Chapter 05 – Market Failures: Public Goods and Externalities
5-1
CHAPTER 5
Market Failures: Public Goods and Externalities
A. Short-Answer, Essays, and Problems
1. Explain the two types of market failure and given an example of each one.
2. Define “consumer surplus.”
3. Are consumer surplus and equilibrium price directly or inversely related? Explain your answer.
4. Define “producer surplus.”
5. At the beginning of the school year, used couches are in high demand among State University freshman
living on the sixth floor of Beta Dormitory. Fortunately for the freshman, the upperclassmen moving off of
the sixth floor are very willing to sell their used couches. Answer the following questions about the sixth
floor used-couch market.
(a) Complete the table below containing the market demand for used couches on the sixth floor. What is
the total consumer surplus?
FreshmanMaximum price willing to pay Equilibrium price Consumer surplus
Rita $100 $50 _____
Emily 90 50 _____
Chris 80 50 _____
Pedro 70 50 _____
Zak 60 50 _____
Natalie 50 50 _____
(b) Complete the table below containing the market supply for used couches on the sixth floor. What is
the total producer surplus?
UpperclassmanMaximum acceptable price Equilibrium price Producer surplus
Frank $25 $50 _____
Cho 30 50 _____
Toby 35 50 _____
Susie 40 50 _____
Rob 45 50 _____
Anisha 50 50 _____
6. In terms of consumer and producer surplus, when is economic efficiency achieved?
7. What are the three conditions that must exist when there is allocative efficiency?
8. Explain why underproduction or overproduction of a good results in efficiency losses.
Chapter 05 – Market Failures: Public Goods and Externalities
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9. Use the graph below to identify the efficiency loss when there is underproduction (Q1) and the efficiency
loss when there is overproduction (Q3) in a market.
10. What is the basic difference between a public good and a private good?
11. Compare and contrast the difference in private and public goods based on the characteristics of “rivalry”
and “exclusion.”
12. Why is there a free-rider problem with public goods?
13. What is the free-rider problem and how does it cause the underproduction of a public good in a competitive
market?
14. (Consider This) Why do street performers face a free-rider problem? How do they try to reduce this
problem?
15. How will the market demand curve for a public good differ from the market demand curve for a private
good?
16. Describe the rationale behind supply and demand analysis for public goods.
17. “Since a public good is enjoyed by all members of society, willingness to pay for the good will not
diminish as the amount produced increases.” Evaluate and use an example to support your answer.
18. Data on two individuals’ preferences for a public good are reflected in the table below. PA and PB represent
the prices individuals A and B, the only two people in the society, are willing to pay for the last unit of a
public good, rather than do without.
Quantity PA PB
2 $12 $11
3 10 9
4 8 7
5 6 5
6 4 3
7 2 1
a
b
c
e
d
Q1
Q2
Q3
S
D
P
Chapter 05 – Market Failures: Public Goods and Externalities
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(a) Complete the table below showing the collective willingness to pay for the public good in this society.
Qd Price Qs
2 $_____ 8
3 _____ 7
4 _____ 6
5 _____ 5
6 _____ 4
7 _____ 3
(b) Given the supply schedule for this public good as shown by the Qs column, what is the optimal
quantity of this public good and what is the optimal price?
(c) What is the perceived marginal benefit and perceived marginal cost when 4 units of the public good
are supplied? What does this indicate about the allocation of resources to this public good?
19. Data on two individuals’ preferences for a public good are reflected in the table below. PA and PB represent
the prices individuals A and B, the only two people in the society, are willing to pay for the last unit of a
public good, rather than do without.
Quantity PA PB
1 $36 $35
2 30 30
3 24 25
4 18 20
5 12 15
6 6 10
(a) Complete the table below showing the collective willingness to pay for the public good in this society.
Qd Price Qs
1 $_____ 7
2 _____ 6
3 _____ 5
4 _____ 4
5 _____ 3
6 _____ 2
(b) Given the supply schedule for this public good as shown by the Qs column, what is the optimal
quantity of this public good and what is the optimal price?
(c) What is the perceived marginal benefit and perceived marginal cost when 3 units of the public good
are supplied? What does this indicate about the allocation of resources to this public good?
20. The next three questions refer to the below supply and demand graph for a public good.
(a) What does point c represent?
(b) What does the line segment ef at output Q3 represent?
(c) At what output level is there an underallocation of resources to the production of this public good?
21. Imagine that a state government is considering the construction of a new state office building to consolidate
state operations. Its estimate of the total costs and the total benefits of building a 4– 6-, 8-, or 10-story
building is shown in the table below. (All figures are in millions of dollars.)
