PUBLIC GOODS, PRIVATE GOODS, MIXED GOODS AND

EXTERNALITIES
A pure public good is a good or service, such as defense, the consumption of which by one
person does not reduce its availability to others in society

If we let Y denote the total quantity of a pure public good, YA the consumed by individual A and
YA the quantity consumed by individual B, then we can write:. Y = . YA = YB. The equality signs
show that there is no extra cost in supplying a given quantity of a public good to additional
people -although, of course, the production of additional units of such a good would involve
extra cost.

A private good is a good or service whose consumption by one individual result in the reduction
of its supply to others.

The more bread is consumed by one individual, the less is left for consume; the more petrol this
generation uses, the less it leaves for future generations. If we let Z denote the total supply of a
pure private good, we can write: Z = ZA + ZB' where ZA is the amount consumed by individual
and ZB is the amount consumed by individual B.

A mixed good is a good or service which has both private and public good content.

In real life, there are few pure public or private goods. A public good have some private good
content: for example, a motorist crossing bridge peak-hour traffic affects the supply of bridge-
crossings to other motorists by contributing to congestion and delays; in this case, the marginal
cost of supply is zero for low levels of use, but exceeds zero for higher levels.

Similarly, a private good may have some 'publicness': for example, watching a television at
home (basically, a private good) has Some public good Content as neighbours and friends may
also be invited to watch. Such observations of real life situations show that there are a whole
range of mixed goods, whereas pure public and pure private goods are but extremes of these
situations. Producers depend upon other producers and upon consumers in their attempts to
maximise their profits and thus their behaviour can hardly be described as completely private.
Consumers depend upon other consumers and producers in the attempt to maximize their utilities
and so their behaviour is not completely private either.

It is because of the interdependence of the behaviour of Consumers and producers that

considerable interest has been stimulated in the analysis of externalities.

Externalities are those gains and losses which are sustained by others as a result 0/ actions
initiated by producers or consumers or both and for which no compensation is paid

Externalities are sometimes called 'third party effects', 'neighbourhood effects' or 'spillovers'.
Alfred Marshall, the Victorian economist, used the phrases 'external economies' and 'external

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diseconomies'. As an example of an externality, consider a chemical firm which discharges
noxious wastes into a river estuary, killing all the fish and resulting in the loss of livelihood of a
fisherman: no compensation is paid for this loss. Similarly, the discharge of unclean water from
an industrial city into a river may result in the loss of recreational activities like swimming,
boating and angling. Yet no compensation is claimed for the loss of these pleasures, nor are these
external costs included in the cost calculations of the polluting firms and other agents.

As we shall see, the most important externalities are those which affect the environment within
which mankind seeks to satisfy his economic and biological needs. The most important point to
emphasise at this stage, though, is that externalities can arise from both production and
consumption. Following Buchanan and Stubblebine, a consumption externality may be explained
in the context of a two-person, two-good economy using the following functional notation:

UA = f (a1, a2, ... an; b)

where UA denotes the total utility of individual A; al to an denote the activities from 1 to n which
are directly under the Control of individual A; and b denotes the activity of individual B. The
equation asserts that A's utility is not only dependent on his own activities, but also on the
activity of individual B. For example, an individual's enjoyment of peace and quiet depends not
only on what he does, but also on his neighbours' activities.

It must be noted that interdependence alone is not sufficient to constitute an externality. It must
also be shown that there has been a failure to pay for or 10 receive payment on account of any
gains or losses. Thus, a consumption externality exists where there is interdependence coupled
with an absence of any form of compensation or price paid by the gainers.

A production externality can similarly be defined using the following functional notation:

Pc: f(c1,c2 ... Cn; d)

This states that firm C's profits (Pc) depend on the n activities of firm C (that is, c1 to cn) and on
the activity d of a second firm. Thus, a production externality exists where there is some
interdependence among the activities of firms coupled with an absence of any form of price or
compensation paid on account of the loss or gain.

7.3. The nature of public goods

Pure public goods have two main identifiable characteristics:

(a) Non-rivalness in consumption.

If a public good is supplied to one individual, it is at the same time made available to others at
zero cost. This is true of defense, lighthouses and police protection. Such goods are indivisible in
the sense that the benefits that each user derives from them cannot be measured, nor can the
actual number of users of such goods be identified.
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(b) Non-exclusion.

Once a public good is supplied to individual A, individual B cannot be excluded from consuming
it, whether he Wants to or not. This implies that public goods are impossible to reject: a pacifist,
for example, cannot fail to be affected by defence provided to other members of society. Note
that this characteristic of non-exclusion can also be applied to externalities where, as we noted
above, other members of a group cannot be excluded from suffering a loss or deriving some
benefit as a result of the action of a producer or consumer.

