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Chapter 14: Market Failures and the Potential Role for Government

1. Problems with the market outcome: income distribution.Suppose we have $1 to divvy up between two people. How should we do it? Most will answer: 50 - 50.

Next, suppose person A is rich and person B is poor. How should we divvy up the $1? Many will say give 75¢ to the poor person and 25¢ to the rich person. (Some may go further and give the entire $1 to the poor person.) So the initial wealth of the recipients will matter in deciding on the allocation.

Third, suppose the poor person will probably spend some of whatever he gets on cheap wine. Many will then say that the poor person should only get 5¢ and the other person should get the rest, even if that person is already rich. So the perceived consumption of the recipients will matter in deciding on the allocation.

Fourth, suppose the poor person is mentally challenged and cannot work. Many will transfer more of the dollar, e.g., 95¢, to that person. On the other hand, suppose the poor person doesn't like work and chooses not to work. Most will transfer less to such a person. So the recipient's perceived reason for not working will matter in deciding on the allocation.

Finally, suppose, the poor person must use the funds received to buy medicine for a sick child. Now, many will respond by giving the $1 entirely to the poor person. So the allocation of the $1 will depend on whether or not a child is the ultimate recipient.

The point is that people will generally condition their feelings about the income distribution on a number of factors such as whether the recipient of a transfer is poor because of their own unwillingness to work or whether they are incapable of working, what they will spend the transfer on, whether children will receive the aid or not, and a number of other factors. And views on welfare programs have changed dramatically in the last thirty years. Some analysts believe that people were more willing to transfer to the poor during the 1960's than now in the 1990's simply because the economy was growing much faster then than now and we could afford it better then than now.

Consider point E in the diagram above, the initial endowment point. Person A has most of both goods and the final trade leads to point A where person A is clearly a rich person consuming most of both goods and person B is poor. Some would want to redistribute the endowment to point E' and then allow trading to take place. In that case, the final outcome, point

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A', is more egalitarian. This means that in the new equilibrium the goods are more evenly distributed across agents than in the original equilibrium at point A. Many would regard this favorably.

However, there might be a tradeoff between equity and the efficiency of production. Consider the following Edgeworth Box with the associated competitive equilibrium allocation at point C. One might object to C because person B receives most of everything and so would be considered a rich person whereas A receives little of the two goods and would be considered the

poor person. Society might view this unfavorably and consider redistributing from person B to person A. This might lead to different relative prices and a new allocation point like C'. Clearly, A is better off under such a policy while B is worse off. Since C was on the contract curve, it is Pareto optimal, meaning that a move away can not generally be done without hurting someone, in this case person B. C' is also on the contract curve and is Pareto optimal. Unfortunately, there is no way to make an objective comparison between C and C', only subjective comparisons based on opinions can be made.

However, this is not the end of the story. When the government redistributes income from one person to another it must do so within the context of a particular program. So it will use a progressive tax system, which taxes the wealthy at higher rates than the poor, and it will typically transfer to the poor through the aegis of a welfare style program. Taxes reduce the incentive to work and save and anti-poverty programs also reduce the incentive to work. Therefore, less will be produced when such programs exist and the PPF will shift in as depicted above, i.e., x* > x** and y* > y**.

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This shrinking of production is the loss in efficiency the economy experiences when it tries to redistribute income from one group to another, e.g., from the young to the old through social security, from the rich to the poor through the income tax or welfare programs, from the middle class to wealthy defense contractors through defense spending. This depicts a tradeoff between equity and efficiency. The more equity we want to achieve, the more we will have to give up in production efficiency, as depicted by a shrinking PPF.

Application: Steve Forbes, the publisher of the magazine that bears his name ran for president in 1996. He did not fare well in the Republican primaries and was forced to drop out of the race. However, the remaining candidates had to deal with several issues Forbes raised. His main issue was the federal income tax code. He wanted to make it simpler by having only one tax rate (the so-called flat tax), eliminating capital gains taxes (If an asset appreciates in value it experiences a capital gain. Approximately 75% of all capital gains accrue to people in the top 1% of the income distribution.), among other things. Indeed, his goal was to make the tax so simple that we could replace the existing 1040 form with a form the size of a post card. Thirty years ago the income tax was highly progressive in the sense that at the margin a person would pay more tax as their income increased. For example, one would pay 14% on the first $50 over $2000, 15% on the next $50, and so on. So if someone earned $2215, she would pay nothing on the first $2000, 14% on the next $50, 15% on the next $50 after that and so on. Obviously, a wealthy person earning a large income would pay a much higher rate on the last $50 she earned than a poor person. In recent years we have reformed the tax so as to make the rates much flatter and the tax less progressive. In 1982 we began to implement the so-called Kemp-Roth tax cut of a phased-in tax rate cut of 10% the first year, 10% the second year, and 5% the third year. This was followed by another tax reform in 1987 that further flattened the rate structure. These changes in the tax code signal a major shift in what people believe is "fair." In the 1960's most people thought it was "fair" to have wealthier people pay a higher tax rate at the margin than poorer people. Now, attitudes appear to have changed so that people now believe it is "fair" for everyone to pay the same rate. In 1980 there were 14 tax brackets. By 1990, there were only four.

Historically, the distribution of income in the United States, as in most western countries is skewed toward the top where more of the income is earned by the rich. The top 20% of households earn approximately 50% of the income and the top 1% earn about 20% of the income. The bottom 20% of households only earn about 3.4% of income. This is depicted in the first figure, which gives the share of income earned by each quintile (20% bracket) and the top 1% for 2008. (Source: Census Bureau)

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We can also ask how the distribution of income has changed over time. In the second figure we depict each quintile and the top 1% of households from 1971 – 2008. The top 20% of households has increased dramatically from 43% to 50% and the top 1% of households has increased from 16.7% to over 20%. At the same time the lowest 20% of households receive less income; their share has fallen from 4.1% of income to 3.4% and the second fifth has fallen from 10.6% to 8.6%. The middle third has also fallen as well. It appears that income is more skewed toward the top earners now than forty years ago and some have suggested that the middle class is shrinking as more people shift to a lower part of the distribution and a few move up.

If we focus on the share of income earned by the top 1% it is fairly apparent that the increase in the share of income for this group started in the early 1980s. It continued after the recession of 1991-92, and then it flattened out in the 2000s.

Consider a simple example: suppose there are three types of people, rich (R), middle income (M), and poor (P). Initially there are 12 M people, 2 P people, and 1 R person. However, since 1980, there have been some changes in the distribution of before tax income. Some people have moved out of the middle by becoming wealthier and some have become poorer and moved down in the distribution. In fact, it appears that more people have moved to a lower position in the distribution than have moved up in the distribution. Continuing with our previous example, suppose the distribution has changed so there are now 2 R people, 4 P people, and 9 M people. This would reflect the changes in the distribution since 1980. The middle class appears to be shrinking slightly. It was reported (Headline News, Dec. 17, 1997) that the gap

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between the wealthiest 1% and the poorest 10% of the population continued to grow. This is evident from the tables above.

Application: International comparisons.

The gini coefficient is a measure of income inequality. As you can see from the map, most countries have less inequality than the US. In other data, however, covering the countries in the OECD, which comprise the advanced industrial economies of the world, inequality has increased in almost all of the advanced countries since 1980.

There have been a number of explanations as to why income is becoming more unequally distributed and many of the explanations are similar to those given as to why the economy is growing less quickly now than thirty years ago. Most of the explanations involve changes in the economic environment that affect people in the middle or the lower end of the distribution. They are the following.

A. Foreign competition for manufacturing jobs has lowered the pay for blue collar workers who are essentially competing with similar workers in Mexico, Indonesia, Malaysia, and so on. This process is now affecting some white collar jobs that are being outsourced.

B. Fewer workers as a percentage of the work force are organized into labor unions. Only about 12% of the work force is in a labor union, down from 39% just after World War Two.

C. There has been a shift from manufacturing to services and service jobs typically experience low productivity growth; it is difficult to improve the productivity of a sales clerk, for example. Furthermore, a job at Wal-Mart's pays much less ($7 per hour) than a job in the steel industry ($25 per hour) and the growth in the wage at Wal-Mart's is less than the growth in wages in heavy manufacturing. In part, this reflects lower productivity in the service sector relative to other sectors.

Consider the example of the clerk in a grocery store, a service oriented type of job. Clerks used to punch in the price of each item into the cash register, while another clerk bags the groceries, and still other clerks had to keep track of the inventory and ordering by hand as well. If a shelf was empty, more was ordered. Now, however, scanners that scan prices with a laser technology are connected to a computer for the entire store. The clerk simply scans the bar code of each item and the computer automatically keeps track of the inventory and ordering. Another clerk types the appropriate prices into the computer for each bar code. These clerks must have greater skill because they must learn how the computer system works and how to make changes when the store has a sale or when new items come on line. The clerk who does the scanning is also more productive because he or she can scan more groceries in an hour. And, of course, now

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in many stores you bag your own groceries. This makes the clerk who keeps her job after the introduction of the computer system much more productive. However, once this equipment is installed, it becomes very difficult, if not impossible, to raise the clerk's productivity again. And this is the problem in the service sector.

D. Many firms are substituting capital (robots and computers, etc.) for labor in manufacturing. In 1970 there were approximately 550,000 people working in the steel industry. In 1990 there were only 330,000, yet, steel output was about the same in total tons in 1990 as it was in 1970. A similar pattern has occurred in other industries like the auto industry.

E. People lack basic skills now especially in science and math more so than thirty years ago and this is especially true of the blue collar work force. Test scores on all of the standardized exams, e.g., ACT, SAT, GRE, GMAT, and so on, all show a decline of at least 8-12% in 1995 relative to 1965. The SAT exam was restructured in 1995, e.g., the exam was extended by one hour, calculators can be used on the math portion of the exam, and the antonym and linguistics section, considered the hardest part, have been downgraded. Scores picked up but then started downward again.

