Government and Market Failure

1
Government and Market Failure

• Chapter 14

2
Market Failure

• A market failure occurs when the market outcome
  is not the socially efficient outcome. It is a
  situation in which resources are not allocated to
  their highest valued use.
• If the market provides a result that we dont
  like, that doesnt mean there was a market
  failure.
• A market failure has to do with something
  interfering with the optimization of agents
  through the market process.

3
Externality

• The uncompensated effects that the production or
  consumption of goods have on third parties.
• The impact of one persons actions on the
  well-being of a bystander.

4
External Benefits Positive Externalities

• The act of producing or consuming goods sometimes
  generates benefits to others that do not have to
  pay for them.
• Immunizations
• Restored historic buildings (through tax breaks)

5
Positive Externalities
With a positive externality, the demand curve
does not reflect all the benefits of the good. As
a result, the demand that is given in DP is less
than it would be if demanders received all the
benefits (including the external one). DS is the
demand as it would be if the demanders received
the external benefit.
6
External Costs Negative Externalities

• The act of producing or consuming goods sometimes
  generates costs to others that are not paid to
  endure them.
• Automobile exhaust
• Cigarette smoking

7
Negative Externalities
With a negative externality, the supply curve
does not reflect the true cost of the good. As a
result, the supply that is provided is greater
than it would be if suppliers had to pay all the
costs (including the external cost). SP is the
supply provided, whereas SS is the supply as it
would be if the suppliers had to pay the external
cost.
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Social Cost (Negative externalities)

• Social cost the total social cost of a
  transaction is the private cost plus the external
  cost.
• The intersection of the demand curve and the
  social-cost curve (Ss) determines the optimal
  output level less than equilibrium quantity.
• The government can internalize the externality by
  imposing a tax on the producer.

9
Pollution Tax
10
Social Cost (Positive externalities)

• The intersection of the demand curve and the
  social-cost curve (Ss) determines the optimal
  output level more than equilibrium quantity.
• The government can internalize the externality by
  subsidizing the production paying the producer
  to produce more than the equilibrium.

11
Subsidy for Inoculations
12
The Coase Theorem

• Ronald Coase of the University of Chicago argues
  that government is not the only solution to the
  externality problem. Coase received the Nobel
  Prize in Economics in 1991 for his work.
• Coase Theorem if private parties can bargain to
  their mutual advantage without cost, then the
  private market will always solve the problem of
  externalities and allocate resources efficiently.

13
Market Failure as a Result of Common Ownership

• The lack of private property rights is a common
  problem in the natural resources area.
• If no one has (exclusive) ownership in a
  resource, no one seeks to optimize its use. Since
  the benefits do not accrue to a specific owner
  exclusively, market allocation fails.
• One persons use of the common resource reduces
  other peoples use.

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Common Ownership (cont.)

• Tragedy of Commons
• When one person uses a common resource, he
  diminishes other peoples enjoyment of it. This
  creates a negative externality. Common resources
  tend to be used excessively.
• Government can impose a tax or regulate the use
  of the common resource or turn the common
  resource into a private good.
• Examples
• No one person owns the air, so no one (in the
  private sector) can charge for polluting it.
• Common grazing lands are over-used, and common
  fish beds are over-fished.
• Congested roads

15
Public Goods

• Group goods into 4 categories based on 2
  characteristics
• Is the good excludable? Can people be prevented
  from using the good?
• Is the good rival? Does one persons use of the
  good diminish another persons enjoyment of it?

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Public Goods (cont.)

• Categories of Goods
• Private Goods both excludable and rival
• Ice cream cone
• Public Goods neither excludable nor rival
• National defense
• Common Resources rival but not excludable
• Fish in the ocean
• Natural Monopoly _ excludable but not rival
• Fire protection in small town

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Public Goods (cont.)

• Free riders consumers or producers who enjoy
  the benefits of a good or services without paying
  for them.
• If a government decides that the total benefits
  of the public good exceed the costs, it can pay
  for the good with tax revenue, making everyone
  better off.

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Adverse selection Moral Hazard

• Adverse selection the problem that occurs when
  higher-quality consumers or producers are driven
  out of the market because unobservable qualities
  are incorrectly valued.
• Example If the cost of insurance rises, sickly
  people are more likely to purchase health
  insurance than healthy people, leaving the
  insurer with the worst risks.
• A related issue is moral hazard the problem
  that arises when people change their behavior
  from what was expected of them when they engage
  in a trade or contract.
• Example A person who drives less carefully once
  he or she has auto insurance.
• Insurance companies attempt to reduce this
  problem by requiring copayments and deductibles.
  They want the insured person to participate in
  the cost of the loss.