Chapter 5: Public Goods
and Externalities
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
Market Failure
 In some cases, certain goods and services might
not be produced at all.
 In other cases, certain goods and services might
be over- or under-produced compared to what
would be best for the society.
 These situations represent a market failure to
achieve the outcome that is best for the society.
 Whenever there is a market failure, there might be
a role for a government to intervene in the
economy.
LO: 5-1
5-2
Market Failure
 Two common cases in which market
failures arise are:
 Production of public goods (and
services)
 Production of goods and services that
involve externalities
Market failure is the inability of a market to produce a
desirable product or produce it in the “right” amount.
LO: 5-1
5-3
Private Goods vs.
Public Goods
 Private goods are
 Rival: if one person
consumes a private good,
the other can’t;
 Excludable: only those who
pay for goods enjoy their
benefits;
 Bought and consumed by
people individually;
 Produced and allocated
efficiently by competitive
markets.
LO: 5-1
 Public goods are
 Non-rival: one person’s
consumption of a public good
does not preclude others from
consuming it too;
 Non-excludable: there is no
efficient way to prevent people
from enjoying a public good
without paying;
 Subject to a free-rider problem –
non-payers can enjoy benefits
of a public good;
 Not produced or underproduced by competitive
markets.
5-4
Private Goods vs.
Public Goods: Examples
 Private goods






A pair of shoes;
A cup of coffee;
A car;
A house;
A haircut;
A circus show.
 Public goods





National defense;
Roads;
Parks;
Street lighting;
Environmental
protection.
Because of free-rider problem, government provides
public goods and finances them through taxes.
LO: 5-1
5-5
Market Demand for Public
Goods and Optimal Quantity
 Market demand for a private good is a horizontal sum
of individual demands: quantities demanded at each
price are added up.
 Market demand for a public good is a vertical sum of
individual demands: individuals’ willingness to pay (per
unit) for each given quantity of a public good are added
up.
 Optimal quantity of a public good is where marginal
benefit of this good (market demand) is equal to the
marginal cost of producing the good (supply).
LO: 5-2
5-6
Demand for Public Goods:
Example with Two Individuals
LO: 5-2
(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
Graphically…
5-7
P
Collective Demand
$7(per item)
for 2 Items
$3 (per item)
for 4 Items
S
$9
7
5
DC
0
1
2
3
4
5
Collective Demand and Supply
Benson’s Demand
$4 (per item)
for 2 Items
$2 (per item)
for 4 Items
Adams’ Demand
$3 (per item)
for 2 Items
$1 (per item)
for 4 Items
LO: 5-2
Collective
Willingness
To Pay
3
1
Connect the Dots
Optimal
Quantity
P
$6
5
4
3
2
1
0
Q
D2
1
2
3
4
5
Q
Benson
P
$6
5
4
3
2
1
0
D1
1
2
3
4
5
Q
Adams
5-8
Externalities: Positive and
Negative
 An externality occurs when some of the costs or the
benefits of a good are passed on to, or “spill over to,”
someone other than the immediate buyer or seller.
 Externalities are benefits or costs that accrue to some
third party that is external to the market transaction.
 Externalities can be positive or negative.
Negative externalities are
spillover production or
consumption costs imposed on
third parties without
compensation to them.
Positive externalities are
spillover production or
consumption benefits conferred
on third parties without
compensation from them.
LO: 5-3
5-9
Externalities: Equilibrium
Output vs. Optimal Output
 With negative
externalities, the
producers’ supply curve
is below (to the right of)
the full-cost supply
curve, therefore
 equilibrium output is
greater than optimal,
i.e. overallocation of
resources.
LO: 5-3
 With positive
externalities, the market
demand curve is below
(to the left of) the fullbenefit demand curve,
therefore
 equilibrium output is
less than optimal, i.e.
underallocation of
resources.
Graphically…
5-10
Externalities: Equilibrium
Output vs. Optimal Output
P
P
Negative
Externalities
St
St
Positive
Externalities
S
Dt
D
D
Overallocation
0
Qo
Qe
Negative
Externalities
Examples: pollution from
factories, traffic jams.
Underallocation
Q
0
Qe
Qo
Q
Positive
Externalities
Examples: inventions,
front yard landscaping.
LO: 5-3
5-11
Ways to Resolve
Externalities Problem
 Individual bargaining: when property rights are clearly
established, externality problems can be resolved through
private negotiations (Coase Theorem).
 Liability rules and lawsuits: the perpetrator of the harmful
externality is forced to pay damages to those injured.
 Government intervention:
 Direct control through legislation;
 Specific taxes to bring producers’ supply curve closer to the fullcost supply curve;
 Subsidies and government provision for goods and services with
positive externalities.
 Market-based approach: government can create a market for
externality rights.
LO: 5-3
5-12
Taxation: Apportioning the
Tax Burden
 To finance government provision of public goods and
subsidies and government provision in case of positive
externalities, government is levying taxes on households
and businesses.
 How is this tax burden distributed?
 Benefits-received principle: people who receive the benefit
from government-provided goods and services should pay the
taxes required to finance them.
 Ability-to-pay principle: people who have greater income
should pay a greater proportion of it as taxes than those who
have less income.
Tax burden is the total cost of taxes imposed on society.
LO: 5-4
5-13
Progressive, Proportional,
and Regressive Taxes
 A progressive tax: average tax rate increases as
the taxpayer’s income increases.
 A regressive tax: average tax rate decreases as
the taxpayer’s income increases.
 A proportional tax: average tax rate remains
constant as the taxpayer’s income increases.
Average tax rate is the total tax paid divided by total taxable
income, as a percentage.
Marginal tax rate is the tax rate paid on each additional dollar of
income.
LO: 5-5
5-14
Tax Progressivity in the U.S.
 The majority view of economists is as follows:
 The Federal tax system is progressive.
 The state and local tax structures are largely
regressive. A general sales tax and property taxes
are regressive with respect to income.
 The overall U.S. tax system is slightly progressive.
Government’s Role: A Qualification
In addition to correcting externalities and providing public goods,
government also sets the rules and regulations for the economy,
redistributes income when desirable, and takes macroeconomic
actions to stabilize the economy.
LO: 5-5
5-15