Download Market Failures: Public Goods and Externalities

5
Market Failures: Public Goods and
Externalities
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Market Failures
• Market fails to produce the right
•
LO1
amount of the product
Resources may be:
• Over-allocated
• Under-allocated
Demand-Side Failures
• Impossible to charge consumers
what they are willing to pay for the
product
• Some can enjoy benefits without
paying
LO1
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 supply
LO1
Efficiently Functioning Markets
• Demand curve must reflect the
•
LO1
consumers full willingness to pay
Supply curve must reflect all the costs
of production
Consumer Surplus
• Difference between what a consumer
•
LO2
is willing to pay for a good and what
the consumer actually pays
Extra benefit from paying less than
the maximum price
Consumer Surplus
Consumer Surplus
(2)
Maximum
Price Willing
to Pay
(3)
Actual Price
(Equilibrium
Price)
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)
(1)
Person
LO2
(4)
Consumer
Surplus
Price (per bag)
Consumer Surplus
Consumer
Surplus
Equilibrium
Price
P1
D
Q1
Quantity (bags)
LO2
Producer Surplus
• Difference between the actual price a
•
LO2
producer receives and the minimum
price they would accept
Extra benefit from receiving a higher
price
Producer Surplus
Producer Surplus
(2)
Minimum
Acceptable
Price
(3)
Actual Price
(Equilibrium
Price)
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)
(1)
Person
LO2
(4)
Producer
Surplus
Price (per bag)
Producer Surplus
Producer
surplus
S
P1
Equilibrium
price
Q1
Quantity (bags)
LO2
Efficiency Revisited
Price (per bag)
Consumer
surplus
P1
Producer
surplus
Q1
Quantity (bags)
LO2
S
D
Efficiency Losses
Price (per bag)
a
Efficiency loss
from underproduction
S
d
b
e
D
c
Q2 Q1
Quantity (bags)
LO2
Efficiency Losses
Price (per bag)
a
Efficiency loss
from overproduction
S
f
b
g
D
c
Q1 Q3
Quantity (bags)
LO2
Private Goods
• Produced in the market by firms
• Offered for sale
• Characteristics
• Rivalry
• Excludability
LO3
Public Goods
• Provided by government
• Offered for free
• Characteristics
• Nonrivalry
• Nonexcludability
• Free-rider problem
LO3
Demand for Public Goods
Demand for a Public Good, Two Individuals
(1)
Quantity
of Public
Good
(2)
Ambu’s Willingness
to Pay (Price)
1
$4
+
$5
=
$9
2
3
+
4
=
7
3
2
+
3
=
5
4
1
+
2
=
3
5
0
+
1
=
1
LO3
(3)
Brinley’s
Willingness to
Pay (Price)
(4)
Collective
Willingness
to Pay (Price)
Demand for Public Goods
Brinley’s Demand
$4 for 2 Items
$2 for 4 Items
P
$6
5
4
3
2
1
0
D2
1
2
3
4
Q
5
Benson
Ambu’s Demand
$3 for 2 Items
$1 for 4 Items
P
$6
5
4
3
2
1
0
D1
1
2
3
4
Q
5
Adams
P
Collective Demand
$7 for 2 Items
$3 for 4 Items
S
$9
Optimal
Quantity
7
5
Collective
Willingness
To Pay
3
Connect the Dots
DC
1
0
1
2
3
4
5
Collective Demand and Supply
LO3
Q
Cost-Benefit Analysis
• Cost
• Resources diverted from private
•
LO3
good production
• Private goods that will not be
produced
Benefit
• The extra satisfaction from the
output of more public goods
Cost-Benefit Analysis
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
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
22
10
5
D: New 6-lane highways
28
10
26
3
-2
LO3
$0
$0
Quasi-Public Goods
• Could be provided through the market
•
•
LO3
system
Because of positive externalities the
government provides them
Examples: education, streets,
libraries
The Reallocation Process
• Government
• Taxes individuals and businesses
• Takes the money and spends on
production of public goods
LO3
Externalities
• A cost or benefit accruing to a third
•
•
LO4
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
Externalities
P
Negative
Externalities
a
P
St
b
St
y
z
S
Positive
Externalities
Dt
x
c
D
D
Overallocation
0
Qo
Qe
(a)
Negative externalities
LO4
Underallocation
0
Q
Qe
Qo
(b)
Positive externalities
Q
Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies and government
provision
LO4
Government Intervention
P
Negative
Externalities
a
b
P
St
St
a
S
T
c
0
LO4
S
D
Overallocation
Qo Qe
Q
D
0
Qo Qe
Q
(a)
(b)
Negative Externalities
Correct externality with
tax
Government Intervention
y
St
z
St
St
Subsidy
S't
Positive
Externalities
x
Dt
Subsidy Dt
D
D
U
D
Underallocation
0
Qe
Qo
(a)
Positive Externalities
LO4
0
Qe
Qo
(b)
Correcting via a subsidy
to consumers
0
Qe
Qo
(c)
Correcting via a subsidy
to producers
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
1.
2.
3.
4.
5.
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
1.
2.
3.
4.
Private bargaining
Subsidy to consumers
Subsidy to producers
Government provision
LO4
Society’s Marginal Benefit and Marginal
Cost of Pollution Abatement (Dollars)
Society’s Optimal Amounts
MC
Socially
Optimal Amount
Of Pollution
Abatement
MB
0
LO5
Q1
Government’s Role in the Economy
• Government can have a role in
•
•
LO5
correcting externalities
Officials must correctly identify the
existence and cause
Has to be done in the context of
politics
Controlling Carbon Dioxide 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 cost of polluting
• Easier to enforce