PowerPoint Presentation by
Mehdi Arzandeh, University of Manitoba
Market Failures:
Public Goods and
Externalities
4
LEARNING OBJECTIVES
LO4.1
LO4.2
LO4.3
LO4.4
LO4.5
LOA4.1
Differentiate between demand-side market failures and supply-side market failures.
Explain the origin of both consumer surplus and producer surplus, and explain how
properly functioning markets maximize their sum, economic surplus, while optimally
allocating resources.
Describe free riding and public goods, and illustrate why private firms cannot
normally produce public goods.
Explain how positive and negative externalities cause underallocations and
overallocations of resources .
Show why we normally won’t want to pay what it would cost to eliminate every last
bit of a negative externality such as air pollution.
Describe how information failures may justify government intervention in some
markets.
© 2016 McGraw‐Hill Education Limited
4-2
4.1
Market Failures in
Competitive Markets
• A demand-side market failure
• Demand curves do not reflect consumers’ full willingness
to pay for a good or service.
• A supply-side market failure
• Supply curves do not reflect the full cost of producing a
good or service.
LO1
© 2016 McGraw‐Hill Education Limited
4-3
4.2
Efficiently Functioning
Markets
1. Demand curve must reflect the consumers full willingness
to pay
2. Supply curve must reflect all the costs of production
• The market will produce only units for which benefits are at
least equal to costs.
• The market will maximize the amount of benefits surpluses
that are shared between consumers and producers.
LO2
© 2016 McGraw‐Hill Education Limited
4-4
4.2
Efficiently Functioning
Markets
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
© 2016 McGraw‐Hill Education Limited
4-5
TABLE 4-1
(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
Consumer Surplus
© 2016 McGraw‐Hill Education Limited
(4)
Consumer
Surplus
4-6
FIGURE 4-1
Consumer Surplus
Price (per bag)
Consumer
Surplus
Equilibrium
Price = $8
P1
D
0
Q1
Quantity (bags)
LO1
© 2016 McGraw‐Hill Education Limited
4-7
4.2
Efficiently Functioning
Markets
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
© 2016 McGraw‐Hill Education Limited
4-8
TABLE 4-2
(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
Producer Surplus
© 2016 McGraw‐Hill Education Limited
(4)
Producer
Surplus
4-9
FIGURE 4-2
Producer Surplus
Price (per bag)
Producer
surplus
S
P1
Equilibrium
price = $8
Q1
Quantity (bags)
LO2
© 2016 McGraw‐Hill Education Limited
4-10
FIGURE 4-3
Efficiency: Maximum Combined Consumer and
Producer Goods
Price (per bag)
Consumer
surplus
S
P1
Producer
surplus
D
Q1
Quantity (bags)
LO2
© 2016 McGraw‐Hill Education Limited
4-11
FIGURE 4-4(a)
a
Efficiency Losses (or Deadweight Losses)
Efficiency loss
from underproduction
S
Price (per bag)
d
b
e
D
c
Q2 Q1
Quantity (bags)
LO2
© 2016 McGraw‐Hill Education Limited
4-12
FIGURE 4-4(b)
a
Efficiency Losses (or Deadweight Losses)
S
Efficiency loss
from overproduction
Price (per bag)
f
b
g
D
c
Q1
Q3
Quantity (bags)
LO2
© 2016 McGraw‐Hill Education Limited
4-13
4.3
Public Goods
Private goods characteristics
• Produced in the market by firms
• Offered for sale
• Rivalry
• Excludability
LO3
© 2016 McGraw‐Hill Education Limited
4-14
4.3
Public Goods
Public goods characteristics
• Provided by government
• Offered for free
• Nonrivalry
• Nonexcludability
• Free-rider problem
LO3
© 2016 McGraw‐Hill Education Limited
4-15
TABLE 4-3
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)
© 2016 McGraw‐Hill Education Limited
(4)
Collective Willingness
to Pay (Price)
4-16
FIGURE 4-5
The Optimal Amount of a Public Good
Benson’s Demand
$4 for 2 Items
$2 for 4 Items
Adams’ Demand
$3 for 2 Items
$1 for 4 Items
P
$6
5
4
3
2
1
0
P
$6
5
4
3
2
1
0
D2
1
2
3
Benson
4
Q
5
D1
1
2
3
4
Q
5
Adams
Collective Demand
$7 for 2 Items
$3 for 4 Items
Connect the Dots
P
S
$9
7
5
Collective
Willingness
To Pay
3
DC
1
0
1
2
3
4
Collective Demand and Supply
LO3
Optimal
Quantity
© 2016 McGraw‐Hill Education Limited
5
Q
4-17
4.3
Public Goods
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
