Unit 2.4 Market Failure

Unit 2.
4 Market Failure
Unit 2.4: Market Failure and the Role of Government

Unit Overview
Reasons for market failure

• Positive and negative externalities, with appropriate diagrams
• Short-term and long-term environmental concerns, with reference to sustainable
development (IB only)
• Lack of public goods
• Underprovision of merit goods
• Overprovision of demerit goods
• Abuse of monopoly power
Possible government responses

• Legislation
• Direct provision of merit and public goods
• Taxation
• Subsidies
• Tradable permits
• Extension of property rights
• Advertising to encourage or discourage consumption
• International cooperation among governments
Blog posts: "Market Failure" Blog posts: "Environment"
Blog posts: "Public goods" Blog posts: "Externalities"
www.welkerswikinomics.com 1
Unit 2.4 Market Failure
Market Failure
Introduction
Discussion Questions:
1) What is market economics and why do we study it?
2) What types of markets are efficient? What types of market are inefficient?
3) Identify the various roles government has played in our study of

economics up to this point.
4) Identify two examples of instances in which the economic behavior of one

individual has a negative effect on another individual.
6) What are some examples of goods or services that you've consumed that
were not provided by the free market?
7) What is a "market failure"?
Market Failure
Introduction
Market Failure: The market has failed when it results in either an over
or an under-allocation of resources towards a particular product.
Examples of markets failing:
• The market has failed because too many cigarettes are being
produced and consumed in the world today.
• The market has failed because without state funded public

schools, not enough educational institutions would be available for
the nation's youth.
• The market has failed because without the government providing

an Army, Navy and Air Force, not enough national defense would
be provided for the country's citizens.
• The market has failed because too many people have driven SUVs
for too long, resulting in greenhouse gasses to concentrate in the
earth's atmosphere, contributing to global warming.
Audio examples of market failure
Nauru.mp3 E-waste.mp3 Trash Island.mp3
Market Failure
Types of market failure
Sometimes markets fail by...
Not providing ANY of a particular good or service that benefits society,

i.e. national defense, street lights, paved roads, park benches, city
parks, etc. These things are called...
Public goods: goods and services that will not be provided by the free
market. Government must provide public goods.
Not providing ENOUGH of a particular good or service that benefits

society, i.e. education, health care, sporting events, scientific research,
museums, rail transportation, airports, art, etc. These things are called...
Merit goods: goods and services that are under-provided by the free
market. Government may choose to help subsidize or provide merit
goods.
Market Failure
Providing TOO MUCH of a particular good or service that harms others
in society, i.e. tobacco, heroine, child pornogrophy, coal-generated
electricity, greenhouse gas-intensive industry, alcohol, etc. These things
are called...
Demerit goods: goods and services that are over-provided by the free
market. Government is needed to regulate the production and
consumption of these goods, either through taxes, direct controls, bans,
etc...
Global warming a "giant market failures"?.mp3
Market Failure and Externalities...

Positive Externalities: When the production or consumption of a product creates
external benefits for a third party not involved in the market transaction, or for
society as a whole. Merit goods create positive externalities of consumption.
Negative Externalitites: When the production or consumption of a product places

external costs on a third party not involved in the market transaction, or society as
a whole. Demerit goods create negative externalities of consumption or production.
Intro to externalities: The Story of Stuff with Annie Leonard
Market Failure
How is the global financial crisis a result of a market failure?

Information Asymmetry: When the consumers or producers of a particular
good or service, (or financial asset) make their decisions based on
imperfect information.
Information asymmetry in the financial markets: A crash course!
• Americans bought homes in growing numbers in the '90s and early 2000s under the assumption that house
prices would always rise. Banks made loans to Americans who normally wouldn't qualify for loans under the
same assumption.
• Banks "bundled" these loans into securities that they sold to investors all over the world, who assumed that
the lending banks were correct in their assumption that house prices would continue to rise.
• Developers built houses in record numbers based on the assumption that they'd be able to sell them at higher
and higher prices.
• Supply of houses grew faster than demand, and eventually house prices began to fall.
• Borrowers found they could not make their monthly payments because their loans were "adjustable rate"
meaning they required higher payments over time, causing foreclosures to increase and the supply of houses
for sale to grow even more, forcing prices down even more.
• Now investors and banks all over the world hold securities made up of bad loans to Americans that were
made based on the incorrect assumption that house prices would always rise. With bad assets on their
"balance sheets" banks are unable to make new loans to consumers and firms, so spending in the economy has
slowed, meaning recession and high unemployment.
Imperfect information about the true value of houses led to an over-

allocation of the world's financial resources towards the US housing market!
Market Failure
Public Goods
What are three goods or services from which you have benefited in the last
year that were provided by the free market? Three goods that were not?
Private goods: Public goods:

