Market FailureMarket FailureAn Exploration into the Dark An Exploration into the Dark

SideSideJoin me and together we will OWN the

Universe!

Too late, Vader…I already do!

ObjectivesObjectives Explain market failure.Explain market failure. Identify the conditions under which market failure Identify the conditions under which market failure

may occur.may occur. Compare Public and Private goodsCompare Public and Private goods Calculate the optimal provision of a public good.Calculate the optimal provision of a public good. Evaluate the provision of public transportationEvaluate the provision of public transportation Respond to the provision of health care offered in Respond to the provision of health care offered in

major health care plansmajor health care plans Explain the economists definition of an externalityExplain the economists definition of an externality Describe real-world conditions for externalitiesDescribe real-world conditions for externalities Evaluate solutions (pigovian tax, Coase theorem) Evaluate solutions (pigovian tax, Coase theorem)

for externalitiesfor externalities

How do markets fail?How do markets fail?

Market inconsistency – the bumpy Market inconsistency – the bumpy roadroad

Lack of provision of Lack of provision of public goodspublic goods Existence of Existence of externalitiesexternalities InequalityInequality of income and wealth of income and wealth

distributiondistribution MonopolyMonopoly power concentrated into power concentrated into

the hands of a fewthe hands of a few

Market InconsistencyMarket Inconsistency

Markets are a constant battleground Markets are a constant battleground for customers, resources, and profit.for customers, resources, and profit.

Firms never act in the interest of Firms never act in the interest of anyone or anything but themselvesanyone or anything but themselves

Consequence: The consumer and Consequence: The consumer and laborer faces firms entering and laborer faces firms entering and exiting markets, jobs being created exiting markets, jobs being created and lost, and price flucuationsand lost, and price flucuations

Public vs. PrivatePublic vs. Private Public goods are not necessarily government Public goods are not necessarily government

ownedowned Two characteristicsTwo characteristics

RivalryRivalry – use of the good prevents its use by another – use of the good prevents its use by another ExcludabilityExcludability – use of good requires some sort of – use of good requires some sort of

mechanism for distribution: price systemmechanism for distribution: price system Private Goods: Private Goods: RivalrousRivalrous and and ExcludableExcludable

Public Goods: Public Goods: Non-rivalrousNon-rivalrous and and non-non-excludableexcludable

Private Goods:Private Goods: Rivalrous and Excludable Rivalrous and Excludable Markets will not provide public goods…so Markets will not provide public goods…so

who should?who should? Government? Private companies forced?Government? Private companies forced?

Public GoodsPublic Goods

A public good is one that cannot, by A public good is one that cannot, by definition, profit directly from its existencedefinition, profit directly from its existence– Fees could be charged for the view of a statue, Fees could be charged for the view of a statue,

for example, but if there is no means of for example, but if there is no means of stopping someone from viewing the statue for stopping someone from viewing the statue for free, it would reason that many people would free, it would reason that many people would look at the statue for freelook at the statue for free

Public goods are plagued by the problem Public goods are plagued by the problem of of free ridersfree riders..– Free riders are those people who, when not Free riders are those people who, when not

required to pay for a good or service, do not!required to pay for a good or service, do not!

Free Ride…Free Ride… Take it easy!Take it easy! That is a good song but really bad for economists!That is a good song but really bad for economists! The problem of the free-riderThe problem of the free-rider

– Demand for a public good is not expressed by the marketDemand for a public good is not expressed by the market– No profit-maximizing firm, in turn, would be willing to produce No profit-maximizing firm, in turn, would be willing to produce

a public gooda public good– Yet many in the market may greatly desire the public goodYet many in the market may greatly desire the public good– So, the government will step in and provide the good…So, the government will step in and provide the good…

The government, however, cannot know what the demand The government, however, cannot know what the demand for a public good is, so it must guessfor a public good is, so it must guess

In estimating the demand for a public good, the In estimating the demand for a public good, the government would need to poll people and ask them how government would need to poll people and ask them how much they would be willing to pay marginally for an much they would be willing to pay marginally for an additional unit of the public good.additional unit of the public good.– How much would you pay for a 1 lane road? 2 lane road? 4 How much would you pay for a 1 lane road? 2 lane road? 4

lanes?lanes?

