Course Outline
• Role of government
Lecture 6
Dominika Milczarek-Andrzejewska
•
•
•
•
Government and
Market Failure
Public goods
Cost-benefit analysis
Externalities
Reducing the misallocation problem
2
Public Goods
Public Goods
• Public goods
• Goods and services that are provided by
government
are nonrival and nonexcludable
• Why the private sector does not provide
these goods and services efficiently?
suffer from the free-rider problem
a consumer can enjoy the benefit of the good
without having to pay for the benefit
• What is the role of government in bringing
about a better allocation of resources?
3
4
Demand for Public Goods
Optimal Amount of A Public Good
• Differs from the market demand for private
goods
$9 P
• Adding the prices people collectively are willing
to pay for the last unit of the public good at each
quantity demanded
5
When vertically
added equals
collective
willingness
to pay
7
3
D2
D1
1
0
5
1
1
2
3
4
DC
5 Q
6
Optimal Amount of A Public Good
Optimal Amount of A Public Good
$9 P
• The supply curve for any good is its marginal
cost curve
7
• The optimal quantity of a public good can be
determined
3
by looking at the demand and supply (marginal cost)
schedules to see at what price and quantity marginal
benefit equals marginal cost
1
1
2
3
4
5 Q
8
Cost-Benefit Analysis
Optimal Amount of A Public Good
S
7
DC
0
7
P
The public good’s
marginal cost
as shown by S
5
by comparing the collective demand curve with the
supply (marginal cost) curve point of intersection or
$9
S
• Technique for decision making in the public
sector
Yields the
optimum amount
of the public good
• Comparing the benefit of providing incremental
units of public goods with the costs of providing
these additional units
5
MB = MC
3
• If MC > MB => that part of the project should
not be included
DC
1
0
1
2
3
4
5 Q
9
10
Spillover Costs
Externalities
P
St
Spillover
costs
• Externalities or spillovers
S
– A cost or a benefit accruing to an individual
or a group – a third party – that is external to
a market transaction
– Negative and positive externalities
Overallocation
11
0
2
Q0
Qe
D
Q
12
Spillover Benefits
Reducing the externality problem
St
P
• Individual bargaining (Coase Theorem)
Spillover
Benefits
• Liability rules and lawsuits
• Government intervention
– Direct controls
– Specific taxes
Dt
Underallocation
0
Qe
– Subsidies and government provision
• Markets for externality rights
D
Q0
Q
13
14
Individual Bargaining
Liability rules and lawsuits
• The Coase theorem suggests that spillover
costs and benefits will not occur and
government intervention is not necessary
when:
• If one property owner damages another
– A private lawsuit may settle the dispute by
assessing damage liability on the violator
• Limitations:
– property rights are clearly defined
– Cost and organization of the suit
– the number of people involved is small
– and bargaining costs are negligible
15
16
Government Intervention
Correcting Spillover Costs - tax
P
• Direct controls - placing limits on the
amount of the offensive activity
St
Spillover
costs
S
TAX
Overallocation
Corrected
17
0
3
Q0
Qe
D
Q
18
Correcting Spillover Costs
– Subsidy to Producers
Correcting Spillover Costs
– Subsidy to Consumers
P
St
Subsidy to
producers
increases
supply
P
S
S’t
Subsidy to
consumer
increases
demand
Dt
D
Underallocation
Corrected
0
Qe
Q0
Underallocation
Corrected
Q
19
0
Markets for Externality Rights
Qe
Q0
D
Q
20
Markets for Externality Rights
• Policy innovation for dealing with
pollution abatement
• A pollution-control agency
21
Source: McConell and Brue 2005
Key Terms
•
•
•
•
•
•
Public goods
Cost-benefit analysis
Marginal-cost – marginal-benefit rule
Externalities
Coase theorem
Market for externality rights
23
4
22