Chapter 5

Market Failures:
Public Goods,
Externalities, and
Information
McGraw-Hill/Irwin
Asymmetries
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Main discussions
• Market efficiency- Consumer
and Producer Surplus (to be
discuss after elasticity)
• Market failures- (to be discussed
at the end of the course)
• Public goods
• Externalities
• Information asymmetries
16-2
 Efficiently Functioning Markets
• Demand curve must reflect the
consumers full willingness to pay
• Supply curve must reflect all the costs
of production

LO1
 Consumer 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

LO2
 Consumer Surplus
Consumer Surplus

(2) (3)
Maximum Actual Price (4)
(1) Price Willing (Equilibrium Consumer
Person to Pay Price) Surplus
Bob $13 $8 $5 (=$13-$8)
Barb 12 8 4 (=$12-$8)
Bill 11 8 3 (=$11-$8)
Bart 10 8 2 (=$10-$8)
Brent 9 8 1 (= $9-$8)
Betty 8 8 0 (= $8-$8)

LO2
 Consumer Surplus

Consumer
Surplus
Equilibrium
Price
P1

Q1

LO2
 Producer Surplus

• Difference between the actual price a

producer receives and the minimum
price they would accept
• Extra benefit from receiving a higher
price

LO2
 Producer Surplus

Producer Surplus

(2) (3)
Minimum Actual Price (4)
(1) Acceptable (Equilibrium Producer
Person Price Price) Surplus
Carlos $3 $8 $5 (=$8-$3)
Courtney 4 8 4 (=$8-$4)
Chuck 5 8 3 (=$8-$5)
Cindy 6 8 2 (=$8-$6)
Craig 7 8 1 (=$8-$7)
Chad 8 8 0 (=$8-$8)

LO2
 Producer Surplus

Producer S
surplus

P1
Equilibrium
price

Q1

LO2
 Efficiency Revisited

Consumer
surplus
S

P1

Producer D
surplus

Q1

LO2
 Efficiency Losses

a Efficiency loss S
from underproduction
Price (per bag)

d
b

D
c
Q2 Q1
Quantity (bags)

LO2
 Efficiency Losses

a S
Efficiency loss
from overproduction

f
Price (per bag)

b
g

D
c
Q 1 Q3
Quantity (bags)

LO2
 Market Failures
• Market fails to produce the right
amount of the product
• Resources may be:
• Over-allocated
• Under-allocated

LO1
 Demand-Side Failures
• Impossible to charge consumers
what they are willing to pay for the
product
• Some can enjoy benefits without
paying

LO1
 Supply-Side Failures

• 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

LO1
 Public Goods
• Private goods
– Rivalry and excludability
• Public goods
– Nonrivalry
– Nonexcludability
– Free-rider problem
– No market demand

16-16
 Optimal Quantity of a
Public Good
• Supplied by the government
• Government estimates demand
• Compare marginal benefit to
marginal cost
• Demand for a public good
– Sum individual willingness to pay
– Sum vertically
16-17
 Demand for Public Goods
Example: two individuals
(1) (2) (3) (4)
Quantity Adams’ Benson’s Collective
Of Public Willingness Willingness Willingness
Good To Pay (Price) To Pay (Price) To Pay (Price)

1 $4 + $5 = $9
2 3 + 4 = 7
3 2 + 3 = 5
4 1 + 2 = 3
5 0 + 1 = 1

Graphically…
16-18
Demand for Public Goods
P
Collective Demand $9 S Optimal
$7 for 2 Items Quantity
7

5 Collective
$3 for 4 Items Willingness
3
DC To Pay
Connect the Dots 1
0 1 2 3 4 5 Q
Collective Demand and Supply
P
Benson’s Demand $6
5
$4 for 2 Items 4
3
2 D2
$2 for 4 Items 1
0 1 2 3 4 5 Q
Benson
P
Adams’ Demand $6
$3 for 2 Items 5
4
3
2
$1 for 4 Items 1 D1
0 Q
1 2 3 4 5
Adams
16-19
 Cost-Benefit Analysis
• Provide a public good?
• How much should be provided?
• Resources are limited
• Marginal-cost-marginal-benefit
rule
• Allocate government resources to
maximize net benefit
16-20
 Quasi-Public Goods

• Could be provided through the market

system
• Because of positive externalities the
government provides them
• Examples: education, streets,
libraries

LO3
 The Reallocation Process

• Government
• Taxes individuals and businesses
• Takes the money and spends on
production of public goods

LO3
 Externalities
• Market failure
– Can be supply or demand side
• Negative externality
– Firms Externalise costs
– Leads to Overproduction
• Positive externality
– External benefit to others
– Leads to Underproduction
16-23
 Externalities
P P
Negative
Externalities
St St
Positive
S Externalities

Dt

D D
Overallocation Underallocation
0 Qo Qe Q 0 Qe Qo Q

Negative Positive
Externalities Externalities

16-24
 Coase Theorem
• Externalities corrected by
individual bargaining
– Property ownership defined
– Small number people
– Bargaining costs negligible
• Limitations
• Liability rules and lawsuits
16-25
 Government Intervention
• Correct negative externality
– Direct controls
– Specific taxes
• Correct positive externality
– Subsidize buyers or producers
– Government provision

16-26
 Market Based Approach
• Tragedy of the commons
– Resource lacks defined ownership
– Air, lakes, etc.
– No incentive to maintain
• Market for externality rights
– Right to pollute
– Can be bought and sold
16-27
 Market for Pollution Rights
• Advantages
• Real-world examples
P
D2018 S=Supply of
Price Per Pollution Right

Pollution
D2008 Rights
$200

$100

0 500 750 1000 Q

Quantity of 1-Ton Pollution Rights
16-28
 Optimal Externality Reduction
• How much pollution abatement?
• MC = MB
Society’s Marginal Benefit and Marginal MC
Cost of Pollution Abatement (Dollars)

Socially
Optimal Amount
Of Pollution
Abatement

MB

0 Q1
16-29
 Summary

Methods for Dealing with Externalities

Resource Allocation
Problem Outcome Ways to Correct
Negative externalities Overproduction of output 1. Private bargaining
(spillover costs) and therefore 2. Liability rules and lawsuits
overallocation of 3. Tax on producers
resources 4. Direct controls
5. Market for externality rights

Positive externalities Underproduction of output 1. Private bargaining

(spillover benefits) and therefore 2. Subsidy to consumers
underallocation of 3. Subsidy to producers
resources 4. Government provision

LO4
 Information Failures
• Asymmetric information
• Inadequate buyer information
• Inadequate seller information
– Moral hazard problem
– Adverse selection problem

16-31