Mankiw.2003.Principles.of.Economics

CHAPTER 10 EXTERNALITIES 209

“All I can say is that if being a leading manufacturer
means being a leading polluter, so be it.”

production, the value of the aluminum to consumers (as measured by the height of internalizing an externality
the demand curve) exceeds the social cost of producing it (as measured by the height altering incentives so that people
of the social-cost curve). The planner does not produce more than this level because take account of the external effects of
the social cost of producing additional aluminum exceeds the value to consumers. their actions

Note that the equilibrium quantity of aluminum, QMARKET, is larger than the
socially optimal quantity, QOPTIMUM. The reason for this inefficiency is that the mar-
ket equilibrium reflects only the private costs of production. In the market equilib-
rium, the marginal consumer values aluminum at less than the social cost of
producing it. That is, at QMARKET the demand curve lies below the social-cost curve.
Thus, reducing aluminum production and consumption below the market equi-
librium level raises total economic well-being.

How can the social planner achieve the optimal outcome? One way would be
to tax aluminum producers for each ton of aluminum sold. The tax would shift the
supply curve for aluminum upward by the size of the tax. If the tax accurately re-
flected the social cost of smoke released into the atmosphere, the new supply curve
would coincide with the social-cost curve. In the new market equilibrium, alu-
minum producers would produce the socially optimal quantity of aluminum.

The use of such a tax is called internalizing the externality because it gives
buyers and sellers in the market an incentive to take account of the external effects
of their actions. Aluminum producers would, in essence, take the costs of pollution
into account when deciding how much aluminum to supply because the tax now
makes them pay for these external costs. Later in this chapter we consider other
ways in which policymakers can deal with externalities.

POSITIVE EXTERNALITIES IN PRODUCTION

Although in some markets the social cost of production exceeds the private cost, in
other markets the opposite is the case. In these markets, the externality benefits
bystanders, so the social cost of production is less than the private cost. One ex-
ample is the market for industrial robots.

210 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Figure 10-3 Price Value of Supply (private cost)
of Robot technology Social cost
TECHNOLOGY SPILLOVERS AND spillover
THE SOCIAL OPTIMUM. In the
presence of a positive externality Equilibrium
to production, the social cost of
producing robots is less than the Optimum
private cost. The optimal quantity
of robots, QOPTIMUM, is therefore
larger than the equilibrium
quantity, QMARKET.

Demand
(private value)

0 QMARKET QOPTIMUM Quantity

of Robots

Robots are at the frontier of a rapidly changing technology. Whenever a firm
builds a robot, there is some chance that it will discover a new and better design.
This new design will benefit not only this firm but society as a whole because the
design will enter society’s pool of technological knowledge. This type of positive
externality is called a technology spillover.

The analysis of positive externalities is similar to the analysis of negative ex-
ternalities. Figure 10-3 shows the market for robots. In this case, the social cost of
production is less than the private cost reflected in the supply curve. In particular,
the social cost of producing a robot is the private cost less the value of the technol-
ogy spillover. Therefore, the social planner would choose to produce a larger quan-
tity of robots than the private market does.

In this case, the government can internalize the externality by subsidizing the
production of robots. If the government paid firms a subsidy for each robot pro-
duced, the supply curve would shift down by the amount of the subsidy, and this
shift would increase the equilibrium quantity of robots. To ensure that the market
equilibrium equals the social optimum, the subsidy should equal the value of the
technology spillover.

CASE STUDY THE DEBATE OVER TECHNOLOGY POLICY

How large are technology spillovers, and what do they imply for public policy?
This is an important question because technological progress is the key to why
living standards rise from generation to generation. Yet it is also a difficult ques-
tion on which economists often disagree.

Some economists believe that technology spillovers are pervasive and that
the government should encourage those industries that yield the largest
spillovers. For instance, these economists argue that if making computer chips

CHAPTER 10 EXTERNALITIES 211

yields greater spillovers than making potato chips, then the government should
use the tax laws to encourage the production of computer chips relative to the
production of potato chips. Government intervention in the economy that aims
to promote technology-enhancing industries is called technology policy.

Other economists are skeptical about technology policy. Even if technology
spillovers are common, the success of a technology policy requires that the
government be able to measure the size of the spillovers from different mar-
kets. This measurement problem is difficult at best. Moreover, without precise
measurements, the political system may end up subsidizing those industries
with the most political clout, rather than those that yield the largest positive
externalities.

One type of technology policy that most economists endorse is patent pro-
tection. The patent laws protect the rights of inventors by giving them exclusive
use of their inventions for a period of time. When a firm makes a technological
breakthrough, it can patent the idea and capture much of the economic benefit
for itself. The patent is said to internalize the externality by giving the firm a
property right over its invention. If other firms want to use the new technology,
they would have to obtain permission from the inventing firm and pay it some
royalty. Thus, the patent system gives firms a greater incentive to engage in re-
search and other activities that advance technology.

EXTERNALITIES IN CONSUMPTION

The externalities we have discussed so far are associated with the production of
goods. Some externalities, however, are associated with consumption. The con-
sumption of alcohol, for instance, yields negative externalities if consumers are
more likely to drive under its influence and risk the lives of others. Similarly, the
consumption of education yields positive externalities because a more educated
population leads to better government, which benefits everyone.

The analysis of consumption externalities is similar to the analysis of produc-
tion externalities. As Figure 10-4 shows, the demand curve does not reflect the
value to society of the good. Panel (a) shows the case of a negative consumption
externality, such as that associated with alcohol. In this case, the social value is less
than the private value, and the socially optimal quantity is smaller than the quan-
tity determined by the private market. Panel (b) shows the case of a positive con-
sumption externality, like that of education. In this case, the social value is greater
than the private value, and the socially optimal quantity is greater than the quan-
tity determined by the private market.

Once again, the government can correct the market failure by inducing market
participants to internalize the externality. The appropriate response in the case of
consumption externalities is similar to that in the case of production externalities.
To move the market equilibrium closer to the social optimum, a negative external-
ity requires a tax, and a positive externality requires a subsidy. In fact, that is ex-
actly the policy the government follows: Alcoholic beverages are among the most
highly taxed goods in our economy, and education is heavily subsidized through
public schools and government scholarships.

As you may have noticed, these examples of externalities lead to some gen-
eral lessons: Negative externalities in production or consumption lead markets to pro-
duce a larger quantity than is socially desirable. Positive externalities in production

212 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Price of (a) Negative Consumption Externality Price of (b) Positive Consumption Externality
Alcohol Education
Supply Supply
(private cost) (private cost)

Demand Social
(private value) value

Social value Demand
(private value)
0 QOPTIMUM QMARKET Quantity 0 QMARKET
QOPTIMUM Quantity of
of Alcohol Education

Figure 10-4 CONSUMPTION EXTERNALITIES. Panel (a) shows a market with a negative consumption
externality, such as the market for alcoholic beverages. The curve representing social value
is lower than the demand curve, and the socially optimal quantity, QOPTIMUM, is less than
the equilibrium quantity, QMARKET. Panel (b) shows a market with a positive consumption
externality, such as the market for education. The curve representing social value is above
the demand curve, and the socially optimal quantity, QOPTIMUM, is greater than the
equilibrium quantity, QMARKET.

or consumption lead markets to produce a smaller quantity than is socially desirable. To
remedy the problem, the government can internalize the externality by taxing goods that
have negative externalities and subsidizing goods that have positive externalities.

QUICK QUIZ: Give an example of a negative externality and a positive
externality. N Explain why market outcomes are inefficient in the presence of
externalities.

PRIVATE SOLUTIONS TO EXTERNALITIES

We have discussed why externalities lead markets to allocate resources ineffi-
ciently, but have mentioned only briefly how this inefficiency can be remedied. In
practice, both private actors and public policymakers respond to externalities in
various ways. All of the remedies share the goal of moving the allocation of re-
sources closer to the social optimum. In this section we examine private solutions.

THE TYPES OF PRIVATE SOLUTIONS

Although externalities tend to cause markets to be inefficient, government action
is not always needed to solve the problem. In some circumstances, people can de-
velop private solutions.

CHAPTER 10 EXTERNALITIES 213

Sometimes, the problem of externalities is solved with moral codes and social
sanctions. Consider, for instance, why most people do not litter. Although there are
laws against littering, these laws are not vigorously enforced. Most people do not
litter just because it is the wrong thing to do. The Golden Rule taught to most chil-
dren says, “Do unto others as you would have them do unto you.” This moral in-
junction tells us to take account of how our actions affect other people. In
economic terms, it tells us to internalize externalities.

Another private solution to externalities is charities, many of which are estab-
lished to deal with externalities. For example, the Sierra Club, whose goal is to pro-
tect the environment, is a nonprofit organization funded with private donations. As
another example, colleges and universities receive gifts from alumni, corporations,
and foundations in part because education has positive externalities for society.

The private market can often solve the problem of externalities by relying on
the self-interest of the relevant parties. Sometimes the solution takes the form of in-
tegrating different types of business. For example, consider an apple grower and a
beekeeper that are located next to each other. Each business confers a positive ex-
ternality on the other: By pollinating the flowers on the trees, the bees help the or-
chard produce apples. At the same time, the bees use the nectar they get from the
apple trees to produce honey. Nonetheless, when the apple grower is deciding
how many trees to plant and the beekeeper is deciding how many bees to keep,
they neglect the positive externality. As a result, the apple grower plants too few
trees and the beekeeper keeps too few bees. These externalities could be internal-
ized if the beekeeper bought the apple orchard or if the apple grower bought the
beehive: Both activities would then take place within the same firm, and this sin-
gle firm could choose the optimal number of trees and bees. Internalizing exter-
nalities is one reason that some firms are involved in different types of business.

Another way for the private market to deal with external effects is for the in-
terested parties to enter into a contract. In the foregoing example, a contract be-
tween the apple grower and the beekeeper can solve the problem of too few trees
and too few bees. The contract can specify the number of trees, the number of bees,
and perhaps a payment from one party to the other. By setting the right number of
trees and bees, the contract can solve the inefficiency that normally arises from
these externalities and make both parties better off.

THE COASE THEOREM

How effective is the private market in dealing with externalities? A famous re- Coase theorem
sult, called the Coase theorem after economist Ronald Coase, suggests that it can
be very effective in some circumstances. According to the Coase theorem, if pri- the proposition that if private
vate parties can bargain without cost over the allocation of resources, then the pri- parties can bargain without cost over
vate market will always solve the problem of externalities and allocate resources the allocation of resources, they can
efficiently. solve the problem of externalities on
their own
To see how the Coase theorem works, consider an example. Suppose that Dick
owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets
a benefit from owning the dog, but the dog confers a negative externality on Jane.
Should Dick be forced to send Spot to the pound, or should Jane have to suffer
sleepless nights because of Spot’s barking?

Consider first what outcome is socially efficient. A social planner, considering
the two alternatives, would compare the benefit that Dick gets from the dog to the
cost that Jane bears from the barking. If the benefit exceeds the cost, it is efficient

214 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

for Dick to keep the dog and for Jane to live with the barking. Yet if the cost ex-
ceeds the benefit, then Dick should get rid of the dog.

According to the Coase theorem, the private market will reach the efficient
outcome on its own. How? Jane can simply offer to pay Dick to get rid of the dog.
Dick will accept the deal if the amount of money Jane offers is greater than the ben-
efit of keeping the dog.

By bargaining over the price, Dick and Jane can always reach the efficient out-
come. For instance, suppose that Dick gets a $500 benefit from the dog and Jane
bears an $800 cost from the barking. In this case, Jane can offer Dick $600 to get rid
of the dog, and Dick will gladly accept. Both parties are better off than they were
before, and the efficient outcome is reached.

It is possible, of course, that Jane would not be willing to offer any price that
Dick would accept. For instance, suppose that Dick gets a $1,000 benefit from the
dog and Jane bears an $800 cost from the barking. In this case, Dick would turn
down any offer below $1,000, while Jane would not offer any amount above $800.
Therefore, Dick ends up keeping the dog. Given these costs and benefits, however,
this outcome is efficient.

So far, we have assumed that Dick has the legal right to keep a barking dog. In
other words, we have assumed that Dick can keep Spot unless Jane pays him
enough to induce him to give up the dog voluntarily. How different would the
outcome be, on the other hand, if Jane had the legal right to peace and quiet?

According to the Coase theorem, the initial distribution of rights does not mat-
ter for the market’s ability to reach the efficient outcome. For instance, suppose
that Jane can legally compel Dick to get rid of the dog. Although having this right
works to Jane’s advantage, it probably will not change the outcome. In this case,
Dick can offer to pay Jane to allow him to keep the dog. If the benefit of the dog to
Dick exceeds the cost of the barking to Jane, then Dick and Jane will strike a bar-
gain in which Dick keeps the dog.

Although Dick and Jane can reach the efficient outcome regardless of how
rights are initially distributed, the distribution of rights is not irrelevant: It deter-
mines the distribution of economic well-being. Whether Dick has the right to a
barking dog or Jane the right to peace and quiet determines who pays whom in the
final bargain. But, in either case, the two parties can bargain with each other and
solve the externality problem. Dick will end up keeping the dog only if the benefit
exceeds the cost.

To sum up: The Coase theorem says that private economic actors can solve the prob-
lem of externalities among themselves. Whatever the initial distribution of rights, the in-
terested parties can always reach a bargain in which everyone is better off and the outcome
is efficient.

transaction costs WH Y PR IVAT E SO L U T IO N S D O N O T ALWAYS W O R K
the costs that parties incur in the
process of agreeing and following Despite the appealing logic of the Coase theorem, private actors on their own of-
through on a bargain ten fail to resolve the problems caused by externalities. The Coase theorem applies
only when the interested parties have no trouble reaching and enforcing an agree-
ment. In the real world, however, bargaining does not always work, even when a
mutually beneficial agreement is possible.

Sometimes the interested parties fail to solve an externality problem because
of transaction costs, the costs that parties incur in the process of agreeing to and
following through on a bargain. In our example, imagine that Dick and Jane speak

CHAPTER 10 EXTERNALITIES 215

different languages so that, to reach an agreement, they will need to hire a transla-
tor. If the benefit of solving the barking problem is less than the cost of the transla-
tor, Dick and Jane might choose to leave the problem unsolved. In more realistic
examples, the transaction costs are the expenses not of translators but of the
lawyers required to draft and enforce contracts.

Other times bargaining simply breaks down. The recurrence of wars and labor
strikes shows that reaching agreement can be difficult and that failing to reach
agreement can be costly. The problem is often that each party tries to hold out for
a better deal. For example, suppose that Dick gets a $500 benefit from the dog, and
Jane bears an $800 cost from the barking. Although it is efficient for Jane to pay
Dick to get rid of the dog, there are many prices that could lead to this outcome.
Dick might demand $750, and Jane might offer only $550. As they haggle over the
price, the inefficient outcome with the barking dog persists.

