5/28/2023

Chapter 8: The malfunction of

market and the role of government

Introduction
• One type of market failure: externalities.
• Externality: the uncompensated impact of
one person’s actions on the well-being of a bystander
• Negative externality:
the effect on bystanders is adverse
• Positive externality:
the effect on bystanders is beneficial
 Self-interested buyers and sellers neglect the external
effects of their actions, so the market outcome is not efficient.

Pollution: A Negative Externality

• Example of negative externality:
Air pollution from a factory.
• The firm does not bear the full cost of its production,
and so will produce more than the socially efficient quantity.
• How govt may improve the market outcome:
• Impose a tax on the firm equal to the external cost of the pollution it
generates

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Recap of Welfare Economics

P The market for gasoline
$5
The market eq’m
maximizes consumer
+ producer surplus.
4
Supply curve shows private
3 cost, the costs directly
$2.50 incurred by sellers
2
Demand curve shows
private value, the value to
1
buyers (the prices they are
willing to pay)
0
0 10 20 25 30 Q
(gallons)

Analysis of a Negative Externality

P The market for gasoline
$5 Social cost
= private + external cost
4 external
cost Supply (private cost)
3 External cost
= value of the negative
2 impact
on bystanders
1 = $1 per gallon
(value of harm
0 from smog,
0 10 20 30 Q
greenhouse gases)
(gallons)

Analysis of a Negative Externality

P The market for gasoline
The socially
$5 optimal quantity
Social
cost is 20 gallons.
4
S
3

2
D
1

0
0 10 20 25 30 Q
(gallons)

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Analysis of a Negative Externality

P The market for gasoline
$5
Social Market eq’m
cost (Q = 25)
4 is greater than
S
social optimum
3 (Q = 20)

2 One solution:
D tax sellers
1 $1/gallon,
would shift
0 supply curve
0 10 20 25 30 Q up $1.
(gallons)

Other Examples of Negative Externalities

• the neighbor’s barking dog

• late-night stereo blasting from the dorm room next to yours
• noise pollution from construction projects
• talking on cell phone while driving makes the roads less safe for others
• health risk to others from second-hand smoke

Positive Externalities from Education

• A more educated population benefits society:
• lower crime rates: educated people have more opportunities, so less
likely to rob and steal
• better government: educated people make better-informed voters
• People do not consider these external benefits when deciding how
much education to “purchase”
• Result: market eq’m quantity of education too low
• How govt may improve the market outcome:
• subsidize cost of education

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Positive Externalities
• In the presence of a positive externality, the social value of a good includes
• private value – the direct value to buyers
• external benefit – the value of the
positive impact on bystanders.

Analysis of a Positive Externality

Social value The market for education
P
$5 Social value
= private + external value
4 External
benefit S
3 External benefit
= value of the positive
2 impact on bystanders
D = $1 per unit
1

0
0 10 20 25 30 Q

Analysis of a Positive Externality

Social value The market for education
P
The socially
$5 optimal quantity
is 30.
4
S
3
Equilibrium

2
D
1

0
0 10 20 25 30 Q

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Analysis of a Positive Externality

Social value The market for education
P
The socially
$5 optimal quantity
is 30.
4
S Market eq’m
(Q = 25)
3
is lower than
Equilibrium
social optimum
2
(Q = 30)
D
1 One solution:
subsidize sellers
$1/unit,
0
0 10 20 25 30 Q would shift
supply curve
up $1.

Other Examples of Positive Externalities

• Being vaccinated against contagious diseases
protects not only you, but people who visit the salad bar or produce
section after you.
• R&D creates knowledge others can use
• Renovating your house increases neighboring property values

Public Goods
• Free rider
• Person who receives the benefit of a good but avoids paying for it
• The free-rider problem
• Public goods are not excludable, so people have an incentive to be free riders
• Prevents the private market from supplying the goods
• Market failure

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Public Goods
• Government can remedy the free-rider problem
• If total benefits of a public good exceeds its costs
• Provide the public good
• Pay for it with tax revenue
• Make everyone better off
• Problem: Measuring the benefit is usually difficult

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Public Goods
• Some important public goods
• National defense
• Very expensive public good
• $748 billion in 2014
• Basic research
• General knowledge
• Subsidized by government
• The public sector fails to pay for the right amount and the right kinds

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Public Goods
• Some important public goods
• Antipoverty programs financed by taxes
• Welfare system (Temporary Assistance for Needy Families program, TANF)
• Provides a small income for some poor families
• Food stamps (Supplemental Nutrition Assistance Program, SNAP)
• Subsidize the purchase of food for those with low incomes
• Government housing programs
• Make shelter more affordable

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Asymmetric Information
• Asymmetric information occurs when one party to a
transaction has more information than the other.
• Asymmetry information has two types:
• Hidden actions – one person knows more than another
about an action he or she is taking.
• Hidden characteristics – one person knows more than
another about the attributes of good he or she is selling.

• Asymmetry information causes adverse selection and

moral hazard.

Adverse Selection
• Occurs when one party in a transaction has
better information than the other party
• Before transaction occurs
• Ex: The seller knows more than the buyer
about the quality of the used car being sold.

Moral Hazard
• Occurs when one party has an incentive to
behave differently once an agreement is made
between parties
• After transaction occurs
• Ex: Workers sometimes shirk their
responsibilities because their employer cannot
continually monitor their effort and
performance.