This chapter discusses market failures including public goods, externalities, and information problems. It explains how perfectly competitive markets can result in inefficient outcomes in these situations. The chapter then analyzes various government policies for addressing market failures, such as taxes, subsidies, and direct provision of goods. Government intervention aims to maximize total surplus by correcting under- or over-allocation of resources relative to the efficient market outcome.

1. Chapter 4
Market Failures: Public Goods and
Externalities
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2. 4-2
Market Failures
• Competitive markets usually allocate
economy’s scarce resources efficiently.
• Market failures: Markets fail to produce the
right amount of the product
• Relative to efficient allocation of resources,
under market failure resources may be
‒ Over-allocated
‒ Under-allocated
LO1

3. 4-3
Demand-Side Market Failures
• Demand-side market failures
• When it is not possible to charge consumers
for the product
• Some can enjoy benefits without paying
• Firms not willing to produce since they cannot
cover the costs
LO1

4. 4-4
Supply-Side Market Failures
• Supply-side market failures
• Occurs when a firm does not pay the full cost
of producing its output
• External costs of producing the good are not
reflected in supply
LO1

5. 4-5
Efficiently Functioning Markets
• Demand curves must reflect the consumers
full willingness to pay
• Supply curve must reflect all the costs of
production
LO2

6. 4-6
Consumer and Producer Surplus
• There is only one price in the market
(equilibrium price) which every consumer
pays and every producer receives.
• At the equilibrium, the market clears –
whoever willing to pay gets products, and
whoever willing to sell produces products.
• However, each consumer may value the
product differently, while each producer
produces at different cost.
LO2

7. 4-7
Consumer Surplus
• Consumer surplus
• Difference between what a consumer is
willing to pay for a good and what the
consumer actually pays
• Extra benefit from paying less than the
maximum price
LO2

8. 4-8
Consumer Surplus
LO2
Consumer Surplus
(1)
Person
(2)
Maximum Price
Willing to Pay
(3)
Actual Price
(Equilibrium
Price)
(4)
Consumer
Surplus
Bob $13 $8 $5 (=$13-$8)
Barb 12 8 4 (=$12-$8)
Bill 11 8 3 (=$11-$8)
Bart 10 8 2 (=$10-$8)
Brent 9 8 1 (= $9-$8)
Betty 8 8 0 (= $8-$8)

9. 4-9
Consumer Surplus
Price(perbag)
Quantity (bags)
D
Q1
P1
Consumer
surplus
Equilibrium
price = $8
LO2

10. 4-10
Producer Surplus
• Producer surplus
• Difference between the actual price a
producer receives and the minimum price
they would accept
• Extra benefit from receiving a higher price
LO2

11. 4-11
Producer Surplus
LO2
Producer Surplus
(1)
Person
(2)
Minimum
Acceptable
Price
(3)
Actual Price
(Equilibrium
Price)
(4)
Producer
Surplus
Carlos $3 $8 $5 (=$8-$3)
Courtney 4 8 4 (=$8-$4)
Chuck 5 8 3 (=$8-$5)
Cindy 6 8 2 (=$8-$6)
Craig 7 8 1 (=$8-$7)
Chad 8 8 0 (=$8-$8)

12. 4-12
Producer Surplus
LO2
Price(perbag)
Quantity (bags)
S
Q1
P1
Equilibrium
price = $8
Producer
surplus

13. 4-13
Total Surplus
• Total surplus: Sum of consumer surplus and
producer surplus
• Total benefits that an economy gains.
• The economy should produce a quantity of
product that maximizes total surplus -
Efficiency.
LO2

14. 4-14
Efficiency Revisited
LO2
Price(perbag)
Quantity (bags)
S
Q1
P1
D
Consumer
surplus
Producer
surplus

15. 4-15
Efficient Allocation
• Productive efficiency
• Producing goods in the least costly way
• Competition forces producers to produce
least costly way
• Allocative efficiency
• Producing the right mix (quantity) of goods
• Competition leads to the equilibrium
quantity where total surplus is maximized
LO4

16. 4-16
Efficient Allocation in Market
System
• Three Conditions at Equilibrium
• MB = MC
‒ MB (Marginal benefit): the benefit that the last
unit in market provides to consumers
‒ MC (Marginal cost): the producer’s cost to
produce the last unit in market
• Maximum willingness to pay = minimum
acceptable price
• Total surplus is at a maximum
LO2

17. 4-17
Efficiency Losses
• If the economy produces more or less than
the optimal quantity at the equilibrium, its
total surplus will be reduced.
• Efficiency losses (or deadweight losses):
reductions of combined consumer surplus and
producer surplus.
LO2

18. 4-18
Efficiency Losses due to
Underproduction
• Efficiency loss (or deadweight losses)
LO2 Quantity (bags)
Price(perbag)
c
S
Q1Q2
D
b
d
a
e
Efficiency loss
from underproduction

19. 4-19
Efficiency Losses due to
Overproduction
LO2
c
S
Q1 Q3
D
b
f
a
g
Quantity (bags)
Price(perbag)
Efficiency loss
from overproduction

20. 4-20
Causes of Efficiency Losses
• The economy may produce more or less than
the optimal quantity at the equilibrium (not
achieve the equilibrium) under
‒ Government’s control of the price or quantity
in the market (Price ceiling and floor)
‒ Government’s taxes and subsidies
‒ Public Goods
‒ Externalities
LO2

21. 4-21
1. The market is efficient
with marginal benefit
equal to marginal cost.
Price Ceiling
Figure shows an efficient
housing market.
2. Consumer surplus plus ...
3. Producer surplus is as
large as possible.

