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The location of the demand curve in Figure 18-7(a) depends partly on the

demand for the products for which the recycled glass is used. The greater the

demand for those products, the greater the demand for the recyclable input. The

location of the curve also depends on the technology and thus the cost of using orig-

inal raw materials rather than recycled glass in the production process. The more

costly it is to use original materials relative to recycled glass, the farther to the right

will be the demand curve for recyclable glass.

The supply curve for recyclable glass slopes upward, because higher prices

increase the incentive for households to recycle. The location of the supply curve

depends on such factors as the attitudes of households toward recycling and the

cost to them of alternative disposal.

The equilibrium price P

and quantity Q

in Figure 18-7(a) are determined at the

intersection of the supply and demand curves. At price P

the market clears; there

is neither a shortage nor a surplus of recyclable glass.

POLICY

Suppose the government wants to encourage recycling as an alternative to land

dumps or incineration. It could do that in one of two ways.

Demand Incentives The government could increase recycling by increasing the

demand for recycled inputs. If the demand curve in Figure 18-7(b) shifts from D

rightward to D

, the equilibrium price and quantity of recycled glass will increase to

and Q

; more recycling will occur. A policy that might increase demand would be

to place taxes on the inputs that are substitutable for recycled glass in the production

process. Such taxes would encourage ﬁrms to use more of the untaxed recycled glass

and less of the taxed inputs. Or the government could shift its purchases toward

goods produced with recycled inputs and require that its contractors do the same

Also, environmental awareness by the public can contribute to rightward shifts

of the demand curve for recycled resources. Many large ﬁrms that produce waste-

intensive goods have concluded that it is in their interest to support recycling, for

fear of a consumer backlash against their products. Procter & Gamble (disposable

diapers) and McDonald’s (packaging of fast food) have undertaken multimillion-

dollar campaigns to use recycled plastic and paper.

Supply Incentives As shown in Figure 18-7(c), government can also increase recy-

cling by shifting the supply curve rightward, as from S

to S

. The equilibrium price

would fall from P

to P

, but the equilibrium quantity—in this case recyclable

glass—would rise from Q

to Q

. That is, more recycling would occur. Many munic-

ipal governments have implemented speciﬁc policies to do so. For example, they

encourage recycling by providing curbside pickup of recyclable goods such as

glass, aluminum cans, and newspapers at a lower monthly fee than for the pickup

of other garbage, or free of charge.

In a few cases, supply incentives for recyclables have been so effective that the

price of a recycled item has fallen to zero. You can envision this outcome by shifting

the supply curve in Figure 18-7(c) farther rightward. Some cities now are paying

users of recyclable inputs such as mixed paper to truck them away from the recycling

centre, which means that these items have a negative price. If the cost of paying ﬁrms

to take away recyclable products is lower than the cost of alternative methods, even

such paid-for recycling will promote economic efﬁciency. However, if it is more

costly to recycle trash than to bury or incinerate it, even when externalities are con-

sidered, such recycling will reduce efﬁciency rather than increase it. Again, we are

reminded that there can be either too little or too much of a good thing.

472 Part Four • Microeconomics of Government and Public Policy

The government’s task is to ﬁnd the optimal amount of recycling compared with

the alternative disposal of garbage. It can do this by estimating and comparing the

marginal beneﬁt and marginal cost of recycling. Consumers as a group can reduce

the accumulation of garbage by buying products that have minimal packaging.

Global Warming

Canada and the United States have made signiﬁcant progress in cleaning their air.

According to the United States Environment Protection Agency, between 1990 and

2000 clean-air laws and antipollution efforts by businesses and municipal govern-

ments reduced concentrations of carbon monoxide by 36 percent, lead by 60 percent,

nitrogen dioxide by 10 percent, smog by 4 percent, particulate matter by 18 percent,

and sulphur dioxide by 36 percent.