Marginal BenefitMarginal Benefit When we add up how When we add up how

much individuals would be much individuals would be willing to pay marginally willing to pay marginally for a new road, we can for a new road, we can create a “demand” or create a “demand” or “willingness to pay” curve “willingness to pay” curve for a this public goodfor a this public good

In this example, the In this example, the “marginal collective “marginal collective willingness to pay” could willingness to pay” could be called the Marginal be called the Marginal Benefit because it reflects Benefit because it reflects how much value each how much value each person (and society as a person (and society as a whole) has for each unit of whole) has for each unit of the public goodthe public good

Military Military DivisionDivision

ss

Person A’s Person A’s WillingnesWillingness to Pays to Pay

Person Person B’s B’s

WillingneWillingness to Payss to Pay

Social Social Willingness Willingness

to Payto Pay

11 $4$4 $5$5 $9$9

22 $3$3 $4$4 $7$7

33 $2$2 $3$3 $5$5

44 $1$1 $2$2 $3$3

55 $0$0 $1$1 $1$1

Optimum Provision of Public Optimum Provision of Public GoodsGoods

MC = MR, right?MC = MR, right? WRONG!WRONG! MB = MC, stupid!MB = MC, stupid! Sorry, I get mad sometimes.Sorry, I get mad sometimes. When deciding HOW much of a public When deciding HOW much of a public

good to provide, the government needs to good to provide, the government needs to know the marginal cost of the good.know the marginal cost of the good.

At the point where the marginal benefit At the point where the marginal benefit and marginal cost curve intersect the and marginal cost curve intersect the optimum quantity of a public good is found optimum quantity of a public good is found and results in allocative efficiency!and results in allocative efficiency!

Optimum Provision - Optimum Provision - GraphicallyGraphically

Where MB = MC, the Where MB = MC, the optimum net marginal optimum net marginal benefit existsbenefit exists

Hence, government Hence, government should produce a public should produce a public good at this quantity to good at this quantity to maximize the net maximize the net marginal benefit.marginal benefit.

Military Military DivisionDivision

ss

Marginal Marginal Benefit (D)Benefit (D)

Marginal Marginal Cost (S)Cost (S)

Net Marginal Net Marginal BenefitBenefit

11 $9$9 $1$1 $8$8

22 $7$7 $3$3 $12$12

33 $5$5 $5$5 $12$12

44 $3$3 $7$7 $8$8

55 $1$1 $9$9 $0$0MC = S

MB = D

Optimum Q

Impact of Optimum Impact of Optimum ProvisionProvision

Can the government provide too little of a Can the government provide too little of a public good?public good?

Can the government provide too much of Can the government provide too much of a public good?a public good?

Big problem: how do you measure the Big problem: how do you measure the “social” benefit accurately?“social” benefit accurately?

In Charlotte, we could analyze the costs of In Charlotte, we could analyze the costs of the light rail system vs. its marginal the light rail system vs. its marginal benefit…benefit…– Costs?Costs?– Benefits?Benefits?

ExternalitiesExternalities

Benefits and costs that affect those Benefits and costs that affect those outside of private market modelsoutside of private market models

When not considered in the market When not considered in the market model, ignores pushes and pulls that model, ignores pushes and pulls that may drive pricesmay drive prices

If these are significant enough they If these are significant enough they must be consideredmust be considered

Difficult to measure in dollarsDifficult to measure in dollars

Positive ExternalitiesPositive Externalities Merit GoodsMerit Goods

– Any private good that has positive externalitiesAny private good that has positive externalities Examples: Health care, education, entertainmentExamples: Health care, education, entertainment

