Government and Market Failure
- Graphically, the collective demand curve for a particular public good can be found by summing vertically
the individual demand curves for that good. The demand curve resulting from this process indicates the collective
willingness to pay for the last unit of any given amount of the public good.
- The optimal quantity of a public good occurs where the combined willingness to pay for the last unit-the
marginal benefit of the good-equals the good's marginal cost.
- Cost-benefit analysis can provide guidance as to the economic desirability and most efficient scope of public
- Spillovers or externalities cause the equilibrium output of certain goods to vary from the optimal output.
Spillover costs (negative externalities) result in an overallocation of resources that can be corrected by leg-islation
or specific taxes. Spillover benefits (positive externalities) are accompanied by an underallocation of
resources that can be corrected by subsidies to consumers, subsidies to producers, or government provision.
- According to the Coase theorem, private bargaining is capable of solving potential externality problems
where (a) the property rights are clearly defined, (b) the number of people involved is small, and (c) bar-gaining
costs are negligible.
- Clearly established property rights and liability rules permit some spillover costs to be prevented or remedied
through private lawsuits. Lawsuits, however, can be costly, time-consuming, and uncertain as to their
- Direct controls and specific taxes can improve resource allocation in situations where negative externalities
affect many people and community resources. Both direct controls (e.g., smokestack emission standards)
and specific taxes (e.g., taxes on firms producing toxic chemicals) increase production costs and hence product
price. As product price rises, the externality is reduced, because less of the output is bought and sold.
- Markets for pollution rights, where firms can buy and sell the right to discharge a fixed amount of pollution,
put a price on pollution and encourage firms to reduce or eliminate it.
- The socially optimal amount of externality abatement occurs where society's marginal cost and marginal
benefit of reducing the externality are equal. This optimal amount of pollution abatement is likely to be less
than a 100 percent reduction. Changes in technology or changes in society's attitudes toward pollution can
affect the optimal amount of pollution abatement.
- The law of conservation of matter and energy is at the heart of the pollution problem. Matter can be trans-formed
into other matter or into energy but cannot disappear. If not recycled, all production will ultimately
end up as waste. Recycling is a recent response to the growing garbage disposal problem. The equilibrium
price and quantity of recyclable inputs depend on their demand and supply. The government can encourage
recycling through either demand or supply incentives.
- The global warming problem is caused by excessive accumulation of carbon dioxide and other greenhouse
gases in the earth's atmosphere. In the Kyoto Protocol of 1997 the world's nations agreed to reduce their
emissions of greenhouse gases to 6 to 8 percent below 1990 levels by 2012.
- Asymmetric information between sellers and buyers can cause markets to fail. The moral hazard problem
occurs when people alter their behaviour after they sign a contract, imposing costs on the other party. The
adverse selection problem occurs when one party to a contract takes advantage of the other party's inadequate
information, resulting in an unanticipated loss to the latter party.