But signiﬁcant air pollution problems remain. Millions live in areas, such as

southern Ontario, that have unhealthy levels of at least one of the six major air pol-

lutants listed above. Moreover, Canada and the other nations of the world face the

risks of global warming. The balance of scientiﬁc evidence suggests that carbon dioxide

and other gas emissions from factories, power plants, and automobiles are accu-

mulating in the atmosphere and creating a greenhouse effect. As a result, many sci-

entists predict that average temperatures will rise by 1 to 3 degrees Celsius by 2100.

In turn, almost all regions of the world will experience noticeable climatic changes.

Ocean levels will gradually rise by several inches, and rainfall patterns will change.

Snow accumulations will decline in some regions and rise in others. Violent storms

such as tornadoes, typhoons, and hurricanes could increase in frequency and sever-

ity. But the economic effects of global warming will not be uniform; cool and tem-

perate regions and nations may economically beneﬁt, and hot and dry regions and

nations may be harmed. Global Perspective 18.1 lists carbon dioxide emissions on

a per capita basis for selected nations.

The world’s nations have responded to the global warming problem by promising

to limit the growth of carbon dioxide and other greenhouse emissions. Speciﬁcally,

chapter eighteen • government and market failure 473

18.1

Carbon Dioxide Emissions,

(Per Capita, 1999)

Canada

United States

Czech Republic

Australia

Britain

Japan

Germany

Italy

0 5 10 15 20 25

Spain

France

Source: OECD Environmental Data, <www.oecd.org>, Compendium, 1999.

Carbon dioxide

emissions, tonnes per

capita, selected nations

Carbon dioxide emissions, the

major type of greenhouse gas

emissions, vary per capita by

nation primarily because of dif-

ferent degrees of industrialization

and energy production from fossil

fuels (coal, oil, and natural gas). The

burning of such fuels is the major

contributor to global warming.

the industrially advanced nations agreed in the 1997 Kyoto Protocol to cut their

greenhouse gas emissions 6 to 8 percent below 1990 levels by 2012. Canada com-

mitted to a 6 percent reduction below 1990 levels by 2012. Many contentious issues

remain to be resolved through further meetings and negotiations. For example, to

what extent should developing nations such as China and India, currently exempt

from the limits, participate in reducing emissions? Should all industrial countries be

forced to make, say, at least half their agreed-on reduction at home, rather than buy-

ing tradable emissions credits from other nations and making no reductions at

home? Such credits were established as part of the Kyoto Protocol.

Economists stress that global warming policies that reduce greenhouse gas emis-

sions and thus slow or eliminate global warming create costs as well as beneﬁts. It

is imperative to consider the marginal costs and marginal beneﬁts carefully when

making policy decisions. Greenhouse gas limits should not be so stringent that they

end up costing society more than the value of the beneﬁts they produce. But limits

should not be so lenient that society forgoes substantial potential beneﬁts that it

would have otherwise achieved.

Economists also stress that the market mechanism, through its system of prices

and proﬁts and losses, will make appropriate adjustments based on new climatic

realities. Air conditioner sales will rise; snow shovel sales will fall. Some agricultural

lands will be deserted; others further north will be cultivated. The maple syrup

industry in Canada may beneﬁt if production in New England falls as a result of

global warming. Nevertheless, the transition costs—the costs associated with mak-

ing economic adjustments—of global warming will undoubtedly be very high if no

actions are taken to reduce greenhouse gases. The reduction or elimination of these

transition costs is part of the beneﬁt of slowing or eliminating the greenhouse

effect. Such beneﬁts must be fully considered in the cost–beneﬁt analysis.

Thus far, we have added new detail and insights concerning two types of market

failure: public goods and externalities. There is another, subtler, market failure that

results when either buyers or sellers have incomplete or inaccurate information, and

their cost of obtaining better information is prohibitive. Technically stated, this

market failure occurs because of asymmetric information—unequal knowledge

possessed by the parties to a market transaction. Buyers and sellers do not have

identical information about price, quality, or some other aspect of the good or

service.

