Module 2 / Lesson 5.1
Public Goods and Externalities
Lesson 5.1 Overview
Learning: Read the lesson below and watch the videos below to identify the four types of goods and resource failures. Lear about excludability, rivalry in consumption, public goods, externalities, and the tragedy of the commons.
Thinking Tasks: As you learn these ideas, think about the following learning objectives:
- Define and differentiate the two features of a good: Excludability and Rivalry.
- Categorize goods into four quadrants: Private, Public, Common, and Natural Monopolies.
- Explain the concept of the "Tragedy of the Commons" and why it occurs.
- Analyze the concept of Externalities and how they lead to market over/underproduction.
The Lighthouse is the classic example of a Public Good dilemma in economics.
- Cost: It costs a private entrepreneur $10,000 to build and maintain a lighthouse that saves ships from disaster.
- Benefit: Hundreds of ships benefit, each saving thousands in potential damage. The total benefit is $100,000.
- The Problem: Since the light is non-excludable (all passing ships see it), no single ship has an incentive to pay its share. Every ship tries to "free ride" on the payments of others.
The Result: The market fails. Since the entrepreneur cannot collect fees for their lighthouse from passing ships, the lighthouse is never built despite the large social benefit of the lighthouse relative to its small costs.
1. What are key features of a good?
Economists define goods by two key features.
A good is **excludable** if a person can be prevented from using it, typically by way of a price or legal mechanism. There is no way to prevent a passing ship from seeing and therefore benefitting from the lighthouse. There is an easy way to prevent me from taking ice cream from the store without paying for it
Cite: Mankiw, N. G. (9th Ed., 2021). Principles of Economics. Chapter 11.A good is **rival in consumption** if one person's consumption of the unit diminishes another person's ability to use it. When one passing ship sees and therefore benefits from the lighthouse, it does not diminish the usefulness of the lighthouse to other ships or the ability of other ships to see the lighthouse. By contrast, when I take ice cream from the store, there is less available for others.
Cite: Mankiw, N. G. (9th Ed., 2021). Principles of Economics. Chapter 11.2. Types of Goods: The Matrix
By combining the two criteria (excludability and rivalry) above, we can categorize goods into four types:
Private Goods
Examples: Ice cream, clothing, congested toll roads
Markets handle these relatively well.
Common Resources
Examples: Fish in the ocean, congested non-toll roads
Prone to "Tragedy of the Commons."
Natural Monopolies
Examples: Fire protection, cable TV
Public Goods
Examples: Safety due to national defense, lighthouse, clean air, general knowledge, **Protection from Existential Risk**.
Look around the room you are in right now. Identify one item that is a Private Good (you own it, nobody else can use it right now) and one thing that is a Public Good (available to everyone, your use doesn't stop others).
3. Externalities
Markets work well when the buyer and seller are the only ones affected. They will only do a transaction together if both sides benefit, or they wouldn't agree to do it. However, things can break down when a third party is impacted by these decisions but doesn't get a say in what happens.
A cost or benefit that "spills over" to a third party who did not choose to incur that cost or benefit.
Cite: Mankiw, N. G. (9th Ed., 2021). Principles of Economics. Chapter 10.- Negative Externality: A factory pollutes the air. The market produces *too much* of the polluting activity because the full social cost is not included in the price. The public, which is harmed, does not get a say in whether there is pollution. The factory gets the benefits of increased profits that come with running a polluting factory, and when the make their decision to pollute they will naturally ignore the harm this does to the public.
- Positive Externality: A student gets vaccinated. They stay healthy, but they also protect their community (herd immunity). The market produces *too little* of the activity because the full social benefit is not compensated. A self-interested person deciding to get vaccinated may consider only the benefits to themselves (and the costs, like a sore arm or the financial cost) but will ignore the benefit of their own vaccination in preventing others from getting sick.
4. Common Resources, Underinvestment, Free-Riding & the Tragedy of the Commons
Recall that we refer to a good as a common resource if it is rival (you taking it leaves less for others) but non-excludable (people cannot be prevented from using it). Here, we will learn why common resources tend to get depleted, which we call The Tragedy of the Commons.
- Concept Tragedy of the Commons: A situation where individuals, acting independently according to their own self-interest, deplete a shared resource, contrary to the long-term best interests of the group.
- The intuition for this result is that any individual person wants to take as much of the common resource as possible for themselves. They think only of the benefit that taking the resource does to them and ignore the harm that taking the resource does to others. This leads to overuse of the resource, and to the resource becoming depleted.
- Watch this video to see why this happens.
5. Public Goods
- Concept Public Goods: are goods that are both non-rival and non-excludable, such as clean air, the safety that comes from national defense, a lighthouse, or basic research. These goods are under-supplied because they come with a positive externality. When one party decides to expend resources on these goods, everyone benefits (even those who didn't help pay for them). This leads people to under-invest in public goods since they bear the costs of providing them but the benefits accrue elsewhere. Many people have an incentive to free-ride, namely enjoying the benefit of the investment in an non-excludable good made by someone else. Governments often provide public goods to their citizens since the private market provides too few public goods due to free-riding.