1 1. Imperfect Information 2. Externalities 3. Public Goods 4. Lack of Competition 5. Business Cycles Market Failures As Explanation of roles for Government in the economy

Copyright © Houghton Mifflin Company. All rights reserved. 2 Imperfect information leads to market failures that cause inefficiency. False information Asymmetric information Either the buyer or seller has more or better information than the other Imperfect Information

Copyright © Houghton Mifflin Company. All rights reserved. 3 Some solutions: Market Based Solutions: Brand names, franchises, and product warranties Imperfect Information Government Solutions: Requiring full and correct disclosure. (Food labels, stock prospectuses, etc.)

Copyright © Houghton Mifflin Company. All rights reserved. 4 Externalities are the costs or benefits of a transaction that are borne by someone not directly involved in the transaction. Real efficiency occurs only when all the costs and all the benefits accrue to the buyer and seller Externalities

 External Benefits (Positive externalities) when someone outside the transaction is receiving benefits from the transaction. ◦ If buyers are not receiving all benefits, they will demand less than is optimal. ◦ If sellers are not receiving all the benefits from the sale, they will not produce as much as is optimal. ◦ Examples: New large business in a declining neighborhood, Education, Landscaping and painting a formerly unkempt property, Immunizations Copyright © Houghton Mifflin Company. All rights reserved. 5

 External costs (Negative Externalities): when someone outside the transaction is incurring costs related to the transaction. ◦ If buyers are not bearing all the costs of the purchase, they will demand too much. ◦ If producers are not bearing all the costs of production, then they will produce too much. ◦ Example: Pollution by a manufacturer, Second hand tobacco smoke, Smog and traffic congestion from my choice to drive alone. Copyright © Houghton Mifflin Company. All rights reserved. 6

External Costs

 Government imposes costs  Government regulates to internalize external costs. ◦ Examples: Smog fees, mandated pollution controls, banns on indoor smoking etc Copyright © Houghton Mifflin Company. All rights reserved. 8

 Government produces or subsidizes the production/consumption of the good.  Government requires the consumption of the good ◦ Examples: required immunizations, public education, student aid, tax breaks to businesses that locate in run-down areas Copyright © Houghton Mifflin Company. All rights reserved. 9

Clicker :  When the Federal government requires that restaurants list the calorie count on each item on their menu it could be explained as an attempt to A.Embarrass people who eat ice cream B.Fix a market failure based on imperfect information C.Make people stay home to eat D.Resolve a market failure based on the external benefit problem E.None of these

Clicker Which of the following would be an example of a market failure based on the external benefit (or positive externality) problem? A.A business decides to expand its production in response to increasing demand for its product B.A college professor decides to continue driving a 26 year old pickup that is already paid for but leaks oil and puffs out extra fumes C.A retail business decides not to spend the money to clean up graffiti from its back wall that faces a street not usually seen by its own customers D.A smoker decides to walk across campus with her cigarette lit E.None of these demonstrate the external benefit problem

Clicker  What might be an appropriate government response to the discovery that participating in group sports activities  (like softball) dramatically reduces the incidence of road rage and random violence by adults who participate? A.Create a special tax on sports equipment B.Create and run a city-wide public recreational sports program for adults C.Increase the penalties for violence or road rage D.Invest in a larger police force E.None of these would be appropriate.

Clicker  A private market solution is unlikely to provide the adult sports league in the last question. Which category of market failure explains why? A.The business cycle problem B.The external benefit problem C.The external cost problem D.The imperfect information problem E.None of these

Copyright © Houghton Mifflin Company. All rights reserved. 14 Public Goods are goods whose consumption by one person does not diminish the quantity or quality available to other consumers. Specifically, they: – Can be jointly consumed (jointness) Individuals can simultaneously enjoy consumption of same product or service. – Are non-excludable (non-exclusion) Consumption of the good cannot be restricted to the customers who pay for it. Public Goods*

Copyright © Houghton Mifflin Company. All rights reserved. 15 Non-excludability If it is produced for some, it is available to all. There is no way to exclude non-payers. No one enjoys a private property right to the public good. Functioning Private Property Rights require: Exclusivity Transferability Characteristics of a Public Good

