Chapter 5A

Market Failures: Public Goods and

Externalities
Gary Payne, MBA
Sam Houston State University
Market Failures: Public Goods and
Externalities
05
McGraw-Hill/I rwin
Copyright 2012 by The McGraw-Hill Companies, I nc. All rights reserved.
Student Learning Outcomes (SLO)

Describe governmental efforts to address market failure such
as monopoly power, externalities, and public goods.
SLO 9
5 Terms and Concepts
Market failures
Demand-side market failures
Supply-side market failures
Consumer surplus
Producer surplus
Efficiency losses (deadweight
losses)
Private goods
Rivalry
Excludability
Public goods
Nonrivalry
Nonexcludability
Free-rider problem
Cost-benefit analysis
Quasi-public goods
Externality
Coase theorem
Optimal reduction of an
externality
Market Failures: Public Goods and
Externalities
We begin this chapter by demonstrating how properly functioning
markets efficiently allocate resources. We then explore what
happens when markets dont function properly.
In some circumstances, economically desirable goods are not
produced at all. In other situations, they are either overproduced or
under produced. This chapter focuses on these situations, which
economists refer to as market failure.
Market Failures in Competitive Markets
Market failures in competitive markets fall into two categories:
Demand-side market failures happen when demand curves do
not reflect consumers full willingness to pay for a good or
service.
Supply-side market failures occur when supply curves do not
reflect the full cost of producing a good or service.


Market Failures in Competitive Markets
Demand-Side Market Failures
Demand-side market failures arise because it is impossible in
certain cases to charge consumers what they are willing to pay for a
product.
Example: it is impossible to exclude people from viewing
outdoor fireworks displays

Market Failures in Competitive Markets
Supply-Side Market Failures
Supply-side market failures arise in situations in which a firm does
not have to pay the full cost of producing its output.
Example: A coal-burning power plant produces more electricity
and generates more pollution than it would if it had to pay for
each ton of smoke that it released into the atmosphere. The
costs are greater than the benefits.

Efficiently Functioning Markets
Two conditions must hold if a competitive market is to produce
efficient outcomes:
1. The demand curve in the market must reflect consumers full
willingness to pay
2. The supply curve in the market must reflect all the costs of
production

Efficiently Functioning Markets
Consumer Surplus
The benefit surplus received by a consumer or consumers in a
market.
The difference between the maximum price a consumer is willing to
pay for a product and the actual price that they do pay.
The maximum price that a person is willing to pay for a unit of a
product depends on the opportunity cost of that persons
consumption alternatives.
Each consumer who buys a product only has to pay the equilibrium
price even though many would have been willing to pay more than
the equilibrium price to obtain the product.
Efficiently Functioning Markets
Consumer Surplus
The maximum prices that individuals are willing to pay represent
points on a demand curve. The lower the price, the greater the
total quantity demanded as the market price falls below the
maximum prices of more and more consumers.
Lower prices also imply larger consumer surpluses.
Collective consumer surplus is the sum of the vertical distances
between the demand curve and the equilibrium price; the sum of
the gaps between maximum willingness to pay and actual price; the
area that lies below the demand curve and above equilibrium price.
Efficiently Functioning Markets
Consumer Surplus
Consumer surplus and price are inversely (negatively) related.
Higher prices reduce consumer surplus; lower prices increase it.

Consumer Surplus
LO2
Consumer Surplus
(1)
Person
(2)
Maximum
Price Willing
to Pay
(3)
Actual Price
(Equilibrium
Price)
(4)
Consumer
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)
5-13
Consumer Surplus
LO2 LO2
P
r
i
c
e

(
p
e
r

b
a
g
)

Quantity (bags)
D
Q
1
P
1
Consumer
Surplus
Equilibrium
Price
5-14
Efficiently Functioning Markets
Producer Surplus
Like consumers, producers also receive a benefit surplus in markets.
Producer surplus is the difference between the actual price a
producer receives and the minimum acceptable price that a
consumer would have to pay the producer to make a particular unit
of output available.
A producers minimum acceptable price for a particular unit will
equal the producers marginal cost of producing that particular unit.
In addition to equaling marginal cost, a producers minimum
acceptable price can also be interpreted as the opportunity cost of
bidding resources away from the production of other products.
Efficiently Functioning Markets
Producer Surplus
The size of the producer surplus earned on any particular unit will
be the difference between the market price that a producer actually
receives and the producers minimum acceptable price.
Supply curves then are both marginal-cost curves and minimum-
acceptable-price curves.
Sellers producer surplus is the sum of the vertical distances
between the supply curve and the equilibrium price.
There is a direct (positive) relationship between equilibrium price
and the amount of producer surplus. Given the supply curve, lower
prices reduce producer surplus; higher prices increase it.
Producer Surplus
LO2
Producer Surplus
(1)
Person
(2)
Minimum
Acceptable
Price
(3)
Actual Price
(Equilibrium
Price)
(4)
Producer
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)
5-17
Producer Surplus
LO2 LO2
P
r
i
c
e

