The Public Sector

1. The Public Sector Chapter 4

2. Market Failure • An optimal mix of output is the most desirable combination of output attainable with existing resources, technology and social values.

3. Market Failure • Ideally, the market mechanism leads to an optimal mix of output. • The market mechanism uses market prices and sales to signal desired outputs (or resource allocations).

4. Market Failure • Market failure occurs when an imperfection in the market mechanism prevents optimal outcomes. LO1

5. Market Failure • When there is market failure: • The forces of supply and demand don’t lead to the best point on the production possibilities curve. • There is a basis for government intervention to push market outcomes closer to the ideal. LO1

6. Market Failure Computers (units per time period) All Other Goods (units per time period) Production possibilities X (Optimal mix) M (Market mix) LO1

7. Causes of Market Failure • The four specific sources of market failure are: • Public goods • Externalities • Market power • Equity LO1

8. Public Goods • A private good is a good or service whose consumption by one person excludes consumption by others. • A publicgood is a good or service whose consumption by one person does not exclude consumption by others. LO1

9. The Free-Rider Dilemma • The communal nature of public goods may cause consumers to try for a free ride. • A free rider is an individual who reaps direct benefits from someone else’s purchase (consumption) of a public good. LO1

10. Underproduction of Public Goods • Everyone would wait for someone else to pay if public goods were marketed like private goods. • The market tends to underproduce public goods and overproduce private goods. LO1

11. Externalities • Externalitiesare the costs (or benefits) of a market activity borne by a third party. • The difference between the social and private costs (benefits) of a market activity. LO1

12. Externalities • Whenever externalities are present, market prices aren’t a valid measure of a good’s value to society. The market will under-produce goods that yield external benefits and over-produce those that generate external costs. LO1

13. External Costs • Social demand equals market demand plus externalities — the externality is subtracted if it is an external cost. • The optimal production mix is where the social demand curve intersects the supply curve. LO1

14. Externalities Market supply EM External cost per pack EO Price (per pack) Market demand Market output Optimal output qO qM Social demand Quantity of Cigarettes (packs per year) LO1

15. External Benefits • Externalities can also be beneficial. • If a product yields external benefits, the social demand is greater than the market demand. LO1

16. External Benefits and Costs • The market fails by: • Over-producing goods that have external costs. • Under-producing goods that have external benefits. • To get that optimal mix, we need government intervention. LO1

17. Market Power • The market may fail when the response to price signals is flawed, rather than the signals themselves. LO1

18. Restricted Supply • When a firm has market power it has the ability to alter the market price of a good or service. • Market power gives a producer the ability to maximize profits rather than produce the optimal mix of output. LO1

19. Restricted Supply • A monopoly is a firm that produces the entire market supply of a particular good or service. LO1

20. Antitrust Policy • Government follows an antitrust policy when it intervenes to alter market structure or prevent abuse of market power. LO1

21. Natural Monopoly • A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply. LO1

22. Natural Monopoly • The government may have to regulate the behavior of a natural monopoly to ensure that consumers get the benefits of its cost efficiency. LO1

23. Inequity • The distribution of goods and services generated by the marketplace is not necessarily “fair.” LO1

24. Taxes and Transfers • Transfer payments are made to individuals for which no current goods or services are exchanged, like Social Security, welfare, unemployment benefits. LO1

25. Merit Goods • A merit good is a good or service society deems everyone is entitled to some minimal quantity of. • The government is called upon to distribute merit goods when the market does not provide enough. LO1

26. Macro Instability • Micro market failures imply that we are at the wrong point on the production-possibilities curve or inequitably distributing the output produced. LO1

27. Macro Instability • The goal of macro intervention is to foster economic growth. • Get us on the production possibilities curve (full employment). • Avoid inflation (price stability). • Increase our capacity to produce (growth). LO1

28. Macro Instability • Unemploymentis the inability of labor-force participants to find jobs. Inflation is an increase in the average level of prices of goods and services. LO1

29. Government Failure • Governments, like markets, can fail. • Government failure occurs when government intervention fails to improve economic outcomes. LO3

30. Perceptions of Waste • When there is government waste the public sector isn’t producing as many services as it could. • With such inefficiency, we are producing inside our production-possibilities curve. LO3

31. Opportunity Cost • The issue of government waste encompasses two distinct questions: • Efficiency — Are we getting as much service as we could from the resources we allocate to the government? • Opportunity cost— Are we giving up too many private-sector goods in order to get those services? LO3

32. Cost-Benefit Analysis • Additional public-sector activity is desirable only if the benefits from that activity exceed its opportunity costs. LO3

33. Valuation Problems • The value of (benefits) of public services must be estimated because they don’t have (reliable) market prices. LO3

34. Ballot-Box Economics • Voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them. LO3

35. Ballot-Box Economics • We do not know what the real demand for public goods is, and votes alone do not reflect the intensity of individual demands. LO3

36. Public Choice Theory • Public choice is a theory of public-sector behavior emphasizing rational self-interest of decision-makers and voters. • A central tenet of public-choice theory is that bureaucrats are just as selfish (utility maximizing) as everyone else. LO3

37. The Public Sector End of Chapter 4