Market Failures: Public Goods and

Externalities
 The economics of pollution
• Economic production can cause
environmental damage. This tradeoff arises
for all countries, whether high-income or low-
income, and whether their economies are
market-oriented or command-oriented.
• An externality, sometimes called a spillover,
occurs when an exchange between a buyer
and seller has an impact on a third party who
is not part of the exchange. Externalities can
be positive or negative.
• Market failure is when the market does
not allocate resources on its own
efficiently in a way that balances social
costs and benefits; externalities are one
example of a market failure.
• Social costs are costs that include both
the private costs incurred by firms and
also additional external costs incurred
by third parties outside the production
process.
 Market Failures
• Market fails to produce the right
amount of the product
• Resources may be
• Over-allocated
• Under-allocated

LO1 5-4
 Demand-Side Failures
• Impossible to charge consumers
what they are willing to pay for the
product
• Some can enjoy benefits without
paying

LO1 5-5
 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 the supply

LO1 5-6
 Efficiently Functioning Markets

• Demand curve must reflect the

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

LO1 5-7
 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 5-8
 Consumer Surplus

Consumer
Surplus
Equilibrium
Price
P1

Q1

LO2 5-9
 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 5-10
 Producer Surplus

Producer S
surplus

P1
Equilibrium
price

Q1

LO2 5-11
 Efficiency Revisited

Consumer
surplus
S

P1

Producer D
surplus

Q1

LO2 5-12
 Efficiency Losses

a Efficiency loss S
from underproduction
Price (per bag)

d
b

D
c
Q2 Q1
Quantity (bags)

5-
 Efficiency Losses

a S
Efficiency loss
from overproduction

f
Price (per bag)

b
g

D
c
Q 1 Q3
Quantity (bags)

5-14
 Private Goods

• Produced in the market by firms

• Offered for sale
• Characteristics
• Rivalry
• Excludability
 Public Goods

• Provided by government
• Offered for free
• Characteristics
• Nonrivalry
• Nonexcludability
• Free-rider problem
 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
 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
L4 5-18
 Pollution as a negative externality

• Pollution is a negative externality.

Economists illustrate the social costs of
production with a demand and supply
diagram.
• The social costs include the private costs
of production incurred by the company and
the external costs of pollution that are
passed on to society.
 Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies
• Government provision
 Government Intervention

P Negative P
externalities St St
b
a a
S S

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

(a) (b)
Negative externalities Correct externality with
tax
 Government Intervention

Methods for Dealing with Externalities

Resource Allocation
Problem Outcome Ways to Correct
Negative externalities Overproduction of output 1. Private bargaining
(spillover costs) and therefore 2. Liability rules and lawsuits
overallocation of 3. Tax on producers
resources 4. Direct controls
5. Market for externality rights

Positive externalities Underproduction of output 1. Private bargaining

(spillover benefits) and therefore 2. Subsidy to consumers
underallocation of 3. Subsidy to producers
resources 4. Government provision
Government’s 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

523
 Summary
• Economic production can cause
environmental damage. This tradeoff arises
for all countries, whether high-income or low-
income, and whether their economies are
market-oriented or command-oriented.
• An externality, sometimes called a spillover,
occurs when an exchange between a buyer
and seller has an impact on a third party who
is not part of the exchange. Externalities can
be positive or negative.
• Market failure is when the market does not
allocate resources on its own efficiently in
a way that balances social costs and
benefits; externalities are one example of a
market failure.
• Social costs are costs that include both the
private costs incurred by firms and
also additional external costs incurred by
third parties outside the production
process.