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Chapter 1
Microeconomics
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Foundations of Economics
The Basic Economic Problem
An economy is how a society decides what to produce, how to
Scarcity is the basic economic problem; society’s unlimited
produce and for whom to produce.
wants exceed the limited resources available to satisfy those
wants.
Assumptions
1. Ceteris paribus - Means that all other variables remain Choice and Opportunity Cost
constant and unchanging A choice is a decision to use limited resources in a specific way.
2. Rational economic decision-making - Means that decision-
makers behave in their best self-interest and try to get more Opportunity cost is the foregone benefit of the next best
rather than less alternative when a choice is made to use resources for one
purpose rather than another.
Factors of Production
Factors of production are the inputs used to produce all goods Resource Allocation
and services that people need and want. There are four types Resource allocation refers to assigning particular resources to
of resources: the production of particular goods and services.
1. Land refers to all natural resources available for the
production of goods and services (e.g. agricultural land, oil, Reallocation of resources refers to changing the allocation of
and gas) resources, and hence the combination and quantities of goods
2. Labor refers to any human effort (physical or mental) used and services produced.
in the production of goods and services
3. Capital refers to man-made resources used in the Misallocation of resources is an incorrect allocation of
production of goods and services (e.g. machinery and resources (i.e. overallocation/underallocation), causing
computers) allocative inefficiency.
4. Entrepreneurship is the organising and risk-taking factor of
production. Entrepreneurs organise the other three factors
of production to produce goods and services.

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The Production Possibilities Curve (PPC) An economy that is operating on the PPC is productively
The PPC is a curve showing all possible combinations of the efficient because it would be impossible to produce more of
maximum amounts of two goods that can be produced by an one good without decreasing production of the other good,
economy, given fixed resources and technology, when there is (i.e no more outputs can be achieved from the given inputs).
full employment of resources and productive efficiency.
The PPC model shows the following:
1. Due to scarcity, it is impossible to produce outside the PPC
2. Due to scarcity, it is necessary to make choices
3. Choices give rise to opportunity cost

Competitive Markets
A market is any arrangement that allows buyers and sellers to
come together and make an exchange.

A competitive market consists of many buyers and sellers

acting independently so that no one seller has the ability to
control the price of the product sold. Instead, the price of the
product is determined by the market forces of demand and
supply.

Demand
Demand refers to the various quantities of a good or service
that consumers are willing and able to buy at different possible
prices during a particular time period, ceteris paribus.

Productive efficiency means producing goods and services at The law of demand states that there is a negative causal
the lowest possible cost, without wasting productive resources. relationship between the price and quantity of a good
demanded and is illustrated by the downward-sloping demand
curve.

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A movement along the demand curve can only be caused by a A movement along the supply curve can only be caused by a
change in the price of a good. The change in quantity caused change in the price of a good. The change in quantity caused
by a change in price is called a change in quantity demanded. by a change in price is called a change in quantity supplied.

A shift of the demand curve can only be caused by non-price A shift of the supply curve can only be caused by non-price
determinants of demand. A change in quantity caused by a determinants of supply. A change in quantity caused by a non-
non-price determinant of demand is called a change in price determinant of supply is called a change in supply, as it
demand, as it shifts the demand curve. shifts the supply curve.

