Chapter 30: Government and
Market Failure
Alexis Morfa
Lizbeth Mendoza
Public and Private Goods
Private Goods
-Rivalry means that when one person buys and consumes
a product, it is not available for purchase and
consumption by another person.
-Excludability means that sellers can keep people who do
not pay for the product from obtaining its benefits.
Public goods have the opposite characteristics: nonrivalry
and nonexcludability.
-once a producer has provided the good, everyone can
benefit
-one person’s consumption of the good does not prevent
consumption of the same good by others.
Demand for Public Goods
• The government has to try and estimate the
demand through surveys or public votes
• Surveys ask hypothetical questions about how
much each citizen is willing to pay for various
types and amounts of public goods than go
without them.
• The derived (demand) schedule shows the price
people are willing to pay for the extra unit of
each possible quantity.
For a public good, the total willingness to pay is the
vertical summation of each individual demand curve
If a city has 30 acres of parkland, Joe is willing to pay $10
for one more acre and Moe is willing to pay $5 for one
more acre, so collectively they are willing to pay $15 for
one more acre of parkland.
Supply and Optimal Quantity
of a Public Good
•Marginal cost rises as more of a good
is produced because of the law of
diminishing returns.
•In the short run, government has fixed
resources with which to “produce” public
goods such as parks or national
defense. As it adds more units of a
variable resource (labor) to these fixed
resources, total product eventually rises
at a diminishing rate.
•The collective demand curve measures society’s marginal benefit of
each unit of the public good.
•The supply curve measures society’s marginal cost of each unit.
•The optimal quantity of a public good occurs where marginal benefit
equals marginal cost.
Cost-Benefit Analysis
• Cost-benefit analysis is the method of
evaluating alternative projects or sizes of
projects by comparing the marginal cost and
marginal benefit and applying the MC=MB rule.
• The marginal-cost-marginal-benefit rule tells us
which plan provides the maximum excess of
total benefits over total costs or, in other words,
the plan that provides society with the maximum
net benefit.
• Helps allocate resources between the private
and public sectors to achieve maximum net
benefit.
Externalities
• Externalities is synonymous
with spillover (Chapter 5). An
externality is a benefit or cost
from production or
consumption, accruing without
compensation to non-buyers
and non-sellers of the product.
• An example of a negative
externality, is the cost of the
polluted air with breath.
• An example of a positive
externality, is having society
immune to a disease, like
polio.
Spillover Costs
• When there is any type of spillover costs,
suppliers are overallocating resources.
Meaning that firms are producing too
many units. As a result, firms enjoy lower
production costs and transferring cost to
society.
P($)
St
S
D
0
Q
Qo
Overallocation
Q
Spillover costs
Spillover Benefits
• In this case, firms are underallocating their
resources. As a result, equilibrium output
is less than the optimal output.
P($)
St
S
Dt
D
0
Qu
Q
Q
Spillover Benefit
Underallocation
Fixing Externalities
• Coarse Theorem: Is a theorem that
states that government intervention
is not need when;
– Property Ownership is clearly defined
– The number of people involved is small
– Bargaining costs are negligible.
• Liability Rules and Lawsuits: As a
result of the government
establishing and implementing
rules and laws for private property,
property owners can sue for
compensation.
Government Intervention:
Correcting Spillover Costs
• Is needed when externalities affect large number of people or when
community interest are at stake.
• Direct Controls: Raise the marginal cost of production because firms
must operate and maintain certain standards.
– Clean Air Act of 1990
• Specific Taxes: Charging taxes on specific or related goods.
– Excise taxes in CFCs
Graphs on Correcting
Spillover Costs
• Government can correct this spillover cost by either
imposing taxes to firms or by using direct controls. Both
shift S to St thus diminishing the overallocation problem.
P($)
St
P($)
St
Spillover costs
S
S
D
0
Q
Qo
Overallocation
D
Q
0
Q
Qo
Q
Taxes or
Direct Controls
Government Intervention:
Correcting Spillover Benefits
• There are three ways government can correct this
problem:
– Subsidies to buyers
– Subsidies to producers
– Government provision: The government can provide
the public good.
Graphs on Correcting
Spillover Benefits
1. Spillover benefit
P($)
St
S
0
Qu
D
Q
Dt
2. Correcting the
underallocation of resources
via a subsidy to consumers
P($)
St
Q
S
Spillover Benefit
Underallocation
0
Qu
D
Q
Dt
3. Correcting the
underallocation of resources
via a subsidy to producers
by x amount.
P($)
St
Q
Subsidy
S
x
D
0
Q
Qo
Q
Subsidy
Tragedy of the Commons
• Is a situation where people, firm, and society have no
incentive to maintain these rights because they are held
“in common”. As a result, society ends up with a
degradation problem, such as pollution.
• The government knowing this has come up what is
called a “market for externality rights”.
– For example pollution control agencies.
Market for Pollution Rights
S= Supply of
pollution rights
P($)
200
100
0
D2006
700
1000
D2012
Q
Information Failures
• Asymmetric information: unequal knowledge
possessed by the parties to a market
transaction.
• In these markets, society’s scarce resources
may not be used efficiently, thus implying that
the government should intervene by increasing
the information available to the market
participants.
Inadequate Information
Involving Sellers
• Inadequate information involving sellers and
their products can cause market failure in the
form of underallocation of resources.
• Examples: gasoline market and licensing of
surgeons.
-The government has established a system of
weights and measures, employed inspectors to
check the accuracy of gasoline pumps, and
passed laws against fraudulent claims and
misleading advertising.
-Qualifying tests and licensing for surgeons.
Inadequate Information
Involving Buyers
• Moral Hazard Problem is the tendency of one
party to a contract or agreement to alter her or
his behavior, after the contract is signed, in
ways that could be costly to the other party.
• Examples:
-Drivers may be less cautious because they
have car insurance.
-Guaranteed contracts for professional athletes
may reduce the quality of their performance.
Inadequate Information
Involving Buyers… Cont’d.
• Adverse Selection Problem is when
information known by the first party to a
contract or agreement is not known by the
second and, as a result, the second party
incurs major costs.
• Example: An insurance company offering
“no-medical-exam-required” life insurance
policies may attract customers who have a
life-threatening diseases.
Qualification
To overcome information difficulties without
government intervention:
• Product warranties
• Franchising
• Periodicals, such as Consumer Reports
and Mobil Travel Guide.