Market Failures: Public Goods and Externalities

Market Failures: Public Goods and Externalities

05 Market Failures: Public Goods and Externalities McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Market Failures Market fails to produce the right LO1 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 LO1 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 the supply

LO1 5-4 Efficiently Functioning Markets Demand curve must reflect the LO1 consumers full willingness to pay Supply curve must reflect all the costs of production 5-5 Consumer Surplus

Difference between what a consumer LO2 is willing to pay for a good and what the consumer actually pays Extra benefit from paying less than the maximum price 5-6 Price (per bag) Consumer Surplus Consumer Surplus Equilibrium Price

P1 D Q1 Quantity (bags) LO2 5-7 Producer Surplus Difference between the actual price a LO2 producer receives and the minimum price they would accept Extra benefit from receiving a higher

price 5-8 Price (per bag) Producer Surplus Producer surplus P1 S Equilibrium price Q1 Quantity (bags)

LO2 5-9 Efficiency Revisited Price (per bag) Consumer surplus S P1 Producer surplus D

Q1 Quantity (bags) LO2 5-10 Efficiency Losses Price (per bag) a Efficiency loss from underproduction S d b e

D c Q2 Q1 Quantity (bags) LO2 5-11 Efficiency Losses a Efficiency loss from overproduction S

Price (per bag) f b g D c Q1 Q3 Quantity (bags) LO2 5-12 Private Goods Produced in the market by firms Offered for sale

Characteristics Rivalry Excludability LO3 5-13 Public Goods Provided by government Offered for free Characteristics Nonrivalry Nonexcludability Free-rider problem LO3 5-14

Cost-Benefit Analysis Cost Resources diverted from private LO3 good production Private goods that will not be produced Benefit The extra satisfaction from the output of more public goods 5-15 Externalities

A cost or benefit accruing to a third LO4 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 5-16 Government Intervention Correct negative externalities Direct controls Specific taxes

Correct positive externalities Subsidies Government provision LO4 5-17 Government Intervention P Negative externalities a b P St

St a S T c 0 LO4 S D Overallocation Qo Qe

Q D 0 Qo Qe Q (a) (b) Negative externalities Correct externality with tax 5-18

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 LO4 5-19 Governments Role in the Economy Government can have a role in LO5

correcting externalities Officials must correctly identify the existence and cause Has to be done in the context of politics 5-20

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