The Government’s Role

Economic Efficiency and the Role of Government

or What can the

Government do for less cost?

• efficiency - the maximum value/benefit of output from the cost.

What does Efficiency mean?

• 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.

• Marginal (or Additional) Cost to Provide• Marginal Benefit Provided to Society.

Efficiency Graphed

Price

Quantity/timeQ1

Marginal Cost

Q2

Marginal Benefit

Q3

Q1 too little

Q3 too much

Q1 just right

1. Protection of individuals and their property against acts of aggression.• Including prosecution of

aggressors

Functions of Government

2. Provision of goods difficult to supply through the market.• Also a stable monetary and financial

environment

The Role of Government and Shortcomings of the

Invisible Hand

Lack of Competition

Externalities

4 Reasons the Invisible Hand MayFail to Allocate Resources

Efficiently

Public Goods

Poor Information

• Sellers may restrict output and raise price.• Too few units will be produced.

(1) Lack of Competition

Price

Quantity/time

P2

P1

Q1

D

S1(competitive supply)

Q2

S2(restricted supply)

• 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.

(2) Externalities (Spillovers)

sweater factory

beach

brewery

• All of the costs of production are not fully registered, so the supply curve understates the true cost of production. (Shifts left)

• Pollution problems are often a side effect.

External Cost (Spillover)

Price

Quantity/time

P2

P1

Q1

D

S1

Q2

S2(including external costs)

Ideal price and output

Actual price and outputActual price and output

• Too many units are produced.

• The demand curve understates the total value of the output.

External Benefit

• From the viewpoint of efficiency, too few units may be produced.

Price

Quantity/time

P2

P1

Q1

D1

S1

Q2

Ideal price and output

D2(including external benefits)

Actual price and output

• Public goods are:1. jointly consumed

– Individuals can simultaneously enjoy consumption of same product or service

Why the Invisible Hand May Fail(3) Public Goods

• If a public good is made available to one, it is simultaneously made available to others.

• 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.

Characteristics of a Public Good2. non-excludable– Consumption of the good is not able to be restricted to the customers who pay for it

• 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

a. An anti-missile system surrounding Washington.

• 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.

(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

(4) Poor Information

The Opportunity Cost of Government

• Opportunity cost of resources used to produce goods supplied through the public sector.

• Cost of resources expended in the collection of taxes and the enforcement of government mandates.

• Excess burden (deadweight loss) of taxation.

1. Which of the following is the most fundamental function of government?

a. protection of individuals and their propertyb. imposing progressive taxes to fund income-transfer

programsc. regulating prices and wagesd. 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, thea.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 whena. 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 systemb. the Walt Disney World amusement parkc. national defensed. long-distance telephone service

8. Markets may have difficulty providing the proper quantity of a public good becausea.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 namesb. franchisingc. consumer ratings magazinesd. all of the above