10/1/2017

1

Chapter 4Market Failures: Public Goods and Externalities

Market Failures

• Market failures • Markets fail to produce the right amount

of the product• Resources may be

• Over-allocated• Under-allocated

LO1

10/1/2017

2

Demand-Side Market Failures

• Demand-side market failures• When it is not possible to charge

consumers for the product• Some can enjoy benefits without paying• Firms not willing to produce since they

cannot cover the costs

LO1

Supply-Side Market Failures

• Supply-side market 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

Efficiently Functioning Markets• Demand curve must reflect the

consumers’ full willingness to pay• Supply curve must reflect all the costs of

production• Benefit surpluses are maximized for

consumers and producers

LO2

10/1/2017

3

Consumer Surplus

• 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

Consumer Surplus Continued

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)

Consumer Surplus Concluded

Pric

e (p

er b

ag)

Quantity (bags)

D

Q1

P1

Consumer surplus

Equilibrium price = $8

LO2

10/1/2017

4

Producer Surplus

• 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

Producer Surplus Continued

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)

Producer Surplus Concluded

LO2

Pric

e (p

er b

ag)

Quantity (bags)

S

Q1

P1Equilibrium price = $8

Producer surplus

10/1/2017

5

Efficiency Revisited

LO2

Pric

e (p

er b

ag)

Quantity (bags)

S

Q1

P1

D

Consumer surplus

Producer surplus

Efficiency Losses

• Efficiency loss (or deadweight losses)

LO2 Quantity (bags)

Pric

e (p

er b

ag)

c

S

Q1Q2

D

bd

a

e

Efficiency lossfrom underproduction

Efficiency Losses Continued

LO2

c

S

Q1 Q3

D

bf

a

g

Quantity (bags)

Pric

e (p

er b

ag)

Efficiency lossfrom overproduction

10/1/2017

6

Private Goods

• Private goods are produced in the market by firms

• Offered for sale• Characteristics

• Rivalry• Excludability

LO3

Public Goods

• Public goods are goods provided by government

• Offered for free• Characteristics

• Nonrivalry• Nonexcludability• Free-rider problem

LO3

Demand for Public Goods

LO3

Demand for a Public Good, Two Individuals

(1)Quantity of Public Good

(2)Adams’s 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

10/1/2017

7

Demand for Public Goods Continued

LO3

$6543210

P

Q1 2 3 4 5

$6543210

P

Q1 2 3 4 5Adams

Benson

D1

D2

Adams’s Demand

Benson’s Demand

$9

7

5

3

1

0

P

Q1 2 3 4 5Collective Demand and Supply

DC

SCollective Demand Optimalquantity

Collectivewillingness

to pay

Cost-Benefit Analysis

• 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

LO4

Cost-Benefit Analysis Continued

LO4

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 23 10 5

D: New 6-lane highways 28 10 26 3 -2

10/1/2017

8

Quasi-Public Goods

• Quasi-public goods could be provided through the market system

• Because of positive externalities the government provides them

• Examples are education, streets, museums

LO4

The Reallocation Process

• Government• Taxes individuals and businesses• Takes the money and spends on

production of public goods

LO4

Externalities• An externality is a cost or benefit accruing

to a third party external to the market transaction

• Positive externalities• Too little is produced• Demand-side market failures

• Negative externalities• Too much is produced• Supply-side market failures

LO4

10/1/2017

9

Externalities Continued

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

Government Intervention

• Correct negative externalities• Direct controls• Pigovian tax

• Correct positive externalities• Subsidies• Government provision

LO4

Correcting for Negative Externalities

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

10/1/2017

10

Correcting for Positive Externalities

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

StSubsidy

U

Government Intervention Concluded

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

Society’s Optimal Amounts

LO5

0

Soci

ety’

sm

argi

nal b

enef

it an

d m

argi

nal

cost

of p

ollu

tion

abat

emen

t (do

llars

)

Q1

MB

MC

Sociallyoptimal amountof pollutionabatement

10/1/2017

11

Government’s Role in the Economy• Coase theorem

• Private sector bargaining can solve externality problem

• Government’s role in correcting externalities• Optimal reduction of an externality• Officials must correctly identify the existence

and cause• Government failure may occur

LO5

Controlling CO2 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 the cost of polluting• Easier to enforce