Providing Public Goods, Correcting Externalities

The Public Good Problem

In market failures we have seen that there are some goods which the market does not provide at all, becuase the free rider benefits as much as the buyer from use. These goods can still be of great use socially, and make the community a better place. Accident and emergency are close to a public good and the most needed example, we need them.


The needed public goods are provided out of taxpayers money, so in the strict sense nobody can free ride as everyone must pay taxes. The government does this out of a cost benefit analysis of what it can bring to the community minus the cost to the economies resources.

A Decentralised System

Milton Friedmans argument of the inefficiency of government spending shows that in a centralised system, people do not often benefit from provision equally to what they have paid in taxes. Delegating power to local councils is a solution to this.

Why Decentralisation Is Fairer:

  1. Local Knowledge The organisers of government spending have greater knowledge of how to spend the money if the system is local, meaning the money will be spent more usefully.
  2. Balanced Budget: Because a local councils budget must balance, an equal amount is given back to a community to what is taken in taxes, rather than being unequal, often the case of a centralised planning.
  3. Transparancy People have more transparency to see what their taxes are being put towards.
  4. More Power In a centralised system, inefficient use of taxpayers money in one region will only represent one or a few constituents against the current government if the other regions are treated well, unlikely to cause change and leave those people powerless.

See the debate of centralisation, although this version is corporate, rather than public

Externality Correction

The market failure that a third party bears a burden or benefits due to private production and consumptionis another issue which the government tries to balance. Many think it is best that they intervene only in the most extreme examples, externailities cannot be calculated accurately, causing government failures to arise if the externaility is small.

Pollution and Permits

This is the most discussed externaility and solution of it in economics. Perhaps due to the inability to put into numbers damage to the environment, pollution does not have limited geographical scope, the allocative efficiency of this intervention and other factors making it the most interesting.

What are Permits?

The government set a limit of free emissions and, for anybody to pollute further, they need to buy a permit in order to do so without breaking the law. These are issued, and then traded between companies.

The Use of Permits

Companies can profit by cutting their levels of pollution by selling the permits to pollute at a level greater than their now reduced level, likewise the polluter must pay meaning there is hence, an incentive to cut emissions with these being traded.

Firms which pollute have a great rise in costs to bear, hence causing a combination of a fall in profits or a rise in prices causing less market share to be held by a dirty polluting firm.

Prices vary to levels not reflecting external costs of what the permit allows.

An Issue

Pricing issues When the permits are being issued, the pricing of, say, 100 tonnes of sulphur dioxide needs to be estimated hence defining the price of the permit to pollute by that in excess. How does the government know how to price these whe they are being issued?

Reflects Private Costs Again. When they are traded, their price will be the cost of one firm to cut back by the permit’s amount, rather than the external cost if imposes.

Property Rights, The Coase Theorum

The Tragedy of The Commons

This states that areas which there are no property rights will be exhausted quickly. The self interest motive will see at least one attempt to use the resource more than the others before it is gone, and this common instinct makes the dpeletion of the resource inevitable. None will ber a cost of it’s depletion, hence there is little individual incentive to preserve it.

Why The Name? It resembles the former common land of the UK which farmers could use for their cattle. Competition over the finite resource led farmers to use it as much as possible before, say, the other farmer has used most of the grass to feed their livestock. Depletion and privatisation of these areas was inevitable to preserve them.

Allocating Property Rights

With a public good such as the environment is split to belong to different parties, any pollution or depletion of this will only be possible with a compensation payment to the owner. Ownership prevents the tragedy of the commons, another ‘polluter must pay’ principle.

Coase Theorum shows a more allocatively efficient use of resources when property rights are used. Firms which produce adverse externalities have higher costs, meaning a fall in their production whilst they compensate those who pay for their externailities. Less external costs and more external benefits result in private sector activity.

The Issue again is how to allocate those property rights, for this is up to the government. Private allocation has not seen anyone buy these commons, hence any offers to sell off areas is likely to be without a buyer at any price. How can the government allocate private property?

Fiscal Measures of Correction

Traditionally, subsidies and taxes wree seen as the answer and are still an alternative to correct such externailites. Government failures, the law of unintended consequences and public choice theory however has made the above market making solutions more appealing.

Faults of Fiscal Measures It is only since the 1970’s that free market incentives above were seen as a good solution to correcting externailites. Taxes and subsidies do, so long as profit maximising mentaility is kept, affect things for the better when correctly applied. However, the incentive to correct those externailities are unaffected.

If the taxes, however, are in proportion to externailities, such as a hypothecated tax, then incentives are kept intant.


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