Econ 211 Lecture Notes

Parsons - For McConnell/Brue/Flynn, 19th ed.

1 Chapter 5 - Market Failures: Public Goods and

Externalities

1.1 Slide 2

• Although a true market system with robust competition and many buyers andsellers typically produces an efficient outcome, there are some exceptions. Theseexceptions are what we will study in this chapter.

• Note that market failures can also occur because there aren’t enough buyers orsellers to provide adequate competition. These issues will be discussed in laterchapters.

• Overall, there are two broad types of market failure in a competitive market.

– Demand-side market failures occur when demand curves do not represent thefull benefits of the product or service.

– Supply-side market failures occur when supply curves do not include all of thecosts associated with producing the good or service.

1.2 Slide 3

• For some goods and services, it is impossible to charge consumers what they wouldtruly be willing to pay for them, e.g. a public fireworks display.

• In other cases, the consumer does not derive the entire benefit of the good orservice and, as such, is not willing to purchase the amount that would be optimalfor society.

1.3 Slide 4

• Turning to the supply-side, firms often do not have to pay the full cost of theirproduction. For example, a power plant may not have to pay the full cost of thepollution that it emits. In these cases, the firm will produce more than what theywould if forced to pay for their full production costs.

1.4 Slide 5

• To examine market failures, it is useful to more deeply examine situations wherethe market does an efficient job.

• For this analysis, we will return to our demand and supply graphs discussed inChapter 3 and make two assumptions.

– The market demand curve represents the full benefit derived from the goodor service.

– The market supply curve reflects all of the costs of production.

• When these assumptions are met, the market outcome maximizes the total ”benefitsurplus” that can be achieved in the economy.

1.5 Slide 6

• The extra benefit that a consumer (or consumers) receives from the market iscalled consumer surplus. This is the difference between the maximum price thatthe consumer would have been willing to pay for the good and how much theyactually had to pay for it.

Example 1 Right at this moment, what is the maximum amount that they wouldbe willing to pay for a slice of pizza? Now, assume the price is $1 a slice. As-suming your maximum willingness to pay for the slice of pizza is greater than $1,the consumer surplus you would receive from this slice of pizza is your maximumwillingness to pay minus the equilibrium price. For example, if you are willing topay $3 for a slice a pizza, your consumer surplus in this example would be $2.

1.6 Slide 7

• As shown in the table, the above calculation can be made for each consumer in themarket. Summing up these values produces the consumer surplus for the entiremarket.

1.7 Slide 8

• Consumer surplus can also be seen from the demand graph.

• Graphically, the amount that consumers are willing to pay for a product is givenby the demand curve.

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• On the demand graph, the total amount that consumers would have been willingto pay for a given quantity is given by the sum of the yellow rectangle and thegreen triangle. However, the consumers only had to pay the amount shown by theyellow rectangle (total revenue) Hence, the area represented by the green triangleis the extra benefit they received, or consumer surplus.

• Note: Consumer surplus and price are inversely related. As price increases, thegreen triangle (CS) decreases in size.

1.8 Slide 9

• Similar to consumers, producers also receive a surplus from the market. This is thedifference between the minimum amount for which they would be willing to selltheir product and the amount that they actually receive.

Example 2 Right at this moment, what is the minimum wage you would accept fora job? Now, assume the market wage rate is $15/hour. Assuming your minimumacceptable wage is less than $15, the producer surplus you would receive from thisjob is the market wage minus your minimum acceptable wage. For example, if yourminimum acceptable wage is $10/hour, your producer surplus in this example wouldbe $5.

1.9 Slide 10

• As shown in the table, the above calculation can be made for each producer inthe market. Summing up these values produces the producer surplus for the entiremarket.

1.10 Slide 11

• Graphically, the amount that producers are willing to accept for a product is givenby the supply curve.

• On the supply graph, the total amount that producers would have been willingto accept for a given quantity is given by yellow triangle. However, the producersreceived the amount shown by the blue triangle plus the yellow triangle (totalrevenue) Hence, the area represented by the blue triangle is the extra benefit theyreceived, or producer surplus.

• There is a positive relationship between the price and producer surplus. As theequilibrium price rises, the blue triangle gets larger.

