XV.  EXTERNALITIES AND PUBLIC GOODS­­THE MARKET AND THE INVISIBLE FOOT

A.  Negative and Positive Externalities

Pareto optimality is a situation where no one can be made better off without making someone else worse off.  Technical efficiency (producing all products at lowest cost) and allocative efficiency (producing the things consumers desire the most) taken together achieves Pareto optimality.  An externality is a cost or benefit of the use of some resource that is not borne by the producers or consumers in that market.  Examples of external costs (negative externalities) include: 1) the increased medical costs of others from the pollution from your car; 2) the increased costs of downstream water purification caused by the dumping of sewerage into streams by upstream communities; 3) the reduced value of the shrimp population from overfishing; 4) the increased costs of house maintenance (house painting) because of the smudge produced by agricultural burning; 5) the lower grade received by non­cheating students in a class when a classmate cheats and the teacher grades on a curve; and 6) the increased medical costs to surrounding communities from the air pollution from certain refineries and chemical plants.  Non­examples would include: 1) the increased cost of medical care that a smoker must pay because of the ill effects of smoking on health (smokers pay part of the costs of smoking to doctors and so are less willing to pay for cigarettes); 2) the increased medical costs of a chemical plant worker from increased exposure to harmful chemicals (worker can negotiate higher pay for compensation); and 3) the increased costs of cleaning the clothes of garbage collectors (again, higher pay can be negotiated for compensation).  Notice that the difference between the examples and the non­examples hinges on whether the harmer and the harmed are related contractually; the workers and the product consumers are contractually related to the harmer. 

The previous paragraph focused on external costs (often called "negative externalities"), but there is a flip side, external benefits (often called "positive externalities").  An example of an external benefit would be the increased housing values for neighbors when you buy and fix up an old abandoned house in the neighborhood.  A non­example would be the increase in value you receive by fixing the house up.

B.  Public Goods 

An extreme case of a positive externality is the "public good."  A public good is one where one person's consumption does not reduce the amount available for others and it is too costly to prevent non­payers from enjoying the benefits from the good.  Examples of a public good would include: 1) national defense (if you are protected by our armed forces, I am also protected, and it would be difficult to protect only those who pay but withhold protection from those who do not); 2) environmental protection (if you breathe cleaner air outdoors, so does everyone in your community and it would be very hard to keep non­payers from breathing the cleaner air); 3) aid to the poor (if you are made better off because the financial position of the poor is improved, others are also made better off, and this benefit of knowing the poor are better off cannot be withheld from someone who does not pay); and 4) civil liberty protection (if your constitutional rights are upheld, so are mine, and it is difficult to withhold this protection from non­payers).  Non­examples would include: 1) public education (almost all of the benefits go to those who are educated by the process and we could, if we chose, withhold education from non­payers); and 2) public housing (the benefits go to those housed and housing could be withheld from non­payers).  The differences between the examples and non­examples are 1) whether the benefits are general or not, that is, whether we can identify consumers and non­consumers of the good; and 2) whether benefits can be withheld from non­payers. The non-examples here are all termed "private goods," not "public goods."

Private goods are like most goods, those who don't pay don't get, and those who don't get don't enjoy any appreciable benefits from consumption of the good by others. The more one person consumes of a private good means the less available for others. Notice that the difference between a public good and a private good has nothing to do with who pays for it, nothing to do with who owns it, and nothing to do with anything else except whether the good can be somehow kept from use by those who don't pay.

The market has a difficult time in getting public goods supplied because people receive benefits whether they pay or not.  This problem is sometimes referred to as the "free­rider problem" and sometimes as the "prisoners' dilemma."  The free­rider problem is that if you can "ride for free" why pay, so no one pays, and then there is nothing to ride.  This is the "let Mikey try it"  or "let Mikey (the other guy) pay for it" attitude.  We can examine this choice situation better with the prisoners' dilemma example (click here for a link to Roger McCain's Strategy and Conflict: An Introductory Sketch of Game Theory and then click on "The Prisoners' Dilemma").

In the usual tale of the prisoners' dilemma, we have the example of two suspects in police custody who the cops are sure robbed a liquor store at gunpoint.  Armed robbery is very serious, carrying a 10 year sentence.  The cops caught the suspects "redhanded" on a lessor offense, carrying concealed weapons, which carries a two­year sentence.  The cops place them in separate rooms and tell each suspect that if he turns state's evidence and confesses to the armed robbery, all charges will be dropped, if the other suspect does not confess.  If both confess, they will get seven­year sentences instead of ten­year sentences.  The outcomes for the four possible combinations are shown in TABLE 5.

What is the likely result of this situation?  They both confess.  The reason is that no matter what the other one does, confessing gets a lighter sentence.  If the other partner does not confess, the suspect in question goes free by confessing, instead of getting a two­year sentence on the weapons charge.  If the partner does confess, the suspect in question gets a seven­year sentence instead of a ten­year sentence by confessing.  Each is better off by confessing than by not confessing, yet together they could both be better off by keeping quiet and getting the two­year sentence.

TABLE5

Jail Sentences in Years

(Crook #1's jail sentence listed first, then Crook #2's)

What does the prisoners' dilemma have to do with public goods?  The incentive structure is set up similarly so that the incentives to individuals lead to results that are less desirable than other possible results.  The choice is to contribute or not contribute, say $100, to the production of some public good, such as a less polluting sewerage system.  The new sewerage costs $10,000 and is worth $300 to you.  We can see the incentives in Table 6.  Instead of getting a payoff of $200 if you and everyone else contributed to the project, neither you nor anyone else contributes.  Public goods do not get funded on a voluntary basis, but generally require the compulsion of taxation with the threat of punishment for non­payers.  We will see later that democratic institutions also suffer from this public goods problem.

