Private goods - Produced through competitive market system; offered for sale

• Rivalry - When one person buys and consumes a product, it is not available for another person to buy and consume

• Excludability - Sellers can keep people who do not pay for a product from obtaining its benefits

• Market demand - Horizontal summation of the individual demand schedules

• Consumers demand private goods, and profit-seeking suppliers produce goods that satisfy the demand

Public goods

• Non-rivalry - One person’s consumption of a good does not preclude consumption of the good by others

• Non-excludability - No effective way of excluding individuals from the benefit of the good once it comes into existence

• Free-rider problem - Once a producer has provided a public good, everyone including nonpayers can obtain the benefit

  • Example: Public streetlights, which can be used by everyone even if they didn’t pay for it

• Provided by gov’t through taxation

Optimal quantity is defined as MB = MC

Demand for public goods

• Demand schedules show the price someone is willing to pay for the extra unit of each possible quantity

• Find collective willingness to pay for each additional unit → Construct willingness-to-pay schedule for public good

• Adding the prices that people are willing to pay for the last unit of the public good at each possible quantity demanded

• Downward-sloping

Comparing MB and MC

• Supply curve = Marginal cost curve

• Law of diminishing returns

• MB = MC → Cost efficiently allocates resources

Cost-benefit analysis - Used to decide whether to provide a particular public good and how much of it to provide

• Total benefit > Total cost → Project is economically justifiable

• Increase output as long as MB > MC

• Marginal-cost-marginal-benefit rule - Tells us which plan provides the maximum excess of total benefits over total costs or, in other words, the plan that provides society with the maximum net benefit

Externalities - Cost or a benefit accruing to an individual or group—a third party—that is external to a market transaction

Negative externalities

• Overproduction + resource overallocation

• Firm’s supply curve lies to the right of (or below) the full-cost supply curve S, which would include the spillover cost

• Transfers costs to society

Positive externalities

• Underproduction + resource underallocation

• Market demand curve D lies to the left of (or below) the full-benefits demand curve

Coase theorem - Government is not needed to remedy external costs or benefits where (1) property ownership is clearly defined, (2) the number of people involved is small, and (3) bargaining costs are negligible

• Limitations

  • Many externalities involve many people affected + high bargaining costs

  • Must rely on gov’t to represent millions of affected parties

• Example: If a business that produces machines in a factory is subject to a noise complaint initiated by neighboring households who can hear the loud noises of machines being made, the business may choose to offer financial compensation to the affected parties in order to be allowed to continue producing the noise or the business might refrain from producing the noise if the neighbors can be induced to pay the business to do so

Liability rules + lawsuits

• Laws that define private property + protect from damage done by other parties

• Remedy some externality problems

• Private lawsuits to solve externalities also have limitations

Gov’t intervention

• Direct controls - Legislation limiting activities causing negative externalities; raise marginal cost of production

• Specific taxes - Taxes/charges specifically on related good; shifts private supply curve left

• Subsidies + gov’t provision

  • Subsidies to buyers

  • Subsidies to producers

  • Gov’t provision (providing as public good)

Market-based approach to negative externalities

• Tragedy of the commons - As long as “rights” to air, water, and certain land resources are commonly held and are freely available, there is no incentive to maintain them or use them carefully. As a result, these natural resources are overused and thereby degraded or polluted

• Market for externality rights - Market-based approach to correcting negative externalities

• Cap-and-trade program - An appropriate pollution-control agency determines the amount of pollutants that firms can discharge into the water or air of a specific region annually while maintaining the water or air quality at some acceptable level

  • Reduces society’s costs

  • Monetary incentive not to pollute

  • Example: Environmental Protection Agency (EPA)

Society’s optimal amount of externality reduction

• Upward sloping MC, downward sloping MB

• Optimal reduction of an externality - Occurs when society’s marginal cost and marginal benefit of reducing that externality are equal (MC = MB)

• MB and MC curves can shift over time

Climate change

• Climate-change problem - The earth’s surface has warmed over the last century by about 1 degree Fahrenheit, with an acceleration of warming during the past two decades

• Kyoto Protocol

• Climate change policies will create costs as well as benefits

• Market mechanism will adjust based on climatic realities (ex. AC sales rising)

• Transition costs - Costs of making economic adjustments

• General policies to reduce carbon admissions

  • Carbon tax

  • Cap-and-trade program

Information failures

• When either buyers or sellers have incomplete or inaccurate information and their cost of obtaining better information is prohibitive

• Asymmetric information - Unequal knowledge possessed by the parties to a market transaction

• Gov’t should increase info available to market participants

Inadequate buyer info about sellers

• Can cause underallocation of resources

• Examples: Gasoline market + licensing of surgeons

Inadequate seller info about buyers

• Moral hazard problem - Tendency of one party to a contract or agreement to alter her or his behavior, after the contract is signed, in ways that could be costly to the other party

• Adverse selection problem - Arises when information known by the first party to a contract or agreement is not known by the second and, as a result, the second party incurs major costs

Qualification - Ways to overcome information difficulties (Finding ways to overcome information difficulties without government intervention)

• Many firms offer product warranties to overcome the lack of information about themselves and their products

• Franchising

  • Example: When you visit a Wendy’s or a Marriott, you know what you are going to get, as the service offered is the same at every location