Chapter 4Market Failures: Public Goods and

ExternalitiesCopyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4-2

Market Failures

• Market failures • Markets fail to produce the right amount of

the product• Resources may be• Over-allocated• Under-allocated

LO1

4-3

Demand-Side Market Failures

• Demand-side market failures• When it is not possible to charge consumers

for the product• Some can enjoy benefits without paying• Firms not willing to produce since they cannot

cover the costs

LO1

4-4

Supply-Side Market Failures

• Supply-side market 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

4-5

Efficiently Functioning Markets

• Demand curves must reflect the consumers full willingness to pay

• Supply curve must reflect all the costs of production

LO2

4-6

Consumer Surplus

• 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

4-7

Consumer Surplus

LO2

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 8 3 (=$11-$8)

Bart 10 8 2 (=$10-$8)

Brent 9 8 1 (= $9-$8)

Betty 8 8 0 (= $8-$8)

4-8

Consumer Surplus

D

Q1

P1

Consumer surplus

Equilibrium price = $8

LO2

4-9

Producer Surplus

• 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

4-10

Producer Surplus

LO2

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 8 3 (=$8-$5)

Cindy 6 8 2 (=$8-$6)

Craig 7 8 1 (=$8-$7)

Chad 8 8 0 (=$8-$8)

4-11

Producer Surplus

LO2

S

Q1

P1

Equilibrium price = $8

Producer surplus

4-12

Efficiency Revisited

LO2

S

Q1

P1

D

Consumer surplus

Producer surplus

4-13

Efficiency Losses

• Efficiency loss (or deadweight losses)

LO2 Quantity (bags)

Pric

e (p

er b

ag)

c

S

Q1Q2

D

bd

a

e

Efficiency lossfrom underproduction

4-14

Efficiency Losses

LO2

c

S

Q1 Q3

D

bf

a

g

Quantity (bags)

Pric

e (p

er b

ag)

Efficiency lossfrom overproduction

4-15

Private Goods

• Private goods are produced in the market by firms

• Offered for sale• Characteristics• Rivalry• Excludability

LO3

4-16

Public Goods

• Public goods are provided by government• Offered for free• Characteristics• Nonrivalry• Nonexcludability• Free-rider problem

LO3

4-17

Demand for Public Goods

LO3

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

3 2 + 3 = 5

4 1 + 2 = 3

5 0 + 1 = 1

4-18

Demand for Public Goods

LO3

Adams

Benson

D1

D2

Adams’ Demand

Benson’s Demand

$3 for 2 Items

$4 for 2 Items

$1 for 4 Items

$2 for 4 Items

Collective Demand and Supply

DC

SCollective Demand

$7 for 2 Items

$3 for 4 Items

Optimalquantity

Collectivewillingness

to pay

4-19

Cost-Benefit Analysis

• 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

LO4

4-20

Cost-Benefit Analysis

LO4

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 $0 $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

4-21

Quasi-Public Goods

• Quasi-public goods could be provided through the market system

• Because of positive externalities the government provides them

• Examples are education, streets, museums

LO4

4-22

The Reallocation Process

• Government• Taxes individuals and businesses• Takes the money and spends on production

of public goods

LO4

4-23

Externalit ies

• An externality is a cost or benefit accruing to a third party external to the market transaction

• Positive externalities• Too little is produced• Demand-side market failures

• Negative externalities• Too much is produced• Supply-side market failures

LO4

4-24

Externalit ies

LO4

(a)Negative externalities

(b)Positive externalities

0

D

S

St

Overallocation

Negativeexternalities St

Underallocation

Positiveexternalities

Qo QoQe Qe

P P

0Q Q

D

Dt

a

c

z

x

b y

4-25

Government Intervention

• Correct negative externalities• Direct controls• Specific taxes

• Correct positive externalities• Subsidies• Government provision

LO4

4-26

Government Intervention

LO4

(a)

Negative externalities

D

S

St

Overallocation

Negativeexternalities

Qo Qe

P

0 Q

a

c

b

(b)

Correct externality with tax

D

S

St

Qo Qe

P

0Q

a

T

4-27

Government Intervention

LO4

(a)Positive externalities

0

St

Underallocation

Positiveexternalities

QoQe

D

Dt

z

x

y

(b)Correcting via a subsidy

to consumers

0

St

QoQe

D

Dt

(c)Correcting via a subsidy

to producers

0

S't

QoQe

D

Subsidy

StSubsidy

U

4-28

Government Intervention

LO4

Methods for Dealing with Externalities

ProblemResource Allocation Outcome Ways to Correct

Negative externalities (spillover costs)

Overproduction of output and therefore overallocation of resources

1. Private bargaining2. Liability rules and lawsuits3. Tax on producers4. Direct controls5. Market for externality rights

Positive externalities (spillover benefits)

Underproduction of output and therefore underallocation of resources

1. Private bargaining2. Subsidy to consumers3. Subsidy to producers4. Government provision

4-29

Society’s Optimal Amounts

LO5

0

Soci

ety’

s m

argi

nal b

enef

it a

nd m

argi

nal

cost

of p

ollu

tion

aba

tem

ent (

dolla

rs)

Q1

MB

MC

Sociallyoptimal amountof pollutionabatement

4-30

Government’s Role in the Economy

• Coase theorem• Private sector bargaining can solve

externality problem• Government’s role in correcting externalities• Optimal reduction of an externality• Officials must correctly identify the existence

and cause• Has to be done within a political environment

LO5

4-31

Controll ing CO2 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