– Markets do not always provide merit goods in Markets do not always provide merit goods in large enough quantitieslarge enough quantities Government interventionGovernment intervention

– Increase demand for the merit goodIncrease demand for the merit good– Lower or eliminate the price, supply the product Lower or eliminate the price, supply the product

directlydirectly– Subsidize its production and increase the supplySubsidize its production and increase the supply

Question: What is the cost of government Question: What is the cost of government intervention?intervention?– Higher tax ratesHigher tax rates– Waste and inefficiency Waste and inefficiency – Political interference with deliveryPolitical interference with delivery

Positive ExternalitiesPositive Externalities

Beneficial to those who are not part of the Beneficial to those who are not part of the market structuremarket structure– ExamplesExamples

Colleges, Universities, Free museums Colleges, Universities, Free museums Natural resources, tourist attractionsNatural resources, tourist attractions Art in public placesArt in public places

I might be able to sell my house for a I might be able to sell my house for a higher price than I paid if someone built a higher price than I paid if someone built a nice park next to it.nice park next to it.– In this example, I do not pay for the park, but I In this example, I do not pay for the park, but I

benefit from it.benefit from it.

I Can’t Get No…I Can’t Get No…

Satisfaction…Satisfaction… The problem with positive The problem with positive

externalities is that we, the consumer, externalities is that we, the consumer, can’t get enough of them…but the can’t get enough of them…but the market has no incentive to provide market has no incentive to provide large enough quantities of merit large enough quantities of merit goods to satisfy this desire.goods to satisfy this desire.

Hence, Hence, – Merit goods will always be underallocatedMerit goods will always be underallocated

Positive Externality GraphPositive Externality Graph

The positive externality provides society The positive externality provides society with benefits that it does not pay for.with benefits that it does not pay for.

Hence, we say that there are Hence, we say that there are spillover spillover benefitsbenefits from merit goods. from merit goods.

P

Qt

D = MPB

Dt = MSB

Spillover Benefits

S = MPC

Qe

Underallocation

Negative ExternalitiesNegative Externalities

Costs of economic activity not born Costs of economic activity not born by the producer of the good or by the producer of the good or serviceservice– Not reflected in the supply of the goodNot reflected in the supply of the good– Society becomes responsible for the Society becomes responsible for the

costscosts

Negative ExternalitiesNegative Externalities

Demerit GoodsDemerit Goods– Private goods that have negative Private goods that have negative

externalitiesexternalities Examples: Alcohol, Drugs, Cars, etc.Examples: Alcohol, Drugs, Cars, etc.

– The market has a tendency to produce The market has a tendency to produce many of these goodsmany of these goods Government intervention:Government intervention:

– Reduce demand for goods (reduce demand)Reduce demand for goods (reduce demand)– Tax the production of the good (reduce supply)Tax the production of the good (reduce supply)– Outlaw the goodOutlaw the good

Consequences of government interference…Consequences of government interference…

Don’t Tread On Me!Don’t Tread On Me!

The problem with negative The problem with negative externalities is that there is little externalities is that there is little incentive for private firms to reduce incentive for private firms to reduce the production of goods that have the production of goods that have external costs.external costs.

Because these costs are “paid for” Because these costs are “paid for” by society, we would say that there by society, we would say that there is an overallocation of demerit goods.is an overallocation of demerit goods.

Negative Externality GraphNegative Externality Graph The negative externality is not paid for by the The negative externality is not paid for by the

producing firm or consumer of the good. It is a producing firm or consumer of the good. It is a cost that is inflicted on society.cost that is inflicted on society.

Hence, we say that there are Hence, we say that there are spillover costsspillover costs from demerit goods.from demerit goods.

