Post on 18-Jul-2018
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