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# McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Market Failures: Public Goods and Externalities 4

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Page 1: # McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Market Failures: Public Goods and Externalities 4.

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Market Failures: Public Goods and Externalities

4

Page 2: # McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Market Failures: Public Goods and Externalities 4.

4-2

Market Failures

• Market fails to produce the right amount of the product

• Resources may be

• Overallocated

• Underallocated

LO1

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4-3

Demand-Side Failures

• Impossible to charge consumers what they are willing to pay for the product

• Some can enjoy benefits without paying

LO1

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4-4

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

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4-5

Efficiently Functioning Markets

• Demand curve must reflect the consumers, full willingness to pay

• Supply curve must reflect all the costs of production

LO1

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4-6

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

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4-7

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)

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4-8

Consumer Surplus

LO2

D

Q1

P1

Consumer Surplus

Equilibrium Price

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4-9

Producer Surplus

• Difference between the actual price a producer receives and the minimum price the producer would accept

• Extra benefit from receiving a higher price

LO2

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4-10

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)

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4-11

Producer Surplus

LO2

S

Q1

P1Equilibrium price

Producer surplus

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4-12

Efficiency Revisited

LO2

S

Q1

P1

D

Consumer surplus

Producer surplus

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4-13

Quantity (bags)

Pri

ce

(pe

r b

ag

)

Efficiency Losses

LO2

c

S

Q1Q2

D

bd

a

e

Efficiency lossfrom underproduction

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4-14

Efficiency Losses

LO2

c

S

Q1 Q3

D

bf

a

g

Quantity (bags)

Pri

ce

(pe

r b

ag

)

Efficiency lossfrom overproduction

Page 15: # McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Market Failures: Public Goods and Externalities 4.

4-15

Private Goods Characteristics

• Produced in the market by firms

• Offered for sale

• Characteristics

• Rivalry

• Excludability

LO3

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4-16

Public Goods Characteristics

• Provided by government

• Offered for free

• Characteristics

• Nonrivalry

• Nonexcludability

• Free-rider problem

LO3

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4-17

Measuring Demand

LO3

Optimal Quantity 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

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4-18

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

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4-19

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 4

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

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4-20

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

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4-21

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

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4-22

Government Intervention

• Correct negative externalities

• Direct controls

• Specific taxes

• Correct positive externalities

• Subsidies and government provision

LO4

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4-23

Government Intervention

LO4

(a)

Negative Externalities

D

S

St

Overallocation

NegativeExternalities

Qo Qe

P

0 Q

a

c

b

(b)

Correcting the overallocation of

resources via direct controls or via a tax

D

S

St

Qo Qe

P

0Q

a

T

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4-24

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

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4-25

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

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4-26

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

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4-27

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


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