ACCT6252 - Economics Theory

Externalities and Asymmetric

Information

Week 5
 EXTERNALITIES

The existence of externalities, public goods, and

imperfect information are examples of market failure. It
occurs when resources are misallocated or allocated
inefficiently.

externality A cost or benefit resulting from some activity

or transaction that is imposed or bestowed on parties
outside the activity or transaction. Sometimes called
spillovers or neighborhood effects.

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 MARGINAL SOCIAL COST AND
MARGINAL-COST PRICING

marginal social cost (MSC) The total cost to

society of producing an additional unit of
a good or service. MSC is equal to the sum of
the marginal costs of producing the product and
the correctly measured damage
costs involved in the process of production.

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 EXTERNALITIES AND ENVIRONMENTAL ECONOMICS

Profit-Maximizing Perfectly
Competitive Firms Will
Produce Up to the Point That
Price Equals Marginal Cost
(P = MC)

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
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 ENVIRONMENTAL ECONOMICS
Marginal private cost (MPC) is the amount that a consumer
pays to consume an additional unit of a particular good.

Marginal damage cost (MDC) is the additional harm done

by increasing the level of an externality-producing activity
by one unit. If producing product X pollutes the water in a
river, MDC is the additional cost imposed by the added
pollution that results from increasing output by one unit of
X per period.
When economic decisions ignore external costs, whether those
costs are borne by one person or by society, those decisions are
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 INTERNALIZING EXTERNALITIES

Five approaches have been taken to solving the

problem of externalities:
(1) government-imposed taxes and subsidies,
(2) private bargaining and negotiation,
(3) legal rules and procedures,
(4) sale or auctioning of rights to impose
externalities, and
(5) direct government regulation.

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 Taxes and Subsidies

Tax Imposed on
a Firm Equal to
Marginal
Damage Cost

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
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 EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Coase theorem says uncertain conditions, when

externalities are present, private
parties can arrive at the efficient solution without
government involvement.

Legal Rules and Procedures. Laws that require A

to compensate B for damages imposed (liability
rules). A court order forbidding the continuation
of behavior that leads to damages (injunction).

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 Selling or Auctioning Pollution Rights

• Singapore is known for its many laws

designed to reduce negative externalities.
• Externalities as : littering, chewing gum in
public, eating on a subway car, failing to flush
a toilet, and vandalizing public property.
• They are all considered serious offenses that
are punishable by imprisonment, fines,
and/or public chastisement.
Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
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 Direct Regulation of Externalities

Taxes, subsidies, legal rules, and public auction are all

methods of indirect regulation designed to induce
firms and households to weigh the social costs of their
actions against their benefits.
Direct regulation of externalities takes place
at the federal, state, and local level.

public goods (social or collective goods) Goods

that are nonrival in consumption
and/or their benefits are nonexcludable.

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 THE CHARACTERISTICS OF PUBLIC
GOODS
nonrival in consumption A characteristic of public
goods: One person’s enjoyment of the benefits of a
public good does not interfere with another’s
consumption of it.

nonexcludable A characteristic of most public

goods: Once a good is produced,
no one can be excluded from enjoying its
benefits.

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 PUBLIC (SOCIAL) GOODS

free-rider problem is a problem intrinsic to

public goods: Because people can enjoy the
benefits of public goods whether they pay for
them or not, they are usually unwilling to pay
for them.
A problem intrinsic to public goods: The good
or service is usually so costly that its provision
generally does not depend on whether or not
any single person pays.

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 PUBLIC (SOCIAL) GOODS

Mixed goods Goods that have characteristics that

are part public and part private.
INCOME DISTRIBUTION AS A PUBLIC GOOD?
If we accept the idea that redistributing income generates a
public good, private endeavors may fail to do what we want
them to do, and government involvement may be called for.

PUBLIC PROVISION OF PUBLIC GOODS

When members of society get together to form a government, they do
so to provide themselves with goods and services that will not be
provided if they act separately.

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 PUBLIC GOODS

With Public Goods, There Is Only

One Level of Output, and
Consumers Are Willing to Pay
Different Amounts for Each Level

For private goods, market demand is the

horizontal sum of individual demand
curves—we add the different quantities that
households consume (as measured on the
horizontal axis). For public goods, market
demand is the vertical sum of individual
demand curves—we add the different
amounts that households are willing to pay
to obtain each level of output (as measured
on the vertical axis).

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
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 PUBLIC (SOCIAL) GOODS

Optimal Production of a Public Good

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
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 PUBLIC (SOCIAL) GOODS

Optimal level of provision for public goods is the level at which

resources are drawn from the production of other goods and
services only to the extent that people want the public good and
are willing to pay for it. At this level, society’s willingness to pay
per unit is equal to the marginal cost of producing the good.

The Problems of Optimal Provision produce the

optimal amount of each public good, the government
must know something that it cannot possibly know—
everyone’s preferences.

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 LOCAL PROVISION OF PUBLIC GOODS:
TIEBOUT HYPOTHESIS

Tiebout hypothesis says an efficient mix of

public goods is produced when local
land/housing prices and taxes come to reflect
consumer preferences just as they do in the
market for private goods.

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 ASYMMETRIC INFORMATION

adverse selection Can occur when a buyer

or seller enters into an exchange with
another party who has more information.
moral hazard Arises when one party to a
contract passes the cost of its behavior on
to the other party to the contract.

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 MARKET SOLUTIONS ON IMPERFECT INFORMATION

There is an efficient quantity of information production.

Like consumers, profit-maximizing firms will gather information as long

as the marginal benefits from continued search are greater than the
marginal costs.

Goverment can make solution by:

Information. Information is essentially a public good and is
nonrival in consumption. When information is very costly for
individuals to collect and disperse, it may be cheaper for
government to produce it once for everybody.

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 SOCIAL CHOICE

social choice is the problem of deciding what society

wants. The process of adding up individual preferences to
make a choice for society as a whole.

impossibility theorem is a proposition demonstrated

by Kenneth Arrow showing that no system of
aggregating individual preferences into social decisions
will always yield consistent, nonarbitrary results.

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 SOCIAL CHOICE

Preferences of Three Top University Officials

Results of Voting on University’s Plans: The Voting Paradox

VOTES OF:
Vote VP1 VP2 Dean Result a

A versus B A B A A wins: A > B

B versus C B B C B wins: B > C
C versus A A C C C wins: C > A

aA > B is read “A is preferred to B.”

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Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
voting paradox is a simple demonstration of how
majority-rule voting can lead to seemingly contradictory
and inconsistent results. A commonly cited illustration of
the kind of inconsistency described in the
impossibility theorem.

logrolling occurs when congressional representatives

trade votes, agreeing to help each other get certain
pieces of legislation passed.

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 GOVERNMENT INEFFICIENCY: THEORY
OF PUBLIC CHOICE

we need to look less at the preferences of individual members of society and

more at the incentive structures that exist around public officials
understanding the way government functions.

Theory may suggest that unregulated markets fail to produce an efficient

allocation of resources. This should not lead you to the conclusion that
government involvement necessarily leads to efficiency. There are
reasons to believe that government attempts to produce the right goods
and services in the right quantities efficiently may fail.

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 GOVERNMENT INEFFICIENCY: THEORY
OF PUBLIC CHOICE

There is no question that government must be involved in

both the provision of public goods and the control of
externalities.

The question is not whether we need government

involvement. The question is how much and what kind of
government involvement we should have.

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Thank You