Non-Price Determinants of Demand Non-Price Determinants of Supply

1. Changes in tastes and preferences 1. Changes in costs of production
2. Demographic (population) changes 2. Changes in the number of firms in the market
3. Changes in income 3. Technological changes
Inferior = Demand for the good decreases as income increases 4. Changes in expectations
Normal = Demand for the good increases as income increases 5. Changes in an indirect tax
4. Changes in price of related goods An indirect tax is a tax on spending to buy goods and services
Substitutes are goods that satisfy a similar need paid indirectly to the government
Complements are goods that are used together 6. Changes in a subsidy
A subsidy is a government payment in order to lower costs and
Supply prices, and increase supply
Supply refers to the various quantities of a good or service that 7. Changes in price of related goods
firms are willing and able to produce and sell at different Joint supply = When two or more goods are derived from a
possible prices during a particular time period, ceteris paribus. single product, e.g. butter and skim milk, it is not possible to
produce more of one good without producing more of the
The law of supply states that there is a positive causal other
relationship between the price and quantity of a good Competitive supply = When two goods use the same
demanded and is illustrated by the upward-sloping supply resources, e.g. onions and potatoes that grow on the same
curve. agricultural land, it is not possible to produce more of one
good without producing less of the other

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Market Equilibrium A shortage (excess demand) occurs when the quantity of a

Market equilibrium occurs where quantity demanded is equal good demanded is greater than the quantity of a good
to quantity supplied, and there is no tendency for the price or supplied.
quantity to change.
A surplus (excess supply) occurs when the quantity of a good
Equilibrium price is the price determined in a market when supplied is greater than the quantity of a good demanded.
quantity demanded is equal to quantity supplied. Equilibrium
quantity is the quantity that is bought and sold when quantity Market equilibrium can only change if there is a shift in the
demanded is equal to quantity supplied. demand or supply curve, caused by any of their non-price
determinants.
A market disequilibrium occurs when excess demand or excess
supply exists. Market disequilibrium exists at any price other The Role of the Price Mechanism
than equilibrium price. The price mechanism is the signaling and incentive functions of
price that reallocate resources when prices change due to a
change in demand or supply.

Prices as signals is the ability of prices, and changes in prices,

to communicate information to consumers and producers
about changing market conditions.

Prices as incentives is the ability of prices, and changes in

prices, to motivate consumers and producers to act in their
best self-interest.

When there is a shortage, higher prices signal to producers

and consumers that there is a shortage. A shortage is an
incentive to producers to produce more and an incentive to
consumers to consume less.

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Market Efficiency Marginal benefit (MB) is the additional benefit received from
Consumer surplus is the benefit received by consumers who consuming another unit of a good or service.
buy a good at a lower price than the price they are willing to Marginal cost (MC) is the additional cost of producing one
pay. more unit of output.

Producer surplus is the benefit received by producers who sell Allocative efficiency is the best allocation of resources from
a good at a higher price than the price they are willing to society’s point of view. Allocative efficiency is achieved at
receive. competitive market equilibrium, where social surplus is
maximized (i.e. MB = MC).
Social surplus is the sum of consumer and producer surplus.
Social surplus is maximized at market equilibrium, where Elasticities
marginal benefit equals marginal cost. Price Elasticity of Demand (PED)
PED is a measure of the responsiveness of the quantity of a
good demanded to changes in price. PED is given by
percentage change in quantity demanded divided by
percentage change in price.

Determinants of PED
1. The number and closeness of substitutes
2. The degree of necessity
3. The proportion of income spent on the good
4. Length of time of purchasing decision
0 < PED < 1 Price inelastic demand

1 < PED < ∞ Price elastic demand

PED = 1 Unit price elastic demand

PED = 0 Perfectly price inelastic demand

PED = ∞ Perfectly price elastic demand

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If PED is elastic (>1), a percentage increase in price causes a PED for Manufactured Products
larger percentage decrease in quantity demanded, so total Manufactured products have a high PED due to:
revenue decreases. - high number of close substitutes
- low degree of necessity
If PED is inelastic (<1), a percentage increase in price causes a Therefore, demand for manufactured products is price elastic.
smaller percentage decrease in quantity demanded, so total
revenue decreases. PED and the Government
The government might want to know the PED for a good or
If PED is unit elastic (PED=1), a percentage increase in price service to evaluate the effectiveness of an indirect tax.
causes a corresponding percentage decrease in quantity
demanded, so total revenue is unchanged. If demand for a good/service is price elastic, a tax will be
effective in reducing quantity demanded. If demand for a
Role of PED in Firm’s Decision-Making good/service is price inelastic, tax will be effective in
If the firm wants to increase total revenue (TR), it must know the generating government revenue.
PED for its product because changes in price have varying
effects on Qd and therefore TR. TR is maximized at the price
where demand is unit elastic (=1).

