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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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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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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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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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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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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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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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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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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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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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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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