1. Market Failures: Public Goods and Externalities
Chapter 5
Market Failures: Public Goods and Externalities
This chapter seeks to define a market failure and the consequences of a market failure. The chapter begins by looking at the demand side of market failures, the supply side of market failures, and the inefficiencies found. It goes on to describe and show consumer and producer surplus. It defines and describes private goods, public goods, the free-rider problem, and quasi-public goods. It shows how to find the optimal amount of public goods the government should produce using a cost-benefit approach and finishes with a discussion of government failure.
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved

2. Market fails to produce the right amount of the product
Market Failures
Market fails to produce the right amount of the product
Resources may be
Overallocated
Underallocated
Market failure occurs when the competitive market system produces the “wrong” amounts of certain goods or services, or fails to provide any at all.
Resources are either overallocated to the production of the good or underallocated to the production of the good.
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3. Some can enjoy benefits without paying
Demand-Side Failures
Impossible to charge consumers what they are willing to pay for the product
Some can enjoy benefits without paying
Demand-side market failures occur because there are situations where it is impossible to charge all consumers, or any consumers, the price that they are willing to pay. For example: a public fireworks display. People don’t have to pay to enjoy the display. Private firms would be unwilling to produce outdoor displays as it will be impossible to raise enough revenue to cover production costs. Firm can’t prevent people from watching the fireworks if they didn’t pay.
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4. Occurs when a firm does not pay the full cost of producing its output
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 supply
Supply-side market failures occur because there are extra costs associated with producing the good, but the extra costs are not reflected in the supply. For example, a coal-burning power plant: The firm running the plant pays for the land, labor, capital, and entrepreneurship that it uses to generate electricity, but it does not pay for the smoke it releases into the atmosphere and the damage that it causes to the atmosphere.
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5. Efficiently Functioning Markets
Demand curve must reflect the consumers, full willingness to pay
Supply curve must reflect all the costs of production
When there aren’t any market failures and demand fully reflects consumers’ willingness to pay while supply reflects all costs, then by producing at equilibrium the market is efficient. The market is producing the right amount of output that society desires. An efficient market will maximize the combination of consumer and producer surplus.
LO1
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6. Private Goods Characteristics
Produced in the market by firms
Offered for sale
Characteristics
Rivalry
Excludability
Private goods are produced through the market because they have rivalry (one’s use of a good makes it unavailable for others) and come in units small enough to be afforded by individual buyers. Private goods are subject to excludability, the idea that those unable and unwilling to pay do not have access to the benefits of the product.
Since the goods have rivalry and excludability, private firms can produce and sell the goods for a profit.
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7. Public Goods Characteristics
Provided by government
Offered for free
Characteristics
Nonrivalry
Nonexcludability
Free-rider problem
The demand curve of public goods may underreport how much consumers are willing and able to pay. Public or social goods would not be produced through the market because they possess the characteristics of nonrivalry and nonexcludability.
Nonrivalry means that when one consumes the good, this does not preclude another from consuming the good. Nonexcludability means that no one can be prevented from enjoying the benefits of a public good. With nonrivalry and nonexcludability, public goods suffer from the free-rider problem. The free-rider problem means that many people can benefit from the goods without paying, making it unprofitable for firms to produce these goods since they have no way to ensure that only paying consumers will enjoy the good. As a result, government often provides these goods. Examples of public goods include city fireworks shows.
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8. Measuring Demand Optimal Quantity for a Public Good, Two Individuals
(1)
Quantity of Public Good
(2)
Adams’ Willingness to Pay (Price)
(3)
Benson’s Willingness to Pay (Price)
(4)
Collective Willingness
to Pay (Price) 1 $4 + $5 = $9 2 3 4 7 5
The demand for a public good is somewhat unusual. Suppose Adams and Benson are the only two people in society and their marginal willingness to pay for a public good, national defense, is as shown in the columns of the table. Notice that the schedules in this table are price quantity schedules reflecting demand. To find the demand for a public good, we add the total price each individual is willing to pay for the unit rather than summing the quantities at each price.
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9. Cost-Benefit Analysis
Resources diverted from private good production
Private goods that will not be produced
Benefit
The extra satisfaction from the output of more public goods
Government can use a cost-benefit analysis, which is a practical way to decide whether to produce a good and how much to produce. Government might use this method in determining whether or not to build a new highway.
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10. Cost-Benefit Analysis
Cost-Benefit Analysis for a National Highway Construction Project
(in Billions)
(1)
Plan
(2)
Total Cost of Project
(3)
Marginal Cost
(4)
Total Benefit
(5)
Marginal Benefit
(6)
Net Benefit
(4) – (2)
No new construction $0
A: Widen existing highways 4 $4 5 $5 1
B: New 2-lane highways 10 6 13 8 3
C: New 4-lane highways 18 22
D: New 6-lane highways 28 26 -2
The table shows that the total annual benefit (column 4) exceeds the total annual cost (column 2) for plans A, B, and C, indicating that some highway construction is economically justifiable. We see this directly in column 6, where total costs (column 2) are subtracted from total annual benefits (column 4).
