Market Failure: A Role for Government
CHAPTER FIVE
MARKET FAILURE: A ROLE FOR GOVERNMENT
ANSWERS TO END-OF-CHAPTER QUESTIONS
5-1
Use the characteristics of private goods to explain why firms can profitably offer them for sale.
Why do competitive firms tend to produce private goods at minimum average cost? What do
economists mean when they say that private goods tend to be produced in the “right” amounts?
Private goods are “rival,” so goods purchased by one consumer are not available for others to buy
and consume. They are also “excludable,” meaning benefits of the good can be restricted to
those who pay for the product. If rivalry and excludability hold, and assuming the good is
desirable to a sufficient number on consumers, there is potential for profitable sale. Producing
private goods at minimum average cost (“productive efficiency”) maximizes the potential profit
from those goods. Producing goods in the “right” amounts means we have “allocative
efficiency;” the socially optimal level of the good is being produced. Allocative efficiency is
achieved when the marginal benefit of the last unit produced equals the marginal cost of
producing that unit.
5-2
Contrast the characteristics of public goods with those of private goods. Why won’t private
firms produce public goods?
Public goods are nonrival (one person’s consumption does not prevent consumption by another)
and nonexcludable (once the goods are produced nobody—including free riders—can be
excluded from the goods’ benefits). If goods are nonrival, there is less incentive for private firms
to produce them – those purchasing the good could simply allow others the use without
compensation. Similarly, if goods are nonexcludable, private firms are unlikely to produce them
as the potential for profit is low. Private firms would face the free-rider problem of people
benefiting from the public good without contributing to the cost.
5-3
The accompanying table relating to a public good provides information on the prices Young and
Zorn are willing to pay for various quantities of some public good. Young and Zorn are the only
two people in the society. Determine the price that society is willing to pay for the public good
at each quantity of output. If the government’s marginal cost of providing this public good is
constant at $7, how many units of the public good should government provide? Why not less?
Why not more?
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Market Failure: A Role for Government
Young
Price
Qd
$8
7
6
5
4
3
2
1
0
0
0
1
2
3
4
5
Price
Zorn
Qd
Society
Price
Qd
$8
7
6
5
4
3
2
1
1
2
3
4
5
6
7
8
$13
11
9
7
5
3
2
1
1
2
3
4
5
6
7
8
Society’s willingness to pay for each quantity of the public good appears as the underscored
values in the “society” price column. If the marginal cost is $7, government should provide 4
units of the public good. If the government provides less, society is missing out on the net
benefits of those last units (MB>MC at Q = 3). Government should not provide more, because
any units beyond 4 would cost more than they would benefit society.
5-4
The following table shows the total costs and total benefits in four different antipollution
programs of increasing scope. Use cost-benefit analysis to determine which program should be
undertaken. Explain.
Program
Total
Cost
Total
Benefit
A
B
C
D
$ 3
7
12
18
$ 7
12
16
19
Program B since the marginal benefit no longer exceeds marginal cost for programs that are
larger in scope. Plan B is where net benefits—the excess of total benefits over total costs ($9)—
are maximized.
5-5
Why are negative externalities and positive externalities also called spillover costs and spillover
benefits? Show graphically how a tax can correct for a negative externality and a subsidy to
producers can correct for a positive externality. How does a subsidy to consumers differ from a
subsidy to producers in correcting for a spillover benefit?
Negative externalities are called spillover costs because they “spill over” the market transaction
onto third parties, who suffer a reduction in utility. Positive externalities are also called spillover
benefits because they “spill” benefits onto people not directly in the transaction, increasing their
utility. See Figures 5.2 and 5.3 to show the tax and subsidy. Compare (b) and (c) in Figure 5.3
to see how subsidizing consumers (b) differs from subsidizing producers (c).
5-6
An apple-grower’s orchard provides nectar to a neighbor’s bees, while a beekeeper’s bees help
the apple grower by pollinating the apple blossoms. Use Figure 5.1b to explain why this
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Market Failure: A Role for Government
situation might lead to an underallocation of resources to apple growing and to beekeeping. How
might this underallocation get resolved via the means suggested by the Coase theorem?
