Public Goods, Externalities and Taxes Market Failure Chapter 5

Public Goods – Definition and Characteristics Indivisible – once the good is produced, the producer can’t bar non payers from obtaining the benefits Exclusion Principle – when a producer can’t exclude non payers from receiving the benefits of a good, it is difficult for the producer to profitably produce the good Public goods are typically produced by the government Examples: National Defense, Snow Plowing, Public Parks

Public Goods – Optimal Quantity Marginal Benefit – Marginal Cost Analysis Graph

Externalities Externalities occur when the costs of producing or the benefits of consuming a good “spill over” onto those who are neither producing or consuming the good. These are costs or benefits that escape the producer or consumer.

Spillover Costs (negative externalities) Supply curve does not consider all costs Overallocation of resources to production Pollution is the classic example of a negative externality Negative externalities are typically corrected with a tax Graph

Spillover Benefits (positive externalities) Demand curve does not consider all benefits Underallocation of resources to production Spillover benefits may be corrected in three ways subsidize consumers – shifts demand right subsidize producers – shifts supply right provide goods via the government

Pollution Pollution is an economic “bad”. It reduces the utility of those affected. Should society eliminate all of this bad? Society must decide how much of a reduction it wants to “buy”. Because of the Law of Diminishing Returns, cleaning up all pollution would be very costly. The marginal cost to the firm, and hence to society, rises as more and more pollution is reduced. Likewise, the marginal benefit of reducing pollution decreases as more and more pollution is removed

Pollution (cont) Socially Optimal Pollution Reduction – Graph Shifts in Curves – New Technology, New Research

Tax Incidence – Who pays the tax? Assumption: Excise Tax (production tax) – shifts supply to the left The tax shifts supply to the left. The more inelastic the demand is, the more of a tax burden will be shifted to consumers. Graph

Efficiency Loss of a Tax Efficiency Loss is also called Deadweight Loss Graph

Progressive Tax – a tax whose average tax rate increases as the taxpayer’s income increase Income Tax Regressive Tax – a tax whose average tax rate decreases as the taxpayer’s income increases Sales Tax