Click here to try out a prisoners' dilemma game, "Diamond Thief," a game developed by Mikhail Sabaev and Konstantin Lukin, two students at the State University of New York at Stony Brook (SUNY-Stony Brook) for a class project.

C.  The "Commons" Problem

At the root of the externality and public goods problems is a lack of clearly defined property rights.  To see this we will take up the classic example, the commonground,

TABLE 6

Contribute or not to new Sewerage Project

or simply, the "commons," in 18th Century Britain.  Each community had a plot of land for all in the community to use.  Often, people used it for grazing their animals, most notably, for grazing sheep.  Sheep can badly damage grazing land, as they eat grass, roots and all. 

To illustrate the problem, imagine 100 shepherds who make up a community with a commons.  Each sheep added to the commons damages the commons by reducing the value of the land by $100 dollars per year.  The marginal benefits to the individual shepherd are declining as with MPB (marginal private benefits) in :FIGURE XVI.  All of the benefits from the sheep grazing on the commons accrue to the individual shepherd, hence Marginal Private Benefits.  If the only cost of adding a sheep to the commons is the cost of decreased land value, then the Marginal Private Costs (costs to the shepherd) will be only $1.00 ($100 damage to the land divided by 100 individuals in the sharing group comes to $1.00 per person).  We saw above that individuals will keep doing some activity as long as the marginal benefit to them was greater than or equal to the marginal cost to them, as this is where net benefits are the highest.  For society as a whole, net benefits are the highest where marginal social benefits are equal to marginal social costs, at far fewer sheep than the shepherd wants to put on the commons. 

What is occurring is that the pattern of ownership of the land, the commons is common property, allows each shepherd to shift part of the cost his sheep onto others in the community, creating negative externalities.  If each shepherd could only put sheep on his own land, or had to pay the owner of what was the commons rent, there would be no externality, as each shepherd would have to pay the full cost of the damage done by their sheep.

FIG XVI

Marginal Private Benefits, Marginal Private Costs and Marginal Social Costs of Adding

All other occurrences of pollution share the same commons problem.  We may not always readily see what resource is commonly held, but this is always the case.  Table 7 is not exhaustive,but is illustrative.

Though many common property resources can be transformed into private property, this is not always the case.  When the resource freely "roams" as with fish and wildlife, air, and water, it may be impossible to transform the resource into a private property resource.  In the cases of wildlife and fisheries, the transformation is partially accomplished by use of stamps, permits, licenses and limits.  Another possibility is to give an individual or organization sole rights to use of the resource, for example, the government could grant one person, me, a monopoly on shrimp marketing.  I would have an incentive to preserve the species and would cut back on shrimping.  The higher price I would get in the future and no competition for "first grab" would ensure that I would protect the species population.

D.  Coase's Theorem and the Role of Transactions Costs

As to not make too much of the contribution of the common vs. private property ownership pattern to pollution problems, we should consider a contribution made by the most recent Nobel Laureate in Economics, Ronald Coase, in "The Problem of Social Cost" (reprinted in Economics of the Environment, edited by Robert Dorfman and Nancy Dorfman, pp. 142­171). Coase suggests that an important ingredient in the pollution problem is the role of transactions costs.  Transactions costs are costs of making trades and can be thought of as what the buyer pays in excess of what the seller receives.  This includes taxes, lawyers' fees to write up contracts, the costs of getting together to reach some agreement and the costs of information necessary to make a good decision.

Coase notes that in a simple case where one person's actions harms another (where there is a negative externality) and there are no transactions costs, who has the right to do what, property rights, do not matter.  Coase's point is that with little or no transactions costs, one party will pay the other to achieve the desired social cooperation.  Pareto Optimality, the situation where all possible gains from trade are achieved, is easily reached.  This underscores the necessity of the presence of transactions costs in the pollution problem. 

Why don't we just all get together and pay all automobile owners to reduce their emissions or pay chemical companies to reduce their production of hazardous wastes or pay shrimpers to catch less fish in their nets (by­catch)?  The answer is that the costs of making these multi­party trades are prohibitive.  A primary contributor to the transactions costs here are the costs of reaching agreement on how to share the costs of the payments, since each person sees that the higher the costs on others, the lower his costs will be.

Besides externality problems and public goods problems, markets suffer from other problems.  Most notably, monopoly problems and transactions cost problems.  The monopoly problem is that sometimes, competition leads to only one firm left in the market, a sort of king­of­the­mountain result. A monopolist will cut back on production to increase price.  It is only sensible that with one producer or a few producers in a market, the producers will have superior bargaining power and will get a higher price for their goods and produce less than is Pareto Optimal.

The other problem we saw as part of the externality problem, that of transactions costs.  Transactions costs work just as a tax (a tax is a governmentally imposed transactions cost).  Transactions costs, especially of the information cost variety, reduce trade by reducing the number of profitable transactions.

D.  A Note on Externalities

The bottom line with the externality problem and the extreme case of externalities, the public good, is really very simple, and one we should all understand:  individual responsibility (holding the individual accountable for his or her actions) along with individual rewards gives individuals the incentive to behave in a socially acceptable manner, while group rewards and responsibility ("Society" is to blame, its everyone else's fault, etc.) ends up meaning no one is responsible, which leads to socially unacceptable behavior.  Though peer pressure may be useful to make group rewards and group responsibility work in very small groups, such as classrooms, these incentives cannot be relied upon in large societies.

                                                              
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