Using Figure 5.1b in the text the following can be said. The market demand curves for apples
and honey, Da and Dh, would not include the positive externalities accruing to the production of
the other good. The total benefits associated with the consumption and production of each good
could be shown by Dat or Dht and the optimal outputs for each good would be Qao and Qho.
Both of these outputs are greater than equilibrium outputs, Qae and Qhe, leading to an
underallocation of resources to both apple-growing and beekeeping.
Using the Coase theorem, we note that it will be to the advantage of individual apple growers and
beekeepers to negotiate so that beekeepers (whose hives can be moved) locate their production in
or near orchards. This negotiation will occur as long as property ownership is well defined, only
a few people are involved, and bargaining costs are low. For example, an apple grower who
owns an orchard could allow a beekeeper to use a portion of his or her land, charging
below-market rents so that both parties gain from the agreement.
5-7
Explain: “Without a market for pollution rights, dumping pollutants into the air or water is
costless; in the presence of the right to buy and sell pollution rights, dumping pollution creates an
opportunity cost for the polluter.” What is the significance of this fact to the search for better
technology to reduce pollution?
The rights to air and water are held in common by society. Without markets for the use of these
rights, private individuals will not restrict their polluting activities because there is no monetary
incentive to do so. Once these markets are established, the right to pollute will be restricted and
have a positive price associated with it. The price represents an explicit monetary cost to
polluters, providing them with a tangible incentive to seek ways to cut pollution. This will create
potential profits for those who can successfully develop new types of pollution-abatement
equipment, accelerating the rate of technological development in this area.
5-8
Explain the following statement, using cost-benefit analysis: “The optimal amount of pollution
abatement for some substances, say, water from storm drains, is very low; the optimal amount of
abatement for other substances, say, cyanide poison, is close to 100 percent.”
Reducing water flow from storm drains has a low marginal benefit. If graphed, the MB curve
would be located far to the left, and will intersect the MC curve at a low amount of pollution
abatement, indicating the optimal amount of pollution abatement (where MB = MC) is low. Any
cyanide in public water sources could be deadly. Because each unit of cyanide is potentially
lethal, the marginal benefit from abating each unit (and avoiding fatalities) will be extremely
high. Graphically, the MB curve would be located to the extreme right where it would intersect
the MC curve at or near 100 percent.
5-9
Explain how marketable emissions credits add to overall economic efficiency, compared to
across-the-board limitations on maximum discharges of air pollutants by firms.
If company A can reduce pollution by 1 ton at less cost than company B, then company B should
buy emission credits from company A. In doing this, society is using fewer resources (spending
fewer dollars) to achieve the same level of pollution reduction.
5-10
Contrast the benefits-received principle and ability-to-pay principles of taxation. Which of the
following taxes mainly adhere to the benefits-received principle? Which mainly apply to the
ability-to-pay principle?
a. an admission tax on tickets to sporting events at public stadiums
b. the Federal personal income tax
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Market Failure: A Role for Government
c. a sales tax applied only to certain luxury goods such as expensive automobiles, yachts, and
private airplanes
d. a toll charge required to drive on a public highway
e. the Federal and state gasoline tax
The benefits-received principle holds that governments should supply public goods and services
in much the same manner as does private business. Those who make use of government services
should pay for them.
The ability-to-pay principle of taxation assesses tax liability based on a person’s ability to pay:
The higher one’s income, the higher the tax and the higher the percentage of one’s income paid
in tax.
Benefits-received: (a), (d), (e). Ability-to-pay: (b) and (c) (assuming the sales tax revenue on (c)
is not used specifically to benefit the users of those goods).
5-11
Suppose in Fiscalville there is no tax on the first $10,000 of income, but a 20 percent tax on
earnings between $10,000 and 20,000 and a 30 percent tax on income between $20,000 and
$30,000. Any income above $30,000 is taxed at 40 percent. If your income is $50,000, how
much will you pay in taxes? Determine your marginal and average tax rates. Is this a
progressive tax? Explain.
Total tax = $13,000; marginal tax rate = 40% average tax rate = 26%. This is a progressive tax;
the average tax rate rises as income goes up.
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