Unit VI: Market Failures

Unit VI: Market Failures

What is the Free Market?•A economic structure where supply and demand allocate resources. There is little to no government intervention.

What is the Invisible Hand?The concept that society’s goals will be met as individuals seek their own self-interest.Competition and self-interest act as an invisible

hand that regulates the free market.

Example: People love the green shirts that a firm is making…..

What is a Free Market Failure?

•When the free-market system fails to satisfy society’s wants.•Private markets do not efficiently bring about the allocation of resources.

What’s the result…The government must step in to

satisfy society’s wants.

Four Market Failures

1. Public Goods2. Externalities 3. Monopolies4. Unfair distribution of income

In each of the above situations, the government MUST step in to fix the

problem.

Market Failure #1:Market Failure #1:PUBLIC GOODSPUBLIC GOODS

Why must the public sector provide goods and services?

•It is impractical for the free-market to provided these goods because there is no opportunity to earn profit.• This is due to the Free-Rider Problem

•Free Riders are individuals that benefit without paying.

PUBLIC GOODS

•Free-Riders keep firms from making profits.•If left to the free market, essential services would be under produced.

What’s wrong with Free Riders?

Two criteria of public goods:1. Nonexclusion

PUBLIC GOODS

2. Shared Consumption (nonrivalry)

•Everyone can use the good.•Cannot exclude benefits of the good for those who will not pay.•Ex: National Defense

•One person’s consumption of a good does not reduce the usefulness to others.

•Ex: Kit Carson Park

HOW MUCH PUBLIC GOODS?

Can there every be too much of a public good?

Can there be too many parks?

How does the government determine what quantity of public goods to produce?

They use Supply and Demand

Demand for Public Goods-The Marginal Social Benefit of the good determined by citizens willingness to pay.

Supply of Public Goods- The Marginal Social Cost of providing each additional quantity.

Marginal Willingness to Pay Higher Taxes

Quantity

Adams’Willingness

to pay (price)

Benson’sWillingness

to pay (price)

Society’sWillingness

to pay (price)

1 $4 $5 $9+ =

DEMAND FOR A NEW HIGHWAY

Quantity

Adams’Willingness

to pay (price)


to pay (price)

12

$4 3

$5 4

$9 7

++

==


to pay (price)

DEMAND FOR A NEW HIGHWAYMarginal Willingness to Pay Higher

Taxes

Quantity

Adams’Willingness

to pay (price)


to pay (price)

123

$4 3 2

$5 4 3

$9 7 5

+++

===


to pay (price)


Taxes

Quantity

Adams’Willingness

to pay (price)


to pay (price)

1234

$4 3 2 1

$5 4 3 2

$9 7 5 3

++++

====


to pay (price)


Taxes

Quantity

Adams’Willingness

to pay (price)


to pay (price)

12345

$4 3 2 1 0

$5 4 3 2 1

$9 7 5 3 1

+++++

=====


to pay (price)


Taxes

Price

Quantity of Highways

$ 9 7

5

3

1

0 1 2 3 4 5

D=MSB

OPTIMAL AMOUNT OF A PUBLIC GOOD

The Demand is the equal to the marginal benefit

to society

P

Q

$ 9 7

5

3

1

0 1 2 3 4 5

The public good’smarginal cost

S=MSC


D=MSB

P

Q

$ 9 7

5

3

1

0 1 2 3 4 5

D=MSB

S=MSC


Theoptimum amount

of the public good

MSB = MSC

Why shouldn’t 2 highways be made?

Why shouldn’t 4 highways be made?

Market Failure #2:Market Failure #2:EXTERNALITIESEXTERNALITIES

•An externality is a third-person side effect.•Externalities are when there are either EXTERNAL benefits or external costs to someone other than the original decision maker. Why are Externalities Market Failures?•The free market fails to include external costs or external benefits causing misallocation of resources. Example: Smoking Cigarettes.•The free market assumes that the cost of smoking is fully paid by people who smoke. •The government recognizes external costs and makes policies to limit smoking.

What are Externalities?

NegativeExternalities

•Decisions that result in a cost for a different person other than the original decision maker.•The costs “spillover” to other people or society.

EX: Zoram is a chemical company that pollutes the air when it produces its good. •Zoram only looks at its INTERNAL costs.•The firms ignores the social cost of pollution•So, the firm’s marginal cost curve is its supply curve•When you factor in EXTERNAL costs, Zoram is producing too much of its product.•The government recognizes this and limits their production.

Negative Externalities (aka: Spillover Costs)

P

Q

D=MSB

0

Supply = Marginal

Private Cost

Qe

The marginal cost doesn’t include the costs to society.

P

Q0

Spillovercosts

Qe

What will the MC look like when EXTERNAL cost are factor in?

