Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by Mehdi Arzandeh, University of Manitoba

© 2016 McGraw‐Hill Education Limited Market Failures: Public Goods and Externalities 4 LEARNING OBJECTIVES LO4.1 Differentiate between demand-side market failures and supply-side market failures. LO4.2 Explain the origin of both consumer surplus and producer surplus, and explain how properly functioning markets maximize their sum, economic surplus, while optimally allocating resources. LO4.3 Describe free riding and public goods, and illustrate why private firms cannot normally produce public goods. LO4.4 Explain how positive and negative externalities cause underallocations and overallocations of resources . LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every last bit of a negative externality such as air pollution. LOA4.1 Describe how information failures may justify government intervention in some markets. © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Market Failures in Competitive Markets 4.1 A demand-side market failure Demand curves do not reflect consumers’ full willingness to pay for a good or service. A supply-side market failure Supply curves do not reflect the full cost of producing a good or service. LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Efficiently Functioning Markets 4.2 1. Demand curve must reflect the consumers full willingness to pay 2. Supply curve must reflect all the costs of production The market will produce only units for which benefits are at least equal to costs. The market will maximize the amount of benefits surpluses that are shared between consumers and producers. LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Efficiently Functioning Markets 4.2 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 © 2016 McGraw‐Hill Education Limited

Maximum Price Willing to Pay Actual Price (Equilibrium Price) TABLE 4-1 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 3 (=$11-$8) Bart 10 2 (=$10-$8) Brent 9 1 (= $9-$8) Betty 0 (= $8-$8) This table represents the consumer surplus that each buyer receives. The surplus is just the difference between the price that they were willing to pay and the price that they actually paid. It is assumed that all consumers will pay the equilibrium price for the good. As you can see, not all consumers will have a surplus. LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited FIGURE 4-1 Consumer Surplus Price (per bag) Quantity (bags) Consumer Surplus Equilibrium Price = $8 P1 Consumer surplus—shown as the green triangle—is the difference between the maximum prices consumers are willing to pay for a product and the lower equilibrium price, here the equilibrium price is assumed to be $8. For quantity Q1, consumers are willing to pay the sum of the amounts represented by the green triangle and the yellow rectangle. Because they need to pay only the amount shown as the yellow rectangle, the green triangle shows consumer surplus. D Q1 LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Efficiently Functioning Markets 4.2 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 © 2016 McGraw‐Hill Education Limited

Minimum Acceptable Price Actual Price (Equilibrium Price) 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 3 (=$8-$5) Cindy 6 2 (=$8-$6) Craig 7 1 (=$8-$7) Chad 0 (=$8-$8) This table reflects the lowest possible price each seller is willing to accept as payment. If the price that they receive (the equilibrium price) is greater than the minimum acceptable price, then they have a surplus. As you can see, not all producers will have a surplus. LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited FIGURE 4-2 Producer Surplus Price (per bag) Quantity (bags) Producer surplus S Q1 P1 Equilibrium price = $8 Producer surplus—shown as the blue triangle—is the difference between the actual price producers receive for a product (here $8) and the lower minimum payments they are willing to accept. For quantity Q1, producers receive the sum of the amounts represented by the blue triangle plus the yellow area. Because they only need to receive the amount shown by the yellow area to produce Q1, the blue triangle represents producer surplus. LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Efficiency: Maximum Combined Consumer and Producer Goods FIGURE 4-3 Price (per bag) Quantity (bags) Consumer surplus S P1 When the market achieves efficiency, the maximum combined consumer and producer surplus is achieved. At quantity Q1, the combined amount of consumer surplus, shown as the green triangle, and producer surplus, shown as the blue triangle, is maximized. Efficiency occurs because, at Q1, maximum willingness to pay, indicated by the points on the demand curve, equals minimum acceptable price, shown by the points on the supply curve. Productive efficiency is achieved because competition forces producers to use the best available technology and best combination of resources available. Allocative efficiency is achieved because the correct quantity of product is produced relative to other goods and services. Producer surplus D Q1 LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited FIGURE 4-4(a) Efficiency Losses (or Deadweight Losses) Quantity (bags) Price (per bag) a Efficiency loss from underproduction S d b e Efficiency losses (or deadweight losses) are reductions of combined consumer surplus and producer surplus. Quantity levels that are either less than or greater than the efficient quantity, Q1, create efficiency losses. Triangle dbe shows the efficiency loss associated with underproduction at output Q2. D c Q2 Q1 LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited FIGURE 4-4(b) Efficiency Losses (or Deadweight Losses) a S Efficiency loss from overproduction f b Price (per bag) g Efficiency losses (or deadweight losses) are reductions of combined consumer surplus and producer surplus. Quantity levels that are either less than or greater than the efficient quantity, Q1, create efficiency losses. Triangle bfg illustrates the efficiency loss associated with overproduction at output level Q3. D c Q1 Q3 Quantity (bags) LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.3 Public Goods Private goods characteristics Produced in the market by firms Offered for sale Rivalry Excludability LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.3 Public Goods Public goods characteristics Provided by government Offered for free Nonrivalry Nonexcludability Free-rider problem LO3 © 2016 McGraw‐Hill Education Limited

