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Robert F. Mulligan, Ph.D. WESTERN
CAROLINA UNIVERSITY COLLEGE OF BUSINESS |
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chapter Sixteen Public goods, externalities, and
Information Asymmetries (Government & Market Failure) |
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I. Introduction A. Learning objectives After completing this chapter,
students should be able to: 1. Identify the characteristics of
public goods and explain how they differ from private goods. 2. Describe graphically the
collective demand curve for a particular public good and explain this curve. 3. Explain why the supply curve for
public goods is upward sloping and explain how the optimal quantity of a
public good is determined. 4. Identify the purpose of
cost-benefit analysis and explain the major difficulty in applying this
analysis. 5. Explain what is meant by externalities. 6. Describe graphically and verbally
how an overallocation of resources results when negative externalities costs
are present and how this can be corrected by government action. 7. Describe graphically and verbally
how an underallocation of resources occurs when positive externalities are
present and how this can be corrected by government action. 8. Explain the Coase theorem, its
significance, and the three conditions necessary for it to work. 9. Describe three policies that would
reduce negative externalities. 10. Use an example to explain a market
for pollution rights and how this market would lead to a better allocation of
resources. 11. Discuss the predicted effects of
global warming and how cost-benefit could be used to determine international
policies and goals 12. Give two examples of how
inadequate information about sellers can create a market failure. 13. Explain the moral hazard and
adverse selection problems faced by sellers. 14. Define and identify terms and
concepts listed at the end of the chapter. B. We
all use the goods and services that are provided by government. C. The
questions to be answered are why the private sector does not provide these
goods and services efficiently and what is the role of government in bringing
about a better allocation of resources. |
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II. Public Goods A. Private
goods are produced and sold in competitive markets, and have two
characteristics: 1. Rivalry in consumption – when one person
buys and consumes a good, it is not available to others. 2. Excludability – Sellers can restrict the
benefits to those who pay for the good. B. Market
demand for private goods is found by horizontally summing the individual
demand schedules. C. Private
markets allocate goods and resources efficiently – those willing to pay
obtain goods get them. Sellers produce
goods to satisfy consumer wants, and consumer buying behavior tells them
whether to produce more or less of any particular good. D. Unlike
private goods, public goods are those goods that are nonrival and nonexcludable. E. Public
goods suffer from the free-rider problem, where a consumer can enjoy the
benefit of the good without having to pay for the benefit. F. The
demand for public goods differs from the market demand for private goods. 1. It
is a “phantom” demand since the consumers will not be making individual
purchases. 2. To
find the collective demand schedule for a public good, we add the prices
people collectively are willing to pay for the last unit of the public good
at each quantity demanded (Table 16.1). 3. Figure
16.1 is a graphical illustration of this table. A collective demand curve is the vertical
sum of the individual demand curves for the public who want that good. (Key Question 1) 4. Recall
that the market demand for a private good was a horizontal summation of the
individual demand curves. G. The supply curve for any good is its
marginal cost curve. As with private
goods, the law of diminishing returns applies to the supplying of public
goods. H. The
optimal quantity of a public good can be determined by comparing the
collective demand curve with the supply (marginal cost) curve to determine
their point of intersection or by looking at the demand and supply (marginal
cost) schedules to see at what price and quantity marginal benefit equals
marginal cost. I. Cost-benefit
analysis is a technique for decision making in the public sector. 1. The
concept involves comparing the benefit of providing incremental units of
public goods with the costs of providing these additional units. Note that the comparison is a marginal one,
i.e., the comparison is made between the costs and benefits of additional
amounts of a public good or service. 2. Table
16.2 illustrates this concept in determining the scope of a national highway
construction project. Four possible
phases of projects are considered, with costs and benefits compared. By comparing the marginal costs and
benefits as one moves from the least expensive phase to the most‑expensive
phase, we see Plan C is the optimal choice. 3. The
rule for this decision‑making technique is to use the marginal benefit
= marginal cost rule; if the marginal cost exceeds the marginal benefit, that
part of the project should not be included. 4. The
problem with this technique is the difficulty in measuring costs and
benefits. Benefits are particularly
difficult to estimate, because there are many related aspects that are not
easily calculated. Nevertheless, the
method is widely used. (Key Question
3) |
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III. Externalities revisited A. Figures
16.2a and 16.2b, respectively, illustrate that an overallocation of resources
occurs when negative externalities are present and an underallocation of
resources occurs when positive externalities are present. 1. Negative externalities occur when producers
are able to shift some of their costs onto the community. 2. Positive
externalities occur when the benefits of a good are received by others in the
community although they did not pay for them.
