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ExternalitiesSpillover Costs and Benefits
Market Failures—Caused by either externalities (spillover) orinformation problems√ Externalities failures: (cost or benefi...
When there are NO   externalities involved:• No benefits or costs beyond     those to consumer • Qe is efficient allocatio...
OPTIMAL AMOUNT OF A PUBLIC GOODP $9                         S=MSC  7                          The public good’s  5        ...
OPTIMAL AMOUNT OF A PUBLIC GOODP $9                           S=MSC  7                            Yields the              ...
Cost-benefit Analysis Marginal Cost = Marginal Benefit RuleExternalities  Spillover Costs               Overallocation  Sp...
Spillover Costs And Benefits    P          Spillover                S=MSC           costs                                 ...
Overallocation of resources      √ when external costs are present andsuppliers are shifting some of their costs ontothe c...
Spillover Costs And Benefits    P          Spillover                S=MSC           costs                                 ...
Spillover Costs And Benefits  P                               S=MC                        Spillover                       ...
Underallocation of resources     √ when external benefits are presentand the MPB curve reflects only theprivate benefits u...
Spillover Costs And Benefits  P                               S=MC                        Spillover                       ...
Correcting Spillover Costs  Individual Bargaining   Coase Theorem   Liability Rules and Lawsuits  Government Intervention ...
Correcting Spillover Costs                                 S=MSC  P        Spillover            costs                S=MPC...
Correcting for Spillover Benefits   Subsidy to:   • Buyer to “lower” the price;   more units will be sold.   • Seller to “...
Correcting for Spillover Benefits   P   Correcting by Subsidy to Consumers                                  S=MC          ...
Correcting for Spillover Benefits P Correcting by Subsidy to Producers                               S=MPC                ...
Problem     Resource        Ways to Correct            allocationSpillover Overallocation •IndividualCosts     of Resource...
Problem      Resource        Ways to               Allocation      CorrectSpillover     Underallocation •IndividualBenefit...
Market for Externality Rights:                            D 2002   S = Supply                                       √ Dete...
Market for Externality Rights:                                   D 2002   S = SupplyPrice per pollution right             ...
Society’s Optimal Amount OfExternality Reduction                                                                          ...
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Market failure

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Market failure

  1. 1. ExternalitiesSpillover Costs and Benefits
  2. 2. Market Failures—Caused by either externalities (spillover) orinformation problems√ Externalities failures: (cost or benefitaccruing to an individual or group—a thirdparty—which is external to the markettransaction) • Failure of the market to bring about theallocation of resources that best satisfies thewants of society. • Results in either overallocation orunderallocation of resources dedicated to theproduction of a particular good or service.
  3. 3. When there are NO externalities involved:• No benefits or costs beyond those to consumer • Qe is efficient allocation equilibrium, so MB=MC.
  4. 4. OPTIMAL AMOUNT OF A PUBLIC GOODP $9 S=MSC 7 The public good’s 5 marginal Cost as shown by the 3 Supply Curve 1 D=MSB 0 1 2 3 4 5 Q
  5. 5. OPTIMAL AMOUNT OF A PUBLIC GOODP $9 S=MSC 7 Yields the optimum amount 5 of the public good 3 MB = MC 1 D=MSB 0 1 2 3 4 5 Q
  6. 6. Cost-benefit Analysis Marginal Cost = Marginal Benefit RuleExternalities Spillover Costs Overallocation Spillover Benefits Underallocation
  7. 7. Spillover Costs And Benefits P Spillover S=MSC costs S=MPC D=MB Overallocation Q0 Qe Q 0
  8. 8. Overallocation of resources √ when external costs are present andsuppliers are shifting some of their costs ontothe community, making their marginal costslower. √ The supply does not capture all the costswith the MPC curve understating totalproduction costs. √ This means resources are overallocatedto the production of this product. √ By shifting costs to the consumer, thefirm enjoys MSC curve and Qo (optimumoutput ).
  9. 9. Spillover Costs And Benefits P Spillover S=MSC costs S=MPC D=MB Overallocation Q0 Qe Q 0
  10. 10. Spillover Costs And Benefits P S=MC Spillover Benefits D=MSB D=MPB Underallocation Qe Q0 Q 0
  11. 11. Underallocation of resources √ when external benefits are presentand the MPB curve reflects only theprivate benefits understating the totalbenefits, at Qe. √ The output at Qo is optimum andreflects the MSB curve and the S curve. √ External positive benefits willaccrue to society from the consumptionof this product.
  12. 12. Spillover Costs And Benefits P S=MC Spillover Benefits D=MSB D=MPB Underallocation Qe Q0 Q 0
  13. 13. Correcting Spillover Costs Individual Bargaining Coase Theorem Liability Rules and Lawsuits Government Intervention Direct Controls Specific Taxes Subsidies and Government Provision
  14. 14. Correcting Spillover Costs S=MSC P Spillover costs S=MPC TAX Overallocation D=MB Corrected Q0 Qe Q 0
  15. 15. Correcting for Spillover Benefits Subsidy to: • Buyer to “lower” the price; more units will be sold. • Seller to “lower” the marginal cost of producing. More units will be produced and sold.
  16. 16. Correcting for Spillover Benefits P Correcting by Subsidy to Consumers S=MC Subsidy to consumer increases demand D=MSB Underallocation D=MPB Corrected Qe Q Q 0 0
  17. 17. Correcting for Spillover Benefits P Correcting by Subsidy to Producers S=MPC S=MSC Subsidy to producers increases supply D=MB Underallocation Corrected Qe Q0 Q 0
  18. 18. Problem Resource Ways to Correct allocationSpillover Overallocation •IndividualCosts of Resources BargainingNegative •Liability rules andExternal lawsuits-ities •Tax on Producers •Direct Controls •Market for Externality rights
  19. 19. Problem Resource Ways to Allocation CorrectSpillover Underallocation •IndividualBenefits of Resources BargainingPositive •Subsidy toExternalities consumer •Subsidy to producer •Government Provision
  20. 20. Market for Externality Rights: D 2002 S = Supply √ DeterminePrice per pollution right of “rights” (supply is $200 pollution fixed) rights √ Demand is $100 D 2012 downsloping; 500 750 1000 demand will increase over time Quantity of pollution rights as human andEquilibrium price for business“rights” will be intersection populationsof demand and supply. increase.
  21. 21. Market for Externality Rights: D 2002 S = SupplyPrice per pollution right Firms are either of encouraged to $200 pollution reduce or rights eliminate it based $100 D 2012 on their costs and 500 750 1000 the price of the Quantity of pollution rightsright to pollute. Pollution Rights can be bought and sold; conservation groups can “buy” up rights to control spillover costs.
  22. 22. Society’s Optimal Amount OfExternality Reduction MC Society’s marginal benefit and marginal Socially optimum cost of pollution abatement amount of pollution abatement MB 0 QO Amount of pollution abatement

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