Unit VI: Market Failures

1. Unit VI: Market Failures

2. What is the Free Market? • A economic structure where supply and demand allocate resources. There is little to no government intervention. • What is the Invisible Hand? • The concept that society’s goals will be met as individuals seek their own self-interest. • Competition and self-interest act as an invisible hand that regulates the free market. • Example: People love the green shirts that a firm is making…..

3. What is a Free Market Failure? • When the free-market system fails to satisfy society’s wants. • Private markets do not efficiently bring about the allocation of resources. • What’s the result… • The government must step in to satisfy society’s wants.

4. Four Market Failures • Public Goods • 2. Externalities • 3. Monopolies • 4. Unfair distribution of income • In each of the above situations, the government MUST step in to fix the problem.

5. Market Failure #1:PUBLIC GOODS

6. PUBLIC GOODS • Why must the public sector provide goods and services? • It is impractical for the free-market to provided these goods because there is no opportunity to earn profit. • This is due to the Free-Rider Problem • Free Riders are individuals that benefit without paying.

7. What’s wrong with Free Riders? • Free-Riders keep firms from making profits. • If left to the free market, essential services would be under produced.

8. PUBLIC GOODS • Two criteria of public goods: • 1. Nonexclusion • Everyone can use the good. • Cannot exclude benefits of the good for those who will not pay. • Ex: National Defense 2. Shared Consumption (nonrivalry) • One person’s consumption of a good does not reduce the usefulness to others. • Ex: Kit Carson Park

9. HOW MUCH PUBLIC GOODS?

10. Can there every be too much of a public good? • Can there be too many parks? • How does the government determine what quantity of public goods to produce? • They use Supply and Demand • Demand for Public Goods- • The Marginal Social Benefit of the good determined by citizens willingness to pay. • Supply of Public Goods- • The Marginal Social Cost of providing each additional quantity.

11. DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 $4 + $5 = $9

12. DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 $4 3 + + $5 4 = = $9 7

13. DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 3 $4 3 2 + + + $5 4 3 = = = $9 7 5

14. DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 3 4 $4 3 2 1 + + + + $5 4 3 2 = = = = $9 7 5 3

15. DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 3 4 5 $4 3 2 1 0 + + + + + $5 4 3 2 1 = = = = = $9 7 5 3 1

16. OPTIMAL AMOUNT OF A PUBLIC GOOD Price The Demand is the equal to the marginal benefit to society $ 9 7 5 3 1 D=MSB 0 1 2 3 4 5 Quantity of Highways

17. OPTIMAL AMOUNT OF A PUBLIC GOOD P S=MSC $ 9 7 5 3 1 The public good’s marginal cost D=MSB Q 0 1 2 3 4 5

18. OPTIMAL AMOUNT OF A PUBLIC GOOD P S=MSC $ 9 7 5 3 1 Why shouldn’t 2 highways be made? The optimum amount of the public good MSB = MSC Why shouldn’t 4 highways be made? D=MSB Q 0 1 2 3 4 5

19. Market Failure #2:EXTERNALITIES

20. What are Externalities? • An externality is a third-person side effect. • Externalities are when there are either EXTERNAL benefits or external costs to someone other than the original decision maker. • Why are Externalities Market Failures? • The free market fails to include external costs or external benefits causing misallocation of resources. • Example: Smoking Cigarettes. • The free market assumes that the cost of smoking is fully paid by people who smoke. • The government recognizes external costs and makes policies to limit smoking.

21. NegativeExternalities

22. Negative Externalities (aka: Spillover Costs) • Decisions that result in a cost for a different person other than the original decision maker. • The costs “spillover” to other people or society. • EX: Zoram is a chemical company that pollutes the air when it produces its good. • Zoram only looks at its INTERNAL costs. • The firms ignores the social cost of pollution • So, the firm’s marginal cost curve is its supply curve • When you factor in EXTERNAL costs, Zoram is producing too much of its product. • The government recognizes this and limits their production.

