mcgraw-hill/irwin © 2004 the mcgraw-hill companies, inc., all rights reserved. government policy...

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Government Policy and Government Policy and Market FailuresMarket Failures

Chapter 18


Laugher CurveLaugher Curve

Q. How many economists does it take to screw in a light bulb?

A. Eight. One to screw it in and seven to hold everything else constant.


IntroductionIntroduction

Economists use the invisible hand framework to determine whether the government should intervene in the market. Invisible hand framework – perfectly

competitive markets lead individuals to make voluntary choices that are in society’s interest.


Market FailuresMarket Failures

Market failure – the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes.


Market FailuresMarket Failures

When a market failure exists, government intervention into markets to improve the outcome is justified.

Government failure occurs when government intervention does not improve the situation.


ExternalitiesExternalities

Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker.

Externalities can be either positive or negative.



Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others.



Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others.


A Negative Externality A Negative Externality ExampleExample When there is a negative externality,

marginal social cost is greater than marginal private cost. A steel plant benefits the owner of the

plant and the buyers of steel. The plant’s neighbors are made worse

off by the pollution caused by the plant.


A Negative Externality A Negative Externality ExampleExample Marginal social cost includes all the

marginal costs borne by society. It is the marginal private costs of production

plus the cost of the negative externalities associated with that production.


A Negative Externality A Negative Externality ExampleExample When there are negative externalities, the

competitive price is too low and equilibrium quantity too high to maximize social welfare.


A Negative ExternalityA Negative Externality

D = Marginal social benefit

S = Marginal private cost

S1 = Marginal social costCost

Quantity0 Q0

P0

Q1

P1

Marginal cost from externality


A Positive Externality A Positive Externality ExampleExample Private trades can benefit third parties not

involved in the trade. A person who is working and taking

night classes benefits himself directly, and his co-workers indirectly.


A Positive Externality A Positive Externality ExampleExample Marginal social benefit equals the

marginal private benefit of consuming a good plus the positive externalities resulting from consuming that good.


A Positive ExternalityA 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


Alternative Methods of Alternative Methods of Dealing with Dealing with ExternalitiesExternalities Externalities can be dealt with via:

Direct regulation. Incentive policies. Voluntary solutions.


Direct RegulationDirect Regulation

Direct regulation –the amount of a good people are allowed to use is directly limited by the government.


Direct RegulationDirect Regulation

Direct regulation is inefficient, not efficient. Inefficient – achieving a goal in a more

costly manner than necessary. Efficient achieving a goal at the lowest

cost in total resources without consideration as to who pays those costs.


Incentive PoliciesIncentive Policies

Incentive policies are more efficient than direct regulatory policies.

The two types of incentive policies are either taxes or market incentives.


Tax Incentive PoliciesTax Incentive Policies

A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends.

The tax often yields the desired end more efficiently than straight regulation.



This solution embodies a measure of fairness about it – the person who conserves the most pays the least tax.



A way to handle pollution is through a tax called an effluent fee.

Effluent fees – charges imposed by government on the level of pollution created.


Regulation Through Regulation Through TaxationTaxation

Marginal social benefit

Marginal private cost

Marginal social costCost

Quantity0 Q0

P0

Q1

P1 Efficient tax


Market Incentive PoliciesMarket Incentive Policies

Market incentive program – market participants certify they have reduced total consumption – their own and/or other’s – by a specified amount.



A market incentive program is similar to the regulatory solution.

The amount of the good consumed is reduced.



A market incentive program differs from a regulatory solution.

Individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others.


Voluntary ReductionsVoluntary Reductions

Voluntary reductions allow individuals to choose whether to follow what is socially optimal or what is privately optimal.

Economists are dubious of voluntary solutions.



A person’s willingness to do things for the good of society generally depends on the belief that others will also be helping.



The socially conscious will often lose their social conscience when they believe a large number of other people are not contributing. This is example of a free rider

problem – individuals’ unwillingness to share in the cost of a public good.


The Optimal PolicyThe Optimal Policy

An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.



Resources are being wasted if a policy isn’t optimal. What is saved by reducing the program

is worth more than what is lost from the reducing the program.



Some environmentalists want to totally eliminate pollution.

Economists want to reduce pollution to the point where marginal costs of reducing pollution equals the marginal benefits.



Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.


Public GoodsPublic Goods

A public good is nonexclusive and nonrival. Nonexclusive – no one can be excluded

from its benefits. Nonrival – consumption by one does not

preclude consumption by others.



There are no pure examples of a public good. The closest example is national defense.

Technology can change the public nature of goods. Roads are an example.



Once a pure public good is supplied to one individual, it is simultaneously supplied to all.

A private good is only supplied to the individual who bought it.



With public goods, the focus is on groups. With private goods, the focus is on the

individual.



In the case of a public good, the social benefit of a public good is the sum of the individual benefits.



Adding demand curves vertically is easy to do in textbooks, but not in practice.

This is because individuals do not buy public goods directly so that their demand is not revealed in their actions.

The Market Value of a The Market Value of a Public GoodPublic 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



Informational ProblemsInformational Problems

Perfectly competitive markets assume perfect information.

Real-world markets often involve deception, cheating, and inaccurate information.



When there is a lack of information, buyers and sellers do not have equal information, markets may not work properly.



Economists call such market failures adverse selection problems.

Adverse selection problems – problems that occur when a buyer or a seller have different amounts of information about the good for sale.


Policies to Deal with Policies to Deal with Informational ProblemsInformational Problems Regulate the market and see that

individuals provide the correct information. Government licenses individuals in the

market and requires them to provide full information about the good being sold.


A Market in InformationA Market in Information

Information is valuable, and is an economic product in its own right.

Left on their own, markets will develop to provide information that people need and are willing to pay for it.


A Market in InformationA Market in Information

If the government regulates information, then markets for information will not develop.


Licensing of DoctorsLicensing of Doctors

Currently all doctors practicing medicine are required to be licensed.

Licensing of doctors is justified by informational problems.



Some economists argue that licensure laws were established to restrict supply, not to help the consumer. Instead of licensing doctors, the

government could give the public information about which treatments work and which do not.



Providing information rather than licensing would give rise to consumer sovereignty. Consumer sovereignty – the right of

the individual to make choices about what is consumed and produced.


An Informational An Informational Alternative to LicensureAlternative to Licensure In this scenario, the government would

require doctors to post their: Grades in college. Grades in medical school. Success rate for various procedures. References. Medical philosophy. Charges and fees.


An Informational An Informational Alternative to LicensureAlternative to Licensure This information alternative would provide

much more useful information to the public than the present licensing procedure.


Government Failures and Government Failures and Market FailuresMarket Failures Market failures should not automatically

call for government intervention. Why? Because governments fail too.


Government Failures and Government Failures and Market FailuresMarket Failures Government failure occurs when the

government intervention in the market to improve the market failure actually makes the situation worse.


Reasons for Government Reasons for Government FailuresFailures Governments do not have an incentive to

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.


Reasons for Government Reasons for Government FailuresFailures The bureaucratic nature of government

intervention does not allow fine tuning. Government intervention leads to more

government intervention.


Government Policy and Government Policy and Market FailuresMarket Failures

End of Chapter 18

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