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Government and the Market
The Role of Government Capitalism is associated with limited government, but
government is necessary for three reasons: Establish and maintain legal system to protect property
rights. Promote equity in the distribution of income and wealth. Correct inefficiencies that arise from markets (externalities,
public goods, and monopoly power). Public Finance/Choice is the area of economics that
studies the public sector. Incentives are different in markets versus political sphere– in
capitalism preference are revealed with purchases versus votes.
Another Look at Efficiency Efficiency in competitive markets occurs
where MB=MC. Where MB= private (max.) willingness to pay and MC= private (min.) willingness to sell.
More correctly, society will see the outcome as efficiency where marginal social benefits = marginal social costs.
Externalities drive a wedge between private and social benefits and private and social costs.
Figure 1 The Market for Aluminum
Copyright © 2004 South-Western
Quantity ofAluminum
0
Price ofAluminum
Equilibrium MB=MC
Demand(private value)
Supply(private cost)
QMARKET
Externalities Externalities are benefits (costs) received (borne) by
neither the seller or the buyer but by third parties. Private benefits + external benefits = social benefits Private costs + external costs = social costs Since external benefits and costs are not perceived
by buyers and sellers they are not captured in markets.
Therefore, markets may fail to allocate resources inefficiently.
Negative externalities Marginal social costs are greater than marginal private
costs. Pollution is a cost that may not be borne by sellers, but
it is a cost nonetheless to society. Private markets will overproduce (devote too many
resources) to the production of goods with negative externalities.
External costs and the supply curve. Missing the extra costs, markets generate an outcome
where MSC > MSB, signal that decreasing output will increase net social benefits.
Is zero pollution efficient?
Figure 2 Pollution and the Social Optimum
Copyright © 2004 South-Western
Equilibrium
Quantity ofAluminum
0
Price ofAluminum
Demand(private value)MPB=MPB
Supply(private cost)=MPC
SocialCost =MSC
QOPTIMUM
Optimum
Cost ofpollution
QMARKET
MSC
MSB
MSC
MSB
Positive externalities Marginal social benefits are greater than marginal
private benefits. Education is a benefit not only to the individual but to
society in general. Private markets will underproduce (devote too few
resources) to the production of goods with positive externalities.
External benefits and the demand curve. Missing the extra benefits, markets generate
outcomes where MSB > MSC, a signal that increasing production will increase net social benefits.
Figure 3 Education and the Social Optimum
Copyright © 2004 South-Western
Quantity ofEducation
0
Price ofEducation
Demand(private value)
Socialvalue
Supply(private cost)
QMARKET QOPTIMUM
Internalizing or Correcting Externalities
Efficiency versus who ought to modify their behavior? Moral and Ethical Codes Non-governmental organizations or Charities Integrating certain activities (bee keepers and fruit growers) Contract between parties Coase Theorem – if negotiation costs are zero, private
parties can resolve the problem of externalities. An optimal compensatory payment (bribe) = one that makes both
parties better off. Initial distribution of rights does not affect the efficient outcome, but
it does determine who will pay whom. Example of heating the apartment in Santiago
Government policies Regulation
Limits to pollution Specific technology requirements Government production Regulation and least cost solutions
Taxes and Subsidies Who should pay the tax or receive the subsidy?
Tax /subsidy incidence is the same External costs, supply (demand) and the optimal tax. External benefits, demand (supply) and the optimal
subsidy.
Tradeable Pollution Permits The higher costs of avoiding pollution, i.e. the
higher the benefits from polluting, the more a firm is willing to pay.
Criticism of Economic Solutions to Pollution To live is to pollute Natural carrying capacity
The Invisible Hand and Invisible Benefits and Costs Externalities are “invisible” to buyers and sellers in
markets. In some cases, government action may be needed to make them visible and ensure they are included in economic decision-making.
The efficient allocation of resources occurs where:
MSB=MSC
Public Goods and Common Resources Certain kinds of goods or services are
underproduced in markets because the market does not contain sufficient incentives to produce them in efficient amounts.
Certain kinds of resources are overused because they are owned collectively or people cannot prevent them from being used.
Classifying Different Kinds of Goods and Services
Exclusion or non-exclusion– can individuals be excluded from consuming the good or the resource. (e.g. hamburger, houses, physical examination versus fireworks, national defense, and the ocean outside of territorial waters)?
Rival or non-rival – does one person’s use of the good or resource affect another persons use. (e.g. hamburger versus lighthouse, uncongested versus congested highway)
Figure 1 Four Types of Goods
Copyright © 2004 South-Western
Rival?
Yes
Yes
• Ice-cream cones• Clothing• Congested toll roads
• Fire protection• Cable TV• Uncongested toll roads
No
Private Goods Natural Monopolies
No
Excludable?
• Fish in the ocean• The environment• Congested nontoll roads
• Tornado siren• National defense• Uncongested nontoll roads
Common Resources Public Goods
Private Good – excludable and rival (hamburger)
Public Good – not excludable and non-rival (lighthouse, warning siren)
Common Resource – rival but not excludable (ocean, old days pasture land)
Natural Monopoly – excludable but non-rival (protecting another house – MC is small)
Public Goods Examples are fireworks, national defense, basic
research, alleviating poverty) Free-rider problem – another example of revealed
preference. If people cannot be excluded, they have no little incentive to pay for the good or service).
Free-riders make it difficult for private providers to provide the optimal amount of a public good.
Voluntary exchange does not work efficiently and efficiency may be provided by government coercion.
Government Provision versus Production of Public Goods The government must perform cost-benefit
analysis to decide if it is worthwhile to provide the good and determine how much should be produced (valuing a life). Stoplights Highways – public or private, uncongested or
congested
Taxes are then imposed to provide for the good.
Tragedy of the CommonsBoston Commons – overuse of a rival
resource where individuals were not purposively not excluded.
Ocean FishingBison versus Cattle – the importance of
property rightsPricing in national parks
SummaryEfficiency and the market systemMarket failuresGovernment failures