Download The Economic Role of Government

The Government’s Role
Market Failures vs
Government Failures
• A market failure - a situation where individual
decisions do not lead to socially desirable outcomes
• Externalities
• Public goods
• Imperfect information
• Government failures are when the government
intervention actually makes the situation worse
Economic Efficiency and
the Role of Government
or
What can the Government
do for less cost?
What does Efficiency mean?
• efficiency - the maximum value/benefit of
output from the cost.
• 2 conditions necessary for ideal
efficiency:
• All activities with more benefits than
costs must be undertaken.
• No activities that provide benefits less
than costs should be undertaken.
Efficiency Graphed
• Marginal (or Additional) Cost to Provide
• Marginal Benefit Provided to Society.
Price
Marginal Cost
Q1 too little
Q3 too much
Q1 just right
Marginal Benefit
Q1 Q 2
Q3
Quantity/time
The Role of Government
and Shortcomings of the
Invisible Hand
4 Reasons the Invisible Hand May
Fail to Allocate Resources Efficiently
Lack of Competition
Externalities
Public Goods
Poor Information
(1) Lack of Competition
• Sellers may restrict output and raise price.
• Too few units will be produced.
Price
S2(restricted supply)
S1(competitive supply)
P2
P1
D
Q2
Q1
Quantity/time
(2) Externalities (Spillovers)
• Externalities - the market fails to register fully
costs and benefits.
• External costs:
• When the actions of an individual or group incur a
cost to 3rd party.
• External benefits:
• Present when the actions of an individual or group
generate benefits for 3rd parties.
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
• Ex. Second-hand smoke and carbon
monoxide emissions
• Positive externalities occur when the effects are
beneficial to others
• Ex. Education or vaccinations
sweater factory
beach
brewery
External Cost (Spillover)
• All of the costs of production are not fully
registered, so the supply curve understates
the true cost of production. (Shifts left)
Price
S2(including external costs)
Ideal price
and output
S1
P2
Actual price
and output
P1
D
Q2
Q1
Quantity/time
• Too many units are produced.
• Pollution problems are often a side effect.
External Benefit
• The demand curve understates the total value of
the output.
Price
S1
Ideal price
and output
P2
Actual price
and output
P1
D2(including external benefits)
D1
Q1 Q 2
Quantity/time
• From the viewpoint of efficiency, too few units may
be produced.
A Negative Externality Example
Cost, P
S1 = Marginal
Social Cost
S0 = Marginal
Private Cost
P1
Cost of
externality
P0
D = Marginal
Benefit
Q1 Q0
Q
Social
If there are no
externalities, P0Q0 is the
equilibrium
If there are
externalities, the
marginal social cost
differs from the marginal
private cost, and P0 is
too low and Q0 is too
high to maximize social
welfare
Government intervention
may be necessary to
reduce production
A Positive Externality Example
If there are no
externalities, P0Q0 is
the equilibrium
Cost, P
S
P1
P0
Benefit
of
externalit
y
= Marginal
Private Cost
D1
D0
Q0
Q1
= Marginal
Social Benefit
= Marginal
Private Benefit
Q
If there are
externalities, the marginal
social benefit differs
from the marginal private
benefit, and both P0 and
Q0 are too low to
maximize social welfare
Government
intervention may be
necessary to increase
consumption
Methods of Dealing with Externalities
• Direct regulation is when the government
directly limits the amount of a good people are
allowed to use
• Incentive policies
• Tax incentives are programs using a tax to
create incentives for individuals to structure
their activities in a way that is consistent with
the desired ends
• Market incentives are plans requiring market
participants to certify that they have reduced
total consumption by a certain amount
• Voluntary solutions
Why the Invisible Hand May Fail
(3) Public Goods
• Public goods are:
1. jointly consumed
– Individuals can simultaneously enjoy
consumption of same product or service
• If a public good is made available to one,
it is simultaneously made available to others.
Characteristics of a Public Good
2. non-excludable
– Consumption of the good is not able to be
restricted to the customers who pay for it
• Because those who do not pay can not be
excluded, no one has much of an incentive to
pay for such goods; each has an incentive to
become a free rider.
• Free rider:
– a person who receives the benefits of the
good without helping to pay for its cost.
• When a lot of people become free riders, too
little of the good is produced.
• Examples of public goods:
• national defense
• radio and television broadcast signals
• clean air.
