Chapter 5- Market Failures: Public Goods and Externalities

1. October 9, 2013 Chapter 5- Market Failures: Public Goods and Externalities No Ch.5 or Ch.6 Quiz this unit  Today: Market Failures Tomorrow: Public/Private Goods Friday: Externalities HW: Ch. 5 Questions #1-3 and Problems #1-3. McGraw-Hill/Irwin

2. Market Failures • Competition among buyers and sellers may not be enough to guarantee that a market will allocate its’ resources correctly. • Market failures sometimes happen in competitive markets. • Something prevents equilibrium...that is Qd does not equal Qs. • Market fails if optimal allocation of resources is not attained (over-allocated or under-allocated) • Leads to government intervention! • 2 categories of market failures… 5-2 LO1

3. 1. Demand-Side Failures • Sometimes it is impossible to charge consumers what they are willing to pay for a commodity. • Some can enjoy benefits without paying. • i.e. Private fireworks shows • When a demand curve does not accurately reflect consumers willingness to pay. 5-3 LO1

4. 2. Supply-Side Failures • Occurs when a firm does not pay the full cost of producing its output. • i.e. Coal burning power plant • When the external costs of producing the good are not reflected in the supply curve. 5-4 LO1

5. Efficiently Functioning Markets • In a perfect world… • Demand curve must reflect the consumers full willingness to pay • Supply curve must reflect all the costs of production. 5-5 LO1

6. 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 (utility surplus.) 5-6 LO2

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8. Price (per bag) Quantity (bags) Consumer Surplus Consumer Surplus Equilibrium Price P1 D Q1 5-8 LO2 LO2

9. Producer Surplus • Difference between the actual price a producer receives and the minimum price they would accept • Extra benefit for producer from receiving a higher price 5-9 LO2

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11. Price (per bag) Quantity (bags) Producer Surplus Producer surplus S P1 Equilibrium price Q1 5-11 LO2 LO2

12. Price (per bag) Quantity (bags) Efficiency Revisited All free-markets yield consumer and producer surpluses! This equilibrium reflects optimal economic efficiency. Demand Curves are MB Curves Supply Curves are MC Curves Equilibrium is MB=MC Max. willingness to pay = Min. acceptable price TS is @ Maximum! Consumer surplus S P1 Producer surplus D Q1 5-12 LO2

13. Efficiency Losses (Deadweight Losses) Producing at Q1 IS OPTIMAL a Efficiency loss from underproduction S Sum of consumer and producer surplus is now adec. d b Price (per bag) e D c Q2 Q1 Triangle DBE shows DEADWEIGHT loss of net benefits to society. Quantity (bags) 5-13 LO2

14. Efficiency Losses (Deadweight Losses) a S Efficiency loss from overproduction f b Price (per bag) g Triangle BFG subtracts from the ABC producer/consumer surplus Q1 to Q3, costs exceed benefits; poor use of resources D c Q1 Q3 Quantity (bags) 5-14 LO2

15. October 10, 2013 • HW Check • PS, CS, DL Practice • Public and Private Goods Notes Handout • Finish Practice Problems

16. Private Goods • Produced in the market by firms (cars, clothes, computers, etc.) • Offered for sale • Characteristics: • Rivalry (if one buys, not available to another person) • Excludability (you no get if you can’t afford) 5-16 LO3

17. Public Goods • Provided by government • What is optimal amount to produce? • Government estimation (MB=MC) • Create Collective Willingness to Pay curve. • Offered for free (national defense, street lights, etc.) • Characteristics: • Non-rivalry • Non-excludability • Free-rider problem 5-17 LO3