Total revenue (TR) is the amount of money received by firms

from the sale of goods and services. TR = Price x Quantity

PED for Primary Commodities

Primary commodities are goods arising from the use of the
factor of production ‘land’, such as agricultural products, oil and
minerals from the earth.

Primary commodities have a low PED due to:

- low number of close substitutes
- high degree of necessity
Therefore, demand for primary commodities is price inelastic.
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Cross Price Elasticity of Demand (XED) XED and the Government

XED is a measure of the responsiveness of demand for one A government may want to know the XED value for two goods
good to a change in the price of another. XED is given by the because if a large excise tax is placed on one good is likely to
percentage change in quantity demanded of good X divided lead to a large decrease in the demand of it's complement, the
by the percentage change in price of good Y. government may impose a tax on the good to reduce
consumption of the complement.
Negative XED = Complementary goods
Positive XED = Substitute goods Income Elasticity of Demand (YED)
YED is a measure of the responsiveness of demand for a good
Larger negative XED = Greater complementarity, e.g. tennis to changes in income. YED is given by the percentage change
balls and rackets have a larger XED than milk and cereal in quantity demanded divided by the percentage change in
Larger positive XED = Greater substitutability, e.g. apples and income.
pears have a larger XED than apples and ice cream
Income is the money received by individuals and firms for
Implications of XED for Firms supplying the factors of production: land, labour, capital and
When a firm produces two goods that are substitutes, entrepreneurship.
the firm may use the XED value of the two goods to determine
how demand for one good is likely to increase following a Negative YED = Inferior goods
decrease in the price of the other good. Positive YED = Normal goods

For competing firms producing substitutes, knowledge of XED An inferior good is a good for which demand decreases as
allows the firms to predict changes in demand and total consumer income rises, e.g. bikes.
revenue due to changes in price of competitors' goods. A normal good is a good for which demand increases as
consumer income rises, e.g. cars.
Firms that produce goods that are close substitutes may
merge. YED < 1 = Necessities (inelastic)
YED > 1 = Luxuries (elastic)
Firms that produce goods that are strong complements
may collaborate to eliminate competition between them.

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Implications of YED for Firms Price Elasticity of Supply (PES)

Producers may want to know the YED of their product because: PES is a measure of the responsiveness of quantity of a good
1. YED indicates how much demand will change as consumer supplied to changes in its price. PES is given by the percentage
income changes change in quantity supplied divided by the percentage change
2. If an economy is growing, producers may decide to in price.
reallocate resources to production of goods with high YED
0 < PES < 1 Price inelastic supply
YED for Primary Commodities and Manufactured Products
Primary products usually have a YED < 1 (inelastic), so as 1 < PES < ∞ Price elastic supply
consumer income rises due to economic growth, demand for PES = 1 Unit price elastic supply
primary products grows more slowly than the growth in
PES = 0 Perfectly price inelastic supply
income.
PES = ∞ Perfectly price elastic supply
Conversely, manufactured products usually have a YED > 1
(elastic), so that as consumer income grows, demand for Determinants of PES
manufactured products grows faster than income. 1. Mobility of factors of production
2. Unused (i.e. spare) capacity
Therefore prices of manufactured goods are likely to increase 3. Ability to store stocks
by more than the prices of primary commodities. 4. Amount of time firms have to adjust their resources and the
quantity supplied in response to changes in price
Many services have even higher YEDs, so demand for these
services grows faster than the demand for primary and PES for Primary Commodities
manufactured products. Primary goods have low PES (inelastic) as it takes time
for primary commodities to be produced in response to a price
Therefore, over time, the contribution of primary sector change (e.g. trees need time to grow).
output to the economy's GDP shrinks, while the contribution of PES for Manufactured Goods
secondary sector output grows. With continued growth, the Production of manufactured goods is much quicker than
contribution of the service sector grows at the expense of both primary commodities, so PES of manufactured is larger (more
primary and secondary sectors. elastic).

