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Microeconomics: market failures, public goods, and taxes

Market Failures:

  • Market failures occur when a market fails to efficiently allocate goods or services, or when the market fails to provide a specific good or service.
  • Externalities are the side effects of the production and consumption of a good or service.
    • Positive externality: when a good or service produces a benefit for some that are neither the producer or consumer of the good/service.
    • Example: when doctors administer flu shots to their patients. Other people who did not pay to get the vaccine, still benefit from this as the probability of getting the flu is lowered (see herd immunity).
    • If a good creates a positive externality , its marginal social benefit (or MSB) is greater than its marginal private benefit (MPB). MPB is the market demand.
  • The graph above represents the market for flu vaccine. The presence of a positive externality creates a deadweight loss, since the privage market is unable to efficiently allocate vaccine (MSB>MC). The socially optimum price and quantity is attained when MSB=MC
  • Negative externality occurs when someone other than the consumer or producer have to bear some costs of the production.
    • Example: pollution from producing a particular good, people who neither produce or consume the good will be negatively affected by the pollution.
    • Negative externality implies that the marginal cost to society (MSC) is greater than its marginal private cost (MPC) or market supply.
  • This graph represents the market for good X which creates pollution when produced. The presence of a negative externality, implies that MSC>MB. The socially optimal price and quantity is achieved when MSC=MB.
Role of government:
    
  • In the case of a positive externality, the government needs to implement a per unit subisdy in order to increase demand up to its optimum level.
  • In the case of a negative externality, the government needs to implement a per unit tax  on the producers in order to decrease supply up to its optimum level.
Public goods:

  • Sometimes markets fail to provide a good or service.  It is up to the government to provide these public goods.
    • Non rival good: a good where if one person's consumption does not diminish the ability of other to obtain the same good or service
    • Non-excludable: if the good or service cannot be withheld from people who haven't pay for this good/service.
Taxes:

  • Progressive taxation: a system where a higher percentage of the income of high income earners are taxed. The main idea behind this system is to make the income distribution more equal (the government can redistribute the top earners' income to the bottom earners).
  • Regressive taxation: a system that takes a lower percentage of the income of high income earners than of low-income earners. The effect of regressive taxes is to make income distribution less equal. Sales tax is an example of a regressive tax, top income earners only pay a tax on the amount they spend, which represents a much smaller share of their income than low income earners.
  • Proportional taxation: in this system, regardless of income, every income earner pays the same percentage in taxes.
  • The ability to pay principle stipulates that taxes should be collected only from those who can pay the tax. Those with high enough income pay the tax while those who have very little income pay little to no tax.
  • The benefit principle of taxation states that those who benefit from a public good should pay a tax. 
Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 133-144.
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