Lecture 3. Market Failure, Public Goods, Externalities Market Failure & Public Goods ANDREEA STOIAN, PHD DEPARTMENT OF FINANCE AND CEFIMO

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1 Lecture 3 Market Failure, Public Goods, Externalities Market Failure & Public Goods ANDREEA STOIAN, PHD PROFESSOR OF FINANCE DEPARTMENT OF FINANCE AND CEFIMO BUCHAREST UNIVERSITY OF ECONOMIC STUDIES

2 Market failure (I) Markets Individual well-being Invisible hand Efficient allocation (Pareto optimality)

3 Market failure (II) Monopoly Externalities Asymmetric information

4 Market failure (III) Market Individual well being Social responsibility ( ) Pareto optimality Market Government Pareto optimality

5 Public goods Non-rival=a given quantity an be enjoyed by more than one consumer without decreasing the amounts enjoyed by rival consumers Public goods Non-exclusion=it is too costly to develop means of excluding those who refuse to pay from enjoying the benefits of a given quanitity of a public good

6 Public goods vs. private goods Pure public goods a given quantity is consumed by all members of a community as soon as it is produced for, or by any one member The marginal cost of distributing a pure public good to an additional consumer is zero for a given amount of the public good Pure private goods Are rival in consumption and their benefits are easily excluded from those who choose not to pay their market price A unit of a pure private good can be enjoyed only by a single consumer The more units of a given mount available to be consumed by one person, the less is available to rival consumers

7 Classifying goods Excludability 1 Rivalry 1 Semipublic goods (i.e. priceexcludable public goods) Private public goods Excludability Rivalry 0 Pure public goods Semipublic goods (i.e. congestible public goods) Rivalry 1

8 Congestible and price-excludable public goods Congestible Are those for which crowding or congestion reduces the benefits to existing consumers when more consumers are accommodated The marginal cost of accommodating an additional consumer is not zero after the point of congestion is reached Priceexcludable Are those with benefits can be priced Their provision results in positive externalities

9 Provision of goods Pure private goods Priceexcludable public goods Market&Government Market&Government Market&Government Market&Government Congestible public goods Pure public goods

10 Demand for public goods Market demand for a Pure Private Good is derived by adding quantities demanded at each price. Demand for a Pure Public Good is derived by adding how much people will be willing to pay at each quantity.

11 Efficient output of a pure public good The socially optimal level of the public good requires that we set the Marginal Social Benefit of that good equal to its Marginal Social Cost. MSB = MSC MSB = n k=1 MB k = MB i + n 1 j=1 MB j

12 Example Number of security guards per week MB A $300 $250 $200 $150 MB B MB C MB i $750 $600 $450 $300

13 Marginal Benefit (Dollars) MC = AC = MSB D= MB i = MSB MB A MB B MB C Security Guards per Week

14 Lindhal equilibrium through voluntary contributions The amount contributed per unit of the public good by each person must be adjusted so that each individual desires the identical amount of the public good The sum of the amounts contributed by each member of the community per unit must equal the marginal social cost of producing the public good All individuals must agree voluntarily, with no coercion whatsoever, on the cost-sharing arrangement and the quantity of good The equilibrium must occur under the unanimous consent It ensures the efficient outcome

15 The free-rider problem A free-rider is a person who seeks to enjoy the benefits of a public good without contributing anything to the cost of financing the The free-rider problem stems from the incentive people have to enjoy external benefits financed by others, with no cost to themselves Free riding can be a reasonable strategy for any one individual, provided that no penalty exists and that only few individuals choose this strategy If all members of the community choose the free-rider strategy, then no production of the public good would be forthcoming

16 Prisoners dilemma Strategy B contributes B does not contribute A contributes 5,5 5,10 A does not contribute 10,5 0,0

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