Market Failures: Public Goods and Externalities 05 Market Failures: Public Goods and Externalities Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Market fails to produce the right amount of the product Market Failures Market fails to produce the right amount of the product Resources may be Over-allocated Under-allocated LO1 5-2

Some can enjoy benefits without paying Demand-Side Failures Impossible to charge consumers what they are willing to pay for the product Some can enjoy benefits without paying LO1 5-3

Occurs when a firm does not pay the full cost of producing its output 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 the supply LO1 5-4

Efficiently Functioning Markets Demand curve must reflect the consumers full willingness to pay Supply curve must reflect all the costs of production LO1 5-5

Extra benefit from paying less than the maximum price 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 5-6

Consumer Surplus Consumer Surplus Equilibrium Price Price (per bag) P1 Quantity (bags) Consumer Surplus Equilibrium Price P1 D Q1 LO2 LO2 5-7

Extra benefit from receiving a higher price 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 5-8

Producer Surplus Producer surplus S Price (per bag) P1 Quantity (bags) Producer surplus S Q1 P1 Equilibrium price LO2 LO2 5-9

Efficiency Revisited Consumer surplus S Price (per bag) P1 Quantity (bags) Consumer surplus S P1 Producer surplus D Q1 LO2 5-10

Efficiency Losses Quantity (bags) Price (per bag) a S d b e D c Q2 Q1 from underproduction S d b e D c Q2 Q1 LO2 5-11

Efficiency Losses a S f b Price (per bag) g D c Q1 Q3 Quantity (bags) from overproduction f b Price (per bag) g D c Q1 Q3 Quantity (bags) LO2 5-12

Produced in the market by firms Offered for sale Characteristics Private Goods Produced in the market by firms Offered for sale Characteristics Rivalry Excludability LO3 5-13

Provided by government Offered for free Characteristics Nonrivalry Public Goods Provided by government Offered for free Characteristics Nonrivalry Nonexcludability Free-rider problem LO3 5-14

Cost-Benefit Analysis 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 5-15

Positive externalities Too little is produced 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 5-16

Government Intervention Correct negative externalities Direct controls Specific taxes Correct positive externalities Subsidies Government provision LO4 5-17

Government Intervention 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 (b) Correct externality with tax LO4 5-18

Government Intervention Methods for Dealing with Externalities Problem Resource Allocation Outcome Ways to Correct Negative externalities (spillover costs) Overproduction 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) Underproduction of output and therefore underallocation of resources Subsidy to consumers Subsidy to producers Government provision LO4 5-19

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 5-20