Chapter 4 Public Goods & Externalities ECON 201 Chapter 4 Public Goods & Externalities

Market failures When the government perceives that there has been a ‘failure’ in the market system, it tries to correct it. When the competitive market system: Does not allocate any resources whatsoever to the production of certain goods. Either underallocates or overallocates resources to the production of certain goods.

Market Failure Market failure is the inability of a market to produce a desirable product or produce it in the “right” amount. Government could “step-in” Market failure is the inability of a market to produce a desirable product or produce it in the “right” amount. Two common cases in which market failures arise are: Production of public goods (and services); Production of goods and services that involve externalities. LO: 4-1

Market Failure In some cases certain goods and services might not be produced at all. In other cases certain goods and services might be over- or under-produced compared to what would be best for the society. These situations represent a market failure to achieve the outcome that is best for the society. Whenever there is a market failure, there might be a role for a government to intervene in the economy. In some cases certain goods and services might not be produced at all. In other cases certain goods and services might be over- or under-produced compared to what would be best for the society. These situations represent a market failure to achieve the outcome that is best for the society. Whenever there is a market failure, there might be a role for a government to intervene in the economy. LO: 4-1

Private Goods vs. Public Goods: Examples A pair of shoes A cup of coffee A car A house A haircut A circus show Public goods National defense Roads Parks Street lighting Environmental protection Here are some examples of private goods: a pair of shoes, a cup of coffee, a car, a house, a haircut, a circus show. Examples of public goods are national defense, roads, parks, street lighting, environmental protection. Because of the free-rider problem, government provides public goods and finances them through taxes. Because of the free-rider problem, government provides public goods and finances them through taxes. LO: 4-1

Private Goods vs. Public Goods Private goods are Rival: if one person consumes a private good, another cannot Excludable: only those who pay for goods enjoy their benefits Bought and consumed by people individually Produced and allocated efficiently by competitive markets Public goods are Non-rival: one person’s consumption of a public good does not preclude others from consuming it too Non-excludable: there is no efficient way to prevent people from enjoying a public good without paying Subject to a free-rider problem – non-payers can enjoy benefits of a public good Not produced or under-produced by competitive markets What are public goods? All goods could be separated into private and public. Private goods are Rival: if one person consumes a private good, the other can’t; Excludable: only those who pay for goods enjoy their benefits; Bought and consumed by people individually; Produced and allocated efficiently by competitive markets. Public goods are Non-rival: one person’s consumption of a public good does not preclude others from consuming it too; Non-excludable: there is no efficient way to prevent people from enjoying a public good without paying; Subject to a free-rider problem – non-payers can enjoy benefits of a public good; Not produced or under-produced by competitive markets. LO: 4-1

Private Goods vs Public Goods Private goods are produced by the competitive market Rivalry – when I buy it, you can’t have it Excludability – if I can afford it, I can have it. Public goods are available to everyone. One person’s benefit does not reduce the benefit to others. Examples: national defense, environmental protection

Quasi-Public Goods Goods that could be considered ‘public goods’ but could be offered by private firms who could ‘exclude’ people. Examples: streets, museums, fire protection, trash disposal

Free-rider Problem When you gain benefit from something without contributing to its cost. Example – listening to a street performer without paying him for it. Example – I pay for the streets in my town with my taxes, but people from other places can drive on the streets too. Private firms can’t afford to create public goods because of this.

Efficient Allocation A competitive market allocates society’s resources efficiently to the particular product. Productive Efficiency – the production of any particular good in the least costly way.

Market Demand for Public Goods and Optimal Quantity Market demand for a private good is a horizontal sum of individual demands: quantities demanded at each price are added up. Market demand for a public good is a vertical sum of individual demands: individuals’ willingness to pay (per unit) for each given quantity of a public good are added up. Optimal Quantity of a public good is where the marginal benefit of this good (market demand) is equal to the marginal cost of producing it (supply). Market demand is constructed differently for private and public goods. Market demand for a private good is a horizontal sum of individual demands: quantities demanded at each price are added up. Market demand for a public good is a vertical sum of individual demands: individuals’ willingness to pay (per unit) for each given quantity of a public good are added up. Optimal quantity of a public good is where the marginal benefit of this good (market demand) is equal to the marginal cost of producing it (supply). LO: 4-2