Reaching an efficient bargain is especially difficult when the number of inter-
ested parties is large because coordinating everyone is costly. For example, con-
sider a factory that pollutes the water of a nearby lake. The pollution confers a
negative externality on the local fishermen. According to the Coase theorem, if the
pollution is inefficient, then the factory and the fishermen could reach a bargain in
which the fishermen pay the factory not to pollute. If there are many fishermen,
however, trying to coordinate them all to bargain with the factory may be almost
impossible.

When private bargaining does not work, the government can sometimes play
a role. The government is an institution designed for collective action. In this ex-
ample, the government can act on behalf of the fishermen, even when it is imprac-
tical for the fishermen to act for themselves. In the next section, we examine how
the government can try to remedy the problem of externalities.

QUICK QUIZ: Give an example of a private solution to an externality.
N What is the Coase theorem? N Why are private economic actors
sometimes unable to solve the problems caused by an externality?

PUBLIC POLICIES TOWARD EXTERNALITIES

When an externality causes a market to reach an inefficient allocation of resources,
the government can respond in one of two ways. Command-and-control policies reg-
ulate behavior directly. Market-based policies provide incentives so that private de-
cisionmakers will choose to solve the problem on their own.

R E G U L AT I O N

The government can remedy an externality by making certain behaviors either re-
quired or forbidden. For example, it is a crime to dump poisonous chemicals into
the water supply. In this case, the external costs to society far exceed the benefits to
the polluter. The government therefore institutes a command-and-control policy
that prohibits this act altogether.

In most cases of pollution, however, the situation is not this simple. Despite
the stated goals of some environmentalists, it would be impossible to prohibit all

216 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

polluting activity. For example, virtually all forms of transportation—even the
horse—produce some undesirable polluting by-products. But it would not be sen-
sible for the government to ban all transportation. Thus, instead of trying to erad-
icate pollution altogether, society has to weigh the costs and benefits to decide the
kinds and quantities of pollution it will allow. In the United States, the Environ-
mental Protection Agency (EPA) is the government agency with the task of devel-
oping and enforcing regulations aimed at protecting the environment.

Environmental regulations can take many forms. Sometimes the EPA dictates
a maximum level of pollution that a factory may emit. Other times the EPA re-
quires that firms adopt a particular technology to reduce emissions. In all cases, to
design good rules, the government regulators need to know the details about spe-
cific industries and about the alternative technologies that those industries could
adopt. This information is often difficult for government regulators to obtain.

PIGOVIAN TAXES AND SUBSIDIES

Pigovian tax Instead of regulating behavior in response to an externality, the government can use
a tax enacted to correct the effects of market-based policies to align private incentives with social efficiency. For instance,
a negative externality as we saw earlier, the government can internalize the externality by taxing activities
that have negative externalities and subsidizing activities that have positive exter-
nalities. Taxes enacted to correct the effects of negative externalities are called Pigov-
ian taxes, after economist Arthur Pigou (1877–1959), an early advocate of their use.

Economists usually prefer Pigovian taxes over regulations as a way to deal
with pollution because they can reduce pollution at a lower cost to society. To see
why, let us consider an example.

Suppose that two factories—a paper mill and a steel mill—are each dumping
500 tons of glop into a river each year. The EPA decides that it wants to reduce the
amount of pollution. It considers two solutions:

N Regulation: The EPA could tell each factory to reduce its pollution to 300 tons
of glop per year.

N Pigovian tax: The EPA could levy a tax on each factory of $50,000 for each ton
of glop it emits.

The regulation would dictate a level of pollution, whereas the tax would give fac-
tory owners an economic incentive to reduce pollution. Which solution do you
think is better?

Most economists would prefer the tax. They would first point out that a tax is
just as effective as a regulation in reducing the overall level of pollution. The EPA
can achieve whatever level of pollution it wants by setting the tax at the appropri-
ate level. The higher the tax, the larger the reduction in pollution. Indeed, if the tax
is high enough, the factories will close down altogether, reducing pollution to zero.

The reason why economists would prefer the tax is that it reduces pollution
more efficiently. The regulation requires each factory to reduce pollution by the
same amount, but an equal reduction is not necessarily the least expensive way to
clean up the water. It is possible that the paper mill can reduce pollution at lower
cost than the steel mill. If so, the paper mill would respond to the tax by reducing
pollution substantially to avoid the tax, whereas the steel mill would respond by
reducing pollution less and paying the tax.

CHAPTER 10 EXTERNALITIES 217

In essence, the Pigovian tax places a price on the right to pollute. Just as mar-
kets allocate goods to those buyers who value them most highly, a Pigovian tax al-
locates pollution to those factories that face the highest cost of reducing it.
Whatever the level of pollution the EPA chooses, it can achieve this goal at the low-
est total cost using a tax.

Economists also argue that Pigovian taxes are better for the environment. Under
the command-and-control policy of regulation, factories have no reason to reduce
emission further once they have reached the target of 300 tons of glop. By contrast,
the tax gives the factories an incentive to develop cleaner technologies, because a
cleaner technology would reduce the amount of tax the factory has to pay.

Pigovian taxes are unlike most other taxes. As we discussed in Chapter 8, most
taxes distort incentives and move the allocation of resources away from the social
optimum. The reduction in economic well-being—that is, in consumer and pro-
ducer surplus—exceeds the amount of revenue the government raises, resulting in
a deadweight loss. By contrast, when externalities are present, society also cares
about the well-being of the bystanders who are affected. Pigovian taxes correct in-
centives for the presence of externalities and thereby move the allocation of re-
sources closer to the social optimum. Thus, while Pigovian taxes raise revenue for
the government, they enhance economic efficiency.

CASE STUDY WHY IS GASOLINE TAXED SO HEAVILY? “IF THE GAS TAX WERE ANY LARGER, I’D
TAKE THE BUS.”
In many countries, gasoline is among the most heavily taxed goods in the econ-
omy. In the United States, for instance, almost half of what drivers pay for gaso-
line goes to the gas tax. In many European countries, the tax is even larger and
the price of gasoline is three or four times the U.S. price.

Why is this tax so common? One answer is that the gas tax is a Pigovian tax
aimed at correcting three negative externalities associated with driving:

N Congestion: If you have ever been stuck in bumper-to-bumper traffic, you
have probably wished that there were fewer cars on the road. A gasoline tax
keeps congestion down by encouraging people to take public transporta-
tion, car pool more often, and live closer to work.

N Accidents: Whenever a person buys a large car or a sport utility vehicle,
he makes himself safer, but he puts his neighbors at risk. According to the
National Highway Traffic Safety Administration, a person driving a typical
car is five times as likely to die if hit by a sport utility vehicle than if
hit by another car. The gas tax is an indirect way of making people
pay when their large, gas-guzzling vehicles impose risk on others, which in
turn makes them take account of this risk when choosing what vehicle to
purchase.

N Pollution: The burning of fossil fuels such as gasoline is widely believed to
be the cause of global warming. Experts disagree about how dangerous this
threat is, but there is no doubt that the gas tax reduces the risk by reducing
the use of gasoline.

So the gas tax, rather than causing deadweight losses like most taxes, actually
makes the economy work better. It means less traffic congestion, safer roads,
and a cleaner environment.

218 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

TRADABLE POLLUTION PERMITS

Returning to our example of the paper mill and the steel mill, let us suppose that,
despite the advice of its economists, the EPA adopts the regulation and requires
each factory to reduce its pollution to 300 tons of glop per year. Then one day, after
the regulation is in place and both mills have complied, the two firms go to the
EPA with a proposal. The steel mill wants to increase its emission of glop by 100
tons. The paper mill has agreed to reduce its emission by the same amount if
the steel mill pays it $5 million. Should the EPA allow the two factories to make
this deal?

From the standpoint of economic efficiency, allowing the deal is good policy.
The deal must make the owners of the two factories better off, because they are
voluntarily agreeing to it. Moreover, the deal does not have any external effects be-
cause the total amount of pollution remains the same. Thus, social welfare is en-
hanced by allowing the paper mill to sell its right to pollute to the steel mill.

The same logic applies to any voluntary transfer of the right to pollute from
one firm to another. If the EPA allows firms to make these deals, it will, in essence,
have created a new scarce resource: pollution permits. A market to trade these per-
mits will eventually develop, and that market will be governed by the forces of
supply and demand. The invisible hand will ensure that this new market effi-
ciently allocates the right to pollute. The firms that can reduce pollution only at
high cost will be willing to pay the most for the pollution permits. The firms that
can reduce pollution at low cost will prefer to sell whatever permits they have.

One advantage of allowing a market for pollution permits is that the initial al-
location of pollution permits among firms does not matter from the standpoint of
economic efficiency. The logic behind this conclusion is similar to that behind the
Coase theorem. Those firms that can reduce pollution most easily would be will-
ing to sell whatever permits they get, and those firms that can reduce pollution
only at high cost would be willing to buy whatever permits they need. As long as
there is a free market for the pollution rights, the final allocation will be efficient
whatever the initial allocation.

Although reducing pollution using pollution permits may seem quite different
from using Pigovian taxes, in fact the two policies have much in common. In both
cases, firms pay for their pollution. With Pigovian taxes, polluting firms must pay
a tax to the government. With pollution permits, polluting firms must pay to buy
the permit. (Even firms that already own permits must pay to pollute: The oppor-
tunity cost of polluting is what they could have received by selling their permits
on the open market.) Both Pigovian taxes and pollution permits internalize the ex-
ternality of pollution by making it costly for firms to pollute.

The similarity of the two policies can be seen by considering the market for
pollution. Both panels in Figure 10-5 show the demand curve for the right to pol-
lute. This curve shows that the lower the price of polluting, the more firms will
choose to pollute. In panel (a), the EPA uses a Pigovian tax to set a price for pollu-
tion. In this case, the supply curve for pollution rights is perfectly elastic (because
firms can pollute as much as they want by paying the tax), and the position of the
demand curve determines the quantity of pollution. In panel (b), the EPA sets a
quantity of pollution by issuing pollution permits. In this case, the supply curve
for pollution rights is perfectly inelastic (because the quantity of pollution is fixed
by the number of permits), and the position of the demand curve determines the
price of pollution. Hence, for any given demand curve for pollution, the EPA can

(a) Pigovian Tax CHAPTER 10 EXTERNALITIES 219

Price of Price of (b) Pollution Permits
Pollution Pollution Supply of

pollution permits

P Pigovian P
tax
1. A Pigovian 0
tax sets the Demand for 2. . . . which, together Demand for
price of pollution rights with the demand curve, pollution rights
pollution . . . determines the price
Q Quantity of of pollution. Q Quantity of
0 Pollution 1. Pollution Pollution
2. . . . which, together permits set
with the demand curve, the quantity
determines the quantity of pollution . . .
of pollution.

THE EQUIVALENCE OF PIGOVIAN TAXES AND POLLUTION PERMITS. In panel (a), the EPA Figure 10-5
sets a price on pollution by levying a Pigovian tax, and the demand curve determines the
quantity of pollution. In panel (b), the EPA limits the quantity of pollution by limiting the
number of pollution permits, and the demand curve determines the price of pollution. The
price and quantity of pollution are the same in the two cases.

achieve any point on the demand curve either by setting a price with a Pigovian
tax or by setting a quantity with pollution permits.

In some circumstances, however, selling pollution permits may be better than
levying a Pigovian tax. Suppose the EPA wants no more than 600 tons of glop to be
dumped into the river. But, because the EPA does not know the demand curve for
pollution, it is not sure what size tax would achieve that goal. In this case, it can
simply auction off 600 pollution permits. The auction price would yield the ap-
propriate size of the Pigovian tax.

The idea of the government auctioning off the right to pollute may at first
sound like a creature of some economist’s imagination. And, in fact, that is how
the idea began. But increasingly the EPA has used the system as a way to control
pollution. Pollution permits, like Pigovian taxes, are now widely viewed as a cost-
effective way to keep the environment clean.

OBJECTIONS TO THE ECONOMIC ANALYSIS OF POLLUTION

“We cannot give anyone the option of polluting for a fee.” This comment by for-
mer Senator Edmund Muskie reflects the view of some environmentalists. Clean
air and clean water, they argue, are fundamental human rights that should not be
debased by considering them in economic terms. How can you put a price on
clean air and clean water? The environment is so important, they claim, that we
should protect it as much as possible, regardless of the cost.

220 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Economists have little sympathy with this type of argument. To economists,
good environmental policy begins by acknowledging the first of the Ten Principles
of Economics in Chapter 1: People face tradeoffs. Certainly, clean air and clean wa-
ter have value. But their value must be compared to their opportunity cost—that
is, to what one must give up to obtain them. Eliminating all pollution is impossi-
ble. Trying to eliminate all pollution would reverse many of the technological ad-
vances that allow us to enjoy a high standard of living. Few people would be
willing to accept poor nutrition, inadequate medical care, or shoddy housing to
make the environment as clean as possible.

Economists argue that some environmental activists hurt their own cause by
not thinking in economic terms. A clean environment is a good like other goods.
Like all normal goods, it has a positive income elasticity: Rich countries can afford
a cleaner environment than poor ones and, therefore, usually have more rigorous
environmental protection. In addition, like most other goods, clean air and water
obey the law of demand: The lower the price of environmental protection, the
more the public will want. The economic approach of using pollution permits and
Pigovian taxes reduces the cost of environmental protection and should, therefore,
increase the public’s demand for a clean environment.

QUICK QUIZ: A glue factory and a steel mill emit smoke containing a
chemical that is harmful if inhaled in large amounts. Describe three ways the
town government might respond to this externality. What are the pros and
cons of each of your solutions?

CONCLUSION

The invisible hand is powerful but not omnipotent. A market’s equilibrium maxi-
mizes the sum of producer and consumer surplus. When the buyers and sellers in
the market are the only interested parties, this outcome is efficient from the stand-
point of society as a whole. But when there are external effects, such as pollution,
evaluating a market outcome requires taking into account the well-being of third
parties as well. In this case, the invisible hand of the marketplace may fail to allo-
cate resources efficiently.

In some cases, people can solve the problem of externalities on their own. The
Coase theorem suggests that the interested parties can bargain among themselves
and agree on an efficient solution. Sometimes, however, an efficient outcome can-
not be reached, perhaps because the large number of interested parties makes bar-
gaining difficult.

When people cannot solve the problem of externalities privately, the govern-
ment often steps in. Yet, even now, society should not abandon market forces
entirely. Rather, the government can address the problem by requiring decision-
makers to bear the full costs of their actions. Pigovian taxes on emissions and pol-
lution permits, for instance, are designed to internalize the externality of pollution.
More and more, they are the policy of choice for those interested in protecting the
environment. Market forces, properly redirected, are often the best remedy for mar-
ket failure.

