Master of Business Administration

GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

Market Failures in Competitive Markets

Fortunately, the broad picture is simple. Market failures in competitive markets fall into just
two categories:

• Demand-side market failures happen when demand curves do not reflect consumers’
full willingness to pay for a good or service.
• Supply-side market failures occur when supply curves do not reflect the full cost of
producing a good or service.

Efficiently Functioning Markets

Consumer Surplus

The benefit surplus received by a consumer or consumers in a market is called consumer

surplus. It is defined as the difference between the maximum price a consumer is (or
consumers are) willing to pay for a product and the actual price that they do pay.

Producer Surplus

Like consumers, producers also receive a benefit surplus in markets. This producer surplus is
the difference between the actual price a producer receives (or producers receive) and the
minimum acceptable price that a consumer would have to pay the producer to make a
particular unit of output available.

The first way to see why Q1 is the allocatively efficient quantity of oranges is to note that
demand and supply curves can be interpreted as measuring marginal benefit (MB) and
marginal cost (MC). Recall from the discussion relating to Figure 1.3 that optimal allocation is
achieved at the output level where MB = MC. We have already seen that supply curves are
marginal cost curves. As it turns out, demand curves are marginal benefit curves. This is true
because the maximum price that a consumer would be willing to pay for any particular unit is
equal to the benefit that she would get if she were to consume that unit. Thus, each point on
a demand curve represents both some consumer’s maximum willingness to pay as well as the
marginal benefit that he or she would get from consuming the particular unit in question.

Efficiency Losses (or Deadweight Losses)

Figures 4.4a and 4.4b demonstrate that efficiency losses—reductions of combined consumer
and producer surplus—result from both underproduction and overproduction.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

Public Goods

Private Goods Characteristics

We have seen that the market system produces a wide range of private goods. These are the
goods offered for sale in Page 83stores, in shops, and on the Internet. Examples include
automobiles, clothing, personal computers, household appliances, and sporting goods.
Private goods are distinguished by rivalry and excludability.

Rivalry (in consumption) means that when one person buys and consumes a product, it is not
available for another person to buy and consume. When Adams purchases and drinks a bottle
of mineral water, it is not available for Benson to purchase and consume.

Excludability means that sellers can keep people who do not pay for a product from obtaining
its benefits. Only people who are willing and able to pay the market price for bottles of water
can obtain these drinks and the benefits they confer.

Because firms can profitably “tap market demand” for private goods, they will produce and
offer them for sale. Consumers demand private goods, and profit-seeking suppliers produce
goods that satisfy the demand.

Public Goods Characteristics

Public goods have the opposite characteristics of private goods. Public goods are distinguished
by nonrivalry and nonexcludability.

Nonrivalry (in consumption) means that one person’s consumption of a good does not
preclude consumption of the good by others. Everyone can simultaneously obtain the benefit
from a public good such as national defense, street lighting, a global positioning system, or
environmental protection.

Nonexcludability means there is no effective way of excluding individuals from the benefit of
the good once it comes into existence. Once in place, you cannot exclude someone from
benefiting from national defense, street lighting, a global positioning system, or
environmental protection.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

These two characteristics create a free-rider problem. Once a producer has provided a public
good, everyone, including nonpayers, can obtain the benefit.

The low or even zero demand caused by free riding makes it virtually impossible for private
firms to profitably provide public goods. With little or no demand, firms cannot effectively
“tap market demand” for revenues and profits. As a result, they will not produce public goods.
Society will therefore suffer efficiency losses because goods for which marginal benefits
exceed marginal costs are not produced. Thus, if society wants a public good to be produced,
it will have to direct government to provide it. Because the public good will still feature
nonexcludability, the government won’t have any better luck preventing free riding or
charging people for it. But because the government can finance the provision of the public
good through the taxation of other things, the government does not have to worry about
profitability. It can therefore provide the public good even when private firms can’t.