Demand for a Public Good, Two Individuals TABLE 4-3 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 5 The demand for a public good is somewhat unusual. Suppose Adams and Benson are the only two people in society and their marginal willingness to pay for a public good, national defense, is as shown in the columns of the table. Notice that the schedules in Table 4.3 are price quantity schedules reflecting demand. To find the demand for a public good we add the total price each individual is willing to pay for the unit rather than summing the quantities at each price. LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited FIGURE 4-5 The Optimal Amount of a Public Good $6 5 4 3 2 1 P Q Benson’s Demand $4 for 2 Items D2 $2 for 4 Items Benson $6 5 4 3 2 1 P Q Adams’ Demand $3 for 2 Items $1 for 4 Items D1 Adams $9 7 5 3 1 P Q 2 4 Shown here is the individual’s willingness-to-pay curves D1 and D2 for Adams and Benson, the only two people in the economy. The collective demand curve for a public good is found by summing vertically the individual willingness-to-pay curves, D1 and D2, for Adams and Benson. The supply curve of the public good is upward sloping, reflecting rising marginal costs. The optimal amount of the public good is 3 units, determined by the intersection of Dc and S. At that output, the marginal benefit (reflected in the collective demand curve Dc) equals marginal cost (reflected in the supply curve S). Collective Demand S Optimal Quantity $7 for 2 Items $3 for 4 Items Collective Willingness To Pay Connect the Dots DC Collective Demand and Supply LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.3 Public Goods 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 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Cost-Benefit Analysis for a National Highway Construction Project, billions of dollars TABLE 4-4 (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 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 22 D: New 6-lane highways 28 26 -2 The table shows that the total annual benefit (column 4) exceeds the total annual cost (column 2) for plans A, B, and C, indicating that some highway construction is economically justifiable. We see this directly in column 6, where total costs (column 2) are subtracted from total annual benefits (column 4). Net benefits are positive for plans A, B, and C. Plan D is not economically justifiable because net benefits are negative, but the question of optimal size or scope for this project remains. By comparing the marginal cost (the change in total cost) and the marginal benefit (the change in total benefit) we can determine the answer. The guideline is well known to you from previous discussions: Increase an activity, project, or output as long as the marginal benefit (column 5) exceeds the marginal cost (column 3). Stop the activity at, or as close as possible to, the point at which the marginal benefit equals the marginal cost. Do not undertake a project for which marginal cost exceeds marginal benefit. In this case, plan C (building new four-lane highways) is the best plan. Plans A and B are too modest; the marginal benefits exceed the marginal costs, and there is a better option. Plan D’s marginal cost ($10 billion) exceeds the marginal benefit ($3 billion) and therefore cannot be justified; it overallocates resources to the project. LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.3 Public Goods QUASI-PUBLIC GOODS Could be provided through the market system Because of positive externalities the government provides them Examples: education, streets, libraries LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.3 Public Goods THE REALLOCATION PROCESS Government Taxes individuals and businesses Takes the money and spends on production of public goods LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.4 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 © 2016 McGraw‐Hill Education Limited

