ECON 2306 1st EditionExam # 4 Study Guide Lectures: 5Lecture 5 (November 21)Chapter 5: Market FailuresChapter 5: Market Failures: Public Goods and ExternalitiesMarket failure: the inability of a market to produce a desirable product or produce it in the "right" amount. Occurs wen competitive market system 1. does not allocate any resources whatsoever to the production of certain goods, or 2. either underallocates or overallocates resources to the production of certain goods. Market Failures in Competitive Markets2 categories: demand-side, and market-side. Demand-side market failures: underallocations of resources that occur when private demand curves understate consumers' full willingness to pay for a good or service. Supply-side market failures: overallocations of resources that occur when private supply curves understate the full cost of producing a good or service. Demand-Side Market Failures: Rise because its impossible sometimes to charge consumers what they're willing to pay for a product. Such as outdoor fireworks displays. Supply-Side Market Failures: Happens when firm doesn't have to pay full cost of production. Because it's not possible for the market to correctly weigh costs and benefits of a situation. Like a coal-burning plant producing pollution. Efficiently Functioning MarketsCompetitive markets make private goods available to consumers AND allocates society's resources efficiently to the particular product. Productive efficiency: the production of a good in the least costly way. Competitive markets also produce allocative efficiency. Allocative efficiency: the production of the "right" mix of goods and services (minimum-cost production assumed). Ex: society wants MP3 players, not record players. 2 conditions if a competitive market will product efficient outcomes: the demand curve in market must reflect consumers' full willingness to pay and the supply curve in the market must reflect all costs of production. Consumer Surplus: Consumer surplus: the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price they do pay. Lower prices imply more consumer surplus. Consumer surplus and price are inversely related. Producer Surplus: Producer surplus: the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price. Producers minimum acceptable price equals producer's marginal cost of producing the unit. Marginal cost will be sum of rent, wages, interest, and profit producer will need to pay in order to get land, labor, capital, and entrepreneurship to produce unit. Lower producers minimum acceptable price, greater producer surplus. Positive, direct relationship between equilibrium price and producer surplus. Efficiency Revisited: Optimal allocation when Marginal Benefit = Marginal Cost. MB=MC is where supply and demand intersect. Equilibrium is allocatively efficient. Equilibrium where maximum willingness to pay equals minimum acceptable price. Also equilibrium is total surplus (= sum of consumer and producer surplus) is at a maximum. All three of thesethings together make allocative efficiency. Efficiency Losses (or Deadweight Losses): Efficiency (deadweight) losses: reductions in combined consumer and producer surplus caused by an underallocation or overallocation of resources to the production of a good or service. Private and Public GoodsMarkets may fail to product any public goods because its demand curve may reflect none of its consumers' willingness to pay. Private Goods Characteristics: Private goods: goods that people individually buy and consume and that private firms can profitably provide because they keep people who do not pay from receiving the benefits. Like clothes, cars, computers ect. 2 characteristics: rivalry and excludability. Rivalry: when one person buys a product, it isnt available for another to buy and consume. Like buying and drinking a bottle of water. Excludability: sellers can keep people who don’t payfor a product from getting its benefits. Only people who pay for a bottle of water can get it and benefit from it. Profitable Provision: Customers can express their demands for private goods in the market by purchasing products or not purchasing them. Called individual demand. Market demand is horizontal summation of individual demands. Public Goods Characteristics: Public goods: goods that everyone can simultaneously consume and from which no one can be excluded, even if they do not pay. Nonrivalry and nonexcludability. Nonrivalry: one person's consumption of good does not prevent consumption of it by others. Like national defense, street lighting, environmental protection ect. Nonexcludability: no effective way of excluding individuals from the benefit of the good once it is created. These two things create free-rider problem. Free-rider problem: the inability of a firm to profitably provide a good because everyone, including nonpayers, can obtain the benefit. Free-riding reduces demand. Government provides homeland defense through taxes. Optimal Quantity of a Public Good: Government has to try to estimate demand for public good through surveys or public votes. Then it can compare MB against the gov's MC for providing it to try to provide the right amount. Measuring Demand: 1. Quantity of public good, 2. willingness to pay, 3. willingness to pay, 4. collective willingness to pay. 5. marginal cost. Comparing Marginal Benefit and Marginal Cost: Marginal benefit must equal marginal cost at optimal amount. Cost-benefit analysis: the formal comparison of marginal costs and marginal benefits of a government project to decide whether it is worth doing and to what extent resources should be devoted to it. ExternalitiesAn externality happens when some of the costs or the benefits of a good or service are spilled over to someone other than the immediate buyer or seller. Negative Externalities: Negative externalities: spillover production or consumption costs imposed on third parties without compensation to them. Like environmental pollution. Positive Externalities: Positive Externalities: spillover production or consumption benefits conferred on third parties without compensation from them. Like decorative house lights outside, or immunizations, or education. Coase theorem: the idea that externality problems can be resolved through private negotiations by the affected parties when property rights are clearly established. Government