Lesson 14: Market Failure — Externalities & Public Goods

Warm-Up

A factory upriver makes paper cheaply — partly because it doesn't pay for the pollution it sends downstream to the kayak rental and the water-treatment plant. The market price of paper is a lie: it omits real costs borne by bystanders. Meanwhile your flu shot protects classmates who paid nothing for it — a benefit the market ignores in the other direction. When prices don't tell the whole truth, free markets — so efficient in Lesson 5 — produce the wrong quantities. Welcome to market failure, the reason Unit 6 exists and government has an economic job description.

Core Concept

The vocabulary of social cost-benefit

An externality is a cost or benefit that lands on a third party — someone outside the transaction. Four curves organize everything:

• MPC — marginal private cost (the supply curve: producers' own costs)
• MSC — marginal social cost = MPC + external cost
• MPB — marginal private benefit (the demand curve: buyers' own benefit)
• MSB — marginal social benefit = MPB + external benefit

Markets equate MPB and MPC. Society wants MSB = MSC. Whenever the private and social curves split, the market quantity is wrong and deadweight loss appears.

Negative externality (production): too much

Pollution, noise, congestion — external costs.

[GRAPH: Negative externality. X-axis "Quantity of paper", Y-axis "Price/Cost". Demand D = MPB = MSB. Supply S = MPC. A second curve MSC parallel and ABOVE MPC, vertical gap labeled "marginal external cost". Market equilibrium at Qmkt where D crosses MPC. Social optimum at Qopt < Qmkt where D crosses MSC. DWL triangle between MSC and MPB from Qopt to Qmkt, pointing at Qopt. A per-unit tax equal to the external cost shifts MPC up onto MSC.]

• Market output Qmkt > Qopt: overproduction — units between Qopt and Qmkt cost society (MSC) more than they're worth (MSB).
• Remedy: per-unit (Pigouvian) tax = marginal external cost, shifting MPC up to MSC → market lands on Qopt. Other tools: pollution limits, cap-and-trade permits.

Positive externality (consumption): too little

Vaccines, education, research — external benefits.

[GRAPH: Positive externality. Demand D = MPB. A second curve MSB parallel and ABOVE MPB, gap labeled "marginal external benefit". Supply S = MPC = MSC. Market equilibrium at Qmkt where MPB crosses S. Social optimum at Qopt > Qmkt where MSB crosses S. DWL triangle between MSB and MSC from Qmkt to Qopt, pointing at Qopt.]

• Market output Qmkt < Qopt: underproduction — society's full benefit exceeds cost for the missing units.
• Remedy: per-unit subsidy = marginal external benefit (to consumers → shifts effective demand up to MSB; or to producers → shifts supply down/right), pushing quantity to Qopt. Other tools: public provision, mandates.

Orientation tricks: - Negative externality → the social cost curve is the extra one, above supply → optimum is left of market (produce less). - Positive externality → the social benefit curve is the extra one, above demand → optimum is right of market (produce more). - The DWL triangle always sits between the two quantities, with its point at the social optimum (where MSB = MSC).

Public goods and the free-rider problem

Classify goods by two properties:

• Rival: one person's use diminishes another's.
• Excludable: non-payers can be kept out.

Public goods (non-rival + non-excludable) invite free riders: since you get the good whether or not you pay, nobody pays voluntarily, private firms can't profitably supply it, and the market underproduces (often to zero). Government provides public goods funded by taxes — the textbook justification.

Common resources (rival + non-excludable) suffer the tragedy of the commons: each user captures the full benefit of extra use but shares the depletion cost → overuse (overfishing). Remedies: quotas, permits, property rights.

Note the symmetry with externalities: public goods ≈ positive-externality machines (underprovided); commons ≈ negative-externality machines (overused).

Worked Examples

Example 1 (easy): Identify and orient

Loud fireworks factories impose $12 of noise/health costs per crate on neighbors. The market for crates: does it over- or under-produce? What policy restores efficiency?