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1.11 Slide 12

• By bringing together supply and demand, we can now use the concepts of consumerand producer surplus to demonstrate why the equilibrium price and quantity leadto maximum efficiency in the economy.

• Looking at the graph, at a price of P1, the total amount of surplus received byproducers and consumers in the economy is given by the sum of the green and bluetriangles. This amount is maximized by a price of P1 and a quantity of Q1.

• At this point, MB (maximum willingness to pay - demand) = MC (minimum ac-ceptable price - supply). This is the condition required for allocative efficiency.

• Hence, at the market equilibrium,

– MB = MC (the result is allocatively efficient)

– Maximum willingness to pay = minimum acceptable price

– Total Surplus = Consumer Surplus + Producer Surplus is maximized.

1.12 Slide 13

• Consider the case of underproduction.

– If Q2 is produced, total surplus falls from triangle abc to the shape adec. Ascan be seen, the area represented by the grey triangle is lost in the economy.This is called a deadweight loss.

– Between Q2 and Q1, consumers are willing to pay more than suppliers arewilling to accept. Hence, it makes sense for these trades to occur.

1.13 Slide 14

• Now consider the case of over production.

– To sell more items beyond Q1 the producers will have to lower the price belowthe equilibrium. However, since this is below the price they are willing toaccept, this will also lead to a deadweight loss.

– For the items sold beyond Q1, the costs of producing those goods are higherthan the price the firm receives for them.

– In this example, the deadweight loss is given by the grey triangle bfg.

• These examples illustrate why economists, in general, prefer a market system. Aslong as the conditions described above are met, the market allocation is the mostefficient allocation, i.e. no other allocation system (for example, the commandsystem) can come up with a better result.

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1.14 Slide 15

• Now, we need to discuss the cases when those conditions are not met. One suchcase is the provision of Public Goods.

• However, before we talk about public goods, we need to review what we meanby the phrase ”private goods”. Private goods are defined by the following twocharacteristics.

– Rivalry - This means that, if one person buys and consumes the product, it isno longer available to be purchased and consumed by someone else.

– Excludability - Sellers can easily keep people who do not pay for the good fromobtaining its benefits. (If you don’t pay, you don’t get to play.)

• Due to these qualities, consumers’ demands for these goods are fully expressed inthe market, i.e. if consumers like and benefit from the product, it shows up throughtheir willingness to pay for it.

• In these cases, the total market demand of the good is found by horizontally sum-ming the individual demand curves, i.e. adding the quantities demanded for thevarious prices given. (Remember horizontal sums from Chapter 3?)

• Because of this, producers can access market demand and profitably sell the goods.Moreover, those consumers willing and able to pay for the good receive it, non-payers do not. In this case, the free market produces the goods and also results inan efficient allocation of resources (if the market is perfectly competitive).

1.15 Slide 16

• In contrast, public goods are defined by the following (opposite) characteristics.

– Nonrivalry - One person’s consumption does not preclude the consumption ofthe good by others. - Public safety, public artwork, national defense, streetlighting, etc.

– Nonexcludability - There is no way to block people from benefiting from thegood once it has been produced. (Same examples as above.)

• Because of these issues, public goods suffer from the free rider problem. Once theyare produced, everyone (including non-payers) can benefit from them. Hence, thebenefit received from the good is not captured in a market demand curve, as peopleare not willing to pay for something that they can essentially obtain for free.

• Since there is no accessible market demand for these goods, firms can not profitablyproduce them. As a result, governments have to do so. This is paid for throughtaxation.

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• Note that, in a few cases, a public good can be provided by the private sectorbecause the business can make profits from an integrated private good. For exam-ple, local TV stations produce a public good (TV broadcasts) because the costs ofthe public good can be subsidized by profits from the integrated private good (TVadvertising).

1.16 Slide 17

• However, even if government is to produce the good, they must determine how muchof it should be produced. This is done by estimating marginal benefits (perhapsthrough surveys, polls, and public votes) and comparing them to marginal costs.The MB = MC rule will then give the optimal amount that should be producedof the good.

• To determine MB, consider the table shown on Slide 17. Here, two consumers areasked to say how much they would be willing to pay for various units of a publicgood. (Note: This is the opposite of the construction of the demand curve fora private good, where consumers are asked how much they would buy for givenprices.)

