Market failure: Public goods, public bads

and externalities
September 2024
Conventional vs Environmental goods
 Conventional goods: In a competitive economy,
a market equilibrium is Pareto optimal (First
Theorem of Welfare Economics)

 Environmental goods/bads (ex: clean

air/pollution): markets typically fail with
environmental goods/bads – market failure
because complete property rights missing

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Conditions for a competitive market
1. Complete property rights
2. Atomistic participants: consumers and
producers price-takers
3. Complete information: consumers and
producers with full knowledge of prices
(current and future)
4. No transaction costs: costless to attach
prices to goods traded

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Conditions for a competitive market
1. Complete property rights
 Well defined
 Complete (for all goods and bads in the
economy)
 Transferable (excludability regarding access to
consumption)
 Safe
 All benefits and costs belong to the owner
(rivalry in the act of consumption)

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 Excludability regarding access to
consumption
 Consumers are only able to consume the good after
paying the price

 2 crucial factors for excludability

 Excludability needs to be technologically possible
(feasible)
 Benefits of excludability (additional social value of
having limited access to the resource) > Costs of
excludability

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Rivalry in the act of consumption
 Rival if consumption of one unit of the good/bad
diminishes the amount of the good/bad available for
others to consume

 Rivalry  Consumption involves an opportunity cost

 Unlike exclusion, this is not a feature that changes

with technology or costs

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Rivalry and congestion
 Non congested road (low consumption level) – non
rival good: no opportunity cost if another driver
decides to use the road ( marginal opportunity
cost = 0)

 Congested road (high consumption level) – rival

good: opportunity cost if another driver decides to use
the road ( marginal opportunity cost > 0)

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 Non rivalry makes prices undesirable
 Goods
 With rivalry in the consumption of the good 
Opportunity cost for others  Consumer must pay
for the good
 With no rivalry in the consumption of the good 
No reason to pay a price for it

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 Non rivalry makes prices undesirable
 Bads
 With rivalry in the consumption of the bad 
“Opportunity benefit” for society  Consumer
should receive a compensation
 With rivalry in the consumption of the bad  No
reason to receive such a compensation

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Why is rivalry so important?

 Non rival good: marginal opportunity cost of using

the good = 0
Moreover, Price = Marginal cost
Thus, Price = 0

 But, if P = 0, how is it possible to generate

revenues to efficiently provide the good?

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Non excludability

 It makes it impossible to charge for use (public

good) or compensate for use (public bad)

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Example: clean air/ polluted air

 Non excludable access to consumption

 Non rival in the act of consumption (no
opportunity cost/benefit to others)

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Market failure

 Environmental bads/goods violate the condition

of complete property rights. There is no
competitive market. Markets fail to achieve
market efficiency
 With complete property rights over the resource,
the owner has a strong incentive to use the
resource efficiently
 The decrease in value of the resource means a
personal loss

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Economic type of goods/bads
Excludable Non-excludable

Rival Private goods Open access

goods

Non-rival Club goods Pure public

goods
We can have different levels of rivalry and excludability: goods/bads
often between extreme cases

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Private goods
 ≠ Goods produced by private firms

 In a competitive market, private goods are better

produced and traded in a market economy

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Public goods
 ≠ Goods produced by the public sector

 Exs:
 The beauty of a landscape
 Clean air
 Biodiversity
 Clean water

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Public goods and free-riding

 When the good is supplied, even those who do not

pay to produce the good cannot be excluded from
consumption (non-excludable)
 They consume at the expense of those who paid
for the good: the problem of the free-rider

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Free-riding: implications and solutions
 Implications: Less resources available for
production of the public good than there would be if
everybody contributed towards its production to the
extent of the benefits from consumption of the good
 Solutions
 Increasing voluntary contributions of consumers (more
civic-minded behaviors)
 Forced contributions (taxes)
 Joint production of public goods with private goods that
generate revenues which could finance the production
of both types of goods

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Public goods

 Note that it is possible to produce more than

one type of good or service at the same time.
Ex: Forest provides both
 Private goods (timber, resin, biomass for fuel,
pulp and paper, medication, cosmetics…)
 Public services, namely environmental services
(carbon sequestration, biodiversity, prevention of
soil erosion, beauty of landscape …)

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Open-access goods

 Exs:
 Hunting and fishing, when there were no rules
regulating such activities
 Earth’s atmosphere, where pollution is discharged
without any control
 Congested road

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Open access goods and the “Tragedy of
the Commons” (Garret Hardin, 1968)
 When there are no owners of resources (ex. oceans, fish
stocks, atmosphere) or if owners are public entities with no
control over use (ex. open roads) (Tragedy)
 Then, individuals act independently, according to self-
interest, depleting common resources
 They consider only private costs and benefits
 They ignore the negative costs caused to others (negative
externality)
Overexploitation of resources

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Overexploitation: solutions
 Restrict the set of people that can have access to
the resource

 Regulate the nature and quantities of production

factors using the resource

 Regulate the amount of production of goods and

services by the resource

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Club goods
 Exs:
 Non congested highways with tolls
 Services benefiting members of a given
club/association with regulated access

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Efficient provision of public goods

Aggregate demand curve = Aggregate supply curve

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Let’s assume
 2 consumers (A and B)
 2 firms producing the good
 1 cash good (numeraire)
 1 rival good and 1 non-rival good

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 Rival good: aggregate demand curve
 The horizontal sum of individual demands
 For a given price (P=MWTP) we add individual
demanded quantities
 MWTP = marginal willingness to pay

