ECN Chapter 4 - Keyvan Eslami PDF

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ECN 204 Week 8: Market Failures: Public Goods and Externalities Chapter 4

4.1 Market Failures in Competitive Markets LO4.1 Differentiate between demand-side market failures and supply side market failures. ● The main reason markets fail is: ○ Demand and supply curves do not fully reflect consumers’ benefits or producers’ costs ● A demand-side market failure: ○ Demand curves do not reflect consumer’s full willingness to pay for a good or service. ○ Ex. a public firework display ■ In the first case, all people do not have to pay to enjoy the firework. ■ In addition, you cannot prevent people from watching the show. ■ Therefore, the demand curve does not reflect the actual demand in the society for firework ■ This is an example of a public good ○ Ex. Education ■ In the second example, while getting a bachelor’s degree mainly benefits yourself, the society is also benefiting indirectly: ● You become a more informed citizen, a better neighbor, a knowledgeable friend. ■ So, your private demand curve for education does not perfectly reflect the actual benefits that the society receives from education. ■ This is an example of a good with positive externality ● A supply-side market failure: ○ Supply curves do not reflect the full cost of producing a good or service. ○ Ex. coal burning power plant ■ A negative externality 4.2 Efficiently functioning markets LO4.2 Explain the origin of both consumer surplus and producer surplus, and explain how properly functioning markets maximize their sum, economic surplus, while optimally allocating resources.

● DC must reflect the consumer’s full willingness to pay ● SC must reflect all the costs of production ● In equilibrium (competitive market), benefits are maximized for consumers and producers ○ Consumers and producers surplus are maximized ● Consumers 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 ■ Simply, a consumer net benefits from transaction ● Producer Surplus ○ Difference between the actual price a producer receives and the minimum price they would accept ○ Extra benefit from receiving a higher price 4.3 Public Goods LO4.3 Describe free riding and public goods, and illustrate why private firms cannot normally produce public goods.

● Private Goods ○ Characteristics ■ Rivalry ● A good has rivalry property when someone’s consumption of the good prevents others from consuming the same good ■ Excludability ● We say a good is excludable if those unable and unwilling to pay do not have access to the benefits of the product. ○ Produced in the market by firms ○ Offered for sale ● Public Goods ○ Characteristics ■ Nonrivalry

■ Nonexcludability ■ Free-rider problem ● The free-rider problem simply means that many people can ● benefit from the same goods without paying for it. ○ Provided by government ○ Offered for free The reallocation process ● Government ○ Taxes individuals and businesses ○ Takes the money and spends on production of public goods Cost-Benefits 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 4.4 Externalities LO4.4 Explain how positive and negative externalities cause under-allocations and over-allocations of resources. ● Happens when a cost or benefit occurring to a third party external to the transaction ● Positive externalities ○ (often) demand-side market failures ○ Too little is produced ● Negative externalities ○ (often) supply-side market failures ○ Too much is produced Government intervention ● Correct negative externalities ○ Direct controls

○ Pigouvian tax ● Correct positive externalities ○ Subsidies ○ Governement provision

LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every last bit of a negative externality such as air pollution.

LOA4.1 Describe how information failures may justify government intervention in some markets...