17 Externalities and Public Goods

Dr. Savita

 

1. Learning Objectives

 

After completing this module, the students will be able to understand:

  • The concept of Externalities and Public Goods
  • Classification of Public and Private Goods
  • Externalities and Market failure
  • Steps taken by the Government to control Externalities

 

Externalities and Public Goods

 

2. Introduction

 

Externality is that effect of an economic activity which is not incorporated into or reflected in the market price. Externalities are variously known as external effect, external economies and diseconomies, spill over and neighborhood effects. Externalities exist both in consumption and production. When the level of consumption of commodity has a direct effect on the welfare of another consumer it is called externalities in consumption. So when the productive activity of a firm directly affects the production activity of another firm is called externalities in production.

 

In different terms, externalities arise from interaction between the production function of firms, utility function of individuals that are not reflected in prices charged for the goods. If the output of one firm is purchased as an input by another firm and there are no externalities, the pricing system ensures an efficient allocation of resources. Externalities are the beneficial or harmful side effects of market activities that are borne by the people who are not directly involved in the market exchanges. Externalities are pervasive for example, external benefit from education, children gain from educated parents, society benefit in so far as education reduces crime, social unrest and unemployment and welfare costs, and strengthen democratic institutions etc.

 

So in simple words we can say that externalities are that economic effect which arises from the production or the use of goods to other parties. It can be arise between producers, between consumers and producers. When the action of one party benefits another party then it is called positive externalities and when the action of one party imposes cost to another party, then it is called negative externalities. Let us take example of an individual, who is fond of plants, hires a professional landscaper to do up the area surrounding his house. Form this greenery not only he benefited; all people living around the area will be benefitted. It is positive externality. On the other hand, let’s take an example of a factory which is nearby residing area, it polluted the surrounding areas air and have a deteriorate effect on the health of the peoples. It is called negative externality.

 

Prof. B.P.Herber holds that externalities are of two types: (1) market externalities and (2) non market externalities. The effects which can be measured in term of money or in other worlds which can be expressed in term of price and are determined by the market forces that is by demand and supply, are called market external effect or market externalities. On the other hand, those externalities which cannot be expressed in term of price in the market and cannot be made part of the cost of production are called non market externalities.

 

3. Public Goods

 

Public goods are goods which would not be provided in a free market system, because the firms would not be able to adequately charge for them. In simple words Public goods are those goods and services which are jointly and equally consumed by many people at the same time, and its consumption by one person does not alter its availability for another person. These goods may not be produced through the free market pricing mechanism because those persons who do not want to pay the price cannot be prevented from the consumption of these goods and services. So the goods or services which have the features of non-rivalry and non-excludability are termed as public goods. Thus the situation arises because public goods have two particular characteristics:

 

1.Non-excludable: It is non-excludable means if one person consumes the goods; it is not possible to prevent others from consuming it even if they have not paid. This allows ‘free riders’ to consume the goods without paying. It means everyone consumes the public goods in equal amount. There is no other way of distributing public goods in different packages to different individuals. They are lumpy and have to be supplied in a bulk. Public goods are consumed equally by all. In case the benefit is available to anyone, it is available to everyone too.

 

2.Non-rival: This means no one has an exclusive right over the consumption of the good. The quantity that a person consumes does not affect the quantity that other can consume.

 

So we can say that, consumption of public goods is always joint and equal. Thus public goods are produced and supplied by the society to meet its collective wants for increasing social welfare. In other words public goods are of collective consumption and are indivisible in nature. It may or may not produce through the free market price mechanism. Let’s clear it with an example of street light. Street light is a public good as it cannot exclude people benefitting from it. It is not possible to charge people who walk under it. When people walk under it, it is also true that they do not make it go dimmer- they do not diminish the amount of light available for the next person. Street lights are therefore non-excludable and non-rival. So they are public goods. Clean air and roads are also an example of public goods.

 

Prof. Musgrave called Public goods as Social wants or Public wants and was of the view that they should be satisfied by the government. Musgrave said, Social wants must be satisfied through the budget. Thus, defence services, for example, are public goods which cannot be left to the productive sphere of the private sector. Government may get some materials produced by a private contractor or may purchase some equipments necessary to build up the defence structure, but the supply of defence services as such must be made by the government through budget. Every citizen of the country enjoys the benefit of this public good in the form of security from foreign aggression equally. Since public goods are supplied free of direct charges through the budget, we can say that any provision of budgetary expenditure is associated with an element of public want and the good that satisfies this want is a public good. Professor Musgrave further classifies public wants into two types: (1) social wants (2) merit wants.

