Chapter 4 Market Failures Public Goods and Externalities PDF

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Chapter 4: Market Failures: Public Goods and Externalities Wednesday, August 5, 2020

AM 4.1 Market Failures10:43 in Competitive Markets

○ Market failures sometimes happen in competitive markets, they fall into two categories: ○ Demand-side market failures ▪ When demand curve do not reflect consumers' full willingness to pay for a good or service. ▪ Because it is impossible in certain cases to charge consumers what they are willing to pay □ i.e. outdoor firework displays - no way to exclude people who haven't pay also enjoying the show private firms will therefore

○ Supply-side market failures ▪ When supply curves do not reflect the full cost of producing a good or service. ▪ Arise in situations which a firm does not have to pay the full cost of producing its output ▪ It is not possible for the market to correctly weight costs and benefits in a situation in which some of the costs are completely unaccounted for. □ i.e. coal-burning power plant produces more electricity and generates more pollution. (cost > benefit)

Efficiently Functioning Markets ○ Two conditions must hold if a competitive market is to produce efficient outcomes: ▪ Demand curve must reflect consumers' full willingness to pay ▪ Supply curve must reflect all the costs of production ○ If these two conditions hold, then market will produce only units for benefits are at least equal to cost. ▪ It will also maximize the amount of "benefit surpluses" that are shared between consumers and producers Consumer Surplus ○ Consumer surplus - difference between the maximum price a consumer is willing to pay and the actual price they pay. ▪ The area below the demand curve and above the price line P ▪ Inversely related with price ○ The maximum price a person is willing to pay depends on the o person's consumption alternatives. ▪ i.e. Tom wants to buy an apple $1.25, if he is charged less receive a consumer surplus equal to the difference betwe would willing to pay and the lower market price. ○ Nearly all markets, consumers gain greater total utility or satisfaction in dollar terms from their purchases than the amount of their expenditures (= product price x quantity) ○ Lower prices → large consumer surpluses ○ Figure 4.1, to obtain Q1 bags of oranges, consumers need pay only the amount represented by yellow rectangle (= P1 x Q1)

Producer Surplus ○ Producer surplus - difference between the actual price a producer receives and the minimum acceptable price that consumer would have to pay the producer to m ▪ Area shown in blue triangle ▪ Directly related with price ○ Surplus is the sum of the vertical distances between supply price to the left of Q1 ○ The size of the producer surplus = market price - producer's

○ A producer's minimum acceptable price for a unit will equal the producer's marginal cost of producing that unit. ▪ Marginal cost = Σ rent, wages, interest, profit ○ Producer's minimum acceptable price can also be interpreted as opportunity cost of bidding resource away from the production of other products.

○ If producer A's minimum acceptable price is lower than producer B's it is because producer A uses less-costly combination of resources than producer B uses. ○ Producer B then has a higher marginal cost (Mc)

CHAPTER 4 (Overview) Chapter 4 Sections ✓ Section 4.1 ✓ Section 4.2 ✓ Section 4.3

Quick Review 4.1 ✓ Market failures in competitive markets have two possible causes: demand curves do not reflect consumer's willingness to pay and supply curves do not reflect producers' full cost of production ✓ Consumer surplus is the difference between the maximum price that a consumer is willing to pay for a product and the lower price actually paid ✓ At the equilibrium price and quantity in competitive markets, MB = MC, maximum willingness to pay = minimum acceptable price, and total of consumer surplus and producer surplus is maximized. Each of these conditions defines allocative efficiency

✓ Quantities less than or greater than allocatively efficient level of output create efficiency losses, often called deadweight losses. KEY CONCEPTS - Demand-side market failures - Supply-side market failures DEFINITIONS - Consumer Surplus ✓ Consumer surplus - Producer Surplus ✓ Producer surplus - Efficiency Revisited ✓ Efficiency Losses