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GRAPHICAL SUMMARY of Elasticities


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Government Intervention Ad Valorem Tax

Government intervention is government interference in An ad valorem tax is a fixed percentage of the price of the good
markets to preventing the free functioning of the markets. or service, so the amount of tax increases as the price of the
Government intervention is intended to achieve specific good or service increases. 
economic and/or social objectives. Government intervention
includes indirect taxes, subsidies, price controls and direct
provision of goods and services. 

Indirect (Excise) Taxes

Indirect taxes are taxes on spending to buy particular goods
and services, paid indirectly to the government by the seller.

Reasons for the Imposition of Indirect Taxes

1. Raise government tax revenue
2. Discourage consumption (such as cigarettes)
3. Redistribute income
4. Improve the allocation of resources when there are
negative externalities

Specific Tax
A specific tax is a tax Consequences of Indirect Taxes on Stakeholders
calculated as a fixed - Consumers are worse off; higher prices paid and lower
amount per unit of quantity received
the good or service - Producers are worse off; lower prices received and lower
sold (e.g. €5 per quantity sold
packet of cigarettes).  - Workers are worse off; lower output = fewer workers needed
- Government is better off; higher tax revenue
- Society as a whole is worse off; underallocation of resources
and allocative inefficiency as shown by the welfare loss

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Subsidies Consequences of Subsidies on Stakeholders

A subsidy is an amount of money paid by the government to - Consumers are better off; lower prices paid and larger
firms to lower firms’ productions costs and thus enable firms to quantity received
supply goods at lower prices. A subsidy is usually a fixed - Producers are better off; higher prices received and larger
amount per unit of output (i.e. a specific subsidy).  quantity sold
- Workers are better off; higher output = more workers
Reasons for the Use of Subsidies needed
1. Protection of producers - Government is worse off; burden on government budget
2. More affordable goods for low-income consumers and opportunity cost
3. Incentive to the production of beneficial goods - Foreign producers are worse off; lower prices of exports and
4. Encouragement of exports higher quantity of exports, more competition
5. Improve the allocation of resources when there are positive - Society as a whole is worse off; overallocation of resources
externalities and allocative inefficiency

Price Controls
Price controls are legal minimum or maximum prices set by the
government so that prices are unable to adjust to their
equilibrium level determined by the market forces of demand
and supply.

Price Ceilings
A price ceiling is a legal maximum price for a particular product
set below the equilibrium price by the government. A price
ceiling results in the shortage of the product.

Price ceilings are used to make necessities more affordable,

e.g. rent and food.

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Price Floors
A price floor is a legal minimum price for a particular product
set above the equilibrium price by the government. A price
floor results in a surplus of the product.

Price floors are used to provide income support for farmers

and used to protect low-skilled, low-wage workers by offering
higher wage.

Consequences of Price Ceilings for the Economy

- Shortages
- Non-price rationing
- Underground markets
- Underallocation of resources

