05 Market Failures Public Goods and Externalities Mc

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 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

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 LO 2 (4) Consumer Surplus 5 -7

Consumer Surplus Equilibrium Price P 1 D Q 1 LO 2 5 -8

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 -9

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 LO 2 (4) Producer Surplus 5 -10

Producer Surplus Producer surplus P 1 S Equilibrium price Q 1 LO 2 5 -11

Efficiency Revisited Consumer surplus S P 1 Producer surplus D Q 1 LO 2 5 -12

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 -13

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 -14

Private Goods • Produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO 3 5 -15

Public Goods • Provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO 3 5 -16

Demand for Public Goods Demand for a Public Good, Two Individuals (1) Quantity of (2) Public Adams’ Willingness Good to Pay (Price) LO 3 (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 5 -17

Demand for Public Goods Benson’s Demand $4 for 2 Items D 2 $2 for 4 Items Benson Adams’ Demand $3 for 2 Items $1 for 4 Items D 1 Adams Collective Demand $7 for 2 Items S $3 for 4 Items Connect the Dots DC Collective Demand Supply LO 3 Optimal Quantity Collective Willingness To Pay 5 -18

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 -19

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 LO 3 $0 $0 5 -20

Quasi-Public Goods • Could be provided through the market • • LO 3 system Because of positive externalities the government provides them Examples: education, streets, libraries 5 -21

The Reallocation Process • Government • Taxes individuals and businesses • Takes the money and spends on production of public goods LO 3 5 -22

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 -23

Externalities P Negative Externalities a P St b y S St z Positive Externalities Dt x c D D 0 Overallocation Qo Qe (a) Negative externalities LO 4 Q 0 Underallocation Qe Qo Q (b) Positive externalities 5 -24

Government Intervention • Correct negative externalities • Direct controls • Specific taxes • Correct positive externalities • Subsidies and government provision LO 4 5 -25

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 -26

Government Intervention y z St Qo (a) Positive Externalities LO 4 S't Dt Subsidy Dt D D Underallocation Qe Subsidy Positive Externalities x 0 St St 0 Qe Qo (b) Correcting via a subsidy to consumers U D 0 Qe Qo (c) Correcting via a subsidy to producers 5 -27

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 -28

Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Society’s Optimal Amounts LO 5 MC Socially Optimal Amount Of Pollution Abatement MB 0 Q 1 5 -29

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 -30

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 5 -31