 

Social wants: People who do not pay for the services cannot be excluded from the benefits that results, and since they cannot be excluded from the benefit, they will not engage in voluntary payments. Hence, such wants cannot be satisfied through the mechanism of market because their enjoyment cannot be made subject to price payment, budgetary provision is needed, if they are to be satisfied at all. Examples are national parks, defence, judicial, education and other services.The government provides them out of the general budget.

 

Merit wants: some goods are considered meritorious while other are held undesirable. For example low cost housing is subsidized because decent housing is held to be desirable, while regulatory taxes are imposed on liquor because drinking is held undesirable. So, goods for which it is thought that consumption should be encouraged are called merit goods and those goods which have a opposite character is called non-merit goods. Thus merit goods are goods, which the society, operating through the government, feels the individuals should be encouraged to consume. Such goods are housing, education, health care, etc.

 

Although social wants and merit wants seem to be same, yet there are some differences:

 

Social wants satisfy the condition of non excludability, indivisibility and non-rival nature of consumption of goods and services while these are not the necessary conditions for merit wants. It may or may not apply.

 

The satisfaction of social wants provided benefit to all while the satisfaction of merit wants involves interference with consumer preferences.

 

Merit wants may have a substantial element of social wants.

 

4.  Private goods

 

Private goods are those goods and services which satisfy individual wants and have the characteristics of rivalry and exclusiveness. The goods can be produced by the free market pricing mechanism. Private consumption reduces the amount available to others. Private goods are competitive in consumption. All those people who want to consume them pay for it and who do not want to pay will be excluded from their use. It means the principle of exclusion is applicable in case of private goods. The goods become divisible so far its use is concerned. Suppose an individual does not voluntarily agree to pay the market price for milk, the market would refuse to supply him the required quantity. Thus, the ability to pay the price of a goods, the divisibility of a goods, and the exclusion principle, all go together in case of private goods. These relate to food, clothing, shelter, transportation and communication etc. marginal cost of providing a private good to an extra consumer is always positive.

 

5.  Public goods Vs private goods

 

Public goods satisfy social wants or merit wants whereas private goods satisfy individual wants.

 

Public goods are non-exclusive whereas private goods permit exclusion.

 

The marginal cost of providing a private good to an extra consumer is positive whereas the marginal cost of providing a public good to an extra consumer is always zero.

 

Public goods are non-rival in consumption whereas private goods are rivalries.

 

Public goods cannot be provided by the free market pricing mechanism while private goods are price in the market.

 

6. Externalities and Market failure

 

Externalities refer to the beneficial and detrimental effects of an economic unit on others. The beneficial externalities created by a consumer or a firm for others are known external economies and detrimental or negative externalities imposed on others by a productive firm or consumer are known as external diseconomies. A firm or an economic unit gets beneficial externalities or external economies when it creates benefits for others and in return does not receive any payment. On the other side, when an economic unit impose costs on others for which he does not make any payment is called detrimental externalities or external diseconomies. So externalities cover both external economies as well as external diseconomies. When firms private marginal cost would be higher than its social marginal cost then there is external economies and it has created a beneficial external effect and when the firms private marginal cost would be lower than the social marginal cost then there is detrimental externalities or external diseconomies. Thus when an economic or production unit expands its activities, it increases the pollution as well and thereby threaten the health of the surrounding areas people

 

Now the question is why the presence of externalities makes market outcomes inefficient? As we all know, an externality causes a conflicts between the private and social cost of benefits .A positive externality causes either the social cost to be lower than the supply curve that is technology spillover or the social benefits to be higher than the demand curve whereas negative externality causes either the social costs to be higher than the supply curve or the demand curve to be higher than the social benefit. So in the presence of externalities the market outcome is inefficient. But it is different from the social optimum:

 

In the case of a positive externality, the market output is less than the social optimum.

 

In case of a negative externality, the market outcome is greater than the social optimum.

 

Now that we have considered both the sides of the coin that is the positive and the negative externalities and its relationship with inefficiency, we will see how externalities affect the market allocation. Let’s take an example of production of iron; it generates air pollution that adversely affects the welfare of the people in the surrounding areas. The cost of iron includes the cost of the labor, machines, iron ore, coal and the other inputs directly required to produce the iron and it also include the costs borne by members of the community in the form of air pollution damages.

 

Thus market failure denotes the circumstances under which market fails to allocate resources efficiently. It can occur due to externalities and public goods. The presence of externalities in production and consumption lead to the market failure. Externalities are market imperfections where the market offers no price for service or ill service. These externalities contribute to misallocation of resources hence cause consumption or production to fall short of an optimum level. They do not lead to the maximum social welfare. They also lead to the divergence of social cost from private cost and of social benefits from private benefits. When social and private costs and social and private benefits diverge, perfect competition will not achieve maximum social welfare. This is because under perfect competition private marginal cost is equated to private marginal benefit.

