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Introduction
Should the government intervene inthe market? The framework presented might be called
the invisible hand framework. Invisible hand frameworkperfectly
competitive lead individuals to make
voluntary choices that are in societysinterest.
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Market Failures
A market failureoccurs when theinvisible hand pushes in such a way thatindividual decisions do not lead to
socially desirable outcomes.
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Market Failures
Any time a market failure exists, thereis a reason for possible governmentintervention into markets to improve
the outcome.
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Market Failures
Because the politics of implementingthe solution often leads to furtherproblems, government intervention may
not necessarily improve the situation.
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Externalities
Externalitiesare the effect of adecision on a third party that is nottaken into account by the decision-
maker. Externalities can be both positive and
negative.
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Externalities
Negative externalitiesoccur when theeffect of a decision on others that isnot taken into account by the decision-
maker is detrimental to the thirdparty.
Examples include second-hand smoke,
water pollution, and congestion.
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Externalities
Positive externalitiesoccur when theeffect of a decision on others that isnot taken into account by the decision-
maker is beneficial to others.
Examples include innovation,
education, and new businessformation.
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Negative Externalities
When negative externalities ensuethird parties are hurt.
Marginal social cost is greater thanmarginal private cost.
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Negative Externalities
Marginal social costincludes all themarginal costs borne by society.
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Negative Externalities
Marginal social cost is calculated byadding the negative externalitiesassociated with production to the
marginal private costs of thatproduction.
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The Effect of a Negative Externality
Marginal socialbenefit
Marginal private cost
Marginal social costCost
Quantity0 Q0
P0
Q1
P1
Marginal costfrom externality
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Positive Externalities
Private trades can benefit thirdparties not involved in the trade.
Marginal social benefitequals themarginal private benefit of consuminga good or service plus the positiveexternalities resulting from consuming
that good or service.
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A Positive Externality
Cost
Quantity0
Marginal benefit of an externality
D0= Marginal private benefit
D1= Marginal social benefit
Q0
P0
Q1
P1
S = Marginal private and social cost
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Alternative Methods of Dealing withExternalities
Externalities can be dealt with viadirect regulation, incentive policies,and voluntary solutions.
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Direct Regulation
A program of direct regulationiswhere the amount of a good people areallowed to use is directly limited by
the government.
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Direct Regulation
Economists do not like this solutionsince it does not achieve the desiredend as efficiently(at the lowest cost
possible in total resources withoutconsideration as to who pays thosecosts) and fairly as possible.
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Direct Regulation
Direct regulation is inefficientbecause it achieves a goal in a morecostly manner than necessary.
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Incentive Policies
Incentive programs are more efficientthan direct regulatory policies.
The two types of incentive policies areeither taxes or market incentives.
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Tax Incentive Policies
A tax incentive programuses a tax tocreate incentives for individuals tostructure their activities in a way that
is consistent with the desired ends. Often the tax yields the desired end
more efficiently than straight
regulation.
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Tax Incentive Policies
This solution embodies a measure offairness about it the person whoconserves the most pays the least tax.
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Tax Incentive Policies
Another way to handle a negativeexternality is through a pollution taxor effluent fees.
Effluent feescharges imposed bygovernment on the level of pollution
created.
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Regulation Through Taxation
Marginal socialbenefit
Marginal private cost
Marginal social costCost
Quantity0 Q0
P0
Q1
P1Efficient tax
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Market Incentive Policies
An alternative to direct regulation issome type of market incentiveprogram.
Market incentive programa planrequiring market participants tocertify total consumption their own
or others has been reduced by aspecified amount.
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Market Incentive Policies
A market incentive program is similarto the regulatory solution in that theamount of the good used is reduced.
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Market Incentive Policies
A market incentive program differsfrom a regulatory solution in thatindividuals who reduce consumption by
more than the required amount aregiven a marketable certificate that canbe sold to someone else.
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Voluntary Reductions
Voluntary reductions leave individualsfree to choose whether to follow whatis socially optimal or what is privately
optimal. Economists are dubious of voluntary
solutions.
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Voluntary Reductions
A persons social conscience andwillingness to do things for the good ofsociety generally depend on his or her
belief that others will also be helping.
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Voluntary Reductions
If a socially conscious person comes tobelieve a large number of other peoplewill not contribute, he or she will often
lose their social conscience.
This is another example of a free
rider problemindividualsunwillingness to share in the cost of apublic good.
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The Optimal Policy
An optimal policyis one in which themarginal cost of undertaking the policyequals the marginal benefit of that
policy.
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The Optimal Policy
Should pollution be totally eliminated?