These benefits are not reflected in the individual demand curve. B. One
approach to reducing the externality or misallocation problem is the market
approach of individual bargaining. 1. The
Coase theorem, named after Nobel prize‑winning economist Ronald Coase,
suggests that government is not needed to remedy external costs and benefits
when property rights are clearly defined, the number of people involved is
small, and bargaining costs are negligible. 2. Government’s
role should be to encourage bargaining wherever possible, rather than to get
involved in direct restrictions or subsidies. 3. The
extended example in the text looks at the owner of a forest who wants to
contract with a logging company to clear‑cut his land. The land surrounds a lake with a nationally
known resort, which depends on the beauty of the forest for its success. Should the state or government intervene? a. The
Coase theorem would assign property rights over the issue and let both
parties negotiate a solution. Since
the forest owner has the right over the trees, the resort should negotiate to
reduce the logging impact because it has economic incentive to do so. The resort owner should be willing to pay
the forest owner to avoid or minimize the external cost. b.
The Coase theorem argues that it doesn’t matter which party is assigned the
property rights. If the resort owner
had been assigned the right to prevent logging, the forest owner would have
to negotiate and pay the resort owner for the right to cut the forest. Both parties would have an economic
incentive to eliminate the externality in this situation also. In the unlikely event that this was the
case, the resort owner’s property would have been much more valuable in the
first place, because it included the rights over the logging permission. 4. Limitations
exist with the Coase theorem, because many problems involving externalities
affect many people and bargaining is too costly and inefficient to accomplish
solutions effectively. C. A
second approach is by the assignment of liability through lawsuits. If one property owner damages another, a
private lawsuit may settle the dispute by assessing damage liability on the
violator. Once again, however, this
solution is limited to cases in which the damaged parties can afford to
initiate the suit, or in the case of many people, can organize to sue. D. A
third approach is to apply direct government controls or taxes to reduce
negative externalities, or to provide subsidies or government provision where
positive externalities exist. 1. Direct
controls place limits on the amount of the offensive activity that can
occur. Clean air and water legislation
are examples. The effect is to force
the offenders to incur costs associated with pollution control. This should shift the product supply curve
leftward and reduce the equilibrium quantity.
Therefore, it should reduce the resource allocation in a socially
optimal way. 2. Specific
taxes can be levied on polluters. The
tax payment will increase costs to the producer, shifting the product supply
curve leftward, and reducing resource allocation to this type of production
as desired. (See Figure 16.3) 3. Subsidies
and government provision suggest three options. a. Buyers
may be subsidized. For example, new
parents may be given coupons to receive inoculations at reduced prices for
their children. This would increase
the number of vaccinations and eliminate the underallocation of
resources (Figure 16.4a and b). b. Producers
could be subsidized so that producers’ costs are reduced, thus shifting the
supply curve rightward, increasing equilibrium output, and eliminating the
underallocation shown in Figure 16.4c. c. The
government could provide the product as a public good where spillover
benefits are extremely large. An example
would be administering free vaccines to all children in E. A
fourth corrective approach is the development of markets for externality
rights. This is the latest policy
innovation for dealing with pollution abatement. 1. A
pollution‑control agency decides the acceptable amount of pollution in
a particular region and creates rights that firms can purchase to allow them
to pollute. Each right will allow a
certain amount of pollution. The total
supply of rights is perfectly inelastic (Figure 16.5). 2. The
demand for rights should be downward sloping.