In a recent international comparison of twelfth graders, the USA was not highly ranked in science and math. This is perhaps signaling us that worker productivity will be lower than it was thirty years ago. In addition, international comparisons among OECD countries indicate that US high school students rank low in science and math. This is also true of samples of the best students, i.e., even when comparing the best US students against the best of other countries, the US ranks low in science and math. Finally, American students who study abroad their senior year in the AFS program are routinely put a year or two back when attending school in Germany, for example,

F. Government Regulations reduce efficiency in production since it is very costly for private business to comply with the regulations and the pace of regulation has increased dramatically in the last twenty years. Two laws in particular are very costly to comply with, the original Environmental Protection Act of 1970 and the more recent Americans with Disabilities Act. (The latter was guided through the Congress by Senator Bob Dole, a crippled World War Two veteran. When running for president in 1996, Dole constantly extolled the virtues of his work on the Americans with Disabilities Act but at the same time also proclaimed that he wanted to do away with government regulations.) Some regulations are desirable since they serve a useful purpose, some simply create more paperwork and are not desirable. However, we must realize that we live in a complex society and that some regulation is necessary if we are to enjoy clean air and water, drive safe cars, eat food that is properly labeled, and so on. We must also recognize that this activity is very costly and can reduce efficiency. Recent evidence suggests that these costs are not as large as previously thought, however.

These explanations may work for the US but do not explain what is going on in the rest of the advanced nations, however. One explanation does. As a country accumulates more capital, it needs more of the other inputs like labor as the economy grows. If skilled labor and capital are complements in production, an increase in capital will cause an increase in the demand for skilled labor raising wages for that type of labor. If, in addition, unskilled labor and capital are substitutes, then an increase in capital will cause a shift away from unskilled labor. So as capital accumulates, wages of skilled labor rise and wages of unskilled labor fall causing greater income inequality. There is some evidence from the US that this has been going on since the mid 1970s.

Questions about the distribution of income and wealth cannot generally be answered in an objective manner. They depend on subjective evaluations. This is not a trivial problem. Three examples illustrate the nature of the issues involved. How progressive should a tax system be?

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With the fall of Communism in Russia and Eastern Europe, how should state owned enterprises be distributed? And, finally, how should land be distributed?

Application: Zimbabwe and the distribution of land. White settlers arrived in the southern portion of Africa in the 16th century and eventually migrated northward to what is now Zimbabwe. Gold and diamonds were discovered in the 19th century and a massive migration began. Cecil Rhodes, who made his first fortune in gold mining, made a second fortune in diamonds and started the diamond cartel DeBeers. Rhodes also founded the country Rhodesia, modestly named after himself, and funded the Rhodes Scholar program in perpetuity. White settlers owned the land and mining concerns and imposed harsh conditions on the local blacks, who did most of the hard labor and lived in tremendous poverty amidst incredible wealth. However, France and Britain began to pull out of Africa in the 1960's ending years of colonial rule and Rhodesia eventually gained its independence. However, the whites dominated the political system until 1980 when they were forced to give up power. Robert Mugabe became the first black head of state in Zimbabwe.

The main political question, both then and now, is how to distribute the land. White farmers own most of it because of their dominant position prior to 1980. They argue that they have the management expertise and the scientific knowledge regarding modern farming techniques, and that they should keep their land as a result. Blacks argue that whites simply took the land away from their ancestors a century earlier and now it is time to give it back. Agriculture is an important part of the economy and counts for about 20% of Zimbabwe's GDP, and many blacks work the land and so it provides jobs. It was reported in the NY Times December 21, 1997 that Mugabe constantly promised to redistribute land to the blacks. Indeed, this was one of his original campaign slogans when he first won election. Since then some land has been redistributed. However, most of it has gone to government officials, some say to buy their support for the Mugabe government, or cronies and friends of Mugabe, not the people. Two years later Mugabe's government put out a list of white owned farms that were to be confiscated thus raising the issue once again. Food production has fallen dramatically in the 1990s and 2000s and Zimbabwe now has to import some of its food despite the incredible richness of the land.

No objective answer can be given to the question of who should own the land. Any answer is based on subjective opinion. If you take land from white owners now and give it to blacks, the whites are worse off, while the blacks are obviously better off. So this cannot be Pareto Optimal. This move may improve "society's welfare" under some other criterion, e.g., a general notion of fairness for past injustice. However, this is completely subjective.

Whites, who have been threatened with losing their land, have argued that black owned farms typically are much less productive than white owned farms, whites have a higher rate of repaying their loans on time than black owners, and that white owners pay their workers a higher wage than many black owners. The available data appears to support their position as of the year 1997. (One black worker was asked by the reporter writing the story whom he would prefer working for and he stated that he would rather work for whites because they pay his wage on time.) White landowners argue that they employ a large work force composed mainly of blacks who would be out of a job if the land were taken away.

This is a clever argument. How can we apply our definition of Pareto Optimality? Apparently, we need to apply it over time. If the land is taken away from whites and is then farmed by less experienced blacks, the argument is that productivity will suffer and this will mean that black workers working for black owners may receive a lower wage in the future than they are receiving right now from white farmers. So if we apply our concept of Pareto Optimality over time, whites are worse off now if the land is taken away from them and black

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workers in the future may also be worse off if they receive a lower wage. Black owners may also be worse off in the future if the banks foreclose on their land. Redistributing land may lead to a Pareto inferior outcome in the sense that everyone could be made worse off, according to this argument.

On the other hand, whites have also argued that every year there are white farms for sale. The government could buy the farms and then give them to blacks and teach the blacks about modern farming and management techniques. Black activists argue this would take too long. Mugabe has balked at such a proposal because it would be very expensive for the government. First, he wanted Britain to pay for the farms because of their colonial status. Britain refused. Then he wanted the US to pay for reasons no one seems able to fathom. Of course, the US has politely declined.

Extraordinary violence has erupted in the 2000s as the Mugabe regime has clamped down on the opposition. Murder, rioting, and extreme violence, has locked the country into a downward spiral. What was once a productive country able to produce food for export cannot even feed its own people. It is certainly possible that the people may be better off in the long run since they own the land if the regime is replaced with a stable government and advanced farming techniques are widely taught and practiced. They are also inflating as well simply printing money to pay people. Inflation quickly turned into a hyperinflation. Eventually, the government issued a 100 trillion dollar note. You can buy one for about $0.45 USD on Ebay.

2. Problems with the market outcome: monopoly.Monopolists choose output where MR = MC, and price = p > MC. This is not Pareto optimal since as we have seen, optimality requires p = MC. So the existence of monopoly can lead to a suboptimal outcome; output is too low and price is too high.

There is some tension here. A monopoly is created when someone has a new idea and receives a patent for it. This is where new products come from and clearly people living in countries like the United States demand such products. So it seems we have to provide people with an incentive to produce new ideas and new products from those ideas. So perhaps we should distinguish between monopolies that generate new products consumers obtain utility from and old monopolies that exist simply to keep the price high by restricting output.

Regulation of monopoly would appear to be one possible solution. Another is to try to induce competition whenever possible. Of course, as we have seen, regulating a monopolist can be fraught with difficulties and the technology may involve increasing returns making it difficult, if not impossible, for competition to exist. The outcome after government intervention may not be better than before the intervention.

A caveat is in order. A firm may not be able to maintain a monopoly advantage for long. It is certainly possible to alter a patent enough to allow a competitor to produce its own version of a product. And there is competition in areas now that did not exist twenty years ago. There is now competition in the telephone business which didn't exist 15 years ago and even power companies can sell power outside their immediate jurisdiction. So the "traditional monopolists" in the United States have recently begun competing. However, many times firms are unwilling to compete and will sometimes choose actions that avoid competition. This makes it even more difficult for regulators and for the government to know when competition has been subverted and when it has not.

Application: Some activities that firms engage in are illegal. For example, conspiring to fix prices is illegal. In a newspaper article in the New York Times (October 15, 1996) it was reported that the Archer Daniels Midland Co.(ADM), the giant food processing company and self styled "supermarket to the world," pleaded guilty to charges of price fixing with its

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competitors and agreed to pay a fine of $100 million. This was the largest fine obtained by the Justice Department for price fixing ever. An inside informer, Mark Whitacre, secretly taped hundreds of conversations where company officials conspired to fix the price of lysine, an input of animal feed. They used cash payments and other illegal means to steal technology from competitors and fix other prices as well, e.g., carbon dioxide. Archer Daniels Midland is also one of the largest political contributors in the U. S. forging ties with politicians over the years like Hubert Humphrey, Ronald Reagan, Bill Clinton, Bob Dole, and Newt Gingrich. The company has had a tremendous impact on agricultural policies especially those involving grain exports and subsidies to ethanol producers.

Interestingly enough, ADM has been in trouble before. In 1978 it pled no contest to charges that it fixed prices with two of its competitors on contracts with the federal government's Food for Peace Program. Since 1992 the company has settled several class action law suits against it for $1.5 million contending that it fixed the price of carbon dioxide. In 2001 it was cited for violating the Clean Air Act in one of its food processing plants and had to pay a fine of $1.46 million. It settled another pollution complaint in 2003 and paid a fine of $4.5 million. In 2005 they were sued by an international human rights group who charged that several companies including ADM trafficked in children, who were taken from Mali to the Ivory Coast and forced to work twelve hour days for no pay and very little food. ADM has received billions of dollars in federal agriculture subsidies over the years.

3. Problems with the market outcome: uncertainty.Sometimes markets fail to exist or do not function properly. There are actually a number of situations where this can arise. When a market doesn't exist or functions improperly, this can provide a potential role for government intervention. Whether the government solves the problem when it intervenes or makes the problem worse is another matter.