Chapter 05 – Market Failures: Public Goods and Externalities
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Project Total cost Marginal cost Total benefit Marginal benefit
No building $ 0 $ 0
4-story building 7 $_____ 8 $_____
6-story building 16 _____ 23 _____
8-story building 24 _____ 28 _____
10-story building 34 _____ 31 _____
(a) Compute the marginal cost and the marginal benefit of the 4–, 6-, 8-, and 10-story buildings.
(b) Should the state build a new office building? If so, what size building and what will be the total
benefit, total cost, and net benefit to society?
22. In the current presidential election, one candidate argues: “The government is extremely inefficient. To fix
this, government spending should be substantially reduced.” Evaluate this statement.
23. Can economic analysis precisely determine the proper levels of government spending and taxation? In
your answer explain the problems in using cost-benefit analysis.
24. How do quasi-public goods differ from pure public goods? Give examples of both types. Explain the
rationale as to why quasi-public goods are often provided by government rather than private businesses.
25. Define negative externality and give an example.
26. Define positive externality and give an example.
27. Demand and supply curves for products for which there are negative or positive externalities are shown in
the three graphs below.
(a) On this graph draw in another curve that indicates what might happen after the producer was prevented
from causing a negative externality or was forced to pay a tax to cover these costs.
(b) On this graph draw in another curve that indicates the situation after the government subsidizes the
producer because there are positive externalities from this product.
(c) On this graph draw in another curve that indicates the situation after the government subsidizes
consumers for this product which has a positive externality.
28. What are negative externalities and positive externalities? How do they affect supply and demand curves?
29. (Consider This) How could you use the Coase theorem to predict what would happen when smoke from a
factory creates dirty air and slightly acid rain for all the residents in the area in a one-mile radius of the
plant?
30. How do direct controls and specific taxes affect externalities? Briefly explain in terms of supply and
demand.
31. What resource problem is created by negative externalities and what methods are suggested for dealing
with this problem?
Quantity
(a)
P
D
S
0
Quantity
(b)
P
D
S
0
Quantity
(c)
P
D
S
0
Chapter 05 – Market Failures: Public Goods and Externalities
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32. What resource problem is created by positive externalities and what methods are suggested for dealing with
this problem?
33. Explain the statement: “Clean air and water have become increasingly scarce and valuable resources
because they have been treated in the past as if they were free and unlimited in supply.” What methods
might be used to internalize spillover costs?
34. Suppose a local coffee shop in the downtown area decides to purchase a neighboring abandoned lot and
convert it into a garden area with outdoor seating.
(a) Does this decision create an externality? If so, what kind?
(b) Despite the city’s positive response to the coffee shop’s renovation, other businesses in the area have
not followed suit in renovating the many decrepit buildings and abandoned lots. How might the
presence of an externality be in part the cause of this?
(c) In response to the lack of effort on the part of businesses to renovate the downtown area, city council
members to take action. What are some ways that the city government could promote this kind of
revival?
35. Should all pollution be banned? Why might some level of pollution be economically efficient?
36. The following table shows marginal costs and benefits of the optimal quantity of pollution abatement that
will occur at a local factory.
Quantity of pollution abatement Marginal cost Marginal benefit
700 tons $100,000 $ 20,000
600 tons 60,000 30,000
500 tons 40,000 40,000
400 tons 20,000 60,000
300 tons 10,000 80,000
200 tons 5,000 160,000
(a) What is the optimal level of pollution abatement? Why?
(b) If the marginal benefit of pollution abatement were to increase by $30,000 at each level because of the
factory’s desire to improve its image and environment, what would the optimal level be? Why?
(c) What might cause the optimal level of pollution abatement to be 400 tons?
Chapter 05 – Market Failures: Public Goods and Externalities
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37. The following table shows marginal costs and benefits of the optimal quantity of pollution abatement that
will occur at a local factory.
Quantity of pollution abatement Marginal cost Marginal benefit
200 tons $300,000 $ 20,000
180 tons 180,000 30,000
160 tons 120,000 40,000
140 tons 60,000 60,000
120 tons 30,000 80,000
100 tons 15,000 160,000
(a) What is the optimal level of pollution abatement? Why?
(b) If the marginal benefit of pollution abatement were to increase by $150,000 at each level because of
the factory’s desire to improve its image and environment, what would the optimal level be? Why?
(c) What might cause the optimal level of pollution abatement to be 120 tons?
38. “Pollution should be completely eliminated.” Evaluate. Support your answer using MB and MC analysis.
39. What perspective do economists use to evaluate the issue of the amount of pollution control?
40. What are the limitations to government’s role in the economy?
41. (Last Word) Describe the idea behind the cap-and-trade program for improving environmental quality.
