Market Failures: Public Goods and Externalities

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.

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