Net benefits are positive for plans A, B, and C. Plan D is not economically justifiable because net benefits are negative, but the question of optimal size or scope for this project remains. By comparing the marginal cost (the change in total cost) and the marginal benefit (the change in total benefit) we can determine the answer.
The guideline is well known to you from previous discussions: Increase an activity, project, or output as long as the marginal benefit (column 5) exceeds the marginal cost (column 3). Stop the activity at, or as close as possible to, the point at which the marginal benefit equals the marginal cost. Do not undertake a project for which marginal cost exceeds marginal benefit.
In this case, plan C (building new four-lane highways) is the best plan. Plans A and B are too modest; the marginal benefits exceed the marginal costs, and there is a better option. Plan D’s marginal cost ($10 billion) exceeds the marginal benefit ($3 billion) and therefore cannot be justified; it overallocates resources to the project.
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11. 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
Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way. The good is underproduced when positive externalities are present. The equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output or engage in its own production of the item with the external benefits.
Negative externalities occur when a third person, or persons, external to the transaction is affected from the transaction in a negative way. The good is overproduced and the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.
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12. Negative externalities Positive externalitiesQ
Negative
Externalities St St y b a z
Positive
Externalities S Dt x c D D
Overallocation
Underallocation
With negative externalities borne by society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St. Consequently, the equilibrium output Qe is greater than the optimal output Qo, and the efficiency loss is abc. When positive externalities accrue to society, the market demand curve D is to the left of (below) the total-benefit demand curve Dt. As a result, the equilibrium output, Qe is less than the optimal output Qo, and the efficiency loss is xyz. Qo Qe Qe Qo
(a)
Negative externalities
(b)
Positive externalities
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13. Government Intervention
Correct negative externalities
Direct controls
Specific taxes
Correct positive externalities
Subsidies and government provision
Negative externalities result in an overallocation of resources. Government can correct this overallocation in two ways: (1) using direct controls which, reduce supply by driving up costs of production and would shift the supply curve and reduce output, or (2) imposing a specific tax, T, to the extent that the cost of producing the goods increases, which would also shift the supply curve to the left, eliminating the overallocation of resources and thus the efficiency loss.
When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must engage in its own production of the item or aid the producer with subsidies to encourage more production.
In either case, the supply curve shifts to the right, which lowers the equilibrium price and leads to a greater equilibrium output level.
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14. Government InterventionP Q P Q
Negative
Externalities St St b a a S S T c D D
Overallocation Qo Qe Qo Qe
(a) Negative externalities result in an overallocation of resources. (b) Government can correct this overallocation in two ways: (1) using direct controls, which would shift the supply curve from S to St and reduce output from Qe to Qo, or (2) imposing a specific tax, T, which would also shift the supply curve from S to St, eliminating the overallocation of resources and thus the efficiency loss.
(a)
Negative Externalities
(b)
Correcting the overallocation of resources via direct controls or via a tax
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15. Government InterventionSt St St y
Subsidy z
Positive
externalities
S't x Dt Dt
Subsidy U D D D
Underallocation Qe Qo Qe Qo Qe Qo
(a) Positive externalities result in an underallocation of resources. (b) This underallocation can be corrected through a subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Q0. (c) Alternatively, the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to S’t and increases output from Qe to Q0. This eliminates the underallocation of output, and thus the efficiency loss, shown in graph (a).
(a)
Positive externalities
(b)
Correcting via a subsidy
to consumers
(c)
Correcting via a subsidy
to producers
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16. Government Intervention
Methods for Dealing with Externalities
Problem
Resource Allocation Outcome
Ways to Correct
Negative externalities
(spillover costs)
Overproduction of output and therefore overallocation of resources
Private bargaining
Liability rules and lawsuits
Tax on producers
Direct controls
Market for externality rights
Positive externalities
(spillover benefits)
Underproduction of output and therefore underallocation of resources
Subsidy to consumers
Subsidy to producers
Government provision
This table lists several methods for correcting externalities.
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17. Society’s Optimal AmountsMC
Socially
Optimal Amount
of Pollution
Abatement
Society’s Marginal Benefit and Marginal
Cost of Pollution Abatement (Dollars)
Reducing pollution and negative externalities is not free. Society must decide how much pollution abatement it wants to “buy.” High costs may mean that totally eliminating pollution may not be desirable. The marginal cost rises as pollution is reduced more and more and at some point the marginal cost is higher than the marginal benefit. Additional actions to reduce pollution will therefore lower society’s well-being because total costs will rise more than total benefits.
