Market Failures: Public Goods and Externalities5McGraw-Hill/IrwinCopyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Market FailuresMarket fails to produce the right amount of the productResources may beOver-allocatedUnder-allocatedLO1

Demand-Side FailuresImpossible to charge consumers what they are willing to pay for the productSome can enjoy benefits without paying

LO1

Supply-Side FailuresOccurs when a firm does not pay the full cost of producing its outputExternal costs of producing the good are not reflected in the supplyLO1

Efficiently Functioning MarketsDemand curve must reflect the consumers full willingness to paySupply curve must reflect all the costs of productionLO1

Consumer SurplusDifference between what a consumer is willing to pay for a good and what the consumer actually paysExtra benefit from paying less than the maximum priceLO2

Consumer SurplusLO2LO2DQ1P1

Producer SurplusDifference between the actual price a producer receives and the minimum price they would acceptExtra benefit from receiving a higher price

LO2

Producer SurplusLO2LO2S

Efficiency RevisitedLO2SQ1P1D

Efficiency LossesLO2cSQ1Q2Dbdae

Efficiency LossesLO2cSQ1Q3DbfagQuantity (bags)

Price (per bag)

Private GoodsProduced in the market by firmsOffered for saleCharacteristicsRivalryExcludabilityLO3

Public GoodsProvided by governmentOffered for freeCharacteristicsNonrivalryNonexcludabilityFree-rider problemLO3

Cost-Benefit AnalysisCost Resources diverted from private good productionPrivate goods that will not be producedBenefitThe extra satisfaction from the output of more public goods

LO3

ExternalitiesA cost or benefit accruing to a third party external to the transactionPositive externalitiesToo little is producedDemand-side market failuresNegative externalitiesToo much is producedSupply side market failuresLO4

Government InterventionCorrect negative externalitiesDirect controlsSpecific taxesCorrect positive externalitiesSubsidies Government provision

LO4

Government InterventionLO4(a)Negative externalitiesDSStOverallocationNegativeexternalitiesQoQeacb(b)Correct externality with taxDSStQoQeaT

Government InterventionLO4

Methods for Dealing with ExternalitiesProblemResource Allocation OutcomeWays to CorrectNegative externalities (spillover costs)Overproduction of output and therefore overallocation of resourcesPrivate bargainingLiability rules and lawsuitsTax on producersDirect controlsMarket for externality rightsPositive externalities (spillover benefits)Underproduction of output and therefore underallocation of resourcesPrivate bargainingSubsidy to consumersSubsidy to producersGovernment provision

Governments Role in the EconomyGovernment can have a role in correcting externalitiesOfficials must correctly identify the existence and causeHas to be done in the context of politicsLO5

********************