Economics
CHAPTER 4 Market failures: Public goods and Externalities
Learning objectives
LO4.1 Differentiate between demand-side market failures and supply-side market failures
LO4.2 Explain the origin of both consumer surplus and producer surplus and explain how properly
functioning markets maximize their sum, total surplus, while optimally allocating resources
LO4.3 Describe free riding and public goods and illustrate why private firms cannot normally produce
public goods
LO4.4 Explain how positive and negative externalities cause under- and overallocations of resources
LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every bit of a negative
externality such as air pollution
LO4.1
Market failures in competitive markets
Sometimes the presence of robust competition involving many buyers and many sellers may not, by
itself, be enough to guarantee that a market will allocate resources correctly. Market failures sometimes
happen in competitive markets.
Market failures in competitive markets fall into 2 categories:
Demand-side market failures happen when demand curves do not reflect consumers’ full
willingness to pay for a good or service
Supply-side market failures occur when supply curves do not reflect the full cost of producing a
good or service
Demand-side market failures
Demand-side market failures arise because it is impossible in certain cases to charge consumers what
they are willing to pay for a product.
Example with fireworks: People enjoy fireworks and are willing to pay for a firework display but because
the displays are outside and public, people don’t have to pay to see them. Therefore private firms will be
unwilling to produce displays because it is impossible for them to raise enough money.
CHAPTER 4 Market failures: Public goods and Externalities
Learning objectives
LO4.1 Differentiate between demand-side market failures and supply-side market failures
LO4.2 Explain the origin of both consumer surplus and producer surplus and explain how properly
functioning markets maximize their sum, total surplus, while optimally allocating resources
LO4.3 Describe free riding and public goods and illustrate why private firms cannot normally produce
public goods
LO4.4 Explain how positive and negative externalities cause under- and overallocations of resources
LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every bit of a negative
externality such as air pollution
LO4.1
Market failures in competitive markets
Sometimes the presence of robust competition involving many buyers and many sellers may not, by
itself, be enough to guarantee that a market will allocate resources correctly. Market failures sometimes
happen in competitive markets.
Market failures in competitive markets fall into 2 categories:
Demand-side market failures happen when demand curves do not reflect consumers’ full
willingness to pay for a good or service
Supply-side market failures occur when supply curves do not reflect the full cost of producing a
good or service
Demand-side market failures
Demand-side market failures arise because it is impossible in certain cases to charge consumers what
they are willing to pay for a product.
Example with fireworks: People enjoy fireworks and are willing to pay for a firework display but because
the displays are outside and public, people don’t have to pay to see them. Therefore private firms will be
unwilling to produce displays because it is impossible for them to raise enough money.