• ________________ • _________________
• ________________ • _________________
• ________________ • _________________
Private goods are:

• Rivalrous in consumption: When I purchase and use an iPod, it is not
available for another person's purchase and consumption.
• Excludable by seller: Apple can keep people who do not pay for an iPod from
obtaining its benefits. Only people who are willing to pay for an iPod can
enjoy its benefits.
Because of their rivalry and excludability, firms in a free market find it profitable
to produce and sell private goods.
Market Failure
Public Goods
Public goods: or social goods would not be produced through the

market, because they are non-rivalrous and are not subject to the
exclusion principle.
Public goods are:

• Nonrivalrous: one person's consumption of a good does not prevent
others from consuming it too.
• Nonexcludable: once the good comes into existence (it is produced), it is

impossible from excluding certain individuals from benefiting from it.
These characteristics create the free-rider problem. No one will voluntarily pay
for a product or service they could just as easily consume without paying for. Since
firms cannot effectively "tap the market demand", they will simply not produce
public goods.
Resources are reallocated from private to public use by levying taxes on households
and businesses government uses tax revenue to provide the public goods, correcting
the market failure.
Blog posts: "Public goods"
Market Failure
Public Goods
Below are a selection of goods or services you may have "consumed" recently.
• Which are "private goods", i.e. rivalrous and excludable?
• Which are "public goods", i.e. nonrivalrous and nonexcludable?
Private goods Public goods
Market Failure
Public Goods
Demand for public goods: NATIONAL DEFENSE - Every individual in society may have
a different demand for national defense.
• Jimmy may be willing to spend $200 a year for one tank to provide military protection.
• Jenny, a pacifist, may only be willing to pay $50 a year to build tanks.
If Jimmy and Jenny are the only two people in the country, then the total willingness to
pay for 1 tanks for military protection is only $250. The government will clearly not be
able to provide even one tank. However, since there are millions of people like Jimmy
and Jenny, society's total willingness to pay for military protection is significantly
greater than $250.
Quantity of tanks Society's Marginal Benefit (millions) Marginal Cost of tanks (millions)
100 $250 $35
200 $190 $55
300 $130 $90
400 $70 $145
500 $30 $210
Marginal Social Benefit and Marginal Social Cost:

• As the number of tanks increases, the society's marginal benefit from additional
tanks declines. This is due to the law of diminishing marginal utility
• As the number of tanks increases, the marginal cost to society of producing more
tanks increases. This is due to the law of diminishing returns
Market Failure
Public Goods
What is the optimal quantity of tanks for the government to provide?

B/C
To determine the optimal 250 Marginal
quantity of tanks, the 225
social cost
government should
compare society's marginal 200
benefit (demand for tanks) 175

to the marginal cost of 150
providing tanks (the supply
of tanks). 125
100
The government should
75
provide tanks up to the
point where the marginal 50
benefit equals the marginal 25 Marginal
cost. social benefit
1 2 3 4 5 Q
Conclusion: firms in a free market would provide ZERO tanks for military protection, since their
benefits are non-rivalrous and non-excludable. Therefore, the government should do so, up to the
point where the MB to society equals the MC to society.
Practice Public Goods: NCEE workbook Activities 52 and 53
Market Failure
Public Goods
Private vs. Public - the never-ending debate! Move the following goods or
services to where they belong along the spectrum.
Rivalrous/Exclusive Shared/Nonexclusive
Purely Private Quasi-public Purely Public

Health care Elementary schooling
National rail line
National Defense
Professional sports events Water
College education
Groceries Postal service
Interstate highway facilities
Cable TV Garbage collection
Radio Park benches

Recreational facilities Police protection
Electric power
Based on the outcome of the activity above, which goods should be provided
by government, which by the free market and which are uncertain?
Free market? Uncertain? Government?

