Saturday, 13 April 2013

Externalities and Public Goods

Externalities are the effect on the third party of an action made by an individual or a firm - whether it be for the better or the worse. A lot of the time externalities are negative, pollution for example, and this is the example we will use here. We'll look at a firm in industry creating a good that means they are polluting the atmosphere.

With externalities being ignored, the firm will hire workers and capital according to the rule: (Marginal revenue product of labour = marginal cost of labour = wage = marginal cost of labour)

Marginal Revenue Product of Labour

In Layman's terms, this means they'll employ labour up until the point where the marginal revenue product of labour is equal to the marginal cost of labour, meaning profits are being maximised. If the producer had to clean up the pollution as well then the amount they'd employ would become:

Marginal Revenue Product of Labour with Externality

What has been added is a new Price, the price of cleaning pollution. This is taken away from the price of the product they're producing which will overall leave a lower figure. If we rearranged above we could achieve this:

The marginal cost of the good will now be the wage plus the marginal cost of cleaning up the pollution. This means the social cost of the firms actions have been taken into account. Previously, the marginal cost of production was below the marginal social cost - leading to an overproduction. Here it is graphically:

Marginal Cost and Marginal Social Cost

Q2 is the social optimum when the cost of clearing the pollution is taken into account. If MSC is greater than MC then there are external costs of production, if it's the other way round there are external benefits to production.

Now for a quick look at public goods, a fairly simple sub-topic. A public good is one that has the characteristics 'non rival' and 'non excludable'. What does this mean? It means that my consumption of the good does not stop other people consuming it (non rival) and I cannot be prevented from consuming the good once it is provided (non excludable). Street lighting is a good example. It's a good that generally has to be provided by a government because no individual or firm would pay for it - they'd just wait for someone else to buy and free ride. A good that has only one of the characteristics stated above but not both is known as a 'quasi-public good'.

That's all boys and girls! Comment if you need more help, share the blog if it has assisted you. Cheers!

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