Examples of public goods include national defense, outdoor fireworks displays, the light
beams thrown out by lighthouses, public art displays, public music concerts, MP3 music files
posted to file-sharing websites, and ideas and inventions that are not protected by patents or
copyrights.

Optimal Quantity of a Public Good

If consumers need not reveal their true demand for a public good in the marketplace, how can
society determine the optimal amount of that good? The answer is that the government has
to try to estimate the demand for a public good through surveys or public votes. It can then
compare the marginal benefit (MB) of an added unit of the good against the government’s
marginal cost (MC) of providing it. Adhering to the MB = MC rule, government can provide the
“right,” meaning “efficient,” amount of the public good.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

FIGURE 4.5 The optimal amount of a public good. Two people—Adams and Benson—are the only
members of a hypothetical economy. (a) D1 shows Adams’s willingness to pay for various quantities of
a particular public good. (b) D2 shows Benson’s willingness to pay for these same quantities of this
public good. (c) The collective demand for this public good is shown by Dc and is found by summing
vertically Adams’s and Benson’s individual willingness-to-pay curves. The supply (S) of the public good
is upsloping, reflecting rising marginal costs. The optimal amount of the public good is 3 units,
determined by the intersection of Dc and S. At that output, marginal benefit (reflected in the collective
demand curve Dc) equals marginal cost (reflected in the supply curve S).’

What does it mean in Figure 4.5a that, for example, Adams is willing to pay $3 for the second
unit of the public good? It means that Adams expects to receive $3 of extra benefit or utility
from that unit. And we know from our discussion of diminishing marginal utility in Chapter
3 that successive units of any good yield less and less added benefit.

Comparing MB and MC
We can now determine the optimal quantity of the public good. The collective demand curve
Dc in Figure 4.5c measures society’s marginal benefit of each unit of this particular good. The
supply curve S in that figure measures society’s marginal cost of each unit.

Cost-Benefit Analysis
The above example suggests a practical means, called cost-benefit analysis, for deciding
whether to provide a particular public good and how much of it to provide. Like our example,
cost-benefit analysis (or marginal-benefit–marginal-cost analysis) involves a comparison of
marginal costs and marginal benefits.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

Concept

Suppose the federal government is contemplating a highway construction plan. Because the
economy’s resources are limited, any decision to use more resources in the public sector will
mean fewer resources for the private sector. There will be an opportunity cost, as well as a
benefit. The cost is the loss of satisfaction resulting from the accompanying decline in the
production of private goods; the benefit is the extra satisfaction resulting from the output of
more public goods. Should the needed resources be shifted from the private to the public
sector? The answer is yes if the benefit from the extra public goods exceeds the cost that
results from having fewer private goods. The answer is no if the cost of the forgone private
goods is greater than the benefit associated with the extra public goods.

TABLE 4.4 Cost-Benefit Analysis for a National Highway Construction Project (in Billions)

Comparing the marginal cost (the change in total cost) and the marginal benefit (the change
in total benefit) relating to each plan determines the answer. The guideline is well known to
you from previous discussions: Increase an activity, project, or output as long as the marginal
benefit (column 5) exceeds the marginal cost (column 3).

Quasi-Public Goods

Such goods, called quasi-public goods, include education, streets and highways, police and fire
protection, libraries and museums, preventive medicine, and sewage disposal. They could all
be priced and provided by private firms through the market system. But, because the benefits
of these goods flow well beyond the benefit to individual buyers, these goods would be
underproduced by the market system. Therefore, government often provides them to avoid
the underallocation of resources that would otherwise occur.

