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Chapter 04 - Market Failures: Public Goods and Externalities
Chapter 04 - Market Failures: Public Goods and Externalities
McConnell Brue Flynn 19e
DISCUSSION QUESTIONS
1. Explain the two causes of market failures. Given their definitions, could a market be affected
by both types of market failures simultaneously? LO1
Answer: A public good is one where consumption in non-rival and non-excludable.
Private goods are not profitable because of the free rider problem. If we want to set off
fireworks and charge for the event, we probably wouldn't generate much revenue. We
Answer 1: Yes, it is possible for both to occur if an individual values the good, such as
Answer 2: No, because if the free-rider problem is present firms will not produce any of
2. Use the ideas of consumer surplus and producer surplus to explain why economists say
competitive markets are efficient. Why are below- or above-equilibrium levels of output
inefficient, according to these two sets of ideas? LO2
Answer: When the consumers’ utility exceeds the price paid, consumer surplus is
generated. Likewise, when producers receive a price greater than marginal cost, producer
3. What are the two characteristics of public goods? Explain the significance of each for public
provision as opposed to private provision. What is the free-rider problem as it relates to public
goods? Is U.S. border patrol a public good or a private good? Why? How about satellite TV?
Explain. LO3
Answer: Public goods are nonrival (one person’s consumption does not prevent
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consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
including free riders—can be excluded from the goods’ benefits). If goods are nonrival,
there is less incentive for private firms to produce them – those purchasing the good
4. What divergences arise between equilibrium output and efficient output when (a) negative
externalities and (b) positive externalities are present? How might government correct these
divergences? Cite an example (other than the text examples) of an external cost and an external
benefit. LO4
Answers:
(a) When negative externalities are present, the equilibrium output will be greater
(b) When positive externalities are present, the equilibrium output will be smaller
than the efficient output because the consumer is willing to pay a price equal
Government might correct external costs through regulation, which requires
firms to internalize these external costs, or it might tax the externality until it
Other examples of external costs might include secondhand smoke, noise
5. Why are spillover costs and spillover benefits also called negative and positive externalities?
Show graphically how a tax can correct for a negative externality and how a subsidy to producers
can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to
producers in correcting for a positive externality? LO4
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
Answers: Spillover costs are called negative externalities because they are external to the
participants in the transaction and reduce the utility of affected third parties (thus
6. An apple grower’s orchard provides nectar to a neighbor’s bees, while the beekeeper’s bees
help the apple grower by pollinating his apple blossoms. Use Figure 4.6b to explain why this
situation of dual positive externalities might lead to an underallocation of resources to both apple
growing and beekeeping. How might this underallocation get resolved via the means suggested
by the Coase theorem? LO4
Answers: Using Figure 4.6b in the text the following can be said: The market demand
curves for apples and honey, Da and Dh, would not include the spillover benefits
Using the Coase theorem, we note that it will be to the advantage of individual
apple growers and beekeepers to negotiate so that beekeepers (whose hives can be
7. The LoJack car recovery system allows the police to track stolen cars. As a result, they not only
recover 90% of LoJack-equipped cars that are stolen but also arrest many auto thieves and shut
down many “chop shops” that take apart stolen vehicles to get at their used parts. Thus, LoJack
provides both private benefits and positive externalities. Should the government consider
subsidizing LoJack purchases? LO4
Answers: If the government were to subsidize LoJack purchases, this would reduce the
private cost of the anti-theft devices. This reduction in the private cost would, in-turn,
8. Explain why zoning laws, which allow certain land uses only in specific locations, might be
justified in dealing with a problem of negative externalities. Explain why in areas where buildings
sit close together tax breaks to property owners for installing extra fire prevention equipment
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consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
might be justified in view of positive externalities. Explain why excise taxes on beer might be
justified in dealing with a problem of external costs. LO5
Answers: Zoning could force businesses producing negative externalities to
locate in regions where these costs would not spill over onto third parties, or
where such costs would at least be reduced. Businesses wanting to locate in
9. LAST WORD Distinguish between a carbon-tax and a cap-and-trade strategy for reducing
carbon dioxide and other so-called greenhouse gases (that are believed by many scientists to be
causing global warming). Which of the two strategies do you think would have the most political
support in an election in your home state? Explain your thinking.
