EKN 310
Chapter 3 – Public Goods and Externalities
Previously (Chap 2)
• We were introduced to the benchmark model that describes economic
e4iciency in a perfectly competitive market.
• E4iciency is only achieved in benchmark model because:
- Preferences/demand for g&s are revealed by consumers
- This signals to producers the types and quantities of goods to produce
- Competition amongst producers ensures minimum cost-model
- Perfect information ensures general equilibrium by producers and
consumers
• But this is not reality.
• In reality we have many things that cause market failures.
• Market failure = the inability of real-world markets to achieve the e4icient
outcomes of the benchmark model.
• and thus there is a need for government intervention.
• Governments have an allocative, distributive and stabilisation function in
this regard.
• This chapter provides detailed discussions on 2 important sources of
market failure, namely public goods and externalities.
Private Goods and the benchmark model
• Markets will only achieve e4iciency if consumers and reveal their
preferences, markets will fail otherwise.
• Whether consumers reveal their preferences depends on the type of good.
• Private goods allow consumers to show their preferences
• So the benchmark model is focused on private goods.
,Markets work well for private goods because they have 2 key characteristics:
1) Rivalry in Consumption
o Goods are divisible among individuals
o This means that one person’s consumption of the good
reduces its availability for other potential consumers.
o Eg) the consumption of an apple by Christine reduces the
quantity of apples Thandi can consume by one
2) Excludability
o This means that the consumption of a private good can be
restricted to persons who will pay the indicated prices.
o Once private goods have been paid for, ownership is certain
(or the assignment of property rights).
o Eg) Thabo pays for a drink at the restaurant, he gains the sole
right to consume that drink and has legally excluded Charles
from enjoying it.
The rivalry and excludability of private goods force potential consumers to reveal
their preferences for these goods – which sets in motion the competitive
processes that result in allocative e4iciency.
Pricing Model for Private goods:
Consider the market for takeaway co4ees…
, - DB and DJ are the individual demand curves for the 2 consumers, Bongani
and Joan.
- NB: Recall that the benchmark model only has 2 consumers
- Each demand curve depicts the quantities of takeaway co4ees that the
respective consumer would demand at di4erent prices.
- DB+J is the market demand curve (this is imply the horizontal sum of the
individual quantities demanded at each price).
- Market equilibrium occurs at point E, where market demand = market
supply.
- The equilibrium price is 0P and Bongani and Joan cannot a4ect this price
so they are price takers.
- The equilibrium output is 0Q.
- The quantity demanded by Joan is 0J and the quantity demanded by
Bongani is 0B.
- 0J and 0B add up to 0Q but 0J and 0B are not necessarily equal.
NB: The pricing rule or private goods
• The area under the demand curve gives total utility (sum of marginal
utilities) derived from consuming takeaway co4ees.
• The area under supply curve gives the sum of marginal costs for producing
takeaway co4ees
• Therefore at equilibrium price P, the marginal utility of Bongani (BF) equals
the marginal utility of Joan (JG)
• And both BF and JG equal the total marginal cost QE
• \marginal utility of both consumers = marginal cost
• This is the condition for the e4icient supply of a private good
Pure Public Goods
• The 2 characteristics of a private goods are rivalry and excludability.
• Mixed goods have only one of these characteristics (they are either non-
rival and excludable or rival and non-excludable).
• Pure Public goods exhibit neither of these characteristics (they are non-
rival and non-excludable).
Chapter 3 – Public Goods and Externalities
Previously (Chap 2)
• We were introduced to the benchmark model that describes economic
e4iciency in a perfectly competitive market.
• E4iciency is only achieved in benchmark model because:
- Preferences/demand for g&s are revealed by consumers
- This signals to producers the types and quantities of goods to produce
- Competition amongst producers ensures minimum cost-model
- Perfect information ensures general equilibrium by producers and
consumers
• But this is not reality.
• In reality we have many things that cause market failures.
• Market failure = the inability of real-world markets to achieve the e4icient
outcomes of the benchmark model.
• and thus there is a need for government intervention.
• Governments have an allocative, distributive and stabilisation function in
this regard.
• This chapter provides detailed discussions on 2 important sources of
market failure, namely public goods and externalities.
Private Goods and the benchmark model
• Markets will only achieve e4iciency if consumers and reveal their
preferences, markets will fail otherwise.
• Whether consumers reveal their preferences depends on the type of good.
• Private goods allow consumers to show their preferences
• So the benchmark model is focused on private goods.
,Markets work well for private goods because they have 2 key characteristics:
1) Rivalry in Consumption
o Goods are divisible among individuals
o This means that one person’s consumption of the good
reduces its availability for other potential consumers.
o Eg) the consumption of an apple by Christine reduces the
quantity of apples Thandi can consume by one
2) Excludability
o This means that the consumption of a private good can be
restricted to persons who will pay the indicated prices.
o Once private goods have been paid for, ownership is certain
(or the assignment of property rights).
o Eg) Thabo pays for a drink at the restaurant, he gains the sole
right to consume that drink and has legally excluded Charles
from enjoying it.
The rivalry and excludability of private goods force potential consumers to reveal
their preferences for these goods – which sets in motion the competitive
processes that result in allocative e4iciency.
Pricing Model for Private goods:
Consider the market for takeaway co4ees…
, - DB and DJ are the individual demand curves for the 2 consumers, Bongani
and Joan.
- NB: Recall that the benchmark model only has 2 consumers
- Each demand curve depicts the quantities of takeaway co4ees that the
respective consumer would demand at di4erent prices.
- DB+J is the market demand curve (this is imply the horizontal sum of the
individual quantities demanded at each price).
- Market equilibrium occurs at point E, where market demand = market
supply.
- The equilibrium price is 0P and Bongani and Joan cannot a4ect this price
so they are price takers.
- The equilibrium output is 0Q.
- The quantity demanded by Joan is 0J and the quantity demanded by
Bongani is 0B.
- 0J and 0B add up to 0Q but 0J and 0B are not necessarily equal.
NB: The pricing rule or private goods
• The area under the demand curve gives total utility (sum of marginal
utilities) derived from consuming takeaway co4ees.
• The area under supply curve gives the sum of marginal costs for producing
takeaway co4ees
• Therefore at equilibrium price P, the marginal utility of Bongani (BF) equals
the marginal utility of Joan (JG)
• And both BF and JG equal the total marginal cost QE
• \marginal utility of both consumers = marginal cost
• This is the condition for the e4icient supply of a private good
Pure Public Goods
• The 2 characteristics of a private goods are rivalry and excludability.
• Mixed goods have only one of these characteristics (they are either non-
rival and excludable or rival and non-excludable).
• Pure Public goods exhibit neither of these characteristics (they are non-
rival and non-excludable).
