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Chapter 04 - Market Failures: Public Goods and Externalities
CHAPTER FOUR
MARKET FAILURES: PUBLIC GOODS AND EXTERNALITIES
CHAPTER OVERVIEW
Chapter 3 touched on how properly functioning, competitive markets achieve economic efficiency, but
this chapter extends and deepens the analysis by including consumer and producer surplus along with
efficiency losses (deadweight losses). The chapter examines demand-side and supply-side market failures
and their impacts on resource allocation. Students will learn that under some circumstances goods are
overproduced while in other situations goods are under-produced.
Then the chapter analyzes government’s role in producing public goods and how this impacts resource
allocation. Marginal analysis is used to evaluate public goods and externalities. Various approaches for
limiting negative externalities are also presented.
The end of the chapter addresses potential government inefficiencies that may arise, mitigating the
benefits from government’s policies.
The appendix discusses how asymmetric information results in a third type of market failure. Since
individuals may possess different information at a given time markets may fail to develop or operate in a
limited capacity.
WHAT’S NEW
This chapter on Market Failures was chapter 5 in the 19e. It takes the spot of the elasticity chapter, which
is being moved out of the five “core” chapters (the elasticity is now chapter 6 in this edition). The next
chapter is a new companion chapter that addresses the government’s role in society and potential
inefficiencies that may result from government intervention in markets.
There is a new appendix to this chapter discussing a third type of potential market failure that results from
asymmetric information. This material pulls heavily from chapter 17 in the 19e.
Along with the new appendix there is a new learning objective for this chapter.
The “Consider This … Art for Art’s Sake” has been replaced with a new “Consider This … Responding to
Digital Free-riding.” This should make the discussion more relevant for today’s students.
Finally the ‘end of chapter’ questions have been updated to reflect the changes in the chapter.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Distinguish between demand-side and supply-side market failures and the kinds of externalities
that are created by each.
2. Define, measure, and graphically identify consumer surplus.
3. Define, measure, and graphically identify producer surplus.
4. Identify and explain efficiency (or deadweight loss) using consumer and producer surplus.
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Chapter 04 - Market Failures: Public Goods and Externalities
5. Explain how equilibrium achieves both productive and allocative efficiency.
6. Identify the characteristics of public goods and explain how they differ from private goods.
7. Describe graphically the collective demand curve for a particular public good and explain this
curve.
8. Explain why the supply curve for public goods is upward sloping and explain how the optimal
quantity of a public good is determined.
9. Identify the purpose of cost-benefit analysis and explain the major difficulty in applying this
analysis.
10. Explain what is meant by externalities.
11. Describe graphically and verbally how an over allocation of resources results when negative
externalities costs are present and how this can be corrected by government action.
12. Describe graphically and verbally how an under allocation of resources occurs when positive
externalities are present and how this can be corrected by government action.
13. Describe government policies that would reduce negative externalities.
14. Analyze government’s role in the economy and government’s inefficiencies.
15. Define and identify terms and concepts listed at the end of the chapter.
16. (Appendix) Discuss the role information asymmetries play in market development.
17. (Appendix) Discuss how government may intervene to deal with this potential market failure.
COMMENTS AND TEACHING SUGGESTIONS
1. As the text does, you will want to build up the concepts of consumer and producer surplus from the
individual to the market. Students will understand, for example, that there are goods that they
purchase for which they would pay more if necessary. To motivate producer surplus, you may
want to appeal to the labor market decision. A student may be willing to work for $6.00 per hour
but because of minimum wage laws or local labor market conditions earns $7.00 per hour. The
additional $1.00 per hour represents the student’s producer surplus.
2. You may wish to extend the chapter’s discussion of consumer and producer surplus by
demonstrating the impact (or having students work through them) of shifting supply and demand.
It could provide a nice setup for issues discussed in later chapters, such as tax incidence analysis.
Note, however, that changes in consumer and producer surplus resulting from supply and demand
shifts do not necessarily imply efficiency loss. A shift in demand resulting from a change in
preferences will alter the level of consumer and producer surplus, but the gains or losses are to the
surpluses, not to efficiency.
