1. An efficient allocation of resources is an allocation that satisfies the rule marginal benefit=marginal cost.
2. For each individual, the marginal benefit curve is the demand curve.
3. For each firm, the marginal cost curve is the supply curve.
4. Thus, when quantity supplied equals quantity demanded, we have an efficient allocation of resources.

This efficient-market theory rests on these three assumptions, among others:

• Competition is strong enough to push the price to the supply-and-demand level
• Everybody pays for all the goods, services, and resources they use, at equilibrium prices
• The equilibrium prices will be enough to pay all costs

Smith observed that it would be impossible to try to charge seamen according to their use or benefit from the lighthouse, and might therefore be most convenient for the government to provide the lighthouse and pay for it out of tax moneys.

Another thing about the lighthouse is that its cost does not depend on the number of ships that use it. The lighthouse is absolutely indivisible, and the cost of keeping it up is fixed.

This is an extreme case of "economies of scale:" we recall that indivisibility causes economies of scale in general, but in this extreme case there is just one possible scale of operation -- one lighthouse -- and so long as it operates it costs the same, no matter how many ships it warns off the rocks.

Adam Smith's Lighthouse

We draw two conclusions.

1. Since it is impractical to try to charge the ships for the use of the lighthouse, there is no good alternative to government provision of lighthouses.
2. If the government does provide lighthouses without charge, they will in fact be used at the efficient rate where the marginal benefit equals the marginal cost -- zero.

1. It is not practically possible to charge for the use of the good
2. The cost of the good is indivisible, so that its marginal cost is zero

1. It is difficult or costly to charge some of the beneficiaries, but it is possible
2. The marginal cost of the good is less than the average cost (economies of scale) but not zero

highways

it is possible to collect tolls, and marginal cost is not zero when we allow for congestion

broadcast television

off-air viewers cannot be charged, and the marginal cost to them is zero, but advertisers can be charged, and those charges can cover the cost.

In the "public goods" case, it is practically impossible to charge people for the benefits they get from the "public good," and that creates a problem of inefficiency for market allocation of resources. That point can be generalized somewhat.

The term for this in economics is "externality."

External Costs and Benefits

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When some people bear costs that they are not paid for, these costs are said to be external costs.

When some people get benefits that they do not pay for, these benefits are said to be external benefits.

The idea is that the decision-maker, who does not pay for the costs nor get paid for the benefits, doesn't take them into consideration in deciding how resources shall be allocated. They are "external" to his calculation of costs and benefits.

In general, if there are "external" costs or benefits or both, we say that there are "externalities," and we can expect markets to be inefficient when there are "externalities."

Public Goods and Externality

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In the Public Goods case, there are two reasons why markets do not give an efficient allocation of resources: indivisibility and externality. Since it is not practically possible for people to be charge for the benefit from the lighthouse (for example), these benefits are "external." But -- when government provides the public good, for free -- the externality just balances the indivisibility and free provision is efficient.

In general, unfortunately, it's a bit more complicated.

Social Costs and Benefits

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Again, external costs and benefits are the costs and benefits that decision-makers do not take account of, so market decisions on the allocation of resources do not reflect the external costs and benefits.

The costs and benefits that decision-makers do take account of, because they pay the costs and enjoy the benefits, are called private costs and benefits.

In turn

Social costs are the sum of private and external costs

Social benefits are the sum of private and external benefits.

Social Optimum 1

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The economist's concept of "optimum allocation of resources" is a social optimum. That is, the idea is to maximize the net benefits for everybody in society, regardless of who enjoys the benefits or pays the cost. In the ideal P-competitive economy, this is no problem. Everyone maximizes their private benefit, but since everyone pays for any benefits they receive, and bears only the corresponding costs, the result of this private-benefit maximization is that social net benefits are maximized.

When there are externalities, however, this is no longer true. In maximizing their private net benefits, people will overlook some (external) costs and benefits, and maximization of private benefits will no longer lead to maximization of social net benefits.