 

So external economies and diseconomies affects the allocation of resources and lead to market failure as given below:

  • External economies of production: With the expansion of the firm these types of economies accrue to other firms in the industry. In this situation social marginal benefit will exceed private marginal benefit so SMB>PMB and private marginal cost will exceed social marginal cost i.e. PMC>SMC. In such a case firm will produce less than the socially optimum level of output. In the following figure PMC is a private marginal cost curve. It is a supply curve of firms and SMC is a social marginal cost curve. D is the demand curve. The demand curve D cut the PMC at point E and at this point market price OP and output OQ determines.

 

Social marginal cost curve is denoted by SMC and it cut the demand curve D at point E1. At this situation social optimum level of output OQ1 at price OP1 determines. So it is clear from the figure that industry is producing Q1Q less than the socially optimum output OQ1. So it is clear that social marginal cost is less than the market price, its production involves a social gain. Hence there is a market failure.

 

External diseconomies of production: When social margin is higher than social marginal benefit then there are external diseconomies of production. In this situation firms will attain socially optimum level of output. So in this case SMC>SMB. For example an industry situated in a residential area expels smoke which adversely affects the health of the people of the surrounding areas. In this case social marginal costs are higher than private marginal cost and also social marginal benefit. It can be shown with the help of following figure.

In this figure PMC curve intersects the demand curve D curve at point E and determines the market price OP and output OQ. But SMC cut the demand curve D at point E1 and at this point

 

Socially optimum output is OQ1 and price is OP1.Thus the firms are producing Q1 Q more than the social optimal output OQ1. In this case, for every unit between Q1 and Q, social marginal cost (SMC) is more than the competitive market price OP. Thus its production involves a social loss. This is again a market failure.

  • External economies in consumption: External economies in consumption lead to non-attainment of maximum social welfare. The consumption of goods or services by one consumer affects other consumers as it increases their utility or satisfaction levels. Let’s take an example of TV set installed by individual. It increases the satisfaction of his neighbor as they can watch TV programmes free at his place. Thus social cost is lower than private cost and benefit and in this case social benefit is larger.
  • External diseconomies of consumption: The consumption of goods or services by one consumer affects the other consumers as it reduces their utility or satisfaction level. Consumption diseconomies arise in the case of dress, fashion which reduces their utility to some consumers.
  1. Steps taken by the Government to control Externalities

 

The government takes many steps to control and adjust externalities like taxes, regulations and subsidies. To adjust the externalities, economists have suggested the following measures which may be adopted by the government.

 

Tax on output: since the consumption and production of commodities generate pollution, a straightforward means of limiting pollution would be reduce such production- consumption activities by taxing them. For example a tax on automobiles would mean to reduce their number and thereby reduces air pollution from that source.

 

Standards and regulations: in order to check pollution, government can set and enforce pollution standards and attempt thereby to direct control the level of pollution. Standard can be applied to the emissions by the producers or to the quality of complying with the standards would be borne by the producers or their customers or by both as was the case with taxation.

 

Emission tax: Though such cars might be more expensive yet an emission tax on autos would encourage production of low-emission cars. The price of cars would tend to rise on an average and their number would tend to fall. However, in order to achieve a given degree of control, an emission tax would raise price and lessen the output tax. Some control would likely be obtained with an emission tax by changing the production process so that less pollution is generated per unit of output.

 

Subsidies and Public Production of Pollution: Public subsidies can also play a very important role in encouraging the pollution control and public production of pollution control. Tax-payers are unlikely to generate pollution in proportion to their payment of taxes, and the subsidy and public production mechanism of control tend to be more advantageous for those who pollute. Public subsidies and production of pollution control, assign the right to use air (water) to those who pollute. That is, they imply that pollution is legal. Subsidies may take the form of direct grants or tax breaks for producers that install specified pollution control equipment. Subsidies may be used in conjunction with standards. For example, the federal government imposes standard on sewage treatment by cities and provides federal grants for construction of sewage treatment facilities.

  1. Summary

 

Externalities refer to the economic effects which occur from the production or the use of goods to other parties. Externalities can arise between producers, between consumers and producers. Externalities can be negative- when the action of one party imposes cost on another party or it becomes positive when the action of one party benefits another party. The lack of inclusion of these externalities leads to an under or over production of goods. The government can check externalities by imposing taxes, by the creation of market for pollution rights, and by regulation. Public goods have two features- they are non rival and non excludable. These two features make it impossible for provision through markets. Therefore the government takes on the responsibility for these public goods. In recent years, the public-private partnership model is being used. This model promises to provide public goods more efficiently and effective through partnership with private parties and non-governmental organizations.

 

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