Government Policy and Market FailuresGovernment Policy and Market
Failures
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Laugher 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.
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Introduction
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.
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Market Failures
Market failure – the invisible hand pushes in such a way that
individual decisions do not lead to socially desirable
outcomes.
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Market 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.
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Externalities
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.
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Externalities
Negative externalities occur when the effects of a decision not
taken into account by the decision-maker are detrimental to
others.
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Externalities
Positive externalities occur when the effects of a decision not
taken into account by the decision-maker is beneficial to
others.
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A Negative Externality Example
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.
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A Negative Externality Example
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.
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A Negative Externality Example
When there are negative externalities, the competitive price is too
low and equilibrium quantity too high to maximize social
welfare.
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A Negative Externality
A Positive Externality Example
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.
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A Positive Externality Example
Marginal social benefit equals the marginal private benefit of
consuming a good plus the positive externalities resulting from
consuming that good.
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A Positive Externality
D0 = Marginal private benefit
D1 = Marginal social benefit
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Alternative Methods of Dealing with Externalities
Externalities can be dealt with via:
Direct regulation.
Incentive policies.
Voluntary solutions.
Direct Regulation
Direct regulation –the amount of a good people are allowed to use
is directly limited by the government.
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Direct 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.
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Incentive Policies
Incentive policies are more efficient than direct regulatory
policies.
The two types of incentive policies are either taxes or market
incentives.
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Tax 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.
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Tax Incentive Policies
This solution embodies a measure of fairness about it – the person
who conserves the most pays the least tax.
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Tax Incentive Policies
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.
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Regulation Through Taxation
Marginal social benefit
Marginal private cost
Marginal social cost
Market Incentive Policies
Market incentive program – market participants certify they have
reduced total consumption – their own and/or other’s – by a
specified amount.
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Market Incentive Policies
A market incentive program is similar to the regulatory
solution.
The amount of the good consumed is reduced.
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Market Incentive Policies
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.
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Voluntary 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.
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Voluntary Reductions
A person’s willingness to do things for the good of society
generally depends on the belief that others will also be
helping.
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Voluntary Reductions
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.
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The Optimal Policy
An optimal policy is one in which the marginal cost of undertaking
the policy equals the marginal benefit of that policy.
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The Optimal 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.
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The Optimal Policy
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.
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The Optimal Policy
Optimal level of pollution – the amount of pollution at which the
marginal benefit of reducing pollution equals the marginal
cost.
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Public Goods
Nonexclusive – no one can be excluded from its benefits.
Nonrival – consumption by one does not preclude consumption by
others.
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Public Goods
The closest example is national defense.
Technology can change the public nature of goods.
Roads are an example.
Public Goods
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.
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Public Goods
With private goods, the focus is on the individual.
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Public Goods
In the case of a public good, the social benefit of a public good
is the sum of the individual benefits.
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Public Goods
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.
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The Market Value of a Public Good
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0.50
Price
1
2
3
Quantity
.80
.60
.40
.20
1.00
Informational Problems
Real-world markets often involve deception, cheating, and
inaccurate information.
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Informational Problems
When there is a lack of information, buyers and sellers do not have
equal information, markets may not work properly.
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Informational Problems
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.
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Policies to Deal with Informational 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.
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A 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.
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A Market in Information
If the government regulates information, then markets for
information will not develop.
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Licensing of Doctors
Currently all doctors practicing medicine are required to be
licensed.
Licensing of doctors is justified by informational problems.
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Licensing of Doctors
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.
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Licensing of Doctors
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.
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An Informational Alternative to Licensure
In this scenario, the government would require doctors to post
their:
Grades in college.
References.
An Informational Alternative to Licensure
This information alternative would provide much more useful
information to the public than the present licensing
procedure.
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Government Failures and Market Failures
Market failures should not automatically call for government
intervention.
Why? Because governments fail too.
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Government Failures and Market Failures
Government failure occurs when the government intervention in the
market to improve the market failure actually makes the situation
worse.
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Reasons for Government Failures
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.
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Reasons for Government Failures
The bureaucratic nature of government intervention does not allow
fine tuning.
Government intervention leads to more government
intervention.
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