Quick Review 4.2 ✓ Public goods are characterized by nonrivalry and nonexcludability. ✓ The demand (Mb) curve for a public good is found by vertically adding the prices that all the members of society are willing to pay for the last unit of output at various output levels. ✓ The socially optimal amount of public good is the amount at which the marginal cost and marginal benefit of the good are equal. ✓ Cost-benefit analysis is the method of evaluating alternative projects or sizes of projects by comparing the marginal cost and marginal benefit and applying the MC = MB rule. KEY CONCEPTS ✓ The government uses taxes to reallocate resources from the production of private Characteristics - Public Goods goods to the production of public and quasi-public - Demand for Publicgoods. Goods - Cost-Benefit Analysis - Quasi-Public Goods DEFINITIONS - The Reallocation Process ✓ Private goods ✓ Rivalry ✓ Excludability ✓ Public goods ✓ Nonrivalry ✓ Nonexcludability ✓ Free riding ✓ Cost-Benefit Analysis ✓ Marginal-Cost-Marginal-Benefit Rule

Quick Review 4.3

✓ Policies for coping with the overallocation of resources and therefore efficiency losses, caused by negative externalities are (a) private bargaining, (b) liability rules and lawsuits, (c) direct controls, (d) specific taxes, and (e) markets for externally rights. ✓ Policies for correcting the underallocation of resources, and therefore efficiency losses, associated with positive externalities are (a) private bargaining, (b) subsidies to producers, (c) subsidies to consumers and (d) government provision. KEY CONCEPTS - Negative reduction occurs where society's Mc = M b Externalities ✓ The optimal amount of negative externality for reducing externality. - Positive Externalities - Direct controls ✓ Political pressures often lead government Taxes - Pigouvian to respond inefficiently when attempting - Subsidies and Government Provision to correct for market failures. - Society's Optimal Amount of Externality Reduction DEFINITIONS - Government's Role in the Economy ✓ Optimal Reduction of an Externality

○ Producer revenue (P1 x Q1) illustrated by the yellow area would be required to entice producers to offer Q1 ○ Gap between minimum acceptable payments and actual prices widen when prices increases.

Learning Objectives

1. Differentiate between demand-side market failures and supply-side market failures

Efficiency Revisited ○ Productive efficiency - achieve because competition forces producers to use best technologies and combinations of resources available → minimize per-unit costs of output produced.

- A market failure happens in a particular market when the market produces an equilibrium level of output that either overallocates or underallocates resources to the product being traded in the market.

○ Allocative efficiency - achieve because the correct quantity Q1 is produced

- In competitive markets that feature many buyers and many sellers, market failures can be divided into two types: demand-side market failures occur when demand curves do not reflect consumers' full willingness to pay; supplyside market failures occur when supply curves do not reflect all production costs, including that may be borne by third parties.

○ Why Q1 is the allocatively efficient quantity? ▪ Optimal allocation is achieved at MB = MC □ Demand curves are MB curves (Maximum price consumer are willing to pay = benefit they would get) □ Supply curves are MC curves □ Points on the demand curves measure the marginal benefit at each level of output □ Points on the supply curve measure the marginal cost at each level of output □ MB = MC means that the equilibrium quantity Q 1 must be allocatively efficient

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2. 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. - Consumer surplus is the difference between the maximum price that a consumer is willing to pay for a product and the lower price actually paid; producer surplus is the difference between the minimum price that a producer

properly functioning markets maximize their sum, total surplus, while optimally allocating resources.

□ Points on the demand curves measure the marginal benefit at each level of output □ Points on the supply curve measure the marginal cost at each level of output □ MB = MC means that the equilibrium quantity Q 1 must be allocatively efficient

- Consumer surplus is the difference between the maximum price that a consumer is willing to pay for a product and the lower price actually paid; producer surplus is the difference between the minimum price that a producer is willing to accept for a product and the higher price actually received. Collectively, consumer surplus is represented by the triangle under the demand curve and above the supply curve and below the actual price.

▪ Notice for every unit up to Q1, MB > MC □ Because MC includes the opportunity cost of not ma that people are made better off when resources are instead of other products)

- Graphically, the combined amount of producer and consumer surplus is represented by the triangle to the left of the intersection of the supply and demand curves that is below the demand curve and above the supply curve. At the equilibrium price and quantity in competitive markets, Mb = Mc, maximum willingness to pay equals minimum acceptable price, and the combined amount of consumer surplus and producer surplus is maximized.