• If the government produces,

1. One unit of the good. Both consume it, and total willingness to pay is $9.

2. Two units of the good. Both consume, and total willingness to pay for thissecond good is $7.

3. Three units = a willingness to pay of $5.

4. Four units = a willingness to pay of $3.

5. Five units = a willingness to pay of $1.

• This yields a collective demand schedule for the good. Once again, this is constructedin a way that is entirely the opposite of the construction of market demand for aprivate good. Here, willingness to pay (prices) are added, not quantities. This canbe done because the goods are non-rival. Once the government produces one unitof the good, both of the consumers can use it.

1.17 Slide 18

• Slide 18 demonstrates this graphically. Note that the curves are summed vertically,like functions in algebra, rather than horizontally.

• Since each point represents the consumers willingness to pay for that extra unit, it isthe same as the marginal benefit received for that unit. Since diminishing marginalutility also holds for public goods, the demand curve is downward sloping.

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• Supply of a public good is simply given by its MC curve, which is upwards slopingdue to the law of diminishing returns. Hence, the optimal production of the goodwill be 3 units. At that amount, total willingness to pay is $5.

1.18 Slide 19

• This MC = MB rule can help guide us on a wide variety of public goods allocationissues.

• The marginal cost of the product, in opportunity cost terms, is the value the privategoods that would have been produced with the resources used to produce the publicgood.

• On the opposite side, the marginal benefit can be seen as the extra benefit that thepublic receives from the public good, as is measured by their willingness to pay.

• Applying the MC = MB rule can help the government determine not only if aproject should be pursued, but how extensive it should be.

1.19 Slide 20

• Consider the example on Slide 20. What project should the government pursue inthis case?

• This example also demonstrates that, economically speaking, it is perfectly reason-able for governments to spend money on public goods production. In fact, evenif large sums of money are spent on these items, there production may well beefficient, as long as the marginal benefit of producing them exceeds the marginalcost. (Interstate highways, new energy grids, etc.)

1.20 Slide 21

• There are also a class of goods that is typically provided by the government thatdo not meet the conditions of a public good (non-rivalry and non-excludability),e.g. education, libraries, and health care.

• These are called quasi-public goods and are provided by the government becausethey are associated with a positive externality, a concept we will explore shortly.

1.21 Slide 22

• Note that, to produce public and quasi-public goods, the government must reallo-cate resources from the private sector to the public sector.

• This is accomplished through taxation, which reduces income in the private sectorand, as a result, reduces their demand for goods, services, and resources.

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1.22 Slides 23 and 24

• Another type of market failure occurs in the case of externalities.

• An externality (or spillover) occurs when costs or benefits accrue to a third partythat is not part of the economic transaction, i.e. is external to it.

• Externalities can be one of two types - Positive and Negative.

– Negative Externalities

∗ An example of a negative externality is pollution. We, as a society, paysome of the costs of production because we have to breathe polluted air.

∗ In the case of a negative externality, producers shift some of their costsof production to the community at large. As a result, the firm’s supplycurve lies below the full-cost supply curve and too much of the good inquestion is produced.

∗ This is illustrated by the first graph on Slide 21. Here, the overproductionproduces a deadweight loss illustrated by the triangle abc.

∗ Note that, as a negative externality involves costs, it is a supply-sidemarket failure.

– Positive Externalities

∗ An example of a positive externality is inoculations for diseases. We,as a society, benefit from others getting vaccinations. In the extreme, ifeveryone else is vaccinated against a disease, you won’t get the diseaseeven if you do not get the inoculation.

∗ Here, each individual’s demand curve does not capture the total benefitof consuming the good, as it just captures the benefit that the singleindividual receives (the chance of the single person catching the disease).It does not include the spillover benefits (the lowered chances of thatperson’s friends catching the disease).

∗ As a result, the individual demand curve is lower than if the demandcurve were derived from total benefits received, and too little of the goodis produced.

∗ This case of underproduction is illustrated in the second graph on Slide24. Note the deadweight loss illustrated by the triangle xyz.

∗ Since positive externalities involve buyers, they are a demand-side marketfailure.

1.23 Slides 25-27

• To deal with the problem of externalities, governments can often play a role inhelping the economy achieve an efficient allocation of the resources in question.There are several ways in which they can accomplish this.

