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5 Microeconomics KEY IDEAS

 The economic functions of government  Cleaning up the environment would be effi-

include enforcing laws and contracts, main- cient if it were cleaned up to the point where
taining competition, redistributing income, the marginal social benefits of the cleanup
providing public goods, correcting alloca- were equal to the marginal social costs, and the
tions for externalities and stabilizing the cleanup were done at the least possible cost.
economy.  Most economists believe the environment
 Government must provide public goods can be cleaned up at a lower cost by substi-
because a private market will not provide tuting market incentives for command and
them. Pure public goods must meet the cri- control policies.
teria of shared consumption and nonexclu-  Sometimes buyers and sellers do not have per-
sion. fect information, so the market outcome is not
 Even a perfectly competitive market some- efficient. In these cases, it may be necessary for
times produces too little of some goods and government to intervene in the market.
too much of others; economists call this sit-  The theory of public choice uses economic
uation a market failure. analysis to evaluate government operation
 The market overproduces goods that create and policies.
negative externalities. A negative externality  Public-choice theorists believe politicians
is created when part of the cost of a transac- and government officials are as self-interest-
tion is borne by third parties who are not ed as business people. However, instead of
directly involved in the transaction. Negative trying to maximize profits, “political entre-
externalities include pollution and harmful preneurs” seek to maximize power, salaries,
effects of pesticides and smoking. Negative prestige and votes. This behavior results in
externalities are sometimes called spillover government waste and inefficiency.
costs.
 Governments tax to raise revenue. Some
 The market underproduces goods that cre- taxes are based on the ability-to-pay theory,
ate positive externalities. A positive external- while others are based on the benefits-
ity is created when benefits of a transaction received theory.
or activity are received by third parties who
are not directly involved in the transaction.  Tax rates can be progressive, proportional or
Positive externalities include education, vac- regressive.
cinations against diseases and flood control.  Government taxing and spending policies
Positive externalities are sometimes called can change a society’s distribution of
spillover benefits. income.
 Government tries to discourage the produc-  The incidence of a tax can be shifted from
tion of goods that involve negative externali- the person paying the government to some-
ties and encourage the production of goods one else. This is accomplished through
that involve positive externalities. changes in prices, income and outputs.

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5 Microeconomics LESSON 1  ACTIVITY 52

Private or Public? Public Goods and Services

Our Economic System
An economic system is the way in which people and societies organize economic life to answer three
basic questions: What goods and services will be produced? How will they be produced? For whom
will they be produced?
In the United States and Canada, most production decisions — what, how and for whom to pro-
duce — are made in the marketplace through interactions of buyers and sellers. This is called the pri-
vate sector of our economy. Other decisions are made by different levels of government. This is called
the public sector of our economy. Our economic system is often called a mixed system since we pro-
duce a combination of private and public goods and services.

What Goods and Services Should Governments Provide?

While many goods and services can be provided by the private or the public sector, a few can be pro-
vided effectively only by governments. Generally, governments try to provide the goods and services
that are necessary but that individual consumers might not purchase directly on their own. There are
two criteria that can be used in judging whether something should be provided by governments:
nonexclusion and shared consumption.

Nonexclusion
In some situations people cannot be excluded from the benefits of a good or service even if they do
not pay for it. If only some of the people bought national defense, for example, the others could not
be excluded from the benefits. The nonpurchasers would be protected just as much as the purchasers.
People who receive the benefit of a good but don’t pay for it are called free riders.

Shared consumption (or joint use)

In some situations one person’s use or consumption of a good or service does not reduce its useful-
ness to others. The security one person receives from a street light is not diminished by a neighbor
receiving the same security. The protection the street light provides is not reduced by additional
people using it.
Private businesses will not produce things that people are not willing to buy, and individual con-
sumers are very reluctant to pay directly for goods and services from which others who do not pay
will reap the benefits: “Why should I be the one to buy the street light if everyone else is getting the
benefits?” Governments therefore must provide some goods and services such as national defense,
flood control, and judicial and legal systems that are characterized by shared consumption and are
necessarily or should be nonexclusive. Public goods are goods that are provided by government and
will not be provided by the private sector.

Adapted from A Guide to Give & Take (Bloomington, Ind.: Agency for Instructional Technology, 1982). Reprinted with permission of
the Agency for Instructional Technology, Box A, Bloomington, Ind. 47401. Robert J. Heffern, Maryvale High School, Cheektowaga,
N.Y., and C. Lee McCarty, Solon High School, Solon, Ohio, contributed to this activity.

