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Market Failures: Public Goods and Externalities
05
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Market Failures
• Market fails to produce the right amount of the product
• Resources may be
• Over-allocated
• Under-allocated
LO1 5-2
Demand-Side Failures
• Impossible to charge consumers what they are willing to pay for the product
• Some can enjoy benefits without paying
LO1 5-3
Supply-Side Failures
• Occurs when a firm does not pay the full cost of producing its output
• External costs of producing the good are not reflected in the supply
LO1 5-4
Efficiently Functioning Markets
• Demand curve must reflect the consumers full willingness to pay
• Supply curve must reflect all the costs of production
LO1 5-5
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 5-6
Consumer Surplus
LO2LO2
D
Q1
P1
Consumer Surplus
Equilibrium Price
5-7
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 5-8
Producer Surplus
LO2LO2
S
Q1
P1
Equilibrium price
Producer surplus
5-9
Efficiency Revisited
LO2
S
Q1
P1
D
Consumer surplus
Producer surplus
5-10
Quantity (bags)
Pri
ce
(pe
r b
ag
)
Efficiency Losses
LO2
c
S
Q1Q2
D
bd
a
e
Efficiency lossfrom underproduction
5-11
Efficiency Losses
LO2
c
S
Q1 Q3
D
bf
a
g
Quantity (bags)
Pri
ce
(pe
r b
ag
)
Efficiency lossfrom overproduction
5-12
Private Goods
• Produced in the market by firms
• Offered for sale
• Characteristics
• Rivalry
• Excludability
LO3 5-13
Public Goods
• Provided by government
• Offered for free
• Characteristics
• Nonrivalry
• Nonexcludability
• Free-rider problem
LO3 5-14
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 5-15
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 5-16
Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies
• Government provision
LO4 5-17
Government Intervention
LO4
(a)
Negative externalities
D
S
St
Overallocation
Negativeexternalities
Qo Qe
P
0 Q
a
c
b
(b)
Correct externality with tax
D
S
St
Qo Qe
P
0Q
a
T
5-18
Government Intervention
LO4
Methods for Dealing with Externalities
ProblemResource Allocation Outcome Ways to Correct
Negative externalities (spillover costs)
Overproduction of output and therefore overallocation of resources
1. Private bargaining2. Liability rules and lawsuits3. Tax on producers4. Direct controls5. Market for externality rights
Positive externalities (spillover benefits)
Underproduction of output and therefore underallocation of resources
1. Private bargaining2. Subsidy to consumers3. Subsidy to producers4. Government provision
5-19
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 5-20