Some environmentalists say yes.
Economists would answer that doingso is costly so marginal costs shouldbe balanced against marginal benefits.
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The Optimal Policy
The point where MC = MRis called theoptimal level of pollution.
Optimal level of pollutiontheamount of pollution at which themarginal benefit of reducing pollution
equals the marginal cost.
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Public Goods
Apublicgoodis one that isnonexclusive (no one can be excludedfrom its benefits) and nonrival
(consumption by one does not precludeconsumption by others.
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Public Goods
There are no pure examples of a publicgood.
The closest example is national defense. Technology can change the public
nature of goods.
Roads are an example.
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Public Goods
Once a pure public good is supplied toone individual, it is simultaneouslysupplied to all.
A private good is only supplied to theindividual who bought it.
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Public Goods
With public goods, the focus is ongroups.
With private goods, the focus is onthe individual.
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Public Goods
In the case of a public good, the socialbenefit of a public good is the sum ofthe individual benefits.
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Public Goods
Adding demand curves vertically iseasy to do in textbooks, but not inpractice.
This is because individuals do not buypublic goods directly so that theirdemand is not revealed in their
actions.
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The Market Value of a Public Good
0.50
Price
1 2 3 Quantity
.80
.60
.40
.20
1.00
Market demandDB
DA
0.10
0.40
0.10
0.60 0.50
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Informational Problems
Perfectly competitive markets assumeperfect information.
Real-world markets often involve
deception, cheating, and inaccurateinformation.
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Informational Problems
When there is a lack of information,buyers and sellers do not have equalinformation, markets may not work
properly.
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Informational Problems
Economists call such market failuresadverse selection problems.
Adverse selection problemsproblems that occur when a buyer ora seller have different amounts of
information about the good for sale.
Policies to Deal with Informational
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Policies to Deal with InformationalProblems
One policy alternative to deal withinformation market failures is toregulate the market and see that
individuals provide the correctinformation.
Policies to Deal with Informational
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Policies to Deal with InformationalProblems
Another alternative is for thegovernment to license individuals in themarket and require them to provide
full information about the good beingsold.
Policies to Deal with Informational
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Policies to Deal with InformationalProblems
Regulatory solutions may be overly slowor costly.
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A Market in Information
A market in information is one solutionto the information problem.
Information is valuable, and is an
economic product in its own right.
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A Market in Information
Left on their own, markets will developto provide information that peopleneed and are willing to pay for it.
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A Market in Information
Economists who do not like governmentinterference point out thatinformational problems are not a
problem of the market; it is a problemof government regulation.
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Licensing of Doctors
Licensing of doctors is a debate that ismotivated by information problems.
Currently all doctors practicing
medicine are required to be licensed this was not always so.
Licensing of doctors is justified by
informational problems.
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Licensing of Doctors
Some economists argue that licensingis as much a problem of restrictingsupply as it is to help the consumer.
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Licensing of Doctors
Why, if licensed medical training is sogreat, do we even need formalrestrictions to keep other types of
medicine from being practiced?
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An Informational Alternative to
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An Informational Alternative toLicensure
As an alternative, the governmentcould provide the public withinformation about which treatments
work and which do not. This would give rise to consumersovereigntythe right of the individualto make choices about what is consumedand produced.
An Informational Alternative to
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An Informational Alternative toLicensure
In this scenario, the government wouldprovide such information as:
Grades in college. Grades in medical school. Success rate for various procedures. References.
Medical philosophy. Charges and fees.
An Informational Alternative to
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An Informational Alternative toLicensure
This information alternative wouldprovide much more useful informationto the public than the present licensing
procedure.
An Informational Alternative to
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An Informational Alternative toLicensure
Here are some words of caution aboutthe informational alternative.
To get a true picture of whether thepresent system is best would requireexperts on real-life practices andinstitutions.
The problem is that the experts mayhave a vested interest in keeping thingsjust the way they are.
Government Failures and Market
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Government Failures and MarketFailures
Market failures should notautomatically call for governmentintervention.
Why? Because governments fail too.
Government Failures and Market
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Government Failures and MarketFailures
Government failureoccurs when thegovernment intervention in the marketto improve the market failure actually
makes the situation worse.
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Reasons for Government Failures
Governments do not have an incentiveto correct the problem.
Governments do not have the
information to deal with the problem. Intervention in the markets is almost
always more complicated than it
initially looks.
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Reasons for Government Failures
Government intervention does not allowfine-tuning, and so, when the problemschange, the government solution often
responds far more slowly.
Government intervention leads to
more government intervention.
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Government Policy and Market
Failures
End of Chapter 15
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