Only pure public goods will exhibit both of the above characteristics. The degree of 'publicness'
of other public goods can be restricted by either spatial or capacity limitations. Consider these in
turn

(a) Spatial limitations. The degree of 'publicness' may depend on the geographical area which a
given public good is able to benefit. For example, fire protection is likely to be non-rival in a
compact geographical area, but for once the area is enlarged the 'publicness' element disappears.
Similarly, the Blackpoll illuminations are non-rival only when one is on or near the promenade
and certainly not when one is in London.

(b) Capacity limitations. The number of people able to enjoy a public good; is dictated by the
limits of its capacity. For example, a road bridge has a : given traffic-carrying capacity beyond
which it would become congested and lose its non-rival characteristic.

7.4. Links between Public and Private Goods

Mixed goods exhibit some of the characteristics of both private and public goods. The Possible
linkages between private and public goods are summarized in Table 1, where the following four
cases are identified. 11

Case 1 (rival and excludable) is a clear-cut example of a pure private good, such as a loaf of
bread whose consumption by individual a necessarily reduces its Supply to individual B. When
A pays the price for the loaf, this I entitles him to exclude B from consuming it.

Table 1. Linkages between private and public goods,

Excludable Non-excludable

Rival Case 1 Case 2

None rival Case 3 Case 4

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Case 2 (Rival and non-excludable) illustrates the case of a private good with some public good
Content. As an example, consider a bee-keeper and a flower grower: the bee-keeper is unable to
select which flowers his bees will pollinate and the flower grower is unable to choose which bees
should get the nectar for honey (non-exclusion in both cases). Once a given swarm of bees is
engaged in pollinating the nursery of one flower grower, however, they cannot at the same time
be expected to benefit another nursery (rival consumption).

Case 3 (non-rival and excludable) illustrates a situation of the private provision of goods which
have a public good content and the public provision of goods with a private good Content. As an
example, consider a football stadium with a capacity crowd of 60,000 spectators. Up to this
Capacity, "Watching a match is non-rival. It is made excludable by fencing the ground so that
entry can only be gained by payment or by ticket. The same argument applies to theatres and
cinemas. As an example of a good provided by the government but which has a private good
Contents, consider the National Health Service: this is non-rival up to its capacity, but excludable
in the sense that the beneficiaries of medical care can be identified _ this means that the
government is able to choose to some extent who shall benefit from the service.

Case 4 (non-rival and non-excludable) typifies a pure public good, like defence and lighthouses,
as discussed above.

7.5. Mixed Goods and the Economic Theory of Clubs

As mentioned above, not many goods are pure private goods or pure public goods. It is Possible
to consider the characteristics of 'mixed' goods as resembling those of clubs, Such as Sports
clubs. Like road-bridges and hospitals, clubs have limitations in terms of both capacity and
geographical setting. People voluntarily join clubs which provide indivisible facilities and agree
to share the costs. Sharing costs illustrates both a willingness to pay and the principle of the
exclusion of non-members from the enjoyment of the facilities. Thus, a club is seen as a
mechanism for revealing preferences as regards indivisible mixed goods. In the absence of a
club, an entrepreneur or local authority considering the Provision of Such a facility might
encounter problems in discovering the Potential demand.

A club is a voluntary group of people with similar tastes. Its purpose is to exploit the economies
of Scale associated with a particular facility. The cost of provision is therefore similar to the cost
of providing a bridge or hospital in that none of these items can usually be afforded by a single
person or small group in the area. To achieve efficiency, the management of a club, like the
management of a hospital, has to determine either the optimum size of the facility Or the
Optimum size of the club's membership. In either case, the total cost and the share of the cost to
each member will be determined simultaneously.

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7.6. Differences in the Demand for Private and Public Goods

7.6.1. Demand for a private good

Since consumers of private goods buy quantities but normally-pay the same price, the market
demand curve for such a good is obtained by summing the individual demand curves
horizontally.

Figure 1 shows the derivation of a market demand curve for good X in a simple two-person
economy, with the two individuals A and B. The curve DADA represents A's demand curve for X
and the curve DBDB represents demand for the same good. At price OP, A's demand for X is
equal to and B's demand is equal to OqB: the total market demand at price OP be OqA + OqB =
Oqm. The market demand curve, DMDM, is found by adding A's and B's demands together at
every price - in other words, by horizontal summation.

