Chapter 15

1. Chapter 15 The Shortcomings of Free Markets When she was good She was very, very good, But when she was bad She was horrid. HENRY WADSWORTH LONGFELLOW

2. What Does the Market Do Poorly? • Severe business fluctuations • Unemployment • Inflation • Unequal distribution of income • Monopoly markets • Inefficient resource allocation

3. What Does the Market Do Poorly? • Market - deals poorly with side effects • Market – cannot provide “public goods” • Market - poor allocation of resources between present and future • Market mechanism • Public & personal services – expensive • Socially damaging countermeasures • Government

4. Efficient Resource Allocation: Review • Resource allocation • Quantity of each commodity • Economy produce • Production possibilities frontier • Curve • Maximum quantities of outputs • Produced with • Available resource quantities • Current state of technology

5. Figure 1 The economy’s production possibilities frontier for the production of two goods C 10 B K Number of Backpacks Produced 8 6 4 2 A 0 20 40 60 80 100 Number of Jeans Produced

6. How much does it really cost? • Scarce supplies • Opportunity costs • Produce more of product, A • Take resources away • Producing other product, B • Compare • Utility - increased production of A • Loss of utility – decreased production of B

7. Efficient Resource Allocation: Review • Production possibilities frontier • Attainable • Optimal resource allocation • Efficient allocation of resources • Prices • Equilibrium • Perfect competition • P = MC • Maximize consumer benefits

8. Efficient Resource Allocation: Review • Resources – misallocated • Change use of resources • Change combination of goods • Better off • Producers • Consumers

9. Efficient Resource Allocation: Review • If P > MC • Economy - Produces less • Than quantity maximizing consumer benefits • If P < MC • Economy – produce more • Than quantity maximizing consumer benefits

10. Externalities: Getting the Prices Wrong • Beneficial or detrimental externality • Incidental benefits or damages • To others • Not directly involved • No corresponding compensation • Externalities • Undesirable effects • Allocation of resources

11. Externalities: Getting the Prices Wrong • Marginal social cost (MSC) • Marginal private cost (MPC) • Plus incidental cost • Cost to entire community • Marginal private cost (MPC) • Share of marginal cost • Paid for by firm • Incidental cost • Share paid for by others

12. Externalities: Getting the Prices Wrong • Detrimental externalities • MSC > MPC • Too much output • Marginal benefits < MSC free market • Society – better off • Reduced output

13. Externalities: Getting the Prices Wrong • Marginal social benefit (MSB) • Marginal private benefit (MPB) • Plus incidental benefits (positive/negative) • Marginal private benefit (MPB) • Share of marginal benefit • Received by firm • Incidental benefits (positive or negative) • Received by others

14. Externalities: Getting the Prices Wrong • Beneficial externalities • MSB > MPB • Not enough output • Society – better off • Increased output

15. Figure 2 Equilibrium of a firm whose output produces a detrimental externality (pollution) Marginal social cost Marginal private cost B A Marginal revenue Marginal Cost and Revenue 0 35 100 Thousands of Tons of Paper per Year

16. Figure 3 Externalities, market equilibrium, and efficient resource allocation B K Tulip Output in Dozens T 0 E Electricity Output in Kilowatt-Hours

17. Externalities: Getting the Prices Wrong • Beneficial externalities • On-the-job training • Useful inventions • Detrimental externalities • Pollution • Abandonment of buildings • Global warming • Market • Unable to cope with externalities

18. Externalities: Getting the Prices Wrong • Governments • Support activities - Beneficial externalities • Education • Academic research • Impose fines – Negative externalities • Pollution

19. Externalities • Shortcoming of the market cured by market methods • Externalities • Failures to price resources • Markets – efficient allocation • Deal with externalities • Taxes - Detrimental externalities • Subsidies - Beneficial externalities

20. Externalities: Getting the Prices Wrong • Beneficial externalities • Subsidies per unit of output • =MSC-MPC • Detrimental externalities • Taxed • Firm – pay entire marginal social cost • Difficult to carry out • Social costs - difficult to estimate

21. Provision of Public Goods • Depletable commodity • Used up after consumption • Excludable commodity • Non paying users • Can be kept from enjoying it

22. Provision of Public Goods • Public good • Non depletable • Difficult/impossible to exclude people • Private good • Depletable • Excludable

23. Provision of Public Goods • Government supplies public goods • Unable to charge for it • Not excludable • Undesirable to charge for it • Discourage some users

24. Allocation of Resources: Present &Future • Low interest rates • Low opportunity cost • Invest more now • Durable production facilities • Lower opportunity cost • Large portion of money returns: future • More resources - devoted to future

25. Allocation of Resources: Present &Future • High interest rates • High opportunity cost • Durable investment – less attractive • Yield benefit – future • Use more resources today • Increased output today • Reduced output – future • Irreversible decisions • Some government intervention

26. Some other Sources of Market Failure • Imperfect information • Caveat emptor • Rent seeking • Unproductive activity • Undeserved profit • In excess of competitive earnings • Moral hazard - insurance • Discourage policyholders • Protecting themselves from risk

27. Some other Sources of Market Failure • Principal-agent problem • Agents • Hired to run complex enterprises • On behalf of Principals • Beneficiaries • Problem • Agents – own interest • Solution • Pay agents – success • Stock option

28. Some other Sources of Market Failure • Stock option – contract • Owner – buy specified quantity of stocks • At a future date • At specified price • Stocks price – goes down • Stock option – not used • Stocks price – goes up • Profit - “exercise the option”

29. Some other Sources of Market Failure • Stock option – provisions • Substantial period of time • Performance-based • Approved by stockholders • Sale - made public

30. Market Failure & Government Failure • Market mechanism • May work reasonably well • May fail sometimes • Government intervention • May not succeed sometimes • Try use market-like instruments

31. Cost Disease of some Vital Services • Dramatically rising prices • Deteriorating personal services • Face-to-face interaction • Personal services – more expensive • Education • Health care • Postal deliveries • Libraries • Police & fire protection

32. Figure 4 Average annual growth rates -real (inflation-adjusted) health-care spending per person: 1970 - 2004

33. Figure 5 Increased education spending per pupil: 1985 - 2002

34. Cost Disease of some Vital Services • Cost disease of personal services • Costs and prices • Rise persistently • Faster • Than average output in economy

35. Cost Disease of some Vital Services • Uneven labor productivity growth • Manufacturing & agriculture • Increase 2% per year • College teaching • Increase 1% per year • Elementary & secondary education • Declined • Government • Price controls • May make the problem worse

36. The Market System on Balance • Contribution to general welfare • Market • Stimulates productivity • Market shortcoming • Justice & injustice