One such situation occurs when there is uncertainty and information is asymmetric across the market so that one side of the market knows something the other side does not. If one side of the market (suppliers) knows something the other side (demanders) does not, it may be able to use this knowledge to its advantage. If the other side (demanders) of the market can anticipate that it will be taken advantage of, it may be unwilling to engage in market transactions with the first side and the market may not exist as a result. However, profits are to be made and whenever that is so private individuals will come up with solutions, e.g., developing a reputation for dependable work, money back guarantees, and warranties.

For example, consider the following game between an employer and an employee. The employee can work hard or can shirk and take it easy. The worker knows whether he is a shirker or a hard worker, however, the firm may not know this. The employer would like to observe the worker to make sure the worker is working hard and not shirking. However, it is impossible to observe the worker all the time. So the employer must observe certain signals that can instruct the employer as to whether the employee is working hard or not. One signal is the employee's output. How much did the employee produce in a given work shift? If output is low, then maybe the worker is shirking. If it is high, then the worker must be working hard. Unfortunately, most signals are somewhat imperfect. Indeed, the output produced by the employee may be an imperfect signal. If the employee must rely on other people in order to produce output, the output can be low because someone else shirked. Or it can be low if a critical machine used in producing the output breaks down unexpectedly.

This is an example of the kind of problem that can arise when information is imperfect and asymmetric, e.g., workers know more about themselves than the firm does. There are several mechanisms that have evolved over time to deal with this sort of situation. Piece-work pays the

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worker for how much is produced in a given shift. The higher production is, the greater the pay. Obviously, a hard worker will earn more than a shirker and workers understand this. End-of-the-year bonuses, which are very popular in Japan, are another example of a mechanism designed to possibly get around the problem. A stock option bonus tied to the firm's sales or share price is another example.

Unfortunately, there are several problems with piece-work and end-of-the-year bonuses. First, there are horror stories of piece work "sweat shops" where women had to sew a large number of garments per hour, worked 12-14 hour shifts with few breaks under horrendous working conditions in the garment district in New York City at the turn of the century (1900). A fire broke out in one such "factory" and most of the women were killed. "Sweat shops" were outlawed after that but still exist surreptitiously even today. And the story has taken a new twist. It was revealed in 1996 that large apparel companies like Nike, one of the world's largest producers of shoes, uses "sweat shop" type labor in less developed countries to produce its shoes. Workers are paid low wages and work in appalling conditions. Nike responded by arguing that it pays a wage that is higher than the local labor market pays and also disputed the "sweat shop" terminology.

Second, piece-work by team might be unfair. Suppose workers work in a team and one of them shirks so the output of the team is low. Why penalize all of the workers just because one shirked? Bonuses may also fail to solve the problem. For example, in Japan workers have come to expect the bonuses as a part of their pay. If the bonus comes to be expected regardless of performance, then the bonus may not solve the shirking problem.

Third, a recession may eliminate the bonus for a while so workers won't receive their extra pay even though they may deserve it. This might lower morale significantly and create more shirking.

Fourth, when business slows down the firm has an incentive to maintain profits by cutting the piece-work rate. Historically, this has happened in industries using piece rates. A cut in the piece rate can create more shirking, however.

Finally, tying executive salaries to the company's share price might cause managers to take a short term view rather than a long term view in the company's business strategy.

In the simplest setting we can model a situation involving uncertainty as we have suggested in earlier lectures by assuming "nature" chooses whether a good state or a bad state occurs and the decision maker has to make a choice based on her assessment of the probability of the good or bad state occurring. However, there are two problems that almost always emerge in situations involving uncertainty. Moral hazard is any situation where the existence of insurance affects the probability of the bad state of nature occurring. Having auto insurance may cause people to drive less safely and cause more accidents to occur, the bad state of nature being an accident. The existence of flood insurance may cause more people to move to a flood plain. This will increase the number of people who get flooded out on average over time, the bad state of nature, and this will in turn increase the amount the insurance company must pay in the event of a flood. Adverse selection is a situation where the people who are the bad risks want to buy the insurance more than the people who are the good risks. For example, bad drivers are more likely to buy collision insurance than good drivers.

These two problems arise in any situation involving uncertainty. The more information that is available about the individual wanting to buy insurance, the better it is for the company because this allows the insurance company to classify the risk and charge an appropriate premium. For example, there is a considerable amount of information about auto accident rates. Teenage boys get into more accidents than teenage girls and so pay a higher premium for their insurance. 'A' students are involved in fewer accidents than 'C' students and so pay a lower

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premium. People who drive in low density driving areas are involved in fewer accidents and pay a lower premium than people who drive in high density areas. People who drive station wagons, as opposed to sports cars, speed less often and pay a lower premium, and so on.

The general rule, however, is that the good risks always subsidize the bad risks. The insurance company collects premiums from all drivers, for example, but only pays out when someone has an accident. More of the bad risks will have accidents than the good risks. Indeed, many of the good risks won't have any accidents at all, yet, will still pay premiums for their insurance coverage. So the good risks always subsidize the bad risks. The insurance company would like to have more good risks than bad risks but risk is not something they can calculate perfectly. And they will usually try to charge the bad risks more for their insurance once the company has discovered a person is a bad risk, than the people who are good risks. Still, the good risks will typically subsidize the bad risks. The problem remains even if the company can classify consumers on the basis of the perceived risks since classification is imperfect.

Moral hazard and adverse selection always exist to a certain degree in situations involving uncertainty. If they are acute enough, the insurance might not exist at all. Consider the following somewhat frivolous example of "grade insurance." Courses at WSU are expensive and your grade is somewhat uncertain. Suppose the professor offers the following contract. At the beginning of the semester you state a final grade, e.g., B, and your current cumulative GPA, e.g., 2.79, and the professor uses this information to charge you a premium, e.g., $124. If your actual grade at the end of the semester is below the grade you stated at the beginning of the semester, e.g., C-, you receive a refund of the tuition you paid for the course and can take the course over again without any repercussions. If you receive the appropriate grade or a higher grade at the end of the semester, e.g., A-, you keep the higher grade and the professor keeps the premium. Who would want to buy such insurance? Probably the weaker students or the bad risks more so than the good students so adverse selection probably exists. Will the availability of the insurance affect behavior? Probably. Students will spend less time studying thus increasing the probability that the bad state of nature will occur so moral hazard also exists. (As an aside, the professor may "water down" the course to make sure more students pass in order to keep more of the premiums.) Aside from ethical problems in offering such insurance, adverse selection and moral hazard are acute enough to cause the market for "grade insurance" to fail to exist. The same can be true of other situations involving uncertainty like unemployment, health, and out living one's retirement savings.

Sometimes, the risk cannot be classified properly or is too costly to insure. For example, consider health care. We know that smoking and drinking too much is injurious to your health. But there are people who smoke and drink for a long time without getting sick. There are other people who don't smoke or drink yet die early. So pricing health insurance is very difficult to do. Generally, the good risks are the people who eat a low fat, high fiber diet, do not smoke, drink moderately, and exercise regularly. The bad risks are the heavy drinkers, smokers, and couch potatoes (people who do not exercise). Who is most likely to want to buy the health insurance? Bad risks; people who are sick a lot. So adverse selection exists. If the health insurance is available, people might change their behavior and go to their doctor more often for even the most trivial reasons, e.g., minor cold. So moral hazard also exists. Bad risks can be charged a higher premium for their insurance. However, many such people cannot afford the premiums and go without insurance. Many of them end up in emergency units when a real problem arises and this is very costly to society.

Deductibles and copayments are an attempt to get the individual to face part of the cost of their health care and be more responsible in choosing when to see the doctor. Yet the copayments cannot be too high because that will defeat the purpose of having the insurance in

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the first place. And many people cannot afford the health insurance premiums and so are not covered. It was estimated that about 50 million Americans did not have health insurance in 2007, and many were children.

Consider unemployment. There is some risk that one can lose one's job through no fault of your own. There can be a general downturn in the economy, or a specific drop in demand for your firm's product because a competitor has just introduced a better product, and this can cost you your job. In the 1950s and 1960s it was almost unheard of for white collar workers to lose their jobs even during a recession. Many white collar workers started working for a firm and stayed with that firm for their entire career. During recessions in the 1950s, for example, the white collar unemployment rate did not increase appreciably. This is no longer true in the 2000s. Now it is estimated that even white collar workers will change jobs three or four times in a career.

Consider a private firm that will offer unemployment insurance. How would it work? The worker would pay a premium and when the worker became unemployed, the worker would file a claim to receive unemployment benefits. The insurance company doesn't want to pay out in the event the worker is fired. Why? Because workers might alter their behavior vis-a-vis their boss and get fired more often, i.e., they might be more willing to tell the boss off and get fired as a result. Also, the most vulnerable workers would be most likely to buy the insurance. So both moral hazard and adverse selection exist. Unfortunately, it might be impossible for the firm to tell if the worker was fired for insubordination and having a lousy attitude, e.g., showing up for work late, being argumentative, and taking long lunches, or lost his job because of a recession. This is why private unemployment insurance does not exist. Yet the risk still exists. How can we solve this problem and help workers who do lose their jobs get back on their feet? One answer is social insurance. Firms pay a tax that collects in a fund. When a worker becomes unemployed she can apply to the government for unemployment benefits. Everyone pays into the system and everyone potentially benefits from it.