CHAPTER 10 EXTERNALITIES 221

IN THE NEWS
Children as Externalities

THIS TONGUE-IN-CHEEK EDITORIAL FROM
THE Economist, an international news-
magazine, calls attention to a common
externality that is not fully appreciated.

Mum’s the Word: A NEGATIVE EXTERNALITY
When Children Should Be
Screened and Not Heard of their proclivities. The invisible hand of do not bear the full costs (indeed young
the market fumbles, leading resources babies travel free), so they are too ready
We live in increasingly intolerant times. astray. Thus, because a driver’s private to take their noisy brats with them.
Signs proliferate demanding no smoking, motoring costs do not reflect the costs he Where is the invisible hand when it is
no spitting, no parking, even no walking. imposes on others in the form of pollution needed to administer a good smack?
. . . Posh clubs and restaurants have and congestion, he uses the car more
long had “no jeans” rules, but these than is socially desirable. Likewise, it is ar- The solution is obvious. All airlines,
days you can be too smart. Some Lon- gued, smokers take too little care to en- trains, and restaurants should create
don hostelries have “no suits” policies, sure that their acrid fumes do not damage child-free zones. Put all those children at
for fear that boisterous city traders in other people around them. the back of the plane and parents might
suits might spoil the atmosphere. Envi- make more effort to minimize their noise
ronmentalists have long demanded all Governments typically respond to pollution. And instead of letting children
sorts of bans on cars. Mobile telephones such market failures in two ways. One is pay less and babies go free, they should
are the latest target: some trains, airline higher taxes, to make polluters pay the be charged (or taxed) more than adults,
lounges, restaurants, and even golf full cost of their anti-social behavior. The with the revenues used to subsidize seats
courses are being designated “no other is regulation, such as emission immediately in front of the war-zone.
phone” areas. standards or bans on smoking in public
places. Both approaches might work for Passengers could then request a
If intolerance really has to be the children. no-children seat, just as they now ask for
spirit of this age, The Economist would a no-smoking one. As more women
like to suggest restrictions on another For children, just like cigarettes or choose not to have children and the
source of noise pollution: children. Lest mobile phones, clearly impose a nega- number of older people without young
you dismiss this as mere prejudice, we tive externality on people who are near children increases, the demand for child-
can even produce a good economic them. Anybody who has suffered a 12- free travel will expand. Well, yes, it is a
argument for it. Smoking, driving, and mo- hour flight with a bawling baby in the row bit intolerant—but why shouldn’t parents
bile phones all cause what economists immediately ahead, or a bored youngster be treated as badly as smokers? And at
call “negative externalities.” That is, the viciously kicking their seat from behind, least there is an obvious airline to pio-
costs of these activities to other people will grasp this as quickly as they would neer the scheme: Virgin.
tend to exceed the costs to the individuals love to grasp the youngster’s neck. Here
is a clear case of market failure: parents SOURCE: The Economist, December 5, 1998, p. 20.

222 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Summary

N When a transaction between a buyer and seller directly they can always reach an agreement in which resources
affects a third party, the effect is called an externality. are allocated efficiently. In many cases, however,
Negative externalities, such as pollution, cause the reaching a bargain among the many interested parties is
socially optimal quantity in a market to be less than the difficult, so the Coase theorem does not apply.
equilibrium quantity. Positive externalities, such as
technology spillovers, cause the socially optimal N When private parties cannot adequately deal with
quantity to be greater than the equilibrium quantity. external effects, such as pollution, the government often
steps in. Sometimes the government prevents socially
N Those affected by externalities can sometimes solve the inefficient activity by regulating behavior. Other times it
problem privately. For instance, when one business internalizes an externality using Pigovian taxes. Another
confers an externality on another business, the two way to protect the environment is for the government to
businesses can internalize the externality by merging. issue a limited number of pollution permits. The end
Alternatively, the interested parties can solve the result of this policy is largely the same as imposing
problem by negotiating a contract. According to the Pigovian taxes on polluters.
Coase theorem, if people can bargain without cost, then

externality, p. 206 Key Concepts Pigovian tax, p. 216
internalizing an externality, p. 209
Coase theorem, p. 213
transaction costs, p. 214

Questions for Review

1. Give an example of a negative externality and an 5. Imagine that you are a nonsmoker sharing a room with
example of a positive externality. a smoker. According to the Coase theorem, what
determines whether your roommate smokes in the
2. Use a supply-and-demand diagram to explain the effect room? Is this outcome efficient? How do you and your
of a negative externality in production. roommate reach this solution?

3. In what way does the patent system help society solve 6. What are Pigovian taxes? Why do economists prefer
an externality problem? them over regulations as a way to protect the
environment from pollution?
4. List some of the ways that the problems caused by
externalities can be solved without government
intervention.

Problems and Applications

1. Do you agree with the following statements? Why or consumption externality calls for a Pigovian tax on
why not? consumers.”

a. “The benefits of Pigovian taxes as a way to reduce 2. Consider the market for fire extinguishers.
pollution have to be weighed against the a. Why might fire extinguishers exhibit positive
deadweight losses that these taxes cause.” externalities in consumption?
b. Draw a graph of the market for fire extinguishers,
b. “A negative production externality calls for a labeling the demand curve, the social-value
Pigovian tax on producers, whereas a negative

CHAPTER 10 EXTERNALITIES 223

curve, the supply curve, and the social-cost approaches generally unable to target the firms that
curve. should undertake bigger reductions?
c. Indicate the market equilibrium level of output and c. Economists argue that appropriate Pigovian taxes
the efficient level of output. Give an intuitive or tradable pollution rights will result in efficient
explanation for why these quantities differ. pollution reduction. How do these approaches
d. If the external benefit is $10 per extinguisher, target the firms that should undertake bigger
describe a government policy that would result in reductions?
the efficient outcome.
8. The Pristine River has two polluting firms on its banks.
3. Contributions to charitable organizations are deductible Acme Industrial and Creative Chemicals each dump 100
under the federal income tax. In what way does this tons of glop into the river each year. The cost of
government policy encourage private solutions to reducing glop emissions per ton equals $10 for Acme
externalities? and $100 for Creative. The local government wants to
reduce overall pollution from 200 tons to 50 tons.
4. Ringo loves playing rock and roll music at high volume. a. If the government knew the cost of reduction for
Luciano loves opera and hates rock and roll. each firm, what reductions would it impose to
Unfortunately, they are next-door neighbors in an reach its overall goal? What would be the cost to
apartment building with paper-thin walls. each firm and the total cost to the firms together?
a. What is the externality here? b. In a more typical situation, the government would
b. What command-and-control policy might the not know the cost of pollution reduction at each
landlord impose? Could such a policy lead to an firm. If the government decided to reach its overall
inefficient outcome? goal by imposing uniform reductions on the firms,
c. Suppose the landlord lets the tenants do whatever calculate the reduction made by each firm, the cost
they want. According to the Coase theorem, how to each firm, and the total cost to the firms together.
might Ringo and Luciano reach an efficient c. Compare the total cost of pollution reduction in
outcome on their own? What might prevent them parts (a) and (b). If the government does not know
from reaching an efficient outcome? the cost of reduction for each firm, is there still
some way for it to reduce pollution to 50 tons at the
5. It is rumored that the Swiss government subsidizes total cost you calculated in part (a)? Explain.
cattle farming, and that the subsidy is larger in areas
with more tourist attractions. Can you think of a reason 9. Figure 10-5 shows that for any given demand curve for
why this policy might be efficient? the right to pollute, the government can achieve the
same outcome either by setting a price with a Pigovian
6. Greater consumption of alcohol leads to more motor tax or by setting a quantity with pollution permits.
vehicle accidents and, thus, imposes costs on people Suppose there is a sharp improvement in the technology
who do not drink and drive. for controlling pollution.
a. Illustrate the market for alcohol, labeling the a. Using graphs similar to those in Figure 10-5,
demand curve, the social-value curve, the supply illustrate the effect of this development on the
curve, the social-cost curve, the market equilibrium demand for pollution rights.
level of output, and the efficient level of output. b. What is the effect on the price and quantity of
b. On your graph, shade the area corresponding to the pollution under each regulatory system? Explain.
deadweight loss of the market equilibrium. (Hint:
The deadweight loss occurs because some units of 10. Suppose that the government decides to issue tradable
alcohol are consumed for which the social cost permits for a certain form of pollution.
exceeds the social value.) Explain. a. Does it matter for economic efficiency whether the
government distributes or auctions the permits?
7. Many observers believe that the levels of pollution in Does it matter in any other ways?
our economy are too high. b. If the government chooses to distribute the permits,
a. If society wishes to reduce overall pollution by a does the allocation of permits among firms matter
certain amount, why is it efficient to have different for efficiency? Does it matter in any other ways?
amounts of reduction at different firms?
b. Command-and-control approaches often rely on 11. The primary cause of global warming is carbon dioxide,
uniform reductions among firms. Why are these which enters the atmosphere in varying amounts from

224 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

different countries but is distributed equally around the 13. (This problem is challenging.) There are three industrial
globe within a year. In an article in The Boston Globe (July firms in Happy Valley.
3, 1990), Martin and Kathleen Feldstein argue that the
correct approach to global warming is “not to ask FIRM INITIAL COST OF REDUCING
individual countries to stabilize their emissions of POLLUTION LEVEL POLLUTION BY 1 UNIT
carbon dioxide at current levels,” as some have A
suggested. Instead, they argue that “carbon dioxide B 70 units $20
emissions should be reduced in countries where the C 80 25
costs are least, and the countries that bear that burden 50 10
should be compensated by the rest of the world.”
a. Why is international cooperation necessary to reach The government wants to reduce pollution to 120 units,
so it gives each firm 40 tradable pollution permits.
an efficient outcome? a. Who sells permits and how many do they sell?
b. Is it possible to devise a compensation scheme such
Who buys permits and how many do they buy?
that all countries would be better off than under a Briefly explain why the sellers and buyers are each
system of uniform emission reductions? Explain. willing to do so. What is the total cost of pollution
reduction in this situation?
12. Some people object to market-based policies to reduce b. How much higher would the costs of pollution
pollution, claiming that they place a dollar value on reduction be if the permits could not be traded?
cleaning our air and water. Economists reply that
society implicitly places a dollar value on environmental
cleanup even under command-and-control policies.
Discuss why this is true.

IN THIS CHAPTER
YOU WILL . . .

PUBLIC GOODS AND Learn the defining
characteristics of
COMMON RESOURCES public goods and
common resources
An old song lyric maintains that “the best things in life are free.” A moment’s
thought reveals a long list of goods that the songwriter could have had in mind. Na- Examine why
ture provides some of them, such as rivers, mountains, beaches, lakes, and oceans. private markets
The government provides others, such as playgrounds, parks, and parades. In each fail to provide
case, people do not pay a fee when they choose to enjoy the benefit of the good.
public goods
Free goods provide a special challenge for economic analysis. Most goods in
our economy are allocated in markets, where buyers pay for what they receive and Consider some of
sellers are paid for what they provide. For these goods, prices are the signals that the important
guide the decisions of buyers and sellers. When goods are available free of charge,
however, the market forces that normally allocate resources in our economy are public goods in our
absent. economy

In this chapter we examine the problems that arise for goods without market See why the cost-
prices. Our analysis will shed light on one of the Ten Principles of Economics benefit analysis

225 of public goods is
both necessary
and difficult

Examine why people
tend to use common
resources too much

Consider some of
the important

common resources
in our economy

226 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

in Chapter 1: Governments can sometimes improve market outcomes. When a
good does not have a price attached to it, private markets cannot ensure that the
good is produced and consumed in the proper amounts. In such cases, government
policy can potentially remedy the market failure and raise economic well-being.

THE DIFFERENT KINDS OF GOODS

excludability How well do markets work in providing the goods that people want? The answer
the property of a good whereby a to this question depends on the good being considered. As we discussed in Chapter
person can be prevented from 7, we can rely on the market to provide the efficient number of ice-cream cones: The
using it price of ice-cream cones adjusts to balance supply and demand, and this equilib-
rivalry rium maximizes the sum of producer and consumer surplus. Yet, as we discussed in
the property of a good whereby one Chapter 10, we cannot rely on the market to prevent aluminum manufacturers from
person’s use diminishes other polluting the air we breathe: Buyers and sellers in a market typically do not take ac-
people’s use count of the external effects of their decisions. Thus, markets work well when the
private goods good is ice cream, but they work badly when the good is clean air.
goods that are both excludable
and rival In thinking about the various goods in the economy, it is useful to group them
according to two characteristics:
public goods
goods that are neither excludable N Is the good excludable? Can people be prevented from using the good?
nor rival
N Is the good rival? Does one person’s use of the good diminish another
common resources person’s enjoyment of it?
goods that are rival but not
excludable Using these two characteristics, Figure 11-1 divides goods into four categories:

1. Private goods are both excludable and rival. Consider an ice-cream cone, for
example. An ice-cream cone is excludable because it is possible to prevent
someone from eating an ice-cream cone—you just don’t give it to him. An
ice-cream cone is rival because if one person eats an ice-cream cone, another
person cannot eat the same cone. Most goods in the economy are private
goods like ice-cream cones. When we analyzed supply and demand in
Chapters 4, 5, and 6 and the efficiency of markets in Chapters 7, 8, and 9, we
implicitly assumed that goods were both excludable and rival.

2. Public goods are neither excludable nor rival. That is, people cannot be
prevented from using a public good, and one person’s enjoyment of a public
good does not reduce another person’s enjoyment of it. For example, national
defense is a public good. Once the country is defended from foreign
aggressors, it is impossible to prevent any single person from enjoying the
benefit of this defense. Moreover, when one person enjoys the benefit of
national defense, he does not reduce the benefit to anyone else.

3. Common resources are rival but not excludable. For example, fish in the
ocean are a rival good: When one person catches fish, there are fewer fish for
the next person to catch. Yet these fish are not an excludable good because it
is difficult to charge fishermen for the fish that they catch.