3. The difficulties, yet importance, of using cost-benefit analysis can be demonstrated through class
role-playing exercises in which students consider the costs and benefits of various proposals for
public investment projects under consideration in their community, state, or region. Even national
projects can be considered. Citizens and legislators often consider only the costs of a proposed
project without considering the benefits (or the reverse). Have students identify an actual issue in
which benefit-cost analysis would be appropriate, analyze if it has been used and, if so, discuss the
outcome. A debate over whether it is appropriate to use an efficiency standard (using benefit-cost)
or a safety standard in regulation will be interesting as this is an ongoing issue.
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Chapter 04 - Market Failures: Public Goods and Externalities
4. The concept of selling pollution rights is generally an unfamiliar and interesting topic for class
discussion. It highlights the economic advantages of this type of pollution control over blanket
regulation. Since the use of pollution rights is expanding and they are actually traded now on
commodity exchanges, it would be a good topic for students to research in recent periodicals.
5. Another activity useful for illustrating concepts in this chapter is the budget game. You can devise
your own version of the game by taking major categories from the federal, state, or local budget
and creating a worksheet whereby the students have the actual budget figures for each of perhaps,
ten categories. Then tell them that the budget must be cut by a certain dollar figure or by a certain
percentage and have them decide which categories must be reduced and which have priority for
maintaining current spending (or even increasing current levels). This can be a group or individual
exercise, but at the end of the exercise, have each student or each group explain their decision.
This usually leads to some lively discussion as groups will undoubtedly have different priorities.
Be sure to emphasize cost-benefit thinking during this exercise.
6. The degree of government involvement in the economy is a controversial topic in most of the areas
discussed in this chapter. Good debates can center on questions related to government’s role in
protecting the environment, the social security program, welfare programs, health care, and tax
policy, among others.
7. The “Consider This” box on street entertainers provides an excellent illustration of public goods. It
is a unique example in that it is a public good that is not necessarily financed by the government.
STUDENT STUMBLING BLOCKS
1. Students sometimes confuse the vocabulary of consumer and producer “surplus” with a market
surplus (quantity supplied exceeding quantity demanded) resulting from a price above equilibrium.
2. External costs and benefits are not easy concepts for students to grasp because our systems of
economic measurement (national income accounts, etc.) traditionally ignore them. For example,
the average person thinks of investment in pollution control as a cost having no productive return.
However, once students grasp the concept of external benefits, they can understand that not all
positive production is measured officially. Yet the benefits from investment in pollution control are
real and often can and should be measured. The difficult point to grasp is that markets do fail and
that the public sector can have a positive role to play when this happens.
3. Students easily confuse the concept of “public goods” as defined by economists with the goods and
services that are provided by the public sector. The two are not necessarily synonymous. For
example, electric power is provided by the public sector in some areas and by private corporations
in other areas. This provides a good example of the fact that goods and services provided by the
government do not necessarily fit the definition of “public goods and services.”
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Chapter 04 - Market Failures: Public Goods and Externalities
LECTURE NOTES
I. Introduction
A. Learning objectives – After reading this chapter, students should be able to:
1. Differentiate between demand-side market failures and supply-side market failures.
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.
3. Describe free riding and public goods, and illustrate why private firms cannot normally
produce public goods.
4. Explain how positive and negative externalities cause under- and over-allocation of
resources.
5. Show why we normally won’t want to pay what it would cost to eliminate every last bit
of a negative externality like air pollution.
6. (Appendix) Describe how information failures may justify government intervention in
some markets.
B. Everyone uses goods and services that are provided by government.
C. The questions to be answered are: why the private sector does not provide these goods and
services efficiently, and what is the role of government in bringing about a better allocation of
resources?
II. Market Failures in Competitive Markets
A. Market failures can occur in competitive markets.
B. Demand-side market failures:
1. Occur because at times it’s impossible to charge people what they’re willing to pay.
2. Fireworks are an example.
3. There’s no way to prevent people who didn’t pay to see fireworks from watching them.
4. Private firms therefore are not willing to produce the fireworks.
C. Supply-side market failures:
1. Occur because the producer fails to pay the full cost of production.
2. Pollution is an example.
3. The firm pays for all of the resources it uses, but it doesn’t pay for the pollution it creates.
4. The firm therefore produces more electricity and pollution than the firm would produce if
they paid for the pollution they emit.
