and Government
Policy
Market Failures: Externalities and
Public Goods
• Society's microeconomic objectives
– equity
– social efficiency
MC = S
Costs and benefits
P D
O Q1
Quantity
External costs in production
MSC
MC = S
Costs and benefits
P D
External cost
O Q2 Q1
Social optimum
Quantity
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
External benefits in production
MC = S
Costs and benefits
P D
O Q1
Quantity
External benefits in production
MC = S MSC
Costs and benefits
External benefit
P D
O Q1 Q2
Social optimum
Quantity
External costs and benefits in production
MSC MC = S MC = S MSC
External benefit
P D P D
External cost
O Q2 Q1 O Q1 Q2
Quantity Quantity
P D
(MB)
MU = D
O Q1
Quantity
External costs in consumption
External cost
Costs and benefits
P D
(MB)
MU = D
MSB
O Q2 Q1
Social optimum
Quantity
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
Costs and benefits External benefits in consumption
P D
(MB)
MU = D
O Q1
Quantity
External benefits in consumption
External benefit
Costs and benefits
P D
MSB
(MB)
MU = D
O Q1 Q2
Social optimum
Quantity
External costs and benefits in consumption
External benefit
External cost
P P P P
MSB
MB MB
MSB
O Q2 Q1 O Q1 Q2
P1
MC1
AR
MR
O Q1 Q
Monopoly output
A monopolist producing less than the social optimum
£
MC = MSC
P1
P2 = MSB
= MSC
MC1
AR = MSB
MR
O Q1 Q2 Q
Monopoly output Perfectly competitive output
Market Failures: Monopoly Power
Consumer
surplus
a
Ppc
Producer
surplus
AR = D
O Qpc Q
(a) Industry equilibrium under perfect competition
Market Failures: Monopoly Power
Deadweight
Consumer welfare loss
surplus b
Pm
Ppc Producer a
surplus
MR AR = D
O Qpc Qpc Q
(b) Industry equilibrium under monopoly
Deadweight loss under monopoly
£ MC
(= S under perfect competition)
Perfect
competition
Consumer
surplus
a
Ppc
Producer
surplus
AR = D
O Qpc Q
(a) Industry equilibrium under perfect competition
Deadweight loss under monopoly
£ MC
(= S under perfect competition)
Monopoly
Deadweight
Consumer welfare loss
surplus b
Pm
Ppc Producer a
surplus
MR AR = D
O Qpc Qpc Q
(b) Industry equilibrium under monopoly
Market Failures: Monopoly Power
MC = S
Costs and benefits
P D
O Q1
Quantity
Using taxes to correct a market distortion
MSC
MC = S
Costs and benefits
P D
External cost
O Q2 Q1
Social optimum
Quantity
Using taxes to correct a market distortion
MSC
MC = S
P D
MC
O Q2 Q1
Quantity
Government Intervention: Taxes
and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
– the optimum size of a subsidy
Using subsidies to correct a market distortion
MC = S
Costs and benefits
P D
O Q1
Quantity
Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits
External benefit
P D
O Q1 Q2
Social optimum
Quantity
Using subsidies to correct a market distortion
MC = S MSC
MC
Costs and benefits
Optimum subsidy
= MC – MSC
P D
O Q1 Q2
Quantity
Government Intervention: Taxes
and Subsidies
• The use of taxes and subsidies to
correct for monopoly
– use of lump-sum taxes
• Provision of information
– consumer information
– information on jobs
– information to firms
Other Forms of Government Intervention
– poor information
• Market failures
– environment as a common resource
– externalities
– ignorance
– inter-generational problems
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
An emissions charge
MSC
Costs and benefits (£)
P2
MB = MSB
P1 = 0
L2 L1
Level of emission
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
Green tax revenues as a % of GDP
Green tax revenues as a % of GDP
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
• advantages and disadvantages
The Environment: a Case Study