Government and Market Failure

1. 28 Government and Market Failure

2. Chapter Objectives • How Public Goods are Distinguished from Private Goods • The Method of Determining the Optimal Quantity of a Public Good • The Basics of Cost-Benefit Analysis • About Externalities (Spillover Costs and Benefits) and the Methods to Remedy Them • How Information Failures Can Justify Government Interventions in Some Markets

3. W 28.1 Public Goods vs. Private Goods • Private Goods • Rivalry • Excludability • Public Goods • Nonrivalry • Nonexcludability • Free-Rider Problem • Optimal Quantity of a Public Good

4. Characteristics of Private Goods • Goods produced in competitive market system • Two characteristics: • 1. Rivalry – when a person buys/consumes a product, it is not available for another person to buy • 2. Excludability – people who do not pay for good or service are unable to obtain its benefits

5. Characteristics of Public Goods • Provided by gov b/c of free rider problem • Two characteristics: • 1. nonrivalry – one person’s consumption of a g/s does not prevent the consumption of the good by others • Ex. street lights, national defense, library, road systems

6. 2. Nonexcludability: no way to prevent individuals from benefiting from the g/s once it exists • Ex. police protection, streets, national defense • These 2 characteristics create free rider problem – once a producer provides a public good, everyone, including nonpayers, will benefit

7. Optimal Quantity of Public Good • Gov must try to estimate demand for public good, then compare MB to MC • Follows MB=MC rule

8. Demand for Public Goods • See Table 28.1 • Schedules show the price someone is willing to pay for the extra unit of each possible quantity • Represents collective willingness to pay • Not adding the QD at each possible price, but are adding the prices that people are willing to pay for each additional unit

9. Demand for Public Goods Two Individuals (1) Quantity Of Public Good (2) Adams’ Willingness To Pay (Price) (3) Benson’s Willingness To Pay (Price) (4) Collective Willingness To Pay (Price) = = = = = $9 7 5 3 1 + + + + + $5 4 3 2 1 $4 3 2 1 0 1 2 3 4 5 Graphically…

10. P $9 7 5 3 1 0 Q 1 2 3 4 5 P $6 5 4 3 2 1 0 Q 1 2 3 4 5 P $6 5 4 3 2 1 0 Q 1 2 3 4 5 Demand for Public Goods S Collective Demand Optimal Quantity $7 for 2 Items Collective Willingness To Pay $3 for 4 Items DC Connect the Dots Comparing MB and MC Collective Demand and Supply Benson’s Demand $4 for 2 Items D2 $2 for 4 Items Benson Adams’ Demand $3 for 2 Items $1 for 4 Items D1 Adams

11. Comparing MB and MC • Supply curve for public good is MC curve • Upward sloping due to law of diminishing returns

12. Cost-Benefit Analysis • Concept • Marginal-Cost-Marginal-Benefit Rule

13. Cost-Benefit Analysis • Used to decide whether to provide a public good and how much to provide • Read Concept and Illustration on p.546-547 • Marginal-cost-marginal benefit rule : MB=MC ideal, will provide society with maximum net benefit

14. Externalities • Cost or benefit accruing to an individual/group (third party) NOT involved in original economic action • May be positive or negative

15. Negative Externalities • Costs affecting uninvolved third party • Ex. cost of breathing polluted air • Leads to overproduction and overallocation of resources • Through transferring cost to society, firm enjoys lower production costs • See Figure 28.2 A

16. Positive Externalities • benefits affecting uninvolved third party • Ex. vaccinations • Leads to underproduction and underallocation of resources • See Figure 28.2 B

17. P P O 28.2 O 28.1 G 28.1 0 Q Q Externalities Negative Externalities Positive Externalities • Individual Bargaining: Coase Theorem • Limitations • Liability Rules and Lawsuits Negative Externalities St St Positive Externalities S Dt D D Overallocation Underallocation 0 Qo Qe Qe Qo

18. Liability Rules and Lawsuits • Clearly established property rights important • Property rights and liability laws help alleviate externality problems • Force perpetrator of externality to pay damages • Public property tends to face negative externalities

19. Externalities • Government Intervention • Direct Controls • Specific Taxes • Subsidies and Government Provision • Subsidies to Buyers • Subsidies to Producers • A Market-Based Approach • The Tragedy of the Commons • A Market for Externality Rights