Notice also that the marginal benefits derived by the two people are same, indicated on the graph
by α and β, and that these in turn are the market marginal valuation o. These marginal benefits
are all equal to prevailing price OP.

7.6.2. Demand for a public good: Since each additional unit of a public good benefits
everyone, we must add all the individuals' valuations placed on extra

Price

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Horizontal Summation of individual demand Curves

units of such a good in order to obtain its market demand curve. To find society's willingness to
pay, the rice each individual would be willing to pay if he revealed his true preferences must be-
added: graphically, this means that individual demand curve must be summed vertically, as
shown in Fig. 2:. The graph again portrays an economy with two persons, A and B. The curves
DADA, and DBDB represent the two individuals' demand curves -for the public good Y. The
market demand curve is represented by DMDM", Consider the quantity OQ*: individual A is
willing to pay the price OP1 for this quantity and B is willing to pay the price OP2' the marginal
benefits derived from the good by the two individuals differ. Thus, the price which society as a
whole is prepared to pay for the quantity OQ* is OP3 = OP1 + OP2.

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Fig 2 Vertical summation of individual demand curves.

If MC represents the social and private marginal cost of producing the public good, then the
interaction of MC and DMDM determines the socially optimal output of the public good (OQ* in
the diagram).

The number of people participating in the enjoyment of non-excludable and_non-rival

consumption goods is generally-very large. As a result, each individual has little incentive to
reveal his true preference for public goods. Members of large groups are-aware that it is
impossible to exclude them from enjoying the benefits of public goods and so they may try to be
free riders and avoid payment. The potential existence of free riders makes the estimation of the
market demand for public goods exceedingly difficult. Furthermore, unlike most private goods
whose quantities demanded are measurable, there exists no identifiable unit of measurement for
many public goods. For example, defense is not a single concept, but is made up of disparate
elements of men, equipment and strategy. The same is true of the police, education and health.

One important policy conclusion emerging from our discussion of the demand patterns of the
two types of goods is worth noting. (Given the goal of social welfare maximization, it must be
determined whether the most efficient unit of supply of public goods is the central government, a
local authority, a public corporation or any other autonomous public body. For example, street
lighting, sewage disposal and public parks are probably most efficiently supplied by local
authorities: they are in a better position to estimate the demand for these amenities and can more
easily compare the relevant costs and benefits. Where the benefits are diffused and widespread,
however, the most efficient unit of supply may be the central government. This is so in the cases
of external security, space exploration and nuclear energy development, for example.

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7.8. Externalities - Public Goods and Public Bads

Externalities can be classified as either positive or negative. Most of the foregoing discussion
about public and private goods has centered on positive externalities. In addition to these,
though, all economic systems, irrespective of their state of development, are characterized by
negative externalities of differing degrees of severity. Negative externalities are public bads, the
opposite of public goods. Examples include international tension resulting from a doubling of
defence spending by one country; smoke and noise from vehicles, airplanes and factories
creating air pollution and discomfort; nuclear tests polluting the environment and exposing to
radioactive fallout.

A close examination of any economic activity is likely to reveal both positive and negative
externalities and a web of initiating agents and parties, as illustrated in Fig. 3. The arrows in the
diagram indicate the direction of the effects the initiating agents produce on firms or consumers.

As an example, consider an asbestos factory. It may provide jobs to local residents, thereby
raising their living standards (a positive production externality benefiting consumers). At the
same time, the emission of dust may endanger the health of the employees and local residents (a
production externality harming consumers). Yet again, the factory may provide work to local
building and catering firms (a positive production externality benefiting other producers). By the
same token, the factory may discharge its wastes into a river, thereby affecting the profit levels
of firm’s downstream dependent on the supply of clean water from the river (a negative
production externality harming producers).

We note from this that externalities, positive or negative, can run from production to production
and from production to consumption. In addition they can run from consumption to production
and from consumption to consumption.

An important problem is how to determine whether a given. Externality-generating activity is

one of net external costs (that is, a or net external benefits (that is, a positive externality).
Broadly the externality leads to a net increase in the total of consumer and surplus, it can be said
to be a positive externality and, in that case, state action might be called for to encourage it.
Conversely, if the externality to a net reduction in the total of consumer and producer surplus,
government action may be called for to curtail it or even to ban it completely.

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 Initiating Agent Initiating Agent

= FIRM = CONSUMER

Affected party Affected party

= FIRM = CONSUMER

Fig. 3. Externalities

7.9. The Divergence between Private and Social Costs

Where there is a negative externality, we can say that there exists a divergence between private
and social costs. To illustrate this graphically, consider a

Fig 4: The divergence between private and social costs.

