Chapter 5: Market Failures: Public Goods and Externalities

Chapter 5Market Failures: Public Goods and ExternalitiesMcGraw-Hill/IrwinCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reservedMarket FailuresMarket fails to produce the right amount of the productResources may beOverallocatedUnderallocated5-*Demand-Side FailuresImpossible to charge consumers what they are willing to pay for the productSome can enjoy benefits without paying5-*Supply-Side FailuresOccurs when a firm does not pay the full cost of producing its outputExternal costs of producing the good are not reflected in supplyLO15-*Efficiently Functioning MarketsDemand curve must reflect the consumers, full willingness to paySupply curve must reflect all the costs of productionLO15-*Private Goods CharacteristicsProduced in the market by firmsOffered for saleCharacteristicsRivalryExcludabilityLO35-*Public Goods CharacteristicsProvided by governmentOffered for freeCharacteristicsNonrivalryNonexcludabilityFree-rider problem5-*Measuring DemandLO3Optimal Quantity 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=$923+4=732+3=541+2=350+1=15-*Cost-Benefit AnalysisCost Resources diverted from private good productionPrivate goods that will not be producedBenefitThe extra satisfaction from the output of more public goods5-*Cost-Benefit AnalysisLO3Cost-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$0A: Widen existing highways4$45$51B: New 2-lane highways1061383C: New 4-lane highways18822104D: New 6-lane highways2810263-25-*ExternalitiesA cost or benefit accruing to a third party external to the transactionPositive externalitiesToo little is producedDemand-side market failuresNegative externalitiesToo much is producedSupply-side market failuresLO45-*ExternalitiesLO4(a)Negative externalities(b)Positive externalities0DSStOverallocationNegativeExternalitiesStUnderallocationPositiveExternalitiesQoQoQeQePP0QQDDtaczxby5-*Government InterventionCorrect negative externalitiesDirect controlsSpecific taxesCorrect positive externalitiesSubsidies and government provision5-*Government Intervention(a)Negative ExternalitiesDSStOverallocationNegativeExternalitiesQoQeP0Qacb(b)Correcting the overallocation of resources via direct controls or via a taxDSStQoQeP0QaT5-*Government Intervention(a)Positive externalities0StUnderallocationPositiveexternalitiesQoQeDDtzxy(b)Correcting via a subsidy to consumers0StQoQeDDt(c)Correcting via a subsidy to producers0S'tQoQeDSubsidyStSubsidyU5-*Government InterventionLO4Methods for Dealing with ExternalitiesProblemResource Allocation OutcomeWays to CorrectNegative externalities(spillover costs)Overproduction of output and therefore overallocation of resourcesPrivate bargainingLiability rules and lawsuitsTax on producersDirect controlsMarket for externality rightsPositive externalities(spillover benefits)Underproduction of output and therefore underallocation of resourcesPrivate bargainingSubsidy to consumersSubsidy to producersGovernment provision5-*Society’s Optimal AmountsLO50Society’s Marginal Benefit and MarginalCost of Pollution Abatement (Dollars)Q1MBMCSociallyOptimal Amountof PollutionAbatement5-*Apportioning the Tax BurdenSize, distribution, and impact of the costs that taxes impose on societyBenefits-received principleAbility-to-pay principle5-*Progressive, Proportional, and Regressive TaxesProgressive tax—average tax rates increase as income increasesRegressive tax—average tax rate declines as income increasesProportional tax—average rate stays the same as income increases5-*Tax Progressivity in the United StatesApplicationsPersonal income tax: progressiveSales tax: regressiveCorporate tax: proportionalPayroll tax: regressive5-*LO1 Personal income tax Progressive tax Marginal tax rate Payroll taxes Corporate income tax Excise taxesTax Progressivity in the United States5-*LO3Type of taxProbable Incidence Personal income taxTax falls on the household or individual on which it is leviedPayroll taxesWorkers pay the full tax levied on their earnings and partof the tax levied on their employersCorporate income taxShort run: Full tax falls on owners of the businessesLong run: Some of the tax may be borne by workers through lower wagesSales taxTax falls on consumers who buy the taxed productsSpecific excise taxesTaxes fall on consumers, producers, or both, depending on elasticity of supply and demandProperty TaxesTaxes fall on owners in the case of land and owner-occupied residences, tenants in the case of rented property, consumers in the case of business propertyTax Progressivity in the United States5-*(1)Total Taxable Income (2)Marginal TaxRate % (3)Total Taxon HighestIncome inBracket (4) Average Tax Rate on Highest Income in Bracket % (3) / (1)$1–$17,00010$ 170010$17,001–$69,00015950014$69,001–$139,5002527,12519$139,501–$212,3002847,50922$212,301–$379,15033103,57027Over $379,15035Federal Personal Tax Rates, 2011** For a married couple filing a joint returnTax Progressivity in the United States5-*Federal tax system is progressiveState and local tax structures are largely regressiveOverall U.S. tax system is progressiveTax Progressivity in the United States5-*Government’s Role in the EconomyGovernment can have a role in correcting externalitiesOfficials must correctly identify the existence and causeHas to be done in the context of politics5-*