20. Government Intervention • May be needed to achieve efficiency when externalities affect entire community • May use direct controls and taxes to counter negative externalities, may subsidize or provide public goods to encourage positive externalities

21. Direct Controls • Reduces negative externalities • Legislation limiting the activity • Ex. emissions standards • Cause leftward shift of supply curve

22. Specific Taxes • Gov levies taxes or charges on related good • Tax raises MC, shifts supply curve left • See Figure 28.3

23. Subsidies and Government Provision • Subsidy to buyers – causes inc. in demand • Ex. coupon to inoculate child • Subsidy to producers – causes supply to inc. • Ex. subsidy to doctors or health centers who inoculate • Government provision – where positive externalities are extremely large

24. Market-Based Approach • Create a market for externality rights • Tragedy of the commons – as long as property rights are commonly held, there is little incentive to maintain them or use them carefully • Society ends up with degradation/pollution problems

25. Market for Externality Rights • Market-based approach to correcting negative externalities • Gov creates a market for externality rights (Ex. EPA and pollution rights on p.553) • Use supply and demand to allocate externality rights • Advantages: reduces costs to society, incentive not to pollute, rising prices stimulate research for more efficient methods

26. P Price Per Pollution Right Q 0 Quantity of 1-Ton Pollution Rights Externalities • Operation of the Market • Advantages • Real-World Examples S=Supply of Pollution Rights D2016 D2006 $200 $100 500 750 1000

27. Society’s Optimal Amount of Externality Reduction • Why should society allow any negative externalities? • Reducing negative externalities has a price, society must determine how much reduction it wants to “buy” • Ex. pollution – MC of eliminating pollution rises as pollution is reduced more and more

28. MC, MB and Equilibrium Quantity • Optimal reduction of an externality occurs where MB=MC • See Figure 28.6

29. Externalities • Society’s Optimal Amount of Externality Reduction • MC, MB, and Equilibrium MC Socially Optimum Amount Of Pollution Abatement Society’s Marginal Benefit and Marginal Cost of Pollution Abatement (Dollars) MB 0 Q1

30. Global Warming • Society’s polluting problem result of inc. population, rising consumption, changes in technology, and tragedy of the commons • Industrial nations struggle to reduce emissions of greenhouse gases (believed to contribute to global warming)

31. GLOBAL PERSPECTIVE Global Warming Carbon-Dioxide Emissions, Tons Per Capita, Selected Nations 2004 0 5 10 15 20 25 United States Australia Canada Czech Republic Germany Japan United Kingdom Italy Spain France 19.8 17.0 16.2 11.8 10.3 9.2 8.8 7.4 7.2 6.2 Source: OECD Environmental Data

32. O 28.3 Information Failures • Asymmetric Information • Inadequate Information Involving Sellers • Example: Gasoline Market • Example: Licensing of Surgeons • Inadequate Information Involving Buyers • Moral Hazard Problem • Adverse Selection Problem • Workplace Safety • Qualification

33. Information Failures • Market failures due to asymmetric information – unequal knowledge possessed by the parties to a market transaction • May affect buyers or sellers

34. Inadequate Info Involving Sellers • Ex. gasoline market – establishment of a system of weights and measures • Ex. Licensing of surgeons – gov establishes qualifying tests and licensing

35. Inadequate Info Involving Buyers • Moral hazard problem – tendency of one party to a contract to alter his behavior after the contract is signed in ways that could cost other party • Adverse selection problem – info known by the first party to contract is not known by second party, second party incurs cost • Ex. those who are already sick are more likely to buy insurance

36. Workplace Safety • Safe workplace is expensive, but will achieve economic efficiency and maximize firm’s profits • Safer workplaces will reduce wage expenses

37. Lojack: A Case of Positive Externalities Last Word • Private Crime Reduction Expenditures $300 Billion • Some Redistribute Rather than Reduce Crime • Lojack Car Recoveries are 95% Versus 60% for Others • Locates and Stops Chop Shops • Estimated 15 Times MSB to Consumers • Underallocation Result • Subsidize Consumer Purchase with Lower Insurance Rates • Discounts too Small to Offset Underallocation

38. private goods public goods free-rider problem cost-benefit analysis marginal-cost-marginal-benefit-rule externalities Coase theorem tragedy of the commons market for externality rights optimum reduction of an externality asymmetric information moral hazard problem adverse selection problem Key Terms

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