David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 13 Welfare economics
have considered private goods. Private goods are those that can be consumed only by the buyer. For
example, if you buy a can of Coke, you pay for it and you drink it. Other consumers cannot drink the same can
of Coke. In contrast to private goods, public goods are those that, if consumed by one person, must be
consumed by others in exactly the same quantity. For example, national defence. Since you get the same
quantity of national defence as everyone else, whether or not you pay for it, you never buy national defence in
a private market. Therefore, in the case of public goods, we have goods that society would like to consume
but the private market mechanism cannot provide (or will underprovide). Taxes and public goods are
analysed in detail in Chapter 14.
Externalities
Externalities are things like pollution, noise and congestion. One person's actions have direct costs or
benefits for other people, but the individual does not take these into account. Much of the rest of this
chapter examines this distortion. The problem arises because there is no market for things like noise.
Hence markets and prices cannot ensure that the marginal benefit you get from making a noise equals the
marginal cost of that noise to other people.
Asymmetric information
In Chapter 12 we saw how moral hazard and adverse selection inhibit the setting up of insurance markets
to deal with risk. The fact that there exists imperfect information in certain markets may lead to a failure
in such markets.
Under asymmetric information, one party in a market transaction has more information than the other
party. For example, a seller may know the true quality of the good she is selling while the buyer does not.
Suppose that buyers want to buy used cars. There are various sellers in the market, some selling highquality
used cars some selling low-quality cars. If the buyers cannot tell the difference between low and
high quality, they will probably be unwilling to pay much for a used car (they always face the possibility of
getting a low-quality used car). As a result, the sellers with high-quality used cars may end up selling them
at a price that is lower than their value, meaning it is unprofitable for those sellers to stay in the market. In
practice, under asymmetric information, the existence of the low-quality product drives the high-quality
product out of the market. This is a market failure since the market for the high-quality product is
eliminated even if the buyers value it at more than the cost of producing it.
The case of used cars is known as the market for 'lemons' (whereby lemons means the low-quality used
cars) - a typical example of adverse selection.
Ai Externalities
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An externality arises if
one person's production or
consumption physically affects
the production or consumption
of others.
A chemical firm discharges waste into a lake, polluting the water. It affects the
production of anglers (fewer fish, harder to catch) or the consumption of swimmers
(dirty water). Without a 'market' for pollution, the firm can pollute the lake without
cost. Its self-interest leads it to pollute until the marginal benefit of polluting (cheaper
production of chemicals) equals its own marginal cost of polluting, which is zero.
It ignores the marginal cost that pollution imposed on anglers and swimmers.
Conversely, by painting your house you make the whole street look nicer and give consumption benefits
to your neighbour. But you paint only up to the point on which your own marginal benefit equals the
marginal cost of the paint you buy and the time you spend. Your marginal costs are also society's marginal
costs, but society's marginal benefits exceed your own. Hence, there is too little house painting.
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