The Power Of Microeconomics

1
The Power Of Microeconomics
2
Public Goods and Externalities
3
In The Next Two Lectures

• We will examine the role of government in the
  economy.
• In this lecture, we will focus on why and how the
  government intervenes in the private marketplace
  to correct two particular market failures, that
  of public goods and externalities.
• In the next lecture, we will look at the broader
  issue of government taxation and expenditures.

4
Lesson 12 Colander McConnell Samuelson
Schiller Brue Nordhaus
Complete Textbook (includes both Micro-and
Macroeconomics) Microeconomics Text Only
31(optional) 30 18 28 32
17(optional) 17 18 13 18
Page Down to advance the presentation
5
Introduction

• Government intervention into the free market has
  an enormous effect on our everyday lives.
• As a student at a public college or university,
  taxpayers heavily subsidize your education.
• As an employer or worker in a private
  corporation, the government imposes a wide range
  of health, safety, and environmental regulations
  at the same time that it takes a large tax bite
  out of your profits or wages.

6
The Governments Role

• When you visit a restaurant or butcher shop, the
  government is there, too, helping to prevent food
  poisoning through meat inspections.
• And as you jump into your car or on to your
  motorcycle, that seat belt or helmet you must
  wear has been mandated by the government as well.

7
In Fact

• From cradle to grave, the government always seems
  to be with us, whether it is providing police
  protection or a national defense system or roads
  and bridges and clean air.
• What we want to do in the next two lectures is
  better understand the economic underpinnings of
  government intervention in the marketplace.

8
In This Lecture

• We are going to return to some unfinished
  business from Lecture Five.
• In that lecture, we illustrated how perfect
  competition provides an efficient allocation of
  societys resources.
• When one or more of the assumptions of perfect
  competition are not met, we have what is called a
  market failure.

9
Public Goods and Externalities

• Weve examined the market failure of imperfect
  competition in our discussions of monopoly,
  monopolistic competition and oligopoly.
• In Lecture Five, I also briefly mentioned two
  additional market failures dealing with what are
  called public goods and externalities.
• It is to these two extremely important market
  failures that we now turn.

10
Public Goods

• Each year, the United States government spends
  almost 300 billion dollars on one public good
  alone, national defense and these defense
  expenditures represent a full 15 percent of the
  total federal budget.
• Billions more are spent on other public goods
  ranging from parks, roads, and bridges to our
  criminal justice system, flood control programs,
  and even our lighthouses on the high seas.

11
The Nature of Public Goods

• So why is it that the government rather than the
  private marketplace has to provide for all these
  public goods?
• The answer lies in understanding the nature of
  the public goods market failure.
• To start towards that answer, lets first
  contrast private versus public goods.

12
Private Goods

• Private goods are divisible.
• They come in small enough units to be afforded by
  individual buyers.
• A private good is also rival in consumption.
• If I consume the good, you can't.
• Finally, a private good is subject to the
  exclusion principle.
• Those unable or unwilling to pay can be excluded
  from the product's benefits.

Page Down to advance the presentation
13
Public Goods

• Public goods are indivisible.
• They come in such large units that individual
  buyers cannot afford them.
• Public goods are also non-rival in consumption.
• Both you and I can consume a public good without
  interfering with the other's enjoyment.

Page Down to advance the presentation
14
Most Important of All

• Exclusion from the consumption of a public good
  is difficult or impossible.
• As we shall see, this non-excludability makes it
  very difficult for the private marketplace to
  supply the good.

Page Down to advance the presentation
15
Lets Be More Specific

• Suppose you are holding a hot dog in your hand.
• And further suppose that I tell you that I'm
  really hungry and want your hot dog.
• But youre hungry, too, so that if I eat that hot
  dog, you can't.
• In other words, that hot dog is rival in
  consumption.

16
Compare This To National Defense

• Here you are standing on American soil protected
  by an Army, a Navy, an Air Force, and a deadly
  array of nuclear missiles.
• But guess what I am protected as well.
• More importantly, my protection by this defense
  umbrella does not interfere with your protection.

17
In Other Words

• The defense umbrella is non-rival in consumption
  and one of the reasons is that public goods like
  national defense are indivisible and too large to
  be purchased by one individual.

Page Down to advance the presentation
18
Non-Excludability

• Now heres the problem we face when we try to
  rely on the free market to provide public goods
  like national defense.
• Nobody wants to pay for public goods.
• The reason has to do with the third
  characteristic of a public good
  non-excludability.

