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 the 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
Price (per bag)

Equilibrium
Price
P1

Q1
Quantity (bags)

LO2 5-7
 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 5-8
 Producer Surplus

Producer S
surplus
Price (per bag)

P1
Equilibrium
price

Q1
Quantity (bags)

LO2 5-9
 Efficiency Revisited

Consumer
surplus
S
Price (per bag)

P1

Producer D
surplus

Q1
Quantity (bags)

LO2 5-10
 Efficiency Losses

a Efficiency loss S
from underproduction
Price (per bag)

d
b

D
c
Q2 Q1
Quantity (bags)

LO2 5-11
 Efficiency Losses

a S
Efficiency loss
from overproduction

f
Price (per bag)

b
g

D
c
Q 1 Q3
Quantity (bags)

LO2 5-12
 Private Goods

• Produced in the market by firms

• Offered for sale
• Characteristics
• Rivalry
• Excludability

LO3 5-13
 Public Goods

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

LO3 5-14
 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 5-15
 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
LO4 5-16
 Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies
• Government provision

LO4 5-17
 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 5-18
 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

LO4 5-19
 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

LO5 5-20