Supply = Marginal

Private Cost

D=MSB

P

Q0 Qe

Supply = Marginal

Private Cost

Supply = Marginal

Social Cost

This is the REAL supply curve

D=MSB

P

Q0

S=MSC

S= Private

Overallocation

QOptimal Qe

Compare MSB and MSC at Qe

Is too much or too little being produced?

D=MSB

PositiveExternalities

Positive Externalities (aka: Spillover Benefits)

•Decisions that result in a benefit for someone other than the original decision maker.•The benefits “spillover” to other people or society.(EX: Flu Vaccines, Education, Home Renovation)

Example: A mom decides to get a flu vaccine for her child•Mom only looks at the INTERNAL benefits.•She ignores the social benefits of a healthier society.•So, her private marginal benefit is her demand •When you factor in EXTERNAL benefits the marginal benefit and demand would be greater.•The government recognizes this and subsidizes flu shots.

P

Q0 Qe

S=MC

Demand=Marginal Private Benefit

The marginal benefit doesn’t include the benefits to society.

P

Q0

SpilloverBenefits

Qe

What will the demand look like when EXTERNAL benefits are factor in?


S=MC

P

Q0 Qe

This is the REAL demand curve


S=MC

Demand=Marginal Social Benefit

P

0 Qe

D=MPB

S=MC

D=MSB

Compare MSB and MSC at Qe

Is too much or too little being produced?

UnderallocationQOptimal

CORRECTINGEXTERNALITIES

P

Q

CORRECTING SPILLOVER COSTS

D

0

Spillovercosts

S=MSC

S Private

TAX

OverallocationCorrected

Q0 Qe

(Solution: Tax the amount of the externality)

P

Q

CORRECTING SPILLOVER BENFITS

0 QOptimalQe

D Private

S

D=MSB

SpilloverBenefits

UnderallocationCorrected

(Subsidize either producers or consumers the amount of the externality)

The Economics of Pollution

Economics of PollutionWhy are public bathrooms so gross?

The Tragedy of the Commons (AKA: The Common Pool Problem)•Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted since no one has the incentive to keep them clean. •There is no monetary incentive to use them efficiently.•Result is high spillover costs.

Market Failure #3:Market Failure #3:MonopoliesMonopolies

Government in Action:

Antitrust Laws

WHAT ARE ANTITRUST LAWS?Laws designed to prevent monopolies and promote competition.

Why are monopolies a Market Failure?

•Monopolies destroy the key ingredient of the free market system- Competition. •To fix this MARKET FAILURE the government must get involved.•Identify the socially optimal and fair return points.

Market Failure #4Unfair Distribution of

Income

Income Inequality In 2001, the average American family made $66,863. Everyone is obviously rich.

What’s wrong with using the average?

Averages reveal absolutely nothing about how income is distributed.

How does the government measure distribution of income?

The LAST graph to learn for Microeconomics

THE LORENZ CURVE

Measuring Income Distribution Review the process:• The government divides all income earning

families into five equal groups (quintiles) from poorest to richest.

• Each groups represents 20% of the population.• If there was perfect equality then 20% of the

families should earn 20% of the income, 40% should earn 40% (and so on)

• The government compares how far the actual distribution is from perfect distribution then attempts to redistribute money fairly.

20 40 60 80 100

100

80

60

40

20

0

Percent of Families

Per

cen

t o

f In

com

ePerfect Equality

THE LORENZ CURVE

20 40 60 80 100

100

80

60

55

40

30

2015

5 0

Percent of Families

Per

cen

t o

f In

com

e

THE LORENZ CURVE

Perfect Equality

Lorenz Curve (actual distribution)

20 40 60 80 100

100

80

60

40

20

0

Percent of Families

Per

cen

t o

f In

com

ePerfect Equality


Area betweenthe lines shows

the degree ofincome inequality

THE LORENZ CURVE

20 40 60 80 100

100

80

60

40

20

0

Percent of Families

Per

cen

t o

f In

com

e Perfect Equality


THE LORENZ CURVE

We have a Market Failure.Income is extremely unfairly

distributed.How does this get fixed?

20 40 60 80 100

100

80

60

40

20

0

Percent of Families

Per

cen

t o

f In

com

e Perfect Equality


THE LORENZ CURVE

Lorenz curveafter government

re-distribution

Taxes

Three Types of Taxes

What kind of taxes are these? (THINK % of Income)1. Toll road tax ($1 per day)2. State income tax where richer citizens pay higher % 3. $.45 excise tax on cigarettes4. Medicare tax of 1.45% of every dollar earned 5. 6% California sales tax

1. Progressive Taxes -takes a larger percent of income as income rises (takes more from rich people) Ex: Current Federal Income Tax system

3. Regressive Taxes –takes a larger percentage from low income groups. (takes more from poor people) Ex: Sales tax; any consumption tax.

2. Proportional Taxes (flat rate) –takes the same percent of income from all income groups. Ex: 20% flat income tax on all income groups

GREAT NEWS…

YOU ARE DONE WITH MICRO!!!!

Documents

Unit VI: Market Failures