Abbreviations

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The rule for a socially optimal allocation of resources is still the equimarginal rule, MB=MC. However, we now have two kinds each of costs and benefits. We will abbreviate

MSC

marginal social cost

MSB

marginal social benefit

MPB

marginal private benefit

MPC

marginal private cost

Social Optimum 2

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Now we can state the rule for a social optimum, and the problem of externality, more precisely. The rule for a socially optimal allocation of resources is

MSB=MSC

and the problem is that rational self-interested decision-makers operate according to a different rule

MPB=MPC

So now let's look at some examples -- practically important ones.

A Fish Story 1

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Fish have been in the news, recently, as major world fisheries have been overexploited and are now very unproductive. I have claimed that this is a problem of resource allocation. Here is what I mean.

When a fisherman catches a fish and sells it, that fisherman gets a private benefit -- the revenue from selling the fish. But there is a cost -- because there are fewer fish to reproduce, there will be less fish caught (ceteris paribus) in the next and future years. But this cost is spread out over all the fishermen and consumers of fish, and thus is "external" to the individual fisherman's decision how many fish to take.

A Fish Story 2

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Here is the picture.

In the diagram, the difference between MPC and MSC is the market value of fish that might be caught in the future (discounted to present value) if one less fish were taken this year.

A Fish Story 3

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In the diagram, the marginal revenue, MR, is also the marginal private and marginal social cost. So the socially optimal output is Q1. However, fishermen -- balancing marginal private benefit against marginal private cost, MPC -- choose Q2, overallocating resources to fishing.

A Fish Story 4

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That would be inefficient in itself. But unfortunately the story does not stop here. Leaving fish in the ocean to reproduce is an investment decision, and as a result of this externality, the fishing industries are underinvesting. Underinvestment will cause the cost curves to shift back toward the left, making the problem worse as time goes on. This process has led to the deterioration in fisheries production we have seen.

Now let's look at an example with external benefits.

Commuters 1

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In many cities streets are congested -- inconveniently, and, perhaps, inefficiently. This inefficient congestion is itself a result of an externality. The cost of congestion is (mostly) external to the car commuter, and so he does not take it adequately into account, and too much resources are allocated to car commuting. But this is not what we are directly concerned with.

On the other side of it, when a commuter chooses public transportation instead of a private car, that choice decreases congestion. One less car, a bit less congestion -- but the benefit of the decrease in congestion goes to the commuters who continue to use their cars, not to the public transportation commuter. The benefit of decreased street congestion is an external benefit, from the point of view of the public transportation commuter.

Commuters 2

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Here's the picture:

The difference between MSB, marginal social benefit, and MPB, marginal private benefit, is the external benefit of street decongestion -- faster car trips to work and less gasoline burned, and less wear and tear on cars

Commuters 3

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In this problem, marginal private cost is assumed equal to marginal social cost, i.e, public transportation commuters pay the full cost of their ride. The optimum number of commuters on public transportation is Q1, where MSB=MC (=MSC). However, only Q2 commuters ride public transportation, where MPB-MC(=MPC).

Commuters 4

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This example illustrates another important point about externalities -- they can be interdependent. In this case, if there were no external cost of street use, there might not be any external benefits from public transportation.

In any case, it is time to go on to consider some proposed solutions, in the form of government actions.

Policies

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A wide range of government policies have been proposed to deal with externalities. Here is a quick overview. Most of the proposals fall in three broad categories.

• regulation
• taxes and subsidies
• market-based regulation

We will take a closer look at each of these in turn.

Regulation

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Thus, fishermen would be legally limited in how much fish they can catch. It is difficult to see how regulation could apply to the public transportation example. In any case, regulation has some strong disadvantages -- it is inflexible and tends to create problems as well as (perhaps) solve them.

All the same, regulation has been the favorite response of government (perhaps because it is cheap and/or easy to understand) and as a result we have a good deal of experience in making regulations work not too badly.

Taxes and Subsidies

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Thus, fishermen would pay a penalty tax to bring the private cost of fishing up to the social cost, and public transportation would be subsidized to bring the cost down and raise ridership toward the optimal level. Economists have often favored these approaches, because they work more like markets -- we like the carrot better than the stick, as a rule -- but governments have not been very committed to, or successful at, putting them into practice. This is especially true of penalty taxes, which are, after all politically unpopular.