As another example, consider "old age" insurance that will pay a retirement benefit once the individual retires for the rest of his lifetime and charges a premium while the person is working. The "insurance-annuity" company that offers such an annuity must balance the good risks against the bad risks. People do not know how long they will live. The good risks, from the insurance company's perspective, are people who will pay premiums all their lives for the life insurance or an annuity and then drop dead the day of their retirement. Why? Because the company doesn't have to pay out on the annuity for such a person but receives the premiums while the person is working. So the good risk is the heavy drinker or smoker who lives a short life span. The bad risk from the insurance company's perspective is the jogger and vegetarian who expects to live a long life. The bad risks are most likely to be the ones to demand the insurance while the good risks won't. And the availability of the annuity may cause people to retire earlier than they otherwise would have. So both adverse selection and moral hazard exist. Of course, the company would like to charge the bad risks a higher price for their annuity insurance contract. However, it might be very difficult for the company to tell who the good risks are and who the bad risks are.

Private companies do offer both health insurance and annuities. However, because of the market imperfections that exist due to uncertainty and the inability to classify risk perfectly, moral hazard and adverse selection exist, and the premiums charged for these contracts may price some people out of the market. And some may not be offered such a contract because of their occupation or the company they work for. This leads to another example where there is a role for social insurance. Examples include social security, public disability insurance, health

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insurance programs like Medicare (for the elderly) and Medicaid (for the poor), unemployment insurance, and so on.

There is another problem with such situations as health care and "old age" insurance. Someone might refuse to buy private insurance when they are young, either because they want to spend their money on other things, or because they think they will be able to work as long as they like. If they become sick, or have to retire early, they would be destitute. If that were to happen, they might throw themselves on the mercy of society, who might respond by helping them out. The issue then becomes: how can we eliminate this type of situation where people take advantage of society's altruism? The answer is to force everyone to contribute to helping such people out, including those people themselves, by taxing everyone and then paying benefits out to people who are retired, or who need health care. This is another justification for programs like social security.

Therefore, because of uncertainty, private insurance markets may fail to exist or may not function properly. For example, flood and earthquake insurance are very expensive and do not cover many situations. Some may not buy the insurance as a result. (Of course, some states require that you have such insurance. However, one might choose the minimum amount of coverage rather than the optimal amount because the price is too high. The price is high because of adverse selection and moral hazard.) This may lead to a role for government to play in providing "social insurance."

Application: There was record flooding in the United States in the 1990s. In 1995 -1997 there was considerable flooding of the Ohio, Mississippi, and Missouri rivers. Flooding occurred in the Northwest in 1995 and 1996 and threatened to occur again in 1997. Unfortunately, moral hazard and adverse selection exist in this market. The existence of flood insurance may cause more people to move to the flood plain and thus increase the probability the insurance company will have to pay out a large amount in the event of a flood. And, people living on a flood plain are more likely to buy flood insurance than not. Insurance companies recognize that moral hazard and adverse selection exist and only offer policies giving people partial coverage with high deductibles and companies charge high premiums for these policies. This can price a lot of people out of this particular insurance market. Who should pay for the clean up after a major flood, given that moral hazard and adverse selection may exist and that many people will be without adequate insurance coverage? All of this is also true with regard to the recent hurricanes and tropical storms like Katrina, which wiped out New Orleans. It will be years before the city is rebuilt. Who should pay to rebuild the levee?

The policy of the federal government in the United States with respect to disaster relief has changed dramatically in the last ten years or so. It used to be the case that the Governor of a state stricken with a natural disaster, e.g., earthquake, flood, hurricane, volcano, would declare a particular area a "disaster area" and then could apply to the federal government for assistance. Prior to the mid 1980's the federal government would give people money to help them rebuild and also offered low interest loans if a major rebuilding effort was required. The emphasis at the time was on giving people grants to get started again. However, the Reagan Administration, and later the Bush Administration, changed the policy to emphasize low interest loans instead of grants mainly because of budgetary pressures due to the deficit. The Clinton Administration continued this practice, although there is usually some money given to states to repair roads, bridges, and basic public infrastructure.

(If people move to a flood plain, the Army Corps of Engineers will begin dredging operations and build dikes and levees to hold back the water. They may even redirect the flow of the water away from inhabited areas. This becomes harder to do as inhabited areas on the flood plain continue to expand. When a terrible flood occurs, dikes and levees break (hence the

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famous Led Zeppelin song, "When the Levy Breaks") and people are flooded out. One could question the wisdom of allowing people to live in a flood plain to begin with, however. Recently, several members of Congress began to question this policy because a large number of people living in the Mississippi valley have been flooded out several times in the last thirty years. Helping them rebuild each time is very costly to society. However, due to political pressure, nothing has been done to keep people from moving to flood plains.)

Application: Deposits in banks and savings and loan associations (S&L's) are federally insured up to $100,000 from 1982 until 2008 when it was raised to $200,000. Are bank officials going to be as careful in their investing strategy as they would be if deposits were not insured? Does the existence of this "insurance" cause banks to over-invest in risky properties?

In 1981 - 1982 Congress passed massive bank deregulation legislation which essentially allowed S&L's to invest in a much broader variety of possible investments. Prior to 1982, S&L's could only invest by lending money to home buyers for mortgages so they knew a lot about the risks of investing in the home mortgage market. After 1982, they could invest in practically any type of venture. Why did the Congress allow this? Because interest rates in the late 1970's were rising and S&L's had difficulty competing for depositors. In order to attract depositors they had to pay higher interest rates and in order to pay higher interest rates they had to earn higher returns on their investments. So they had to start investing in riskier investments because riskier investments pay higher returns (to compensate for the increased risk). So S&L's were investing in strip malls in California, office buildings in Houston, and condominiums in Denver. Unfortunately, these were investments they knew little about simply because they had little experience with such investments. So they had difficulty classifying the risks involved.

Money flowed into real estate during the early to mid 1980s, because of the favorable tax treatment of real estate and the seemingly high returns. In 1986 Congress reformed the tax code and removed many of the provisions that favored real estate. All of a sudden, everyone wanted to get out of real estate; there were sellers but no buyers. As a result, the real estate market collapsed. S&L's were especially vulnerable because they were heavily invested in real estate and because they had invested in properties experiencing higher risks to begin with. The S&L crisis of the late 1980's was, therefore, directly linked to the banking deregulation of the early 1980's and the tax reform of 1986. Many observers believe that the S&L's invested in riskier assets partly because they knew their deposits were federally insured by the federal government and hence the taxpayer. If an S&L went "bankrupt," depositors would not lose their money because it would be repaid by the federal government. The S&L bailout eventually cost taxpayers about six hundred billion dollars.

Application: The International Monetary Fund (IMF) routinely bails out less developed countries, like Mexico in the 1980's and Indonesia in 1998, who get into financial difficulty, with low interest loans. They also impose stringent requirements on the local government receiving aid forcing it to balance its budget, slow down the growth in its money supply, deregulate its economy, reduce corruption, and protect property rights. Does the existence of this sort of "insurance" affect the behavior of the countries involved? Do they have an incentive to be efficient in providing government services to the people if they know that if they get into budgetary trouble they will always be bailed out by the IMF?

4. Problems with the market outcome: public goods.At the beginning of the semester when we initially discussed the Invisible Hand Theorem we considered an example which led us to conclude that the private sector could not provide all goods that people gain benefits from. For example, it could not provide traffic lights. So the private sector will not be able to provide some "commodities" under competition. There is

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actually a large class of goods the private sector has a great deal of difficulty providing. If people gain utility from such goods but the private sector cannot provide them, there is a potential role for government to take on.

Consider the following game. Assume there is no government. There are two neighbors A and B who live at the end of a cul-de-sac and there is no street lighting. They meet in the middle of the street to watch the sun go down and both remark on how dark it gets at the end of the street and how nice it would be if there were a street light. Assume the street light costs $100 per week and that a single family would receive a benefit measured at $80 per week from the street light. Clearly, a single family would not want to provide the light by itself. The problem is that if family A provides the light, B also benefits, but A does not take this into account in calculating its own benefit from the light. If A provides the light, some of the benefit "spills over" to B, and similarly if B provides the light. Sharing the cost seems like the way to go in this case. The point is that self interest may not be enough to get the commodity produced; the individual's incentive differs from the group incentive.

Suppose that the two neighbors try to share the cost of the light and assume that if both neighbors contribute to the light they split the cost evenly. Imagine that the two neighbors agree to contribute to paying for the streetlight, but then must go back to their respective houses to actually write the check to the power company who will install and maintain the light. If only one family sends a check to the power company assume the power company sends that family a bill for the rest of the cost of providing the light. The payoffs are given in the following table. (30 = 80 - 50, - 20 = 80 - 100 and so on.)

There is only one equilibrium if the game is played once: (don't contribute, don't contribute) and the associated payoffs are (0, 0) because the streetlight doesn't get built. This is yet another example of the famous prisoner's dilemma game. Notice that the action "don't contribute" is a dominant strategy; its payoff is always higher than "contribute" for any action the other player can take (80 > 30 for A when B chooses "contribute" and 0 > - 20 for A when B chooses don't contribute.").

What happens if the game is played repeatedly? A strategy must tell the player what to do under every circumstance so a strategy is more complex than an action. If the game is played over an infinite number of periods, the strategy "never contribute" is an equilibrium if both players decide to play it. (Check your understanding of this. The payoff from playing this strategy is 0/(1 - ) = 0, where is the discount factor. However, if A deviates on the first move and then goes back to playing the strategy, her payoff is - 20 + 0/(1 - ) = - 20. So deviating reduces her total payoff.) On the other hand, the strategy "always contribute" is not an equilibrium. This is because cheating on every move yields a higher payoff than playing the strategy "always contribute," 80/(1 - ) > 30/(1 - ).

