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

LO2LO2

Pri

ce

(pe

r b

ag

)

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

LO2LO2

Pri

ce

(pe

r b

ag

)

Quantity (bags)

S

Q1

P1

Equilibrium price

Producer surplus

5-11

Efficiency Revisited

LO2

Pri

ce

(pe

r b

ag

)

Quantity (bags)

S

Q1

P1

D

Consumer surplus

Producer surplus

5-12

Quantity (bags)

Pri

ce

(pe

r b

ag

)

Efficiency Losses

LO2

c

S

Q1Q2

D

bd

a

e

Efficiency lossfrom underproduction

5-13

Efficiency Losses

LO2

c

S

Q1 Q3

D

bf

a

g

Quantity (bags)

Pri

ce

(pe

r b

ag

)

Efficiency lossfrom 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

$654321

0

P

Q1 2 3 4 5

$6543210

P

Q1 2 3 4 5Adams

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

10

P

Q1 2 3 4 5Collective Demand and Supply

DC

SCollective Demand

$7 for 2 Items

$3 for 4 Items

Connect the Dots

OptimalQuantity

CollectiveWillingness

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

NegativeExternalities

St

Underallocation

PositiveExternalities

Qo QoQe Qe

P P

0Q 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

NegativeExternalities

Qo Qe

P

0 Q

a

c

b

(b)

Correct externality with tax

D

S

St

Qo Qe

P

0Q

a

T

5-26

Government Intervention

LO4

(a)Positive Externalities

0

St

Underallocation

PositiveExternalities

QoQe

D

Dt

z

x

y

(b)Correcting via a subsidy

to consumers

0

St

QoQe

D

Dt

(c)Correcting via a subsidy

to producers

0

S't

QoQe

D

Subsidy

St

Subsidy

U

5-27

Government Intervention

LO4

Methods for Dealing with Externalities

ProblemResource Allocation Outcome Ways to Correct

Negative externalities (spillover costs)

Overproduction of output and therefore overallocation of resources

1. Private bargaining2. Liability rules and lawsuits3. Tax on producers4. Direct controls5. Market for externality rights

Positive externalities (spillover benefits)

Underproduction of output and therefore underallocation of resources

1. Private bargaining2. Subsidy to consumers3. Subsidy to producers4. Government provision

5-28

Society’s Optimal Amounts

LO5

0

So

ciet

y’s

Mar

gin

al B

enef

it a

nd

Mar

gin

alC

ost

of

Po

lluti

on

Ab

atem

ent

(Do

llars

)

Q1

MB

MC

SociallyOptimal AmountOf PollutionAbatement

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