4 Market Failures Public Goods and Externalities Mc
4 # Market Failures: Public Goods and Externalities Mc. Graw-Hill/Irwin Copyright © 2013 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 • Overallocated • Underallocated 4 -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 4 -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 4 -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 4 -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 4 -6
Consumer Surplus LO 2 (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 -7
Consumer Surplus Equilibrium Price P 1 D Q 1 LO 2 4 -8
Producer Surplus • Difference between the actual price a • LO 2 producer receives and the minimum price the producer would accept Extra benefit from receiving a higher price 4 -9
Producer Surplus LO 2 (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 -10
Producer Surplus Producer surplus P 1 S Equilibrium price Q 1 LO 2 4 -11
Efficiency Revisited Consumer surplus S P 1 Producer surplus D Q 1 LO 2 4 -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 4 -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 4 -14
Private Goods Characteristics • Produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO 3 4 -15
Public Goods Characteristics • Provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO 3 4 -16
Measuring Demand Optimal Quantity for a Public Good, Two Individuals (1) Quantity of Public Good (2) Adams’ Willingness to Pay (Price) 1 $4 + $5 = $9 2 3 + 4 = 7 3 2 + 3 = 5 4 1 + 2 = 3 5 0 + 1 = 1 LO 3 (3) Benson’s Willingness to Pay (Price) (4) Collective Willingness to Pay (Price) 4 -17
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 4 -18
Cost-Benefit Analysis for a National Highway Construction Project (in Billions) (2) Total Cost of Project (3) (4) (5) Marginal Total Marginal Cost 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 4 D: New 6 -lane highways 28 10 26 3 -2 (1) Plan LO 3 4 -19
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 4 -20
Externalities Negative Externalities P a P St b y S St z Dt x c D D 0 Overallocation Qo Qe (a) Negative externalities LO 4 Positive Externalities Q 0 Underallocation Qe Qo Q (b) Positive externalities 4 -21
Government Intervention • Correct negative externalities • Direct controls • Specific taxes • Correct positive externalities • Subsidies and government provision LO 4 4 -22
Government Intervention P Negative Externalities a b P St St a S T c 0 LO 4 Qo D Overallocation Q Qe S D 0 Qo Qe (a) (b) Negative Externalities Correcting the overallocation of resources via direct controls or via a tax Q 4 -23
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 4 -24
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 4 -25
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 4 -26
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 4 -27
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