Chapter 4 Market Failures Public Goods and Externalities

Chapter 4 Market Failures: Public Goods and Externalities Copyright © 2018 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -4

Efficiently Functioning Markets • Demand curve must reflect the consumers’ full willingness to pay • Supply curve must reflect all the costs of production • Benefit surpluses are maximized for consumers and producers LO 2 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -6

Consumer Surplus Continued 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -7

Price (per bag) Consumer Surplus Concluded Consumer surplus Equilibrium price = $8 P 1 D Q 1 Quantity (bags) LO 2 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -8

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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -9

Producer Surplus Continued 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -10

Price (per bag) Producer Surplus Concluded Producer surplus P 1 S Equilibrium price = $8 Q 1 Quantity (bags) LO 2 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -11

Efficiency Revisited Price (per bag) Consumer surplus S P 1 Producer surplus D Q 1 Quantity (bags) LO 2 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -12

Efficiency Losses • Efficiency loss (or deadweight losses) a Efficiency loss from underproduction Price (per bag) d S b e D c LO 2 Q 1 Quantity (bags) Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -13

Efficiency Losses Continued a Efficiency loss from overproduction S Price (per bag) f b g D c Q 1 Q 3 Quantity (bags) LO 2 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -14

Private Goods • Private goods are produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO 3 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -15

Public Goods • Public goods are goods provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO 3 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -16

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’s 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) Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -17

Demand for Public Goods Continued Adams’s Demand Benson’s Demand Collective Demand P $6 5 4 3 2 1 0 1 2 3 Adams 4 D 1 Q 5 D 2 1 2 P 3 Benson 4 Q 5 Optimal quantity S $9 7 5 3 DC 1 0 Collective willingness to pay 1 2 3 4 5 Collective Demand Supply Q LO 3 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -18

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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -19

Cost-Benefit Analysis Continued 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -20

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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -21

The Reallocation Process • Government • Taxes individuals and businesses • Takes the money and spends on production of public goods LO 4 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -22

Externalities LO 4 • 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -23

Externalities Continued 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -24

Government Intervention • Correct negative externalities • Direct controls • Pigovian tax • Correct positive externalities • Subsidies • Government provision LO 4 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -25

Correcting for Negative Externalities P Negative externalities a b P St St a S T c 0 Q Qe (a) Negative externalities LO 4 D D Overallocation Qo S 0 Qo Qe Q (b) Correct externality with tax Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -26

Correcting for Positive Externalities y z St Dt Subsidy D Qe Qo Underallocation (a) Positive externalities LO 4 Subsidy S't Positive externalities x 0 St St Dt U D D 0 Qe Qo (b) Correcting via a subsidy to consumers 0 Qe Qo (c) Correcting via a subsidy to producers Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -27

Government Intervention Concluded 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 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -28

Society’s Optimal Amounts Society’s marginal benefit and marginal cost of pollution abatement (dollars) MC Socially optimal amount of pollution abatement MB 0 LO 5 Q 1 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -29

Government’s Role in the Economy • Coase theorem • Private sector bargaining can solve externality problem • Government’s role in correcting externalities • Optimal reduction of an externality • Officials must correctly identify the existence and cause • Government failure may occur LO 5 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 4 -30

Controlling CO 2 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 the cost of polluting • Easier to enforce 4 -31 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.