Market system has many positive characteristics, but there are also some things that make it to failure. This failure may occur when market produces the wrong quantity of goods or even fails to allocate resources to produce some goods and services. First failure results from spillovers but second one is related to public goods.
When we talk about efficiency of a market, we thinks that all costs and benefits related to the production of it are showed on PPC, indeed sometimes certain benefits and costs aren’t showed by PPC. A spillover situation may happen when the benefits or costs are passed to someone else than immediate buyer or seller. Spillover is also called externality.
Spillover costs are some costs that are related to a third person or group of people, and they are not compensated by initial seller or buyer. An example can be the harsh sounds produced by a factory to environment. So the habitat of some organisms may be destroyed.
So what are the economical effects? Since these costs aren’t included to PPC then this curve lies further to the right. So the price of the product is too low, but output is too large to achieve allocative efficiency. Then there happens an over-allocation of resources.
Eliminating Spillover Costs
There are two ways by which government can correct this over-allocation of resources:
- Legislation– Government is adopting some laws which enforce factory owners to pay for the disturbing of animal’s habitat, by installing better isolation materials or buying better equipment.
- Specific taxes-Government might include levy specific taxes from factory owners. So this will be included in the total cost of production. Then the amount of this tax will be equal to the spillover tax.
Sometimes, spillovers can be turned into benefits to the third person or group of people. These benefits aren’t paid to the immediate producer or consumer of that good and services. An example can be education. More educated people receive higher wages. But education has an impact over society. Education lowers crime possibility and promotes fast growing economy.
Spillover benefits make demand curve lie farther to the left, because benefits are underestimated, so a smaller amount of good or service will be produced, then an under-allocation of resources will occur.
Eliminating Spillover Benefits.
Again government has to solve this problem of under-allocation of resources. Here are two solution subsidize consumers(increase demand), subsidize producers(lower the price) or in other case government has to produce it.
- Subsidize consumers. To correct the problem of under-allocation of resources government has to give some loans or grants to students, so they will be able to afford more education.
- Subsidize producers. Sometimes government finds it more useful to subsidize producers what means that they will be able to increase budget places at colleges and universities. Such subsidies reduce the price of “producing” higher education.
- Provide goods by government. The last solution for government is to own these industries.
Certain goods are private goods because they can be divisible. However, public goods are indivisible. Private goods can be subjected to exclusion principle, so demanders who are willing and able to pay obtain it, others are excluded from getting this product and its benefits. Exclusion principle isn’t applied to public goods since you can’t exclude someone from using this good. To get benefits from private good you need to buy it, but to get benefits from public goods then it just should be available. For example acquiring the Eiffel Tower isn’t economically justified. Since its ratio of total utility over price is very small in comparison to total utility gained from all people who see it. Also if you buy it you can’t stop everyone to see it. In economics this is called free-rider problem, when a group of people receive benefit from a good without paying for it.
Because services of Eiffel Tower can’t be bought or sold there is no reason to buy it. So here is a service which could yield benefits for a nation as a whole but no reason for someone to allocate resource for it. Other public goods are public health, national defense. Society wants like these goods that’s why it supports some political parties.
However, there are some public goods for which exclusion principle may apply, they are called quasi-public goods. Such goods may be education, streets, police, and museums. They could be provided by private firms.
Production of Public Goods
From where government takes resources to produce public goods? As you may guess, it collects money by levying taxes to firm, businesses and households. With less money households and businesses must buy and produce fewer goods. So, demand for goods and demand for resources diminishes. So by decreasing purchasing power, taxes remove resources from private usage. Governments spend these money on purchasing public goods and quasi-public goods, so it changes the composition of economy’s total output.
Spillover Costs-A cost imposed without compensation on third parties by the production or consumption of sellers or buyers.
Spillover Benefit-A benefit obtained without compensation by third parties from the production or consumption of sellers or buyers.
EXCLUSION PRINCIPLE-The ability to exclude those who do not pay for a product from receiving its benefits.
Public Good-A good or service that is indivisible and to which the exclusion principle does not apply.
Free-rider problem- The inability of potential providers of an economically desirable but indivisible good or service to obtain payment from those who benefit, because the exclusion principle is not applicable