© 2016 McGraw‐Hill Education Limited
4-18
TABLE 4-4
(1)
Plan
Cost-Benefit Analysis for a National Highway
Construction Project, billions of dollars
(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
© 2016 McGraw‐Hill Education Limited
$0
4-19
4.3
Public Goods
QUASI-PUBLIC GOODS
• Could be provided through the market system
• Because of positive externalities the government
provides them
• Examples: education, streets, libraries
LO3
© 2016 McGraw‐Hill Education Limited
4-20
4.3
Public Goods
THE REALLOCATION PROCESS
• Government
• Taxes individuals and businesses
• Takes the money and spends on
production of public goods
LO3
© 2016 McGraw‐Hill Education Limited
4-21
4.4
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
© 2016 McGraw‐Hill Education Limited
4-22
FIGURE 4-6
P
Negative Externalities and Positive Externalities
Negative
Externalities
a
P
St
b
St
y
z
S
Positive
Externalities
Dt
x
c
D
D
Overallocation
0
Qo
Qe
Underallocation
Q
0
Qe
(a)
Negative externalities
LO4
© 2016 McGraw‐Hill Education Limited
Qo
Q
(b)
Positive externalities
4-23
4.4
Externalities
Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies and government provision
LO4
© 2016 McGraw‐Hill Education Limited
4-24
FIGURE 4-7
P
Correcting for Negative Externalities
Negative
Externalities
a
b
P
St
St
a
S
T
c
0
LO4
D
D
Overallocation
Qo
S
Q
Qe
0
Qo
Qe
Q
(a)
(b)
Negative Externalities
Correct externality with tax
© 2016 McGraw‐Hill Education Limited
4-25
FIGURE 4-8
y
Correcting for Positive Externalities
St
z
S't
Dt
Subsidy
D
Underallocation
Qe
Qo
(a)
Positive Externalities
LO4
Subsidy
Positive
Externalities
x
0
St
St
Dt
U
D
0
Qe
Qo
(b)
Correcting via a subsidy
to consumers
© 2016 McGraw‐Hill Education Limited
D
0
Qe
Qo
(c)
Correcting via a subsidy
to producers
4-26
TABLE 4-5
Methods for Dealing with Externalities
Problem
Resource allocation outcome
Ways to correct
Negative externalities
(spillover costs)
Over production 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)
Under production of output and
therefore underallocation of
resources
1.
2.
3.
4.
Private bargaining
Subsidy to consumers
Subsidy to producers
Government provision
LO4
© 2016 McGraw‐Hill Education Limited
4-27
4.5
Society’s Optimal Amount of
Externality Reduction
MC, MB, AND EQUILIBRIUM QUANTITY
Downsloping marginal-benefit curve, MB, for pollution reduction
(diminishing marginal utility)
Rising marginal-cost curve, MC, for pollution reduction (increasing
opportunity costs)
Optimal reduction of an externality
When society’s MC and MB of reducing the externality are equal.
LO5
© 2016 McGraw‐Hill Education Limited
4-28
4.5
Society’s Optimal Amount of
Externality Reduction
SHIFTS IN LOCATIONS OF THE CURVES
• Shifts in MC (e.g. due to technology)
• Shifts in MB (e.g. due to preferences)
LO5
© 2016 McGraw‐Hill Education Limited
4-29
FIGURE 4-9
Society’s Marginal Benefit and Marginal
Cost of Pollution Abatement (Dollars)
MC
Socially
Optimal Amount
Of Pollution
Abatement
MB
0
LO5
Society’s Optimal Amount of Pollution Abatement
Q1
© 2016 McGraw‐Hill Education Limited
4-30
4.5
Society’s Optimal Amount of
Externality Reduction
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
© 2016 McGraw‐Hill Education Limited
4-31
The LAST
WORD
Carbon Dioxide Emissions, Cap-and-Trade,
and Carbon Taxes
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
© 2016 McGraw‐Hill Education Limited
4-32
Chapter Summary
LO4.1 Differences between demand-side market failure and supply-side market
failures.
LO4.2 Explain the origin of both consumer surplus and producer surplus, and
explain how properly functioning markets maximize their sum, economic
surplus, while optimally allocating resources.
LO4.3 Describe free riding and public goods, and illustrate why private firms
cannot normally produce public goods.
LO4.4 Explain how positive and negative externalities cause underallocations
and overallocations of resources.
LO4.5 Show why we normally won’t want to pay what it would cost to eliminate
every last bit of a negative externality such as air pollution.
© 2016 McGraw‐Hill Education Limited
4-33