Negative externalities Positive externalities FIGURE 4-6 Negative Externalities and Positive Externalities P Q Negative Externalities St St y b a z Positive Externalities S x Dt c D D Overallocation Underallocation Qo Qe Qe Qo With negative externalities borne by society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St. Consequently, the equilibrium output Qe is greater than the optimal output Qo, and the efficiency loss is abc. When positive externalities accrue to society, the market demand curve D is to the left of (below) the total-benefit demand curve Dt. As a result, the equilibrium output, Qe is less than the optimal output Qo, and the efficiency loss is xyz. (a) Negative externalities (b) Positive externalities LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 4.4 Externalities Government Intervention Correct negative externalities Direct controls Specific taxes Correct positive externalities Subsidies and government provision LO4 © 2016 McGraw‐Hill Education Limited

Negative Externalities Correct externality with tax FIGURE 4-7 Correcting for Negative Externalities Negative Externalities P Q P Q St St b a a S S T c D D Overallocation Qo Qe Qo Qe (a) Negative externalities result in an overallocation of resources. (b) Government can correct this overallocation in two ways: (1) using direct controls, which would shift the supply curve from S to St and reduce output from Qe to Qo, or (2) imposing a specific tax, T, which would also shift the supply curve from S to St, eliminating the overallocation of resources and thus the efficiency loss. (a) Negative Externalities (b) Correct externality with tax LO4 © 2016 McGraw‐Hill Education Limited

Correcting for Positive Externalities FIGURE 4-8 Correcting for Positive Externalities St St St y Subsidy z S't Positive Externalities x Dt Dt Subsidy U D D D Underallocation Qe Qo Qe Qo (a) Positive externalities result in an underallocation of resources. (b) This underallocation can be corrected through a subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Q0. (c) Alternatively, the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to S’t and increases output from Qe to Q0. This eliminates the underallocation of output, and thus the efficiency loss, shown in graph (a). Qe Qo (a) Positive Externalities (b) Correcting via a subsidy to consumers (c) Correcting via a subsidy to producers LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited TABLE 4-5 Methods for Dealing with Externalities Problem Resource allocation outcome Ways to correct Negative externalities (spillover costs) Over production of output and therefore overallocation of resources Private bargaining Liability rules and lawsuits Tax on producers Direct controls Market for externality rights Positive externalities (spillover benefits) Under production of output and therefore underallocation of resources Subsidy to consumers Subsidy to producers Government provision LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Society’s Optimal Amount of Externality Reduction 4.5 MC, MB, AND EQUILIBRIUM QUANTITY Downsloping marginal-benefit curve, MB, for pollution reduction (diminishing marginal utility) Rising marginal-cost curve, MC, for pollution reduction (increasing opportunity costs) Optimal reduction of an externality When society’s MC and MB of reducing the externality are equal. LO5 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Society’s Optimal Amount of Externality Reduction 4.5 SHIFTS IN LOCATIONS OF THE CURVES Shifts in MC (e.g. due to technology) Shifts in MB (e.g. due to preferences) LO5 © 2016 McGraw‐Hill Education Limited

MC Socially Optimal Amount Of Pollution Abatement MB Q1 FIGURE 4-9 Society’s Optimal Amount of Pollution Abatement MC Socially Optimal Amount Of Pollution Abatement Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Reducing pollution and negative externalities is not free. Society must decide how much pollution abatement it wants to “buy”. High costs may mean that totally eliminating pollution may not be desirable. The marginal cost rises as pollution is reduced more and more and at some point the marginal cost is higher than the marginal benefit. Additional actions to reduce pollution will therefore lower society’s well-being because total costs will rise more than total benefits. The optimal amount of externality reduction—in this case, pollution abatement—occurs at Q1, where society’s marginal cost, MC, and marginal benefit, MB, of reducing the spillover are equal. MB Q1 LO5 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Society’s Optimal Amount of Externality Reduction 4.5 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 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Carbon Dioxide Emissions, Cap-and-Trade, and Carbon Taxes The LAST WORD 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 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Chapter Summary LO4.1 Differences between demand-side market failure and supply-side market failures. LO4.2 Explain the origin of both consumer surplus and producer surplus, and explain how properly functioning markets maximize their sum, economic surplus, while optimally allocating resources. LO4.3 Describe free riding and public goods, and illustrate why private firms cannot normally produce public goods. LO4.4 Explain how positive and negative externalities cause underallocations and overallocations of resources. LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every last bit of a negative externality such as air pollution. © 2016 McGraw‐Hill Education Limited