III. Efficiently Functioning Markets
A. To be efficient:
1. Demand must fully reflect consumers’ willingness to pay.
2. Supply must fully reflect all costs of production.
B. Consumer Surplus
1. Definition – the difference between the maximum price a consumer is (or consumers are)
willing to pay for a product and the actual price.
2. The surplus, measurable in dollar terms, reflects the extra utility gained from paying a
lower price than what is required to obtain the good.
3. Maximum price a consumer is willing to pay depends on the opportunity cost of goods
and services he must forego.
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Chapter 04 - Market Failures: Public Goods and Externalities
4. Consumer surplus can be measured by calculating the difference between the maximum
willingness to pay and the actual price for each consumer, and then summing those
differences.
5. Consumer surplus is measured and represented graphically by the area under the demand
curve and above the equilibrium price. (Figure 4.1)
6. Consumer surplus and price are inversely related – all else equal, a higher price reduces
consumer surplus.
C. Producer Surplus
1. Definition – the difference between the actual price a producer receives (or producers
receive) and the minimum acceptable price.
2. Producer surplus can be measured by calculating the difference between the minimum
acceptable price and the actual price for each unit sold, and then summing those
differences.
3. A producer’s minimum acceptable price is based on his marginal cost and the opportunity
cost of using resources to produce other goods.
4. Producer surplus is measured and represented graphically by the area above the supply
curve and below the equilibrium price. (Figure 4.2)
5. Producer surplus and price are directly related – all else equal, a higher price increases
producer surplus.
IV. Efficiency Revisited and Efficiency Losses
A. Efficiency is attained at equilibrium, where the combined consumer and producer surplus is
maximized. (Figure 4.3)
1. Consumers receive utility up to their maximum willingness to pay, but only have to pay
the equilibrium price.
2. Producers receive the equilibrium price for each unit, but it only costs the minimum
acceptable price to produce.
3. Allocative efficiency occurs at quantity levels where three conditions exist:
a. MB = MC (as represented by demand and supply).
b. Maximum willingness to pay = minimum acceptable price.
c. Combined consumer and producer surplus is at a maximum.
B. Efficiency (Deadweight) Losses
1. Underproduction reduces both consumer and producer surplus, and efficiency is lost
because both buyers and sellers would be willing to exchange a higher quantity. (Figure
4.4a)
2. Overproduction causes inefficiency because past the equilibrium quantity, it costs society
more to produce the good than it is worth to the consumer in terms of willingness to
pay. (Figure 4.4b)
V. Public Goods
A. Private goods are produced and sold in competitive markets, and have two characteristics:
1. Rivalry in consumption – when one person buys and consumes a good, it is not available
to others.
2. Excludability – Sellers can restrict the benefits to those who pay for the good.
B. Market demand for private goods is found by horizontally summing the individual demand
schedules.
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Chapter 04 - Market Failures: Public Goods and Externalities
C. Private markets allocate goods and resources efficiently – those willing to pay obtain goods
get them. Sellers produce goods to satisfy consumer wants, and consumer buying behavior
tells them whether to produce more or less of any particular good.
D. Unlike private goods, public goods are those goods that are nonrival and nonexcludable.
E. Public goods suffer from the free-rider problem, where a consumer can enjoy the benefit of
the good without having to pay for it.
1. As a result of free-riders government must provide the good.
2. Government doesn’t prevent free-riders, but government can finance production of the
good through taxes.
3. Sometimes public goods can be subsidized through private related goods and therefore
provided by private firms.
F. Consider This … Street Entertainers
1. Street entertainers regularly appear in popular tourist areas in major cities. Even though
some people pay when the “hat is passed,” many benefit from the shows without
contributing to the cost (free-riding).
2. Because local businesses benefit from the customers attracted by these performers, the
businesses or local government will sometimes pay these entertainers.
3. Even when government is not contributing to the cost of street entertainers, a public good
is still being provided.
G. The demand for public goods differs from the market demand for private goods.
1. It is a “phantom” demand since the consumers will not be making individual purchases.
2. To find the collective demand schedule for a public good, we add the prices people
collectively are willing to pay for the last unit of the public good at each quantity
demanded (Table 4.3).
3. Figure 4.5 is a graphical illustration of this table. A collective demand curve is the
vertical sum of the individual demand curves for the public who want that good.
