CHAPTER
8
Market Failure:
Spillovers and
Imperfect Information
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Rationale for the Existence of
Government

Certain goods and services
would not exist unless we make
a collective effort to produce
them.

The government can help make
collective decisions about paying
for goods that generate spillover
benefits.
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2
Spillover Benefits & Public Goods
There are three cases under which
markets fail to allocate resources
Efficiently:

When there are spillover benefits;

When there are spillover costs; and

When there is imperfect information.
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Spillover Benefits & Public Goods

A market with spillover benefits is
inefficient, so there is an opportunity
for government to promote efficiency.
Spillover PRINCIPLE
For some goods, the costs or benefits
associated with the good are not confined to
the person or organization that decides how
much of the good to produce or consume.
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Spillover Benefits: An Example
Number of people
100,000
Benefit per person
$5
Total benefit of dam
(100,000 x $5)
$500,000
Assumed total cost of
dam (greater than
personal benefit of
$5)
$200,000
Tax per person
$2
Tax revenue
(100,000 x $2)
$200,000
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
In this example, if each person
considers only the personal
benefit relative to the cost of
the dam, no dam will be built.

Since everyone will support a
tax per person that is less than
the benefit per person, the
government can use its taxing
power to provide a good that
would otherwise not be
provided.
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Public Goods
A
public good is a good
available for everyone to
consume, regardless of who
pays and who doesn’t.
 A private good is consumed
by a single person or
household.
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Public Goods

Public goods are nonrival in
consumption (available for everyone
to consume) and nonexcludable (it is
impractical to exclude people who
don’t pay).

Private goods are rival in
consumption (only one person can
consume the good), and excludable (it
is possible to exclude a person who
does not pay for the good).
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Public Goods
Examples of public goods:

National defense

Law enforcement

Space exploration
Preservation of
endangered
species

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

Protecting the
earth’s ozone
layer
Fireworks display
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The Free-rider Problem

The problem with using
voluntary contributions to
support public goods is the freerider problem.
 Each
person will try to get the
benefits of a public good without
paying for it.
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Overcoming the Free-rider Problem
Techniques to encourage people to
contribute:



Give contributors something in return
Arrange matching contributions
Appeal to people’s sense of civic or
moral responsibility
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Private Goods With Spillover Benefits
A good such as education generates:

workplace spillover benefits; and

Civic spillovers benefits
■ Thus, the government should adopt policies to
encourage people to become educated.
■ Local governments provide free primary and
secondary education. States subsidize higher
education, and the federal government
provides financial aid to students in private
and public schools.
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11
Spillover Costs

Just as the government has a role in
markets with spillover benefits, the
government also plays a role in
markets with spillover costs (or
externality).
Spillover PRINCIPLE
For some goods, the costs or benefits
associated with the good are not confined to
the person or organization that decides how
much of the good to produce or consume.
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Advantages of a Pollution Tax

The economist’s response to a pollution
problem is to impose a pollution tax
(internalize the pollution externality).

A pollution tax that is equal to the

spillover cost per unit of waste forces
firms to pay for the waste they
generate, causing firms to produce less
of the polluting good.
The tax also encourages firms to spend
money to abate pollution.
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The Firm’s Response to a Pollution Tax
Waste Production
per Ton
Cost per
(gallons)
Ton
5
4
3
2
1
0
$60
61
64
71
86
116
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Tax
Cost
per
Ton
$20
16
12
8
4
0

This table shows the
hypothetical cost per ton of
paper with varying amounts of
pollution.

Tax per gallon of waste = $4

As the firm decreases its
waste, the cost of production
rises because additional efforts
to decrease waste become
progressively more expensive.
Total
Cost
per Ton
$80
77
76
79
90
116
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The Firm’s Response to a Pollution Tax
Waste Production
per Ton
Cost per
(gallons)
Ton
5
4
3
2
1
0
$60
61
64
71
86
116
© 2005 Prentice Hall Business Publishing
Tax
Cost
per
Ton
$20
16
12
8
4
0

As the firm continues to
decrease the volume of
waste, the production cost
increases while the tax
cost decreases.

The total cost per ton of
paper is minimized at $76 and
3 gallons of waste.

The typical firm will decrease
its waste from 5 to 3 gallons.
This result is consistent with
the marginal principle.
Total
Cost
per Ton
$80
77
76
79
90
116
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The Firm’s Response to a Pollution Tax

Waste Production
per Ton
cost per
(gallons)
Ton
5
4
3
2
1
0
$60
61
64
71
86
116
© 2005 Prentice Hall Business Publishing
Tax
cost
per
Ton
$20
16
12
8
4
0
Total
Cost
per Ton
$80
77
76
79
90
116
Survey of Economics, 2/e

As long as the marginal
benefit ($4 savings in taxes per
gallon of waste reduced)
exceeds the marginal cost (or
extra production cost from
cutting back a gallon of
waste), the firm should
continue to scale back its
waste.
Beyond 3 gallons, the
additional production cost
exceeds the additional tax
savings.
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The Firm’s Response to a Pollution Tax

The tax shifts the supply
curve leftward.

