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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

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

LO1

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 supply

LO1

5-4

Efficiently Functioning Markets

Demand curve must reflect the

consumers full willingness to pay Supply curve must reflect all the costs of production

LO1

5-5

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

5-6

Consumer Surplus
Consumer Surplus (2) Maximum Price Willing to Pay $13 12 11 10 9 (3) Actual Price (Equilibrium Price) $8 8 8 8 8

(1) Person Bob Barb Bill Bart Brent

(4) Consumer Surplus $5 (=$13-$8) 4 (=$12-$8) 3 (=$11-$8) 2 (=$10-$8) 1 (= $9-$8)

Betty

0 (= $8-$8)

LO2

5-7

Consumer Surplus

Price (per bag)

Consumer Surplus
Equilibrium Price

P1

D Q1 Quantity (bags)
5-8

LO2

Producer Surplus

Difference between the actual price a


producer receives and the minimum price they would accept Extra benefit from receiving a higher price

LO2

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Producer Surplus
Producer Surplus (2) Minimum Acceptable Price $3 4 5 6 (3) Actual Price (Equilibrium Price) $8 8 8 8 (4) Producer Surplus $5 (=$8-$3) 4 (=$8-$4) 3 (=$8-$5) 2 (=$8-$6)

(1) Person Carlos Courtney Chuck Cindy

Craig
Chad

7
8

8
8

1 (=$8-$7)
0 (=$8-$8)

LO2

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Producer Surplus

Price (per bag)

Producer surplus
P1

Equilibrium price

Q1 Quantity (bags)

LO2

5-11

Efficiency Revisited

Consumer surplus Price (per bag)

P1

Producer surplus Q1 Quantity (bags)


LO2

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Efficiency Losses
a
Efficiency loss from underproduction

Price (per bag)

b e

D c

Q2 Q1 Quantity (bags)
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LO2

Efficiency Losses
a S

Efficiency loss from overproduction

Price (per bag)

f b g

D c Q1 Q3 Quantity (bags)

LO2

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Private Goods

Produced in the market by firms Offered for sale Characteristics Rivalry Excludability

LO3

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Public Goods

Provided by government Offered for free Characteristics Nonrivalry Nonexcludability Free-rider problem

LO3

5-16

Summary
Excludable Rivalrous Non-excludable

Private Good
Food, clothing, cars, personal electronics

Common Goods
Fish stocks, timber, coal

Non-rivalrous

Club Good
Cinemas, private parks, satellite television

Public Good
Free-to-air television, air, national defense, city fireworks shows

LO3

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Demand for Public Goods


Demand for a Public Good, Two Individuals (1) Quantity of Public Good 1 2 3 4 5 (3) Bensons Willingness to Pay (Price) + + + + + $5 4 3 2 1 = = = = = (4) Collective Willingness to Pay (Price) $9 7 5 3 1

(2) Adams Willingness to Pay (Price) $4 3 2 1 0

LO3

5-18

Demand for Public Goods


Bensons Demand $4 for 2 Items $2 for 4 Items
Adams Demand $3 for 2 Items $1 for 4 Items
P $6 5 4 3 2 1 0 P $6 5 4 3 2 1 0

D2
1 2 3 4 5 Q

Benson

D1
1 2 3 4 5 Q

Adams P

Collective Demand $7 for 2 Items


$3 for 4 Items Connect the Dots

$9 7 5 3 1 0 1 2 3 4

Optimal Quantity
Collective Willingness To Pay
Q

DC
5

Collective Demand and Supply


LO3

5-19

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
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LO3

Cost-Benefit Analysis
Cost-Benefit Analysis for a National Highway Construction Project (in Billions)

(1) Plan
No new construction A: Widen existing highways B: New 2-lane highways C: New 4-lane highways D: New 6-lane highways

(2) Total Cost of Project $0 4 10 18 28

(3) Marginal Cost $4 6 8 10

(4) Total Benefit $0 5 13 22 26

(5) Marginal Benefit $5 8 10 3

(6) Net Benefit (4) (2) $0 1 3 5 -2

LO3

5-21

Quasi-Public Goods

Could be provided through the market


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

LO3

5-22

The Reallocation Process

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

LO3

5-23

Externalities

A cost or benefit accruing 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
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LO4

Externalities

Negative Externalities

P
St S y z x D
Overallocation

St
Positive Externalities

Dt D
Underallocation

Qo

Qe

0 Q Qe Qo Q

(a) Negative externalities

(b) Positive externalities

LO4

5-25

Government Intervention

Correct negative externalities Direct controls Specific taxes Correct positive externalities Subsidies and government
provision

LO4

5-26

Government Intervention
P
Negative Externalities
a

P
St S

St a T S

c D Overallocation

D 0 Q o Qe
(b)

Qo Qe
(a)

Negative Externalities

Correct externality with tax

LO4

5-27

Government Intervention

St z
Positive Externalities

St

St
Subsidy

S't

Dt D
Underallocation

Subsidy Dt

D
0 Qe Qo 0 Qe Qo

Qe

Qo

(a) Positive Externalities

(b) Correcting via a subsidy to consumers

(c) Correcting via a subsidy to producers

LO4

5-28

Government Intervention
Methods for Dealing with Externalities Resource Allocation Outcome

Problem

Ways to Correct

Negative externalities (spillover costs)

Overproduction of output and therefore overallocation of resources

1. 2. 3. 4. 5.
1. 2. 3. 4.

