42
Market Failures: Public Goods and Externalities 05
Market Failures: Public Goods and Externalities
05
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 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
LO2
Consumer Surplus
(1)Person
(2)Maximum
Price Willing to Pay
(3)Actual Price (Equilibrium
Price)
(4)Consumer
SurplusBob $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)
5-7
Consumer Surplus
LO2LO2 5-8
D
P1
Q1
Equilibrium Price
Consumer Surplus
EP
Consumer Surplus
LO2LO2 5-8
D
P1
Q1
Equilibrium Price
Consumer Surplus
EP
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 5-9
Producer Surplus
LO2
Producer Surplus
(1)Person
(2)Minimum
Acceptable Price
(3)Actual Price (Equilibrium
Price)
(4)Producer Surplus
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)
5-10
Producer Surplus
LO2LO2 5-11
S
Q1
P1Equilibrium price
Producer surplus
Producer Surplus
LO2LO2 5-11
S
Q1
P1Equilibrium price
Producer surplus
Efficiency Revisited
LO2 5-12
D
S
P1
Q1
Consumer surplus
Producer surplus
Efficiency Revisited
LO2 5-12
D
S
P1
Q1
Consumer surplus
Producer surplus
Quantity (bags)
Pric
e (p
er b
ag)
Efficiency Losses
LO2
c
S
Q1
D
b
a
5-13
e
Q2
db
d
e
Efficiency lossfrom underproduction
Quantity (bags)
Pric
e (p
er b
ag)
Efficiency Losses
LO2
c
S
Q1
D
b
a
5-13
e
Q2
db
d
e
Efficiency lossfrom underproduction
Efficiency Losses
LO2
c
S
Q1
D
b
a
Quantity (bags)
Pric
e (p
er b
ag)
5-14
g
Q3
fb
f
g
Efficiency lossfrom overproduction
Efficiency Losses
LO2
c
S
Q1
D
b
a
Quantity (bags)
Pric
e (p
er b
ag)
5-14
g
Q3
fb
f
g
Efficiency lossfrom overproduction
Private Goods
• Produced in the market by firms• Offered for sale• Characteristics
• Rivalry• Excludability
LO3 5-15
Public Goods
• Provided by government• Offered for free
• Characteristics• Nonrivalry• Nonexcludability• Free-rider problem
LO3 5-16
Demand for Public Goods
LO3
Demand for a Public Good, Two Individuals
(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
5-17
Demand for Public Goods
LO3
Adams
Benson
D1
D2
Adams’ Demand
Benson’s Demand
Collective Demand and Supply
SCollective Demand
Connect the Dots
5-18
$4 for 2 Items
$3 for 2 Items
$7 for 2 Items
$2 for 4 Items
$1 for 4 Items
$3 for 4 ItemsDC
CollectiveWillingness
To Pay
OptimalQuantity
Demand for Public Goods
LO3
Adams
Benson
D1
D2
Adams’ Demand
Benson’s Demand
Collective Demand and Supply
SCollective Demand
Connect the Dots
5-18
$4 for 2 Items
$3 for 2 Items
$7 for 2 Items
$2 for 4 Items
$1 for 4 Items
$3 for 4 ItemsDC
CollectiveWillingness
To Pay
OptimalQuantity
Demand for Public Goods
LO3
Adams
Benson
D1
D2
Adams’ Demand
Benson’s Demand
Collective Demand and Supply
SCollective Demand
Connect the Dots
5-18
$4 for 2 Items
$3 for 2 Items
$7 for 2 Items
$2 for 4 Items
$1 for 4 Items
$3 for 4 ItemsDC
CollectiveWillingness
To Pay
OptimalQuantity
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 5-19
Cost-Benefit Analysis
LO3
Cost-Benefit Analysis for a National Highway Construction Project (in Billions)
(1)Plan
(2)Total Cost of Project
(3)Marginal
Cost
(4)Total
Benefit
(5)Marginal Benefit
(6)Net Benefit
(4) – (2)No new construction $0 $0 $0A: Widen existing highways 4 $4 5 $5 1B: New 2-lane highways 10 6 13 8 3C: New 4-lane highways 18 8 22 10 5D: New 6-lane highways 28 10 26 3 -2
5-20
Quasi-Public Goods
• Could be provided through the market system
• Because of positive externalities the government provides them
• Examples: education, streets, libraries
LO3 5-21
The Reallocation Process
• Government• Taxes individuals and businesses• Takes the money and spends on
production of public goods
LO3 5-22
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 5-23
Externalities
LO4
(a)Negative externalities
(b)Positive externalities
0
D
S
St St
Qe
P P
0Q Q
D
5-24
c
NegativeExternalities
a
Qo
Overallocation
ba
xx
Qe
Dt
PositiveExternalities
D
z
Qo
Underallocation
yz
y
Externalities
LO4
(a)Negative externalities
(b)Positive externalities
0
D
S
St St
Qe
P P
0Q Q
D
5-24
c
NegativeExternalities
a
Qo
Overallocation
ba
xx
Qe
Dt
PositiveExternalities
D
z
Qo
Underallocation
yz
y
Externalities
LO4
(a)Negative externalities
(b)Positive externalities
0
D
S
St St
Qe
P P
0Q Q
D
5-24
S
S
c
NegativeExternalities
a
Qo
Overallocation
ba
xx
Qe
Dt
PositiveExternalities
D
z
Qo
Underallocation
yz
y
Externalities
LO4
(a)Negative externalities
(b)Positive externalities
0
D
S
St St
Qe
P P
0Q Q
D
5-24
S
S
c
NegativeExternalities
a
Qo
Overallocation
ba
xx
Qe
Dt
PositiveExternalities
D
z
Qo
Underallocation
yz
y
Externalities
LO4
(a)Negative externalities
(b)Positive externalities
0
D
S
St St
Qe
P P
0Q Q
D
5-24
S
S
xc
NegativeExternalities
a
Qo
Overallocation
ba
xx
Qe
Dt
PositiveExternalities
D
z
Qo
Underallocation
yz
y
Government Intervention
• Correct negative externalities• Direct controls• Specific taxes
• Correct positive externalities• Subsidies and government
provision
LO4 5-25
Government Intervention
LO4 5-26
(a)Negative Externalities
P
0 Q
D
S
Qe
St
NegativeExternalities
Qo
Overallocation
b
c
a
(b)Correct externality with
tax
P
0Q
D
S
Qe
S
St
T
Qo
a
Government Intervention
LO4 5-27
(a)Positive Externalities
0
D
St
Qe
Dt
PositiveExternalities
PositExterna
Qo
Underallocation
y
x
zzy
(b)Correcting via a subsidy
to consumers
0
D
St
Qe
Subsidy DtS
Qo
(c)Correcting via a subsidy
to producers
0
D
Qe
U
S't
Qo
SubsidySt
SubsS
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
5-28
Society’s Optimal Amounts
LO5 5-29
0
Soci
ety’
s M
argi
nal B
enef
it an
d M
argi
nal
Cos
t of P
ollu
tion
Aba
tem
ent (
Dol
lars
)
MB
MC
Q1
SociallyOptimal AmountOf PollutionAbatement
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 5-30
Controlling Carbon Dioxide Emissions
• 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
5-31