▪ We can interpret demand and supply curves in terms of minimum acceptable price □ In Figure 4.3, the maximum willingness to pay on de exceeds the corresponding minimum acceptable pr (people gain more utility) ▪ Producing Q1 units therefore achieves allocative efficiency □ Maximized the combined area of consumer and producer surplus

- Output levels that are either less than or greater than the equilibrium output creates efficiency losses, also called deadweight losses. These losses are reductions in the combined amount of consumer surplus and producer surplus.

○ Allocative efficiency occurs at the market equilibrium quantity simultaneously ▪ MB = MC ▪ Maximum willingness to pay = minimum acceptable price ▪ Total surplus (=sum of consumer and product surplus) is

Efficiency Losses (or Deadweight Losses)

- Underproduction creates efficiency losses because output is not being produced for which maximum willingness to pay exceeds minimum acceptable price. Overproduction creates efficiency losses because output exceeds maximum willingness to pay. 3. Describe free riding and public goods and illustrate why private firms cannot normally produce public goods.

○ Efficiency losses - reductions of combined consumer and producer surplus ▪ Result from both underproduction and overproduction

- Public goods are distinguished from private goods. Private goods are characterized by rivalry (in consumption) and excludability. One person's purchase and consumption of a private good precludes others from also buying and consuming it. Producers can exclude non=payers (free-riders) from receiving the benefits. In contrast, public goods are characterized by nonrivalry (in consumption) and nonexcludability. Public good are not profitable to private firms because nonpayers (free-riders) can obtain and consume these goods without paying. Government can, however, provide desirable public goods, financing them through taxation.

○ Underproduction (Figure 4.4a) ▪ Output falls from Q1 to the smaller Q2

▪ Sum of consumer and producer surplus (abc falls to adec) □ Both combined consumer and producer surplus declines by the amount of gray triangle to the left ▪ The triangle represents an efficiency loss to buyers and sellers

- The collective demand schedule for a particular public good is found by summing the prices that each individual is willing to pay for an additional unit. Graphically, that demand curve is found by summing vertically the individual demand curves for that good. The resulting total demand curve indicates the collective willingness to pay for (or marginal benefit of) any given amount of the public good.

▪ Consumer's willingness to pay > producer's minimum acceptable price □ Resources should be gone to product this unit instead of others □ Triangle dbe shows the total loss of net benefits

○ Overproduction (Figure 4.4b) ▪ Number of produce is Q3 instead of Q1 ▪ Combined consumer and producer surplus declines by bfg. (triangle to the right of Q1) ▪ Q1 to Q3 costs that exceeds benefits, or economic loss shown by bfg ▪ Total economic surplus from 0 to Q3 = abc(units from 0 to Q1) - bfg(units from Q1 to Q3)

- The optimal quantity of a public good occurs where the society's willingness to pay for the last unit - the marginal benefit of the good - equals the marginal cost of the good. 4. Explain how positive and negative externalities cause under- and overallocations of resources.

▪ Consumer's willingness to pay < producer's minimum acceptable price □ Resources should be used in elsewhere □ Triangle bfg shows total efficiency loss from overproduction at Q 3

- Externalities, or spillovers, are cost or benefits that accrue to someone other than the immediate buyer or seller. Such costs or benefits are not captured in the market demand or supply curves and therefore cause the output of certain goods to vary from society's optimal output. Negative externalities (or spillover costs or external costs) result in an overallocation of resources to a particular product.

4.2 Public Goods  Private Goods Characteristics ○ Private goods - goods offered for sale in stores, shops, Internet ○ i.e. automobiles, clothing, personal computers, household appliances, sporting goods ○ Distinguished by rivalry and excludability

- Direct controls and specifically targeted Pigouvian taxes can improve resource allocation in situations where negative externalities affect many people and community resources. Both direct controls (ex. Smokestack emission standards) and Pigouvian taxes (ex. Taxes on firms producing toxic chemicals) increase production costs and hence product price. As product price rises, the externality, overallocation of resources, and efficiency loss are reduced since less of the output is produced.

