Externalities and Public Goods: Scope and Importance of Institutions

Abstract

The essay explores the fundamental differences in resource allocation conditions between private goods and public goods, defining the latter as an extreme case of externalities. Through four main theoretical results, the author explains how efficient allocation in private goods occurs when the marginal cost of production equals the consumers' marginal valuation. To address externalities, the text contrasts the solutions proposed by Pigou (direct taxes and subsidies) with the Coase Theorem (private negotiation without state intervention). The document concludes that in the presence of high transaction costs or significant information asymmetries, public intervention and the design of institutions are crucial to correct market inefficiencies, prevent the underprovision of public goods, and mitigate opportunistic behaviors such as the free rider.