Explain how supply and demand determine the price for pollution rights in this case.
42. (Last Word) Describe how a market for externality rights or cap-and-trade system would work in terms of
supply and demand.
43. (Last Word) Assume the atmosphere of an urban area is able to reabsorb 4000 tons of pollutants per year.
The schedule below shows the price polluters would be willing to pay for the right to dispose of 1 ton of
pollutants per year and the total quantity of pollutants they would wish to dispose of at each price.
Price
(per ton of pollutant rights) Total quantity of pollutant rights demanded
(tons)
$ 0 8000
1000 7000
2000 6000
3000 5000
4000 4000
5000 3000
6000 2000
7000 1000
(a) If there were no emission fee, how many tons of pollutants would there be and how much greater
would this amount be than the capacity for reabsorption?
(b) What pollution fee should the urban authorities charge to solve the problem?
(c) What would happen in this market for pollution rights if quantity demanded increased by 1000 tons at
each price?
Chapter 05 – Market Failures: Public Goods and Externalities
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44. (Last Word) Assume the atmosphere of an urban area is able to reabsorb 8000 tons of pollutants per year.
The schedule below shows the price polluters would be willing to pay for the right to dispose of 1 ton of
pollutants per year and the total quantity of pollutants they would wish to dispose of at each price.
Price
(per ton of pollutant rights) Total quantity of pollutant rights demanded
(tons)
$ 0 13,000
1000 12,000
2000 11,000
3000 10,000
4000 9,000
5000 8,000
6000 7,000
7000 6,000
(a) If there were no emission fee, how many tons of pollutants would there be and how much greater
would this amount be than the capacity for reabsorption?
(b) What pollution fee should the urban authorities charge to solve the problem?
(c) What would happen in this market for pollution rights if quantity demanded increased by 1000 tons at
each price?
45. (Last Word) Draw a supply and demand graph on the below diagram that illustrates the market for
pollution rights. Label the axes and curves. Then show what happens to price and quantity when the
demand for pollution rights increases in the market.
Chapter 05 – Market Failures: Public Goods and Externalities
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B. Answers to Short-Answer, Essays, and Problems
1. Explain the two types of market failure and given an example of each one.
2. Define “consumer surplus.”
3. Are consumer surplus and equilibrium price directly or inversely related? Explain your answer.
4. Define “producer surplus.”
5. At the beginning of the school year, used couches are in high demand among State University freshman
living on the sixth floor of Beta Dormitory. Fortunately for the freshman, the upperclassmen moving off of
the sixth floor are very willing to sell their used couches. Answer the following questions about the sixth
floor used-couch market.
(a) Complete the table below containing the market demand for used couches on the sixth floor. What is
the total consumer surplus?
FreshmanMaximum price willing to pay Equilibrium price Consumer surplus
Rita $100 $50 _____
Emily 90 50 _____
Chris 80 50 _____
Pedro 70 50 _____
Zak 60 50 _____
Natalie 50 50 _____
(b) Complete the table below containing the market supply for used couches on the sixth floor. What is
the total producer surplus?
UpperclassmanMaximum acceptable price Equilibrium price Producer surplus
Chapter 05 – Market Failures: Public Goods and Externalities
Frank $25 $50 _____
Cho 30 50 _____
Toby 35 50 _____
Susie 40 50 _____
Rob 45 50 _____
Anisha 50 50 _____
6. In terms of consumer and producer surplus, when is economic efficiency achieved?
7. What are the three conditions that must exist when there is allocative efficiency?
8. Explain why underproduction or overproduction of a good results in efficiency losses.
9. Use the graph below to identify the efficiency loss when there is underproduction (Q1) and the efficiency
loss when there is overproduction (Q3) in a market.
D
Chapter 05 – Market Failures: Public Goods and Externalities
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10. What is the basic difference between a public good and a private good?
11. Compare and contrast the difference in private and public goods based on the characteristics of “rivalry”
and “exclusion.”
12. Why is there a free-rider problem with public goods?
Chapter 05 – Market Failures: Public Goods and Externalities
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13. What is the free-rider problem and how does it cause the underproduction of a public good in a competitive
market?
14. (Consider This) Why do street performers face a free-rider problem? How do they try to reduce this
problem?
15. How will the market demand curve for a public good differ from the market demand curve for a private
good?
16. Describe the rationale behind supply and demand analysis for public goods.
17. “Since a public good is enjoyed by all members of society, willingness to pay for the good will not
diminish as the amount produced increases.” Evaluate and use an example to support your answer.