(
p
e
r

b
a
g
)

Quantity (bags)
S
Q
1
P
1
Equilibrium
price
Producer
surplus
5-18
Efficiently Functioning Markets
Efficiency Revisited
All markets that have downsloping demand curves and upsloping
supply curves yield consumer and producer surplus.
The demand curve reflects buyers full willingness to pay and the
supply curve reflects all of the costs facing sellers, the equilibrium
quantity reflects economic efficiency, which consists of productive
efficiency and allocative efficiency.
Efficiency Revisited
LO2
P
r
i
c
e

(
p
e
r

b
a
g
)

Quantity (bags)
S
Q
1
P
1
D
Consumer
surplus
Producer
surplus
5-20
Efficiently Functioning Markets
Efficiency Revisited
Productive efficiency is achieved because competition forces
producers to use the best technologies and combinations of
resources available. Doing so minimizes the per-unit cost of the
output produced.

Allocative efficiency is achieved because the correct quantity of
product is produced relative to other goods and services.
Efficiently Functioning Markets
Efficiency Revisited
Any resources directed toward the production of one product are
resources that could have been used to produce other products.
Thus, the only way to justify taking any amount of any resource
(land, labor, capital, entrepreneurship) away from the production of
other products is if it brings more utility or satisfaction when
devoted to the production of one product than it would if it were
used to produce other products.

Efficiently Functioning Markets
Efficiency Revisited
Demand and supply curves can be interpreted as measuring
marginal benefit (MB) and marginal cost (MC).
Supply curves are marginal cost curves; demand curves are
marginal benefit curves.
The maximum price that a consumer would be willing to pay for any
particular unit is equal to the benefit that the consumer would get
if he/she were to consume that unit.

Optimal allocation is achieved at the output level where MB = MC.

Efficiently Functioning Markets
Efficiency Revisited
Only at equilibrium quantity where the maximum willingness to
pay exactly equals the minimum acceptable price does society
exhaust all opportunities to produce units for which benefits exceed
costs (including opportunity costs).
Producing at the equilibrium quantity maximizes the combined area
of consumer and producer surplus (total surplus).

Efficiently Functioning Markets
Efficiency Revisited
When demand curves reflect buyers full willingness to pay and
when supply curves reflect all the costs facing sellers, competitive
markets produce equilibrium quantities that maximize the sum of
consumer and producer surplus.
Allocative efficiency occurs at the market equilibrium quantity
where three conditions exist simultaneously:
1. MB = MC
2. Maximum willingness to pay = minimum acceptable price
3. Total surplus (sum of consumer and producer surplus) is at a
maximum
Efficiently Functioning Markets
Efficiency Losses (Deadweight Losses)
Efficiency losses reductions of combined consumer and producer
surplus result from both underproduction and overproduction.
When output falls below equilibrium, the sum of consumer and
producer surplus falls an efficiency loss (deadweight loss) to
society occurs.



Quantity (bags)
P
r
i
c
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(
p
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b
a
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)

Efficiency Losses
LO2
c
S

Q
1
Q
2
D
b
d
a
e
Efficiency loss
from underproduction
5-27
Efficiently Functioning Markets
Efficiency Losses (Deadweight Losses)
Where overproduction occurs (to the right of equilibrium), costs
exceed benefits; an economic efficiency loss occurs.
In the case of overproduction, combined consumer and producer
surplus declines.

The magic of markets is that when demand reflects consumers full
willingness to pay and when supply reflects all costs, the market
equilibrium quantity will automatically equal the allocatively
efficient output level.
Efficiency Losses
LO2
c
S

Q
1
Q
3
D
b
f
a
g
Quantity (bags)

P
r
i
c
e

(
p
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b
a
g
)

Efficiency loss
from overproduction
5-29

Appendix

EXTERNALITIES 31
Externalities and Economic Efficiency
The Effect of Externalities
The Effect of Pollution on
Economic Efficiency
How a Negative Externality in Production Reduces Economic
Efficiency
Externalities and Economic Efficiency
The Effect of Externalities
How a Positive Externality in Consumption Reduces
Economic Efficiency
The Effect of a Positive
Externality on Efficiency
Private cost The cost borne by the producer of a good or service.

Social cost The total cost of producing a good, including both the
private cost and any external cost.

Private benefit The benefit received by the consumer of a good or
service.

Social benefit The total benefit from consuming a good or service,
including both the private benefit and any external benefit.

Externalities and Economic Efficiency
The Effect of Externalities