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.

Market Failures • Market failures • Markets fail to produce the right amount of the product • Resources may be • Over-allocated • Under-allocated LO 1 4 -2

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 LO 1 4 -3

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 LO 1 4 -4

Efficiently Functioning Markets • Demand curves must reflect the consumers full willingness to pay • Supply curve must reflect all the costs of production LO 2 4 -5

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 LO 2 4 -6

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 LO 2 4 -7

Efficiency Revisited Consumer surplus Producer surplus LO 2 4 -8

Efficiency Losses • Efficiency loss (or deadweight losses) Price (per bag) a Efficiency loss from underproduction d S b e D c LO 2 Quantity (bags) Q 2 Q 1 4 -9

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 -10

Private Goods • Private goods are produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO 3 4 -11

Public Goods • Public goods are provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO 3 4 -12

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 -13

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 -14

The Reallocation Process • Government • Taxes individuals and businesses • Takes the money and spends on production of public goods LO 4 4 -15

Externalities • 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 LO 4 4 -16

Externalities P Negative externalities a P St b y S St z Positive externalities Dt x c D 0 Overallocation Qo Qe (a) Negative externalities LO 4 D Underallocation Q 0 Qe Qo Q (b) Positive externalities 4 -17

Government Intervention • Correct negative externalities • Direct controls • Specific taxes • Correct positive externalities • Subsidies • Government provision LO 4 4 -18

Government’s Role in the Economy • Coase theorem • Private sector bargaining can solve • • LO 5 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 4 -19