Price SMC=PMC + EMC

j PMC

D h g D

0 q1 q2

Quantity

firm which is polluting a river with noxious chemical wastes. This pollution creates an external
marginal cost which is imposed on society, but which is not included-in the firm's own private
marginal cost. This is shown in Fig. 4, The social marginal cost curve (SMC) represents the extra
cost to society of producing an additional unit of the good; it lies above the private marginal cost
curve (PMC) because private producers fail to take account of the external marginal cost (EMC).

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Notice that the infinitely elastic demand curve facing the firm, DO, implies that the market is
assumed for convenience to be perfectly competitive. It can be seen that Oq1 is the Pareto
optimal level of output where SMC intersects Db at point h. A profit-maximizing firm, however
will produce the larger quantity Oq2 at which point social marginal cost (equal to q,j) exceeds
private marginal cost (equal to q2g), Thus, the good in question may be said to be oversupplied.

7.9. Causes of Externalities

Consider the following four possible reasons for the existence of externalities.

7.9.1. Interaction between the Economic System and the Environment

A most important reason for the existence of externalities is that every economic activity begins
and ends with the environment. All initiating agents draw resources, such as air, water and raw
materials, from the environment. They then transform these resources partly directly into
consumption, and partly into the production of intermediate and finished goods. The resources
are then returned to the environment as wastes - for example, in the form of polluted air, unclean
water, empty tins and bottles. This constant interaction between the economic system and the
environment is illustrated in Fig.5; the direction of the arrows indicates flows to initiating agents
in the top half of the diagram. The bottom half of the diagram shows the waste disposal flows
from initiating agents into the environment which then recycles these flows back to producers
and consumers. The recycling process is shown by the dotted arrows from the environment as a
waste sink.

Environment as a supplier
of resources

Production Production

Environment as an amenity

Environment as a
Waste sink

Fig. 5. The economic system and the environment

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Externalities arise because the environment has only a limited assimilative capacity as a waste
disposal sink. Given the existing state of technological knowledge, the environment has a zero
assimilative capacity for of wastes - for example, cumulative pollutants such as cadmium and
mercury. For wastes like polluted water, the assimilation process takes the length of time
depending on the biochemical and organic composition the waste substances.

7.9.2. Lack of developed markets

Most human societies have developed for intermediate and finished goods and services. They
also have labour markets for human resources. Markets for some environmental resources
however, are non-existent - for example, there can be none. In other instances, markets do not
take account cost to future generations: this may be the case in markets for non-renewable
resources like oil, coal and copper. Glaring deficiencies exist in the for waste disposal; indeed,
producers and consumers often regard the environment as a free good for waste disposal.

7.9.3 Interdependence of production and consumption

Even if the economic system could be completely isolated from the environment, the
interdependence of production and consumption activities by itself would generate potential
externalities (see Fig. 3 above).

7.9.4. Incomplete property rights

Since human societies have less developed private and communal property rights over resources
like land, air, water than over other goods, both positive and negative externalities can arise. It is
because these resources cannot easily be owned that firms and consumers are not excluded from
using them in ways which affect third parties.

7.10. Methods of dealing with externalities

A number of methods have been suggested for dealing with externalities. Consider the following.

7.10.1 Pigou's tax-subsidy solution

Pigou suggested that a tax be imposed on generators of negative externalities and a subsidy be
given to generators of positive externalities.

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First, consider the tax solution to a negative externality such as river pollution caused by a
perfectly competitive chemical industry, as shown in Fig. 6. DD is the market demand curve and
SS is the supply curve for the industry's product, reflecting only the industry's private marginal
costs (∑PMC). The price OP and quantity OQ are determined by market forces. Suppose,
however, that the industry's production imposes an external marginal cost on society in the form
of river.sh pollution, shown by the EMC curve in the graph. Thus, at output OQ, the external
marginal cost is equal to QA. To allow for this, the government can impose an excise tax equal
to EMC at each level of output, which shifts the supply curve upwards from SS to S + T. This
induces the industry to reduce its level of activity to the optimal level OQ1 where price equals
social marginal cost (SMC). Notice that this method of pollution control is generally one of
reducing the level of pollution rather than eliminating it completely. This is shown in Fig. 6
where the post-tax EMC, equal to Q1B, is less than the pre-tax EMC, QA.

