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Week 14 · Lecture outline

Week 14 — Lecture Outline · Externalities, Public Goods & Market Failure

Principles of Microeconomics · ECON 1 Fall 2026 · Prof. Kessler Fictional sample

Course: Principles of Microeconomics (ECON 1) · Silver Oak University (fictional sample) · Prof. Kessler
Objective 8 — market failure: externalities, Pigouvian taxes, the Coase theorem, public goods & common resources · SLO A & B
Meeting pattern: two 75-min sessions (≈150 min). Segment minutes below total ~150 — scale to your room.

The deck (E), the tutorial (C), and the workshop (P) all teach from this outline. Every number here is pre-computed and independently verified (see the verified box in §4).

Week at a glance
Big question When do markets get the quantity wrong — and what can be done about it?
By week's end students can (1) define externality and identify over- vs. underproduction; (2) find the market equilibrium (MB = MPC) and social optimum (MB = MSC); (3) compute the Pigouvian tax; (4) state the Coase theorem + conditions; (5) classify goods on the rival/excludable grid; (6) explain the free-rider problem and the tragedy of the commons.
Key vocabulary externality, negative externality, positive externality, marginal private cost (MPC), marginal social cost (MSC), marginal external cost, social optimum, Pigouvian tax, Coase theorem, public good, non-rival, non-excludable, free-rider problem, common resource, tragedy of the commons
Materials whiteboard; Desmos; approved chatbot
Timing note 8 segments ≈ 150 min across two sessions. Trim Segment 7 (AI-critique) to 10 min if needed.

Segment 1 — HOOK: "Who's paying for the smoke?" (10 min)

Open with a concrete image: a factory produces cheap widgets and dumps smoke into the neighborhood — the buyers and sellers split the surplus, but the neighbors cough. Ask: "Who's paying for the smoke, and why doesn't the market fix it?" The answer is the week's engine: markets only account for costs and benefits that flow to the buyer and seller. Costs (or benefits) that fall on third parties are externalities, and they drive a wedge between the private and social value of production.

Preview the week: two directions (negative → overproduction; positive → underproduction), two fixes (Pigouvian tax/subsidy and the Coase theorem), and then public goods and common resources as the hardest cases.

Segment 2 — PLAIN-LANGUAGE IDEA: what is an externality? (15 min)

Define precisely:

An externality occurs when the production or consumption of a good affects a third party who is not part of the transaction and whose costs or benefits are not reflected in the market price.

Two types:
- Negative externality (cost spill): a cost imposed on third parties. The market ignores it → overproduction. Examples: factory pollution, cigarette smoke, traffic congestion, loud music at midnight.
- Positive externality (benefit spill): a benefit conferred on third parties. The market ignores it → underproduction. Examples: vaccination (herd immunity), education (a more informed citizenry), basic research, beekeeping next to an orchard.

Key vocabulary to build:
- Marginal private cost (MPC): what the producer actually pays per unit — the supply curve in the ordinary diagram.
- Marginal social cost (MSC): MPC plus the marginal external cost. MSC = MPC + external cost.
- Social optimum: where MB = MSC (not MB = MPC). The market misses this when external costs exist.

Segment 3 — WORKED EXAMPLE #1: the negative-externality diagram (30 min)

Set it up on the board and do every step out loud. Draw the three lines.

The market: MB (demand) and MPC (private supply):
- MB = 40 − Q (consumers' willingness to pay)
- MPC = 4 + 0.5Q (producers' private cost)

Step 1 — Market equilibrium (MB = MPC):

40 − Q = 4 + 0.5Q
36 = 1.5Q
Q = 24, P = 16

Step 2 — Add the external cost:
- Marginal external cost = $6 per unit (e.g., pollution damage borne by neighbors)
- MSC = MPC + 6 = (4 + 0.5Q) + 6 = 10 + 0.5Q

Step 3 — Social optimum (MB = MSC):

40 − Q = 10 + 0.5Q
30 = 1.5Q
Q_soc = 20, P_soc = 20 (read P off MB: 40 − 20 = 20)

✅ VERIFIED NUMBERS (pre-computed; do not recompute live)