What about the impact on the government deficit? In principle, the penalty taxes might more or less balance out the subsidies -- perhaps even balance out to zero.

But it's hard to imagine a government with the self-discipline this would require.

Market-Based Regulation

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Economists have proposed that market principles could be put to work by appropriate regulations, and there have been some trials.

For example, the fish catch could be limited by licenses. Each license would entitle the holder to catch a limited number of fish of a certain species.

However, the licenses would be salable, so that larger-scale efficient fishermen could buy up licenses from the smaller fishermen, and fish on an efficient scale.

And at least the little guys would have something -- the market price of the license -- to apply toward the retirement fund.

A scheme of this kind was actually enacted two years ago in the US, but I'm not sure it has been put into effect. It may have come too late.

Political Viewpoints

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Here in the United States, we have a tendency to line up our political viewpoints by "conservative" or "free-market" and "liberal" or "government activist" viewpoints. And while "central planners" or "radicals" are not much heard from lately, they would complete the set.

Let's see how those views would be expressed in terms of public goods and externalities.

Do keep in mind, of course, that this is not the whole story. Some conservatives are much more concerned with family values than free markets, and most radicals would reject this whole approach. And there may be other views that just don't fit into any of the three categories.

All the same, I think the comparison will be useful.

Central Planning

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Let's begin with the central planner's view.

"Public goods, quasipublic goods, and externalities are the real world of the market system.

"These 'problems' are so pervasive that the only hope for an efficient allocation of resources is for the government to take control of the allocation of resources, do the statistical work necessary to discover the social costs and benefits, solve for the optimal allocation of resources, and direct the managers of the economy to realize it.

"It's true that this is very difficult -- the Soviet Union clearly never came anywhere close. But even if the plan is pretty far off from the optimum, it can't be much worse than a market economy riddled with inefficiencies due to externalities and underprovided public goods."

The deterioration of the Soviet economy in its last years makes this last point pretty difficult to swallow, of course, but this is one possible interpretation of public goods and externalities.

The Liberal View

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Now the liberal view.

"Public goods, quasipublic goods, and externalities are fairly common in the real world.

"They are common enough that it is necessary to take proposals for government intervention in the economy on a case-by-case basis. Government action can never be ruled in or ruled out on principle. Only with attention to detail and prudent judgment based on the facts of the case can we hope to approach an optimal allocation of resources.

"That means the government will always have a full agenda for reform -- and in some cases, as in deregulation, that will mean undoing the actions of government in an earlier generation. This is not evidence of failure but of an alert, active government aware of changing circumstances. "

The Conservative View

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While there are at least several varieties of conservatives in the modern world, this view is expressed by the editorial page of The Economist, and I think it corresponds to the core economic ideas of many conservatives.

"One cannot deny that there are some public goods, quasipublic goods, and externalities in the real world.

"However, government isn't perfect either. The policies we get when we rely on government are not 'optimal' policies, but politically convenient ones. There is little reason to think that they will come closer to an 'optimal allocation of resources' than the market will.

"At least we know that the market has some forces tending to promote efficient allocation of resources. Government has none, or at best, those forces are far weaker. Thus, government action should be considered only where it is clearly essential -- as it will be in a few cases, but very few. In general, better an imperfect market than an imperfect government."

That's pretty clearly the most popular of the three positions in the 1990's.

Summary on the Role of Government

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We have considered a family of cases in which the assumptions underlying the Fundamental Theorem do not apply. What all these cases have in common is that it is practically impossible for people to be charged (in the market) for the benefits they gain or to be compensated for the costs they bear. This means that market equilibrium will be inefficient in these cases.

There are four major cases.

Public Goods

Free provision by government is efficient.

Quasipublic goods

The case is less clear, but government provision or support might in some cases improve on market outcomes.

External costs

Markets will overallocate resources. Regulations or penalty taxes to limit this may be in order.

External Benefits

Markets will underallocate resources. Subsidies may be proposed to offset this.