What are the implications for government, for politicians, for households and businesses of your
conclusions? What makes the provision of public goods such a sensitive political topic?
Market Failure
The Tragedy of the Commons
The Tragedy of the Commons: an Essay by Garrett Hardin, 1968

The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected
that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement
may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the
numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes
the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality.
At this point, the inherent logic of the commons remorselessly generates tragedy.
As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less
consciously, he asks, "What is the utility to me of adding one more animal to my herd?" This utility
has one negative and one positive component.
1) The positive component is a function of the increment of one animal. Since the herdsman receives
all the proceeds from the sale of the additional animal, the positive utility is nearly +1.
2) The negative component is a function of the additional overgrazing created by one more animal.
Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any
particular decision-making herdsman is only a fraction of -1.
(Welker's thoughts: as we know, rational beings humans base all decisions on marginal benefit /
marginal cost analysis. For this herdsman, the marginal benefit of grazing one more animal will
always exceed the marginal cost since the cost is shared by all herdsemen, but the benefit accrues
only to himself)
Adding together the component partial utilities, the rational herdsman concludes that the only
sensible course for him to pursue is to add another animal to his herd. And another; and another....
But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is
the tragedy. Each man is locked into a system that compels him to increase his herd without
limit--in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his
own best interest in a society that believes in the freedom of the commons. Freedom in a commons
brings ruin to all.
Market Failure
Examples of "the Commons" Public land and the open seas

Even at this late date, cattlemen leasing national land on the western ranges
demonstrate no more than an ambivalent understanding, in constantly pressuring
federal authorities to increase the head count to the point where overgrazing
produces erosion and weed-dominance. Likewise, the oceans of the world continue to
suffer from the survival of the philosophy of the commons. Maritime nations still
respond automatically to the shibboleth of the "freedom of the seas." Professing to
believe in "the inexhaustible resources of the oceans," they bring species after
species of fish and whales closer to extinction (9).
The National Parks present another instance of the working out of the tragedy of the
commons. At present, they are open to all, without limit. The parks themselves are
limited in extent--there is only one Yosemite Valley--whereas population seems to
grow without limit. The values that visitors seek the parks are steadily eroded. Plainly,
we must soon cease to treat the parks as commons or they will be of no value
anyone.
What shall we do? We have several options. We might sell them off as private
property. We might keep them as public property, but allocate the right enter
them. The allocation might be on the basis of wealth, by the use of an auction system.
It might be on the basis merit, as defined by some agreed-upon standards. It might be
by lottery. Or it might be on a first-come, first-served basis, administered to long
queues. These, I think, are all the reasonable possibilities. They are all objectionable.
But we must choose--or acquiesce in the destruction of the commons that we call our
National Parks.
Market Failure
Examples of "the Commons": The air we breath and the water we drink
In a reverse way, the tragedy of the commons reappears in problems of pollution.
Here it is not a question of taking something out of the commons, but of putting
something in--sewage, or chemical, radioactive, and heat wastes into water; noxious
and dangerous fumes into the air, and distracting and unpleasant advertising signs
into the line of sight. The calculations of utility are much the same as before. The
rational man finds that his share of the cost of the wastes he discharges into the
commons is less than the cost of purifying his wastes before releasing them. Since
this is true for everyone, we are locked into a system of "fouling our own nest," so
long as we behave only as independent, rational, free-enterprises.
The tragedy of the commons as a food basket is averted by private property, or

something formally like it. But the air and waters surrounding us cannot readily be
fenced, and so the tragedy of the commons as a cesspool must be prevented by
different means, by coercive laws or taxing devices that make it cheaper for the
polluter to treat his pollutants than to discharge them untreated. We have not
progressed as far with the solution of this problem as we have with the first. Indeed,
our particular concept of private property, which deters us from exhausting the
positive resources of the earth, favors pollution. The owner of a factory on the bank
of a stream--whose property extends to the middle of the stream, often has difficulty
seeing why it is not his natural right to muddy the waters flowing past his door. The
law, always behind the times, requires elaborate stitching and fitting to adapt it to
this newly perceived aspect of the commons.
The pollution problem is a consequence of population. It did not much matter how a
lonely American frontiersman disposed of his waste. "Flowing water purifies itself
every 10 miles," my grandfather used to say, and the myth was near enough to the
truth when he was a boy, for there were not too many people. But as population
became denser, the natural chemical and biological recycling processes became
overloaded, calling for a redefinition of property rights.
Market Failure
1. What is Garret Hardin most concerned about?
2. How can "the commons" best be defined?
3. Are individuals who overuse "the commons" acting irrationally? Explain.
4. Besides the "common pasture", what other resources does Hardin identify as
"commons"?
5. What are some of the possible solutions he suggests for the problems faced
by America's National Parks?
6. How are air and water different from pastures, the oceans, and national parks
in the "tragedy" presented by the common resources?
7. What are some of the possible solutions Hardin suggests for the "cesspool"
tragedy represented by the pollution of our air and water?
8. What do you think a hard-core, free-markete economist would say is the