474 Part Four • Microeconomics of Government and Public Policy

<www.crt.umontreal.ca/

~amit/papers/cjm.pdf>

The Kyoto Protocol

● The ultimate reason for pollution is the law of

conservation of matter and energy, which holds

that matter can be transformed into other mat-

ter or into energy but cannot vanish.

● Society’s pollution problem has largely resulted

from increasing population, levels rising per

capita consumption, certain changes in technol-

ogy, and the so-called tragedy of the commons.

● The government can encourage recycling

through demand and supply incentives; its task

is to determine the optimal amount of recycling.

● Under terms of the 1997 Kyoto Protocol, the

industrial nations agreed to cut emissions of

greenhouse gases by 6 to 8 percent below the

1990 levels by 2012.

asymmetric

information

A situation in which

one party to a mar-

ket transaction has

much more informa-

tion about a product

or service than the

other does.

Information Failures

The Role of

Governments

Sufﬁcient market information normally is available to ensure that goods and

services are produced and purchased efﬁciently. But in some cases, inadequate

information makes it difﬁcult to distinguish trustworthy from untrustworthy sell-

ers or trustworthy from untrustworthy buyers. In these markets, society’s scarce

resources may not be used efﬁciently, implying that the government should inter-

vene by increasing the information available to the market participants. Under rare

circumstances the government may itself supply a good for which information

problems have prohibited efﬁcient production.

Inadequate Information Involving Sellers

Inadequate information about sellers and their products can cause market failure in

the form of underallocation of resources. Examining the markets for gasoline and

for the services of surgeons will show us how this comes about.

EXAMPLE: THE GASOLINE MARKET

Assume an absurd situation: Suppose no system of weights and measures was

established by law, no government inspection of gasoline pumps took place, and no

law against false advertising existed. Each gas station can use whatever measure it

chooses; it can deﬁne a litre of gas as it pleases. A station can advertise that its gas

is 87 octane when in fact it is only 75. It can rig its pumps to indicate that it is pro-

viding more gas than the amount being delivered.

Obviously, the consumers’ cost of obtaining reliable information under such

chaotic conditions is exceptionally high, if not prohibitive. Customers or their rep-

resentatives would have to buy samples of gas from various gas stations, have them

tested for octane level, and test the accuracy of calibrations at the pump. These activ-

ities would have to be repeated regularly, because a station owner could alter the

product quality and the accuracy of the pump at will.

Because of the high costs of obtaining information about the seller, many cus-

tomers would opt out of this chaotic market. One tankful of a 50 percent solution of

gasoline and water would be enough to discourage most motorists from further

driving. More realistically, the conditions in this market would encourage con-

sumers to vote for political candidates who promised to provide a governmental

solution. The oil companies and honest gasoline stations would not object to gov-

ernment intervention. They would realize that accurate information, by enabling

this market to work, would expand their total sales and proﬁt.

The government has in fact intervened in the market for gasoline and other

markets with similar potential information difﬁculties. It established a system of

weights and measures, employs inspectors to check the accuracy of gasoline

pumps, and passed laws against fraudulent claims and misleading advertising.

There can be no doubt that these government activities have produced net beneﬁts

for society.

EXAMPLE: LICENSING OF SURGEONS

Suppose now that anyone could hang out a shingle and claim to be a surgeon, much

as anyone can become a house painter. The market would eventually sort out the

true surgeons from those who were learning by doing or were ﬂy-by-night opera-

tors who moved into and out of an area. As people died from unsuccessful surgery,

lawsuits for malpractice eventually would eliminate the medical impostors. People

needing surgery for themselves or their loved ones could obtain information from

newspaper reports or from people who had undergone similar operations.

chapter eighteen • government and market failure 475

But this process of obtaining information for those needing surgery would take

considerable time and would impose unacceptably high human and economic costs.

