Question

Public goods have a marginal social benefit that is higher than the private demand curve. (Why is that?), absent intervention-> the equilibrium will be at the lower price and quantity than the socially optimal level (Why is that?), How government uses tax and quota to lower the dead weight loss caused by the externality?

Answer 1

Public goods lead to market failure because-

• Pure public goods aren’t usually supplied by the private sector as they would be unable to provide them for a profit.
• Its up to the government to decide what output level of public goods is apt for society.
• To do so, it must anticipate the social benefits from making the public goods available.

The Free Rider Problem-

• As public goods are non-excludable its tough to charge persons for benefitting from a good / service once it is supplied
• The free rider issue leads to under-provision of a commodity & hence leads to market failure

An externality is a type of market failure which arises as market participants don’t consider factors external to the market. This renders the market quantity too low / too high comparative to the socially optimal production level. Fortunately, there are policies to set quantity where MSB =MSC.

We can either set the appropriate amount directly thru a quota, price ceiling or price floor. Usually, governments address the externality thru a tax / subsidy. In this case, the state introduces a tax which will make the market participants act like they care about participants external to the market( internalizing the externality).

The market naturally tends to Q^E (where MPC=MPB) and this results in a deadweight loss .Preferably, we want the quantity exchanged to be equivalent to Q*, which is the social surplus optimizing production level (at this level of output MSB = MSC). If the government levies a taxation equal to the marginal external cost at the efficient amount (Q*). This makes the firm face a cost curve of MPC plus tax, & as the tax is equivalent to external costs, this will cause firms to act as if they recognize the externality.