  • Market: Q = 24, P = 16 (MB = MPC; ignores external cost)
  • Social optimum: Q = 20, P = 20 (MB = MSC)
  • Overproduction: market produces 4 extra units (24 − 20 = 4)
  • Pigouvian tax = $6 (= marginal external cost; shifts MPC up by 6 → new MPC becomes MSC)
  • DWL = ½ × (24 − 20) × 6 = ½ × 4 × 6 = 12 (the triangle between Q_soc and Q_mkt, bounded above by MSC and below by MB)

Step 4 — Reading the graph out loud:
- The gap between MPC and MSC = the external cost borne by third parties.
- At Q = 24, MSC (10 + 0.5·24 = 22) > MB (40 − 24 = 16): the last 4 units cost society more than they're worth. Society loses that DWL.
- At Q = 20, MB = MSC = 20: every unit produced is worth what it costs all parties. Efficient.

Step 5 — The Pigouvian tax:
- Tax = $6/unit on producers. It shifts MPC up by exactly the external cost: new supply = (4 + 6) + 0.5Q = 10 + 0.5Q = MSC.
- After the tax: the market equilibrium IS the social optimum. Overproduction eliminated. DWL gone.

Trap to kill: "Tax the consumer, not the producer — then the supply curve doesn't shift." Incidence is independent of who legally pays (recall Week 7). The physical tax on sellers raises effective costs and shifts supply; you can also frame it as a tax on buyers that lowers effective demand — both reach the same efficient Q. The key is the size = the external cost.

Segment 4 — POSITIVE EXTERNALITIES & SUBSIDIES (15 min)

Flip the logic:
- When a positive externality exists: MSB > MPB (the social benefit exceeds what the private buyer values). The market settles at MPB = MPC → too little is produced.
- Fix: a subsidy equal to the marginal external benefit, which shifts the demand curve up (or the supply curve down) to the social optimum.

Quick example (no algebra required here — just the diagram in words): Vaccination against a contagious disease. A student's private benefit = protection for herself. But each vaccinated student also reduces transmission — conferring a benefit on everyone around her. The private MB understates the social MB; the market under-provides vaccination relative to the social optimum. A per-dose subsidy raises the effective demand to the social level.

The direction table (drill this):

Externality type Which curve is wrong? Market failure Correction
Negative (MSC > MPC) MPC too low Overproduction Pigouvian tax
Positive (MSB > MPB) MPB too low Underproduction Subsidy

Segment 5 — THE COASE THEOREM (12 min)

The Coase theorem: if property rights are clearly defined and transaction costs are low, private parties can bargain to an efficient outcome regardless of who holds the property right — without any government intervention.

Example: a factory's smoke damages a nearby rancher's cattle. If the factory has the right to pollute, the rancher can pay the factory to cut emissions (up to the rancher's damage). If the rancher has the right to clean air, the factory can pay the rancher to allow some pollution (up to the factory's profit from it). Either way, they negotiate to the efficient level of emissions.

Why it matters and where it breaks down:
- It says that externality problems are fundamentally about missing or unclear property rights.
- But it only works when transaction costs are low and the number of affected parties is small. When pollution affects millions of people (e.g., greenhouse gases), the Coase theorem offers limited guidance — coordination costs explode, free-rider problems dominate, and government intervention (a tax, a cap) is typically the more practical fix.

Segment 6 — PUBLIC GOODS & COMMON RESOURCES (20 min)

The rival/excludable grid classifies every good:

Excludable Non-excludable
Rival Private good (food, clothing) Common resource (fisheries, groundwater)
Non-rival Club good (Netflix, toll road with spare capacity) Public good (national defense, broadcast TV)

Public goods (non-rival + non-excludable):
- Non-rival: one person's use does not reduce the amount available to others.
- Non-excludable: once provided, you cannot prevent anyone from using it.
- Result: the free-rider problem — individuals have an incentive to not pay, hoping others will provide the good. Markets systematically underprovide public goods (even if they're worth more than their cost in total). Government provision or subsidization is the standard response.
- Examples: national defense, clean air (as a recipient), basic scientific research, the justice system, broadcast radio & TV.

