Download - Public Goods and Externalities
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