We can design a trigger strategy that can support contributing as an equilibrium. The strategy is ST = 1.) Choose "contribute" at t = 1; 2a.) For t > 1, choose "contribute" if the

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opponent chose "contribute" at t-1; 2b.) For t > 1, choose "don't contribute" forever after if the opponent chose "don't contribute" at t-1. The payoff for the pair (ST, ST) is 30/(1 - ). Suppose A deviates on the first move. She gets 80 at t=1. At t=2, she is punished and gets 0 forever after for a total payoff of 80. If 30/(1 - ) > 80, she should choose "contribute." Why 0 forever? Because player B punishes by choosing don't contribute at t = 2 and so for t = 3 part 2b of the trigger strategy kicks in for A and she chooses not to contribute forever after. Rearrange the inequality,30 > 80 - 80, or, > 5/8. If satisfies the inequality condition, then both players will stick with the trigger strategy and not deviate. For example, if = .5, then compare 30/(1-) = 60 with 80 and obviously she will deviate so (ST, ST) is not an equilibrium. If = .75, then compare 30/(1-) = 120 with 80, and she will choose not to deviate.

Other examples of public goods include national defense, lighthouses, public infrastructure like roads, bridges, highways, streets, water and sewer systems, clean air and water, basic research, air traffic control, the general health of the population, police and fire protection, satellite weather information, and mosquito control. There are even "international public goods" like peacekeeping efforts in places where there are conflicts like Somalia, the information provided by Interpol about criminals who cross country borders, saving the whales, and foreign aid. In many cases, governments provide these goods and in some cases such a good is related to goods that are provided by the private sector.

5. Complements: Public goods and private goods The government can aid the private sector by essentially providing goods that are complementary to goods produced in the private sector. Many public goods are related to private goods and many times they are complements. Examples include air travel and air safety, picnics near a lake and mosquito control, automobiles and highways, boating and docking facilities, and ultimately, the ownership of private property and the defense of property rights.

Imagine a lake with houses arranged around it. In the warm weather there is a mosquito problem. The problem won't be solved if one homeowner sprays for mosquitoes. Only if they all spray will they eliminate the mosquitoes. It might be difficult for the individuals to organize if there are a lot of owners. So government can usefully step in, charge a small fee, and oversee the spraying. Mosquito control can be thought of as a public good. And once the mosquitoes are gone, people can enjoy picnics. Thus, the demand for picnics is positively related to mosquito control.

These so-called "public goods" have certain characteristics that make them difficult, if not impossible, for the private sector to provide. First, consider a private good. A private good is a commodity that exhibits exclusion and depletion. Exclusion is where people who benefit from the existence of the good are forced to pay for the good and those who do not want to pay for the good are excluded from enjoying the benefits of the good. For example, if you wish to consume an apple you must pay the owner of the apple. If you don't pay, then the owner can exclude you from consuming the apple and enjoying its benefits. Paying for the good essentially transfers the property right from the owner to the buyer. Depletion, which is sometimes referred to as rivalry, means that more resources have to be used up to produce one more unit of the good so another consumer can enjoy the benefits of the good. To produce one more apple will cost society an additional expenditure of resources. It cannot be produced for nothing. A private good exhibits exclusion and depletion.

A pure public good exhibits non-exclusion and non-depletion. For example, "clean air" is a public good. No one can be excluded from enjoying the benefits of "clean air" once the good "clean air" has been produced (non-exclusion) and we can provide one more person with the

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commodity "clean air" without expending any additional resources (non-depletion or non-rivalry).

Mosquito control exhibits both non-exclusion and non-depletion. It is impossible to exclude one homeowner from enjoying the benefits of mosquito control once all the mosquitoes are eliminated and one more homeowner can build a house and join the community without causing society to spend more on mosquito control.

It is really exclusion that creates a problem for the private sector. If the owner of the good cannot exclude people who do not pay from enjoying the benefits of the good in question, then the owner has no incentive to provide the good. For example, imagine a company that produces "clean air" and tries to sell it. In order to be compensated for providing the good, the company would have to charge people for the air they breathe. How would it collect? Would people send a check to the company every month or would they "free ride?" They would probably free ride and try not to pay. But if everyone does this, the company would go bankrupt and not provide the good "clean air."

As another example, it is technically possible for a private company to operate a highway by charging tolls and restricting access to the road. There were even private companies who ran lighthouses in the 17th and 18th centuries. Every ship that sailed past the lighthouse would dock at the local harbor and would have to pay a fee to the harbormaster for sailing past the lighthouse. However, governments realized the problems involved. For example, some toll collectors on some of the toll roads in New York were corrupt. They would set up wealthy travelers for "highwaymen" who would rob them. And governments also realized the amount of revenue they could obtain for themselves by controlling the roads and harbors. Indeed, this was a major source of revenue in the 18th and 19th centuries. Thus, control of the roads and other infrastructure passed over to the state in the early part of the last century.

Some goods are impure public goods because they exhibit one but not both properties of a public good. For example, a congested road may exhibit non-exclusion because it is too costly to keep some drivers from using the road, e.g., downtown Spokane. However, it also exhibits depletion because each new car that drives on the road creates more congestion and thus reduces the driving speed of the other cars. In order to provide each new car entering the roadway with the same driving experience as the previous cars, we would have to build a bigger road and thus deplete more resources. An uncongested highway with limited access points would also be an imperfect public good. It exhibits non-depletion (because it is uncongested) but exclusion is possible (because of the limited access).

There is a certain symmetry between a private good and a public good. For a private good everyone pays the same price but would like to consume different quantities. For a public good everyone must consume the same quantity but would be willing to pay a different price. Why? Suppose the public good is "clean air." Presumably, anyone who breathes the air consumes the same commodity "clean air." However, because people differ, each person would be willing to pay a different amount for the good "clean air."

6. Equilibrium with public goodsTo obtain the market demand for a private good earlier in the course we summed horizontally. We fixed the price and determined how many units each person was willing to buy at the going price. Then we summed up horizontally across different consumers. Why horizontally? Because in a supply and demand graph price is on the vertical axis and quantity is on the horizontal axis. When we sum horizontally everyone pays the same price but consumes different quantities. To obtain the demand for a public good, we sum vertically, rather than horizontally,

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because everyone consumes the same quantity of a public good but is willing to pay a different price.

Suppose there are two types of agent who will benefit from the provision of some public good, A and B. Their respective demand curves or "willingness-to-pay for the public good" curves are depicted below as dA and dB. Imagine the public commodity is "quality of the driving experience across a new bridge," measured in the time it takes to cross the bridge and how much congestion there is on the road, and G = size of the bridge, e.g., one lane, two lanes, and so on. We would like to obtain the market or total demand for the public good and then use it in conjunction with the marginal cost curve to determine the optimal amount of the public good to provide. Pick a level for G, the public good, say, G1, and ask how much is each agent willing to pay for G1? A is willing to pay $9 while B is only willing to pay $3. Sum them to get the total willingness to pay for G1, $12, point a in the diagram. Do the same thing for G2 ($7.5 + $3 = $10.5, point b) and G3 ($6 + $3 = $9, point c) and so on. This yields society's total willingness to pay for G or its total demand curve, D. We can then combine the market demand curve with the marginal cost curve of producing G to obtain the optimal solution for G. Apparently, the optimal level of G is given by G3 where D = MC.

For a private good, the marginal rate of substitution, or MRS for short, is the willingness of the consumer to pay for another unit of good x by giving up some of another good, say y, i.e.,

(Ux/Uy)A is A's willingness to pay for another unit of x or the amount of y the consumer is willing to give up for one more unit of x. The consumer chooses her optimal consumption bundle of private goods where her willingness to pay for more x, (Ux/Uy)A, is equal to what she actually has to pay, px/py, i.e., in equilibrium, (Ux/Uy)A = px/py. The price ratio is also the marginal rate of transforming y into x, i.e., px/py = MRT. So, MRS = MRT for two private goods in equilibrium. For private goods, every consumer adjusts her consumption to the price ratio, which is given by the marketplace. This is why we say everyone pays the same price for a private good, the going market price, but will generally consume a different amount.

For a public good, it is the exact opposite; everyone consumes the same amount of the public good but is willing to pay a different price. For G3, person A is willing to pay $6 while person B is willing to pay $3. In a sense, person A is willing to give up more of a private good for the public good than person B. The willingness to pay for the public good is equal to the

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MRS of a private good and the public good. For example, (UG/Ux)A = A's willingness to pay for the public good, where UG = A's marginal utility of the public good. For G3, (UG/Ux)A = $6 and (UG/Ux)B = $3. Above, we added these to get the total willingness to pay and we set that equal to the MC of producing G. In other words, we used the following rule to choose the optimal level of the public good,

(UG/Ux)A + (UG/Ux)B = MC,assuming the price of good x is equal to one for simplicity, e.g., at G3, 6 + 3 = MC = 9. This rule is known as Samuelson's rule for choosing a public good; at the optimal choice for the public good, the sum of benefits equals the cost at the margin.

The question then becomes: how do we actually pay for G3? Since A and B are willing to pay different amounts it seems reasonable to charge them different amounts. Optimally, we should charge A $6 because that is her willingness to pay for G3 and we should charge B $3 because that is what he is willing to pay. In fact, this is known as Lindahl's solution after the Swedish economist who first proposed it.

This is where a number of problems arise. Suppose A and B can figure out what the government is trying to do. The government might not know what type of person each agent is. It might only know there are some people who really like the public good, type A people, and some who don't care as much, type B people, but it won't know which type of agent a particular person is. So the government would have to try to elicit that information from the agents themselves. What will person A say when the government asks what type she is? Knowing she will have to pay a larger fee for the public good than B she might be tempted to lie and say she is a B type. This is free riding behavior once again, where each agent tries to underestimate their willingness to pay for the public good in an attempt to lower their own tax burden hoping the public good will get produced anyway. (The individual is trying to free ride on everyone else.) The government might try to get around the problem by charging an average of $4.50 (6 + 3)/ 2 = $4.50). However, that would be overcharging B types and they would not like that.

