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CHAPTER 5
Market Failures: Public Goods and Externalities
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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.
Market fails to produce the right amount of the product.
Resources may be:
Overallocated
Underallocated
Market Failures
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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.
Impossible to charge consumers what they are willing to pay for the product.
Some can enjoy benefits without paying.
Demand-Side Failures
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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. Firms can’t prevent people from watching the fireworks if they didn’t pay.
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 Failures
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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.
Demand curve must reflect the consumers’ full willingness to pay.
Supply curve must reflect all the costs of production.
Efficiently Functioning Markets
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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.
Productive efficiency: production at the lowest cost
Allocative efficiency: production most valued by society, resources allocated efficiently.
Productive and Allocative Efficiency
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Productive efficiency is based on the lowest cost where average total cost is at a minimum
Allocative efficiency is based on where marginal cost and marginal benefit (price) are equal
Markets are most efficient when both of these conditions are met.
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Consumer surplus: The difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price paid.
Consumer surplus and price are inversely related. All else equal, a higher price reduces consumer surplus.
Consumer Surplus
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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.
Consumer Surplus (continued)
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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.
Producer surplus: The difference between the actual price a producer receives (or producers receive) and the minimum acceptable price.
Producer surplus and price are directly related. All else equal, a higher price increases producer surplus.
Producer Surplus
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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.
Producer Surplus (continued)
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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.
Efficiency Revisited and Efficiency Losses
Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized.
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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.
There are three conditions for allocative efficiency:
MB = MC
Maximum willingness to pay = Minimum acceptable price
Combined consumer and producer surplus is at a maximum.
Allocative Efficiency
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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.
Underproduction
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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.
Overproduction
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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.
Produced in the market by firms
Offered for sale
Characteristics
Rivalry
Excludability
Private Goods Characteristics
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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.
Provided by government
Offered for free
Characteristics
Nonrivalry
Nonexcludability
Create a free-rider problem
Public Goods Characteristics
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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 It 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.
| 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 |
| 3 | 2 | 3 | 5 |
| 4 | 1 | 2 | 3 |
| 5 | 0 | 1 | 1 |
Measuring Demand
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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.
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
Cost-Benefit Analysis
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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.
| 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 | $0 | $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 | 8 | 22 | 10 | 4 |
| D: New 6-lane highways | 28 | 10 | 26 | 3 | -2 |
Cost-Benefit Analysis (continued)
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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; and 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.
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
Externalities
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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 by 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.
Externalities (continued)
Negative Externalities
Positive Externalities
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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.
Correct negative externalities
Direct controls
Specific taxes (Pigovian Taxes)
Correct positive externalities
Subsidies and government provision
Government Intervention (1 of 4)
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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.
Government Intervention (2 of 4)
Negative Externalities (a)
Correcting the Overallocation of Resources via Direct Controls or Via a Tax (b)
D
S
St
Overallocation
Negative
Externalities
Qo
Qe
P
0
Q
a
c
b
D
S
St
Qo
Qe
P
0
Q
a
T
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Negative externalities result in an overallocation of resources.
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.
Government Intervention (3 of 4)
(a)
Positive externalities
0
St
Underallocation
Positive
externalities
Qo
Qe
D
Dt
z
x
y
(b)
Correcting via a subsidy
to consumers
0
St
Qo
Qe
D
Dt
(c)
Correcting via a subsidy
to producers
0
S't
Qo
Qe
D
Subsidy
St
Subsidy
U
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Positive externalities result in an underallocation of resources.
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.
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).
| 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 |
Government Intervention (4 of 4)
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This table lists several methods for correcting externalities.
Society’s Optimal Amounts
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Society’s Marginal Benefit and Marginal
Cost of Pollution Abatement (Dollars)
Q1
MB
MC
Socially
Optimal Amount
of Pollution
Abatement
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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.
Based on:
Size, distribution, and impact of the costs that taxes impose on society
Benefits-received principle
Ability-to-pay principle
Apportioning the Tax Burden
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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.
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.
Progressive, Proportional, and Regressive Taxes
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Taxes are classified into one of the above categories based upon the relationship between average tax rates and the taxpayer incomes.
Applications
Personal income tax: progressive
Sales tax: regressive
Corporate tax: proportional
Payroll tax: regressive
Tax Progressivity in the United States (1 of 5)
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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.
Personal income tax
Progressive tax
Marginal tax rate
Tax Progressivity in the United States (2 of 5)
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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.
| 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 |
Tax Progressivity in the United States (3 of 5)
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This table looks at the probable outcome of taxes on each of the major sources of tax revenue 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 | $ 1,700 | 10 |
| $17,001–$69,000 | 15 | 9,500 | 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 | ||
| * For a married couple filing a joint return. |
Tax Progressivity in the United States (4 of 5)
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This table shows the tax rates for a married couple filing a joint return, 2011.
Federal tax system is progressive.
State and local tax structures are largely regressive.
Overall U.S. tax system is progressive.
Tax Progressivity in the United States (5 of 5)
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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.
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.
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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.