solution to "the tragedy of the commons"?
Market Failure
Negative Externalities
Negative externality: A negative externality occurs anytime an individual or a

group that plays no part in a market transaction is negatively affected by
bearing some of the costs of someone else's transaction.
"The Middle of Nowhere".mp3
Questions on audio:
1) What is the "tragedy of the commons" as portrayed in this story?
2) What is the market failure present in the story?
3) Why is it impossible to get anyone to do anything about the problem?
Cause of negative externalities: Over-allocation of resources towards

products that have spillover costs associated with either their production
or consumption.
Consumption: Unertain? Production:
traffic water pollution
cigarette smoke
airport noise drunk driving
air pollution fast food
acid rain body oder
over-fishing global warming
nuclear waste
Effects: spillover costs born by groups external to the market

transaction (sometimes society as a whole).
Market Failure
Negative Externalities of production
Graphical portrayal of a negative externality of production.
Polluting industry D=MSB: Marginal social benefit. This

represents the amount of output demanded by
B/C S=MSC society at different prices. Due to diminishing
S=MPC utility, society's marginal benefit declines the
more output is provided.
distance b/w MPC S=MPC: Marginal private cost. Because the

Cso & MSC = external costs producer is able to externalize some of its
costs, its MC is lower than it would be were it
Ce to bear all the costs of production.
S=MSC: Marginal social cost. Since some of

the costs of production are externalized, they
DWL are ultimately born by society. The cost to
society is greater than the cost to the
individual firm.
D=MSB
Qe > Qso: Equilibrium quantity is greater than
Qso Qe Q the socially-optimal quantity. Represents
overallocation of resources towards this
Qe > Qso: resources are
over-allocated towards
product.
the polluting industry
Market Failure
Government solution to negative externality of production: CORRECTIVE TAX!
Polluting Industry
Corrective taxes: can be levied on
S+tax=MSC polluters.
P
S=MPC • The tax payment will increase costs to the
producer, shifting the product supply curve
leftward, and reducing resource allocation to
Pb-Ps=
this type of production as desired.
Pb amount of tax
C • Notice that in the case of a tax, the burden is
Pe not placed entirely on the sellers, rather it's
P shared by consumers and producers of the
Ps harmful product.
• The challenge to policymakers is to set the

level of the tax as close as possible to the
D=MSB amount of the costs externalized by the firm
on society.
Qso Qe Q • The result is a higher price paid by
consumers, lower quantity demanded, and tax
revenue for the government. Fewer resources
C = consumer tax burden are allocated towards the polluting industry
P = producer tax burden after the tax.
Market Failure
Alternative to corrective taxes: DIRECT GOVERNMENT CONTROLS

Direct controls: Governments may choose to legislate pollution control.
Requiring firms to limit their emissions of harmful pollutants presents
challenges of its own.
• Monitoring: The government must monitor emissions of polluters, which

can be costly and difficult.
• Enforcement: The government must have a way to enforce legislation on

polluters.
• Penalties: The penalties for violations must be significant enough to

dissuade firms from ignoring legislation
• Incentives: If the penalty is not harsh enough, the firm will simply ignore
regulations and pollute anyway. The fine must be greater than the cost of
pollution abatement, otherwise firms will keep polluting.
Market Failure
Alternative to corrective taxes: DIRECT GOVERNMENT CONTROLS

Polluting Industry
Swith abatement costs The intended effect of direct
P
S=MPC
government control is to force
the polluters to incur costs
Pb-Ps=cost of pollution associated with pollution control.
Pb abatement
Firms forced to reduce their
Pe pollution will face higher costs,
shifting the market supply curve
for a polluting product to the left.
Equilibrium quantity should fall
closer to the socially optimal
D=MSB level.
Qso Qe Q
Clean air and water legislation and "CAFE" standards are examples.
Corporate Average Fuel Economy - Wikipedia

