Market Failures: Public Goods and Externalities

05

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Market Failures

• Market fails to produce the right

amount of the product

• Resources may be:

•Over-allocated

•Under-allocated

LO1 5-2

Demand-Side Failures

• Impossible to charge consumers

what they are willing to pay for the

product

•Some can enjoy benefits without

paying

LO1 5-3

Supply-Side Failures

•Occurs when a firm does not pay

the full cost of producing its output

•External costs of producing the

good are not reflected in supply

LO1 5-4

Efficiently Functioning Markets

• Demand curve must reflect the

consumers full willingness to pay

• Supply curve must reflect all the costs

of production

LO1 5-5

Consumer Surplus

• Difference between what a consumer

is willing to pay for a good and what

the consumer actually pays

• Extra benefit from paying less than

the maximum price

LO2 5-6

Consumer Surplus

LO2

Consumer Surplus

(1)

Person

(2)

Maximum

Price Willing

to Pay

(3)

Actual Price

(Equilibrium

Price)

(4)

Consumer

Surplus

Bob $13 $8 $5 (=$13-$8)

Barb 12 8 4 (=$12-$8)

Bill 11 8 3 (=$11-$8)

Bart 10 8 2 (=$10-$8)

Brent 9 8 1 (= $9-$8)

Betty 8 8 0 (= $8-$8)

5-7

Consumer Surplus

LO2 LO2

Pri

ce

(p

er

ba

g)

Quantity (bags)

D

Q1

P1

Consumer

Surplus

Equilibrium

Price

5-8

Producer Surplus

• Difference between the actual price a

producer receives and the minimum

price they would accept

• Extra benefit from receiving a higher

price

LO2 5-9

Producer Surplus

LO2

Producer Surplus

(1)

Person

(2)

Minimum

Acceptable

Price

(3)

Actual Price

(Equilibrium

Price)

(4)

Producer

Surplus

Carlos $3 $8 $5 (=$8-$3)

Courtney 4 8 4 (=$8-$4)

Chuck 5 8 3 (=$8-$5)

Cindy 6 8 2 (=$8-$6)

Craig 7 8 1 (=$8-$7)

Chad 8 8 0 (=$8-$8)

5-10

Producer Surplus

LO2 LO2

Pri

ce (

per

bag

)

Quantity (bags)

S

Q1

P1

Equilibrium

price

Producer

surplus

5-11

Efficiency Revisited

LO2

Pri

ce

(p

er

ba

g)

Quantity (bags)

S

Q1

P1

D

Consumer

surplus

Producer

surplus

5-12

Quantity (bags)

Pri

ce (

per

bag

)

Efficiency Losses

LO2

c

S

Q1 Q2

D

b

d

a

e

Efficiency loss

from underproduction

5-13

Efficiency Losses

LO2

c

S

Q1 Q3

D

b

f

a

g

Quantity (bags)

Pri

ce

(p

er

ba

g)

Efficiency loss

from overproduction

5-14

Private Goods

• Produced in the market by firms

• Offered for sale

• Characteristics

•Rivalry

•Excludability

LO3 5-15

Public Goods

• Provided by government

•Offered for free

• Characteristics

•Nonrivalry

•Nonexcludability

• Free-rider problem

LO3 5-16

Demand for Public Goods

LO3

Demand for a Public Good, Two Individuals

(1)

Quantity

of Public

Good

(2)

Adams’ Willingness

to Pay (Price)

(3)

Benson’s

Willingness to

Pay (Price)

(4)

Collective

Willingness

to Pay (Price)

