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Chapter 19
MARKET
FAILURE versus
GVOERNMENT
FAILURE
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-2
Today’s lecture will:
• Explain what an externality is and
•
•
show how it affects the market
outcome.
Describe three methods of dealing
with externalities.
Define public good and explain the
problem with determining the value of
a public good to society.
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-3
Today’s lecture will:
• Explain how informational
•
problems can lead to market
failure.
Discuss five reasons why a
government’s solution to a market
failure could worsen the situation.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-4
Market Failures
• Market failure – the invisible hand pushes in
such a way that individual decisions do not
lead to socially desirable outcomes.
 Externalities
 Public goods
 Imperfect information
• Government failure – the government
intervention actually makes the situation
worse.
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-5
Externalities
• Externalities are the effects of a decision
•
•
on a third party that are not taken into
account by the decision-maker.
Negative externalities occur when the
effects are detrimental to others.
Positive externalities occur when the
effects are beneficial to others.
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-6
A Negative Externality
S1 = Marginal social cost
Cost,
Price
S = Marginal private cost
Marginal cost
from
externality
P1
P0
0
McGraw-Hill/Irwin
Q1 Q0
D = Marginal
social
benefit
Quantity
The competitive price,
P0, is too low and the
quantity, Q0, is too
high to maximize
welfare.
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-7
A Positive Externality
S = Marginal private and social cost
Cost,
Price
P1
D1 = Marginal social benefit
Marginal benefit of an
externality
P0
D0 = Marginal private benefit
0
Q0 Q1
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The competitive
price, P0, and
quantity, Q0, are too
low to maximize
welfare.
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-8
Alternative Methods of
Dealing with Externalities
• Direct regulation
• Incentive policies
 Tax incentives
 Market incentives
• Voluntary solutions
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-9
Tax Incentive Policies
Marginal social cost
Cost,
Price
Marginal private cost
P1
Efficient tax
P0
A tax on pollution that
equals the social cost of
the negative externality
will cause individuals to
reduce the quantity of
the pollution-causing
activity to a level, Q1.
Marginal
social
benefit
0
McGraw-Hill/Irwin
Q1 Q0
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-10
Market Incentive Policies
• A market incentive plan is similar to
•
direct regulation in that the amount of
the good consumed is reduced.
A market incentive plan differs from
direct regulation because individuals
who reduce consumption by more than
the required amount receive marketable
certificates that can be sold to others.
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19-11
Voluntary Reductions
• Voluntary reductions allow individuals to
•
•
choose whether to follow what is socially
optimal or what is privately optimal.
The socially conscious will often become
discouraged and quit contributing when
they believe a large number of people are
free riding.
Free rider problem – individuals’
unwillingness to share in the cost of a
public good.
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19-12
The 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.
For example, the optimal level of
pollution is not zero pollution, but the
amount where the marginal benefit of
reducing pollution equals the marginal
cost.
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-13
Public 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 public goods, but
national defense is the closest
example.
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-14
Public Goods
• A private good is only supplied to the
•
•
individual who bought it.
Once a pure public good is supplied to
one individual, it is simultaneously
supplied to all.
In the case of a public good, the social
benefit of a public good (its demand
curve) is the sum of the individual
benefits.
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19-15
The Market Value of a Public Good
Price
(0.60 + 0.50)
$1.10
1.00
.80
0.50
.60
.50
.40
0.10
0.60
.20
1
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0.40
0.50
2
Market demand
DB (0.10 + 0.40)
DA
0.10
3
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-16
economists
prefer to
classify
goods
according to
their degree
of rivalry and
excludability.
Rival
Apple
0% Fish in ocean
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NonRival
100%
Degree of Excludability
• Some
Degree of Rivalry in
Consumption
Encoded radio
broadcast
General R & D
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-17
Informational Problems
• Perfectly competitive markets
•
•
assume perfect information.
In the real world, buyers and sellers
do not usually have equal
information, and market failure due
to adverse selection may occur.
Adverse selection – problems that
occur when buyers and sellers have
different amounts of information
about the good for sale.
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19-18
Signaling May Offset
Information Problems
• Signaling – an action taken by an
•
•
informed party that reveals information
to an uninformed party that offsets the
false signal that caused the adverse
selection in the first place.
Selling a used car may provide a signal
to the buyer that the car is a lemon.
The false signal can by offset by a
warranty.
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19-19
Policies to Deal with
Informational Problems
• Regulate the market and see that
•
•
individuals provide the correct
information.
License individuals in the market and
require them to provide full information
about the good being sold.
Allow markets to develop to provide
information that people need and will
buy.
McGraw-Hill/Irwin
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19-20
Licensing of Doctors
• Medical care is an example of imperfect
•
•
information (patients usually don’t have a
way to know if a doctor is good).
Current practice is to require medical
licenses to establish a minimum level of
competency.
Another option is to provide the public with
information on:
 Grades in medical school
 Success rate for various procedures
 Charges and fees
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-21
Government Failures
and Market Failures
• Market failures should not
•
automatically call for government
intervention because governments
fail, too.
Government failure occurs when the
government intervention in the
market to improve the market failure
actually makes the situation worse.
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19-22
Reasons for Government Failures
• Governments do not have an incentive
•
•
•
and/or the information to correct the
problem.
Intervention is almost always more
complicated than it initially seems.
The bureaucratic nature of government
intervention does not allow fine tuning.
Government intervention leads to more
government intervention.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-23
Summary
• Three sources of market failure are
•
externalities, public goods, and imperfect
information.
An externality is the effect of a decision on a
third party that is not taken into account by the
decision maker.
 Positive externalities provide third-party benefits.

Markets for these goods produce too little for too
great a price.
Negative externalities impose third-party costs, and
markets produce too much for too low a price.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-24
Summary
• Economists generally prefer incentive-based
•
•
programs, such as a tax on the producer of a
good with a negative externality, because they
are more efficient than direct regulation or
voluntary programs.
Voluntary solutions are difficult to maintain
because people become free riders.
An optimal policy is one in which the marginal
benefit of the undertaking equals its marginal
cost.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-25
Summary
• Public goods are nonexclusive and nonrival.
• Theoretically the market value of a public good
•
•
can be calculated by summing the value that
each individual places on every quantity.
Adverse selection occurs when buyers or seller
withhold information causing the market for the
good to disappear.
Licensure and full disclosure are solutions to
the information problem.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-26
Summary
• Government failure, in which intervention
worsens the problem, occurs because:
 Governments don’t have incentives and/or
information to correct the problem.
 Intervention is more complicated than it
initially seems.
 The bureaucratic nature of government
precludes fine-tuning.
 Government intervention leads to more
government intervention.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-27
Review Question 18-1 Explain why, if there is a negative
externality, the market equilibrium is inefficient.
When there are negative externalities, the market supply
curve reflects only the private marginal cost, so marginal
social cost exceeds marginal benefit. If the cost to the
third party could be added in, the price would be higher
and the output lower.
Review Question 18-2 What are the differences between
public goods and private goods?
A public good is nonexclusive (no one can be excluded
from its benefits) and nonrival (consumption by one does
not preclude consumption by others). National defense is
the closest example of a public good. A private good is
exclusive and rival. A pizza is an example of a private
good.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.