Clean Water Act - Wikipedia Clean Air Act - Wikipedia
Market Failure
Discussion Question:
Why doesn't the government simply ban the production and consumption of
all goods that cause negative externalities?
What are two alternatives to a complete ban a government can use to

correct such a market failure? Give an example of each.
Example of direct government control: the "CAFE" standards:

"The Corporate Average Fuel Economy (CAFE) regulations in the United States,
first enacted by Congress in 1975, are federal regulations intended to
improve the average fuel economy of cars and light trucks (trucks, vans and
sport utility vehicles) sold in the US in the wake of the 1973 Arab Oil
Embargo." -from Wikipedia
Alternatives to direct government controls:
Blog post: "When more tax is a good tax"

Blog post: "Reducing negative externalities –
the European market for carbon emissions"
Market Failure
The latest, most innovative method for combating pollution and global warming is
a market for pollution rights.
Carbon Market How it works:
S2012 • A government or multi-national governing
S2008=supply of carbon body issues or auctions off permits to
emmissions permits polluting industries which allow them to
(determined by officials emit a certain amount of carbon.
based on environmental
Price per pollution right
studies) • Some firms pollute beyond their permitted

amount, so will either have to acquire more
P2012 permits or reduce their emissions.
• To acquire more permits, they must buy

them from in the market from firms that do
not need all of their permits.
P2008
D2012 • The supply of permits is fixed and
determined by the government, the demand
D2008 for permits therefore determines the price of
pollution. The more firms want to pollute,
the more expensive it becomes to pollute.
Q2012 Q2008
Quantity of pollution rights • There is a strong incentive for firms to
reduce their emissions, because they can
then sell the permits they do not need,
"Tighter European limits set to
adding to firm profit.
push up price of carbon emissions"
"Price of carbon in Europe is

expected to rise"
Market Failure
Tradeable pollution permits, how they work:

Carbon Market
• A pollution-control agency decides the acceptable
amount of pollution in a particular region and creates S=supply of
pollution rights
rights that firms can purchase to allow them to (determined by
Price per pollution right

pollute. Each right will allow a certain amount of officials based on
pollution. The total supply of rights is perfectly environmental
P2018 studies)
inelastic
• The demand for pollution rights should be
downward sloping. At high prices, firms will either
P2008
stop polluting or pollute less by acquiring pollution- D2018
abatement equipment, which is more attractive when
the rights are more expensive.
• With the given supply of rights, and a demand for D2008
rights, an equilibrium price will be established for Qso

Quantity of pollution rights
each right to pollute.
There are several advantages to this system:

• It reduces society’s costs because pollution rights can be bought and sold. Some firms will
find it cheaper to buy the rights than to acquire abatement equipment; other firms can sell
their rights because they may be able to reduce pollution at a lower cost.
• Conservation groups as well as producers can buy rights. If conservation groups are
unhappy with the existing amount of pollution, they can acquire pollution rights and hold
them. Drives up the price of remaining rights, further encouraging polluters to reduce
emissions.
• The revenue from the sale of pollution rights could be used to improve the environment.
• The rising cost of pollution rights should lead to improved pollution-control techniques.
Market Failure
Positive Externalities of consumption
Definition of positive externality of consumption: Exists when the consumption of a good or

service leads to benefits to society that are greater than the benefits to the individual consuming
the good or service.
Examples:
• vaccinations: when anyone receives a vaccine, everyone benefits b/c of the reduced
likelihood of a disease spreading.
• education: if you receive a college education, the people around you will benefit
because you will be a more productive member of the economy. As more people
receive educations, more uneducated people benefit as the workforce as a whole
becomes more productive and society becomes richer.
• condoms: (probably not in your textbook), for the same reason as vaccinations,
basically.
• healthy school lunches: healthier kids means less demand for thus lower health care
costs, good for all of society!
the list goes on and on... sometimes good that create positive externalities are called
"MERIT GOODS". Merit is defined as "something that deserves or justifies a reward or
commendation"
Cause of positive externalities: Underallocation of resources towards products that

have spillover benefits associated with either their consumption.
Market Failure
Graphical portrayal of positive externalities of consumption