○ Rivalry - when one person buys and consumes a product, it is not available for another person to buy and consume ○ Excludability - sellers can keep people who do not pay for a product from obtaining its benefits

- Government can correct the underallocation of resources and therefore the efficiency losses that result from positive externalities in a particular market either by subsidizing consumers (increases market demand) or by subsidizing producers (increases market supply). Such subsidies increase the equilibrium output, reducing or eliminating the positive externality and consequent underallocation of resources and efficiency loss.

 Public Goods Characteristics ○ Public goods - opposite characteristics of private goods ▪ Distinguished by non-rivalry and non-excludability ○ Non-rivalry - one person's consumption does not preclude consumption of the good by others ▪ i.e. national defense, street lighting, GPS, environmental protection. ○ Non-excludability - no effective way of excluding individuals from the benefit of the good once it comes into existence. ▪ You cannot exclude someone from benefiting from national defense, street lighting, etc. ○ This creates a free-rider problem - everyone, including nonpayers, can obtain the benefit ○ Free riding - the willingness to pay of the free riders is not expressed in the market ○ The low or zero demand caused by free riding makes it virtually impossible to profitably provide public goods

▪ Society therefore suffers efficiency losses because goods that are MB>MC are not produced. ▪ Government can finance provision of public good through taxation of other things, and does not have to worry about profitability, therefore can provide public goods even when private firms can't.

○ Only a few public goods can be subsidized by closely related private goods (i.e. TV broadcast) ▪ For the large majority of public goods, private provision is unprofitable ○ Two remaining ways for public good to be provided: ▪ private philanthropy (fireworks display) ▪ government provision(national defense system).

 Optimal Quantity of Public Good ○ Government had to try to estimate the demand for a public good through surveys or public votes ▪ Th MB i t MC

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 Optimal Quantity of Public Good ○ Government had to try to estimate the demand for a public good through surveys or public votes ▪ Then compare MB against MC ▪ Adhering to the MB = MC rule, government can provide the "right" or "efficient" amount of public good.  Demand for Public Goods ○ Notice that schedules in Table 4.3 are price-quantity schedules, implying that they are demand schedules ▪ Rather than depicting demand in the usual way, these schedules show the price someone is willing to pay for an extra unit at each possible quantity. ▪ i.e. Adam is willing to pay $4 for the 1st unit of good, $3 for the second, and $2 for the third and so on.

 Comparing MB and MC ○ The collective demand curve Dc measures society's MB ○ The collective supply curve S measures society's MC ○ Optimal quantity of this public good occurs where MB = MC  Cost-Benefit Analysis ○ Cost-benefit analysis - deciding whether to provide a particular public good and how much of it will provide. ▪ If the benefit exceeds the cost, the resources should be shifted ▪ Helps government decide on the extent to which project should be pursued.

○ Example (Highway construction) ▪ Decision to use more resourced in the public section mean fewer resources for the private sector. ▪ Since highway system satisfies nonrivalry and nonexclusive, it is effectively a public good. ▪ Should the government expand the size of federal highway system? □ Widening existing 2 lane highways or building new six -lane highways? □ Depends on the costs and benefits

▪ Table 4.4 shows that: □ total annual benefit (c4) exceeds total annual cost (c2) for plans A, B, C indicating some highway construction is economically justifiable. □ C6 where total costs = total annual benefits (c4) - total costs (c2) □ Net benefits are positive for A, B, C, but D is not economically justifiable because net benefits are negative. □ In this case plan C is the best plan. ○ To determine the optimal size or scope for this project ▪ Increase activity, project or output when Mb > Mc ▪ Stop the activity at, or as close as possible to the point where Mb = Mc ▪ Do not undertake project for which Mb < Mc ○ Marginal-cost-marginal-benefit rule tells us which plan provides maximum excess of total benefits over total cost. ○ Economy in government does not mean minimizing public spending. It means allocating resources between private and public sectors and among public goods to achieve maximum net benefit

 Quasi-Public Goods ○ Other goods and services that could be produced and delivered such that exclusion would be possible ▪ Examples include education, streets, highways, police and fire protection, libraries and museums, preventive medicine and sewage disposal.

○ They could all be priced ...