05
Market Failures: Public Goods and
Externalities
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Market Failures
• Market fails to produce the right
•
LO1
amount of the product
Resources may be:
• Over-allocated
• Under-allocated
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
•
LO1
consumers full willingness to pay
Supply curve must reflect all the costs
of production
5-5
Consumer Surplus
• Difference between what a consumer
•
LO2
is willing to pay for a good and what
the consumer actually pays
Extra benefit from paying less than
the maximum price
5-6
Consumer Surplus
Consumer Surplus
(2)
Maximum
Price Willing
to Pay
(3)
Actual Price
(Equilibrium
Price)
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)
(1)
Person
LO2
(4)
Consumer
Surplus
5-7
Price (per bag)
Consumer Surplus
Consumer
Surplus
Equilibrium
Price
P1
D
Q1
Quantity (bags)
LO2
5-8
Producer Surplus
• Difference between the actual price a
•
LO2
producer receives and the minimum
price they would accept
Extra benefit from receiving a higher
price
5-9
Producer Surplus
Producer Surplus
(2)
Minimum
Acceptable
Price
(3)
Actual Price
(Equilibrium
Price)
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)
(1)
Person
LO2
(4)
Producer
Surplus
5-10
Price (per bag)
Producer Surplus
Producer
surplus
S
P1
Equilibrium
price
Q1
Quantity (bags)
LO2
5-11
Efficiency Revisited
Price (per bag)
Consumer
surplus
S
P1
Producer
surplus
D
Q1
Quantity (bags)
LO2
5-12
Efficiency Losses
Price (per bag)
a
Efficiency loss
from underproduction
S
d
b
e
D
c
Q2 Q 1
Quantity (bags)
LO2
5-13
Efficiency Losses
Price (per bag)
a
Efficiency loss
from overproduction
S
f
b
g
D
c
Q1 Q 3
Quantity (bags)
LO2
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
Demand for a Public Good, Two Individuals
(1)
Quantity
of Public
Good
(2)
Adams’ Willingness
to Pay (Price)
1
$4
+
$5
=
$9
2
3
+
4
=
7
3
2
+
3
=
5
4
1
+
2
=
3
5
0
+
1
=
1
LO3
(3)
Benson’s
Willingness to
Pay (Price)
(4)
Collective
Willingness
to Pay (Price)
5-17
Demand for Public Goods
Benson’s Demand
$4 for 2 Items
$2 for 4 Items
P
$6
5
4
3
2
1
0
D2
1
2
3
4
Q
5
Benson
Adams’ Demand
$3 for 2 Items
$1 for 4 Items
P
$6
5
4
3
2
1
0
D1
1
2
3
4
Q
5
Adams
P
Collective Demand
$7 for 2 Items
$3 for 4 Items
S
$9
Optimal
Quantity
7
5
Collective
Willingness
To Pay
3
Connect the Dots
DC
1
0
1
2
3
4
5
Q
Collective Demand and Supply
LO3
5-18
Cost-Benefit Analysis
• Cost
• Resources diverted from private
•
LO3
good production
• Private goods that will not be
produced
Benefit
• The extra satisfaction from the
output of more public goods
5-19
Cost-Benefit Analysis
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
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
LO3
$0
$0
5-20
Quasi-Public Goods
• Could be provided through the market
•
•
LO3
system
Because of positive externalities the
government provides them
Examples: education, streets,
libraries
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
•
•
LO4
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
5-23
Externalities
P
Negative
Externalities
a
P
St
b
St
y
z
S
Positive
Externalities
Dt
x
c
D
D
Overallocation
0
Qo
Qe
(a)
Negative externalities
LO4
Underallocation
0
Q
Qe
Qo
Q
(b)
Positive externalities
5-24
Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies and government
provision
LO4
5-25
Government Intervention
P
Negative
Externalities
a
b
P
St
St
a
S
T
c
0
LO4
S
D
Overallocation
Qo Qe
Q
D
0
Qo Qe
Q
(a)
(b)
Negative Externalities
Correct externality with
tax
5-26
Government Intervention
y
St
z
St
St
Subsidy
S't
Positive
Externalities
x
Dt
Subsidy Dt
D
D
U
D
Underallocation
0
Qe
Qo
(a)
Positive Externalities
LO4
0
Qe
Qo
(b)
Correcting via a subsidy
to consumers
0
Qe
Qo
(c)
Correcting via a subsidy
to producers
5-27
Government Intervention
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.
2.
3.
4.
5.
Private bargaining
Liability rules and lawsuits
Tax on producers
Direct controls
Market for externality rights
Positive externalities
(spillover benefits)
Underproduction of output
and therefore
underallocation of
resources
1.
2.
3.
4.
Private bargaining
Subsidy to consumers
Subsidy to producers
Government provision
LO4
5-28
Society’s Marginal Benefit and Marginal
Cost of Pollution Abatement (Dollars)
Society’s Optimal Amounts
MC
Socially
Optimal Amount
Of Pollution
Abatement
MB
0
LO5
Q1
5-29
Government’s Role in the Economy
• Government can have a role in
•
•
LO5
correcting externalities
Officials must correctly identify the
existence and cause
Has to be done in the context of
politics
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