22. 4-22
Price Ceiling
Figure shows the inefficiency
of a rent ceiling.
A rent ceiling restricts the
quantity supplied and
marginal benefit exceeds
marginal cost.

23. 4-23
Price Ceiling
1. Consumer surplus
increases.
2. Producer surplus shrinks.
3. A deadweight loss arises.
Resource use is inefficient.
.
Consumer

24. 4-24
Price Floor
Figure shows an efficient
labor market.
1. At the market equilibrium,
the marginal benefit of
labor to firms equals the
marginal cost of working.
2. The sum of the firms’ and
workers’ surpluses is as
large as possible.

25. 4-25
Price Floor
Figure shows an inefficient
labor market with a
minimum wage.
The minimum wage restricts
the quantity demanded.
1. The firms’ surplus shrinks.
2. The workers’ surplus
shrinks.

26. 4-26
Price Floor
1. The firms’ surplus shrinks.
2. The workers’ surplus
increases.
3. A deadweight loss arises.
The outcome is inefficient.

27. 4-27
Private Goods
• Private goods are mostly produced in the
market by (for-profit) firms
• Rivalry: Once one person buys and
consumes a product, it is no longer
available for another person.
• Excludability: Sellers can keep persons who
do not pay for a product from obtaining its
benefits.
LO3

28. 4-28
Public Goods
• Public goods are most likely provided by
government (because for-profit firms will not
produce them)
• Nonrivalry: One person’s consumption of a
good does not preclude consumption of the
same good by others.
• Nonexcludability: Cannot exclude
individuals from the benefit of the good.
LO3

29. 4-29
Free-Rider Problem
• Free-rider problem: The inability of potential
providers of goods to obtain payment from
those who benefit
• Due to nonexcludability (and nonrivarlry)
• Because of free-rider problem, the public
goods are usually not provided by firms even
though products are desirable for the
economy.
LO3

30. 4-30
Demand for Public Goods
LO3
Demand for a Public Good, Two Individuals
(1)
Quantity of
Public Good
(2)
Adams’ Willingness to
Pay (Price)
(3)
Benson’s
Willingness to
Pay (Price)
(4)
Collective Willingness
to Pay (Price)
1 $4 + $5 = $9
2 3 + 4 = 7
3 2 + 3 = 5
4 1 + 2 = 3
5 0 + 1 = 1

31. 4-31
Demand for Public Goods
LO3
$6
5
4
3
2
1
0
P
Q1 2 3 4 5
$6
5
4
3
2
1
0
P
Q1 2 3 4 5
Adams
Benson
D1
D2
Adams’ Demand
Benson’s Demand
$3 for 2 Items
$4 for 2 Items
$1 for 4 Items
$2 for 4 Items
$9
7
5
3
1
0
P
Q1 2 3 4 5
Collective Demand and Supply
DC
SCollective Demand
$7 for 2 Items
$3 for 4 Items
Optimal
quantity
Collective
willingness
to pay

32. 4-32
Cost-Benefit Analysis
• The government needs to apply the cost-
benefit analysis to determine quantities of
public goods it provides, because the market
system fails to determine the optimal quantity
of production.
• Cost: Resources diverted from private good
production
• Benefit: The extra satisfaction from the output
of more public goods
LO4

33. 4-33
Cost-Benefit Analysis
LO4
Cost-Benefit Analysis for a National Highway Construction Project (in Billions)
(1)
Plan
(2)
Total Cost of
Project
(3)
Marginal
Cost
(4)
Total
Benefit
(5)
Marginal
Benefit
(6)
Net Benefit
(4) – (2)
No new construction $0 $0 $0
A: Widen existing highways 4 $4 5 $5 1
B: New 2-lane highways 10 6 13 8 3
C: New 4-lane highways 18 8 22 10 5
D: New 6-lane highways 28 10 26 3 -2

34. 4-34
Quasi-Public Goods
• Quasi-public goods (private goods by
definition) could be provided through the
market system
• Because of positive externalities the
government provides them
• Examples are education, streets, museums
LO4

35. 4-35
The Reallocation Process
• Government
• Taxes individuals and businesses
• Takes the money and spends on production
of public goods
LO4

36. 4-36
Externalities
• An externality is a cost or benefit accruing to a
third party external to the market transaction
• Positive externalities (benefit to others)
• When a person consumes a good, others
who did not pay benefits from it.
• Negative externalities (cost to others)
• When a person consumes a good, it
imposes costs to others.
LO4

