Chapter 4 Market Failures Public Goods and Externalities

Chapter 4 Market Failures: Public Goods and Externalities Copyright © 2015 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Efficiently Functioning Markets • Demand curve must reflect the consumers full willingness to pay • Supply curve must reflect all the costs of production LO 2 4 -2

Consumer Surplus • Consumer surplus • Difference between what a consumer is willing to pay for a good and what the consumer actually pays • Max price consumer is willing pay is equal to their MB • Extra benefit from paying less than the maximum price LO 2 4 -3

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 4 -4

Producer Surplus • Producer surplus • Difference between the actual price a producer receives and the minimum price they would accept • Min price seller will accept is equal to the MC of producing good. • Extra benefit to the seller from receiving a higher price LO 2 4 -5

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 4 -6

Efficiency • Allocative Efficiency • Correct amount of a good is produced • Productive Efficiency • Produced at lowest possible cost LO 3 4 -7

Private Goods • Private goods are produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO 3 4 -8

Public Goods • Public goods are provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO 3 4 -9

Demand for Public Goods Demand for a Public Good, Two Individuals (3) Benson’s Willingness to Pay (Price) (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 (4) Collective Willingness to Pay (Price) 4 -10

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 LO 4 4 -11

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 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 23 10 5 D: New 6 -lane highways 28 10 26 3 -2 LO 4 $0 (6) Net Benefit (4) – (2) $0 4 -12

The Reallocation Process • Government • Taxes individuals and businesses • Takes the money and spends on production of public goods LO 4 4 -13

Market Failures • Market failures • Markets fail to produce the right amount of the product • Resources end up: • Over-allocated • Under-allocated LO 1 4 -14

Externalities • An externality is a cost or benefit accruing to a third party external to the market transaction LO 4 4 -15

Demand-Side Market Failures • Demand-side market failures • Demand does not reflect full amount consumers are willing to pay • Some can enjoy benefits without paying • Associated with positive externalities • Firms won’t produce the good or produce too little – resources underallocated LO 1 4 -16

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 LO 4 4 -17

Supply-Side Market Failures • Supply-side market failures • Supply does not reflect all of the costs of production • External costs of producing the good are not reflected in supply • Associated with negative externalities. • Firms produce too much – resources overallocated LO 1 4 -18

Government Intervention • Correct negative externalities • Direct controls • Pigovian taxes • Correct positive externalities • Subsidies • Government provision LO 4 4 -19

Government Intervention Methods for Dealing with Externalities Problem Resource Allocation Outcome Ways to Correct Negative externalities (spillover costs) Overproduction of output 1. Private bargaining and therefore overallocation 2. Liability rules and lawsuits of resources 3. Tax on producers 4. Direct controls 5. Market for externality rights Positive externalities (spillover benefits) Underproduction of output 1. Private bargaining and therefore 2. Subsidy to consumers underallocation of resources 3. Subsidy to producers 4. Government provision LO 4 4 -20

Government’s Role in the Economy • Government’s role in correcting externalities • Optimal reduction of an externality up to MB = MC • Officials must correctly identify the existence and cause • Has to be done within a political environment LO 5 4 -21