4. When a good is excludable but not rival, it is an example of a natural
monopoly. For instance, consider fire protection in a small town. It is easy to

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 227

Rival? Figure 11-1

Yes No FOUR TYPES OF GOODS.
Private Goods Goods can be grouped into four
Natural Monopolies categories according to two
questions: (1) Is the good
Yes • Ice-cream cones • Fire protection excludable? That is, can people
Excludable? • Clothing • Cable TV be prevented from using it? (2) Is
• Congested toll roads • Uncongested toll roads the good rival? That is, does one
person’s use of the good diminish
Common Resources Public Goods other people’s use of it? This
table gives examples of goods in
No • Fish in the ocean • National defense each of the four categories.
• The environment • Knowledge
• Congested nontoll roads • Uncongested nontoll roads

exclude people from enjoying this good: The fire department can just let their
house burn down. Yet fire protection is not rival. Firefighters spend much of
their time waiting for a fire, so protecting an extra house is unlikely to reduce
the protection available to others. In other words, once a town has paid for
the fire department, the additional cost of protecting one more house is
small. In Chapter 15 we give a more complete definition of natural
monopolies and study them in some detail.

In this chapter we examine goods that are not excludable and, therefore, are
available to everyone free of charge: public goods and common resources. As we
will see, this topic is closely related to the study of externalities. For both public
goods and common resources, externalities arise because something of value has
no price attached to it. If one person were to provide a public good, such as na-
tional defense, other people would be better off, and yet they could not be charged
for this benefit. Similarly, when one person uses a common resource, such as the
fish in the ocean, other people are worse off, and yet they are not compensated for
this loss. Because of these external effects, private decisions about consumption
and production can lead to an inefficient allocation of resources, and government
intervention can potentially raise economic well-being.

Q U I C K Q U I Z : Define public goods and common resources, and give an
example of each.

PUBLIC GOODS

To understand how public goods differ from other goods and what problems they
present for society, let’s consider an example: a fireworks display. This good is not
excludable because it is impossible to prevent someone from seeing fireworks, and
it is not rival because one person’s enjoyment of fireworks does not reduce anyone
else’s enjoyment of them.

228 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

THE FREE-RIDER PROBLEM

free rider The citizens of Smalltown, U.S.A., like seeing fireworks on the Fourth of July. Each
a person who receives the benefit of a of the town’s 500 residents places a $10 value on the experience. The cost of
good but avoids paying for it putting on a fireworks display is $1,000. Because the $5,000 of benefits exceed the
$1,000 of costs, it is efficient for Smalltown residents to see fireworks on the Fourth
of July.

Would the private market produce the efficient outcome? Probably not. Imag-
ine that Ellen, a Smalltown entrepreneur, decided to put on a fireworks display.
Ellen would surely have trouble selling tickets to the event because her potential
customers would quickly figure out that they could see the fireworks even without
a ticket. Fireworks are not excludable, so people have an incentive to be free riders.
A free rider is a person who receives the benefit of a good but avoids paying for it.

One way to view this market failure is that it arises because of an externality.
If Ellen did put on the fireworks display, she would confer an external benefit on
those who saw the display without paying for it. When deciding whether to put
on the display, Ellen ignores these external benefits. Even though a fireworks dis-
play is socially desirable, it is not privately profitable. As a result, Ellen makes the
socially inefficient decision not to put on the display.

Although the private market fails to supply the fireworks display demanded
by Smalltown residents, the solution to Smalltown’s problem is obvious: The local
government can sponsor a Fourth of July celebration. The town council can raise
everyone’s taxes by $2 and use the revenue to hire Ellen to produce the fireworks.
Everyone in Smalltown is better off by $8—the $10 in value from the fireworks mi-
nus the $2 tax bill. Ellen can help Smalltown reach the efficient outcome as a pub-
lic employee even though she could not do so as a private entrepreneur.

The story of Smalltown is simplified, but it is also realistic. In fact, many local
governments in the United States do pay for fireworks on the Fourth of July. More-
over, the story shows a general lesson about public goods: Because public goods
are not excludable, the free-rider problem prevents the private market from sup-
plying them. The government, however, can potentially remedy the problem. If
the government decides that the total benefits exceed the costs, it can provide the
public good and pay for it with tax revenue, making everyone better off.

SOME IMPORTANT PUBLIC GOODS

There are many examples of public goods. Here we consider three of the most
important.

N a t i o n a l D e f e n s e The defense of the country from foreign aggressors is a
classic example of a public good. It is also one of the most expensive. In 1999 the
U.S. federal government spent a total of $277 billion on national defense, or about
$1,018 per person. People disagree about whether this amount is too small or too
large, but almost no one doubts that some government spending for national de-
fense is necessary. Even economists who advocate small government agree that the
national defense is a public good the government should provide.

B a s i c R e s e a r c h The creation of knowledge is a public good. If a mathe-
matician proves a new theorem, the theorem enters the general pool of knowledge

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 229

“I like the concept if we can do it with no new taxes.”

that anyone can use without charge. Because knowledge is a public good, profit-
seeking firms tend to free ride on the knowledge created by others and, as a result,
devote too few resources to the creation of knowledge.

In evaluating the appropriate policy toward knowledge creation, it is impor-
tant to distinguish general knowledge from specific, technological knowledge.
Specific, technological knowledge, such as the invention of a better battery, can be
patented. The inventor thus obtains much of the benefit of his invention, although
certainly not all of it. By contrast, a mathematician cannot patent a theorem; such
general knowledge is freely available to everyone. In other words, the patent sys-
tem makes specific, technological knowledge excludable, whereas general knowl-
edge is not excludable.

The government tries to provide the public good of general knowledge in var-
ious ways. Government agencies, such as the National Institutes of Health and the
National Science Foundation, subsidize basic research in medicine, mathematics,
physics, chemistry, biology, and even economics. Some people justify government
funding of the space program on the grounds that it adds to society’s pool of
knowledge. Certainly, many private goods, including bullet-proof vests and the in-
stant drink Tang, use materials that were first developed by scientists and engi-
neers trying to land a man on the moon. Determining the appropriate level of
governmental support for these endeavors is difficult because the benefits are hard
to measure. Moreover, the members of Congress who appropriate funds for re-
search usually have little expertise in science and, therefore, are not in the best po-
sition to judge what lines of research will produce the largest benefits.

F i g h t i n g P o v e r t y Many government programs are aimed at helping the
poor. The welfare system (officially called Temporary Assistance for Needy Fami-
lies) provides a small income for some poor families. Similarly, the Food Stamp
program subsidizes the purchase of food for those with low incomes, and various
government housing programs make shelter more affordable. These antipoverty
programs are financed by taxes on families that are financially more successful.

230 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Economists disagree among themselves about what role the government
should play in fighting poverty. Although we will discuss this debate more fully in
Chapter 20, here we note one important argument: Advocates of antipoverty pro-
grams claim that fighting poverty is a public good.

Suppose that everyone prefers to live in a society without poverty. Even if this
preference is strong and widespread, fighting poverty is not a “good” that the pri-
vate market can provide. No single individual can eliminate poverty because the
problem is so large. Moreover, private charity is hard pressed to solve the problem:
People who do not donate to charity can free ride on the generosity of others. In
this case, taxing the wealthy to raise the living standards of the poor can make
everyone better off. The poor are better off because they now enjoy a higher stan-
dard of living, and those paying the taxes are better off because they enjoy living
in a society with less poverty.

C A S E S T U D Y ARE LIGHTHOUSES PUBLIC GOODS?

Some goods can switch between being public goods and being private goods
depending on the circumstances. For example, a fireworks display is a public
good if performed in a town with many residents. Yet if performed at a private
amusement park, such as Walt Disney World, a fireworks display is more like a
private good because visitors to the park pay for admission.

Another example is a lighthouse. Economists have long used lighthouses as
examples of a public good. Lighthouses are used to mark specific locations so
that passing ships can avoid treacherous waters. The benefit that the lighthouse
provides to the ship captain is neither excludable nor rival, so each captain has
an incentive to free ride by using the lighthouse to navigate without paying for
the service. Because of this free-rider problem, private markets usually fail to
provide the lighthouses that ship captains need. As a result, most lighthouses
today are operated by the government.

USE OF THE LIGHTHOUSE IS FREE TO THE BOAT OWNER. DOES THIS MAKE THE LIGHTHOUSE A PUBLIC GOOD?

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 231

In some cases, however, lighthouses may be closer to private goods. On the
coast of England in the nineteenth century, some lighthouses were privately
owned and operated. The owner of the local lighthouse did not try to charge
ship captains for the service but did charge the owner of the nearby port. If the
port owner did not pay, the lighthouse owner turned off the light, and ships
avoided that port.

In deciding whether something is a public good, one must determine the
number of beneficiaries and whether these beneficiaries can be excluded from
enjoying the good. A free-rider problem arises when the number of beneficiaries
is large and exclusion of any one of them is impossible. If a lighthouse benefits
many ship captains, it is a public good. Yet if it primarily benefits a single port
owner, it is more like a private good.

THE DIFFICULT JOB OF COST-BENEFIT ANALYSIS

So far we have seen that the government provides public goods because the pri- cost-benefit analysis
vate market on its own will not produce an efficient quantity. Yet deciding that the a study that compares the costs and
government must play a role is only the first step. The government must then de- benefits to society of providing a
termine what kinds of public goods to provide and in what quantities. public good

Suppose that the government is considering a public project, such as building
a new highway. To judge whether to build the highway, it must compare the total
benefits of all those who would use it to the costs of building and maintaining it.
To make this decision, the government might hire a team of economists and engi-
neers to conduct a study, called a cost-benefit analysis, the goal of which is to es-
timate the total costs and benefits of the project to society as a whole.

Cost-benefit analysts have a tough job. Because the highway will be available
to everyone free of charge, there is no price with which to judge the value of the
highway. Simply asking people how much they would value the highway is not
reliable. First, quantifying benefits is difficult using the results from a question-
naire. Second, respondents have little incentive to tell the truth. Those who would
use the highway have an incentive to exaggerate the benefit they receive to get the
highway built. Those who would be harmed by the highway have an incentive to
exaggerate the costs to them to prevent the highway from being built.

The efficient provision of public goods is, therefore, intrinsically more difficult
than the efficient provision of private goods. Private goods are provided in the
market. Buyers of a private good reveal the value they place on it by the prices
they are willing to pay. Sellers reveal their costs by the prices they are willing to
accept. By contrast, cost-benefit analysts do not observe any price signals when
evaluating whether the government should provide a public good. Their findings
on the costs and benefits of public projects are, therefore, rough approximations
at best.

C A S E S T U D Y HOW MUCH IS A LIFE WORTH?

Imagine that you have been elected to serve as a member of your local town
council. The town engineer comes to you with a proposal: The town can spend
$10,000 to build and operate a traffic light at a town intersection that now has
only a stop sign. The benefit of the traffic light is increased safety. The engineer

232 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

estimates, based on data from similar intersections, that the traffic light would
reduce the risk of a fatal traffic accident over the lifetime of the traffic light from
1.6 to 1.1 percent. Should you spend the money for the new light?

To answer this question, you turn to cost-benefit analysis. But you quickly
run into an obstacle: The costs and benefits must be measured in the same units
if you are to compare them meaningfully. The cost is measured in dollars, but
the benefit—the possibility of saving a person’s life—is not directly monetary.
To make your decision, you have to put a dollar value on a human life.

At first, you may be tempted to conclude that a human life is priceless. Af-
ter all, there is probably no amount of money that you could be paid to volun-
tarily give up your life or that of a loved one. This suggests that a human life
has an infinite dollar value.

For the purposes of cost-benefit analysis, however, this answer leads to
nonsensical results. If we truly placed an infinite value on human life, we
should be placing traffic lights on every street corner. Similarly, we should all be
driving large cars with all the latest safety features, instead of smaller ones with
fewer safety features. Yet traffic lights are not at every corner, and people some-
times choose to buy small cars without side-impact air bags or antilock brakes.
In both our public and private decisions, we are at times willing to risk our lives
to save some money.

Once we have accepted the idea that a person’s life does have an implicit
dollar value, how can we determine what that value is? One approach, some-
times used by courts to award damages in wrongful-death suits, is to look at the
total amount of money a person would have earned if he or she had lived.
Economists are often critical of this approach. It has the bizarre implication that
the life of a retired or disabled person has no value.

A better way to value human life is to look at the risks that people are vol-
untarily willing to take and how much they must be paid for taking them. Mor-
tality risk varies across jobs, for example. Construction workers in high-rise
buildings face greater risk of death on the job than office workers do. By com-
paring wages in risky and less risky occupations, controlling for education, ex-
perience, and other determinants of wages, economists can get some sense
about what value people put on their own lives. Studies using this approach
conclude that the value of a human life is about $10 million.

EVERYONE WOULD

LIKE TO AVOID THE

RISK OF THIS, BUT AT
WHAT COST?

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 233

IN THE NEWS In the midst of a major study of controversy, really, is mostly about
Existence Value whether or not to breach four huge hy- measurability.”
droelectric dams on the Snake River in
COST-BENEFIT ANALYSTS OFTEN RUN INTO eastern Washington, economists with Proponents of the dam-breaching
hard questions. Here’s an example. the Army Corps of Engineers are adding proposal have pointed to polls suggest-
a factor known as “existence value” to ing that Seattle-area residents would be
They Exist. Therefore They their list of costs and benefits of the con- willing to pay a few extra dollars a month
Are. But, Do You Care? tentious proposal. on their electricity bills into order to save
salmon runs. . . . Economists at the
BY SAM HOWE VERHOVEK Breaching the dams would restore Corps of Engineers have calculated that
It sounds like a philosophical cousin to 140 miles of the lower Snake to its wild, breaching the four Snake River dams
the age-old question of whether a tree free-flowing condition and would, many and successfully restoring the salmon is
falling in the forest makes a sound if no biologists argue, stand a good chance of an idea for which Americans would be
one is around to hear it. In this case, revitalizing endangered salmon runs in willing to shell out [in total] as much as
though, federal officials are seeking to the river. Aside from calculating the pro- $1 billion. . . .
add an economic variable to the puzzle: posal’s effects on jobs, electric bills, and
Just how much is it worth to you to know shipping rates, the Government is now Others question whether such a
that a once-dammed river is running wild hoping to assign a dollar value to Ameri- value can be accurately measured. “The
again—even if you never visit it? cans’ knowledge that a piece of their only way to do it is to ask people what
wilderness might be regained. . . . they would be willing to pay, and in my
view you ask people questions like that
“The idea that you’d be willing to and you get very upwardly biased re-
pay something for some state of the sults,” said Jerry Hausman, an econom-
world to exist, as you would pay for a ics professor at M.I.T. “When somebody
commodity or a contract for services, is calls you on the phone to ask, it’s not
not at all crazy,” said Alan Randall, chair- real money.”
man of the department of agricultural,
environmental, and development eco- SOURCE: The New York Times, Week in Review,
nomics at Ohio State University. “The October 17, 1999, p. 5.

We can now return to our original example and respond to the town engi-
neer. The traffic light reduces the risk of fatality by 0.5 percent. Thus, the ex-
pected benefit from having the traffic light is 0.005 ϫ $10 million, or $50,000.
This estimate of the benefit well exceeds the cost of $10,000, so you should ap-
prove the project.