37. 4-37
Positive Externalities
• Only a part of benefits is paid by buyers
• Actual MB to the society is greater than
market demand (MB of persons who pay)
• Too little is produced
• Demand-side market failures
LO4

38. 4-38
Negative Externalities
• Only a part of costs is incurred by producers
• Actual MC (cost to the society) is greater than
market supply (MC of producers)
• Too much is produced
• Supply-side market failures
LO4

39. 4-39
Externalities
LO4
(a)
Negative externalities
(b)
Positive externalities
0
D
S
St
Overallocation
Negative
externalities St
Underallocation
Positive
externalities
Qo Qo
Qe Qe
P P
0
Q Q
D
Dt
a
c
z
x
b y

40. 4-40
Government Intervention
• Correct negative externalities
• Direct controls: Government restriction of
production
• Specific taxes: Raise MC to reflect true cost
to the society
‒ Shift the supply curve up
LO4

41. 4-41
Government Intervention
LO4
(a)
Negative externalities
D
S
St
Overallocation
Negative
externalities
Qo Qe
P
0
Q
a
c
b
(b)
Correct externality with tax
D
S
St
Qo Qe
P
0
Q
a
T

42. 4-42
Government Intervention
• Correct positive externalities
• Government provision: Government produces
additional good to supplement the private
production
• Subsidies to consumers: lower the price to
encourage consumers to purchase more
‒ Raise demand curve
• Subsidies to producers: lower the cost to
encourage producers to produce more
‒ Lower supply curve
LO4

43. 4-43
Government Intervention
LO4
(a)
Positive externalities
0
St
Underallocation
Positive
externalities
QoQe
D
Dt
z
x
y
(b)
Correcting via a subsidy
to consumers
0
St
QoQe
D
Dt
(c)
Correcting via a subsidy
to producers
0
S't
QoQe
D
Subsidy
St
Subsidy
U

44. 4-44
Government Intervention
LO4
Methods for Dealing with Externalities
Problem
Resource Allocation
Outcome Ways to Correct
Negative externalities
(spillover costs)
Overproduction of output
and therefore overallocation
of resources
1. Private bargaining
2. Liability rules and lawsuits
3. Tax on producers
4. Direct controls
5. Market for externality rights
Positive externalities
(spillover benefits)
Underproduction of output
and therefore
underallocation of resources
1. Private bargaining
2. Subsidy to consumers
3. Subsidy to producers
4. Government provision

45. 4-45
Society’s Optimal Amounts
LO5
0
Society’smarginalbenefitandmarginal
costofpollutionabatement(dollars)
Q1
MB
MC
Socially
optimal amount
of pollution
abatement

46. 4-46
Government’s Role in the Economy
• Private solution: Coase theorem
• Private sector bargaining can solve
externality problem
• Government’s role in correcting externalities
• Optimal reduction of an externality
• Officials must correctly identify the
existence and cause
• Has to be done within a political
environment
LO5

47. 4-47
Controlling CO2 Emissions
• Cap and trade
• Sets a cap for the total amount of emissions
• Assigns property rights to pollute
• Rights can then be bought and sold
• Carbon tax
• Raises cost of polluting
• Easier to enforce

48. 4-48
Inadequate Information
• Asymmetric information: One party in
transaction does not know enough about the
other party to make accurate decisions.
• Underallocation of resources
• Better information too costly
LO6

49. 4-49
Inadequate Information
• Moral hazard problem: the risk that one party
to a transaction will engage in activities that
are undesirable from the other party’s point of
view.
• Occurs after the contract is signed
• Once purchased an insurance, buyers may
abuse using insurance.
LO6

50. 4-50
Inadequate Information
• Adverse selection problem: the people who
are the most undesirable from the other
party’s point of view are the ones who are
most likely to want to engage in the
transaction.
• Occurs before the contract is signed
• Those most in need of insurance will be those
who want purchase it most.
LO6

51. 4-51
Lemon Problem
• A lemons problems arises when it is not
possible to distinguish reliable products from
lemons (defective products).
• Buyers are only willing to pay at lemon price.
• Sellers of reliable products exit from market.
• Only lemon products remain in market.

52. 4-52
Principal-agent Problem
• The managers in control (the agent) act in
their own interest rather than in the interest
of the owners (the principal) due to different
sets of the incentives.
• Example: CEO of a corporation only cares
about getting all kind of benefits (luxury
office, chauffeured limousine, personal jet and
cruiser, etc.) which may not bring any benefits
or profits to shareholders of the corporation.

53. 4-53
Conflict of Interest
• Moral hazard problem that occurs when a
person or institution has multiple objectives
(interests) and has conflicts between them.
• Example: Arthur Andersen was supposed to
provide accurate financial information to
holders of Enron stocks (owners of Enron), but
instead it helped top managers of Enron in
expense of stockholders.

54. 4-54
Solutions
• Screening
• Risk-based premium
• Monitoring & Restrictive provision
• Collateral
• Deductible & coinsurance
• Government mandate
• Disclosure requirement
• Government regulation & punishment
LO6