1. McGraw-Hill/Irwin Chapter 5: Public Goods and Externalities Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

2. 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. LO: 5-1 5-2

3. Market Failure  Two common cases in which market failures arise are:  Production of public goods (and services)  Production of goods and services that involve externalities LO: 5-1 Market failure is the inability of a market to produce a desirable product or produce it in the “right” amount. 5-3

4. Private Goods vs. Public Goods  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: 5-1 5-4

5. Private Goods vs. Public Goods: Examples  Private goods  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. LO: 5-1 Because of free-rider problem, government provides public goods and finances them through taxes. 5-5

6. 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 marginal benefit of this good (market demand) is equal to the marginal cost of producing the good (supply). LO: 5-2 5-6

7. Demand for Public Goods: Example with 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) 1234512345 $4 3 2 1 0 $5 4 3 2 1 $9 7 5 3 1 ++++++++++ ========== Graphically… LO: 5-2 5-7

8. $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 (per item) for 2 Items $4 (per item) for 2 Items $7(per item) for 2 Items $1 (per item) for 4 Items $2 (per item) for 4 Items $3 (per item) for 4 Items Connect the Dots Collective Willingness To Pay Optimal Quantity LO: 5-2 5-8

9. 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. LO: 5-3 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. 5-9

10. 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. LO: 5-3 Graphically… 5-10

11. Externalities: Equilibrium Output vs. Optimal Output Negative Externalities Examples: pollution from factories, traffic jams. Positive Externalities Examples: inventions, front yard landscaping. 0 D S StSt Overallocation Negative Externalities StSt Underallocation Positive Externalities QoQo QoQo QeQe QeQe P P 0 Q Q D DtDt LO: 5-3 5-11

12. 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. LO: 5-3 5-12

13. 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. LO: 5-4 Tax burden is the total cost of taxes imposed on society. 5-13

14. 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. LO: 5-5 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. 5-14

15. 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. LO: 5-5 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. 5-15