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• To improve efficiency in the presence of negative externalities, the government canimpose

– Direct Controls

∗ These occur when the government passes legislation specifically limitingan activity that leads to negative externalities, e.g. strict emissions lawson automobiles.

∗ Such legislation increases costs for the business, shifting their supply curveup to the total cost position.

– Specific Taxes

∗ A second option that can be used in place of direct controls is to place anexcise tax on the good producing the negative externality, e.g. CFCs.

∗ In this case, the tax boosts the marginal cost of producing the good,pushing the supply curve back to the societally appropriate position. Thisis illustrated graphically on Slide 26.

• To improve efficiency in the presence of positive externalities, the government canemploy subsidies.

– One option is to subsidize buyers of the good. This works like a reverse tax,giving the consumer money to pay for the good. For example, federal financialaid to help students pay for higher education. This boosts demand, increasingequilibrium quantity. This situation is illustrated by the second graph on Slide27.

– Another option is to subsidize producers, e.g. provide funding to colleges anduniversities directly to help them cover their costs. This effectively lowers theinstitutions costs and shifts their supply curve outward, as illustrated by thethird graph on Slide 27.

– A third option is for the government to provide the good itself. This was donewith the polio vaccine to help eradicate the disease in the US.

1.24 Slide 28

• This table provides a nice summary of externalities and the various ways thatgovernments can attempt to correct them.

• As you can see, private bargaining is included on the list but has not been dis-cussed so far in the chapter. The ability to use private bargaining to correct for anexternality is an application of the Coase Theorem.

• According to the Coase theorem, developed (sort of) by Ronald Coase at the Uni-versity of Chicago, government intervention to fix these types of spillover effects isnot necessary if the following conditions are met.

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1. Property rights are clearly defined.

2. The number of people involved is small.

3. Bargaining costs are negligible.

• In these cases, the property rights put a price tag on the spillover effects and, as aresult, there are are opportunity costs that can be tapped into for negotiations.

Example 3 Suppose that a forestry company is planning on harvesting trees froma large stretch of forested land in the mountains. However, this forest borders alake that is the home to a popular tourist resort. This resort is on land ownedby the owner of the resort. However, the owner does not own the adjacent forest.Moreover, the resort is popular due to the beauty of the forest and the lake. Doesthe government need to intervene?

Are the Coase conditions met?

If so, then how might this situation be resolved?

• Unfortunately, the Coase conditions are not always met. For example, externalitieslike pollution affect many people and also involve a commonly held resource (the en-vironment) where there are no defined property rights. Moreover, big negotiationsentail high bargaining costs. So, what are the options in these cases?

• If negotiations are not workable but property rights are still defined, one option isprovided by a legal framework allowing for liability lawsuits, i.e. people sufferingfrom negative externalities can sue for compensation.

• For example, if a company is discovered secretly dumping waste on your property,they can be sued for cleanup and damages.

• This method also has limitations, however.

– First, it still depends on private property ownership.

– It often entails large legal fees and time delays.

– Since there is uncertainty involved in the court’s decision, some people withvalid cases may decide not to take them to court, especially if the legal fessare likely to be high.

– What happens if the company goes out of business before they settlement hasbeen reached?

• Hence, when the first two options are unavailable, the government can apply themethods discussed previously in this chapter.

• Finally, market rights for externalities will be discussed further in this chapter’sLast Word.

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1.25 Slide 29

• In discussions such as these, it is also common to wonder why we should allowpollution at all.

• The reason is because pollution reduction entails a cost, i.e. it takes resources tostop or reduce pollution. Since this is not a free action, resources spent on it involvean opportunity cost.

• Furthermore, this marginal cost is rising. For example, consider cleaning the litterbeside a road. The first bits are big and easy to collect. However, what if you triedto collect EVERY item of debris, no matter how small?

• In addition, the marginal benefits of a reduction in pollution are downward sloping.In our litter example, you notice the big pieces, so removing them improves yourutility. However, whether or not a tiny piece of plastic is removed is unlikely to benoticed by you or to adversely affect the environment.

• Combining these two produces the given graph. The optimal amount of pollutionto be cleaned up is given by Q1. To cut pollution below that amount would costsociety more than it would benefit. (Would it really be possible to remove ALL thepollution from the world?)