1 $4 + $5 = $9

2 3 + 4 = 7

3 2 + 3 = 5

4 1 + 2 = 3

5 0 + 1 = 1

5-17

Demand for Public Goods

LO3

$6

5

4

3

2

1

0

P

Q 1 2 3 4 5

$6

5

4

3

2

1 0

P

Q 1 2 3 4 5 Adams

Benson

D1

D2

Adams’ Demand

Benson’s Demand

$3 for 2 Items

$4 for 2 Items

$1 for 4 Items

$2 for 4 Items

$9

7

5

3

1

0

P

Q 1 2 3 4 5 Collective Demand and Supply

DC

S Collective Demand

$7 for 2 Items

$3 for 4 Items

Connect the Dots

Optimal Quantity

Collective Willingness

To Pay

5-18

Cost-Benefit Analysis

• Cost

•Resources diverted from private

good production

•Private goods that will not be

produced

• Benefit

• The extra satisfaction from the

output of more public goods

LO3 5-19

Cost-Benefit Analysis

LO3

Cost-Benefit Analysis for a National Highway Construction Project

(in Billions)

(1)

Plan

(2)

Total Cost

of Project

(3)

Marginal

Cost

(4)

Total

Benefit

(5)

Marginal

Benefit

(6)

Net Benefit

(4) – (2)

No new construction $0 $0 $0

A: Widen existing highways 4 $4 5 $5 1

B: New 2-lane highways 10 6 13 8 3

C: New 4-lane highways 18 8 22 10 5

D: New 6-lane highways 28 10 26 3 -2

5-20

Quasi-Public Goods

• Could be provided through the market

system

• Because of positive externalities the

government provides them

• Examples: education, streets,

libraries

LO3 5-21

The Reallocation Process

• Government

• Taxes individuals and businesses

• Takes the money and spends on

production of public goods

LO3 5-22

Externalities

• A cost or benefit accruing to a third

party external to the transaction

• Positive externalities

• Too little is produced

•Demand-side market failures

• Negative externalities

• Too much is produced

•Supply side market failures

LO4 5-23

Externalities

LO4

(a)

Negative externalities (b)

Positive externalities

0

D

S

St

Overallocation

Negative

Externalities St

Underallocation

Positive

Externalities

Qo Qo Qe Qe

P P

0 Q Q

D

Dt

a

c

z

x

b y

5-24

Government Intervention

• Correct negative externalities

•Direct controls

•Specific taxes

• Correct positive externalities

•Subsidies and government

provision

LO4 5-25

Government Intervention

LO4

(a)

Negative Externalities

D

S

St

Overallocation

Negative

Externalities

Qo Qe

P

0 Q

a

c

b

(b)

Correct externality with

tax

D

S

St

Qo Qe

P

0 Q

a

T

5-26

Government Intervention

LO4

(a)

Positive Externalities

0

St

Underallocation

Positive

Externalities

Qo Qe

D

Dt

z

x

y

(b)

Correcting via a subsidy

to consumers

0

St

Qo Qe

D

Dt

(c)

Correcting via a subsidy

to producers

0

S't

Qo Qe

D

Subsidy

St

Subsidy

U

5-27

Government Intervention

LO4

Methods for Dealing with Externalities

Problem

Resource Allocation

Outcome Ways to Correct

Negative externalities

(spillover costs)

Overproduction of output

and therefore

overallocation of

resources

1. Private bargaining

2. Liability rules and lawsuits

3. Tax on producers

4. Direct controls

5. Market for externality rights

Positive externalities

(spillover benefits)

Underproduction of output

and therefore

underallocation of

resources

1. Private bargaining

2. Subsidy to consumers

3. Subsidy to producers

4. Government provision

5-28

Society’s Optimal Amounts

LO5

0

So

cie

ty’s

Marg

inal

Ben

efi

t an

d M

arg

inal

Co

st

of

Po

llu

tio

n A

ba

tem

en

t (D

ollars

)

Q1

MB

MC

Socially

Optimal Amount

Of Pollution

Abatement

5-29

Government’s Role in the Economy

• Government can have a role in

correcting externalities

• Officials must correctly identify the

existence and cause

• Has to be done in the context of

politics

LO5 5-30

Controlling Carbon Dioxide Emissions

• Cap and trade

•Sets a cap for the total amount of

emissions

•Assigns property rights to pollute

•Rights can then be bought and sold

• Carbon tax

•Raises cost of polluting

• Easier to enforce

5-31