CHAPTER 35
Market Failures
Public Goods, Market Power, and Externalities
LEARNING OBJECTIVES
Define and describe different types of market failures.
Distinguish between private and public goods, and explain why government allocation of
OUTLINE OF CHAPTER
I. Market Failure and the Government
II. Public Goods
III. Externalities
IV. Principles of Taxation: Efficiency versus Equity
Tax Efficiency
Tax Equity
Earmarked Taxes
V. Progressive Criticism of Neoclassical View of Market Failure
VI. Summary
KEY TERMS
ability-to-pay principle
people should pay higher taxes if they receive higher benefits from government programs
exclusion principle
a person using a private good can exclude others from using it
externality
exists whenever the market does not recognize all of the costs or benefits of production or
consumption
ANSWERS TO END OF CHAPTER REVIEW QUESTIONS
Define and describe different types of market failures.
1. What is the definition of a market failure? Why do they occur?
Market failure is a situation in which market outcomes are not socially optimal or
2. Early in the chapter, it was suggested that there is a market failure if ice cream
consumers are not aware of the high fat content of ice cream. Suppose that the
government requires all ice cream producers to label the fat content of their ice cream
and a stern warning that high-fat diets can lead to heart disease. Some people would
ignore the warnings and continue to consume mass quantities of both Ben and
Cherry Garcia and Häagen-
this mean that the labeling did not eliminate the market failure? Why or why not?
If the consumer chose high fat ice cream because of lack of information, i.e., the
Distinguish between private and public goods, and explain why government allocation of
public goods is necessary.
3. What are the two main attributes that distinguish public goods from private goods?
What conditions must hold for optimal allocation of public goods?
A private good is subject to the exclusion principle and rival consumption. Optimal
4. Identify the public good attributes of each of the following. Also, explain how (and if)
these goods could be efficiently provided by the private sector.
a. lighthouse
c. universal health care
d. snow removal service
e. cable television
f. broadcast television
5. The national parks received millions of visitors annually, and there is often a bumper-to-
bumper traffic jam on the roads throughout the parks. Do you think this would be true if
the national parks were sold to private business? Would you favor such a sale? Why or
why not? Can you think of an alternative solution to the crowding problem in the
national parks?
Private businesses would have to change the configuration of national parks to impose
Explain how government policies are used to deal with external costs and benefits.
6. What policies can be used to internalize externalities? Draw diagrams to illustrate your
answer.
A policy of taxing production would be aimed at equating marginal social cost and
7. Suppose that a factory currently dumps waste into the river. Explain how taxes could be
used to solve this problem.
Understand the principles of taxation.
8. Define the benefits-received and the ability-to-pay principles of taxation. How do these
principles relate to tax efficiency and tax equity? What are earmarked taxes?
See definitions above. The benefits-received and ability-to-pay principles are directed at
9. In many states, property taxes are earmarked for public schools. There is the perennial
argument that property owners who do not have children should pay less or even be
exempt from property taxes. Explain why this argument may be fallacious.
10. Many states have policies that tuition at public universities is set at a fixed fraction –
often 20 or 25 percent
reasonable program? Why or why not?
Education at public universities provides positive benefits for society as well as for
APPENDIX 35.1
Further Aspects of Neoclassical Theories of Market Failure
LEARNING OBJECTIVES FOR APPENDIX 35.1
Define the free rider problem and why it happens.
Describe allocative efficiency and why it breaks down.
OUTLINE OF APPENDIX
I. Free Riders
Some Real-World Complications
Property Rights and the Coast Theorem
KEY TERMS
al
locative efficiency
Coase theorem
free rider
transactions costs
ANSWERS TO APPENDIX 35.1 REVIEW QUESTIONS
Define the free rider problem and why it happens.
1.
and give examples.
2. What is it about goods that are not subject to the exclusion principle and non-rival
consumption that lead to free riding? Explain.
Describe allocative efficiency and why it breaks down.
3. Define allocative efficiency. What are two complications that arise when applying the
concept of allocative efficiency?
See definition above. Two complications are that people may not reveal their preferences
receives the same amount of the good regardless of individual preferences.
4. What are some methods that can be used to fund public goods?
Discuss the problems with government provision and allocation of public goods.
5. Is the distinction between public and private goods always clear? Explain and give
examples.
Define the Coase theorem, and describe how it will solve externalities.
6. Explain how application of the Coase theorem would make pollution taxes unnecessary.
Property rights will eliminate the externality of pollution according to Coase in one of
7. Do you think assigning private property rights would get rid of all pollution? Explain.
The Coast theorem does not guarantee that pollution will be eliminated only that
Discuss the real-world problems in the application of the Coase theorem.
8. What might be some problems in assigning private property rights?
Although assignment of property rights does not affect the operation of the Coast
9. What are transactions costs and how to they make the application of the Coase theorem
more difficult?
See definition above. There may be significant transactions costs in setting up a