Consequences of Price Ceilings on Stakeholders

- Consumers partly gain and partly lose; those who are able to
purchase a product at the lower price gain, while those who
cannot purchase the product lose
Consequences of Price Floors for the Economy
- Producers are worse off; lower prices received and lower
- Surpluses
quantity sold
- Government measures to dispose of surpluses
- Workers are worse off; less output = less workers needed
- Productive inefficiency
- Government is not affected, although they may gain
- Overallocation of resources
popularity
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Consequences of Price Floors on Stakeholders Consequences of Minimum Wage for the Economy
- Consumers are worse off; higher prices paid and lower - Illegal workers
quantity received - Misallocation of resources in the labour market
- Producers are better off; higher prices received - Misallocation of resources in product markets (unskilled
- Workers are better off; more output = more workers needed labour = higher production costs)
- Government is worse off; disposing of surpluses
Consequences of Minimum Wage on Stakeholders
- Workers who receive the minimum wage benefit, whereas
Minimum Wage workers who are left unemployed are worse off
Minimum wage is a minimum price of labour usually set by the - Firms who are hiring unskilled workers may be worse off
government to protect low-skilled workers and ensure that they - Consumers are worse off due to a leftward shift of the supply
can achieve a minimum standard of consumption. curve and higher prices caused by productive inefficiency

Market Failure
Market failure occurs when the price mechanism fails to
allocate resources efficiently.

Marginal Costs and Benefits

Marginal private costs (MPC) refer to the costs to producers of
producing one more unit of a good.

Marginal social costs (MPS) refer to the costs to society of

producing one more unit of a good.

Marginal private benefits (MPB) refer to the benefits to

consumers from consuming one more unit of a good.

Marginal social benefits (MSB) refer to the benefits to society

from consuming one more unit of a good.

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Allocative efficiency is achieved when MSC = MSB External benefits are created by consumers.
MSB > MPB at Qm
Types of Market Failure Qm < Qopt which means that there is an underallocation of
An externality is an action by either a producer or consumer resources as shown by the welfare loss. Welfare loss involves a
which affects third parties, but is not accounted for in the reduction in social benefits due to the misallocation of
market price. resources.

Positive Externalities Correcting Positive Externalities of Consumption

A positive externality is a type of externality where the side- Legislation can be used to promote greater consumption of
effects on third parties are positive or beneficial. goods with positive consumption externalities, such as making
primary school compulsory for all children.
MPB shifts towards MSB curve to Qopt
Positive Externality of Consumption
A positive externality of consumption is a positive externality
caused by consumption activities, leading to a situation where Advertising can be used to persuade consumers to buy more
marginal social benefits are greater than marginal private goods with positive externalities of consumption, e.g. by
benefits (MSB>MPB). Examples include education and health encouraging parents to vaccine their children.
care. MPB curve shifts towards MSB curve to Qopt

Direct government provision can be used to promote the

consumption of goods with positive consumption externalities,
e.g. education and health care.
MPB curve shifts towards MSB curve to Qopt

Subsidies can be used to promote the consumption of goods

with positive consumption externalities by supplying the
socially optimum quantity Qopt at a lower price Pc.

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Evaluation of Legislation, Advertising and Government

Provision to Correct Positive Consumption Externalities
+ Simple to implement
+ Effective in increasing demand for the good causing the
positive externality
- Advertising and government provision are unlikely to
increase demand to the required level (MPB to MSB) and so
can only partially eliminate the externality
- Advertising and direct government provision have
opportunity costs as funds are diverted from other
objectives
- Difficulties of compliance and enforcement of legislation
(e.g. children in low-income countries may be sent to work
rather than school)
- Increase in demand leads to higher prices, possibly making
goods unaffordable to low-income groups and must
therefore be used together with subsidies or direct
government provision

Evaluation of Subsidies and Direct Government Provision

to Correct Positive Consumption Externalities
+ Highly effective in increasing the quantity supplied and
consumed
+ Key factors in making goods with positive consumption
externalities affordable to all
- Difficulties in measuring the value of external benefits

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- Difficulties in determining the amount of government External benefits are created by producers.
provision and/or subsidy that will equal the external benefits
- MSC < MPC at Qm
Opportunity costs of government spending on direct
Qm < Qopt meaning that the market underallocates resources
government provision and/or subsidy
as shown by the welfare loss. Welfare loss involves a reduction
- Difficulties faced by the government in making choices on in social benefits due to the misallocation of resources.
what to support and by how much

Positive Externality of Production

A positive externality of production is a positive externality Correcting Positive Externalities of Production
caused by production activities, leading to a situation where Direct government provision, such as in the case of R&D for
marginal social costs are less than marginal private costs the development of new technologies, can be used to correct
(MSC<MPC). Examples include R&D and provision of training. positive externalities of production. The MPC curve therefore
shifts towards the MSC curve, reaching the socially optimum
quantity Qopt and price Popt.

