2.9 (Public Goods and Positive Externalities)

Question 1

What are positive externalities?

Answer 1

• Occur when production and/or consumption creates external benefits on third parties outside of the market.
• Leads to an underallocation of resources to the good in question and therefore to its underprovision.

Question 2

Give examples of positive production externalities.

Answer 2

• Firms train workers who later switch jobs and work elsewhere; the external benefits are created as the new employers and society benefit from the trained workers.
• A pharmaceutical company develops a new medication that benefits not only its users but also those around them for the improved quality of life and increased life expectancy.
• A firm invests in research and development, and succeeds in developing a new technology that spreads throughout the economy, there are external benefits because not only the firm but also society benefits from the widespread adoption of the new technology.

Question 3

What are positive production externalities and how may these be corrected?

Answer 3

• When there is a positive production externality, the free market underallocates resources to the production of the good; too few resources are allocated to its production and too little of it is produced.
• Involves shifting the MPC curve downward toward the MSC curve through direct government provision or by subsidies. For allocative efficiency to be achieved, the quantity produced and consumed must increase to Qopt as price falls to Popt.

Question 4

Give examples of positive consumption externalities.

Answer 4

• The consumption of education benefits the person who receives the education, but in addition gives rise to external benefits, involving social benefits from a more productive workforce, lower unemployment, higher rate of growth, more economic development, lower crime rate etc.
• The consumption of health care services benefits not only the person receiving the services but also society and the economy, because a healthier population is more productive, ejoys a higher standard of living and may have a higher rate of economic growth.

Question 5

What are positive consumption externalities?

Answer 5

• The free market underallocates resources to the production of the good and too little of it is produced relative to the social optimum.

Question 6

What are merit goods?

Answer 6

Merit goods are goods that are held to be desirable for consumers, but which are underprovided by the market.

Question 7

What are reasons for under-provision?

Answer 7

• Positive externalities: Too little is provided by the market.
• Low income and poverty: Some consumers not willing and able to buy at certain prices.
• Consumer ignorance: Of the benefits, and so do not demand them.

Question 8

How may positive consumption externalities be corrected (5)?

Answer 8

• Legislation can be used to promote greater consumption of goods with positive externalities.
• Governments can use advertising to try to persuade consumers to buy more goods with positive externalities.
• Nudges have similar effects as education and awareness creation programmes. Government can use nudges like the creation of bicycle lanes to encourage the use of bike riding for more physical exercise. Here too, the objective is to increase demand from D1 to D2.
• Governments are frequently involved in the direct provision of goods and services with positive
  consumption externalities.
• A subsidy to the producer of the good with the positive externality has the same effects as direct government provision. It results in increasing supply and shifting the supply curve rightward (or downward). If the subsidy is equal to the external benefit, the new supply curve is MPC – subsidy and it intersects the MPB at the Qopt level of output. Again the price falls from Pm to Pc and Qopt is produced and allocative efficiency is achieved.

Question 9

Describe the free rider problem.

Answer 9

• Public goods illustrate the free rider problem: people can enjoy the use of a good without paying for it.
• This arises from non-excludability: people cannot be excluded from using the good.
• Public goods are a type of market failure because due to the free rider problem, private firms do not produce these goods.
• As such, the market fails to allocate resources to their production.

Question 10

What are the implications of government provision of public goods?

Answer 10

• Market fails to allocate resources to public goods.
• Government steps in to ensure public goods are produced at socially desirable levels.
• Financed out of tax revenue (free or nearly free of charge).
• Limited government funds, therefore opportunity costs.
• Government to decide which public good and how much.
• Government estimates the expected benefit for public goods using cost-benefit analysis.

Question 11

What does it mean to contract out to the private sector?

Answer 11

Contracting out by the public sector to the private sector occurs when a government makes an agreement (or contract) with a private firm to carry out an activity that the government was previously doing itself.

Question 12

Evaluate contracting out to the private sector.

Answer 12

Advantages:

• Involves competitive tendering.
• Detailed specifications and criteria required to be adhered to, to ensure quality outcomes/performance.
• Access to a broader range of skills and technology prevalent in the private sector.
• Private firm may be more flexible.
• Often private provision is less costly and of higher quality/efficiency compared.

Disadvantages:

• Government becomes less accountable for the public goods it provides.
• Government loses control over the services it has contracted out.
• The cost of contracting out may be greater than if the government had provided the public good itself.
• Quality may be reduced because of the competitive forces between firms.
• Additional costs of monitoring private providers may increase costs.