19
The Free Rider Problem

• A producer cannot exclude non-payers from
  receiving its indivisible benefits.
• This creates a perverse incentive among potential
  buyers to want to free ride.
• That is, potential buyers will not want to pay
  for a good that they can obtain the benefit of
  for free.
• Nor will they want to reveal their true
  preferences as to how much they value the good
  and would be willing to pay for it prior to its
  provision for fear of being taxed that amount.

Page Down to advance the presentation
20
As A Result

• The market demand curve for a public good is
  either non-existent or significantly understated.
  
• The result of this free rider problem which, by
  the way, is one of the most famous concepts in
  economics -- is that the perceived demand for the
  public good doesnt generate enough revenue to
  cover the costs of production.
• This is so even though the collective benefits of
  the public good may exceed the economic costs.

Page Down to advance the presentation
21
Flood Control and Free Riders

• No one in the valley wants to be flooded out, but
  each landowner knows that a flood control program
  will protect all landowners, regardless of who
  pays.

• Accordingly, individual farmers and landowners
  may say they dont really want a dam and arent
  willing to pay for it.
• What they are really doing is waiting for
  someone else to pay for the flood control.
• If we leave this project to market forces, all
  the property in the valley will be washed away.

22
The Punchline

• The economic difference between public goods and
  private goods rests on technical considerations,
  not political philosophy.
• Do we have the technical capability to exclude
  non-payers from non-rival goods like national
  defense or flood control?
• And it's not just that we must have the technical
  capability.
• It's also that exclusion must be economically
  feasible.

Page Down to advance the presentation
23
City StreetsExclusion Not Feasible

• In theory, we could restrict the use of such
  streets to only those who pay to use them.
• We could do this by putting a gate on every
  corner but, of course, that would be exceedingly
  expensive and impractical to do so.
• So city streets have the characteristics of a
  public good.

Page Down to advance the presentation
24
Other Public Goods

• And to our list of public goods, we can also add
  the administration of justice, the regulation of
  commerce, the conduct of foreign relations, and
  the provision of certain types of goods such as
  lighthouses, bridges, and roads.

Page Down to advance the presentation
25
Economic Efficiency and Public Goods

• The private marketplace wont provide public
  goods or will under-supply them.
• How do we ensure that the government provides an
  economically efficient supply of a public good?
  
• In real world terms, how do we as a society
  decide how much national defense and flood
  control is optimal?
• And how many lighthouses and parks should our
  government provide?

26
To Answer These Questions

• We have to understand more about the demand for
  public goods and, more importantly, how the
  market demand curves for private and public goods
  differ.

27
The Horizontal Sum

• The demand curve for private goods is the
  horizontal sum of the individual demand curves.
• Because of this, individual consumers will pay
  the same price for a good but consume different
  quantities.

Page Down to advance the presentation
28
The Vertical Sum

• The market demand curve for a public good is the
  vertical sum of the individual demand curves.
• Individual consumers will all consume the same
  amount of the good but value that amount at
  different prices.

Page Down to advance the presentation
29
Market demand for corn, three buyers
5 10 12 8 30 4 20 23
17 3 35 39 26 100
2 55 60 39 1 80 87 54 221
Page Down to advance the presentation
30
Market demand for corn, three buyers
Total Price Quantity demanded quantity Per
demanded bushel Carlos Carla Leon per week
Here's what your figure should look like.
5 10 12 8 30
4 20 23 17 60 3 35 39 26
100 2 55 60 39 154
1 80 87 54 221
Carlos
Carla
Leon
Total
P
P
P
P



(Total)
3
3
3
3
D1
D2
D3
D
Q
35
0
Q
39
0
Q
26
0
Q
100 353926
0
Page Down to advance the presentation
31
Market demand for corn, three buyers
Total Price Quantity demanded quantity Per
demanded bushel Carlos Carla Leon per week
5 10 12 8 30
4 20 23 17 60 3 35 39 26
100 2 55 60 39 154
1 80 87 54 221
Carlos
Carla
Leon
Total
P
P
P
P



(Total)
3
3
3
3
D1
D2
D3
D
Q
35
0
Q
39
0
Q
26
0
Q
100 353926
0
Page Down to advance the presentation
32
Demand for a public good, two individuals
(1) (2) (3) (4) Quantity Mr. Doves Mr.
Hawks Collective willingness willingness willi
ngness to pay(price) to pay(price) to pay(price)
1 4 5 9 2 3
4 7 3 2 3 5 4 1 2 3 5
0 1 1

• Can you draw the market demand curve for this
  public good?
• Just remember to sum vertically.

