cause too much or too little output?
Too much. The market ignores the external cost, so it produces where demand meets private supply, beyond the point where demand meets marginal social cost. Units in between cost society more than buyers value them.
Why does a corrective tax have no excess burden?
It moves output from the market level to the efficient level, eliminating the deadweight loss instead of creating one. Revenue is collected, but no valuable trades are prevented.
Why are marginal benefits added vertically for a public good?
Everyone consumes the same units, so the value of one more unit to the community is the sum of each person’s value of that unit. For private goods, quantities are added instead.
How does a permit system differ from a pollution tax?
A tax fixes the price of each unit of pollution and lets firms decide how much to emit. Permits fix the total quantity and let trading decide the price. With full information both can reach the same efficient abatement, with the cheaper abater doing more.
Exam move
Solve one externality problem fully: market and efficient outputs, the tax, the deadweight loss and the gain to society with and without the tax. Then find the efficient quantity of a public good for a small group of residents. Practise one ten-mark externality question in full under time, including the graph, the tax and the reason the tax creates no excess burden.
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