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 Rival good: aggregate demand curve

p p p
(MWTP) (MWTP) (MWTP)

+ =

3 q 5 q 8 q

Aggregate demand
curve (D)

Individual demand
curves

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 Rival good: aggregate supply curve
 The horizontal sum of individual supplies
 For a given price, we add individual supplied
quantities
 With multiple producers MRTA= MRTB (marginal cost
of supplying the good must be the same for different
producers)

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Rival good: aggregate supply curve

p p p

+ =

5 q 1 q 6 q

Aggregate supply
Individual supply curve (S)
curves

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 Rival good: efficient provision
p

q* q

MRS1 = MRS2 = MRTA = MRTB

Eq: (q*; p*)

(optimum amount to be produced/consumed; market price)
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Non rival good: aggregate demand curve
 The vertical sum of individual demands since all
individuals consume the same amount of the good
 For a given amount of a non-rival good, we add
individual MWTP and obtain social MWTP

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Non rival good: aggregate demand curve
MWTP

+ q
MWTP

q
=
MWTP

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Non rival good: aggregate supply curve
 Rivalry is linked to consumption (not to production)
 Thus, no difference in production between rival/non-
rival good

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Non rival good: efficient provision
MWTP

q* q

MRS1 + MRS2 = MRTA = MRTB

Eq: (optimal amount of the good; social MWTP)

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The Samuelson condition

 Efficiency condition:

Σi MRSi = MRTj

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Non rival good: efficient provision

 If every consumer contributed with his individual MWTP

for q* (Lindahl prices)
 If one gives high value to the public good, high MWTP
 If one gives low value to the public good, low MWTP
Then, amount collected = amount necessary to provide q*
It is possible the optimal provision of the good

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Efficient provision of public good
 But free-riding problem of public goods (non-
rival)
 Individuals do not reveal their true individual
willingness to pay
 Individuals have an incentive to tell they value less
the good than they do, thus pay less. Still can
benefit from the public good

 Thus, the public good is undersupplied

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Efficient provision of public good
 Moreover, price of non rival good = 0.
Impossible to generate revenues to cover costs
and efficiently provide the public good

 Thus, the public good is undersupplied

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Efficient provision of public good

 Example: Biodiversity preservation

 Campaign to raise funds to finance
 Revenues from such fundraising efforts would not
be enough to pay for the efficient level of
biodiversity
 Each person may become a free-rider of the
contributions made by others
 Thus, contributions are not enough to fund the
efficient amount of the public good
 Therefore, the public good is under-supplied

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Efficient provision of public bad
 No rivalry in consumption of the public bad. No
reason why consumers should receive a
compensation from polluters
 Polluters save money because of pollution
 With no intervention, the polluter ignores the negative
externality and does not care about pollution
abatement
 Thus, the public bad is oversupplied

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Note well

 There are supply and demand curves for all

goods, regardless of whether there is a market for
such a good or not

 Rarely, there are markets for public goods/bads,

but there are demand curves, even though they
might not be well known

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Summarizing,

 Private goods are efficiently supplied by a competitive

market
 Public goods are not. If markets operate without
intervention:
 Public goods are under-supplied 
Market provision < Efficient provision
 Public bads are oversupplied 
Market provision > Efficient provision

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Externalities
 The consumption/production choices of a
person/firm enter the utility or the production
function of another entity (consumer/firm) without
that entity’s permission or compensation. Exs.
 A hotel located close to a steel factory
 A laundry located close to a steel factory
 One more driver on a congested road

 Those actions between two agents when there is

mutual agreement and for which there is payment
are not externalities

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Classification of externalities

 Positive externalities/Negative externalities

 Externalities in production/consumption

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Negative externality
 Private costs do not include the costs of negative
effects caused to others: Social costs > private costs
 Social cost = private cost + cost of externality
 Those who cause negative externality don’t do
anything to reduce it or to compensate those
negatively affected
 If costs are external, producers with no incentive to
generate less pollution

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Positive externality
 Private benefits do not include the benefits of positive
effects caused to others: Social benefits > private
benefits
 Social benefit = private benefit + benefit of externality
 Those benefiting from the externality don’t do
anything to contribute towards its production or
compensate those producing it
 If benefits are external, producers with no incentive to
produce more good

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Internalization of negative externality
 Those who cause it, do something to reduce its
effects on other people or to compensate them
 Internalization increases private costs which become
closer to social costs

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Internalization of positive externality
 Those benefiting from the externality do something to
contribute towards its production or compensate
those producing it
 Internalization increases private benefits which
become closer to social benefits

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Externality in production

• Profits are involuntarily affected by others. Ex.

Laundry production L = fL (x1, x 2 ,..., x n , e )

L = laundry production
x1,…, xn = n inputs
e = emissions from the steel factory (laundry
does not control the level of emissions/how it
influences its production function)

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Externality in consumption
• Very similar idea but now we are dealing with utility
function, instead of production function

Utility function U(w,e)

w set of consumption goods

e pollution (the consumer does not control the
level of pollution)

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Externalities as public bads
 Positive/negative externality is somehow redundant
with the concept of public good/bad
 Everyone consumes the same quantity of the good/bad
 The amount consumed is chosen by those generating
the good/bad
 The consumer has no choice, since the good/bad is
non-excludable

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Externalities as public bads

 Prices of most goods do not reflect their total costs

associated with their use (ex: cost of pollution/
environmental damages)
 There is a market failure when a firm produces units of
output but also imposes external costs to society
 Only when such external costs are internalized, we will
get the socially optimal amount of output

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