Collective Demand Optimal Quantity $7(per item) for 2 Items $9 7 5 3 1 P Q 2 4 Collective Demand S Optimal Quantity $7(per item) for 2 Items Collective Willingness To Pay $3 (per item) for 4 Items DC Connect the Dots Collective Demand and Supply $6 5 4 3 2 1 P Q Benson’s Demand $4 (per item) for 2 Items D2 $2 (per item) for 4 Items Benson Start with the bottom graphs that give us individual demand curves. Add them up vertically to get the collective demand curve. If supply is given by the supply curve S, the optimal quantity of the public good would be three and the price will be $5. At this price the collective willingness to pay for the public good is equal to the cost of producing this public good. $6 5 4 3 2 1 P Q Adams’ Demand $3 (per item) for 2 Items $1 (per item) for 4 Items D1 Adams LO: 45-2

Externalities: Positive and Negative An externality occurs when some of the costs or the benefits of a good are passed on to or “spill over to” someone other than the immediate buyer or seller. Externalities are benefits or costs that accrue to some third party that is external to the market transaction. Externalities can be positive or negative. Negative externalities are spillover production or consumption costs imposed on third parties without compensation to them. Positive externalities are spillover production or consumption benefits conferred on third parties without compensation from them. Now let us turn to externalities. An externality occurs when some of the costs or the benefits of a good are passed on to or “spill over to” someone other than the immediate buyer or seller. Externalities are benefits or costs that accrue to some third party that is external to the market transaction. Externalities can be positive or negative. Negative externalities are spillover production or consumption costs imposed on third parties without compensation to the third party. Positive externalities are spillover production or consumption benefits conferred on third parties without compensation from the third party. LO: 4-2

Negative externalities When one person’s action harms another Example: pollution When a business dumps chemicals in a river that a city gets their drinking water from, the government will step in and force the business to clean it up.

Correcting negative externalities Legislation – passing laws that prohibit pollution is one way to prevent it. Specific taxes – if the government won’t pass a law to prevent it, then a new tax could be enacted that ‘discourage’ the activity, and at the same time collect money that can be used to solve the problem.

Positive externalities When one person benefits from another’s actions. Example: education. Better educated people get better jobs, which generate more income for the government and benefit those around them.

Corrections for positive external. Subsidize consumers – giving low-interest government loans to students so they can attend college. Subsidize suppliers – state governments supply large amounts of money to colleges so they can operate and keep tuition costs down Provide goods via government – to ensure that everyone has a fair chance to participate in something…the postal service.

Externalities: Equilibrium Output vs. Optimal Output With negative externalities, the producers’ supply curve is below (to the right of) the full-cost supply curve, therefore equilibrium output is greater than optimal, i.e. overallocation of resources. With positive externalities, the market demand curve is below (to the left of) the full-benefit demand curve, therefore equilibrium output is less than optimal, i.e. underallocation of resources. When externalities are present, equilibrium output is not the same as optimal output. With negative externalities, the producers’ supply curve is below (to the right of) the full-cost supply curve; therefore, equilibrium output is greater than optimal, i.e. overallocation of resources. With positive externalities, the market demand curve is below (to the left of) the full-benefit demand curve; therefore, equilibrium output is less than optimal, i.e. underallocation of resources. Graphically… Graphically… LO: 4-3

Externalities: Equilibrium Output vs. Optimal Output Q Negative Externalities St St Positive Externalities S Dt D D Overallocation Underallocation Qo Qe Qe Qo Consider negative externalities when the full cost of production is higher than that internalized by the producer (such as with pollution from factories). Then, the total supply curve will be higher than the producers’ and therefore, optimal quantity will be lower and price will be higher than in equilibrium, i.e. there will be overallocation of resources to the good with negative externality. Now consider positive externalities when total utility from a good is higher than individual utility (such as front yard landscaping). Then, the total demand curve will be higher than market demand based on individual demand curves. As a result, optimum quantity of a good that has a positive externality will be higher than the equilibrium quantity, i.e. there will be underallocation of resources to this good. Negative Externalities Examples: pollution from factories, traffic jams. Positive Externalities Examples: inventions, front yard landscaping. LO: 4-3