23. The marginal cost doesn’t include the costs to society. P Supply = Marginal Private Cost D=MSB Q Qe 0

24. What will the MC look like when EXTERNAL cost are factor in? P Spillover costs Supply = Marginal Private Cost D=MSB Q Qe 0

25. This is the REAL supply curve Supply = Marginal Social Cost P Supply = Marginal Private Cost D=MSB Q Qe 0

26. Compare MSB and MSC at Qe Is too much or too little being produced? P S=MSC S= Private D=MSB Overallocation Q QOptimal Qe 0

27. PositiveExternalities

28. Positive Externalities (aka: Spillover Benefits) • Decisions that result in a benefit for someone other than the original decision maker. • The benefits “spillover” to other people or society. • (EX: Flu Vaccines, Education, Home Renovation) • Example: A mom decides to get a flu vaccine for her child • Mom only looks at the INTERNAL benefits. • She ignores the social benefits of a healthier society. • So, her private marginal benefit is her demand • When you factor in EXTERNAL benefits the marginal benefit and demand would be greater. • The government recognizes this and subsidizes flu shots.

29. The marginal benefit doesn’t include the benefits to society. P S=MC Demand=Marginal Private Benefit Q Qe 0

30. What will the demand look like when EXTERNAL benefits are factor in? P S=MC Spillover Benefits Demand=Marginal Private Benefit Q Qe 0

31. This is the REAL demand curve P S=MC Demand=Marginal Social Benefit Demand=Marginal Private Benefit Q Qe 0

32. Compare MSB and MSC at Qe Is too much or too little being produced? P S=MC D=MSB D=MPB Underallocation Qe QOptimal 0

33. CORRECTINGEXTERNALITIES

34. CORRECTING SPILLOVER COSTS (Solution: Tax the amount of the externality) S=MSC P Spillover costs S Private TAX Overallocation Corrected D Q Q0 Qe 0

35. CORRECTING SPILLOVER BENFITS (Subsidize either producers or consumers the amount of the externality) P S Spillover Benefits D=MSB D Private Underallocation Corrected Q Qe QOptimal 0

36. The Economics of Pollution

37. Economics of Pollution • Why are public bathrooms so gross? • The Tragedy of the Commons • (AKA: The Common Pool Problem) • Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted since no one has the incentive to keep them clean. • There is no monetary incentive to use them efficiently. • Result is high spillover costs.

38. Market Failure #3: Monopolies

39. Government in Action:Antitrust Laws

40. WHAT ARE ANTITRUST LAWS? • Laws designed to prevent monopolies and promote competition. • Why are monopolies a Market Failure? • Monopolies destroy the key ingredient of the free market system- Competition. • To fix this MARKET FAILURE the government must get involved. • Identify the socially optimal and fair return points.

41. Market Failure #4Unfair Distribution of Income

42. Income Inequality In 2001, the average American family made $66,863. Everyone is obviously rich. What’s wrong with using the average? Averages reveal absolutely nothing about how income is distributed. How does the government measure distribution of income?

43. THE LORENZ CURVE The LAST graph to learn for Microeconomics

44. Measuring Income Distribution • Review the process: • The government divides all income earning families into five equal groups (quintiles) from poorest to richest. • Each groups represents 20% of the population. • If there was perfect equality then 20% of the families should earn 20% of the income, 40% should earn 40% (and so on) • The government compares how far the actual distribution is from perfect distribution then attempts to redistribute money fairly.

45. THE LORENZ CURVE 100 80 60 40 20 Perfect Equality Percent of Income 0 20 40 60 80 100 Percent of Families

46. THE LORENZ CURVE 100 80 60 55 40 30 20 15 5 Lorenz Curve (actual distribution) Perfect Equality Percent of Income 0 20 40 60 80 100 Percent of Families

47. THE LORENZ CURVE 100 80 60 40 20 Lorenz Curve (actual distribution) Perfect Equality Percent of Income Area between the lines shows the degree of income inequality 0 20 40 60 80 100 Percent of Families

48. THE LORENZ CURVE 100 80 60 40 20 Lorenz Curve (actual distribution) Perfect Equality We have a Market Failure. Income is extremely unfairly distributed. How does this get fixed? Percent of Income 0 20 40 60 80 100 Percent of Families

49. THE LORENZ CURVE 100 80 60 40 20 Lorenz Curve (actual distribution) Perfect Equality Percent of Income Lorenz curve after government re-distribution 0 20 40 60 80 100 Percent of Families

50. Taxes