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5 Microeconomics LESSON 1  ACTIVITY 52 (continued)

Private and Public Goods

Pure private goods are subject to exclusion and not subject to shared consumption. They are pur-
chased directly in the marketplace. Pure public goods are subject to nonexclusion and shared
consumption. They are purchased indirectly through tax dollars.
Some goods have elements of both private goods and public goods. Fishing in the ocean, for
example, is generally not subject to exclusion; but once one person catches a fish, it is not available
to others. Likewise, it is sometimes possible to exclude people from theaters, national parks or even
roads by charging admission fees or tolls. But one person camping in a park or driving on a highway
usually does not reduce the usefulness of these places to others. Controversy often arises over how
these mixed goods — sometimes called common-pool resources and toll goods — should be provided
and who should pay for them. Some goods do not fall into neat boxes, but show degrees of nonexclu-
sion and shared consumption.

Figure 52.1
Combinations of Exclusion and Shared Consumption
Shared Consumption
No Yes

Yes Pure private goods: haircuts, Toll goods: theaters, cable TV,
bread, ice cream parks, toll roads
Exclusion

No Common-pool resources: fish Pure public goods: national

taken from the ocean, irrigation defense, flood control, street
water taken from a river, lights, mosquito abatement,
congested roads judicial and legal system

1. What is the difference between the private and public sectors of our economy?

2. What are the characteristics of a pure private good?

3. What are the characteristics of a pure public good?

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5 Microeconomics LESSON 1  ACTIVITY 52 (continued)

4. Place each of the goods and services in the list below into one of the four boxes in Figure 52.2.
Circle the box that contains pure private goods. Then draw two circles around the box that con-
tains pure public goods.
(A) A college education (G) Cable television (L) Police and fire protection
(B) Electric power (H) Canine rabies shots (M) Health care
(C) A haircut (I) Street lights (N) National forest
(D) National defense (J) The St. Lawrence Seaway campgrounds
(E) A private amusement park (K) Public toll roads and (O) Potato chips
(F) Spraying for mosquitoes bridges (P) Auto airbags

Figure 52.2
Determining Combinations of Exclusion and Shared Consumption
Shared Consumption
No Yes

Yes
Exclusion

No

5. What is a free rider? Select three goods from the list in Question 4 that could have free riders.

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5 Microeconomics LESSON 1  ACTIVITY 53

Private versus Public

Most people can agree about which goods and services are purely private and which are purely pub-
lic. The goods and services that do not nicely fall into these two categories often lead to debate —
sometimes heated debate — in our society.
Indicate your judgments concerning the degree to which you believe the goods and services listed
below can best be provided by the government or by private business. Do so by placing the capital
letter that precedes each good or service on the continuum at the bottom of the page. If you believe
private business should provide a particular good or service, place its capital letter at or near the left
end of the line, where the words “Purely Private” appear. Place toward the right end of the line letters
for the goods or services you think are better provided by government. If you regard the answer as
debatable, place the letter in or near the middle.
When you have placed all the letters on the continuum, draw two vertical lines. One line separates
the purely private goods from the goods and services that may provoke an argument; the other line sep-
arates the purely public goods and services from the goods and services that may provoke an argument.
Now propose a set of criteria or process to divide the continuum of goods and services between
purely private and purely public goods. Then divide the continuum based on the criteria you have
established.
(A) College education (G) Postal Service
(B) Electric power (H) Interstate highway facilities
(C) National defense (I) Elementary schooling
(D) Groceries (J) Police protection
(E) Water (K) Garbage collection
(F) Professional sports events (L) Recreational facilities

Who Should Provide the Product?

Rival / Exclusive Either Shared / Nonexclusive

Purely Private Purely Public

From Master Curriculum Guide in Economics: Teaching Strategies for Consumer Economics (Secondary), (New York: National Council
on Economic Education, 1985)

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5 Microeconomics LESSON 2  ACTIVITY 54

Externalities
A market externality refers to a situation where some of the costs or benefits from an activity fall on
someone other than the one pursuing the activity. Externalities may be either positive (the activity
provides a benefit to someone else) or negative (the activity places a cost on someone else). Costs that
fall on someone else are called external or social costs, and benefits that fall on someone else are called
external or social benefits.
Total cost = Private cost + Social cost
Total benefit = Private benefit + Social benefit
Externalities are sometimes referred to as third-party costs or third-party benefits, when they fall on
a third party: someone outside the transaction, not one of the buyers or sellers in a market.
In the presence of externalities, the demand curve still represents the private marginal benefit of a
given unit, and the supply curve represents the private marginal cost. Now, however, we need to dif-
ferentiate among the total, private and social components of costs and benefits.
For decision making on the margin, we can rewrite the above equations as
MCT = MCP + MCS
MBT = MBP + MBS
(Careful here, the terminology may be different in your book. For example, in many textbooks, the
marginal social cost encompasses the private and nonprivate components.)

