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Lecture Macroeconomics (19/e) - Chapter 5: Market failures: Public goods and externalities

After reading this chapter, you should be able to: Differentiate between demand-side market failures and supply-side market failures; explain the origin of both consumer surplus and producer surplus, and explain how properly functioning markets maximize their sum, total surplus, while optimally allocating resources; describe free riding and public goods, and illustrate why private firms cannot normally produce public goods;. | Market Failures: Public Goods and Externalities 05 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- Demand-Side Failures Impossible to charge consumers what they are willing to pay for the product Some can enjoy benefits without paying LO1 5- 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- Efficiently Functioning Markets Demand curve must reflect the consumers full willingness to pay Supply curve must reflect all the costs of production LO1 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- Consumer Surplus LO2 LO2 D Q1 P1 Consumer Surplus Equilibrium Price 5- 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- Producer Surplus LO2 LO2 S Q1 P1 Equilibrium price Producer surplus 5- Efficiency Revisited LO2 S Q1 P1 D Consumer surplus Producer surplus 5- Quantity (bags) Price (per bag) Efficiency Losses LO2 c S Q1 Q2 D b d a e Efficiency loss from underproduction 5- Efficiency Losses LO2 c S Q1 Q3 D b f a g Quantity (bags) Price (per bag) Efficiency loss from overproduction 5- Private Goods Produced in the market by firms Offered for sale Characteristics Rivalry Excludability LO3 5- Public Goods Provided by government Offered for free Characteristics Nonrivalry Nonexcludability Free-rider problem LO3 5- 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- 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- Government Intervention Correct negative externalities Direct controls Specific taxes Correct positive externalities Subsidies Government provision LO4 5- Government Intervention LO4 (a) Negative externalities D S St Overallocation Negative externalities Qo Qe P 0 Q a c b (b) Correct externality with tax D S St Qo Qe P 0 Q a T 5- Government Intervention LO4 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 Private bargaining Subsidy to consumers Subsidy to producers Government provision 5- 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-