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Ch 28.
Gov’t and Market Failure
Public Goods


Nonrivalry – Once a producer has produced
a public good, everyone can obtain the
benefit.
Nonexcludability – One persons
consumption of the good does not
preclude consumption of the same good
by others.
-- Because of these, private firms cannot profitably produce a public good.
Demand for Public Goods
Two Individuals
(1)
Quantity
Of Public
Good
(2)
Adams’
Willingness
To Pay (Price)
(3)
Benson’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
Graphically…
(4)
Collective
Willingness
To Pay (Price)
Demand for Public Goods
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
Q
Collective Demand and Supply
Benson’s Demand
$4 for 2 Items
$2 for 4 Items
P
$6
5
4
3
2
1
0
D2
1
2
3
4
5
Q
Benson
Adams’ Demand
$3 for 2 Items
$1 for 4 Items
P
$6
5
4
3
2
1
0
D1
1
2
3
Adams
4
5
Q
Comparing
MB and MC
The optimal amount of a public good
-- The collective demand curve for a public good, shown by Dc
is found by summing vertically the individual willingness-topay curves (D1 and D2 on previous slide).
-- The supply curve of the public good slopes upward and to
the right, reflecting rising marginal costs.
-- The optimal amount of the public good is 3 units,
determined by the intersection of Dc and S.
Cost-Benefit Analysis


Deciding whether to provide a particular public good
and how much of it to provide.
Cost-benefit analysis table in the textbook.
Externalities
Negative Externalities
Positive Externalities
P
P
Negative
Externalities
St
St
Positive
Externalities
S
Dt
D
D
Overallocation
0

Qe
Q
Qe
Qo
Individual Bargaining: Coase Theorem


Qo
Underallocation
0
Limitations
Liability Rules and Lawsuits
Q
Externalities
Spillover Costs and Spillover Benefits




(a) With spillover costs borne by society, the producers’ supply curve S is
to the right of (below) the full-cost curve St.
Consequently, the equilibrium output Qe is greater than the optimal
output Qo.
(b) When spillover benefits accrue to society, the market demand curve D
is to the left (below) the full-benefit demand curve Dt.
As a result, the equilibrium output Qe is less than the optimal output Qo.
Coase Theorem


In law and economics, the Coase theorem, attributed
to Ronald Coase, describes the economic efficiency of
an economic allocation or outcome in the presence of
externalities. The theorem states that when trade in an
externality is possible and there are no transaction costs,
bargaining will lead to an efficient outcome regardless of the initial
allocation of property rights. In practice, obstacles to bargaining or
poorly defined property rights can prevent Coasian bargaining.
This theorem, along with his 1937 paper on the nature of the firm
(which also emphasizes the role of transaction costs), earned Coase
the 1991 Nobel Prize in Economics. The Coase theorem is an
important basis for most modern economic analyses of government
regulation, especially in the case of externalities. George Stigler
summarized the resolution of the externality problem in the absence
of transaction costs in a 1966 economics textbook in terms of
private and social cost, and for the first time called it a "theorem."
Since the 1960s, a voluminous literature on the Coase theorem and
its various interpretations, proofs, and criticism has developed and
continues to grow.
Gov’t Intervention
Correcting for spillover costs (negative externalities)


(a) Spillover costs result in an overallocation of resources.
(b) Gov’t can correct this overallocation in 2 ways:
1 - use of direct controls, which would shift the supply curve from S to
St and reduce the output from Qe to Qo, or
2 – imposition of a special tax T, which would also shift the supply curve
from S to St , eliminating the overallocation of resources.
Gov’t Intervention
Correcting for spillover benefits (positive externalities)



(a) Spillover benefits result in an underallocation of resources.
(b) This underallocation can be corrected by a subsidy to consumers,
which shifts market demand from D to Dt and increases output from Qe
to Qo.
(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, increasing output from Qe to Qo.
Externalities
 Operation
of the Market
 Advantages
A market for pollution rights:
The supply of pollution rights S is
set by the gov’t, which determines
that a specific body of water can
safely recycle 500 tons of waste.
In 2006, the demand for
pollution rights is D2006 and the
1-ton price is $100. The pollution
quantity is 500 tons, not the 750
tons it would have been without
the pollution rights. Over time,
pollution rights increases to
D2016, the 1-ton cost is $200,
and the pollution stays at 500
tons instead of rising to 1000
tons.
Examples
P
Price Per Pollution Right
 Real-World
D2016
D2006
S=Supply of
Pollution
Rights
$200
$100
0
500
750
1000
Quantity of 1-Ton Pollution Rights
Q
Externalities
Society’s Optimal Amount of Externality
Reduction

MC, MB, and Equilibrium
Society’s optimal
amount of
pollution abatement:
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.
Society’s Marginal Benefit and Marginal
Cost of Pollution Abatement (Dollars)

MC
Socially
Optimum Amount
Of Pollution
Abatement
MB
0
Q1
The economics of recycling



(a) The equilibrium price and amount of materials recycled are
determined by supply S1 and demand D1.
(b) Policies that increase the incentives for producers to buy recyclable
inputs shift the demand curve rightward to D2, and raise both the
equilibrium price and the amount of recycling.
(c) Policies that encourage households to recycle shift the supply curve
rightward to S2, and expand the equilibrium amount of recycling.
However, these policies also reduce the equilibrium price of the recycled
inputs.