Solution: Negative production externality → MSC = MPC + $12 → market (MPB = MPC) overproduces. A $12 per-crate tax shifts MPC up to MSC; new equilibrium = social optimum.

Interpretation: The tax must equal the marginal external cost — that magnitude statement earns the FRQ point.

Example 2 (medium): Numbers on the graph

Demand (MPB = MSB): P = 30 − Q. Supply (MPC): P = 6 + Q. Each unit emits pollution costing $4. Find the market quantity, the socially optimal quantity, and the DWL.

Solution: - Market: 30 − Q = 6 + Q → Qmkt = 12 (P = 18). - MSC = 6 + Q + 4 = 10 + Q. Optimum: 30 − Q = 10 + Q → Qopt = 10 (P = 20). - DWL = ½ × (12 − 10) × 4 = $4 (triangle base = overproduced units, height = the $4 external cost at Qmkt where MSC−MSB = 4… at Q = 12: MSC = 22, MSB = 18, gap = 4 ✓).

Interpretation: At the optimum the gap is zero; at the market quantity the gap equals the external cost — that's the triangle.

Example 3 (AP-style): Positive externality policy

Each flu shot delivers $15 of benefits to people other than the person vaccinated. The market provides 2 million shots; the social optimum is 3 million. (i) Show this on a graph description. (ii) Recommend a specific policy and its size. (iii) Who might oppose a mandate instead?

Solution: - (i) MSB lies $15 above MPB; supply crosses MPB at 2M and MSB at 3M; DWL triangle between MSB and MSC from 2M to 3M. - (ii) A $15-per-shot subsidy (to consumers or providers) closes the wedge → quantity rises to 3M. - (iii) A mandate reaches Qopt without a price signal; opposition on cost-burden or liberty grounds — economics only requires that the quantity end up at MSB = MSC.

Interpretation: Policy size = the externality per unit. Never just say "subsidize" — say how much.

Example 4 (AP-style): Classify the goods

Classify: (i) a congested toll road; (ii) an uncongested toll road; (iii) open-ocean tuna; (iv) a mosquito-control program.

Solution: (i) rival + excludable → effectively a private good while congested. (ii) non-rival + excludable → club/toll good. (iii) rival + non-excludable → common resource (tragedy of the commons). (iv) non-rival + non-excludable → public good (free riders — everyone in town benefits, none can be excluded).

Interpretation: Congestion can flip rivalry — the exam tests goods whose classification depends on conditions.

Common Mistakes

1. Drawing the extra curve on the wrong side. Negative externality: MSC above MPC (supply side). Positive externality: MSB above MPB (demand side). "Above" both times — the difference is which curve gets the twin.
2. Pointing the DWL triangle at the market quantity. The triangle's vertex is at the social optimum (MSB = MSC); it opens toward the market quantity.
3. Taxing positive externalities / subsidizing negative ones. Tax what you want less of; subsidize what you want more of. Obvious in words, botched under time pressure.
4. "Public good = anything provided by government." The definition is non-rival + non-excludable. Public schools are actually rival/excludable (government-provided private-type goods); national defense is the real thing.
5. Confusing common resources with public goods. Both non-excludable; commons are rival → overuse; public goods are non-rival → underprovision.
6. Forgetting the market ignores what it can't price. The market equilibrium is always MPB = MPC — write that, then locate the social optimum separately at MSB = MSC.

Practice Problems

10. (FRQ-style) The market for gas-powered leaf blowers is competitive. Each blower used imposes $30 of noise and emissions costs on neighbors. (a) Draw a correctly labeled graph of this market, showing MPB (= MSB), MPC, MSC, the market equilibrium quantity Qm, and the socially optimal quantity Qs. (b) Shade the deadweight loss at the market equilibrium and explain why it exists. (c) The city imposes a $30 per-blower tax on sellers. Show the effect on your graph and explain why this achieves the social optimum. (d) Would a $50 tax be better? Explain.