At high prices, polluters will either stop polluting or pollute less
by acquiring pollution‑abatement equipment, which is more attractive
when the rights are more expensive. 3. With
the given supply of rights, and a demand for rights, an equilibrium price
will be established for each right to pollute. 4. There
are several advantages to this system. a. 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; in both
situations, the firms reduce their cost below what the cost would have been
under direct controls. b. 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. c. The
revenue from the sale of pollution rights could be used to improve the
environment. d. The
rising cost of pollution rights should lead to improved pollution-control
techniques. e. A
market for air pollution rights has emerged and is expanding. F. Table
16.3 reviews the methods for correcting externalities. G. Society’s
optimal amount of externality reduction is not necessarily total elimination. 1. The
cost of reducing spillover costs increases with each additional unit of
reduction. The benefit received from
each additional unit of reduction decreases due to diminishing marginal
utility. 2. In
general, the marginal benefit of reducing pollution should equal the marginal
cost. At this point, society has found
its optimal amount of pollution abatement (Figure 28.6). 3. In
reality it is difficult to measure benefits as well as costs, but this
analysis demonstrates that some degree of pollution may be socially
efficient. H. Global
warming and Climate Change 1. The global warming problem is an example of
how cost-benefit analysis can be used to establish policies that will deal
with a global environmental problem. 2. Scientific evidence suggests that carbon
dioxide and other gas emissions are creating a greenhouse effect. 3. It is predicted that all regions of the
world will experience climatic changes. 4. Industrially advanced countries agreed in
the Kyoto Protocol of 1997 to reduce their gas emissions 6 to 8 percent below
1990 levels by 2012. The 5. In
setting policies and goals, the costs and benefits of the reduction in gas
emissions must be considered. |
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IV. Information failures are another form
of market failure. A. Information
is often asymmetric – buyers and sellers don’t have the same information
about the good, service or resource being sold, and the cost of obtaining
better information is often prohibitive. B. Inadequate
information about sellers—two examples: 1. Assume
that the gasoline market exists in an absurd situation in which there is no
system of weights and measures established by law. In such a world, the station could
advertise high‑octane gas that was actually low‑octane gas; pumps
could register more gallons than were actually being pumped. Without government regulation, one could
imagine some incentive for some stations to cheat in such ways. Government intervenes in such markets to
prevent such cases of market failure.
This provides reliable information to buyers and also helps sellers
through enforcement of fair sales practices. 2. Licensing
of surgeons is another example in which the consumer would find it difficult
to gather information about a physician’s expertise without government
licensing standards. Such rules set
minimum standards for competence.
There will still be physicians of varying abilities, but the consumer
can be confident that basic standards were met. C. Inadequate
information about buyers may lead to potential problems for sellers. 1. The
moral hazard problem occurs when there is a tendency of one party to a
contract to alter his/her behavior in ways that are costly to the other
party. Examples include the driver who
behaves more recklessly after obtaining insurance; guaranteed contracts for
athletes, which may reduce their performance; unemployment compensation
insurance, which may discourage incentives to work. 2. The
adverse selection problem arises when information known by the first party to
a contract is unknown to the second and, as a result, the second party incurs
major costs. Examples include those in
poor health who take out health insurance, the person planning an arson
attempt who takes out fire insurance, and the person whose marriage is
failing who takes out the book’s hypothetical “divorce” insurance. In areas where insurance is traditionally
underprovided, the government has provided insurance or subsidized
insurance. 3. Workplace
safety becomes a problem if workers do not know particular occupations or
workplaces are less safe than others.
Without accurate information about employers (buyers), workers will
not demand higher wages for less-safe jobs.
This is a market failure involving information about buyers
(employers) where the government has intervened. a. Government
can directly provide information to workers. b. Policies
can mandate that firms provide information. c. Standards
of workplace safety can be set. 4. Qualification: There are private methods of overcoming
lack of information problems. a. Product
warranties overcome lack of information about the seller or product. b. Franchising
helps set uniform standards, so that most McDonalds or Holiday Inns have
similar quality. c. Firms have specialized in providing information to buyers and sellers; consumer reports, travel guides, and credit-checking agencies are some examples. |
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