4. Recall that the market demand for a private good was a horizontal summation of the
individual demand curves.
H. The supply curve for any good is its marginal cost curve. As with private goods, the law of
diminishing returns applies to the supply of public goods.
I. The optimal quantity of a public good can be determined by comparing the collective demand
curve with the supply (marginal cost) curve to determine their point of intersection or by
looking at the demand and supply (marginal cost) schedules to see at what price and quantity
marginal benefit equals marginal cost (Figure 4.5c).
J. Cost-benefit analysis is a technique for decision making in the public sector.
1. The concept involves comparing the benefit of providing incremental units of public
goods with the costs of providing these additional units. Note that the comparison is a
marginal one, i.e., the comparison is made between the costs and benefits of additional
amounts of a public good or service.
2. Table 4.4 illustrates this concept in determining the scope of a national highway
construction project. Four possible phases of projects are considered, with costs and
benefits compared. By comparing the marginal costs and benefits as one moves from the
least expensive phase to the most-expensive phase, we see Plan C is the optimal choice.
3. The rule for this decision-making technique is to use the marginal benefit = marginal cost
rule; if the marginal cost exceeds the marginal benefit, that part of the project should not
be included.
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Chapter 04 - Market Failures: Public Goods and Externalities
4. The problem with this technique is the difficulty in measuring costs and benefits.
Benefits are particularly difficult to estimate, because there are many related aspects that
are not easily calculated. Nevertheless, the method is widely used.
K. Quasi-public goods are those that have large positive externalities, so government will
sponsor their provision. Otherwise, they would be under produced. Medical care, education,
and public housing are examples.
L. Resources are reallocated from private to public use by levying taxes on households and
businesses, thus reducing their purchasing power and using the proceeds to purchase public and
quasi-public goods. This can bring about a significant change in the composition of the economy’s total
output.
M. Consider This … Responding to Digital Free-riding
1. The music industry struggles with digital piracy. In this example four friends start a rock
band and eventually get signed by a major record label. However, since people can
download their music for free they have a difficult time making a living.
2. To overcome this problem the band provides the free music downloads to increase their
popularity (they do not fight the public goods nature of their music). However, they now
charge a higher price to attend their concerts, which is still a private good.
VI. Externalities
A. Externalities occur when costs or benefits accrue to an individual who is external to the
market transaction.
B. Figures 4.6a and 4.6b, respectively, illustrate that an over allocation of resources occurs when
negative externalities are present and an under allocation of resources occurs when positive
externalities are present.
1. Negative externalities occur when producers are able to shift some of their costs onto the
community.
2. Positive externalities occur when the benefits of a good are received by others in the
community although they did not pay for them. These benefits are not reflected in the
individual demand curve.
C. Consider This…The Fable of the Bees
1. The Coase theorem, named after Nobel prize-winning economist Ronald Coase, suggests
that government is not always needed to remedy external costs and benefits.
2. With the right conditions, externalities can be solved with a market approach to
individual bargaining.
3. Bees provide many positive externalities to farmers by pollinating their crops.
a. Farmers and beekeepers used individual bargaining to determine payment, avoiding
government intervention.
b. All farmers in an area hire beekeepers simultaneously, avoiding free-riders.
c. Farmers willingly pay the beekeepers to maintain their services because without the
bees the farmers’ crops would be devastated.
4. Government’s role should be to encourage bargaining wherever possible, rather than to
get involved in direct restrictions or subsidies.
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Chapter 04 - Market Failures: Public Goods and Externalities
D. Direct government controls or taxes may be needed to reduce negative externalities, or
provide subsidies or government provision where positive externalities exist.
1. Direct controls place limits on the amount of the offensive activity that can occur. Clean
air and water legislation are examples. The effect is to force the offenders to incur costs
associated with pollution control. This should shift the product supply curve leftward and
reduce the equilibrium quantity. Therefore, it should reduce the resource allocation in a
socially optimal way. (See Figure 4.7a)
2. Specific taxes can be levied on polluters. The tax payment will increase costs to the
producer, shifting the product supply curve leftward, and reducing resource allocation to
this type of production as desired and increasing the equilibrium price. (See Figure 4.7b)
3. Subsidies and government provision suggest three options.
a. Buyers may be subsidized. For example, new parents may be given coupons to
receive inoculations at reduced prices for their children. This would increase the
number of vaccinations and eliminate the under allocation of resources. (Figures 4.8a
and 4.8b)
b. Producers could be subsidized so that producers’ costs are reduced, thus shifting the
supply curve rightward, increasing equilibrium output, and eliminating the under
allocation shown in Figure 4.8c.
c. The government could provide the product as a public good where spillover benefits
are extremely large. An example would be administering free vaccines to all children
in India to end smallpox.