D=MPB: Represents the private benefit an
Market for college education individual receives from the consumption of a
"merit good".
B/C S=MSC MPB is less than D=MSB, since society as a
whole benefits more than the individual
alone from the consumption of the merit
good.
Bso
S=MSC: Represents the marginal cost of
Be producing the merit good. Since most merit
goods create spillover costs from their
DWL consumption, we are only concerned here with
the social cost (there is no difference between
D=MSB
MSC and MPC as in the case of negative
externalities.
D=MPB
Qso - Qe: Represents the underallocation of
resources towards the merit good.
Qe Qso Q
Market Failure
Goods which create positive externalities of consumption represent a market failure

because resources will be UNDER-allocated towards these goods if the free market is
left to itself.
P Pos. Ext of Consumption
Government response to the
existence of positive externalities: MSC
Subsidies to producers: lower

costs to producers of the merit
good. Lower costs shift market P1
supply out, lowering the price to Pe
consumers and increasing quantity
demanded.
MSB
Subsidies to consumers:
MPB
Government may help pay for part
of a merit good, increasing demand Q
Qe Qso
Government provision: Resources are underallocated when
Government pay chose to provide there's a positive externality
merit goods.
Merit goods vs. Public goods, what's the difference? A merit good will be provided
by the free market, just under-provided. A public good will not be provided by the
free market thus must be provided by government!
Market Failure
Market for college education Using subsidies, the government can

(subsidize universities) S
P correct the market failure of too few
resources being allocated towards merit
S+subsidy goods
size of Subsidize consumers: Shift demand

subsidy curve out, increasing price, but the
price increase would not be born by
Ps consumers, rather, the government.
D+subsidy
Subsidize producers: Would shift S out,
D=MPB increasing output and lowering price.
Qso Q Government provision: Some merit

goods may just be provided by the
government, if the free market fails to
Examples: provide them. These are public goods.
• free and reduced lunches
• subsidized student loans
• free flu shots
• free condoms at some public schools
Market Failure
What is the difference between a negative externality and a positive

externality?
If positive externalities are so positive, what makes them a market failure?
If taxes can be used to correct a negative externality, what type of

government measure can be used to correct a positive externality?
Positive externality of consumption: When one person's consumption of a

particular good or service has positive spillover effects on those around them or
on society as a whole. The marginal social benefit of consumption exceeds the
marginal private benefit.
Examples: vaccines, education, flower gardens, driver's training courses,

hybrid cars, bicycles, renewable energies, Others?
Goods that create positive externalities and are under-provided

by the market are called MERIT GOODS
Market Failure
Negative Externalities of consumption
Negative externalities of consumption exist when the consumption of a particular

good by one individual places spillover costs on others who do not participate in the
original transaction.
Negative Ext of Consumption MPB: the benefit to the individual of

C/B
consuming the good.
MSC MSB: the benefit to society of derived

from the consumption of the good.
Be MPB>MSB: the individual consumer

DWL benefits more from the consumption of
Bso a good than society as a whole. There
are spillover costs of consumption not
experienced by the consumer himself.
D=MPB
Since consumers base their decisions
D=MSB on their own self-interest, Qe will be
consumed, which is greater than Qso,
Qso Qe the socially optimal quantity.
Q
Resources are over-allocated towards goods that create negative externalities
of consumption. These are called "demerit goods"
Market Failure
Government solution to negative externality of consumption: CORRECTIVE TAX!
P Negative Ext of Consumption Corrective tax shifts the market

S+tax supply to the left, increasing the
equilibrium price, and reducing the
S=MSC
quantity demanded by consumers to
P1 the socially optimal level.
Pe
Examples:
• Alcohol taxes
• Cigarette taxes
• Petrol taxes
D=MPB
• Garbage bags in Zurich
D=MSB • Plastic bags at grocery stores
Qso Qe Q
Blot posts: "Externalities"
Market Failure
Gov't solution to negative externality of consumption: Negative advertising
P Negative Ext of Consumption

Negative advertising can be used to
S=MSC=MPC decrease the marginal private benefit
to consumers of the good. If MPB falls
it will be closer to the MSB, resulting in
a more efficient allocation of
Pe resources.
Examples:
• "Don't drink and drive" campaigns
D=MPB • Anti-smoking campaigns
• Drug awareness programs
D=MSB • Harsh punishments for drug and
alcohol violations
Qso Qe Q
Tax Incidence
and Deadweight Loss
When does an excise tax create a loss of welfare to society? When the good being taxed was
already being produced at the socially optimal level!
When does an excise tax create an improvement in welfare? When the good being taxes was
being over-produced by the free market.
Market for De-merit good S+tax=MSC Market for a normal good

