Lecture Essentials of economics (3/e): Chapter 5 - Brue, McConnell, Flynn

Chapter 5 - Market failures: Public goods and externalities. This chapter seeks to define a market failure and the consequences of a market failure. The chapter begins by looking at the demand side of market failures, the supply side of market failures, and the inefficiencies found.

Chapter Market Failures: Public Goods and Externalities McGraw­Hill/Irwin         Copyright © 2013 by The McGraw­Hill Companies, Inc. All rights reserved Copyrightâ2014byTheMcGrawưHillCompanies,Inc.Allrightsreserved1ư1 MarketFailures Market fails to produce the right amount of the product Resources may be • Overallocated • Underallocated 5­2 Demand­Side Failures • Impossible to charge consumers what they are willing to pay for the product • Some can enjoy benefits without paying 5­3 Supply­Side Failures • Occurs when a firm does not pay the full cost of producing its output • External costs of producing the good are not reflected in supply LO1 5­4 Efficiently Functioning Markets • Demand curve must reflect the • LO1 consumers, full willingness to pay Supply curve must reflect all the costs of production 5­5 Private Goods Characteristics • Produced in the market by firms • Offered for sale • Characteristics • Rivalry • Excludability LO3 5­6 Public Goods Characteristics • Provided by government • Offered for free • Characteristics • Nonrivalry • Nonexcludability • Free-rider problem 5­7 Measuring Demand Optimal Quantity for a Public Good, Two Individuals (1) Quantity of Public Good (2) Adams’ Willingness to Pay (Price) $4 LO3 + (3) Benson’s Willingness to Pay (Price) $5 = (4) Collective Willingness to Pay (Price) $9 + = + = + = + = 5­8 Cost­Benefit Analysis • Cost • Resources diverted from private • good production • Private goods that will not be produced Benefit • The extra satisfaction from the output of more public goods 5­9 Cost­Benefit Analysis Cost-Benefit Analysis for a National Highway Construction Project (in Billions) (1) Plan No new construction (2) Total Cost of Project (3) (4) (5) Marginal Total Marginal Cost Benefit Benefit (6) Net Benefit (4) – (2) $0 $0 $0 A: Widen existing highways $4 $5 B: New 2-lane highways 10 13 C: New 4-lane highways 18 22 10 D: New 6-lane highways 28 10 26 -2 LO3 5­10 Externalities • A cost or benefit accruing to a third party • • LO4 external to the transaction Positive externalities • Too little is produced • Demand-side market failures Negative externalities • Too much is produced • Supply-side market failures 5­11 Externalities Negative Externalities P a P St b y S St z Dt x c D D Overallocation Qo Qe (a) Negative externalities LO4 Positive Externalities Q Underallocation Qe Qo Q (b) Positive externalities 5­12 Government Intervention • Correct negative externalities • Direct controls • Specific taxes • Correct positive externalities • Subsidies and government provision 5­13 Government Intervention P Negative Externalities a b P St St a S T c Qo D Overallocation Q Qe S D Qo Qe (a) (b) Negative Externalities Correcting the overallocation of resources via direct controls or via a tax Q 5­14 Government Intervention y z St S't Dt Subsidy Dt D D Underallocation Qe Subsidy Positive externalities x St St Qo (a) Positive externalities Qe Qo (b) Correcting via a subsidy to consumers U D Qe Qo (c) Correcting via a subsidy to producers 5­15 Government Intervention Methods for Dealing with Externalities Problem Negative externalities (spillover costs) Positive externalities (spillover benefits) LO4 Resource Allocation Outcome Overproduction of output and therefore overallocation of resources Underproduction of output and therefore underallocation of resources Ways to Correct Private bargaining Liability rules and lawsuits Tax on producers Direct controls Market for externality rights Private bargaining Subsidy to consumers Subsidy to producers Government provision 5­16 Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Society’s Optimal Amounts LO5 MC Socially Optimal Amount of Pollution Abatement MB Q1 5­17 Apportioning the Tax Burden • • • Size, distribution, and impact of the costs that taxes impose on society Benefits-received principle Ability-to-pay principle 5­18 • • • Progressive, Proportional, and  Regressive Taxes Progressive tax—average tax rates increase as income increases Regressive tax—average tax rate declines as income increases Proportional tax—average rate stays the same as income increases 5­19 Tax Progressivity in the United  States • Applications • Personal income tax: progressive • Sales tax: regressive • Corporate tax: proportional • Payroll tax: regressive 5­20 Tax Progressivity in the United  States • Personal income tax • Progressive tax • Marginal tax rate • Payroll taxes • Corporate income tax • Excise taxes LO1 5­21 Tax Progressivity in the United  States Type of tax Probable Incidence Personal income tax Tax falls on the household or individual on which it is levied Payroll taxes Workers pay the full tax levied on their earnings and part of the tax levied on their employers Corporate income tax Short run: Full tax falls on owners of the businesses Long run: Some of the tax may be borne by workers through lower wages Sales tax Tax falls on consumers who buy the taxed products Specific excise taxes Taxes fall on consumers, producers, or both, depending on elasticity of supply and demand Property Taxes Taxes 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 property LO3 5­22 Tax Progressivity in the United  States Federal Personal Tax Rates, 2011* (1) Total Taxable Income (2) Marginal Tax Rate % $1–$17,000 10 $17,001–$69,000 (3) Total Tax on Highest Income in Bracket $ (4) Average Tax Rate on Highest Income in Bracket % (3) / (1) 1700 10 15 9500 14 $69,001–$139,500 25 27,125 19 $139,501–$212,300 28 47,509 22 $212,301–$379,150 33 103,570 27 Over $379,150 35 * For a married couple filing a joint return 5­23 Tax Progressivity in the United  States • Federal tax system is progressive • State and local tax structures are • largely regressive Overall U.S tax system is progressive 5­24 Government’s Role in the  Economy • Government can have a role in • • correcting externalities Officials must correctly identify the existence and cause Has to be done in the context of politics 5­25 ... (1) 1700 10 15 950 0 14 $69,001–$139 ,50 0 25 27,1 25 19 $139 ,50 1–$212,300 28 47 ,50 9 22 $212,301–$379, 150 33 103 ,57 0 27 Over $379, 150 35 * For a married couple filing a joint return 5 23 Tax Progressivity in the United ... (4) (5) Marginal Total Marginal Cost Benefit Benefit (6) Net Benefit (4) – (2) $0 $0 $0 A: Widen existing highways $4 $5 B: New 2-lane highways 10 13 C: New 4-lane highways 18 22 10 D: New 6-lane... Government provision 5 16 Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) Society’s Optimal Amounts LO5 MC Socially Optimal Amount of Pollution Abatement MB Q1 5 17 Apportioning the Tax Burden