Q U I C K Q U I Z : What is the free-rider problem? N Why does the free-rider
problem induce the government to provide public goods? N How should the
government decide whether to provide a public good?

COMMON RESOURCES

Common resources, like public goods, are not excludable: They are available free of
charge to anyone who wants to use them. Common resources are, however, rival:

234 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Tragedy of the Commons One person’s use of the common resource reduces other people’s enjoyment of it.
Thus, common resources give rise to a new problem. Once the good is provided,
a parable that illustrates why policymakers need to be concerned about how much it is used. This problem is best
common resources get used more understood from the classic parable called the Tragedy of the Commons.
than is desirable from the standpoint
of society as a whole THE TRAGEDY OF THE COMMONS

Consider life in a small medieval town. Of the many economic activities that take
place in the town, one of the most important is raising sheep. Many of the town’s
families own flocks of sheep and support themselves by selling the sheep’s wool,
which is used to make clothing.

As our story begins, the sheep spend much of their time grazing on the land
surrounding the town, called the Town Common. No family owns the land. In-
stead, the town residents own the land collectively, and all the residents are al-
lowed to graze their sheep on it. Collective ownership works well because land is
plentiful. As long as everyone can get all the good grazing land they want, the
Town Common is not a rival good, and allowing residents’ sheep to graze for free
causes no problems. Everyone in town is happy.

As the years pass, the population of the town grows, and so does the number
of sheep grazing on the Town Common. With a growing number of sheep and a
fixed amount of land, the land starts to lose its ability to replenish itself. Eventu-
ally, the land is grazed so heavily that it becomes barren. With no grass left on the
Town Common, raising sheep is impossible, and the town’s once prosperous wool
industry disappears. Many families lose their source of livelihood.

What causes the tragedy? Why do the shepherds allow the sheep population
to grow so large that it destroys the Town Common? The reason is that social and
private incentives differ. Avoiding the destruction of the grazing land depends on
the collective action of the shepherds. If the shepherds acted together, they could
reduce the sheep population to a size that the Town Common can support. Yet no
single family has an incentive to reduce the size of its own flock because each flock
represents only a small part of the problem.

In essence, the Tragedy of the Commons arises because of an externality. When
one family’s flock grazes on the common land, it reduces the quality of the land
available for other families. Because people neglect this negative externality when
deciding how many sheep to own, the result is an excessive number of sheep.

If the tragedy had been foreseen, the town could have solved the problem
in various ways. It could have regulated the number of sheep in each family’s
flock, internalized the externality by taxing sheep, or auctioned off a limited num-
ber of sheep-grazing permits. That is, the medieval town could have dealt with the
problem of overgrazing in the way that modern society deals with the problem of
pollution.

In the case of land, however, there is a simpler solution. The town can divide
up the land among town families. Each family can enclose its parcel of land with a
fence and then protect it from excessive grazing. In this way, the land becomes a
private good rather than a common resource. This outcome in fact occurred dur-
ing the enclosure movement in England in the seventeenth century.

The Tragedy of the Commons is a story with a general lesson: When one per-
son uses a common resource, he diminishes other people’s enjoyment of it. Be-
cause of this negative externality, common resources tend to be used excessively.

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 235

The government can solve the problem by reducing use of the common resource
through regulation or taxes. Alternatively, the government can sometimes turn the
common resource into a private good.

This lesson has been known for thousands of years. The ancient Greek
philosopher Aristotle pointed out the problem with common resources: “What is
common to many is taken least care of, for all men have greater regard for what is
their own than for what they possess in common with others.”

SOME IMPORTANT COMMON RESOURCES

There are many examples of common resources. In almost all cases, the same prob-
lem arises as in the Tragedy of the Commons: Private decisionmakers use the com-
mon resource too much. Governments often regulate behavior or impose fees to
mitigate the problem of overuse.

C l e a n A i r a n d Wa t e r As we discussed in Chapter 10, markets do not ad-
equately protect the environment. Pollution is a negative externality that can be
remedied with regulations or with Pigovian taxes on polluting activities. One can
view this market failure as an example of a common-resource problem. Clean air
and clean water are common resources like open grazing land, and excessive pol-
lution is like excessive grazing. Environmental degradation is a modern Tragedy
of the Commons.

O i l P o o l s Consider an underground pool of oil so large that it lies under
many properties with different owners. Any of the owners can drill and extract the
oil, but when one owner extracts oil, less is available for the others. The oil is a
common resource.

Just as the number of sheep grazing on the Town Common was inefficiently
large, the number of wells drawing from the oil pool will be inefficiently large. Be-
cause each owner who drills a well imposes a negative externality on the other
owners, the benefit to society of drilling a well is less than the benefit to the owner
who drills it. That is, drilling a well can be privately profitable even when it is so-
cially undesirable. If owners of the properties decide individually how many oil
wells to drill, they will drill too many.

To ensure that the oil is extracted at lowest cost, some type of joint action
among the owners is necessary to solve the common-resource problem. The Coase
theorem, which we discussed in Chapter 10, suggests that a private solution might
be possible. The owners could reach an agreement among themselves about how
to extract the oil and divide the profits. In essence, the owners would then act as if
they were in a single business.

When there are many owners, however, a private solution is more difficult. In
this case, government regulation could ensure that the oil is extracted efficiently.

C o n g e s t e d R o a d s Roads can be either public goods or common resources.
If a road is not congested, then one person’s use does not affect anyone else. In this
case, use is not rival, and the road is a public good. Yet if a road is congested, then
use of that road yields a negative externality. When one person drives on the road,
it becomes more crowded, and other people must drive more slowly. In this case,
the road is a common resource.

236 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

IN THE NEWS
The Singapore Solution

TOLLS ARE A SIMPLE WAY TO SOLVE THE HOW CAN WE CLEAR THIS MARKET?
problem of road congestion and, ac-
cording to some economists, are not
used as much as they should be. In this
opinion column, economist Lester
Thurow describes Singapore’s success
in dealing with congestion.

Economics of Road Pricing

BY LESTER C. THUROW has had a lot of autos) but the degrees the entire central city down to make
Start with a simple observational truth. of congestion and pollution don’t differ room for roads and would still have
No city has ever been able to solve its very much. More roads simply encour- something approaching gridlock.
congestion and pollution problems by age more people to use their cars, to live
building more roads. farther away from work, and thus use Economists have always had a the-
more road space. . . . A recent analysis oretical answer for auto congestion and
Some of the world’s cities have built of congestion problems in London came pollution problems—road pricing. Charge
a lot of roads (Los Angeles) and some to the conclusion that London could tear people for using roads based on what
have very few (Shanghai only recently roads they use, what time of day and

One way for the government to address the problem of road congestion is to
charge drivers a toll. A toll is, in essence, a Pigovian tax on the externality of con-
gestion. Often, as in the case of local roads, tolls are not a practical solution because
the cost of collecting them is too high.

Sometimes congestion is a problem only at certain times of day. If a bridge is
heavily traveled only during rush hour, for instance, the congestion externality is
larger during this time than during other times of day. The efficient way to deal
with these externalities is to charge higher tolls during rush hour. This toll would
provide an incentive for drivers to alter their schedules and would reduce traffic
when congestion is greatest.

Another policy that responds to the problem of road congestion, discussed in
a case study in the previous chapter, is the tax on gasoline. Gasoline is a comple-
mentary good to driving: An increase in the price of gasoline tends to reduce the
quantity of driving demanded. Therefore, a gasoline tax reduces road congestion.

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 237

year they use those roads, and the degrees of usage. A plate that allows goes by each point a certain amount is
degree to which pollution problems exist one to use their car at any time is much deducted from the driver’s debit card ac-
at the time they are using those roads. more expensive than a plate that only al- count depending upon weather, time of
Set prices at the levels that yield the op- lows one to use their car on weekends— day, and location.
timal amounts of usage. a time when congestion problems are
much less intense. Prices depend on Inside the car, the driver has a me-
Until Singapore decided to try, no supply and demand. ter that tells him how much he has been
city had ever had the nerve to use road charged and how much remains in his
pricing. Many ideas seem good theo- With this system Singapore ends debit card account. . . .
retically but have some hidden unex- up not wasting resources on infrastruc-
pected flaws. Singapore now has more ture projects that won’t cure congestion If one is an egalitarian and thinks
than a decade of experience. The sys- and pollution problems. The revenue col- that driving privileges should be distrib-
tem works! There are no unexpected lected from the system is used to lower uted equally (i.e., not based upon in-
flaws. Singapore is the only city on the other taxes. come) then each auto can be given a
face of the earth without congestion and specified debit card balance every year
auto-induced pollution problems. If that is so, why then did London re- and those who are willing to drive less
ject road pricing in its recent report on its can sell their unused balances to those
In Singapore a series of toll booths auto congestion and pollution problems? that want to drive more.
surrounds the central core of the city. To They feared that such a system would be
drive into the city, each car must pay a seen as too much interference from the Instead of giving the city extra tax
toll based on the roads being used, the heavy hand of government and that the revenue, this system gives those who
time of day when the driving will occur, public would not put up with a system are willing to live near work or to use
and that day’s pollution problem. Prices that allows the rich to drive more than public transit an income supplement.
are raised and lowered to get optimal the poor. Since poor people drive less than rich
usage. people, the system ends up being an
Both arguments ignore the fact that egalitarian redistribution of income from
In addition, Singapore calculates the we already have toll roads, but new tech- the rich to the poor.
maximum number of cars that can be nologies now also make it possible to
supported without pollution outside of avoid both problems. SOURCE: The Boston Globe, February 28, 1995, p. 40.
the central city and auctions off the
rights to license new cars each month. Using bar codes and debit cards, a
Different types of plates allow different city can install bar code readers at differ-
ent points around the city. As any car

A gasoline tax, however, is an imperfect solution to road congestion. The problem
is that the gasoline tax affects other decisions besides the amount of driving on
congested roads. For example, the gasoline tax discourages driving on noncon-
gested roads, even though there is no congestion externality for these roads.

F i s h , W h a l e s , a n d O t h e r W i l d l i f e Many species of animals are com-
mon resources. Fish and whales, for instance, have commercial value, and anyone
can go to the ocean and catch whatever is available. Each person has little incen-
tive to maintain the species for the next year. Just as excessive grazing can destroy
the Town Common, excessive fishing and whaling can destroy commercially valu-
able marine populations.

The ocean remains one of the least regulated common resources. Two prob-
lems prevent an easy solution. First, many countries have access to the oceans, so
any solution would require international cooperation among countries that hold

238 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

IN THE NEWS Congress to increase financing to the the overcrowding and deterioration in
Should Yellowstone National Park Service. But to an econo- our parks by cutting down on the number
Charge as Much as mist, there is a more obvious solution: of visitors or it would substantially raise
Disney World? Raise the entrance fees. fee revenues for the Park Service (as-
suming that legislation was passed that
NATIONAL PARKS, LIKE ROADS, CAN BE When the National Park Service would let the park system keep this
either public goods or common re- was established in 1916, the admission money). Greater revenue is the more
sources. If congestion is not a problem, price to Yellowstone for a family of five likely outcome. After spending several
a visit to a park is not rival. Yet once a arriving by car was $7.50; today, the hundred dollars to reach Yellowstone
park becomes popular, it suffers from price is only $10. Had the 1916 price Park, few people would be deterred by
the same problem as the Town Com- been adjusted for inflation, the compara- another $20.
mon. In this opinion column, an econo- ble 1995 fee would be $120 a day—
mist argues for the use of higher about what that family would pay for a The added revenues would bring
entrance fees to solve the problem. day of rides at Disney World, . . . or to more possibilities for outdoor recreation,
see a professional football game. both through expansion of the National
Save the Parks, Park Service and by encouraging private
and Make a Profit No wonder our national parks are entrepreneurs to carve out and operate
overrun and overtrampled. We are treat- their own parks, something they cannot
BY ALLEN R. SANDERSON ing our natural and historical treasures as do alongside a public competitor giving
It is common knowledge that our national free goods when they are not. We are ig- away his product well below cost.
parks are overcrowded, deteriorating, noring the costs of maintaining these
and broke. Some suggest that we ad- places and rationing by congestion— It is time to put our money where
dress these problems by requiring reser- when it gets too crowded, no more visi- our Patagonia outfits are: Either we value
vations, closing some areas, or asking tors are allowed—perhaps the most the Grand Canyon and Yosemite and
inefficient way to allocate scarce re- won’t complain about paying a realistic
sources. The price of a family’s day in a entrance fee, or we don’t really value
national park has not kept pace with them and shouldn’t wring our hands over
most other forms of recreation. Sys- their present sorry state and likely sorrier
temwide, it barely averages a dollar a fate.
person. . . .
SOURCE: The New York Times, September 30,
An increase in daily user fees to, 1995, p. 19.
say, $20 per person would either reduce

different values. Second, because the oceans are so vast, enforcing any agreement
is difficult. As a result, fishing rights have been a frequent source of international
tension among normally friendly countries.

Within the United States, various laws aim to protect fish and other wildlife.
For example, the government charges for fishing and hunting licenses, and it re-
stricts the lengths of the fishing and hunting seasons. Fishermen are often re-
quired to throw back small fish, and hunters can kill only a limited number of
animals. All these laws reduce the use of a common resource and help maintain
animal populations.

C A S E S T U D Y WHY THE COW IS NOT EXTINCT

Throughout history, many species of animals have been threatened with extinc-
tion. When Europeans first arrived in North America, more than 60 million

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 239

buffalo roamed the continent. Yet hunting the buffalo was so popular during the “WILL THE MARKET PROTECT ME?”
nineteenth century that by 1900 the animal’s population fell to about 400 before
the government stepped in to protect the species. In some African countries to-
day, the elephant faces a similar challenge, as poachers kill the animals for the
ivory in their tusks.

Yet not all animals with commercial value face this threat. The cow, for ex-
ample, is a valuable source of food, but no one worries that the cow will soon be
extinct. Indeed, the great demand for beef seems to ensure that the species will
continue to thrive.

Why is the commercial value of ivory a threat to the elephant, while the
commercial value of beef is a guardian of the cow? The reason is that elephants
are a common resource, whereas cows are a private good. Elephants roam
freely without any owners. Each poacher has a strong incentive to kill as many
elephants as he can find. Because poachers are numerous, each poacher has
only a slight incentive to preserve the elephant population. By contrast, cows
live on ranches that are privately owned. Each rancher takes great effort to
maintain the cow population on his ranch because he reaps the benefit of these
efforts.

