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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. McGraw-Hill/Irwin 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. McGraw-Hill/Irwin 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. McGraw-Hill/Irwin 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 McGraw-Hill/Irwin 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 McGraw-Hill/Irwin 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. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw-Hill/Irwin 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. McGraw-Hill/Irwin 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. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill/Irwin 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 McGraw-Hill/Irwin 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. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill/Irwin 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. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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.