Practice Problem

Practice Problem • Mexico represents a small part of the world orange market: • Draw a diagram depicting the equilibrium in the Mexican orange market without international trade. Identify the equilibrium price, equilibrium quantity, consumer surplus and producer surplus. • Suppose that the world orange price is below the Mexican price before trade and that the Mexican orange market is opened to trade. Identify the new equilibrium price, quantity consumed, quantity produced domestically, and quantity imported. Also show the change in the surplus of domestic consumers and producers. Has total surplus increased/decreased?

Government and Market Failure: Public Goods, Externalities, and Information Problems

Private Goods Have Rivalry/No Shared Consumption: if one person buys a good/service, no other person can buy that same good/service. - You cannot buy my same puppy…he’s mine! Have Excludability: people can be prevented from using the good/service - If I don’t want to sell a puppy to you…I don’t have to

Public Goods Are Indivisible: units are not small enough for individuals to buy • A tornado siren…anyone have one? Anyone want to know when a tornado comes? Exclusion principle does not hold: producer cannot bar nonpayers from obtaining benefits • After I build my tornado siren, how could I prevent you from hearing it…I don’t want you to know what’s coming!

Public Goods No rivalry: No market demand due to free rider problem (consumers can benefit from the good without paying for it) • Why would you pay for something when someone else can buy it and you use it? • What are some examples of “free riders” you know?

Public Goods No rivalry: No profit incentive for firms to provide these goods • I can’t make money off of producing tornado sirens can I? I mean once people have it they are pretty much set!

Rivalry and Exclusion

Your turn! • Classify these: • Ice-cream cones • Fish in the ocean • GA Power • National defense

Your turn! • Classify these: • Ice-cream cones • Private Good • Fish in the ocean • Common Resource • GA Power • Natural Monopoly • National defense • Public Good

Your turn! • Come up with one example of each of these: • Private Good • Common Resources • Natural Monopoly • Public Good

Externality • Uncompensated impact of one person’s actions on the well being of a bystander • Can be positive or negative

Positive vs. Negative Exhaust from an automobile? • Negative Externality Restoring a historic building? • Positive Externality Barking Dogs? • Negative Externality

Externalities in the Market So how does an externality impact our market? • Social Costs = cost to bystanders impacted by negative externalities • Have to add these to the actual costs…aka the supply curve

Externalities in the Market Here is our market for aluminum Let’s say that aluminum production releases pollution into the air • Causes a negative externality • Adds an external cost on top of cost of production

Externalities in the Market Supply curve shifts left • At every quantity there is the private cost to the company and the external cost to those impacted by the pollution • Curve is often called Marginal Social Cost Curve

Externalities in the Market Market quantity will prevail…even though it’s not the best for society. How could we get the market supply curve to be where the social cost curve is? Taxes!

Externalities in the Market So how does a positive externality impact our market? • Social Value – extra benefit received from positive externality • Have to add these to the actual value in the market…aka the demand curve

Externalities in the Market Here is our market for education Education has been linked to lower crime rates • Causes a positive externality • Adds an external benefit on top of the value to consumers.

Externalities in the Market Demand curve shifts right • At every quantity there is the private value to the consumer and the external benefit to all of having lower crime rates • Curve is often called Marginal Social Benefit Curve

Externalities in the Market Market quantity will prevail…even though it’s not the best for society. How could we get the market demand curve to be where the social value curve is? Subsidies!

Moral of the Story Negative externalities = market quantity is larger than socially desirable • Govt. can remedy the problem through taxes Positive externalities = market quantity is smaller than socially desirable • Govt. can remedy the problem through subsidies

Coase Theorem Idea that private parties can bargain without cost over the allocation of resources. They can solve the problem of externalities on their own…no govt. needed!

Coase Theorem • Government intervention is not necessary when negative externalities occur under the following conditions • Property ownership is clearly defined • Number of people involved is small • Bargaining costs are negligible

Example One • A forest owner wishes to cut down trees on his land to sell the lumber • The forest is located behind a hotel – the view of the forest is part of the selling point and the hotel does not want the forest owner to cut down the trees • The forest owner and the hotel can negotiate and perhaps come to an agreement where the trees stay in place for a set amount of money

Coase Theorem Pollution Example • A salmon farm is impacted by the pollution emitted from a oil refinery upstream • Salmon farm decides to sue the refinery • The threat of the lawsuit causes the refinery to change its practices • Potential problems: • Lawsuits take a long time • Not always easy to prove one’s case

Tragedy of the Commons • Society overuses resources to which no one holds property rights • Common resources • Once we have a good that is available to us…we use it til it’s gone • What is an example of a “tragedy of the commons” resource?

Tragedy of the Commons Ex: • Overgrazing leading to a shortage in open grazing land • Excessive fishing leading to a shortage of fish • Congested roads

Information Failures: Asymmetric Information

Moral Hazard Problem • “Tendency of one party to a contract to alter his behavior after the contract is signed in ways which could be costly to the other party” • The overuse of certain services

Moral Hazard Examples • Drivers may be less cautious because of car insurance • Medical malpractice might increase due to having insurance • Guaranteed contracts can reduce quality of work performance (athletes, tenured professors, teachers) • Unemployment insurance may cause workers to work less diligently • Government insurance may encourage banks to make riskier loans

Adverse Selection Problems • Information known by the first party to a contract is not known by the second, and as a result, the second party incurs major costs • Sick people will seek out the most generous health care plans • Someone who is going to set fire to his business will have an incentive to take out fire insurance

Practice Problem