There is a fundamental difference between getting an amateurish paint job on one’s

house and being on the receiving end of heart surgery by a bogus physician. The

marginal cost of obtaining information about sellers in the surgery market would be

excessively high. The risk of proceeding without good information would result in

much less surgery than desirable—an underallocation of resources to surgery.

The government has remedied this market failure through a system of qualifying

tests and licensing. The licensing provides consumers with inexpensive information

about a service they infrequently buy. The government has taken a similar role in

several other areas of the economy. For example, it approves new medicines, regu-

lates the securities industry, and requires warnings on containers of potentially haz-

ardous substances. It also requires warning labels on cigarette packages and

disseminates information about communicable diseases. And it issues warnings

about unsafe toys and inspects restaurants for health-related violations.

Inadequate Information Involving Buyers

Just as inadequate information involving sellers can keep markets from achieving

economic efﬁciency, so can inadequate information relating to buyers. The buyers

may be consumers who buy products or ﬁrms that buy resources.

MORAL HAZARD PROBLEM

Private markets may underallocate resources to a particular good or service for

which there is a severe moral hazard problem. The moral hazard problem is the ten-

dency of one party to a contract to alter her or his behaviour after the contract is

signed in ways that could be costly to the other party.

Suppose a ﬁrm offers an insurance policy that pays a set amount of money per

month to people who suffer divorces. The attractiveness of such insurance is that it

would pool the economic risk of divorce among thousands of people and, in par-

ticular, would protect spouses and children from the economic hardship that

divorce often brings. Unfortunately, the moral hazard problem reduces the likeli-

hood that insurance companies can proﬁtably provide this type of insurance.

After taking out such insurance, some people would alter their behaviour in

ways that impose heavy costs on the insurer. For example, married couples would

have less incentive to get along and to iron out marital difﬁculties. At the extreme,

some people might be motivated to obtain a divorce, collect the insurance, and then

continue to live together. Such insurance could even promote more divorces, the

very outcome it is intended to protect against. The moral hazard problem would

force the insurer to charge such high premiums for this insurance that few policies

would be bought. If the insurer could identify in advance those people most prone

to alter their behaviour, the ﬁrm could exclude them from buying it. But the ﬁrm’s

marginal cost of getting such information is too high compared with the marginal

beneﬁt. Thus, this market would fail.

Although divorce insurance is not available in the marketplace, society recog-

nizes the beneﬁts of insuring against the hardships of divorce. It has corrected for

this underallocation of hardship insurance through child-support laws that dictate

payments to the spouse who retains the children, when the economic circumstances

warrant such payments. Alimony laws also play a role.

The moral hazard problem is also illustrated in the following statements:

476 Part Four • Microeconomics of Government and Public Policy

moral

hazard

problem

The

possibility that indi-

viduals or institu-

tions will change

their behaviour as

the result of a con-

tract or agreement.

● Drivers may be less cautious because they have car insurance.

● Medical malpractice insurance may increase the amount of malpractice.

● Guaranteed contracts for professional athletes may reduce the quality of their

performance.

● Employment compensation insurance may lead some workers to shirk.

● Government insurance on bank deposits may encourage banks to make risky

loans.

ADVERSE SELECTION PROBLEM

Another information problem resulting from inadequate information involving

buyers is the adverse selection problem. This problem arises when information

known by the ﬁrst party to a contract is not known by the second and, as a result,

the second party incurs major costs. Unlike the moral hazard problem, which arises

after a person signs a contract, the adverse selection problem arises at the time a per-

son signs a contract.

In insurance, the adverse selection problem is that people who are most likely to

need insurance payouts are those who buy insurance. For example, those in poor-

est health will seek to buy the most generous health insurance policies. Or, at the

extreme, a person planning to hire an arsonist to torch his failing business has an

incentive to buy ﬁre insurance.

Our hypothetical divorce insurance sheds further light on the adverse selec-

tion problem. If the insurance ﬁrm sets the premiums based on the average divorce

rate, many married couples who are about to obtain a divorce will buy insurance.

