12

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
amount of the product
• Resources may be:
• Over-allocated
• Under-allocated

LO1
 (a) Demand-Side Failures
• Impossible to charge all or any
consumers what they are willing to
pay for the product
• Some can enjoy benefits without
paying

LO1
 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 supply

LO1
 Efficiently Functioning Markets
• Demand curve must reflect the
consumers full willingness to pay
• Supply curve must reflect all the costs
of production
• Then an efficient market will maximize
the combination of consumer and
producer surplus.

LO1
 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

LO2
 Consumer Surplus
Consumer Surplus

(2) (3)
Maximum Actual Price (4)
(1) Price Willing (Equilibrium Consumer
Person to Pay Price) Surplus
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)

LO2
 Consumer Surplus

Consumer
Surplus
Price (per bag)

Equilibrium
Price
P1

Q1
Quantity (bags)

LO2
 Producer Surplus

• Difference between the actual price a

producer receives and the minimum
price (or MC) they would accept
• Extra benefit from receiving a higher
price

LO2
 Producer Surplus

Producer Surplus

(2) (3)
Minimum Actual Price (4)
(1) Acceptable (Equilibrium Producer
Person Price Price) Surplus
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)

LO2
 Producer Surplus

Producer S
surplus
Price (per bag)

P1
Equilibrium
price

Q1
Quantity (bags)

LO2
 *Efficiency Revisited

Consumer
surplus
S
Price (per bag)

P1

Producer D
surplus

Q1
Quantity (bags)

LO2
 *Efficiency Losses

a Efficiency loss S
from underproduction
Price (per bag)

d
b

D
c
Q2 Q1
Quantity (bags)

LO2
 Efficiency Losses

a S
Efficiency loss
from overproduction

f
Price (per bag)

b
g

D
c
Q1 Q3
Quantity (bags)

LO2
 (b) Private Goods

• Produced in the market by firms

• Offered for sale
• Characteristics
• Rivalry in consumption(one’s use of a
good makes it unavailable for others)
• Excludability (can exclude others)

LO3
 Public Goods

• Provided by government
• Offered for free
• Characteristics
• Nonrivalry (e.g. street lighting)
• Nonexcludability
• Free-rider problem

LO3
 Demand for Public Goods

Demand for a Public Good, Two Individuals

(1) (3) (4)

Quantity (2) Brinley’s Collective
of Public Ambu’s Willingness Willingness to Willingness
Good to Pay (Price) Pay (Price) to Pay (Price)
1 $4 + $5 = $9
2 3 + 4 = 7
3 2 + 3 = 5
4 1 + 2 = 3
5 0 + 1 = 1

LO3
 Demand for Public Goods
P
Brinley’s Demand $6
5
$4 for 2 Items 4
3
2 D2
$2 for 4 Items 1
0 1 2 3 4 5 Q
Benson
P
Ambu’s Demand $6
$3 for 2 Items 5
4
3
2
$1 for 4 Items 1 D1
0 Q
1 2 3 4 5
Adams
P
Collective Demand $9 S Optimal
Quantity
$7 for 2 Items 7

5 Collective
$3 for 4 Items Willingness
3
DC To Pay
Connect the Dots 1
0 1 2 3 4 5 Q
Collective Demand and Supply
LO3
 *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

LO3
 Cost-Benefit Analysis

Cost-Benefit Analysis for a National Highway Construction Project

(in Billions)
(2) (3) (4) (5) (6)
(1) Total Cost Marginal Total Marginal Net Benefit
Plan of Project Cost Benefit Benefit (4) – (2)
No new construction $0 $0 $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

LO3
 Quasi-Public Goods

• Could be provided through the market

system
• Because of positive externalities the
government provides them
• Examples: education, streets,
libraries

LO3
 The Reallocation Process

• Government
• Taxes individuals and businesses
• Takes the money and spends on
production of public goods

LO3
 Externalities
• A cost or benefit accruing(spill over)
to a third 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
LO4
 Externalities

P Negative P
Externalities
St y St
b
a z Positive
S Externalities

x Dt
c
D D
Overallocation Underallocation
0 0
Qo Qe Q Qe Qo Q

(a) (b)
Negative externalities Positive externalities (like imperfect market)

LO4
 Government Intervention
• Correct negative externalities (shift
SS to the left)
• Direct controls(e.g. emission stdds)
• Specific taxes
• Correct positive externalities (shift SS
to the right)
• Subsidies and government
provision

LO4
 Government Intervention

P Negative P
Externalities St St
b
a a
S S

c T
D D
Overallocation
0 0
Qo Qe Q Qo Qe Q

(a) (b)
Negative Externalities Correct externality with
tax

LO4
 Government Intervention

St
y St St Subsidy
z Positive S't
Externalities

x Dt Subsidy Dt U

D D D
Underallocation
0 Qe Qo 0 Qe Qo 0
Qe Qo

(a) (b) (c)

Positive Externalities Correcting via a subsidy Correcting via a subsidy
to consumers to producers

LO4