Private bargaining Liability rules and lawsuits Tax on producers Direct controls Market for externality rights
Private bargaining Subsidy to consumers Subsidy to producers Government provision

Positive externalities (spillover benefits)

Underproduction of output and therefore underallocation of resources

LO4

5-29

Societys Optimal Amounts


Societys Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars)

MC

Socially Optimal Amount Of Pollution Abatement MB


0

Q1

LO5

5-30

Governments Role in the Economy

Government can have a role in


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

LO5

5-31

Controlling Carbon Dioxide 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 cost of polluting Easier to enforce
5-32

Problem #1
Market failure is said to occur whenever: A. private markets do not allocate resources in the most economically desirable way. B. prices rise. C. some consumers who want a good do not obtain it because the price is higher than they are willing to pay. D. government intervenes in the functioning of private markets.

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Problem #2

Refer to the diagrams for two separate product markets. Assume that society's optimal level of output in each market is Q0 and that government purposely shifts the market supply curve from S to S1 in diagram (a) and from S to S2 in diagram (b). We can conclude that the government is correcting for: A. negative externalities in diagram (a) and positive externalities in diagram (b). B. positive externalities in diagram (a) and negative externalities in diagram (b). C. negative externalities in both diagrams. D. positive externalities in both diagrams.

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Problem #3

Refer to the diagrams for two separate product markets. Assume that society's optimal level of output in each market is Q0 and that government purposely shifts the market supply curve from S to S1 in diagram (a) and from S to S2 in diagram (b). The shift of the supply curve from S to S1 in diagram (a) might be caused by a per unit: A. subsidy paid to the producers of this product. B. tax on the producers of this product. C. subsidy paid to the buyers of this product. D. tax on the buyers of this product.

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Problem #4
Producer surplus: A. is the difference between the maximum prices consumers are willing to pay for a product and the lower equilibrium price. B. rises as equilibrium price falls. C. is the difference between the minimum prices producers are willing to accept for a product and the higher equilibrium price. D. is the difference between the maximum prices consumers are willing to pay for a product and the minimum prices producers are willing to accept.

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Problem #5 The two main characteristics of a public good are: A. production at constant marginal cost and rising demand. B. nonexcludability and production at rising marginal cost. C. nonrivalry and nonexcludability. D. nonrivalry and large negative externalities.

5-37

Problem #6
Demand-side market failures occur when: A. the demand and supply curves don't reflect consumers' full willingness to pay for a good or service. B. the demand and supply curves don't reflect the full cost of producing a good or service. C. government imposes a tax on a good or service. D. a good or service is not produced because no one demands it.

5-38

Problem #7
Amanda buys a ruby for $330 for which she was willing to pay $340. The minimum acceptable price to the seller, Tony, was $140. Amanda experiences: A. a consumer surplus of $10 and Tony experiences a producer surplus of $190. B. a producer surplus of $200 and Tony experiences a consumer surplus of $10. C. a consumer surplus of $670 and Tony experiences a producer surplus of $200. D. a producer surplus of $10 and Tony experiences a consumer surplus of $190.

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Problem #8 Unlike a private good, a public good: A. has no opportunity costs. B. has benefits available to all, including nonpayers. C. produces no positive or negative externalities. D. is characterized by rivalry and excludability.

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Problem #9 Refer to the above diagram. Assuming equilibrium price P1, consumer surplus is represented by areas: A. a + b. B. a + b + c + d. C. c + d. D. a + c.

5-41

Problem #10
From society's perspective, in the presence of a supply-side market failure, the last unit of a good produced typically: A. generates more of a benefit than it costs to produce. B. produces a benefit exactly equal to the cost of producing the last unit. C. maximizes the net benefit to society. D. costs more to produce than it provides in benefits.

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Problem #11 Public goods are those for which there: A. is no free-rider problem. B. are no externalities. C. is nonrivalry and nonexcludability. D. is rivalry and excludability.

5-43

Problem #12 Refer to the diagram. With MB1 and MC1, society's optimal amount of pollution abatement is: A. Q1. B. Q2. C. Q3. D. Q4.

5-44

Problem #13
Which of the following statements is not true? A. Some public goods are paid for by private philanthropy. B. Private provision of public goods is usually unprofitable. C. The free-rider problem results from the characteristics of nonrivalry and nonexcludability. D. Public goods are only provided by government.

5-45

Problem #14
If the demand curve reflects consumers' full willingness to pay, and the supply curve reflects all costs of production, then which of the following is true? A. The benefit surpluses shared between consumers and producers will be maximized. B. The benefit surpluses received by consumers and producers will be equal. C. There will be no consumer or producer surplus. D. Consumer surplus will be maximized, and producer surplus will be minimized.

5-46

Problem #15
Which of the following statements is not true? A. Some public goods are paid for by private philanthropy. B. Private provision of public goods is usually unprofitable. C. The free-rider problem results from the characteristics of nonrivalry and nonexcludability. D. Public goods are only provided by government.

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Problem #16
Refer to the diagram. If actual production and consumption occur at Q1: A. efficiency is achieved. B. consumer surplus is maximized. C. an efficiency loss (or deadweight loss) of b + d occurs. D. an efficiency loss (or deadweight loss) of e + d occurs.

5-48

Problem #17
Allocative efficiency occurs only at that output where: A. marginal benefit exceeds marginal cost by the greatest amount. B. consumer surplus exceeds producer surplus by the greatest amount. C. the combined amounts of consumer surplus and producer surplus are maximized. D. the areas of consumer and producer surplus are equal.

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Problem #18
An efficiency loss (or deadweight loss): A. is measured as the combined loss of consumer surplus and producer surplus. B. results from producing a unit of output for which the maximum willingness to pay exceeds the minimum acceptable price. C. can result from underproduction, but not from overproduction. D. can result from overproduction, but not from underproduction.

5-50

Problem #19
The MC curves in the above diagram slope upward because of the law of: A. demand. B. conservation of matter and energy. C. diminishing marginal utility. D. diminishing returns.

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