1. Ch 28. Gov’t and Market Failure

2. Public Goods Nonrivalry – Once a producer has produced a public good, everyone can obtain the benefit. Nonrivalry – Once a producer has produced a public good, everyone can obtain the benefit. Nonexcludability – One persons consumption of the good does not preclude consumption of the same good by others. Nonexcludability – One persons consumption of the good does not preclude consumption of the same good by others. -- Because of these, private firms cannot profitably produce a public good.

3. Demand for Public Goods (1) Quantity Of Public Good (2) Adams’ Willingness To Pay (Price) (3) Benson’s Willingness To Pay (Price) (4) Collective Willingness To Pay (Price) 1234512345 $4 3 2 1 0 $5 4 3 2 1 $9 7 5 3 1 ++++++++++ ========== Two Individuals Graphically…

4. Demand for Public Goods $9 7 5 3 1 0 P Q 12345 $6 5 4 3 2 1 0 P Q 12345 $6 5 4 3 2 1 0 P Q 12345 Adams Benson Collective Demand and Supply D1D1 D2D2 DCDC S Adams’ Demand Benson’s Demand Collective Demand $3 for 2 Items $4 for 2 Items $7 for 2 Items $1 for 4 Items $2 for 4 Items $3 for 4 Items Connect the Dots Collective Willingness To Pay Optimal Quantity Comparing MB and MC The optimal amount of a public good.

5. The optimal amount of a public good -- The collective demand curve for a public good, shown by D c is found by summing vertically the individual willingness-to- pay curves (D 1 and D 2 on previous slide). -- The supply curve of the public good slopes upward and to the right, reflecting rising marginal costs. -- The optimal amount of the public good is 3 units, determined by the intersection of D c and S.

6. Cost-Benefit Analysis Deciding whether to provide a particular public good and how much of it to provide. Deciding whether to provide a particular public good and how much of it to provide. Cost-benefit analysis table in the textbook. Cost-benefit analysis table in the textbook.

7. Externalities Negative Externalities Positive Externalities 0 D S StSt Overallocation Negative Externalities StSt Underallocation Positive Externalities QoQo QoQo QeQe QeQe P P 0 Q Q Individual Bargaining: Coase Theorem Individual Bargaining: Coase Theorem Limitations Limitations Liability Rules and Lawsuits Liability Rules and Lawsuits D DtDt

8. Externalities Spillover Costs and Spillover Benefits (a) With spillover costs borne by society, the producers’ supply curve S is to the right of (below) the full-cost curve S t. (a) With spillover costs borne by society, the producers’ supply curve S is to the right of (below) the full-cost curve S t. Consequently, the equilibrium output Q e is greater than the optimal output Q o. Consequently, the equilibrium output Q e is greater than the optimal output Q o. (b) When spillover benefits accrue to society, the market demand curve D is to the left (below) the full-benefit demand curve D t. (b) When spillover benefits accrue to society, the market demand curve D is to the left (below) the full-benefit demand curve D t. As a result, the equilibrium output Q e is less than the optimal output Q o. As a result, the equilibrium output Q e is less than the optimal output Q o.

9. Coase Theorem In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining. In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining. This theorem, along with his 1937 paper on the nature of the firm (which also emphasizes the role of transaction costs), earned Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a "theorem." Since the 1960s, a voluminous literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow. This theorem, along with his 1937 paper on the nature of the firm (which also emphasizes the role of transaction costs), earned Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a "theorem." Since the 1960s, a voluminous literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.

10. Gov’t Intervention Correcting for spillover costs (negative externalities) (a) Spillover costs result in an overallocation of resources. (a) Spillover costs result in an overallocation of resources. (b) Gov’t can correct this overallocation in 2 ways: (b) Gov’t can correct this overallocation in 2 ways: 1 - use of direct controls, which would shift the supply curve from S to S t and reduce the output from Q e to Q o, or 2 – imposition of a special tax T, which would also shift the supply curve from S to S t, eliminating the overallocation of resources.

11. (a) Spillover benefits result in an underallocation of resources. (a) Spillover benefits result in an underallocation of resources. (b) This underallocation can be corrected by a subsidy to consumers, which shifts market demand from D to D t and increases output from Q e to Q o. (b) This underallocation can be corrected by a subsidy to consumers, which shifts market demand from D to D t and increases output from Q e to Q o. (c) Alternatively, the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from S t to S’ t, increasing output from Q e to Q o. (c) Alternatively, the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from S t to S’ t, increasing output from Q e to Q o. Gov’t Intervention Correcting for spillover benefits (positive externalities)

12. Externalities Operation of the Market Operation of the Market Advantages Advantages Real-World Examples Real-World Examples D 2006 D 2016 S=Supply of Pollution Rights 500 750 1000 $100 $200 P 0 Q Price Per Pollution Right Quantity of 1-Ton Pollution Rights A market for pollution rights: The supply of pollution rights S is set by the gov’t, which determines that a specific body of water can safely recycle 500 tons of waste. In 2006, the demand for pollution rights is D 2006 and the 1-ton price is $100. The pollution quantity is 500 tons, not the 750 tons it would have been without the pollution rights. Over time, pollution rights increases to D 2016, the 1-ton cost is $200, and the pollution stays at 500 tons instead of rising to 1000 tons.

13. Externalities Society’s Optimal Amount of Externality Reduction Society’s Optimal Amount of Externality Reduction MC, MB, and Equilibrium MC, MB, and Equilibrium 0 Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Q1Q1 MB MC Socially Optimum Amount Of Pollution Abatement Society’s optimal amount of pollution abatement: The optimal amount of externality reduction – in this case, pollution abatement – occurs at Q 1, where society’s marginal cost MC and marginal benefit MB of reducing the spillover are equal.

14. The economics of recycling (a) The equilibrium price and amount of materials recycled are determined by supply S1 and demand D1. (a) The equilibrium price and amount of materials recycled are determined by supply S1 and demand D1. (b) Policies that increase the incentives for producers to buy recyclable inputs shift the demand curve rightward to D2, and raise both the equilibrium price and the amount of recycling. (b) Policies that increase the incentives for producers to buy recyclable inputs shift the demand curve rightward to D2, and raise both the equilibrium price and the amount of recycling. (c) Policies that encourage households to recycle shift the supply curve rightward to S2, and expand the equilibrium amount of recycling. However, these policies also reduce the equilibrium price of the recycled inputs. (c) Policies that encourage households to recycle shift the supply curve rightward to S2, and expand the equilibrium amount of recycling. However, these policies also reduce the equilibrium price of the recycled inputs.