Externalities

In addition to providing public goods, governments can also improve the allocation of
resources in the economy by correcting for market failures caused by externalities. An
externality occurs when some of the costs or the benefits of a good or service are passed onto
or “spill over to” someone other than the immediate buyer or seller. Such spillovers are called
externalities because they are benefits or costs that accrue to some third party that is external
to the market transaction.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

Negative Externalities

Negative externalities cause supply-side market failures. These failures happen because
producers do not take into account the costs that their negative externalities impose on
others. This failure to account for all production costs causes firms’ supply curves to shift to
the right of (or below) where they would be if firms properly accounted for all costs.
FIGURE 4.6 Negative externalities and positive externalities. (a) With negative externalities borne by
society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St.
Consequently, the equilibrium output Qe is greater than the optimal output Qo, and the efficiency loss
is abc. (b) When positive externalities accrue to society, the market demand curve D is to the left of
(below) the total-benefit demand curve Dt. As a result, the equilibrium output Qe is less than the
optimal output Qo, and the efficiency loss is xyz.

The outcome is shown in Figure 4.6a, where equilibrium output Qe is larger than the optimal

The outcome is shown in Figure 4.6a, where equilibrium output Qe is larger than the optimal
output Qo. This means that resources are overallocated to the production of this commodity;
too many units of it are produced.

Positive Externalities

This failure to account for all benefits shifts market demand curves to the left of (or below)
where they would be if they included all benefits and the willingness to pay of both the third
parties as well as the primary beneficiaries. Because demand curves fail to take into account
all benefits when there are positive externalities, markets in such cases fail to produce all units
for which benefits (including those that are received by third parties) exceed costs. As a result,
products featuring positive externalities are underproduced.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

Government Intervention

Government intervention may be called upon to achieve economic efficiency when

externalities affect large numbers of people or when community interests are at stake.

The direct way to reduce negative externalities from a certain activity is to pass legislation
limiting that activity.

Subsidies and Government Provision

Where spillover benefits are large and diffuse, as in our earlier example of inoculations,
government has three options for correcting the underallocation of resources:

Subsidies to buyers - Figure 4.8a again shows the supply-demand situation for positive
externalities. Government could correct the underallocation of resources, for example, to
inoculations, by subsidizing consumers of the product. It could give each new mother in the
United States a discount coupon to be used to obtain a series of inoculations for her child. The
coupon would reduce the “price” to the mother by, say, 50 percent. As shown in Figure 4.8b,
this program would shift the demand curve for inoculations from too-low D to the appropriate
Dt. The number of inoculations would rise from Qe to the economically optimal Qo,
eliminating the underallocation of resources and efficiency loss shown in Figure 4.8a.
FIGURE 4.8 Correcting for positive externalities. (a) Positive externalities result in an underallocation
of resources. (b) This underallocation can be corrected through a subsidy to consumers, which shifts
market demand from D to Dt and increases output from Qe to Qo. (c) Alternatively, the underallocation
can be eliminated by providing producers with a subsidy of U, which shifts their supply curve
from St to St′, increasing output from Qe to Qo and eliminating the underallocation, and thus the
efficiency loss, shown in graph a.

Subsidies to producers - A subsidy to producers is a tax in reverse. Taxes are payments to the
government that increase producers’ costs. Subsidies are payments from the government that
decrease producers’ costs. As shown in Figure 4.8c, a subsidy of U per inoculation to physicians
and medical clinics would reduce their marginal costs and shift their supply curve rightward

Government provision - Finally, where positive externalities are extremely large, the
government may decide to provide the product for free to everyone. The U.S. government
largely eradicated the crippling disease polio by administering free vaccines to all children.
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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 2, Chapter 4: Market Failures: Public Goods and Externalities

India ended smallpox by paying people in rural areas to come to public clinics to have their
children vaccinated.

Government’s Role in the Economy

Market failures can be used to justify government interventions in the economy.

Policies for coping with the overallocation of resources, and therefore efficiency losses,
caused by negative externalities are (a) private bargaining, (b) liability rules and lawsuits, (c)
direct controls, (d) specific taxes, and (e) markets for externality rights.

End of Chapter excerpts. For wider reading coverage, please refer to the eBook provided in this course.

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