05 Market Failures Public Goods and Externalities Mc
05 Market Failures: Public Goods and Externalities Mc. Graw-Hill/Irwin Copyright © 2012 by The Mc. Graw-Hill Companies, Inc. All rights reserved.
Market Failures • Market fails to produce the right • LO 1 amount of the product Resources may be • Over-allocated • Under-allocated 5 -2
Demand-Side Failures • Impossible to charge consumers what they are willing to pay for the product • Some can enjoy benefits without paying LO 1 5 -3
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 LO 1 5 -4
Efficiently Functioning Markets • Demand curve must reflect the • LO 1 consumers full willingness to pay Supply curve must reflect all the costs of production 5 -5
Consumer Surplus • Difference between what a consumer • LO 2 is willing to pay for a good and what the consumer actually pays Extra benefit from paying less than the maximum price 5 -6
Price (per bag) Consumer Surplus Equilibrium Price P 1 D Q 1 Quantity (bags) LO 2 5 -7
Producer Surplus • Difference between the actual price a • LO 2 producer receives and the minimum price they would accept Extra benefit from receiving a higher price 5 -8
Price (per bag) Producer Surplus Producer surplus P 1 S Equilibrium price Q 1 Quantity (bags) LO 2 5 -9
Efficiency Revisited Price (per bag) Consumer surplus S P 1 Producer surplus D Q 1 Quantity (bags) LO 2 5 -10
Efficiency Losses Price (per bag) a Efficiency loss from underproduction S d b e D c Q 2 Q 1 Quantity (bags) LO 2 5 -11
Efficiency Losses a Efficiency loss from overproduction S Price (per bag) f b g D c Q 1 Q 3 Quantity (bags) LO 2 5 -12
Private Goods • Produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO 3 5 -13
Public Goods • Provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO 3 5 -14
Cost-Benefit Analysis • Cost • Resources diverted from private • LO 3 good production • Private goods that will not be produced Benefit • The extra satisfaction from the output of more public goods 5 -15
Externalities • A cost or benefit accruing to a third • • LO 4 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 5 -16
Government Intervention • Correct negative externalities • Direct controls • Specific taxes • Correct positive externalities • Subsidies • Government provision LO 4 5 -17
Government Intervention P Negative externalities a b P St St a S T c 0 LO 4 S D Overallocation Qo Qe Q D 0 Qo Qe Q (a) (b) Negative externalities Correct externality with tax 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 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 LO 4 5 -19
Government’s Role in the Economy • Government can have a role in • • LO 5 correcting externalities Officials must correctly identify the existence and cause Has to be done in the context of politics 5 -20
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