Lecture 3
Market Failure, Public Goods, Externalities
Market Failure & Public Goods
ANDREEA STOIAN, PHD
ASSOCIATE PROFESSOR
DEPARTMENT OF FINANCE AND CEFIMO
BUCHAREST UNIVERSITY OF ECONOMIC STUDIES
Market failure (I)
Markets
Individual
well-being
Invisible hand
Efficient
allocation
(Pareto
optimality)
Market failure (II)
Monopoly
Externalities
Asymmetric
information
Market failure (III)
Individual well being
Market
Social responsibility
Pareto optimality
(http://en.wikipedia.org/wiki/Social_responsibility )
Market
Government
Pareto optimality
Public goods
Non-rival=a given
quantity an be
enjoyed by more
than one consumer
without decreasing
the amounts
enjoyed by rival
consumers
Non-exclusion=it is
too costly to develop
means of excluding
those who refuse to
pay from enjoying
the benefits of a
given quanitity of a
public good
Public
goods
Public goods vs. private goods
Pure public goods
a given quantity is consumed by all
members of a community as soon as it is
produced for, or by any one member
The marginal cost of distributing a pure
public good to an additional consumer is
zero for a given amount of the public good
Pure private goods
Are rival in consumption and their benefits
are easily excluded from those who choose
not to pay their market price
A unit of a pure private good can be
enjoyed only by a single consumer
The more units of a given mount available
to be consumed by one person, the less is
available to rival consumers
Classifying goods
• Excludability
•1
• Rivalry
•1
Semipublic
goods (i.e.
priceexcludable
public goods)
Pure public
goods
• Excludability
• Rivalry
•0
Private public
goods
Semipublic
goods
(i.e.
congestible
public goods)
• Rivalry
•1
Congestible and price-excludable public
goods
Congestible
Priceexcludable
• Are those for which crowding or congestion reduces the
benefits to existing consumers when more consumers are
accommodated
• The marginal cost of accommodating an additional consumer
is not zero after the point of congestion is reached
• Are those with benefits can be priced
• Their provision results in positive externalities
Provision of goods
• Pure private
goods
• Congestible
public goods
• Priceexcludable
public goods
Market&Government
Market&Government
Market&Government
Market&Government
• Pure public
goods
Demand for public goods
Market demand for a Pure Private Good is
derived by adding quantities demanded at each
price.
Demand for a Pure Public Good is derived by
adding how much people will be willing to pay at
each quantity.
Efficient output of a pure public good
The socially optimal level of the public good
requires that we set the Marginal Social
Benefit of that good equal to its Marginal
Social Cost. MSB = MSC
𝑛−1
𝑛
𝑀𝑆𝐵 = 𝑘=1 𝑀𝐵𝑘 = 𝑀𝐵𝑖 + 𝑗=1 𝑀𝐵𝑗
Example
Number of security
guards per week
1
2
3
4
MBA
$300
$250
$200
$150
MBB
250
200
150
100
MBC
200
150
100
50
$750
$600
$450
$300
𝑀𝐵𝑖
Marginal Benefit (Dollars)
800
700
600
500
MC = AC = MSB
400
D= MBi = MSB
300
200
MBA
100
MBB
MBC
0
1
2
3
4
Security Guards per Week
5
Lindhal equilibrium through voluntary
contributions
 The amount contributed per unit of the public good by each person must be
adjusted so that each individual desires the identical amount of the public
good
 The sum of the amounts contributed by each member of the community
per unit must equal the marginal social cost of producing the public good
 All individuals must agree voluntarily, with no coercion whatsoever, on the
cost-sharing arrangement and the quantity of good
 The equilibrium must occur under the unanimous consent
 It ensures the efficient outcome
• Free riding can be a
reasonable strategy for
any one individual ,
provided that no penalty
exists and that only few
individuals choose this
strategy
3.
• A free-rider is a person
who seeks to enjoy the
benefits of a public good
without contributing
anything to the cost of
financing the
• The free-rider problem
stems from the incentive
people have to enjoy
external benefits financed
by others, with no cost to
themselves
2.
1.
The free-rider problem
• If all members of the
community choose the
free-rider strategy , then
no production of the
public good would be
forthcoming
Prisoners’ dilemma
Strategy
B contributes
B does not
contribute
A contributes
5,5
5,10
A does not
contribute
10,5
0,0