If both A and B understate their true preferences, what happens? If everyone understates their true demand, then when we sum up the individual demands for G to get the market demand

for G, we do not obtain the "true demand" for G as we did above. Instead we obtain the "understated demand" for G which is below the true demand for G (Shift D down by the amount agents understate by). As a result, the actual amount of the public good that gets produced is less than the optimal amount. This sort of bias means that less of the public good gets produced than should have been produced and government spending on public projects is

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possibly lower as a result. So, for example, a one-lane bridge might get built instead of a two-lane bridge, and people have to put up with excess congestion when they drive across the bridge in commuting to work every day. Too few employees might be hired to work at the DMV and it takes much longer to get your driver's license than it should. Too few teachers are hired and class size is greater than perhaps it should be. The selection at the local library is not as good as it otherwise would be.

For pure public goods, it is widely believed that the government must provide the good in question. Taxes must generally be imposed to pay for the good. However, some public goods are impure in that there is congestion, hence depletion, associated with the good, e.g., crowded museum. To whatever extent it can, government should probably charge user fees to help cover the cost of an impure public good and to cut down on congestion. In fact, it is actually optimal to charge a "user" fee to reduce congestion. So people who use public docking facilities, national parks, museums, and the like should pay an admission fee and then they will economize on their visits to the public good. Charging user fees to use the roads, bridges, and highways when possible might be a useful idea.

Application: How much should we charge for the student health service and how should the fee be paid? At many universities students pay a fixed fee and can visit the health service as much as they wish. Sometimes the waiting room is full, i.e., there is congestion. If a nominal fee, say $10, is charged for each visit, some students might not go to the health service, certain illnesses would become more prevalent on campus, the likelihood of contracting such illnesses would increase for many students, and additional problems might arise as the diseases spread more rapidly through the population. The quality of health for students on campus is probably a pure public good and visits to the health service contribute to it. So charging a fee to cut down on congestion might not be a good idea in this case even though there is congestion.

Application: Privately provided public goods. Sometimes a "public good" can be provided by the market. Charity is one example. Another example is when a flood threatens a town and complete strangers send money to help the flood victims. Volunteering time is a third example. When George Bush accepted the nomination of the Republican Party in 1988, he stated in his acceptance speech to the convention that he saw "a thousand points of light" out in the country, where each "point of light" represented a private citizen helping someone else in need or helping to solve a problem out of a sense of altruism. Essentially, this is providing a private solution to a public problem. We can apply our analysis of the free rider problem to the case of "privately provided public goods" and conclude that the private sector will not usually provide enough of these sorts of solutions. Indeed, the problem the private sector is supposed to solve will typically exist because the private sector was unable to solve it in the first place!

Application: Even governments may not be able to solve social problems in an open economy. An open economy is one where resources are mobile and can flow across the boundary of the economy easily. If governments try to tax such resources it can run into a problem. For example, resources can move across state lines. So if Oregon raises its tax rate, firms may move to Washington, produce and then truck the goods across the border thus evading the tax. And as anyone buying liquor knows, it is cheaper in Idaho! This problem is known as tax competition and it can make it hard for governments to raise revenue to meet society’s needs in building roads, highways, and bridges, providing schools, defending the country, and setting up social insurance program to help people in need.

Unfortunately, history has taught us that many social problems exist because there is something in the structure of society or the economy which causes the private sector to be unable to solve them. The general Prisoner’s Dilemma problem, where people behave rationally but the outcome appears irrational, is an example. Given that, it is not surprising that governments have

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difficulty coming up with solutions. Pollution is a case in point. It is rational for a firm not to clean up its own pollution. But when all firms do not, the environment becomes toxic.

7. Problems with the market outcome: externalities. An externality is any situation where one agent's behavior or action affects another agent. A pecuniary externality occurs within a market. A non-pecuniary externality occurs outside a market. Externalities can also be classified as to whether they are beneficial or harmful. Sometimes these effects are called "spill over" effects because the agent's action "spills over" and affects another person.

Examples of various externalitiesExternality: Someone sneezes and we all catch a cold.Externality: You hold the door for the next person going out of a room.Non-pecuniary externality: The Exxon Valdez spilled a large amount of oil off Prince

William Sound and ruined the local habitat and killed many animals living in the Sound.Pecuniary Externality: The Exxon Valdez spilled a large amount of oil off Prince

William Sound and the resulting shortage raised gasoline prices on the west coast by about 10-15¢ per gallon.

Non-pecuniary externality: An outbreak of salmonella, a deadly bacteria, in peanut butter originating at the Peanut Corporation of America, caused a dramatic drop in sales of Skippy, Jif, and Peter Pan, even though salmonella was not found among those name brands.

Beneficial Externality: Research that finds a cure for cancer.Harmful Externality: Pollution.It is widely believed that the government should only intervene in important cases

involving non-pecuniary externalities, where the externality occurs outside the market. Markets essentially allocate goods across potential buyers and sellers. If the price is high, few will wish to buy. If the price is low, more will want to buy the good. When a "shock" hits the market, the price will rise or fall. If it rises, fewer people will be able to afford the good. If it falls instead, more will. Obviously, consumers are happier when the price falls than when the price rises. The government should interfere with this process as little as possible. As we have seen in other circumstances like price controls, when the government does intervene it can make the markets function less efficiently and a misallocation of resources can easily result. For example, during the Christmas shopping season there always seems to be one toy children have to have. Effective advertising essentially creates a demand and parents frantically scurry around trying to fulfill that demand. The price of the toy rises and parents who are desperate enough, will pay the price. Others won't. The market will allocate the good across all of those potential consumers. Should the government intervene and pass a law stating that every family that wants one should get the toy?

Example: Beanie Babies were all the rage in the 1990s and young children and even some adults collected them. They usually sold for about $4.95 and cost about $0.75 to produce. A Beanie Baby was even produced to commemorate Diana, Princess of Wales, who died in a tragic auto accident in Paris in 1997, and it was only sold at auction, not in stores. The highest bid? $1,200!!!!! $1,200, for a toy that costs about $0.75 to produce! Some people will pay the price, most won't. Should the government intervene? Probably not.

Second, the government would also find it impossible to intervene in all cases of non-pecuniary externalities. Consider what happens when a price war breaks out among the airlines. Cheaper fares are the result and more people get to fly. But this also means that there will be greater congestion at airports; fewer parking spaces to park your car, more screaming babies on the plane, less space for your carry on trunks, and so on. These are all non-pecuniary

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externalities generated by the price war. Should the government intervene in each case? Probably not. The costs of intervening would probably easily outweigh the benefits from doing so. In some cases it is not immediately obvious how the government should intervene. Consider the case of the fare war leading to more airplane travel by young families. Young families have babies and some of them scream on airplanes. Indeed, when the cabin compresses and decompresses, the inner ear is affected and most babies will become extremely irritated, agitated, and upset. They then feel compelled to share this irritation, agitation, and upsetedness, with everyone else on board. This is obviously a negative non-pecuniary externality. What should the government do? Should it ban screaming babies from flights? Should it pass a law creating a "screaming baby" section of the plane? Should it impose a tax on screaming babies? The costs of intervening in this case would probably outweigh the benefits.

The only exception to the rule of only intervening in the case of an important non-pecuniary externality is when the shock to the market in question adversely affects the income distribution. For example, home heating oil prices increased dramatically during the Gulf War. The Gulf War caused a shortage of oil, and thus gasoline and home heating oil, causing prices to increase. Home heating oil is very expensive and an increase in its price can create a hardship for poor people.

Application: The New York Times reported (September 15, 1997) that thousands of fish stricken with a microbial affliction were dying on the Chicamacomico River in Maryland leading the state to close the waterway to fishing and recreation. The microbe not only infects fish, it can also cause flu like symptoms in people if the fish is ingested. Scientists now believe the microbe stems from manure runoff from hog and chicken farms near the river. (Nutrients in the manure runoff allow the bacteria to thrive and become toxic.) Farmers are bracing themselves for increased regulation involving runoff. Businesses that rely on the tourist trade have already been hurt by the bad publicity.

What policy should the government pursue in the case of an externality that occurs outside the market? This depends on the individual situation. However, in general, it should pursue policies aimed at having economic agents face the social marginal cost of their actions. This includes the private marginal cost we have been studying all along this semester. In addition, it also includes any additional positive or negative externality costs the agent may perpetrate on others at the margin. Consider the following example.

Example: Suppose there is a chemical producer that builds a new factory and begins dumping toxic waste into a river. Further suppose there is a fishing village downstream. The toxic waste reduces the number of fish and thus raises the cost of fishing to the fishing village. Essentially, the chemical producer's action affects the fishing village adversely and it is outside the normal market system so it is a harmful or negative, non-pecuniary, externality. Also assume that both the chemical producer and the fishing village behave competitively so each takes the price in its market as given. In the diagram below the chemical producer faces the private marginal cost (PMC) of producing its product but not the social marginal cost (SMC) of its actions which includes the damage to the fishing village. It produces at point a, where Pc = PMC, which maximizes its profit. The fishing village produces at point a' where Pf = MC before the chemical plants opens up because this is where it maximizes its profit. After the chemical plant opens, pollution increases and it becomes more costly to catch fish so the fishing village's cost curve shifts up. Given the increase in its cost, output drops from a' to b' and people are laid off and some fisher people will go out of business. Under competition, the chemical producer is at point a and the fishing village is at point b' after chemical production starts and the pollution problem begins. Too much is being produced by the chemical producer because the chemical producer is not facing the social marginal cost of production and not enough is being produced

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by the fishing village relative to the optimal levels of production at points b and a', respectively. The problem is that the chemical producer is not taking into account the impact it has on the fishing village.