Provision of subsidies to private firms and universities

involved with R&D can also be used to correct positive
externalities of production. The MPC curve therefore shifts
towards the MSC curve, reaching the socially optimum quantity
Qopt and price Popt.

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- The governments selection process on what activities to

support is often subject to political pressures with choices
made on political grounds rather than economic grounds

Negative Externalities
A negative externality is a type of externality where the side-
effects on third parties are negative or harmful.

Negative Externality of Consumption

A negative externality of consumption is a negative externality
caused by consumption activities, leading to a situation where
marginal social benefits are less than marginal private benefits
(MSB<MPB). Examples include smoking cigarettes and use of
cars using gasoline.

Evaluation of Subsidies and Direct Government Provision

to Correct Positive Production Externalities
+ Highly effective in increasing the supply of goods with
positive externalities of production
- Difficulties in measuring the value of external benefits
- Difficulties in determining the amount of government
provision and/or subsidy that will equal the external benefits
- Use of government funds that have opportunity costs
- Difficulties of deciding which particular activities to support
and by how much

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External costs are created by consumers. Market-based policies can be used to change price incentives
of firms and consumers. An indirect tax on the good causing
MPB > MSB at Qm the negative externality causes the supply curve to shift from
Qm > Qopt meaning that the market overallocates resources MPC to MPC+tax, causing price to increase and quantity to fall.
as shown by the welfare loss. Welfare loss involves a reduction
in social benefits due to the misallocation of resources. If the tax is directly equal to the value of the external cost,
MPC+tax will intersect MPB at the level of Qopt, hence
Correcting Negative Externalities of Consumption eliminating the externality and welfare loss, and charging a
Command approaches include legislation, advertising and higher price, Pc.
educating the public in order to influence the behavior and
reduce demand so that the MPB curve shifts towards the MSB
curve, leading to Qopt and Popt.
- Legislation such as no smoking in public places
- Negative advertisements to change the customer’s
preferences, e.g. informing consumers about the dangers of
smoking
- Education for consumers, e.g. encouraging the use of public
transportation to reduce carbon emissions

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Evaluation of Legislation, Advertising and Education to - Difficulties in determining the size of the tax that will be
Correct Negative Consumption Externalities equal to external costs
+ Simple to implement compared to market-based policies - If the demand for the good being taxed is inelastic, the tax is
+ Effective in reducing demand for a particular product unlikely to result in a large decrease in quantity produced
+ Sometimes more appropriate than market-based solutions and consumed, and hence is not effective in eliminating the
(e.g. banning smoking in public places) negative externality
- Unlikely to reduce demand to the required level (MPB to - Indirect taxes are regressive and hence affect low-income
MSB) and so can only partially eliminate the externality earners more strongly, sometimes causing them to switch to
- Advertising and direct government provision have lower quality substitutes that are more harmful
opportunity costs as funds are diverted from other
objectives Negative Externality of Production
- Difficulties of compliance and enforcement of legislation A negative externally of production is a negative externality
(e.g. children in low-income countries may be sent to work caused by production activities, leading to a situation where
rather than school) marginal social costs are greater than marginal private costs
(MSC>MPC).