E. Table 4.5 reviews the methods for correcting externalities.
F. Society’s optimal amount of externality reduction is not necessarily total elimination.
1. To determine the correct amount of negative externalities like pollution, it’s necessary to
find the point where the MC of cleaning it up equals the MB of cleaner air.
2. The cost of reducing spillover costs increases with each additional unit of reduction. The
benefit received from each additional unit of reduction decreases due to diminishing
marginal utility.
3. When MC=MB, society has found its optimal amount of pollution abatement (Figure
4.9).
4. In reality it is difficult to measure benefits as well as costs, but this analysis demonstrates
that some degree of pollution may be socially efficient.
VII. Government’s Role in the Economy
A. This chapter has shown that government can have a positive role in a market economy by
providing public goods and correcting for over- and under-allocation of resources when there
are externalities.
B. Identifying and correcting for market failures can be difficult, time consuming, and costly.
C. Introducing politics into the equation complicates the situation even more and can lead to
undesirable economic outcomes.
1. In the political environment, there can be over- and under regulation.
2. Public and quasi-public goods may be produced because of powerful politicians, not
because the benefits of the good exceed its costs.
3. Without a profit incentive, government is often inefficient.
D. Government failure is the term used to describe inefficient outcomes as a result of
shortcomings in the public sector.
VIII. Last Word…Carbon Dioxide Emissions, Cap-and-Trade, and Carbon Taxes
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Chapter 04 - Market Failures: Public Goods and Externalities
A. An owner of a landfill has full property rights and charges people to dump their garbage.
B. The payment that the landowner receives fails to account for the negative externalities from
pollution.
C. It is possible to use cap-and-trade systems where government sets a limit on the total amount
of a particular pollutant allowed then issues permits to firms, enabling them to emit a certain
amount of the pollutant.
D. Firms can then trade permits with each other.
1. Smokestack Toys might have a permit for 100 tons of carbon dioxide that can be used to
produce toys that will generate a profit of $100,000.
2. A power plant could use the 100 tons of carbon dioxide to produce energy and generate
$1 million in profit.
3. Smokestack Toys can sell its permit for more than $100,000 to the power plant who will
willingly buy it for up to $1 million (its expected profit).
4. Society benefits because when the energy company emits the carbon dioxide, society gets
greater net benefits from it than it would from the production of toy cars as implied by
the much greater profits without any change in the total amount of pollution.
E. Cap-and-trade systems are ineffective when it’s difficult for regulators to verify that firms are
following the standards like the problems with the European Union’s cap-and-trade system
for carbon dioxide.
F. Cap-and-Trade has been very effective in the U.S. for sulfur dioxide emissions because there
are very few firms emitting this pollutant so regulators can easily verify that firms are not
exceeding their limit.
G. To control carbon dioxide, economists recommend a carbon tax.
QUIZ
1. Consumer surplus arises in a market because:
A. At the market price, quantity supplied is greater than quantity demanded
B. At the current market price, quantity demanded is greater than quantity supplied
C. Some consumers are willing to pay more than the equilibrium price but do not need to do so
D. Some consumers are willing to pay less than the equilibrium price but do not need to do so
2. Negative externalities arise:
A. when firms pay more than the opportunity cost of resources.
B. when the demand curve for a product is located too far to the left.
C. when firms "use" resources without being compelled to pay for their full costs.
D. only in capitalistic societies.
3. Rivalry and excludability are the main characteristics of:
A. capital goods.
B. private goods.
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Chapter 04 - Market Failures: Public Goods and Externalities
C. public goods.
D. consumption goods.
4. The market system does not produce public goods because:
A. there is no need or demand for such goods.
B. private firms cannot stop consumers who are unwilling to pay for such goods from benefiting
from them.