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19. P $9 7 5 3 1 0 Q 1 2 3 4 5 P $6 5 4 3 2 1 0 Q 1 2 3 4 5 P $6 5 4 3 2 1 0 Q 1 2 3 4 5 Demand for Public Goods Benson’s Demand $4 for 2 Items D2 $2 for 4 Items Benson Adams’ Demand $3 for 2 Items S Curve measures society MC of each unit Optimal Quantity $1 for 4 Items D1 Adams S Collective Demand $7 for 2 Items Collective Willingness To Pay $3 for 4 Items DC Connect the Dots Collective Demand and Supply 5-19 LO3

20. Cost-Benefit Analysis • Used for deciding whether to provide a particular public and how much to provide. • 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 MARGINAL COST-MARGINAL BENEFIT RULE 5-20 LO3

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22. Quasi-Public Goods • Could be provided through the market system, BUT TOO MAN YPEOPLE SEE BEENFITS OTHER THAN INDIVIDUAL BUYER (police, fire dept, roads, etc.) • The government provides them • More examples: education, streets, libraries 5-22 LO3

23. October 11, 2013 • Collect Current Event • Review Problems Packet Solutions • Externalities…oh boy… • HW: Read chapter 5 and do problems #4-7 and both externality AP Exam practice problems on handout.

24. Externalities • Externality: Cost or benefit that “spills over” to a third party external to a transaction. • Can be positive or negative. • Leads to government intervention as resources are not being allocated efficiently! • Positive externalities (spill-over benefits) • Vaccinations…gardens…people going to college…walking to work • Marginal Social Benefit GREATER than Marginal Private benefit. • Underproduction and Under-consumption. • Demand curves DO NOT reflect 3rd party willingness to pay, only MPB (Not MSB) • Negative externalities (spill-over costs) • Factory pollution…barking dogs…late night neighbor’s stereo…second-hand smoke… • Overproduction and Over-consumption • Marginal Social Cost GREATER than Marginal Private cost. • Supply curves DO NOT reflect total costs on society (MSC), only MPC 5-24 LO4

25. P P 0 Q Q Externalities Note: the demand curve is to the left of the total-benefit demand curve Equilibrium output is less than optimal output Note: Equilibrium Output Is larger than Optimal output MB exceeds MC for all units produced between Qo and Qe Deadweight loss is Triangle abc. Negative Externalities S St (MSC) y b z a Positive Externalities S (MPC) Dt x c D (MSB) D Overallocation = Overproduction Underallocation= Underproduction 0 Qo Qe Qe Qo Qeis less than Qo, deadweight loss is xyz. (a) Negative externalities (b) Positive externalities 5-25 LO4

26. EDUCATION Marginal Private Cost Price Marginal Private Benefit Quantity provided

27. Marginal Social Benefit

29. STEEL PRODUCTION Marginal Private Cost Price Marginal Private Benefit Quantity provided

32. Government Intervention • Bring in the government if externalities affect large numbers of people… • Correct negative externalities (over-allocation): • Direct controls (Legislation!) • Specific taxes • Correct positive externalities (under-allocation): • Subsidies (gov’t discounts or payments to producers and consumers) and government provision (offer for free) 5-32 LO4

33. P P 0 0 Q Q Government Intervention Negative Externalities Tax shifts Supply Curve from S to St St St b a a S S T c D D Overallocation Qo Qe Qo Qe (a) Negative Externalities (b) Correct externality with tax 5-33 LO4

34. Government Intervention Subsidy per-unit amount S S S y Subsidy z S't Positive Externalities Dt Dt x Subsidy U D D D Underallocation 0 0 0 Qe Qo Qe Qo Qe Qo (a) Positive Externalities (b) Correcting via a subsidy to consumers (c) Correcting via a subsidy to producers 5-34 LO4

35. Society’s Optimal Amounts MC Socially Optimal Amount Of Pollution Abatement Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) MB 0 Q1 5-35 LO5

36. 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 5-36 LO5

37. Controlling Carbon Dioxide Emissions • Cap and trade • Sets a cap for the total amount of emissions • Assigns property rights to pollute • Rights can then be bought and sold • Carbon tax • Raises cost of polluting • Easier to enforce 5-37