Page Down to advance the presentation
33
P 9 7 5 3 1 0
Collective willingness to pay
Dc
1 2 3 4
5 Q
P 6 5 4 3 2 1 0
Mr. Hawks willingness to pay
D2
1 2 3 4
5 Q
Mr. Doves willingness to pay
Page Down to advance the presentation
34

• This supply curve slopes upwards because of the
  law of diminishing returns.
• It measures the marginal cost to society of
  providing each unit of defense.

P 9 7 5 3 1 0
Collective willingness to pay
Dc
1 2 3 4
5 Q
Page Down to advance the presentation
35

• The optimal output occurs at the intersection of
  supply and demand where the social marginal
  benefit equals the social marginal cost.
• Whats the optimal quantity in this case?

P 9 7 5 3 1 0
S
Collective willingness to pay
Dc
1 2 3 4
5 Q
Page Down to advance the presentation
36
At 3 units, the combined willingness to pay for
the extra unit--the marginal benefit to
society--just matches that unit's marginal cost
of 5. This marginal benefit equals marginal cost
principle is analogous to both the MRMC output
rule and the MRPMRC input rule for maximizing
profit.
P 9 7 5 3 1 0
S
Collective willingness to pay
Dc
1 2 3 4
5 Q
Page Down to advance the presentation
37
Benefit-Cost Analysis

• Suppose the government is contemplating our
  aforementioned flood-control project.

• Should government undertake the project?
• What is its proper size or scope?

Page Down to advance the presentation
38
The Benefits

• Will come from the reduction in damage to the
  land in the valley in the event of a flood.
• The cost of such a project is the loss of
  satisfaction associated with the accompanying
  decline in the production of private goods or
  some other public good.
• Note that this cost can usually be measured
  simply by the cost of building the project.

Page Down to advance the presentation
39
The Decision Rule

• If the benefits from the project exceed its
  costs, we should build the project.
• However, if the costs exceed the benefits, we
  should not.

Page Down to advance the presentation
40
Benefit-Cost Analysis

• Can indicate much more that just whether a
  public project is worth building.
• It can also help government choose among the
  best competing alternatives.

Page Down to advance the presentation
41
(1) (2) (3) (4) (5) (6) Plan Total
annual Marginal Total annual Marginal Net
benefit cost of cost benefit benefit or
(4)-(2) project (reduction in damage)
Without protection 0 0
0 3,000 6,000 A Levees 3,000
6,000 3,000 7,000 10,000 B
Small reservoir 10,000 16,000 6,000
C Medium reservoir 18,000 25,000
12,000 7,000 D Large reservoir 30,000
32,000 2,000
Page Down to advance the presentation
42
(1) (2) (3) (4) (5) (6) Plan Total
annual Marginal Total annual Marginal Net
benefit cost of cost benefit benefit or
(4)-(2) project (reduction in damage)
Without protection 0 0
0 3,000 6,000 A Levees 3,000
6,000 3,000 7,000 10,000 B
Small reservoir 10,000 16,000 6,000
C Medium reservoir 18,000 25,000
12,000 7,000 D Large reservoir 30,000
32,000 2,000
Page Down to advance the presentation
43
(1) (2) (3) (4) (5) (6) Plan Total
annual Marginal Total annual Marginal Net
benefit cost of cost benefit benefit or
(4)-(2) project (reduction in damage)
Without protection 0 0
0 3,000 6,000 A Levees 3,000
6,000 3,000 7,000 10,000 B
Small reservoir 10,000 16,000 6,000
8,000 9,000 C Medium reservoir 18,000
25,000 7,000 12,000 7,000 D Large
reservoir 30,000 32,000 2,000
Page Down to advance the presentation
44
Which plan we should choose will be determined by
comparing the marginal cost and the marginal
benefit associated with each plan.
(1) (2) (3) (4) (5) (6) Plan Total
annual Marginal Total annual Marginal Net
benefit cost of cost benefit benefit or
(4)-(2) project (reduction in damage)
Without protection 0 0
0 3,000 6,000 A Levees 3,000
6,000 3,000 7,000 10,000 B
Small reservoir 10,000 16,000 6,000
8,000 9,000 C Medium reservoir 18,000
25,000 7,000 12,000 7,000 D Large
reservoir 30,000 32,000 2,000
Page Down to advance the presentation
45
Benefit-Cost Analysis

• It helps shatter the simplistic notion that the
  best way to make government more efficient is to
  always reduce government spending.
• Efficient government does not necessarily mean
  minimizing public spending.

• Rather, it means using tools like benefit-cost
  analysis to efficiently allocate resources
  between the private and public sectors until no
  net benefits can be had from further
  re-allocations of resources.

Click here to go to part 2 of this lesson
46
End Of Part 1
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voice Ashley West Leonard