C. public enterprises can produce such goods at lower cost than can private enterprises.
D. their production seriously distorts the distribution of income.
5. A demand curve for a public good is determined by:
A. summing vertically the individual demand curves for the public good.
B. summing horizontally the individual demand curves for the public good.
C. combining the amounts of the public good that the individual members of society demand at
each price.
D. multiplying the per-unit cost of the public good by the quantity made available.
6. Cost-benefit analysis attempts to:
A. compare the real worth, rather than the market values, of various goods and services.
B. compare the relative desirability of alternative distributions of income.
C. determine whether it is better to cut government expenditures or reduce taxes.
D. compare the benefits and costs associated with any economic project or activity.
7. At the optimal quantity of a public good:
A. marginal benefit exceeds marginal cost by the greatest amount.
B. total benefit equals total cost.
C. marginal benefit equals marginal cost.
D. marginal benefit is zero.
8. An important problem in evaluating public projects through the use of cost-benefit analysis is
that:
A. real costs cannot be stated in monetary terms.
B. one must decide whether to compare total costs and total benefits or marginal costs and
marginal benefits.
C. positive and negative externalities associated with such projects may be difficult to measure.
D. the funding of such projects is inherently inflationary.
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Chapter 04 - Market Failures: Public Goods and Externalities
9. From the economist's perspective, "market failures" basically arise when:
A. The quantity demanded for a good or service is greater than the quantity supplied of the good
or service
B. The quantity supplied of a good or service is greater than the quantity demanded for a good or
service
C. Demand and supply do not accurately reflect all the benefits and all the costs of production
D. The market system is unable to adapt to or to accommodate change
10. When the production of a product creates external costs greater than external benefits, a market
economy will:
A. Not produce the product without government intervention
B. Produce a socially optimal allocation of resources
C. Allocate too few resources to production of the product
D. Allocate too many resources to production of the product
Appendix to Chapter 4
This appendix discusses another potential market failure. Since different individuals have
different information about products, health etc… markets may fail to develop or operate on a
limited basis. For example the buyer of a used car knows less about the quality of the used car
than the seller. Thus, the two may not be able to agree on a price.
Information failures are another form of market failure.
A. Information is often asymmetric – buyers and sellers don’t have the same information about
the good, service or resource being sold, and the cost of obtaining better information is often
prohibitive.
B. Inadequate information about sellers—two examples:
1. Assume that the gasoline market exists in an absurd situation in which there is no system
of weights and measures established by law. In such a world, the station could advertise
high-octane gas that was actually low-octane gas; pumps could register more gallons than
were actually being pumped. Without government regulation, one could imagine some
incentive for some stations to cheat in such ways. Government intervenes in such
markets to prevent such cases of market failure. This provides reliable information to
buyers and also helps sellers through enforcement of fair sales practices.
2. Licensing of surgeons is another example in which the consumer would find it difficult to
gather information about a physician’s expertise without government licensing standards.
Such rules set minimum standards for competence. There will still be physicians of
varying abilities, but the consumer can be confident that basic standards were met.
C. Inadequate information about buyers may lead to potential problems for sellers.
1. The moral hazard problem occurs when there is a tendency of one party to a contract to
alter his/her behavior in ways that are costly to the other party. Examples include the
driver who behaves more recklessly after obtaining insurance; guaranteed contracts for
athletes, which may reduce their performance; unemployment compensation insurance,
which may discourage incentives to work.
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Chapter 04 - Market Failures: Public Goods and Externalities
2. The adverse selection problem arises when information known by the first party to a
contract is unknown to the second and, as a result, the second party incurs major costs.
Examples include those in poor health who take out health insurance, the person planning
an arson attempt who takes out fire insurance and the person whose marriage is failing
who takes out the book’s hypothetical “divorce” insurance. In areas where insurance is
traditionally underprovided, the government has provided insurance or subsidized
insurance.
3. Qualification: There are private methods of overcoming lack of information problems.
a. Product warranties overcome lack of information about the seller or product.
b. Franchising helps set uniform standards, so that most McDonalds or Holiday Inns
have similar quality.
c. Firms have specialized in providing information to buyers and sellers; consumer
reports, travel guides, and credit-checking agencies are some examples.
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