Common resources (rival + non-excludable):
- Rival: one person's use reduces what's available to others.
- Non-excludable: you cannot easily prevent anyone from using it.
- Result: the tragedy of the commons — each individual overuses the resource because they capture the full benefit but share the cost of depletion. Outcome: the resource is depleted beyond the socially optimal level.
- Examples: ocean fisheries, open-access groundwater, uncongested-but-degradable forest.
- Solutions: government regulation (fishing quotas, permits), privatization (assign property rights), or community governance (local norms + enforcement).

Trap to kill: "Public goods are government-provided goods." No — public goods are defined by non-rivalry + non-excludability (economic properties), not by who provides them. A national park has both government and club-good features; broadcast TV is a public good provided privately; education is often government-provided but is excludable (and at least somewhat rival). Read the characteristics, not the provider.

Segment 7 — AI-CRITIQUE MOMENT (12 min)

Live demo: ask the chatbot to solve the Week 14 externality problem.
Prompt: "In a market where MB = 40 − Q, MPC = 4 + 0.5Q, and the marginal external cost is $6, find the market equilibrium, the social optimum, and the Pigouvian tax."

Audit together — classic chatbot errors:
1. Setting MB = MSC but computing MSC incorrectly (e.g., adding 6 to MB instead of MPC, or subtracting).
2. Getting Q = 24 and Q_soc = 20 correct but misidentifying which is market and which is social.
3. Saying the correction is a subsidy instead of a tax (the most common direction error on positive vs. negative externalities).
4. Computing DWL as ½ × 24 × 6 (using market Q as the base, not the difference ΔQ = 4).
5. For public goods: calling "provided by the government" the definition instead of "non-rival + non-excludable."

Right answers to verify: Q = 24, P = 16 (market); Q = 20, P = 20 (social); Pigouvian tax = $6; DWL = ½ × 4 × 6 = 12; public good = non-rival + non-excludable. The habit all term: the tool drafts, you judge.

Segment 8 — CALLBACKS, TEASE & THE WEEK'S WORK (6 min)

  • Callback to Week 7 (taxes): the Pigouvian tax is a tax, but its goal is efficiency restoration rather than revenue — it shifts the supply curve up by exactly the external cost to close the gap between MPC and MSC. The DWL framework from Week 7 applies directly: the DWL of the externality is the triangle we measured.
  • Callback to Week 6 (surplus): the DWL of the externality represents surplus that is lost — real costs imposed on third parties that no one compensates for.
  • Tease next week: Week 15 asks: what about when the information in a market is wrong? Adverse selection (lemons), moral hazard, and behavioral biases — the last category of market failure.
  • The week's work: Lecture Tutorial (externalities → public goods → Coase), Practice (6 reps), Quiz 14 (closed to AI), Discussion 14 (carbon pricing — evenhanded), Assignment 14, and Workshop 14 (find the social optimum and DWL of the externality in Desmos).

Instructor FAQ — common stumbles

  • "Which way is tax vs. subsidy?" Negative externality → market overproduces → tax shifts supply up (raises costs) to close the MSC–MPC gap. Positive externality → market underproduces → subsidy shifts supply down (lowers cost) or demand up to reach MSB = MSC. The direction of the correction always opposes the direction of the market failure.
  • "Where does the DWL triangle sit?" It is the triangle bounded by Q_soc on the left, Q_mkt on the right, MB below, and MSC above. Base = Q_mkt − Q_soc = 4; height = MSC − MB at Q_mkt = (10 + 0.5·24) − (40 − 24) = 22 − 16 = 6. Area = ½ × 4 × 6 = 12.
  • "Why does the Pigouvian tax size equal the external cost?" Because at the social optimum, the externality is exactly the gap between MPC and MSC. Taxing by that amount internalizes the externality — producers now bear the full social cost.
  • "Public goods vs. common resources?" Both are non-excludable. The difference is rivalry: a public good is non-rival (defense protects everyone without being "used up"); a common resource is rival (one person's fish catch reduces what's left for others). Free-rider → underprovision (public goods); overuse → depletion (common resources).
  • "Does the Coase theorem say government intervention is unnecessary?" Only under the (often unrealistic) conditions of well-defined property rights AND low transaction costs. For large-scale externalities like greenhouse gas emissions, transaction costs are prohibitive, making government intervention (carbon tax, cap-and-trade) the more practical route.

~ Prof. Kessler's edition · Fall 2026 · built with thecoursemaker.com