The tax remedy, however, is not entirely satisfactory when we come to consider the scale of
activity of a firm under conditions of imperfect competition. To show this, consider Fig. 7 which
illustrates a monopolistic firm maximizing its profits (where MR equals PMC) by producing
output OQ at price OP before any tax is imposed. The Pareto optimal price and output, though,
are found where price equals social marginal cost - that is, price OP; (lower than OP) and output
OQ1 (greater than OQ). The imposition of an excise tax which shifts the firm's PMC curve
upwards to PMC + T, causes the firm to produce a reduced 'quantity OQ2 and charge a higher
price OP" In this case, therefore, the tax causes the firm to move in the opposite direction to that
required to achieve a Pareto optimum. The reason for this is that the negative externality causes
overproduction which tends to offset the profit-maximizing monopolist's restriction of output.
Notice that this is a clear example of the theory of second best because there are two
imperfections and even after tackling the externality, the market imperfection persists.

Now consider the subsidy solution to a positive externality and take the external benefits of
education as an example. Education directly increases the earning power of those individuals

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who receive it and they in turn benefit those who come into contact with them socially and at
work. For example,

price

P2 SMC= PMC + EMC

P = PMC + T

P1 PMC

D= AR

0 Q2 Q Q1 Quantity

MR

Fig 7. The tax solution in an imperfect market

their increased knowledge and skill may increase the productivity of the economy and so raise
other people's incomes. From the standpoint of as a whole, the number of people likely to benefit
is large and this that, for social welfare maximization, education cannot be left to the ordinary
bargaining process of the market. The case for subsidizing education is illustrated in Fig. 8. In
the absence of government intervention, DD and SS represent the market demand and supply
curves for education respectively. The demand curve reflects individuals' valuation of education
- that is to say, it represents the private marginal benefit education. The external benefits which
education provides for society reflected in the external marginal benefit (EM B) curve. Total
social marginal benefit is equal to the vertical sum of PMB and EMB. In the absence of subsidy,
quantity OQ will be demanded and supplied at price OP. Now suppose the government gives a
subsidy which mirrors EMB. This subsidy might take the form of vouchers to be spent on
education and so will shift the demand curve for education upwards by the full amount of the
subsidy

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Fig. 8. A subsidy on education

(to D'D'). The equilibrium quantity will now be increased to the Pareto optimal level of OQ I' at
which point social marginal cost is equal to social marginal benefit. At this point, the subsidy
paid is equal to AB.

If society considered that the external benefits of education outweighed the private benefits, then
the government may decide to subsidies the entire quantity, making it available free of charge to
all, as with compulsory education in the United Kingdom. In that case, it would become
analogous to pure public good benefiting large groups of people.

7.10.2 Bargaining solution in small groups

Bargaining is another method of dealing with an externality, applicable where only small groups
are involved. Consider the external cost of pollution where there are only two parties involved:
the profit-maximising producer and polluter (P) and the sufferer (S). If P has the prior right to
pollute the environment, S can negotiate and bargain with P to reduce the level of pollution.
Conversely, if S has the prior right to enjoy an uncontaminated environment, P can offer S
compensation. Thus, the question of whether to bribe P to reduce the pollution or to compensate
S for his suffering is determined to a large extent by the existence of property rights. Such a
bargaining solution is generally only appropriate where small numbers of people are involved,
otherwise the transaction and administration costs may be so high that they outweigh the benefits
of bargaining.

7.10.3 Merger solution

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Where one firm imposes an external cost on another, it may be possible to internalize the
externality by merging the two firms into one. Consider two competitive firms, A and B, where
A imposes a negative externality on B. This effectively means that A's social marginal cost of
production exceeds its private marginal cost, as shown in Fig. 9. DD is the demand curve for
firm A's product. Before the merger, A will be producing output OQ1 ignoring the external cost
which it is imposing on B. After the merger, though, the combined management of A and B will
reduce the level of output of firm A to OQ" the Pareto optima! quantity. This is so because what
was previously an external cost to firm A has become a private cost to

SMC = PMC + EMC

PMC

D D

0 Q1 Q

Quantity

Fig 9. The merger solution

the larger, merged firm and must, therefore, be taken into account in determining the profit-
maximizing output level.

Legislation to impose minimum standards this method of dealing externalities belongs to the
wider field of legal rules and regulations. For instance, factory owners could be legally obliged
to raise the height of their chimneys or to install noise abatement equipment. Motor-car
manufacturers may be compelled to fit exhaust systems that reduce emissions from vehicles and
to develop fuel-efficient engines. Airplanes might be required to fly at certain minimum heights
over residential areas. It can be seen that these methods stipulate environmental standards of
minimum desirable quality. There are, however, major difficulties associated with ascertaining
the costs of pollution control and measuring the benefits from pollution control. There are as yet
no precise measurements of the extent of damage caused by environmental pollution.

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