An insurance premium based on average probabilities will make a great buy for

those about to get divorced. Meanwhile, those in highly stable marriages will

not buy it.

The adverse selection problem thus tends to eliminate the pooling of low and

high risks, which is the basis of proﬁtable insurance. Insurance rates then must be

so high that few people would want to (or be able to) buy such insurance.

Where private ﬁrms underprovide insurance because of information problems,

the government often establishes some type of social insurance. It can require every-

one in a particular group to take the insurance and thereby can overcome the

adverse selection problem. For example, although the social insurance system in

Canada is partly insurance and partly an income transfer program, in its broadest

sense it is insurance against poverty during old age. The social insurance program

requires nearly universal participation: People who are most likely to need the min-

imum beneﬁts that social insurance provides are automatically participants in the

program. So, too, are those not likely to need the beneﬁts. No adverse selection

problem exists.

WORKPLACE SAFETY

The labour market also provides an example of how inadequate information about

buyers (employers) can produce market failures.

For several reasons employers have an economic incentive to provide safe work-

places. A safe workplace reduces the amount of disruption of the production

process created by job accidents and lowers the costs of recruiting, screening, train-

ing, and retaining new workers. It also reduces a ﬁrm’s worker compensation insur-

ance premiums (legally required insurance against job injuries).

chapter eighteen • government and market failure 477

adverse

selection

problem

problem arising

when information

known to one party

to a contract is

not known to the

other party, causing

the latter to incur

major costs.

But a safe workplace is expensive: safe equipment, protective gear, and a slower

work pace all entail costs. The ﬁrm will decide how much safety to provide by

comparing the marginal cost and marginal beneﬁt of providing a safer workplace.

Will this amount of job safety achieve economic efﬁciency, as well as maximize the

ﬁrm’s proﬁt?

The answer is yes if the labour and product markets are competitive and if work-

ers are fully aware of the job risks at various places of employment. With full infor-

mation, workers will avoid employers having unsafe workplaces. The supply of

labour to these establishments will be greatly restricted, forcing them to boost their

wages to attract a workforce. The higher wages will then give these employers an

incentive to provide increased workplace safety; safer workplaces will reduce wage

expenses. Only ﬁrms that ﬁnd it very costly to provide safer workplaces will choose

to pay high compensating wage differentials rather than reduce workplace hazards.

A serious problem arises when workers do not know that particular occupations

or workplaces are unsafe. Because information about the buyer—that is, about the

employer and the workplace—is inadequate, the ﬁrm may not need to pay a wage

premium to attract its workforce. Its incentive to remove safety hazards, therefore,

will be diminished, and its proﬁt-maximizing level of workplace safety will be less

than economically desirable. In brief, the labour market will fail because of asym-

metric information—in this case, sellers (workers) having less information than

buyers (employers).

The government has several options for remedying this information problem:

● It can directly provide information to workers about the injury experience of

various employers, much as it publishes the on-time performance of airlines.

● It can require that ﬁrms provide information to workers about known work-

place hazards.

● It can establish standards of workplace safety and enforce them through

inspections and penalties.

Although the federal government has mainly employed the standards and enforce-

ment approach to improve workplace safety, some critics contend that an informa-

tion strategy might be less costly and more effective. (Key Question 13)

Qualiﬁcation

People have found many ingenious ways to overcome information difﬁculties with-

out government intervention. For example, many ﬁrms offer product warranties to

overcome the lack of information about themselves and their products. Franchising

also helps overcome this problem. When you visit a McDonald’s or a Holiday Inn,

you know precisely what you are going to get, as opposed to stopping at Bob’s

Hamburger Shop or the Bates Motel.

Also, some private ﬁrms and organizations specialize in providing information

to buyers and sellers. Consumer Reports provides product information; labour unions

collect and disseminate information about job safety; and credit bureaus provide

information to insurance companies. Brokers, bonding agencies, and intermediaries

also provide information to clients.