Activity written by Margaret Ray, Mary Washington College, Fredericksburg, Va.

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5 Microeconomics LESSON 2  ACTIVITY 54 (continued)

Figure 54.1 Figure 54.2

External Benefits External Costs

MCT = MCP + MCS

MCT = MCP
COSTS/BENEFITS

COSTS/BENEFITS
MCP

MBT = MBP + MBS

MBP MBT = MBP

1 2 3 4 5 6 1 2 3 4 5 6
HOURS OF MUSIC HOURS OF MUSIC

1. Imagine you live with a roommate in a college residence hall. Your roommate has brought an
expensive stereo system to play in your room. Figure 54.1 shows your roommate’s private margin-
al cost (MCP) and marginal benefit (MBP) curves for music played on the stereo system. Based on
your roommate’s private costs and benefits from playing music, answer the following questions.
(A) If your roommate considers only the private costs and benefits from playing music, how
many hours of music are played? _______ Label the number of hours QPRIVATE on the graph.

(B) Assume that your roommate plays music only at times that do not disturb you and plays only
music that you also enjoy. The dashed line shows that MBT exceeds MBP. Therefore, how do total
benefits (social benefits plus private benefits) differ from private benefits? ___________________
If your roommate considers the social benefits from playing music as well as the private benefits,
what happens to the quantity of music played? _____________________________. Label the
number of hours QSOCIAL on the graph.
(C) Now assume that your roommate plays music only at times that you are trying to study and
plays only music that you hate. The dashed line on Figure 54.2 shows that MCT exceeds
MCP. If your roommate considers the social costs from playing music as well as the private
costs, what happens to the quantity of music played? _______________________________
Label the number of hours QSOCIAL on the graph.
(D) When your roommate does not consider your external benefits in the absence of external
costs from playing music, the number of hours played is (efficient / too high / too low). When
your roommate does not consider your external costs in the absence of external benefits, the
number of hours played is (efficient / too high / too low).

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5 Microeconomics LESSON 2  ACTIVITY 54 (continued)

(E) How can government regulation (in this case, residence-hall rules) assure the efficient
quantity of music? Consider the circumstances under which prohibiting stereos or imposing
daily “quiet hours” are efficient ways to regulate stereo use in the hall. Does economics suggest
a more-efficient approach to stereo regulation?

2. For each of these activities, explain whether there is a positive or negative externality:
Private high school education

Smog from an electric power plant

Your neighbor’s yappy dog

Prekindergarten measles vaccinations

3. The Women’s National Basketball Association (WNBA) has awarded a new franchise for a basket-
ball team to be established in Metropolis, but only if the new team has a new arena in which to
play. Proponents of the franchise argue that the team will generate new business, provide jobs,
increase tax revenue and promote tourism in Metropolis. Opponents argue that most of the
money spent on basketball games will come from Metropolis-area residents who will simply
reduce their spending on other activities. Thus there will be few new jobs, little increase in tax
revenue and few new tourists coming to Metropolis. Others say the new stadium will cause
property values to fall and create traffic, parking and noise problems.
Voters have the following three proposals before them:
Proposal 1: No city money should be used in the construction of the arena.
Proposal 2: The city should place a tax on each ticket sold to pay for the arena.
Proposal 3: The city should build the arena and lease the right to play there to the basketball team
at a subsidized rate.
Using your knowledge of externalities, answer the following questions.
(A) What assumption does Proposal 1 make about the size of external costs compared with exter-
nal benefits? Explain.

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5 Microeconomics LESSON 2  ACTIVITY 54 (continued)

(B) How does Proposal 2 change the composition of total costs and benefits to adjust for external-
ities (both positive and negative)?

(C) What assumptions does Proposal 3 make about external costs and benefits to reach an
efficient solution?

Summary
4. When positive externalities are involved, private markets (underproduce / overproduce).

5. When negative externalities are involved, private markets (underproduce / overproduce).

6. Why do economists refer to the presence of an externality as a market failure?

7. How would a tax remedy a negative externality?

8. How would a subsidy mitigate underproduction in the presence of a positive externality?

282 Advanced Placement Economics Microeconomics: Student Activities © National Council on Economic Education, New York, N.Y.