Answers: Scientific evidence suggests that carbon dioxide and other gas
emissions are accumulating and causing the average temperature of the
A carbon-tax affects each polluting firm by charging them for emissions. The cap-
REVIEW QUESTIONS
1. Draw a supply and demand graph and identify the areas of consumer surplus and producer
surplus. Given the demand curve, what impact will an increase in supply have on the amount of
consumer surplus shown in your diagram? Explain why. LO2
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consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
Answer: An increase in supply will lower the price and increase the amount of consumer
2. Assume that candle wax is traded in a perfectly competitive market in which the
demand curve captures buyers’ full willingness to pay while the supply curve reflects all
production costs. For each of the following situations, indicate whether the total output
should be increased, decreased, or kept the same in order to achieve allocative and
productive efficiency. LO2
a. The maximum willingness to pay exceeds minimum acceptable price.
b. Marginal Cost > Marginal Benefit.
c. Total surplus is at a maximum.
d. The current quantity produced exceeds the market equilibrium quantity.
Answer:
a. increased More candle wax should be produced and sold because doing so
would increase allocative efficiency and help to ensure that society’s limited
supply of resources are being used to produce the products that consumers most
b. decreased Output should be reduced in order to improve allocative efficiency.
Because MC > MB at the current level of production, we know that the cost of
producing the final unit of candle wax exceeds the benefit felt by consumers from
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
c. kept the same Production should be kept at the same level because the level of
output that maximizes total surplus is also the level of output that guarantees
allocative efficiency. The easiest way to see this is by nothing that both reducing
d. decreased The most amazing thing about equilibrium in competitive markets is
that when demand curves fully reflect buyers’ willingness to pay and supply
curves fully reflect all production costs, the market equilibrium quantity will be
3. Efficiency losses ____________________________. LO2
a. Are not possible if suppliers are willing to produce and sell a product.
b. Can only result from underproduction.
c. Can only result from overproduction.
d. None of the above.
Efficiency losses can result from either overproduction or underproduction. The
4. Draw a production possibilities curve with public goods on the vertical axis and private goods
on the horizontal axis. Assuming the economy is initially operating on the curve, indicate how the
production of public goods might be increased. How might the output of public goods be
increased if the economy is initially operating at a point inside the curve? LO3
4-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
Answer: On the curve, the only way to obtain more public goods is to reduce the
5. Use the distinction between the characteristics of private and public goods to determine
whether the following should be produced through the market system or provided by government:
(a) French fries, (b) court systems, (c) mail delivery, and (d) medical care. State why you
answered as you did in each case. LO3
Answer:
(a) French fries—market system (rival and excludable).
(b) Court systems—government (nonrival and nonexcludable).
6. Match each of the following characteristics or scenarios with either the term negative
externality or the term positive externality. LO4
a. Overallocation of resources.
b. Tammy installs a very nice front garden, raising the property values of all the other houses on
her block.
c. Market demand curves are too far to the left (too low).
d. Underallocation of resources.
e. Water pollution from a factory forces neighbors to buy water purifiers.
Answer:
a. negative externality Resources are overallocated to products that impose negative
externalities on third parties. This happens because the firms imposing negative
externalities on third parties fail to take into account the costs that would be needed to
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Chapter 04 - Market Failures: Public Goods and Externalities
b. positive externality Tammy’s garden provides a positive externality for her neighbors
c. positive externality Positive externalities cause market demand curves to be too far to
the left (too low) relative to total-benefit demand curves. The problem is that when there
d. positive externality Resources are underallocated to products that impose positive
externalities on third parties. The problem is that when there are positive externalities,
e. negative externality The factory’s water pollution imposes a negative externality on
7. Use marginal cost/marginal benefit analysis to determine if the following statement is true or
false: “The optimal amount of pollution abatement for some substances, say, dirty water from
storm drains, is very low; the optimal amount of abatement for other substances, say, cyanide
poison, is close to 100 percent.” LO5
Answer: Reducing water flow from storm drains has a low marginal benefit, meaning the
MB curve would be located far to the left of where it is in the text diagram. It will
PROBLEMS
1. Refer to Table 4.1. If the six people listed in the table are the only consumers in the market and
the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market
generate? LO2
Answer: $3
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consent of McGraw-Hill Education.
Chapter 04 - Market Failures: Public Goods and Externalities
Feedback: Consider the following table as an example:
Using the values above, and assuming an equilibrium price of $11 (not the $8 shown), we
Bob's consumer surplus is $2 (= $13 - $11)
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consent of McGraw-Hill Education.