Economists agree, however, that the private sector cannot remedy all information

problems. In some situations, government intervention is desirable to promote an

efﬁcient allocation of society’s scarce resources.

478 Part Four • Microeconomics of Government and Public Policy

chapter eighteen • government and market failure 479

● Asymmetric information is a source of poten-

tial market failure, causing society’s scarce re-

sources to be allocated inefﬁciently.

● Inadequate information about sellers and their

products may lead to an underallocation of

resources to those products.

● The moral hazard problem is the tendency of

one party to a contract to alter its behaviour

in ways that are costly to the other party; for

example, a person who buys insurance may

willingly incur added risk.

● The adverse selection problem arises when one

party to a contract has less information than

the other party and incurs a cost because of

that asymmetrical information. For example, an

insurance company offering no-medical-exam-

required life insurance policies may attract cus-

tomers who have life-threatening diseases.

Private expenditures to reduce

crime are estimated to be $30

billion annually and are growing

at a faster rate than spending on

public crime prevention. Unfor-

tunately, some forms of private

crime prevention simply redis-

tribute crime rather than reduce

it. For example, car alarm sys-

tems that have red blinking

warning lights may simply divert

professional auto thieves to ve-

hicles that do not have such

lights and alarms. The owner of

a car with such an alarm system

benefits through the reduced

likelihood of theft but imposes a

cost on other car owners who do

not have such alarms. Their cars

are more likely to be targeted by

thieves because other cars have

visible security systems.

Some private crime preven-

tion measures, however, actually

reduce crime, rather than simply

redistribute it. One such meas-

ure is installation of a Lojack (or

some similar) car retrieval sys-

tem. Lojack is a tiny radio trans-

mitter that is hidden within one

of many possible places within

the car. When an owner reports

a stolen car, the police can re-

motely activate the transmitter.

Police can then determine its

precise location and track its

subsequent movements.

The owner of the car beneﬁts

because the 95 percent retrieval

rate on cars with the Lojack sys-

tem is higher than the 60 percent

retrieval rate for cars without

the system. But, according to a

study by Ayres and Levitt, the

beneﬁt to the car owner is only

10 percent of the total beneﬁt.

Ninety percent of the total bene-

ﬁt is external; it is a spillover

beneﬁt to other car owners in

the community.

There are two sources of this

positive externality. First, the

presence of the Lojack device

sometimes enables police to in-

tercept the car while the thief

is still driving it. For example, in

California the arrest rate for cars

with Lojack was three times

greater than for cars without it.

The arrest puts the car thief out

of commission for a time and

thus reduces subsequent car

thefts in the community. Second,

and far more important, the de-

vice enables police to trace cars

to chop-shops where crooks dis-

assemble cars for resale of the

parts. When police raid the chop-

shop, they put the entire theft

ring out of business. In Los An-

geles alone, Lojack has elimi-

nated 45 chop-shops in just a few

years. The purging of the chop-

shop and theft ring reduces auto

theft in the community. So, auto

LOJACK: A CASE OF POSITIVE

EXTERNALITIES

Economists Ian Ayres and Steven Levitt ﬁnd that

an auto antitheft device called Lojack produces

large spillover beneﬁts.

480 Part Four • Microeconomics of Government and Public Policy

owners who do not have Lojack

devices in their cars beneﬁt from

car owners who do. Ayres and

Levitt estimate the marginal so-

cial beneﬁt of Lojack—the mar-

ginal beneﬁt to the Lojack car

owner plus the spillover beneﬁt

to other car owners—is 15 times

greater than the marginal cost of

the device.