Evaluation of Market-Based Policies to Correct Negative

Consumption Externalities
+ Can internalise the negative externality = make consumers
pay for the external cost
+ Can be more efficient than government regulations because
they are based on the price mechanism, using price
incentives for consumers to respond to
+ If the good being taxed has inelastic demand, the tax will
result in high tax revenues that can be used to finance
government advertising and education programs
- Difficulties in measuring the value of external costs

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External costs are created by producers. Market-based policies can change the price incentives faced
by firms;
MSC > MPC at Qm
Qm > Qopt meaning that the market overallocates resources An indirect tax on output causes the supply to shift from MPC
as shown by the welfare loss. Welfare loss involves a reduction towards MSC, causing price to increase and quantity to fall.
in social benefits due to the misallocation of resources.
An indirect tax on emissions can also cause the supply curve
Correcting Negative Externalities of Production to shift from MPC towards MSC, leading to Qopt and Popt. An
Command approaches include legislation, regulations and indirect tax on emissions creates an incentive for firms to switch
advertising that aim at reducing the negative externality of to clean technologies to avoid paying the tax, e.g the carbon
production. Examples include imposing restrictions on tax.
emissions, limiting the amount of output produced, banning
dangerous substances and restrictions on logging.

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Tradable permits can be used to reduce negative externalities Evaluation of Command Approaches to Correct Negative
of production. A tradable permit is a determined maximum Production Externalities
amount of a pollutant that a firm can emit and is distributed to + Simpler to implement compared to market-based policies
firms by the government. Tradable permits can be bought and
+ Effective in at least partially achieving their objectives
sold in a market, which offers incentives for firms to switch to
+ More appropriate than market solutions in some cases
clean technologies to make additional revenue from the
remaining permits. An example is the European Union Trading - Involve costs of monitoring and enforcement
system covering power and heat generation, etc. - Are inefficient because they do not differentiate between
firms with higher or lower costs of reducing environmental
harm
- Do not provide incentives to switch to clean technologies
- Face incomplete knowledge on extent of damage done by
various pollutants and therefore on how much to restrict
activities

Evaluation of Market-Based Policies to Correct Negative

Production Externalities
+ Can internalise the externality = make producers pay for the
external cost
+ Greater efficiency in reducing pollution than government
regulations
+ The most efficient policies to reduce emissions at a lower
overall cost to society are taxes on emissions and tradable
Tradable permits increase production costs, leading to a permits
decrease in supply from S=MPC to MSC1. The incentive to + Taxes on emissions and tradable permits incentivize the
reduce pollution reduces the external costs by increasing the switch to clean technologies
optimum quantity of output and causes MSC1 to shift towards
MSC2.
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+ A switch to clean technology causes MSC to shift to the right, Public Good
reducing the size of the externality and welfare loss 1. Non-rivalrous - Consumption by one person does not
- For both taxes and tradable permits, there are difficulties in reduce consumption for someone else, e.g. lighthouses
identifying the most harmful pollutants and the value of the 2. Non-excludable - Not possible to exclude someone from
external cost using the good
- For tradable permits, there are difficulties in determining the
correct amount of permissible pollution Quasi-Public Good
- For tradable permits, there are difficulties in determining 1. Non-rivalrous
how to distribute the permits among firms 2. Excludable, e.g. Museums that require the purchase of a
- There are difficulties in ensuring compliance and ticket
enforcement
Free-Rider Problem
Carbon Taxes vs. Tradable Permits Public goods illustrate the free-rider problem, occurring when
Carbon taxes are often preferred to tradable permits because people enjoy the use of a good without paying for it (can arise
they make energy prices more predictable, they can be used from non-excludability).
for all fossil fuel emissions and they are easier to design and
implement. Tradable permits may be preferred because Public goods are a type of market failure because of the free-
carbon taxes cannot set a limit to the permissible amount of rider problem. The market fails to allocate resources to their
carbon and because carbon taxes are regressive. production. Public goods are directly provided by the
government, and therefore financed out of tax revenues and
Private and Public Goods made available to the public free of charge.
Private Good
1. Rivalrous - Consumption by one person reduces its
consumption for someone else, e.g. clothes
2. Excludable - Possible to exclude someone from the good

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