Ways to Resolve Externalities Problem Individual bargaining: When property rights are clearly established, externality problems can be resolved through private negotiations (Coase Theorem). Liability rules and lawsuits: The perpetrator of the harmful externality is forced to pay damages to those injured. Government intervention: Direct control through legislation; Specific taxes to bring producers’ supply curve closer to the full-cost supply curve; Subsidies and government provision for goods and services with positive externalities. Market-based approach: Government can create a market for externality rights. How to resolve the externalities problem? A few ideas were proposed: Individual bargaining: When property rights are clearly established, externality problems can be resolved through private negotiations (Coase Theorem). Liability rules and lawsuits: The perpetrator of the harmful externality is forced to pay damages to those injured. Government intervention: Direct control through legislation; Specific taxes to bring producers’ supply curve closer to the full-cost supply curve; Subsidies and government provision for goods and services with positive externalities. Market-based approach: Government can create a market for externality rights (such as emission permits). LO: 4-3

What is the government’s role? Governments establish the ‘rules’ that everyone must play by. The laws. Government has to watch out for monopolies and get rid of those that cause unfairness. Some monopolies can’t be helped and therefore the government simply ‘controls’ them the best that they can… e.g., electricity, telephone, transportation.

Government Intervention Direct Controls – laws to prevent Clean-Air Act Mandated reductions in emissions Toxic waste laws Specific Taxes – Manufacturing excise tax on CFCs

Government Intervention Positive Externalities Subsidies to buyers –eliminate underallocation of resources. Subsidies to producers – reduce producers’ costs. Government provision –where, positive externalities are extremely large Govt. provides product for free Quasi-public goods

Taxation: Apportioning the Tax Burden To finance government provision of public goods and subsidies and government provision in case of positive externalities, government is levying taxes on households and businesses. How is this tax burden distributed? Benefits-received principle: People who receive the benefit from government-provided goods and services should pay the taxes required to finance them. Ability-to-pay principle: People who have greater income should pay a greater proportion of it as taxes than those who have less income. To finance government provision of public goods and subsidies and government provision in case of positive externalities, government is levying taxes on households and businesses. How is this tax burden (the total cost of taxes imposed on society) distributed? Benefits-received principle: People who receive the benefit from government-provided goods and services should pay the taxes required to finance them. Ability-to-pay principle: People who have greater income should pay a greater proportion of it as taxes than those who have less income. The tax burden is the total cost of taxes imposed on society. LO: 4-4

Progressive, Proportional, and Regressive Taxes A progressive tax: average tax rate increases as the taxpayer’s income increases. A regressive tax: average tax rate decreases as the taxpayer’s income increases. A proportional tax: average tax rate remains constant as the taxpayer’s income increases. The following two concepts are useful when discussing taxes: Average tax rate is the total tax paid divided by total taxable income, as a percentage. Marginal tax rate is the tax rate paid on each additional dollar of income. Three types of tax are distinguished based on how average tax rate changes with individual’s income. A progressive tax: average tax rate increases as the taxpayer’s income increases. A regressive tax: average tax rate decreases as the taxpayer’s income increases. A proportional tax: average tax rate remains constant as the taxpayer’s income increases. Average tax rate is the total tax paid divided by total taxable income, as a percentage. Marginal tax rate is the tax rate paid on each additional dollar of income. LO: 4-5

Tax Progressivity in the U.S. The majority view of economists is as follows: The Federal tax system is progressive. The state and local tax structures are largely regressive. A general sales tax and property taxes are regressive with respect to income. The overall U.S. tax system is slightly progressive. Government’s Role: A Qualification In addition to correcting externalities and providing public goods, government also sets the rules and regulations for the economy, redistributes income when desirable, and takes macroeconomic actions to stabilize the economy. The majority view of economists is as follows: The Federal tax system is progressive. The state and local tax structures are largely regressive. A general sales tax and property taxes are regressive with respect to income. The overall U.S. tax system is slightly progressive. In addition to correcting externalities and providing public goods, government also sets the rules and regulations for the economy, redistributes income when desirable, and takes macroeconomic actions to stabilize the economy. LO: 4-5

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