We saw in Figure 18-4(a) that

the existence of positive exter-

nalities causes an insufﬁcient

quantity of a product and thus

an underallocation of scarce re-

sources to its production. The

two general ways to correct the

outcome are to subsidize the

consumer, as shown in Figure

18-4(b) or to subsidize the pro-

ducer, as shown in Figure 18-

4(c). Currently, there is only one

form of government intervention

in place: provincial-mandated in-

surance discounts for people

who install auto retrieval sys-

tems such as Lojack. Those dis-

counts on insurance premiums,

in effect, subsidize the consumer

by lowering the price of the sys-

tem to consumers: the lower

price raises the number of sys-

tems installed. But based on

their research, Ayres and Levitt

contend that the current levels of

insurance discounts are far too

small to correct the underalloca-

tion that results from the positive

externalities created by Lojack.

Source: Based on Ian Ayres and

Steven D. Levitt, “Measuring Posi-

tive Externalities from Unobservable

Victim Precaution: An Empirical

Analysis of Lojack,” Quarterly Jour-

nal of Economics, February 1998,

pp. 43–77. The authors point out that

Lojack did not fund their work in any

way nor do they have any ﬁnancial

stake in Lojack.

chapter summary

1. 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 col-

lective willingness to pay for the last unit of

any given amount of the public good.

2. 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.

3. Cost–beneﬁt analysis can provide guidance

as to the economic desirability and most efﬁ-

cient scope of public goods output.

4. Spillovers or externalities cause the equilib-

rium 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 legisla-

tion or speciﬁc taxes. Spillover beneﬁts (pos-

itive externalities) are accompanied by an

underallocation of resources that can be cor-

rected by subsidies to consumers, subsidies

to producers, or government provision.

5. According to the Coase theorem, private bar-

gaining is capable of solving potential exter-

nality problems where (a) the property rights

are clearly deﬁned, (b) the number of people

involved is small, and (c) bargaining costs

are negligible.

6. Clearly established property rights and lia-

bility rules permit some spillover costs to be

prevented or remedied through private law-

suits. Lawsuits, however, can be costly, time-

consuming, and uncertain as to their results.

7. Direct controls and speciﬁc taxes can improve

resource allocation in situations where nega-

tive 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.

8. 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.

9. The socially optimal amount of externality

abatement occurs where society’s marginal

cost and marginal beneﬁt of reducing the

chapter eighteen • government and market failure 481

externality are equal. This optimal amount of

pollution abatement is likely to be less than

a 100 percent reduction. Changes in technol-

ogy or changes in society’s attitudes toward

pollution can affect the optimal amount of

pollution abatement.

10. The law of conservation of matter and energy

is at the heart of the pollution problem. Mat-

ter can be transformed into other matter or

into energy but cannot disappear. If not re-

cycled, 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.

11. 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 per-

cent below 1990 levels by 2012.

12. 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.

terms and concepts

cost–beneﬁt analysis, p. 459

marginal cost = marginal

beneﬁt (MC = MB) rule,

p. 461

externalities, p. 461

Coase theorem, p. 462

tragedy of the commons,

p. 466

market for externality rights,

p. 467

optimal reduction of an

externality, p. 470

law of conservation of matter

and energy, p. 470

asymmetric information, p. 474

moral hazard problem, p. 476

adverse selection problem,

p. 477

study questions

1. KEY QUESTION

Based on the follow-

ing three individual demand schedules for a

particular good, and assuming these three peo-

ple are the only ones in the society, determine

(a) the market demand schedule on the as-

sumption that the good is a private good, and

(b) the collective demand schedule on the

assumption that the good is a public good. Ex-

plain the differences, if any, in your schedules.

Individual 1 Individual 2 Individual 3

$8 0 $8 1 $8 0

70 72 70

60 63 61

51 54 52

42 45 43

33 36 34

24 27 25

15 18 16

KEY QUESTION Use your demand

schedule for a public good, determined in

question 1, and the following supply schedule

to ascertain the optimal quantity of this pub-

lic good. Why is this the optimal quantity?

$19 10

16 8

13 6

10 4

KEY QUESTION The following table

shows the total costs and total beneﬁts in bil-

lions for four different antipollution pro-

grams of increasing scope. Which program

should be undertaken? Why?

Program Total cost Total beneﬁt

A$3$7

B712

C1216

D1819