Chapter Market Failures: Public Goods and Externalities Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Efficiently Functioning Markets • Demand curve must reflect the consumers full willingness to pay • Supply curve must reflect all the costs of production LO2 4-2 Consumer Surplus • Consumer surplus • Difference between what a consumer is willing to pay for a good and what the consumer actually pays • Max price consumer is willing pay is equal to their MB • Extra benefit from paying less than the maximum price LO2 4-3 Consumer Surplus Consumer Surplus Bob (2) Maximum Price Willing to Pay $13 (3) Actual Price (Equilibrium Price) $8 (4) Consumer Surplus $5 (=$13-$8) Barb 12 (=$12-$8) Bill 11 (=$11-$8) Bart 10 (=$10-$8) Brent (= $9-$8) Betty 8 (= $8-$8) (1) Person LO2 4-4 Producer Surplus • Producer surplus • Difference between the actual price a producer receives and the minimum price they would accept • Min price seller will accept is equal to the MC of producing good • Extra benefit to the seller from receiving a higher price LO2 4-5 Producer Surplus Producer Surplus (2) Minimum Acceptable Price $3 (3) Actual Price (Equilibrium Price) $8 (4) Producer Surplus $5 (=$8-$3) Courtney (=$8-$4) Chuck (=$8-$5) Cindy (=$8-$6) Craig (=$8-$7) Chad 8 (=$8-$8) (1) Person Carlos LO2 4-6 Efficiency • Allocative Efficiency • Correct amount of a good is produced • Productive Efficiency • Produced at lowest possible cost LO3 4-7 Private Goods • Private goods are produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO3 4-8 Public Goods • Public goods are provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem LO3 4-9 Demand for Public Goods Demand for a Public Good, Two Individuals (1) Quantity of Public Good (2) Adams’ Willingness to Pay (Price) $4 + (3) Benson’s Willingness to Pay (Price) $5 + = + = + = + = LO3 = (4) Collective Willingness to Pay (Price) $9 4-10 Cost-Benefit Analysis • 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 LO4 4-11 Cost-Benefit Analysis Cost-Benefit Analysis for a National Highway Construction Project (in Billions) (2) Total Cost of Project $0 (3) Marginal Cost (4) Total Benefit $0 (5) Marginal Benefit (6) Net Benefit (4) – (2) $0 A: Widen existing highways $4 $5 B: New 2-lane highways 10 13 C: New 4-lane highways 18 23 10 D: New 6-lane highways 28 10 26 -2 (1) Plan No new construction LO4 4-12 Quasi-Public Goods • Quasi-public goods could be provided through the market system • Because of positive externalities the government provides them • Examples are education, streets, museums LO4 4-13 The Reallocation Process • Government • Taxes individuals and businesses • Takes the money and spends on production of public goods LO4 4-14 Market Failures • Market failures • Markets fail to produce the right amount of the product • Resources may be • Over-allocated • Under-allocated LO1 4-15 Externalities • An externality is a cost or benefit accruing to a third party external to the market transaction • Positive externalities • Too little is produced • Demand-side market failures • Negative externalities • Too much is produced • Supply-side market failures LO4 4-16 Demand-Side Market Failures • Demand-side market failures • Demand does not reflect full amount consumers are willing to pay • Some can enjoy benefits without paying • Firms won’t produce the good or produce too little • Associated with positive externalities LO1 4-17 Supply-Side Market Failures • Supply-side market 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 • Associated with negative externalities LO1 4-18 Government Intervention • Correct negative externalities • Direct controls • Pigovian taxes • Correct positive externalities • Subsidies • Government provision LO4 4-19 Government Intervention Methods for Dealing with Externalities Problem Negative externalities (spillover costs) Positive externalities (spillover benefits) LO4 Resource Allocation Outcome Overproduction of output and therefore overallocation of resources Ways to Correct Private bargaining Liability rules and lawsuits Tax on producers Direct controls Market for externality rights Underproduction of output Private bargaining and therefore Subsidy to consumers underallocation of resources Subsidy to producers Government provision 4-20 Government’s Role in the Economy • Government’s role in correcting externalities • Optimal reduction of an externality up to MB = MC • Officials must correctly identify the existence and cause • Has to be done within a political environment LO5 4-21