The optimal amount of externality reduction—in this case, pollution abatement—occurs at Q1, where society’s marginal cost, MC, and marginal benefit, MB, of reducing the spillover are equal. MB Q1
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18. Apportioning the Tax Burden
Size, distribution, and impact of the costs that taxes impose on society
Benefits-received principle
Ability-to-pay principle
Taxes are the major source of funding for goods and services provided by government and the wages and salaries paid to government workers. Without taxes, there would be no public and quasi-public goods provided. Who should pay and how much taxes one should pay continue to stir controversy. Some leading philosophical approaches to splitting the tax burden are based on the benefits-received principle and ability-to-pay principle. Based on the benefits-received principle, those who benefit from the taxes should pay for them. This includes taxes on gas to fund highway construction and repair since these are the individuals using the highways. However, this principle becomes much more difficult to apply to things like public education and defense. Imposing taxes based on the ability-to-pay principle means that the taxes are based upon a person’s income and wealth where individuals with greater income/wealth pay more taxes.
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19. Progressive, Proportional, and Regressive Taxes
Progressive tax—average tax rates increase as income increases
Regressive tax—average tax rate declines as income increases
Proportional tax—average rate stays the same as income increases
Taxes are classified into one of the above categories based upon the relationship between average tax rates and the taxpayer incomes.
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20. Tax Progressivity in the United States
Applications
Personal income tax: progressive
Sales tax: regressive
Corporate tax: proportional
Payroll tax: regressive
Here we show a general application using the tax classification. Personal income taxes are progressive with marginal tax rates rising as incomes increase. A sales tax is regressive relative to income because a larger portion of a low-income household’s income is paid to sales taxes. Corporate taxes are proportional because they are a flat percentage on income. Payroll taxes are regressive because Social Security tax has a limit where once an individual has reached the income limit, he will no longer have to pay Social Security taxes for the year.
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21. Tax Progressivity in the United States
Personal income tax
Progressive tax
Marginal tax rate
Payroll taxes
Corporate income tax
Excise taxes
Personal income taxes are the backbone of the U.S. federal tax system. A tax is levied on taxable incomes of households and unincorporated businesses after certain deductions. A progressive tax means that higher tax rates are applied to higher brackets of income. Marginal tax rate is the tax rate paid on additional income. Payroll taxes are taxes on wages and income that finance Social Security and Medicare for retirees. The corporate income tax is a tax on a corporation’s profit and for most firms it is 35 percent. Excise taxes include sales taxes where sales taxes are placed on a large range of goods and services and excise taxes are imposed on specific goods.
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22. Tax Progressivity in the United States
Type of tax
Probable Incidence
Personal income tax
Tax falls on the household or individual on which it is levied
Payroll taxes
Workers pay the full tax levied on their earnings and part
of the tax levied on their employers
Corporate income tax
Short run: Full tax falls on owners of the businesses
Long run: Some of the tax may be borne by workers
through lower wages
Sales tax
Tax falls on consumers who buy the taxed products
Specific excise taxes
Taxes fall on consumers, producers, or both, depending on elasticity of supply and demand
Property Taxes
Taxes fall on owners in the case of land and owner-occupied residences, tenants in the case of rented property, consumers in the case of business property
This table looks at the probable outcome of taxes on each of the major sources of tax revenue in the United States.
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23. Tax Progressivity in the United States
Federal Personal Tax Rates, 2011*
(1)
Total Taxable
Income
(2)
Marginal Tax
Rate %
(3)
Total Tax
on Highest
Income in
Bracket
(4)
Average Tax Rate on Highest Income in Bracket % (3) / (1)
$1–$17,000 10 $
$17,001–$69,000 15
9500 14
$69,001–$139,500 25
27,125 19
$139,501–$212,300 28
47,509 22
$212,301–$379,150 33
103,570 27
Over $379,150 35
This table shows the tax rates for a married couple filing a joint return, 2011.
* For a married couple filing a joint return
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24. Tax Progressivity in the United States
Federal tax system is progressive
State and local tax structures are largely regressive
Overall U.S. tax system is progressive
The question of whether the overall U.S. tax structure is progressive, regressive, or proportional is difficult to answer. The majority of economists who study taxes feel that the federal system tends to be progressive while the state and local systems are regressive, but overall higher-income people carry a substantially larger tax burden, resulting in an overall progressive system.
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25. 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
The Coase theorem suggests that, under the right conditions, private bargaining can solve externality problems; thus government intervention may not always be necessary. Government can have a role in the economy to correct externalities. This is not easy; it is time-consuming and costly. There is always the chance that a government failure may occur.
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