The social marginal cost curve, SMC, includes all social costs of production including the costs associated with the pollution damage. Y*c is the optimal level of chemical production since this is where Pc = SMC. The problem is how to get the chemical producer to face the SMC curve rather than the PMC curve. The optimal response of the government is to impose a tax or fine per unit of output on the chemical company for creating pollution. This raises its private marginal cost curve until it equals the social marginal cost curve. When the chemical producer faces the SMC curve because of the tax, it will choose the optimal level of production at b. The increase in the PMC curve is the tax rate imposed on the chemical company. Optimally, a producer should always face the social marginal cost of production, SMC. The government can impose a tax or fine on a polluter in order to force the polluter to face the SMC instead of the PMC. If the polluter faces the SMC, its decisions will be socially optimal.

As another example, consider a researcher who produces basic research, upon which applied research later can be based. There is a demand for basic research and a marginal cost of producing basic research. The PMC curve depicted below is the private marginal cost of producing basic research and the SMC curve is the social marginal cost. In a competitive equilibrium, the output of research will occur where D = PMC at point A. However, the socially efficient level of basic research occurs at point B instead because of the possible beneficial externality effects associated with basic research.

How does this work? There are enormous benefits to doing basic research that spill over and help others. A scientific break through published in an academic journal anyone can read

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and study can have an enormous impact on a variety of different companies. If basic research is done and made available to everyone, then each private firm doesn't have to do the basic research itself, i.e., each firm doesn't have to "reinvent the wheel" itself, it need only be invented once, by the basic researcher. Each private firm can instead focus on applied research based on the basic research. This is an example of a beneficial non-pecuniary externality. Basic research increases the productivity of the private sector at the margin. This is an extra benefit of basic research not really reflected in the private marginal cost curve. In fact, basic research actually reduces a private firm's marginal cost making it easier for private firms to produce private goods. Thus, the social marginal cost of producing basic research is lower than the private cost because of these beneficial externality effects. This means that it is socially optimal to produce more research than the market outcome, Goptimal > G*, as depicted at point B.

A solution to this problem is to subsidize basic research. A subsidy shifts the private cost curve down until it is equal to the social marginal cost. The subsidy rate is the distance between the two cost curves, PMC - SMC. The idea is that the researcher in a competitive world faces the PMC curve. However, only G* will be produced in that case and this is suboptimal. A subsidy that lowers the researcher's marginal cost from PMC to SMC will induce the researcher to produce more research, G-optimal, and this is socially efficient.

In general, the government should subsidize those who create a beneficial non-pecuniary externality and tax those who cause a harmful non-pecuniary externality so that they face the social marginal cost of their actions. SMC < PMC when there is a beneficial externality and the appropriate subsidy is PMC - SMC. If SMC > PMC, then there is a harmful externality being generated and the tax is SMC - PMC because the SMC curve is above the PMC curve. This is known as the Pigouvian tax-subsidy policy after A. C. Pigou, the British economist who first worked it out.

8. The Coase Solution.We should note that it will not always be optimal for the government to intervene in an externality situation. Two remarks are in order. First, the benefits of intervening must outweigh the costs. When an oil tanker runs aground and spills thousands of barrels of oil thus destroying natural wildlife areas and fouling the water for miles around, clearly, the benefits of intervening outweigh the costs. However, one can imagine smaller situations where government intervention is not required. For example sneezing on someone giving them your cold is a harmful, non-pecuniary externality. Optimally, the government should impose a tax on the Sneezer or a subsidy for the Sneezee. However, the costs associated with figuring out who should pay the tax or receive the subsidy clearly outweigh the benefits from doing so.

Second, the private sector might find a solution itself thus making government intervention unnecessary. Ronald Coase is credited with this idea and it partly won him the Nobel prize in economics. He argued that most externality situations really involve only two people, the person who creates the externality and the recipient or person affected by the externality. Coase argued that if the two agents involved can bargain with one another, they will reach an optimal solution.

Consider the classic example put forth by Coase. A rancher allows his herd to graze freely and sometimes some of his animals trample the farmer's fence and get into his corn. Under the Pigouvian solution to the problem, the rancher would be taxed. However, Coase argued that the two can bargain and the bargain will be based on the definition of the property rights involved. Suppose the farmer has the property right to not have his crops trampled. If the rancher's cattle trample the corn, the rancher and the farmer can come to a settlement privately

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without any government intrusion. Coase argued that most externality conflicts can be privately settled.

The counter argument to Coase is that he ignored bargaining costs. If there are significant bargaining costs, private negotiation may not resolve the conflict. Many important externality situations involve a large number of people and the greater the number of people involved in the bargaining the higher the bargaining costs will be. Consider a defect in a car. Literally thousands, if not millions, of car owners would be affected and would have to negotiate with GM, for example. This would be very costly. The greater the bargaining costs involved, the lower the likelihood that private bargaining will solve the problem. As another example, it would be impossible for car owners to negotiate with Toyota in Japan if a defect were found in their Camry. Finally, who would negotiate on behalf of a wilderness area if a tanker spills millions of barrels of oil, as occurred in the Exxon Valdez case?

The conclusion is that many externality situations involving low bargaining costs can be privately resolved without government intervention. However, in cases where the bargaining costs are large, some form of government intervention will usually be called for. So the Coase solution is not a general panacea but will work in "small" cases.

9. Application: Salmon wars in the Northwest.The fisher people of western Canada, the Northwest, and Alaska, and environmentalists have been locked in a political battle for years over fishing rights. Various fish, e.g., salmon, migrate from rivers to the ocean and then up the coast until they return to their river of origin in order to spawn. Canadians claim there is too much fishing by people in the Northwest and Alaska and vice versa, which reduces the number of fish returning to spawn. Recently, the controversy heated up once again.

The New York Times reported (Sept. 12, 1997) that angry Canadian fishermen were blockading Alaskan fishermen near Vancouver, BC. This was followed by three international lawsuits and a move to shut down an American torpedo testing range in British Columbia. A Seattle paper ran a headline, "Let's Take Canada, Eh?" The fight is over who gets to keep the fish (salmon) who themselves know no international borders. Premier Glen Clark of British Columbia filed a $300 million lawsuit against the US in Seattle. According to Governor Gary Locke, "I had a private talk with Premier Clark and he made it very clear to me that he is willing to grandstand this issue and fish the salmon to extinction if that's what it takes."

The Canadians claim that Americans "harvest" 500,000 sockeye salmon as they swim through Alaskan waters on their way south to Canada to spawn. The Americans say the Canadians have excessively fished the coho and chinook salmon off Canadian waters near British Columbia as they make their way south to spawn in American waters. Only about 300 jobs are at stake. Even so, tempers have flared on several occasions because of the symbolism involved. The Canadians blockaded the ferry to Prince Rupert Sound and burned an American flag at one point.

The treaty that governed how many fish could be taken expired in 1994 and has not been renewed. We can model this as a game between two players. Each player can choose to fish a lot or a little. There is only one equilibrium in this game if the game is played once : (fish a lot, fish a lot) with payoffs (- 10, -10) and the fish become extinct. This is an example of the Prisoner's Dilemma game.

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Consider a trigger strategy for a repeated game : 1. start by choosing fish a little. 2A. if the other player fished a little last period, continue to fish a little. 2B. if the other player fished a lot last period, punish him by choosing to fish a lot now and forever. Suppose both players start by playing the trigger strategy. What is the US's payoff? UUS = 5 + 5 + 52 + ....... = 5/(1 - ). This is also Canada's payoff as well. Suppose the US deviates on the first move. Its payoff is UUS = 10 - 10 - 102 - 103 - .... = 10 - 10(1 + + 2 + ...) = 10 - 10/(1-). If 5/(1-) > 10 - 10/(1 - ), then the US should continue to choose "fish a little," and similarly for Canada. This is equivalent to: If is such that 1/4 < , then the US should choose "fish a little." Since the game is symmetric, Canada should do the same, and we can achieve a favorable outcome.

What is Premier Clark of BC doing? One interpretation of his behavior is that he is trying to stir up debate on the issue for short term political gains. Perhaps for him < 1/4 since he appears to only be interested in short term political gains and not the long term gain of saving the salmon.

10. Can the private sector solve "social" problems?In his 1988 acceptance speech at the Republican convention, George H. W. Bush used the phrase, written by speechwriter Peggy Noonan, a "thousand points of light" to denote people in the private sector solving social problems. Each point of light was one person solving a problem in their local community.

Many social problems have a "prisoner's dilemma" structure. The structure of the payoffs was discovered by Merrill Flood and Melvin Dresher, two researchers at RAND, a private think tank, in 1950. Albert Tucker came up with a story about two prisoners and prison sentence payoffs and also provided the name of the "Prisoner's Dilemma." (John Nash from the movie "A Beautiful Mind" was a student of Tucker's.) Imagine two criminals have been caught at the scene of a crime. The police have them on a minor charge but take them back to the station to interrogate them separately hoping to get one or both to confess to a more serious crime by cutting a deal with the police. The individual incentive is for each prisoner to cut a deal with the police. However, it is in the interest of each as a group to refuse to talk. This has the same structure as the streetlight game: replace "contribute" with "don't talk to the police" and "don't contribute" with "talk to the police," and the fishing game: replace "fish a lot" with "talk to the police" and "fish a little" with "don't talk to the police."

If both prisoner's talk, the police have enough evidence to get a sentence of 10 years for each prisoner. If A talks and cuts a deal and B does not talk, A only gets 1 year and B gets 12. If neither talk they get a sentence on a minor charge of 2 years. The payoffs are depicted in the figure. The individual incentive is to talk while the group incentive is to not talk. The Nash equilibrium if the game is played once is for both prisoner's to talk.