S+tax
P MPC P MPC = MSC
Pso Pt
Pe Pe DWL
MSB MSB
Qso Qe Q Qt Qe Q
Tax Incidence
and Price Elasticity of Demand
The government has decided to place a tax (let's say $5) on a product to reduce its
consumption and to raise revenues. Questions: 1) In which market will consumption be reduced
the most by the tax? 2) In which market will consumers bear the largest burden of the tax? 3) Producers? 4)
In which market will the most revenue be raised by the tax? 5) What conclusions can you make about the
relationship between PED and tax incidence?
Cigarette Market
S+tax S+tax
Luxury Handbag Market
P S P S
Blue rectagles=
consumer tax burden
Pb
Green rectangles= P
producer tax burden b
Ps
Ps
D
D
QtQe Q Qt Qe Q
Tax Incidence
and Price Elasticity of Supply
The government has decided to place a tax (let's say $5) on a product to reduce its
consumption and to raise revenues. Questions: 1) In which market will consumption be
reduced the most by the tax? 2) In which market will consumers bear the largest burden of the tax? 3)
Producers? 4) In which market will the most revenue be raised by the tax? 5) What conclusions can you
make about the relationship between PES and tax incidence?
S+tax
Market for
Market for Basketball Shoes
P P Christmas
Trees
S
S+tax
amount of tax S
Blue rectagles=
consumer tax burden
Green rectangles=
producer tax burden
D D
Q Q

Unit 2.4 Market Failure

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Unit 2.

Unit 2.4: Market Failure and the Role of Government

Reasons for market failure

Possible government responses

Blog posts: "Market Failure" Blog posts: "Environment"

Blog posts: "Public goods" Blog posts: "Externalities"

1) What is market economics and why do we study it?

3) Identify the various roles government has played in our study of

4) Identify two examples of instances in which the economic behavior of one

7) What is a "market failure"?

• The market has failed because without state funded public

• The market has failed because without the government providing

Sometimes markets fail by...

Not providing ANY of a particular good or service that benefits society,

Sometimes markets fail by...

Not providing ENOUGH of a particular good or service that benefits

Market Failure and Externalities...

Negative Externalitites: When the production or consumption of a product places

Intro to externalities: The Story of Stuff with Annie Leonard

How is the global financial crisis a result of a market failure?

Imperfect information about the true value of houses led to an over-

Private goods: Public goods:

Private goods are:

Public goods: or social goods would not be produced through the

Public goods are:

• Nonexcludable: once the good comes into existence (it is produced), it is

Marginal Social Benefit and Marginal Social Cost:

What is the optimal quantity of tanks for the government to provide?

benefit (demand for tanks) 175

Practice Public Goods: NCEE workbook Activities 52 and 53

Purely Private Quasi-public Purely Public

Radio Park benches

Free market? Uncertain? Government?

The Tragedy of the Commons: an Essay by Garrett Hardin, 1968

Examples of "the Commons" Public land and the open seas

The tragedy of the commons as a food basket is averted by private property, or

1. What is Garret Hardin most concerned about?

2. How can "the commons" best be defined?

3. Are individuals who overuse "the commons" acting irrationally? Explain.

8. What do you think a hard-core, free-markete economist would say is the

Negative externality: A negative externality occurs anytime an individual or a

"The Middle of Nowhere".mp3

Cause of negative externalities: Over-allocation of resources towards

Effects: spillover costs born by groups external to the market

Graphical portrayal of a negative externality of production.

Polluting industry D=MSB: Marginal social benefit. This

distance b/w MPC S=MPC: Marginal private cost. Because the

S=MSC: Marginal social cost. Since some of

Government solution to negative externality of production: CORRECTIVE TAX!

• The challenge to policymakers is to set the

Alternative to corrective taxes: DIRECT GOVERNMENT CONTROLS

• Monitoring: The government must monitor emissions of polluters, which

• Enforcement: The government must have a way to enforce legislation on

• Penalties: The penalties for violations must be significant enough to

Alternative to corrective taxes: DIRECT GOVERNMENT CONTROLS

Corporate Average Fuel Economy - Wikipedia

What are two alternatives to a complete ban a government can use to

Example of direct government control: the "CAFE" standards:

Alternatives to direct government controls:

Blog post: "When more tax is a good tax"