The price of paper
increases from $60 to $68
per ton.

The tax is partially shifted
to consumers in the form of
a higher price, and they
respond by consuming less.
76
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The Firm’s Response to a Pollution Tax

The pollution tax affects the total
volume of waste dumped in two
ways:
Abatement:
there is less waste per ton
of paper—3 instead of 5 gallons per
ton
Lower output: the industry produces
less paper—80 instead of 100 tons per
day
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Traditional Regulation: Command and
Control



An alternative to a pollution tax is a
system of regulations that control the
amount of pollution generated by each
firm.
The label for a traditional regulatory
policy is a command-and-control policy.
In the paper example, the government
would simply mandate firms to produce no
more than, say, 4 gallons of waste per ton
of paper.
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Traditional Regulation: Command and
Control
A problem with the regulatory policy is that the
mandated abatement technology is unlikely to be the
most efficient for two reasons:

A single abatement technology is likely to be
efficient for some firms but not for others.

There is no incentive to cut the volume of waste
below the maximum volume, or develop better
abatement technologies.
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Global Warming and a Carbon Tax



Carbon dioxide is by far the most
important greenhouse gas.
In the last century, we have blown
out more carbon than plants have
been able to suck in, and the volume
of carbon dioxide in the atmosphere
has increased by 25%.
A carbon tax is a tax based on fuel’s
carbon content
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Global Warming and a Carbon Tax
A carbon tax would decrease greenhouse
emissions for three reasons:



The tax will increase the price of energy
and increase the cost of producing energy
intensive goods;
Some energy producers will switch to
noncarbon energy sources, i.e., the wind,
the sun, and geothermal sources
Energy producers will improve the
efficiency of carbon based fuels, squeezing
out more energy per ton of coal or oil.
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Global Warming and a Carbon Tax

The destruction of tropical rain
forests affects the volume of carbon
dioxide in the atmosphere because:


When trees and plants are burned, the
carbon stored in these plants is
converted into carbon dioxide
Once the forest is cleared, there is less
plant material to convert carbon dioxide
into stored carbon
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Coase Bargaining


A spillover problem can be solved
through bargaining among affected
parties;
A solution “Coase bargaining
solution” can be reached when;
There is a small number of affected
parties; and
 Transaction costs of bargaining are
relatively low.

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Coase Bargaining: An example




Consider a lake shared by a steel mill and
a fishing firm;
The mill initially dumps 5 tons of waste
into the lake which reduces the fish
harvest;
The marginal cost of abatement increases
with the level of abatement (from h to m);
The marginal benefit of abatement by the
fishing firm decrease (increases) as the
level of Abatement increases (decreases)
as indicated by the movement from b to g.
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Coase Bargaining: An example
$
b
17
c
13
11
e
k
9
7
5
i
f
h
1
The MB of pollution
abatement Equals the
increase in the fish harvest,
Marginal Cost
While the MC equals the
of abatement
additional abatement cost.
Using the marginal principle,
the efficient level is 3 tons.
m
Coase bargaining generates
the efficient abatement level.
If the steel mill owns the lake,
the fishing firm will pay the
steel mill to abate 3 tons. If
the fishing firm owns the
lake, the steel mill will pay
the fishing firm no to abate
more than 3 tons.
g
Marginal benefit
of abatement
1
4
2
3
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2
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1
5
0
O’Sullivan & Sheffrin
Abatement (tons)
Waste (tons)
26
The Consequences of Global Warming

A doubling of atmospheric carbon dioxide in
about 60 years will increase global temperatures,
although it is unclear by how much.

Most scientists expect total rainfall to increase,
with an overall negative effect on agriculture
because less rainfall is expected in areas with
fertile soil and more rainfall in areas with less
productive soil.
Glaciers will melt, raising sea levels and
inundating the amount of land available for
agriculture or living space.

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A Carbon Tax

The economist’s response to the
accumulation of greenhouse
gases is to impose a tax on fossil
fuels.

The carbon tax for a particular
fuel would be determined by the
fuel’s carbon content.
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Effects of a Carbon Tax on the Market
for Coal


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A carbon tax will add to
the expenses incurred by
coal producers. So some
suppliers will leave the
market.
The supply of coal shifts
to the left and the coal tax
results in an increase in
the price per ton of coal
and a smaller quantity
produced.
O’Sullivan & Sheffrin
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Imperfect Information and
Disappearing Markets
A mixed market is a market where
low-quality goods and high-quality
goods are mixed together.
 A market will break down, or the
high-quality goods will tend to
disappear, if either buyers or sellers
are unable to distinguish between
low-quality goods and high-quality
goods.

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Asymmetric Information
In the model of supply and demand,
the efficiency of markets is based on
the assumption that buyers and
sellers are fully informed.
 If one side of the market, either
buyers or sellers, has better
information than the other, we say
that there is asymmetric information
in that market.