Governments have tried to solve the elephant’s problem in two ways. Some
countries, such as Kenya, Tanzania, and Uganda, have made it illegal to kill ele-
phants and sell their ivory. Yet these laws have been hard to enforce, and ele-
phant populations have continued to dwindle. By contrast, other countries,
such as Botswana, Malawi, Namibia, and Zimbabwe, have made elephants a
private good by allowing people to kill elephants, but only those on their own
property. Landowners now have an incentive to preserve the species on their
own land, and as a result, elephant populations have started to rise. With pri-
vate ownership and the profit motive now on its side, the African elephant
might someday be as safe from extinction as the cow.

Q U I C K Q U I Z : Why do governments try to limit the use of common
resources?

CONCLUSION: THE IMPORTANCE
OF PROPERTY RIGHTS

In this chapter and the previous one, we have seen there are some “goods” that the
market does not provide adequately. Markets do not ensure that the air we breathe
is clean or that our country is defended from foreign aggressors. Instead, societies
rely on the government to protect the environment and to provide for the national
defense.

Although the problems we considered in these chapters arise in many different
markets, they share a common theme. In all cases, the market fails to allocate re-
sources efficiently because property rights are not well established. That is, some
item of value does not have an owner with the legal authority to control it. For ex-
ample, although no one doubts that the “good” of clean air or national defense is
valuable, no one has the right to attach a price to it and profit from its use. A factory

240 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

pollutes too much because no one charges the factory for the pollution it emits. The
market does not provide for national defense because no one can charge those who
are defended for the benefit they receive.

When the absence of property rights causes a market failure, the government
can potentially solve the problem. Sometimes, as in the sale of pollution permits,
the solution is for the government to help define property rights and thereby un-
leash market forces. Other times, as in the restriction on hunting seasons, the solu-
tion is for the government to regulate private behavior. Still other times, as in the
provision of national defense, the solution is for the government to supply a good
that the market fails to supply. In all cases, if the policy is well planned and well
run, it can make the allocation of resources more efficient and thus raise economic
well-being.

Summary

N Goods differ in whether they are excludable and of the public good, they have an incentive to free ride
whether they are rival. A good is excludable if it is when the good is provided privately. Therefore,
possible to prevent someone from using it. A good is governments provide public goods, making their
rival if one person’s enjoyment of the good prevents decision about the quantity based on cost-benefit
other people from enjoying the same unit of the good. analysis.
Markets work best for private goods, which are both
excludable and rival. Markets do not work as well for N Common resources are rival but not excludable.
other types of goods. Examples include common grazing land, clean air, and
congested roads. Because people are not charged for
N Public goods are neither rival nor excludable. their use of common resources, they tend to use them
Examples of public goods include fireworks displays, excessively. Therefore, governments try to limit the use
national defense, and the creation of fundamental of common resources.
knowledge. Because people are not charged for their use

excludability, p. 226 Key Concepts cost-benefit analysis, p. 231
rivalry, p. 226 Tragedy of the Commons, p. 234
private goods, p. 226 public goods, p. 226
common resources, p. 226
free rider, p. 228

Questions for Review

1. Explain what is meant by a good being “excludable.” 3. What is cost-benefit analysis of public goods? Why is it
Explain what is meant by a good being “rival.” Is a important? Why is it hard?
pizza excludable? Is it rival?
4. Define and give an example of a common resource.
2. Define and give an example of a public good. Can Without government intervention, will people use this
the private market provide this good on its own? good too much or too little? Why?
Explain.

CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 241

Problems and Applications

1. The text says that both public goods and common 5. Why is there litter along most highways but rarely in
resources involve externalities. people’s yards?
a. Are the externalities associated with public goods
generally positive or negative? Use examples in 6. The Washington, D.C., metro (subway) system charges
your answer. Is the free-market quantity of public higher fares during rush hours than during the rest of
goods generally greater or less than the efficient the day. Why might it do this?
quantity?
b. Are the externalities associated with common 7. Timber companies in the United States cut down many
resources generally positive or negative? Use trees on publicly owned land and many trees on
examples in your answer. Is the free-market use of privately owned land. Discuss the likely efficiency of
common resources generally greater or less than the logging on each type of land in the absence of
efficient use? government regulation. How do you think the
government should regulate logging on publicly owned
2. Think about the goods and services provided by your lands? Should similar regulations apply to privately
local government. owned land?
a. Using the classification in Figure 11-1, explain what
category each of the following goods falls into: 8. An Economist article (March 19, 1994) states: “In the past
N police protection decade, most of the rich world’s fisheries have been
N snow plowing exploited to the point of near-exhaustion.” The article
N education continues with an analysis of the problem and a
N rural roads discussion of possible private and government solutions:
N city streets a. “Do not blame fishermen for overfishing. They are
b. Why do you think the government provides items behaving rationally, as they have always done.” In
that are not public goods? what sense is “overfishing” rational for fishermen?
b. “A community, held together by ties of obligation
3. Charlie loves watching Teletubbies on his local public TV and mutual self-interest, can manage a common
station, but he never sends any money to support the resource on its own.” Explain how such
station during their fund-raising drives. management can work in principle, and what
a. What name do economists have for Charlie? obstacles it faces in the real world.
b. How can the government solve the problem caused c. “Until 1976 most world fish stocks were open to all
by people like Charlie? comers, making conservation almost impossible.
c. Can you think of ways the private market can solve Then an international agreement extended some
this problem? How does the existence of cable TV aspects of [national] jurisdiction from 12 to 200
alter the situation? miles offshore.” Using the concept of property
rights, discuss how this agreement reduces the
4. The text states that private firms will not undertake the scope of the problem.
efficient amount of basic scientific research. d. The article notes that many governments come to
a. Explain why this is so. In your answer, classify the aid of suffering fishermen in ways that
basic research in one of the categories shown in encourage increased fishing. How do such policies
Figure 11-1. encourage a vicious cycle of overfishing?
b. What sort of policy has the United States adopted e. “Only when fishermen believe they are assured a
in response to this problem? long-term and exclusive right to a fishery are they
c. It is often argued that this policy increases the likely to manage it in the same far-sighted way as
technological capability of American producers good farmers manage their land.” Defend this
relative to that of foreign firms. Is this argument statement.
consistent with your classification of basic research f. What other policies to reduce overfishing might be
in part (a)? (Hint: Can excludability apply to some considered?
potential beneficiaries of a public good and not
others?) 9. In a market economy, information about the quality or
function of goods and services is a valuable good in its

242 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

own right. How does the private market provide this they are more likely to pay for safety features on cars.
information? Can you think of any way in which the Do you think cost-benefit analysts should take this fact
government plays a role in providing this information? into account when evaluating public projects? Consider,
for instance, a rich town and a poor town, both of which
10. Do you think the Internet is a public good? Why or are considering the installation of a traffic light. Should
why not? the rich town use a higher dollar value for a human life
in making this decision? Why or why not?
11. High-income people are willing to pay more than lower-
income people to avoid the risk of death. For example,

IN THIS CHAPTER
YOU WILL . . .

Get an overview of
how the U.S.

government raises
and spends money

Examine the
efficiency costs

of taxes

THE DESIGN OF Learn alternative
ways to judge the
THE TAX SYSTEM
equity of a tax
Al “Scarface” Capone, the notorious 1920s gangster and crime boss, was never system
convicted for his many violent crimes. Yet eventually he did go to jail—for tax eva-
sion. He had neglected to heed Ben Franklin’s observation that “in this world See why studying
nothing is certain, but death and taxes.” tax incidence is

When Franklin made this claim in 1789, the average American paid less than crucial for
5 percent of his income in taxes, and that remained true for the next hundred evaluating tax
years. Over the course of the twentieth century, however, taxes have become ever
more important in the life of the typical person. Today, all taxes taken together— equity
including personal income taxes, corporate income taxes, payroll taxes, sales taxes,
and property taxes—use up about a third of the average American’s income. In Consider the
many European countries, the tax bite is even larger. tradeoff between

Taxes are inevitable because we as citizens expect the government to provide efficiency and
us with various goods and services. The previous two chapters have started to equity in the design

243 of a tax system

244 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

shed light on one of the Ten Principles of Economics from Chapter 1: The govern-
ment can sometimes improve market outcomes. When the government remedies
an externality (such as air pollution), provides a public good (such as national de-
fense), or regulates the use of a common resource (such as fish in a public lake), it
can raise economic well-being. Yet the benefits of government come with costs. For
the government to perform these and its many other functions, it needs to raise
revenue through taxation.

We began our study of taxation in earlier chapters, where we saw how a tax on
a good affects supply and demand for that good. In Chapter 6 we saw that a tax re-
duces the quantity sold in a market, and we examined how the burden of a tax is
shared by buyers and sellers, depending on the elasticities of supply and demand.
In Chapter 8 we examined how taxes affect economic well-being. We learned that
taxes cause deadweight losses: The reduction in consumer and producer surplus re-
sulting from a tax exceeds the revenue raised by the government.

In this chapter we build on these lessons to discuss the design of a tax system.
We begin with a financial overview of the U.S. government. When thinking about
the tax system, it is useful to know some basic facts about how the U.S. govern-
ment raises and spends money. We then consider the fundamental principles of
taxation. Most people agree that taxes should impose as small a cost on society as
possible and that the burden of taxes should be distributed fairly. That is, the tax
system should be both efficient and equitable. As we will see, however, stating these
goals is easier than achieving them.

A FINANCIAL OVERVIEW OF

THE U.S. GOVERNMENT

How much of the nation’s income does the government take as taxes? Figure 12-1
shows government revenue, including federal, state, and local governments, as a
percentage of total income for the U.S. economy. It shows that, over time, the gov-
ernment has taken a larger and larger share of total income. In 1902, the govern-
ment collected 7 percent of total income; in 1998, it collected 32 percent. In other
words, as the economy’s income has grown, the government has grown even
more.

Table 12-1 compares the tax burden for several major countries, as measured
by the central government’s tax revenue as a percentage of the nation’s total in-
come. The United States is in the middle of the pack. The U.S. tax burden is low
compared to many European countries, but it is high compared to many other na-
tions around the world. Poor countries, such as India and Pakistan, usually have
relatively low tax burdens. This fact is consistent with the evidence in Figure 12-1
of a growing tax burden over time: As a nation gets richer, the government typi-
cally takes a larger share of income in taxes.

The overall size of government tells only part of the story. Behind the total dol-
lar figures lie thousands of individual decisions about taxes and spending. To un-
derstand the government’s finances more fully, let’s look at how the total breaks
down into some broad categories.

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 245

Revenue as Total government
Percent of 35 State and local
GDP
30

25

20

15
Federal

10

5

0 1913 1922 1927 1932 1940 1950 1960 1970 1980 1990 1998
1902

GOVERNMENT REVENUE AS A PERCENTAGE OF GDP. This figure shows revenue of the Figure 12-1
federal government and of state and local governments as a percentage of gross domestic
product (GDP), which measures total income in the economy. It shows that the
government plays a large role in the U.S. economy and that its role has grown over time.

SOURCE: Historical Statistics of the United States; Economic Report of the President 1999; and author’s calculations.

France 38.8% Table 12-1
United Kingdom 33.7
Germany 29.4 CENTRAL GOVERNMENT TAX
Brazil 19.7 REVENUE AS A PERCENT OF GDP
United States 19.3
Canada 18.5
Russia 17.4
Pakistan 15.3
Indonesia 14.7
Mexico 12.8
India 10.3

SOURCE: World Development Report 1998/99.

246 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

THE FEDERAL GOVERNMENT

The U.S. federal government collects about two-thirds of the taxes in our economy.
It raises this money in a number of ways, and it finds even more ways to spend it.

R e c e i p t s Table 12-2 shows the receipts of the federal government in 1999. To-
tal receipts in this year were $1,806 billion, a number so large that it is hard to com-
prehend. To bring this astronomical number down to earth, we can divide it by the
size of the U.S. population, which was about 272 million in 1999. We then find that
the average American paid $6,639 to the federal government. A typical family of
four paid $26,556.

The largest source of revenue for the federal government is the individual in-
come tax. As April 15 approaches, almost every American family fills out a tax
form to determine how much income tax it owes the government. Each family is
required to report its income from all sources: wages from working, interest on
savings, dividends from corporations in which it owns shares, profits from any
small businesses it operates, and so on. The family’s tax liability (how much it
owes) is then based on its total income.

A family’s income tax liability is not simply proportional to its income. In-
stead, the law requires a more complicated calculation. Taxable income is com-
puted as total income minus an amount based on the number of dependents
(primarily children) and minus certain expenses that policymakers have deemed
“deductible” (such as mortgage interest payments and charitable giving). Then
the tax liability is calculated from taxable income using the schedule shown in
Table 12-3. This table presents the marginal tax rate—the tax rate applied to each ad-
ditional dollar of income. Because the marginal tax rate rises as income rises,
higher-income families pay a larger percentage of their income in taxes. (We dis-
cuss the concept of marginal tax rate more fully later in this chapter.)

Almost as important to the federal government as the individual income tax
are payroll taxes. A payroll tax is a tax on the wages that a firm pays its workers.
Table 12-2 calls this revenue social insurance taxes because the revenue from these
taxes is earmarked to pay for Social Security and Medicare. Social Security is an in-
come support program, designed primarily to maintain the living standards of the
elderly. Medicare is the government health program for the elderly. Table 12-2
shows that the average American paid $2,239 in social insurance taxes in 1999.

Table 12-2 TAX AMOUNT AMOUNT PERCENT
(IN BILLIONS) PER PERSON OF RECEIPTS
RECEIPTS OF THE FEDERAL
GOVERNMENT: 1999 $3,194 48%
2,239 34
Individual income taxes $ 869 10
Social insurance taxes 609 669 8
Corporate income taxes 182 537
Other 146 100%
$6,639
Total $1,806

SOURCE: Economic Report of the President, 1999, table B-80.

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 247

ON TAXABLE INCOME . . . THE TAX RATE IS . . . Table 12-3

Up to $25,750 15.0% THE FEDERAL INCOME TAX
From $25,750 to $62,450 28.0 RATES: 1999. This table shows
From $62,450 to $130,250 31.0 the marginal tax rates for an
From $130,250 to $283,150 36.0 unmarried taxpayer. The taxes
Over $283,150 39.6 owed by a taxpayer depend on
all the marginal tax rates up to
Next in magnitude, but much smaller than either individual income taxes or his or her income level. For
social insurance taxes, is the corporate income tax. A corporation is a business that example, a taxpayer with income
is set up as a separate legal entity. The government taxes each corporation based of $50,000 pays 15 percent of the
on its profit—the amount the corporation receives for the goods or services it sells first $25,750 of income, and then
minus the costs of producing those goods or services. Notice that corporate prof- 28 percent of the rest.
its are, in essence, taxed twice. They are taxed once by the corporate income tax
when the corporation earns the profits; they are taxed a second time by the indi-
vidual income tax when the corporation uses its profits to pay dividends to its
shareholders.