• Note, these MC and MB curves are likely to change over time. For example,if new technology makes it cheaper to reduce pollution, MC will fall. Or, aspeople develop stronger aversions to pollution, the marginal benefits of cleanupmay increase. Hence, optimal pollution cleanup can vary by time and location.(Developing countries)

1.26 Slide 30

• This chapter has laid out a variety of cases in which government intervention intothe market may be warranted.

• However, the ”clean” theory that we discuss in class is much more difficult to pullof in practice. In fact, there are a variety of ways in which government policy canfail in this regard.

– First, instances of externalities must be recognized, which is not always easyto do. For example, economists are still debating whether the societal benefitsof education outweigh the individual benefits.

– Secondly, if an externality is recognized, it must be accurately measured. Forexample, in the case of pollution, it must be determined exactly how muchoverproduction is occurring. Then, it must be determine exactly what size oftax would fix the problem. This data gathering and analysis process is difficultand not precise.

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– Finally, all of this takes place in the realm of politics. As a result, politiciansoften pursue policies that will lead to their re-election rather than policiesdesigned to appropriately deal with market failures.

• Overall, it is important to always keep in mind the fact that government failurescan often be worse than the market failures they are designed to correct.

1.27 Slide 31

• A Market-Based Approach for dealing with negative externalities

– A new approach to negative externalities involves creating a market for theexternality producing good.

– To understand this method, we must first understand the Tragedy of the Com-mons.

∗ Items that are publicly held (air, water, etc.) are subject to overuse(pollution) because there are no property rights attached to them, i.e. noone has a monetary incentive to keep them clean and well maintained.

∗ The traditional example of this was the common pasture in colonial towns.This land would quickly become overgrazed, since everyone was allowedto use it free of cost.

∗ This is also an example of the fallacy of composition. For each individual(person or firm), it makes sense to use the least-cost method of waste dis-posal (dumping it into the environment). Even the government has beenknown to do this. However, as those individuals add up, the environmentis degraded.

∗ Note that the 2009 Nobel Laureate in Economics, Elinor Ostrom, hasspent much of her career studying how societies develop rules to dealwith the Tragedy of the Commons. These arrangements often developnaturally without government intervention.

– Hence, to fix this problem, the government can work to create a market forexternality rights, thus dealing with the issue of commonly held property.

– In this system, the regulatory agency determines how much pollution of acertain type could be released without degrading the environment beyond anacceptable level.

– Then, pollution rights for that amount are made available for sale. For exam-ple, if it is determined that the environment can recycle 500 tons of a givenpollutant per year, then 500 pollution rights would be offered for sale, eachpermitting 1 ton of the pollutant to be released. Hence, the supply of thesepollution rights is fixed at that amount.

– The demand for these rights will have the normal downwards sloping shape,because at high prices, firms will find it cheaper to either not pollute or pur-chase pollution abatement equipment.

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– As time goes by and industry advances, the demand for the rights increases,but the supply remains fixed. Hence, the price rises, but pollution levels don’tchange.

– These types of market based systems have many advantages.

∗ To begin with, they help society to allocate resources efficiently. Considerthe case of two companies. One can reduce/stop a ton of pollution for acost of $800, while the other can do so for $20. Suppose the first companywants to increase production, which would lead to an increase of one tonpollution. If there was no market for pollution credits, they would have tospend $800 to do this. However, they can now buy one credit from Firm2. Firm 1 is $700 ($800 - $100) better off. Firm 2 is $80 better off ($100- $20. They have to cut their pollution by one ton). And society is $780better off because $20 was used to cut the one ton of pollution, not $800.

∗ Also, firms now have incentives not to pollute because the permits arevaluable and can be sold in the market.

∗ Furthermore, environmental groups can buy up the permits and cut pol-lution below the government mandated values.

∗ Finally, revenue raised from the selling of these permits (which will in-crease with demand) can be used to help pay for environmental improve-ment.

– The EPA has actually used these types of market-based policies to help fightacid rain and air and water pollution. However, a broader roll-out of suchpolicies has been limited by administrative and political hurdles.

1.28 Homework

• Chapter 5

– Questions - 1, 2, 4-11, 13

– Problems - 4-6

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