S = MPC

St = MSC

D = MPB

Spillover Costs

Overallocation

QeQt

P

Problems in Measuring Problems in Measuring ExternalitiesExternalities

Subjectivity of ExternalitiesSubjectivity of Externalities– What is a merit good to one person/country could not be What is a merit good to one person/country could not be

to another…to another…– The degree of merit or demerit is highly debatableThe degree of merit or demerit is highly debatable

Source of externalities and regulation Source of externalities and regulation – international environmental degradationinternational environmental degradation

Estimation of values of externalitiesEstimation of values of externalities– Use of social cost benefit analysis attempts to price on Use of social cost benefit analysis attempts to price on

externalitiesexternalities– In most cases, externalities do not warrant banning the In most cases, externalities do not warrant banning the

good, yet often governments look to do this.good, yet often governments look to do this. Future externalities are less of an issue for us Future externalities are less of an issue for us

today…less likely to considertoday…less likely to consider

Responses to ExternalitiesResponses to Externalities

We will discuss more completely the We will discuss more completely the responses that can be made to responses that can be made to externalities later.externalities later.

But keep this in mind:But keep this in mind:– Abatement of negative externalities has a cost Abatement of negative externalities has a cost

as does provision of positive externalities.as does provision of positive externalities.– Hence, the marginal cost of a response to Hence, the marginal cost of a response to

either problem has to be weighed against the either problem has to be weighed against the marginal benefit of the response.marginal benefit of the response.

– In turn, there can be too much response In turn, there can be too much response (action) and too little response (action) to (action) and too little response (action) to externalities. In either case, we do not achieve externalities. In either case, we do not achieve the socially optimal quantity of response.the socially optimal quantity of response.

Inequality of Income and Inequality of Income and WealthWealth

IncomeIncome– The flow of economic payments: rent, wages, The flow of economic payments: rent, wages,

interest, and profitinterest, and profit WealthWealth

– The stock of economic goods and services The stock of economic goods and services ownedowned

Government intervention is better at Government intervention is better at equalizing these among people in a equalizing these among people in a country…country…but at a cost… (dum dum but at a cost… (dum dum

dum!!)dum!!)

……TAXES!!!!! Welfare! Transfer payments! Oh My!!!

Abuse of Monopoly PowerAbuse of Monopoly Power

Concentration of power is the goal of Concentration of power is the goal of firmsfirms

Monopoly power does not allow the Monopoly power does not allow the economy to function most efficiently…economy to function most efficiently…(my commentary)(my commentary)

Government anti-trust or anti-Government anti-trust or anti-monopoly laws help eliminate monopoly laws help eliminate monopoly power…monopoly power…

But is Bill Gates all that bad…??? But is Bill Gates all that bad…???

Central PlanningCentral Planning

A solution to economic inequality and A solution to economic inequality and abuse of power is government abuse of power is government interventionintervention

Some forms of intervention take on a Some forms of intervention take on a planning model -> Soviet style planning model -> Soviet style PlanningPlanning

Central PlanningCentral Planning

CharacteristicsCharacteristics– Planners appointed to allocate resourcesPlanners appointed to allocate resources

Which resources is dependent upon the Which resources is dependent upon the countrycountry

– Prices for goods set to match supplyPrices for goods set to match supply– Ownership transferred from private to Ownership transferred from private to

publicpublic– Development plans implementedDevelopment plans implemented

Grow the economyGrow the economy Equalize the economyEqualize the economy

Types of PlanningTypes of Planning Public Sector PlanningPublic Sector Planning

– Occurs in market economiesOccurs in market economies– Allows only for the planning of public goods and some Allows only for the planning of public goods and some

merit goodsmerit goods Indicative PlanningIndicative Planning

– Low impact planning that involves directing the method Low impact planning that involves directing the method of the economy but not directly controlling itof the economy but not directly controlling it

Central PlanningCentral Planning– High impact planning that involves making direct High impact planning that involves making direct

decisions about the means of productiondecisions about the means of production Development PlanningDevelopment Planning

– Planning in LDCs where growth into modern economies Planning in LDCs where growth into modern economies is the chief focus.is the chief focus.