The last category, labeled “other” in Table 12-2, makes up 8 percent of receipts.
This category includes excise taxes, which are taxes on specific goods like gasoline,
cigarettes, and alcoholic beverages. It also includes various small items, such as es-
tate taxes and customs duties.

S p e n d i n g Table 12-4 shows the spending of the federal government in 1999.
Total spending was $1,727 billion, or $6,350 per person. This table also shows how
the federal government’s spending was divided among major categories.

The largest category in Table 12-4 is Social Security, which represents mostly
transfer payments to the elderly. (A transfer payment is a government payment not
made in exchange for a good or service.) This category made up 23 percent of
spending by the federal government in 1999 and is growing in importance. The
reason for its growth is that increases in life expectancy and decreases in birthrates
have caused the elderly population to grow more rapidly than the total popula-
tion. Most analysts expect this trend to continue for many years into the future.

The second largest category of spending is national defense. This includes
both the salaries of military personnel and the purchases of military equipment
such as guns, fighter jets, and warships. Spending on national defense fluctuates
over time as international tensions and the political climate change. Not surpris-
ingly, spending on national defense rises substantially during wars.

The third category is spending on income security, which includes transfer
payments to poor families. One program is Temporary Assistance for Needy Fam-
ilies (TANF), often simply called “welfare.” Another is the Food Stamp program,
which gives poor families vouchers that they can use to buy food. The federal gov-
ernment pays some of this money to state and local governments, which admin-
ister the programs under federal guidelines.

A bit smaller than spending on income security is net interest. When a person
borrows from a bank, the bank requires the borrower to pay interest for the loan.
The same is true when the government borrows from the public. The more in-
debted the government, the larger the amount it must spend in interest payments.

248 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Table 12-4 CATEGORY AMOUNT AMOUNT PERCENT
(IN BILLIONS) PER PERSON OF SPENDING
SPENDING OF THE FEDERAL
GOVERNMENT: 1999 $1,445 23%
1,018 16
Social Security $ 393 893 14
National defense 277 835 13
Income security 243 754 12
Net interest 227 526 8
Medicare 205 879 14
Health 143
Other 239 $6,350 100%

Total $1,727

SOURCE: Economic Report of the President, 1999, table B-80.

budget surplus Medicare, the next category in Table 12-4, is the government’s health plan for
an excess of government receipts the elderly. Spending in this category has risen substantially over time for two rea-
over government spending sons. First, the elderly population has grown more quickly than the overall popu-
lation. Second, the cost of health care has risen more rapidly than the cost of other
budget deficit goods and services. The rapid growth of this budget item is one reason that Presi-
an excess of government spending dent Clinton and others have proposed reforms of the health care system.
over government receipts
The next category is health spending other than Medicare. This includes
Medicaid, the federal health program for the poor. It also includes spending on
medical research, such as through the National Institutes of Health.

The “other” category in Table 12-4 consists of many less expensive functions of
government. It includes, for example, the federal court system, the space program,
and farm-support programs, as well as the salaries of Congress and the president.

You might have noticed that total receipts of the federal government shown in
Table 12-2 exceed total spending shown in Table 12-4 by $79 billion. Such an excess
of receipts over spending is called a budget surplus. When receipts fall short
of spending, the government is said to run a budget deficit. The government
finances the budget deficit by borrowing from the public. When the govern-
ment runs a budget surplus, it uses the excess receipts to reduce its outstanding
debts.

STATE AND LOCAL GOVERNMENT

State and local governments collect about 40 percent of all taxes paid. Let’s look at
how they obtain tax revenue and how they spend it.

R e c e i p t s Table 12-5 shows the receipts of U.S. state and local governments.
Total receipts for 1996 were $1,223 billion. Based on the 1996 population of about
265 million, this equals $4,615 per person. The table also shows how this total is
broken down into different kinds of taxes.

The two most important taxes for state and local governments are sales
taxes and property taxes. Sales taxes are levied as a percentage of the total amount
spent at retail stores. Every time a customer buys something, he or she pays the

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 249

TAX AMOUNT AMOUNT PERCENT OF Table 12-5
(IN BILLIONS) PER PERSON OF RECEIPTS
RECEIPTS OF STATE AND LOCAL
$ 940 20% GOVERNMENTS: 1996
789 17
Sales taxes $ 249 554 12
Property taxes 209 121
Individual income taxes 147 887 3
Corporate income taxes 32 19
From federal government 235 1,324 29
Other 351
$4,615 100%
Total $1,223

SOURCE: Economic Report of the President, 1999, table B-86.

storekeeper an extra amount that the storekeeper remits to the government. (Some
states exclude certain items that are considered necessities, such as food and cloth-
ing.) Property taxes are levied as a percentage of the estimated value of land and
structures, and are paid by property owners. Together these two taxes make up
more than a third of all receipts of state and local governments.

State and local governments also levy individual and corporate income taxes.
In many cases, state and local income taxes are similar to federal income taxes. In
other cases, they are quite different. For example, some states tax income from
wages less heavily than income earned in the form of interest and dividends. Some
states do not tax income at all.

State and local governments also receive substantial funds from the federal
government. To some extent, the federal government’s policy of sharing its rev-
enue with state governments redistributes funds from high-income states (who
pay more taxes) to low-income states (who receive more benefits). Often these
funds are tied to specific programs that the federal government wants to subsidize.

Finally, state and local governments receive much of their receipts from vari-
ous sources included in the “other” category in Table 12-5. These include fees for
fishing and hunting licenses, tolls from roads and bridges, and fares for public
buses and subways.

S p e n d i n g Table 12-6 shows the total spending of state and local governments
in 1996 and its breakdown among the major categories.

By far the biggest single expenditure for state and local governments is educa-
tion. Local governments pay for the public schools, which educate most students
from kindergarten to high school. State governments contribute to the support of
public universities. In 1996, education accounted for a third of the spending of
state and local governments.

The second largest category of spending is for public welfare, which includes
transfer payments to the poor. This category includes some federal programs that
are administered by state and local governments. The next category is highways,
which includes the building of new roads and the maintenance of existing ones.
The “other” category in Table 12-6 includes the many additional services provided
by state and local governments, such as libraries, police, garbage removal, fire pro-
tection, park maintenance, and snow removal.

250 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Table 12-6 CATEGORY AMOUNT AMOUNT PERCENT
(IN BILLIONS) PER PERSON OF SPENDING
SPENDING OF STATE AND LOCAL
GOVERNMENTS: 1996 $1,506 33%
743 17
Education $ 399 298 7
Public welfare 197 43
Highways 79 1,955
Other 518 100%
$4,502
Total $1,193

SOURCE: Economic Report of the President, 1999, table B-86.

Q U I C K Q U I Z : What are the two most important sources of tax revenue for
the federal government? N What are the two most important sources of tax
revenue for state and local governments?

TAXES AND EFFICIENCY

Now that we have seen how the U.S. government at various levels raises and
spends money, let’s consider how one might evaluate its tax policy. Obviously, the
aim of a tax system is to raise revenue for the government. But there are many
ways to raise any given amount of money. In designing a tax system, policymakers
have two objectives: efficiency and equity.

One tax system is more efficient than another if it raises the same amount of
revenue at a smaller cost to taxpayers. What are the costs of taxes to taxpayers?
The most obvious cost is the tax payment itself. This transfer of money from the
taxpayer to the government is an inevitable feature of any tax system. Yet taxes
also impose two other costs, which well-designed tax policy tries to avoid or, at
least, minimize:

N The deadweight losses that result when taxes distort the decisions that
people make

N The administrative burdens that taxpayers bear as they comply with the
tax laws

An efficient tax system is one that imposes small deadweight losses and small ad-
ministrative burdens.

DEADWEIGHT LOSSES

Taxes affect the decisions that people make. If the government taxes ice cream,
people eat less ice cream and more frozen yogurt. If the government taxes housing,
people live in smaller houses and spend more of their income on other things. If
the government taxes labor earnings, people work less and enjoy more leisure.

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 251

Because taxes distort incentives, they entail deadweight losses. As we first dis- “I was gonna fix the place up, but
cussed in Chapter 8, the deadweight loss of a tax is the reduction in economic well- if I did the city would just raise
being of taxpayers in excess of the amount of revenue raised by the government. my taxes!”
The deadweight loss is the inefficiency that a tax creates as people allocate re-
sources according to the tax incentive rather than the true costs and benefits of the
goods and services that they buy and sell.

To recall how taxes cause deadweight losses, consider an example. Suppose
that Joe places an $8 value on a pizza, and Jane places a $6 value on it. If there is no
tax on pizza, the price of pizza will reflect the cost of making it. Let’s suppose that
the price of pizza is $5, so both Joe and Jane choose to buy one. Both consumers get
some surplus of value over the amount paid. Joe gets consumer surplus of $3, and
Jane gets consumer surplus of $1. Total surplus is $4.

Now suppose that the government levies a $2 tax on pizza and the price of
pizza rises to $7. Joe still buys a pizza, but now he has consumer surplus of only
$1. Jane now decides not to buy a pizza because its price is higher than its value to
her. The government collects tax revenue of $2 on Joe’s pizza. Total consumer
surplus has fallen by $3 (from $4 to $1). Because total surplus has fallen by more
than the tax revenue, the tax has a deadweight loss. In this case, the deadweight
loss is $1.

Notice that the deadweight loss comes not from Joe, the person who pays the
tax, but from Jane, the person who doesn’t. The reduction of $2 in Joe’s surplus ex-
actly offsets the amount of revenue the government collects. The deadweight loss
arises because the tax causes Jane to alter her behavior. When the tax raises the
price of pizza, Jane is worse off, and yet there is no offsetting revenue to the gov-
ernment. This reduction in Jane’s welfare is the deadweight loss of the tax.

C A S E S T U D Y SHOULD INCOME OR CONSUMPTION BE TAXED?

When taxes induce people to change their behavior—such as inducing Jane to
buy less pizza—the taxes cause deadweight losses and make the allocation of
resources less efficient. As we have already seen, much government revenue
comes from the individual income tax. In a case study in Chapter 8, we dis-
cussed how this tax discourages people from working as hard as they otherwise
might. Another inefficiency caused by this tax is that it discourages people from
saving.

Consider a person 25 years old who is considering saving $100. If he puts
this money in a savings account that earns 8 percent and leaves it there, he
would have $2,172 when he retires at age 65. Yet if the government taxes one-
fourth of his interest income each year, the effective interest rate is only 6 per-
cent. After 40 years of earning 6 percent, the $100 grows to only $1,029, less than
half of what it would have been without taxation. Thus, because interest income
is taxed, saving is much less attractive.

Some economists advocate eliminating the current tax system’s disincentive
toward saving by changing the basis of taxation. Rather than taxing the amount
of income that people earn, the government could tax the amount that people
spend. Under this proposal, all income that is saved would not be taxed until the
saving is later spent. This alternative system, called a consumption tax, would
not distort people’s saving decisions.

This idea has some support from policymakers. Representative Bill Archer,
who in 1995 became chairman of the powerful House Ways and Means

252 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

Committee, has advocated replacing the current income tax system with a con-
sumption tax. Moreover, various provisions of the current tax code already
make the tax system a bit like a consumption tax. Taxpayers can put a limited
amount of their saving into special accounts—such as Individual Retirement
Accounts, Keogh plans, and 401(k) plans—that escape taxation until the money
is withdrawn at retirement. For people who do most of their saving through
these retirement accounts, their tax bill is, in effect, based on their consumption
rather than their income.

ADMINISTRATIVE BURDEN

If you ask the typical person on April 15 for an opinion about the tax system, you
might hear about the headache of filling out tax forms. The administrative burden
of any tax system is part of the inefficiency it creates. This burden includes not
only the time spent in early April filling out forms but also the time spent
throughout the year keeping records for tax purposes and the resources the gov-
ernment has to use to enforce the tax laws.

Many taxpayers—especially those in higher tax brackets—hire tax lawyers
and accountants to help them with their taxes. These experts in the complex tax
laws fill out the tax forms for their clients and help clients arrange their affairs in a
way that reduces the amount of taxes owed. This behavior is legal tax avoidance,
which is different from illegal tax evasion.

Critics of our tax system say that these advisers help their clients avoid taxes
by abusing some of the detailed provisions of the tax code, often dubbed “loop-
holes.” In some cases, loopholes are congressional mistakes: They arise from am-
biguities or omissions in the tax laws. More often, they arise because Congress has
chosen to give special treatment to specific types of behavior. For example, the U.S.
federal tax code gives preferential treatment to investors in municipal bonds be-
cause Congress wanted to make it easier for state and local governments to borrow
money. To some extent, this provision benefits states and localities; to some extent,
it benefits high-income taxpayers. Most loopholes are well known by those in Con-
gress who make tax policy, but what looks like a loophole to one taxpayer may
look like a justifiable tax deduction to another.

The resources devoted to complying with the tax laws are a type of dead-
weight loss. The government gets only the amount of taxes paid. By contrast, the
taxpayer loses not only this amount but also the time and money spent docu-
menting, computing, and avoiding taxes.