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As we have seen in the earlier games, the Nash equilibrium in the one-shot game is where both players follow their individual incentive and don't contribute, fish a lot, and in the Prisoner's Dilemma game talk to the police, whereas the group's incentive is to contribute, fish a little, and not talk to the police. It is also possible to find a trigger strategy that will support the group incentive, which in many cases is socially optimal, or at least preferred to the outcome when individuals follow the individual incentive.

In some cases the social problem exists because the private sector has been unable to solve it. This can be the case when there is a Prisoner's Dilemma type of structure to the interaction. Firms can pollute or not, but if they pollute it may be cheaper to produce and compete, for example, than if they spend some of their profits cleaning up the pollution. In such cases, some sort of government policy is called for. For example, fining (taxing) polluters and forcing them to clean up their own pollution is one such response.

In other cases, the private sector tries to solve the problem but cannot do so completely. For example consider a charity and two donors A and B, Each cares about a private good x and charity C. Utility is UA(xA, C) and UB(xB, C). Let d be a donation to charity. Then C = dA + dB, i.e., total charity spending is equal to the sum of individual donations by A and B. This is a classic example of an externality. Substitute for C, UA(xA, dA + dB) and UB(xB, dA + dB). A's utility partly depends on B's donation and B's utility depends on A's donation, i.e., there is an externality. We might observe donations to charity and so it looks like the private sector is "solving" the externality problem. However, most likely, donor A will ignore the impact his donation has on donors B, D, E, F, and so on, for all who donate to the charity. This means that too little charity will occur. Why? If A took his impact on B and so on into account, he would give more. Since he does not, in general, he will not give more and so too little charity is produced.

A simple solution is for the government is to allow a tax write off for charitable donations. This is an indirect subsidy for charity. Some, like Martin Feldstein of Harvard, have argued that we should rely on private sector alternatives to public programs and simply subsidize private efforts through the income tax code.

11. Government failureEven though we as economists can prescribe a remedy for a perceived problem that exists with the functioning of the market system, there is no guarantee the government can or will implement the proposed solution. We have already seen the problems that arise when the government attempts to regulate monopolists.

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Political failure may take many forms. There may be what is known as "gridlock," where nothing can be accomplished even though the country faces some pretty obvious problems because the President and the Congress are posturing. On other occasions, the two branches of government seem to be able to work together. In general, we can model this interaction as a "game of chicken." In the now famous movie "Rebel without a Cause" James Dean and another young man race their cars to the edge of a cliff to prove who is more courageous. The first one who stops is "chicken" and loses face in front of everyone. Similarly with the Congress and the President. In fact, gridlock under the Bush Administration severely limited the ability of the government to pass legislation and attempt to solve the country's problems. The problem got much worse in the early part of the Clinton Administration and the federal government was forced to shut down several times.

Consider the following game between the President and Congress. We obtain different outcomes depending on the values for a and b.

A. a = b = 0. There is one equilibrium : (don't back down, don't back down) with associated payoffs of (0, 0). This is the case of gridlock. Neither the President, nor Congress is chicken.

B. a = b = -5. Now there are two equilibria : (don't back down, back down) and (back down, don't back down). In the first equilibrium, Congress is "chicken." In the second equilibrium, it is the President who is "chicken."

C. a = - 5, b = 1. There is one equilibrium : (back down, don't back down). Notice that "don't back down" is a dominant strategy for Congress.

D. Opposite of case #3. (a = 1, b = - 5.) The equilibrium is (don't back down, back down). "Don't back down" is now a dominant strategy for the President.

Many times the players engage in what is known as tough talk before the game begins. This can be interpreted as an effort to get the other player to change his belief about the payoffs in the table. When the President talks tough, he is trying to convince the Congress that a = 1 and that he won't back down. When the Congress talks tough, it is trying to get the President to believe that b =1. If both are convincing, gridlock occurs and the government is possibly shut down. Of course, some might think that is not necessarily a bad thing.

11. Can governments solve problems in the new global economy? A closed economy is an economy where the resources do not flow across the boundaries of the economy very easily. An open economy is an economy where the resources flow across the boundary of the economy very easily. The US from the late 1940's until about 1970 could be considered a closed economy since international trade was such a small part of the economy. Other examples of closed economies include China, from 1949 to the early 1980's, who shut herself off from the rest of the world for the most part under Chairman Mao and Deng, and Japan

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several hundred years ago, when she expelled all foreigners. The state of Washington would be considered an open economy.

Many argue that governments are severely limited in what they can do if they exist in an open economy. Why? Because if the "local" government in an open economy tries to do something private agents do not want done, then resources, e.g. people and firms, will move to another location outside the purview of the local government. The key is taxes. Private agents do not like to pay taxes. Unfortunately, most problems that require a social solution need to be financed in some way and taxation is ultimately the only way. For example, suppose capital is freely mobile and the state of Washington imposes a tax on capital income. What will be the response of the private sector? Some firms will move their factories to Oregon, Idaho, and Canada, produce their goods and then transport them back into the state of Washington thus avoiding the tax on capital. (The Constitution forbids states from imposing taxes on commerce so states cannot impose taxes on goods coming into the state.) The key is that the capital can move across the state's border relatively easy and the goods produced in other states or in Canada can be easily trucked back into Washington.

The mobility of goods and people can make it difficult for governments to solve social problems. In a sense there is a prisoner's dilemma game going on. If state A tries to raise its taxes to solve a social problem, e.g., poverty, health care availability, or build better roads, some people and firms may move out of the state taking their jobs with them to avoid the new tax. So social problems may not get solved as a result of the mobility of private resources.

This calls for federal government action rather than state action. The federal government can impose a solution from above, so to speak, by forcing all states to solve the problem. However, in a world economy with resource mobility undertaken by multinational firms and migration, it becomes difficult even for federal governments to solve problems. For example, European states are trying to come together and act as one country in a strong sense through first, the Common Market, and now through the European Union. Their goal is to have one currency, one monetary policy, one fiscal policy, and one foreign policy. However, to do so, is to concede each individual country's sovereignty, something some of the countries like Britain have balked at. If they achieve the goal, then it will become very difficult for an individual country in the EU to solve a problem by itself.

The general point is that as the world economy develops and becomes more integrated, individual countries begin to lose their ability to affect the outcome and solve problems specific to that country. This is, perhaps, the downside of globalization. Furthermore, a problem in one country can easily spill over to other countries. For example, the financial crisis of 2008 may have begun in the US housing market. The Greenspan Fed kept interest rates low after 9/11 to buoy up the economy. This fueled the housing, car, and durable goods markets that rely on interest. When the Fed under Bernanke started to raise rates to fight inflation in late 2006, the housing bubble burst. ARMs (adjustable rate mortgages) started increasing rates and hence monthly mortgage payments, and this led to the foreclosure problem. Further exacerbating the issue was the huge ($85 trillion) derivatives market that issues securities based on the value of mortgages. As mortgages became uncertain in value, so did the securities that relied on that value, the so-called mortgage backed securities. Credit markets locked up as a result, and this spread to other countries, who also found their banking systems vulnerable. Many required bailouts, including Iceland, Germany, and Great Britain, to name a few. And Russia began imposing more state control on its private sector as a result of bank failures and a drop in the Russian stock market. We may not know the extent of the damage for quite some time to come.

12. Conclusion

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We have studied the various tools and models of microeconomics and used them to analyze various problems. Along the way, we have discussed a number of the economic problems facing us. The challenge for the future is to continue developing and using these tools to analyze new problems as they arise.

Important ConceptsIncome distribution

equity - efficiency tradeoffMonopolyUncertainty

moral hazard, adverse selection. social insurancePublic Goods

horizontal versus vertical summationcan the private sector solve social problems?Samuelson's rule for a pure public goodLindahl's solution

Externalitiespecuniary versus non-pecuniaryharmful versus beneficialSolutions: Pigou, Coase

The Prisoner’s Dilemma problem.Can governments solve problems?

Review Questions1. Explain the equity - efficiency tradeoff using the Edgeworth Box.2. What is moral hazard? Why is it a problem? What is adverse selection? Why is it a

problem? What is social insurance? Why do we need it?3. What is a private good? What is a public good? What are exclusion and depletion?4. Will the private market supply public goods? Can the private sector solve social

problems?5. What is an externality? Explain the different types. Are there any solutions to the

externality problem?6. What is government failure?7. Can governments solve problems in a global economy?

Practice Questions1. Is there a deadweight loss if a monopolist charges P = MC?

a. Yes.b. No.

2. Under Samuelson's rulea. a private good is produced where P = MC.b. a private good is produced where MR = MC.c. a public good is produced where P = MC.d. a public good is produced where the sum of marginal benefits is equal to the MC.

3. Social insurance cannot be provided by the market.a. True.

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b. False.

4. Bad drivers are charged a higher premium for auto insurance than goods drivers. This is an example of

a. sound profit maximizing behavior.b. adverse selection.c. moral hazard.d. social insurance.e. a public good.

5. An operating system is a set of instructions that guide the basic functions of a computer. It is useful if there is only one operating system because then software developers know how to program their application, e.g., spreadsheet, word processing, graphics production. A single operating system for desktop publishing is an example of

a. an externality.b. a private good.c. a public good.d. exclusion.e. moral hazard.

6. Consider the provision of a public good. Suppose there are two consumers with the same demand and a single person’s demand is d in the diagram. Find the aggregate demand curve for the public good.

7. Given the supply curve which reflects marginal cost, MC, find the optimal level for the public good. Redraw your result from the last question.

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Answers 1. b.2. d.3. a.4. a.5. c.6.

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The demand for one person is d. To find D, the intercept is 2 x 4 = 8 and at G3 d = 1 so 2 x 1 = 2 for D.7.