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The Mixed Market for Used Cars—
Lemons and Plums
 If buyers cannot distinguish between
lemons (low-quality cars) and plums
(high-quality cars), both will be sold
together, in a mixed market, for the
same price.
 In such a market, the odds of getting a
plum are small. The high-quality
goods will tend to disappear, and in
the extreme case, will be completely
nonexistent.
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Ignorant Consumers and Knowledgeable
Sellers
 To determine the price in a mixed
market we must answer these
questions:
How much is the consumer willing to
pay for a plum—a high-quality car?
 How much is the consumer willing to
pay for a lemon—a low-quality car?
 What is the chance that a used car
purchased in the mixed market will be a
lemon?

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Equilibrium Outcome in the Mixed Market

Suppose that a consumer believes
that the chances of getting a lemon
are 50% (neutral expectations).

To determine whether the actual
chance of getting a lemon is
greater or less than the expected
chance, consider the assumptions
in the following table:
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Equilibrium Outcome in the Mixed Market
Neutral
Expectations
Assumed chance of lemon
50%
Willingness to pay for lemon $2,000
Willingness to pay for plum
$4,000
Willingness to pay for used
car (average)
$3,000
Number of lemons supplied
16 or 80%
Number of plums supplied
4 or 20%
Total number of used cars
20 or 100%
Actual chance of lemon
80%
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
Under neutral
expectations (50%),
consumers will
underestimate the
chance of getting a
lemon (80%).
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Equilibrium Outcome in the Mixed Market
Pessimistic
Expectations
Assumed chance of lemon

100%
Willingness to pay for lemon $2,000
Willingness to pay for plum
$4,000
Willingness to pay for used
car (value of a lemon)
$2,000
Number of lemons supplied
9 or 100%
Number of plums supplied
0
Total number of used cars
9 or 100%
Actual chance of lemon
100%
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

Under pessimistic
expectations, the actual
chance of getting a lemon is
the same as the expected
chance (100%).
The higher the chance of
getting a lemon, the lower
the price consumers are
willing to pay.
Under pessimistic
expectations, the price of
used cars decreases.
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The Supply of Used Cars

The supply of used cars is comprised of people
willing to sell their cars in the used-car
market.
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
Owners of lemons are
willing to sell at a
price of $500 or more.

Owners of plums ask at
least $2,500 before any
plums are supplied.
O’Sullivan & Sheffrin
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Equilibrium Outcome in the Mixed
Market for Used Cars

When consumers’ expectations are consistent with their
actual experiences, the equilibrium price of used cars is
$2,000, and the plums will disappear from the market.
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Adverse Selection

The domination of the used-car market by lemons is an
example of the adverse-selection problem. The
quality of the goods left in the market is adverse, or
undesirable.

Adverse selection is the result of the dynamics of
asymmetric information (one side has better
information than the other), which generates a
downward spiral of price and quantity:

A decrease in price decreases the quantity of plums
supplied, decreasing the price further when buyers
realize that most cars are lemons, which leads to
even fewer plums on the market.
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Thin Market for Plums

It is possible that asymmetric
information generates a thin market—
one in which some high-quality goods
are sold, but fewer than would be sold in
a market with perfect information.
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Thin Market for Plums
Assumed chance of lemon
90%
Willingness to pay for lemon
$2,000
Willingness to pay for plum
$4,000
Willingness to pay for used
car
$2,200
Number of lemons supplied
18 or 90%
Number of plums supplied
2 or 10%
Total number of used cars
20 or 100%
Actual chance of lemon
90%
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
If the chance of getting
a plum is 10%, buyers
are willing to pay
$2,200 for a used car.

The market is in
equilibrium because
consumers accurately
assess the chances of
getting a lemon.
At an equilibrium price
of $2,200, 20 cars are
sold, 10% of which are
plums.

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Thin Market for Plums

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If the supply of plums
starts at $1,800, it is
possible that the
market will have a
small number of
plums when it
reaches equilibrium:
2 plums and 18
lemons sold at $2,200
each.
O’Sullivan & Sheffrin
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Applications


Baseball pitchers who are more
prone to injuries tend to switch
teams more often than pitchers who
aren’t.
This happens because of
asymmetric information and
adverse selection. The new team
has much less information than the
old one.
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Applications


A person who buys an insurance
policy knows much more about his
or her risks than the insurance
company.
Insurance companies must pick
from an adverse or undesirable
selection of customers. Buyers of
insurance policies have more
information than sellers.
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Applications


Careful physicians do not buy
malpractice insurance because
insurance companies are unable to
distinguish between careful and
reckless doctors.
The mixed market increases the cost
of providing insurance and the price
of the malpractice policy.
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Moral Hazard
Moral hazard is a situation that
encourages risky behavior.
 Insurance causes people to take
greater risks. They don’t buy a fire
extinguisher, or tend to drive
recklessly. These are unobserved
actions that increase the probability
of a grim outcome.

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Moral Hazard

The moral hazard is pervasive. The
availability of insurance, for
example, decreases investment in
prevention programs that reduce
risk.

Deposit insurance causes a moral
hazard problem. With insurance
available, depositors are less likely to
evaluate the performance and
riskiness of the financial institution.
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