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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Market Failures: Public Goods and Externalities
4
4-2
Market Failures
• Market fails to produce the right amount of the product
• Resources may be
• Overallocated
• Underallocated
LO1
4-3
Demand-Side Failures
• Impossible to charge consumers what they are willing to pay for the product
• Some can enjoy benefits without paying
LO1
4-4
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
4-5
Efficiently Functioning Markets
• Demand curve must reflect the consumers, full willingness to pay
• Supply curve must reflect all the costs of production
LO1
4-6
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
4-7
Consumer Surplus
LO2
Consumer Surplus
(1)Person
(2)Maximum
Price Willing to Pay
(3)Actual Price (Equilibrium
Price)
(4)Consumer
Surplus
Bob $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)
4-8
Consumer Surplus
LO2
D
Q1
P1
Consumer Surplus
Equilibrium Price
4-9
Producer Surplus
• Difference between the actual price a producer receives and the minimum price the producer would accept
• Extra benefit from receiving a higher price
LO2
4-10
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)
4-11
Producer Surplus
LO2
S
Q1
P1Equilibrium price
Producer surplus
4-12
Efficiency Revisited
LO2
S
Q1
P1
D
Consumer surplus
Producer surplus
4-13
Quantity (bags)
Pri
ce
(pe
r b
ag
)
Efficiency Losses
LO2
c
S
Q1Q2
D
bd
a
e
Efficiency lossfrom underproduction
4-14
Efficiency Losses
LO2
c
S
Q1 Q3
D
bf
a
g
Quantity (bags)
Pri
ce
(pe
r b
ag
)
Efficiency lossfrom overproduction
4-15
Private Goods Characteristics
• Produced in the market by firms
• Offered for sale
• Characteristics
• Rivalry
• Excludability
LO3
4-16
Public Goods Characteristics
• Provided by government
• Offered for free
• Characteristics
• Nonrivalry
• Nonexcludability
• Free-rider problem
LO3
4-17
Measuring Demand
LO3
Optimal Quantity 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
4-18
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
4-19
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 $0
A: Widen existing highways
4 $4 5 $5 1
B: New 2-lane highways 10 6 13 8 3
C: New 4-lane highways 18 8 22 10 4
D: New 6-lane highways 28 10 26 3 -2
4-20
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
4-21
Externalities
LO4
(a)Negative externalities
(b)Positive externalities
0
D
S
St
Overallocation
NegativeExternalities
St
Underallocation
PositiveExternalities
Qo QoQe Qe
P P
0Q Q
D
Dt
a
c
z
x
b y
4-22
Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies and government provision
LO4
4-23
Government Intervention
LO4
(a)
Negative Externalities
D
S
St
Overallocation
NegativeExternalities
Qo Qe
P
0 Q
a
c
b
(b)
Correcting the overallocation of
resources via direct controls or via a tax
D
S
St
Qo Qe
P
0Q
a
T
4-24
Government Intervention
LO4
(a)Positive externalities
0
St
Underallocation
Positiveexternalities
QoQe
D
Dt
z
x
y
(b)Correcting via a subsidy
to consumers
0
St
QoQe
D
Dt
(c)Correcting via a subsidy
to producers
0
S't
QoQe
D
Subsidy
St
Subsidy
U
4-25
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
4-26
Society’s Optimal Amounts
LO5
0
So
ciet
y’s
Mar
gin
al B
enef
it a
nd
Mar
gin
alC
ost
of
Po
lluti
on
Ab
atem
ent
(Do
llars
)
Q1
MB
MC
SociallyOptimal Amountof PollutionAbatement
4-27
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