Question for Thought:
1. Which of the following are public goods?
(using the definition of a public good.)
a. An anti-missile system surrounding Washington.
b. A fire department.
c. Tennis courts.
d. Shenandoah National Park.
e. Elementary schools
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 (value on the vertical axis)
• To create market demand,
• private goods: sum demand curves horizontally
• public goods: sum demand curves vertically
The Market Value of a Public Good
Price
A public good is enjoyed
by many people without
diminishing in value
$1.20
$1.10
$1.00
Individual A’s demand is
vertically summed with…
$0.80
$0.60
Market Demand
$0.40
$0.60
Individual B’s demand
to equal…
Demand B
$0.50
$0.20
Demand A
Quantity
1
2
3
Market demand for a
public good
(4) Poor Information
• A minimal problem if the item is purchased
regularly.
• Problems can arise if goods are:
• difficult to evaluate on inspection and
seldom repeatedly purchased from the
same producer, or,
• potentially capable of serious and
lasting harmful side effects that
cannot be predicted by a lay person.
Informational Problems
• Signaling may offset information problems
• Signaling refers to 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 false signal to
the buyer that the car is a lemon
• The false signal can be offset by a warranty
(4) Poor Information
• Market responses to poor information:
• Consumer information publications
• Provide expert evaluation and unbiased
information
• Brand names and franchises
• Provide standardized quality and dependability
• Warranties
• Supplier promises to repair possible problems
Government Failures and Market Failures
• All real-world markets in some way fail
• 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
Reasons for Government Failures
1. Government doesn’t have an incentive to
correct the problem
2. Government doesn’t have enough information to
deal with the problem
3. Intervention in markets is almost always more
complicated than it initially seems
4. The bureaucratic nature of government intervention
does not allow fine-tuning
5. Government intervention leads to more
government intervention
1. Which of the following is the most fundamental function
of government?
a. protection of individuals and their property
b. imposing progressive taxes to fund income-transfer
programs
c. regulating prices and wages
d. provision of postal services and garbage collection
2.Economic efficiency requires that
a. individuals produce at their maximum level.
b.only long-lasting, high-quality products be produced
without regard to cost.
c. income be distributed equally among consumers.
d.all economic activity generating more benefits than costs
be undertaken
3. When production of a good generates external costs, the
a. demand curve for the good will overstate the true social benefits
from consumption of the good.
b. demand curve for the good will understate the true social benefits
from consumption of the good.
c. supply curve for the good will overstate the true social cost of
producing the good.
d. supply curve for the good will understate the true social cost of
producing the good.
4. From the viewpoint of economic efficiency, when competitive forces
in an industry are weak, market allocation will often lead to
a. an output of the product that exceeds the amount consistent with
ideal economic efficiency.
b. an output of the product that is less than the amount consistent with
ideal economic efficiency.
c. an output of the product that equals the amount consistent with ideal
economic efficiency.
d. product prices that are below the cost of production.
5. Competitive markets generally give consumers and producers correct
incentives when
a. externalities are present in the market.
b. property rights are well-defined and enforced.
c. the good being produced and consumed is a pure public good.
d. there is a substantial lack of information on the part of either buyers or
sellers.
6.
Which of the following correctly describes the external benefit
resulting from an individual’s purchase of a winter flu shot?
a. The flu shot is cheaper than the cost of treatment when you get
the flu.
b. The income of doctors increases when you get the flu shot.
c. The flu shot reduces the likelihood others will catch the flu.
d. The flu shot reduces the likelihood you will miss work as the result
of sickness; therefore, you will earn more income.
7.
Which of the following is the best example of a
public good?
a.
a government-run health care system
b.
the Walt Disney World amusement park
c.
national defense
d.
long-distance telephone service
8.
Markets may have difficulty providing the proper quantity of a
public good because
a. individuals will tend to become free riders, and private firms will
have difficulty generating enough revenue to produce an efficient
quantity of the good.
b. the good generally has a very large value to consumers relative to
its cost of production.
c. the good is one that tends to benefit a large number of people.
d. the large profit involved in the production of a public good is
generally too much for private firms to effectively pay out to
shareholders.
9.
Suppose paper pulp mills are permitted to emit harmful
pollutants, free of charge, into the air. How will the price and output
of paper in a competitive market compare with their values under
conditions of ideal economic efficiency?
a.
The price will be too high, and the output will be too large.
b.
The price will be too low, and the output will be too large.
c.
The price will be too low, and the output will be too small.
d.
The price will be too high, and the output will be too small.
10. Which of the following is a source of information
that helps consumers acquire information about the quality
of a good or service?
a.
brand names
b.
franchising
c.
consumer ratings magazines
d.
all of the above