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The economics of the public sector

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Externalities[edit | edit source]

An externality arises when a person engages in an activity that influences the well- being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality. In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market; it also includes the well-being of bystanders who are affected indirectly. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole.

Externalities come in many varieties, as do the policy responses that try to deal with the market failure.

Externalities and market inefficiency Welfare Economies: A recap[edit | edit source]

The supply and demand curves contain important information about costs and benefits. The demand curve reflects the value of a good to consumers, as measured by the prices they are willing to pay. At any given quantity, the height of the demand curve shows the willingness to pay of the marginal buyer. The supply curve reflects the cost of producing a good. At any given quantity, the height of the supply curve shows the cost of the marginal seller. In absence of the government intervention, the price adjusts to balance the supply and demand for a good. The quantity produced and consumed in the market equilibrium in the sense that it maximizes the sum of producer and consumer surplus.

Negative externalities[edit | edit source]

Let’s suppose a factory emits pollution. If the smoke created by the factory is a health risk for those who breath the air. That would be the negative externality. How does this externality affect the efficiency of the market outcome? Because of the externality, the cost to society is larger than the cost to the producer. For each unit produced, the social cost includes the private costs of the producers plus the cost to those bystanders affected adversely by the pollution.

The social cost curve is above the supply curve because it takes into account the external costs imposed on society by producers. The difference between these two curves reflects the cost of the pollution emitted.

What quantity should be produces? To answer this question we once again consider what a benevolent social planner would do. The planner wants to maximize the total surplus derived from the market – the value to consumers of a good minus the cost of producing it. The planner understands however, that the cost of producing a good includes the external cost of the pollution. The planner would choose the level of a goods production at which the

demand curve crosses the social cost curve. This intersection determines the optimal amount of a good from the standpoint of society as a whole

Note that the equilibrium quantity of a good is larger than the socially optimal quantity. The reason for this inefficiency is that the market equilibrium reflects only the private cost of production.

How can a planner achive the optimal outcome? One way would be to tax producers for each unit sold. The tax would shift the supply curve upward by the size of the tax.

If the tax is accurately reflected the social cost new supply curve would be coincide with the social cost curve. In the new market equilibrium producers would produce the socially optimal quantity of a good. The use of such a tax is called internalizing an externality because it gives buyers and sellers in the market an inventive to take account of the external effects of their actions.

Positive externalities[edit | edit source]

Although some activities impose costs on third parties, other yield benefits. The analysis of positive externalities is similar to the analysis of negative externalities.

The demand curve does not reflect the value to society of the good.

Because the social value is greater than the private value, the social value curve lies above the demand curve. The optimal quantity is found where the social value curve and the supply curve intersect. Hence, the socially optimal quantity is greater than the quantity determined by the private market.

Once again, the government can correct the market failure by inducing market participants to internalize the externality.

Private solutions to externalities[edit | edit source]

In practice, both private actors and public policy makers respond to externalities in various ways. All of the remedies share the goal of moving the allocation of resources closer to the social optimum.

The types of private solutions[edit | edit source]

Sometimes the problem of externalities is solved with moral codes and social sanctions. Another private solution to externalities is charities, many of which are established to deal with externalities.

The private market can often solve the problem of externalities by relying on the self- interest of the relevant parties.

Another way for the private market to deal with external effects is fr the interested parties to enter into a contract.

The coase Theorem[edit | edit source]

How effective is the private market in dealing with externalities? A famous result, called the Coase theorem, suggests that it can be very effective in some circumstances. According to the Coase theorem, the private market will always solve the problem of externalities and allocate resources efficiently.

Why private solutions do not always work[edit | edit source]

Despite the appealing logic of the Coase theorem, private actors on their own often fail to resolve the problems caused by externalities. The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement. In the world however, bargaining does not always work.

Sometimes the interested parties fail to solve an externality problem because of transaction costs, the cost that parties occur in the process of agreeing to and following through on a bargain.

Public policies towards externalities[edit | edit source]

When an externality causes a market to reach an inefficient allocation of resources, the government can respond in one of two ways. Command-and-control-policies regulate behavior directly. Market-based-policies provide incentives so that private decision makers will choose to solve the problem on their own.

Regulation[edit | edit source]

The government can remedy an externality by making certain behaviors either required or forbidden.

Pigovian taxes and subsidies[edit | edit source]

Instead of regulating behavior in response to an externality, the government can use market-based policies to align private incentives with social efficiency.

Taxes enacted to correct the effects of negative externalities are called Pigovian taxes.

Public goods and common resources[edit | edit source]

The different kinds of goods[edit | edit source]

In thinking about the various goods in the economy, it is useful to group them according two characteristics:

  • Excludable goods: Can a person be prevented from using the good
  • Rival goods: Does one person’s use of the good diminish another person’s ability to use it?

Using these two characteristics, we can divide goods into four categories:

  • Private goods are both excludable and rival
  • Public goods are neither excludable nor rival.
  • Common resources are rival but not excludable
  • When a good is excludable but not rival, it is an example of a natural monopoly. Public goods

To understand how public goods differ from other goods and what problems they present for society, let’s consider an example: a fireworks display. Because fireworks are not excludable, people have an incentive to be free riders. A free rider is a person who receives the benefit of a good but avoids paying for it.

One way to view this market failure is that it arises because of an externality.

Because public goods are not excludable, the free-rider problem prevents the private market from supplying them. The government, however, can potentially remedy the problem. If the government decides that the total benefits exceed the cost, it can provide the public good and pay for it with tax revenue, making everyone better off.

Some important public goods are:

  • National defense
  • Basic research
  • Fighting poverty

The difficult job of cost-benefit analysis[edit | edit source]

So far we have seen that the government provides public goods because the private market on its own will not produce an efficient quantity. Yet deciding that the government must play a role is only the first step. The government must then determine what kinds of public goods to provide in what quantities.

To make this decision, the government might hire a team of economists to conduct a study, called a cost-benefit analysis, the goal of which is to estimate the total cost and benefits of the project to society as a whole. The problem with this is, that cost-benefit analysts do not observe any price signals when evaluating whether the government should provide a public good. Their findings on the cost and benefits of public projects are, therefore rough approximations at best.

Common resources[edit | edit source]

Common resources, like public goods, are not excludable: they are available free of chare to anyone who wants to use them. Common resources are, however, rival: one person’s use of the common resource reduces other people’s ability to use it. Thus, common resources give rise to a new problem. Once a good is provided, policy makers need to be concerned about how much it is used. This problem is best understood from the classic parable called the tragedy of the commons.

The tragedy of the commons[edit | edit source]

When one person uses a common resource, he diminishes other people’s enjoyment of it. Because of this negative externality, common resources tend to be used excessively. The government can solve the problem by reducing use of the common resource through regulation or taxes. Alternatively the government can sometimes turn the common resource into a private good.

Some important common resources:

  • Clean air and water
  • Congested roads
  • Fish whales and other wildlife

References[edit | edit source]