The administrative burden of the tax system could be reduced by simplifying
the tax laws. Yet simplification is often politically difficult. Most people are ready
to simplify the tax code by eliminating the loopholes that benefit others, yet few
are eager to give up the loopholes that they use. In the end, the complexity of the
tax law results from the political process as various taxpayers with their own spe-
cial interests lobby for their causes.

average tax rate MARGINAL TAX RATES VERSUS AVERAGE TAX RATES
total taxes paid divided by total
income When discussing the efficiency and equity of income taxes, economists distinguish
between two notions of the tax rate: the average and the marginal. The average tax
marginal tax rate rate is total taxes paid divided by total income. The marginal tax rate is the extra
the extra taxes paid on an additional taxes paid on an additional dollar of income.
dollar of income

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 253

IN THE NEWS including tips, W-4s for withholding, and businesses in 1990, compared with the
Small Business and I-9 citizenship forms. $15.9 billion they spent producing the
the Tax Laws basic corporate forms, the 1120 and
All this doesn’t count the ubiquitous 1120S.
PEOPLE RUNNING SMALL BUSINESSES ARE state and local levies that in Dante’s
most aware of the administrative bur- case are complicated because liquor- “What this means is that the cor-
den of the tax system. Small firms must license considerations mean each of its porate income tax is a very inefficient
comply with many of the same laws as ten restaurants must be separately revenue source for the federal govern-
large ones. Yet, because of their size, incorporated. ment,” Mr. Hall said. . . .
compliance can take a much larger frac-
tion of their revenue. According to one “There is a lot to watch, a lot to Although complaints about the tax
study, the administrative burden is ten worry about,” Mr. Kamin grumbled. . . . system are often aimed at the I.R.S.,
times larger for small firms than for businesspeople and policymakers gener-
large firms. The following article de- This is the real-world side of Ameri- ally contend that the real fault lies with
scribes some of these costs. can taxation, the federal chunk of which Congress and its frequent, often well-
is a system based on a monumentally intentioned tinkering with the law. The
Obeying the Tax Laws: complex set of laws and regulations that resulting complexity is taking an ever-
Small Business’s Burden was just one-third its current size when mounting toll on respect for the system,
Jimmy Carter called it “a disgrace to the and thereby undermines the willingness
BY ROBERT D. HERSHEY, JR. human race.” of even the best-intentioned taxpayer to
In the grand scheme of a federal system figure out what he or she should pay. . . .
that collects more than $1 trillion a year, The code is administered by a
Dante’s Restaurant, Inc., a modest 115,000-member Internal Revenue Ser- Since 1981, Washington has put
three-city chain in Pennsylvania, counts vice army with a $7 billion budget. But ten major tax laws on the books, gener-
for little. that amount is dwarfed by what taxpay- ating changes whose cumulative effect
ers themselves spend on meeting their “is pretty staggering for the small busi-
But to people like Lewis Kamin, obligations. nessperson,” said Edward Koos, a tax-
Dante’s controller, the Internal Revenue policy lawyer at the Small Business
Code is a year-round headache. There Estimates of what it costs American Administration.
are the biweekly remittances of Social businesses to comply with federal tax
Security and withheld income tax, quar- law reach into the hundreds of billions of Harold Apolinsky of the Small Busi-
terly reports of payroll and unem- dollars a year. . . . Big companies are un- ness Council says 9,371 code sections
ployment taxes, quarterly estimated der almost continuous audit. The 1992 have been amended since 1981, a total
corporate income taxes, and, of course, return for one giant company ran to that owes much to the lobbying and
the maintaining of various records, 21,000 pages and 30 volumes. But campaign contributions of the powerful.
the heaviest burden by far falls on small “It appears to me that small business
business. just has no clout,” Mr. Apolinsky said.
“Big business tolerates it,” he added,
In fact, according to Arthur P. Hall, a referring to the resulting complexity.
senior fellow at The Tax Foundation, the “Small business really can’t.”
local hardware store, delicatessen, or
gas station with assets of less than $1 SOURCE: The New York Times, January 30, 1994,
million—a category embracing 90 per- Business Section, p. 4.
cent of the nation’s corporations—
spends $390 for each $100 it sends to
Washington. Put another way, the gov-
ernment got just $4.1 billion from these

For example, suppose that the government taxes 20 percent of the first $50,000
of income and 50 percent of all income above $50,000. Under this tax, a person who
makes $60,000 pays a tax of $15,000. (The tax equals 0.20 ϫ $50,000 plus 0.50 ϫ
$10,000.) For this person, the average tax rate is $15,000/$60,000, or 25 percent. But

254 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

the marginal tax rate is 50 percent because the amount of the tax would rise by
$0.50 if the taxpayer earned an additional dollar.

The marginal and average tax rates each contain a useful piece of information.
If we are trying to gauge the sacrifice made by a taxpayer, the average tax rate is
more appropriate because it measures the fraction of income paid in taxes. By con-
trast, if we are trying to gauge how much the tax system distorts incentives, the
marginal tax rate is more meaningful. One of the Ten Principles of Economics in
Chapter 1 is that rational people think at the margin. A corollary to this principle
is that the marginal tax rate measures how much the tax system discourages peo-
ple from working hard. It is the marginal tax rate, therefore, that determines the
deadweight loss of an income tax.

lump-sum tax LUMP-SUM TAXES
a tax that is the same amount for
every person Suppose the government imposes a tax of $4,000 on everyone. That is, everyone
owes the same amount, regardless of earnings or any actions that a person might
take. Such a tax is called a lump-sum tax.

A lump-sum tax shows clearly the difference between average and marginal
tax rates. For a taxpayer with income of $20,000, the average tax rate of a $4,000
lump-sum tax is 20 percent; for a taxpayer with income of $40,000, the average tax
rate is 10 percent. For both taxpayers, the marginal tax rate is zero because an ad-
ditional dollar of income would not change the amount of tax owed.

A lump-sum tax is the most efficient tax possible. Because a person’s decisions
do not alter the amount owed, the tax does not distort incentives and, therefore,
does not cause deadweight losses. Because everyone can easily compute the
amount owed and because there is no benefit to hiring tax lawyers and accoun-
tants, the lump-sum tax imposes a minimal administrative burden on taxpayers.

If lump-sum taxes are so efficient, why do we rarely observe them in the real
world? The reason is that efficiency is only one goal of the tax system. A lump-sum
tax would take the same amount from the poor and the rich, an outcome most peo-
ple would view as unfair. To understand the tax systems that we observe, we must
therefore consider the other major goal of tax policy: equity.

Q U I C K Q U I Z : What is meant by the efficiency of a tax system? N What can
make a tax system inefficient?

TAXES AND EQUITY

Ever since American colonists dumped imported tea into Boston harbor to protest
high British taxes, tax policy has generated some of the most heated debates in
American politics. The heat is rarely fueled by questions of efficiency. Instead, it
arises from disagreements over how the tax burden should be distributed. Senator
Russell Long once mimicked the public debate with this ditty:

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 255

Don’t tax you.
Don’t tax me.
Tax that fella behind the tree.

Of course, if we are to rely on the government to provide some of the goods and
services we want, taxes must fall on someone. In this section we consider the eq-
uity of a tax system. How should the burden of taxes be divided among the popu-
lation? How do we evaluate whether a tax system is fair? Everyone agrees that the
tax system should be equitable, but there is much disagreement about what equity
means and how the equity of a tax system can be judged.

THE BENEFITS PRINCIPLE

One principle of taxation, called the benefits principle, states that people should benefits principle
pay taxes based on the benefits they receive from government services. This prin- the idea that people should pay taxes
ciple tries to make public goods similar to private goods. It seems fair that a per- based on the benefits they receive
son who often goes to the movies pays more in total for movie tickets than a from government services
person who rarely goes. Similarly, a person who gets great benefit from a public
good should pay more for it than a person who gets little benefit.

The gasoline tax, for instance, is sometimes justified using the benefits princi-
ple. In some states, revenues from the gasoline tax are used to build and maintain
roads. Because those who buy gasoline are the same people who use the roads, the
gasoline tax might be viewed as a fair way to pay for this government service.

The benefits principle can also be used to argue that wealthy citizens should
pay higher taxes than poorer ones. Why? Simply because the wealthy benefit more
from public services. Consider, for example, the benefits of police protection from
theft. Citizens with much to protect get greater benefit from police than do those
with less to protect. Therefore, according to the benefits principle, the wealthy
should contribute more than the poor to the cost of maintaining the police force.
The same argument can be used for many other public services, such as fire pro-
tection, national defense, and the court system.

It is even possible to use the benefits principle to argue for antipoverty pro-
grams funded by taxes on the wealthy. As we discussed in Chapter 11, people pre-
fer living in a society without poverty, suggesting that antipoverty programs are a
public good. If the wealthy place a greater dollar value on this public good than
members of the middle class do, perhaps just because the wealthy have more to
spend, then, according to the benefits principle, they should be taxed more heav-
ily to pay for these programs.

T H E A B I L I T Y - T O - PAY P R I N C I P L E

Another way to evaluate the equity of a tax system is called the ability-to-pay ability-to-pay principle
principle, which states that taxes should be levied on a person according to how the idea that taxes should be levied
well that person can shoulder the burden. This principle is sometimes justified by on a person according to how well
the claim that all citizens should make an “equal sacrifice” to support the govern- that person can shoulder the burden
ment. The magnitude of a person’s sacrifice, however, depends not only on the
size of his tax payment but also on his income and other circumstances. A $1,000
tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by
a rich one.

256 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

PROPORTIONAL TAX REGRESSIVE TAX PROGRESSIVE TAX

INCOME AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
OF TAX OF INCOME OF TAX OF INCOME OF TAX OF INCOME
$ 50,000
100,000 $12,500 25% $15,000 30% $10,000 20%
200,000 25,000 25 25,000 25 25,000 25
50,000 25 40,000 20 60,000 30

Table 12-7 THREE TAX SYSTEMS

vertical equity The ability-to-pay principle leads to two corollary notions of equity: vertical
the idea that taxpayers with a greater equity and horizontal equity. Vertical equity states that taxpayers with a greater
ability to pay taxes should pay larger ability to pay taxes should contribute a larger amount. Horizontal equity states
amounts that taxpayers with similar abilities to pay should contribute the same amount. Al-
though these notions of equity are widely accepted, applying them to evaluate a
horizontal equity tax system is rarely straightforward.
the idea that taxpayers with similar
abilities to pay taxes should pay the Ve r t i c a l E q u i t y If taxes are based on ability to pay, then richer taxpayers
same amount should pay more than poorer taxpayers. But how much more should the rich pay?
Much of the debate over tax policy concerns this question.
proportional tax
a tax for which high-income and Consider the three tax systems in Table 12-7. In each case, taxpayers with
low-income taxpayers pay the same higher incomes pay more. Yet the systems differ in how quickly taxes rise with in-
fraction of income come. The first system is called proportional because all taxpayers pay the same
fraction of income. The second system is called regressive because high-income
regressive tax taxpayers pay a smaller fraction of their income, even though they pay a larger
a tax for which high-income amount. The third system is called progressive because high-income taxpayers
taxpayers pay a smaller fraction of pay a larger fraction of their income.
their income than do low-income
taxpayers Which of these three tax systems is most fair? There is no obvious answer, and
economic theory does not offer any help in trying to find one. Equity, like beauty,
progressive tax is in the eye of the beholder.
a tax for which high-income
taxpayers pay a larger fraction of C A S E S T U D Y HOW THE TAX BURDEN IS DISTRIBUTED
their income than do low-income
taxpayers Much debate over tax policy concerns whether the wealthy pay their fair share.
There is no objective way to make this judgment. In evaluating the issue for
yourself, however, it is useful to know how much families of different incomes
pay under the current tax system.

Table 12-8 shows how all federal taxes are distributed among income
classes. To construct this table, families are ranked according to their income
and placed into five groups of equal size, called quintiles. The second column of
the table shows the average income of each group. The poorest one-fifth of fam-
ilies had average income of $9,880; the richest one-fifth had average income of
$174,000.

The next column of the table shows total taxes as a percent of income. As
you can see, the U.S. federal tax system is progressive. The poorest families paid

CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 257

QUINTILE AVERAGE TAXES AS A PERCENT OF PERCENT OF Table 12-8
INCOME PERCENT OF INCOME ALL INCOME ALL TAXES THE BURDEN OF FEDERAL TAXES

Lowest $ 9,880 8.0% 4% 1%
Second 26,100 15.6 11 7
Middle 44,300 20.3 16 13
Fourth 68,200 23.1 20 19
Highest 174,000 29.1 49 59

SOURCE: Congressional Budget Office; estimates are for 1999.

8.0 percent of their incomes in taxes, and the richest paid 29.1 percent of their
incomes.

The fourth and fifth columns compare the distribution of income and the
distribution of taxes among these five groups. The poorest group earns 4 per-
cent of all income and pays 1 percent of all taxes. The richest group earns 49 per-
cent of all income and pays 59 percent of all taxes.

This table on taxes is a good starting point for understanding the burden of
government, but the picture it offers is incomplete. Although it includes all the
taxes that flow from households to the federal government, it fails to include the
transfer payments, such as Social Security and welfare, that flow from the fed-
eral government back to households. Studies that include both taxes and trans-
fers show more progressivity. The richest group of families still pays about
one-quarter of its income to the government, even after transfers are subtracted.
By contrast, poor families typically receive more in transfers than they pay in
taxes. The average tax rate of the poorest quintile, rather than being 8.0 percent
as in the table, is a negative 30 percent. In other words, their income is about 30
percent higher than it would be without government taxes and transfers. The
lesson is clear: To understand fully the progressivity of government policies,
one must take account of both what people pay and what they receive.

H o r i z o n t a l E q u i t y If taxes are based on ability to pay, then similar tax-
payers should pay similar amounts of taxes. But what determines if two taxpayers
are similar? Families differ in many ways. To evaluate whether a tax code is hori-
zontally equitable, one must determine which differences are relevant for a fam-
ily’s ability to pay and which differences are not.

Suppose the Smith and Jones families each have income of $50,000. The Smiths
have no children, but Mr. Smith has an illness that causes medical expenses of
$20,000. The Joneses are in good health, but they have four children. Two of the
Jones children are in college, generating tuition bills of $30,000. Would it be fair for
these two families to pay the same tax because they have the same income? Would
it be more fair to give the Smiths a tax break to help them offset their high medical
expenses? Would it be more fair to give the Joneses a tax break to help them with
their tuition expenses?

There are no easy answers to these questions. In practice, the U.S. income
tax is filled with special provisions that alter a family’s tax based on its specific
circumstances.

258 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR

C A S E S T U D Y HORIZONTAL EQUITY AND THE MARRIAGE TAX

The treatment of marriage provides an important example of how difficult it is
to achieve horizontal equity in practice. Consider two couples who are exactly
the same except that one couple is married and the other couple is not. A pecu-
liar feature of the U.S. income tax code is that these two couples pay different
taxes. The reason that marriage affects the tax liability of a couple is that the tax
law treats a married couple as a single taxpayer. When a man and woman get
married, they stop paying taxes as individuals and start paying taxes as a fam-
ily. If the man and woman have similar incomes, their total tax liability rises
when they get married.

To see how this “marriage tax” works, consider the following example of a
progressive income tax. Suppose that the government taxes 25 percent of all in-
come above $10,000. Income below $10,000 is excluded from taxation. Let’s see
how this system treats two different couples.

Consider first Sam and Sally. Sam is a struggling poet and earns no income,
whereas Sally is a lawyer and earns $100,000 a year. Before getting married, Sam
pays no tax. Sally pays 25 percent of $90,000 ($100,000 minus the $10,000 exclu-
sion), which is $22,500. After getting married, their tax bill is the same. In this
case, the income tax neither encourages nor discourages marriage.

Now consider John and Joan, two college professors each earning $50,000 a
year. Before getting married, they each pay a tax of $10,000 (25 percent of
$40,000), or a total of $20,000. After getting married, they have a total income of
$100,000, and so they owe a tax of 25 percent of $90,000, or $22,500. Thus, when
John and Joan get married, their tax bill rises by $2,500. This increase is called
the marriage tax.

“And do you promise to love, honor, and cherish each other, and to pay the
United States government more in taxes as a married couple than you
would have paid if you had just continued living together?”