Module 10 — Externalities, Public Goods, and Collective Action

Core question

How should institutions change when a private action affects people who neither choose it nor receive compensation through the market?

Learning outcomes

You will be able to:

• distinguish technological externalities from ordinary price changes;
• calculate a corrective tax and efficient quantity;
• compare Pigouvian taxes, bargaining, standards, and tradable permits;
• derive the public-good provision condition;
• evaluate carbon pricing through incentives, incidence, uncertainty, and implementation.

1. Private and social margins

A negative production externality creates marginal external damage MED:

The market equates marginal benefit with private marginal cost; efficiency equates it with social marginal cost.

Worked pollution market

Let inverse demand be P=100−Q, private marginal cost be 20, and marginal external damage be 20 per unit.

Market outcome:

Efficient outcome:

A per-unit Pigouvian tax of 20 aligns private and social marginal cost in this benchmark.

Tax revenue is a transfer; avoided damage is a social benefit; lost mutually beneficial private trades between 60 and 80 are the cost required to avoid larger external harm. Distribution depends on demand, supply, ownership, and revenue use.

2. An externality is not every indirect effect

• A factory's smoke harming nearby health is a technological externality.
• Higher coffee demand raising the market price is a pecuniary effect already transmitted by price.
• Knowledge spillovers from research can be positive externalities.
• Network effects may be internalised by a platform—or remain external to users and rivals.

Policy needs the unpriced marginal effect, not merely the observation that someone is affected.

3. Match the instrument to information

Under uncertainty, a tax controls marginal cost while quantity adjusts; a cap controls quantity while allowance price adjusts. Relative slopes of marginal damage and abatement cost, catastrophic thresholds, and learning determine which error is more costly.

4. Coasean bargaining clarifies rights and transaction costs

A factory can prevent damage at cost 30; a resident suffers damage 50.

• If the factory has the right to pollute, the resident can pay between 30 and 50 for abatement.
• If the resident has the right to clean air, the factory abates rather than pay at least 50 for permission.

With clear rights, complete information, transferable utility, and costless bargaining, both assignments lead to abatement. The assignment changes the transfer and therefore distribution.

The Coase theorem is a benchmark for diagnosing frictions. With millions of affected people, strategic holdout, uncertain future damage, legal costs, wealth effects, and cross-border enforcement, bargaining may not reach the efficient result.

5. Tradable permits use heterogeneous abatement costs

Suppose firms A and B must jointly cut 10 units. Their marginal abatement costs are:

Cost-effective allocation equalises marginal costs and meets the cap:

Solving gives a_A=6, a_B=4, and allowance price 12. Requiring five units from each would leave marginal costs unequal (10 versus 13) and waste an opportunity to reallocate abatement.

Trading finds the cost-effective allocation only if emissions are measured, permits are enforceable, market power is limited, and local pollutant “hot spots” are addressed.

6. Public goods require adding willingness to pay vertically

A pure public good is non-rival and non-excludable. Everyone consumes the same quantity G, so the Samuelson condition is:

For a project costing 10 with individual values 6, 4, and 3, total value is 13, so provision creates surplus 3. No individual values it enough to pay the full cost, creating a free-rider problem.

Private contributions typically underprovide because each contributor bears the cost but shares the benefit. Tax finance can solve funding but creates information and political-allocation problems: true values are private and agents may understate them.

7. Do not confuse four types of goods

A fishery is rival but difficult to exclude from: overuse is the central problem. A congested road can move from club-like to rival as traffic rises. Classification depends on technology and institutional design, not the product's name.

8. Dynamic externalities and innovation

Climate emissions accumulate; research today changes future technology; antibiotic use affects future resistance. Dynamic policy must consider:

• stock versus flow damage;
• discounting and intergenerational welfare;
• uncertainty and irreversible thresholds;
• innovation and learning-by-doing;
• policy credibility and stranded investment.

A static corrective tax is a starting condition, not a complete transition strategy.

9. Current case: carbon pricing in 2026

The World Bank reports that 87 implemented direct carbon-pricing policies cover nearly 30% of global greenhouse-gas emissions and mobilised more than US$107 billion for public budgets in 2025 (State and Trends of Carbon Pricing 2026).

These facts show institutional reach, not a single causal effect. “Covered” emissions may face different prices, exemptions, free allocations, offsets, enforcement, and expectations. A policy evaluation must examine:

1. effective marginal price and coverage;
2. emissions response and relocation/leakage;
3. household and firm incidence;
4. revenue recycling;
5. interaction with standards, innovation policy, and trade;
6. monitoring and policy durability.

10. Government failure is part of the comparison

Public intervention can be distorted by poor information, capture, administrative cost, weak enforcement, unstable rules, or distributional conflict. The relevant comparison is imperfect market versus feasible policy—not ideal government versus actual market, or vice versa.

Practice

1. Recalculate the pollution example when marginal damage is Q/4.
2. Compare a tax of 20 with a quantity cap of 60 under uncertain demand.
3. Change the bargaining example so abatement costs 60; trace outcomes under each right assignment.
4. Solve the permit allocation when MAC_A=a_A and MAC_B=4+2a_B.
5. Design a carbon-pricing package that protects low-income households without removing the marginal emissions signal.

Quick check

• Efficiency uses marginal social, not only private, cost and benefit.
• Coasean bargaining identifies when rights and transaction costs matter.
• Taxes fix a price; caps fix a quantity.
• Public-good benefits are summed across people at a common quantity.
• Carbon-policy coverage is not the same as a uniform effective incentive.

Next: allocate indivisible positions through matching and market design.