1. Unit 5: Market Failures and Externalities
Topic: Gov’t and Market Failure
Chapter: 30

2. Learning Targets
I will be able to explain what externalities are and when they occur, and I can provide several possible solutions to externalities.

3. Public Goods vs. Private Goods
Produced by gov’t
Non-rivalry (consumption by one does not mean others can’t have it)
Non-excludability (no way to stop people from receiving it – free rider problem)
Efficiency does not accurately reflect supply and demand.
Produced by private firms
Rivalry (consumption by one person may mean that others have to do without)
Excludable (if you don’t pay, you don’t get it)
Supply, demand and efficiency exist in these markets.

4. Externalities
Def: positive and negative spillovers to a third party which were not intended in the original production plan.
Can result from production of either public or private goods

5. Terms
COSTS
Private marginal cost: the actual “numerical” cost of production to the producer.
Social marginal cost: the cost which spills over to society (ex. pollution).
Total cost = private marginal cost + social marginal cost
BENEFITS
Private marginal benefit: the benefit to consumers of the good (measured by utility; consumers pay prices according to utility).
Social marginal benefit: the added benefit to society (consumers who don’t pay for the good); ex. immunizations.
Total benefit = private marginal benefit + social marginal benefit

6. Negative Externalities
Occur when:
there are spillover costs (someone other than the producer is “paying” for the good’s production).
social marginal cost is greater than private marginal cost.
marginal cost is greater than marginal benefit.
there is an overallocation of resources to the good (too much of it is being produced).

7. Negative Externality Steel S (social MC) Price/Cost S (private MC)
Social cost
Private cost/price of good
D (private MB) Q
(optimum) Q
(market) Q

8. What can the gov’t do for neg. externalities?
Gov’t must discourage production by:
Direct controls – laws that regulate the offending activity (ex. pollution prevention technology).
Taxes – applied to firms that produce the harmful good (ex. taxing levels of pollution)

9. Positive Externalities
Occur when:
there are spillover benefits(someone other than the consumer is “gaining” from the good’s consumption).
social marginal benefit is greater than private marginal benefit.
marginal benefit is greater than marginal cost.
there is an underallocation of resources to the good (too little of it is being produced and consumed).

10. Positive Externality Price/Cost Swine Flu Vaccines S (private MC)
Social benefit
Private benefit/price of good
D (social MB)
D (private MB) Q
(market) Q
(optimum) Q

11. What can gov’t do for pos. externalities?
Gov’t must encourage production by:
Subsidies to consumers – discounts, rebates and coupons (ex. cash for clunkers).
Subsidies to sellers – reduces cost that the producer pays (↑ S will cause lower price for more consumers to be able to pay for it).
Provide it as a public good – free for everyone

12. Non-Gov’t Solutions to Mkt Failures
Coase Theorem
If there are clearly-defined property rights and a small number of people involved, problems will work themselves out.
Liability rules and lawsuits
Clearly-defined property rights allow courts to rule on externality cases.
Market-based approach
Development of a market for externality rights (ex. pollution permits)