Copyright © Houghton Mifflin Company. All rights reserved. 16 Without private property rights: People have an incentive to try free ride: Free rider: a person who receives the benefits of the good without helping to pay for it. Because of the Free Rider Problem, too little will be produced; efficiency is not achieved. Characteristics of a Public Good

Copyright © Houghton Mifflin Company. All rights reserved. 17 Examples of public goods: National defense Forest fire protection Broadcast radio and television stations Clean air Unpolluted ground water Examples of Public Goods

Public Goods and Market Failure

 Government production  Government subsidized production  Marketization: Sometimes markets develop ways of providing public goods (e.g. use of advertising to support radio and television). Copyright © Houghton Mifflin Company. All rights reserved. 19

 Goods owned collectively or not owned at all. ◦ Examples: Public Parks, Public highways and roads, Wildlife, River water or underground water. ◦ Common Property Goods DO NOT have Jointness or Non-exclusivity. Copyright © Houghton Mifflin Company. All rights reserved. 20

 Common Property goods tend to be under-produced & over-consumed. ◦ Solutions:  Marketize them like buffalo in the Midwest  Regulate their use like wildlife  Government production & maintenance like city streets and city parks Copyright © Houghton Mifflin Company. All rights reserved. 21

Clicker  The Great Lakes were severely polluted by businesses, cities, and home owners who regularly dumped waste and sewage into the lakes until the 1950s. This is an example of which of the following? A.An imperfect information problem B.The business cycle C.The common property goods problem D.The public goods problem

 Sellers may gain by restricting output and raising price. ◦ Too few units will be produced. ◦ Consumers may not be able to get needed goods.  Monopoly: a market with only one producer ◦ Example: utility companies  Oligopoly: a market with only few producers (who may operate jointly as a monopolist through a cartel). ◦ Example: OPEC  Monopsony: a market with only one buyer Copyright © Houghton Mifflin Company. All rights reserved. 23

Copyright © Houghton Mifflin Company. All rights reserved. 24 Restricting Supply to Raise Prices S 2 Price Quantity D S 1 Q2Q2 P2P2 P1P1 Q1Q1

 Anti-trust laws; ban collusion and anti- competitive behavior  License and regulate monopolies  Government provision of the good Copyright © Houghton Mifflin Company. All rights reserved. 25

 Cycles of Expansion and Contraction create inefficient outcomes:  Expansion, when too rapid or extreme leads to over-production or over-consumption of certain types of goods  Contraction, especially when they lead to recession lead to unemployment of Capital and Labor. Unemployment is not efficient.

 Market Response: natural market responses correct for business cycles in time.  Government Responses to Recession: ◦ Stimulate demand by Fiscal Stimulus – ie; cut taxes or increase spending ◦ Monetary Stimulus – ie; increase money supply or decrease interest rates

 Government Responses to Excessive Expansion: Reign in inflation ◦ Fiscal Contraction – ie; increase taxes or reduce government spending ◦ Monetary Contraction – ie; reduce the money supply or increase the interest rate

Copyright © Houghton Mifflin Company. All rights reserved. 29 Public Choice Analysis Public Choice Theory: Proposes that government activity in the economy has little to do with market failures. Public Choice theory suggests that government may be brought in to benefit specific individuals or groups. People may seek government intervention to improve their own profit in comparison to the market outcome. This is referred to as rent-seeking—the use of resources to transfer wealth from one individual to another without increasing production or total wealth.

 Self-interest directs public sector activity, just as it directs market activity.  Government actions (like price ceilings or floors) are often enacted for political gain, not as a remedy for economic inefficiency.  Government action is likely to create market failure or reduce efficiency. Copyright © Houghton Mifflin Company. All rights reserved. 30

Clicker  What would be a logical response from the Public Choice Theory perspective to a concern that college tuition costs are too high for most people who want an education? A.Government should require people to get the education anyway because it is good for the economy B.Government subsidized student loans or grants should be offered to help students pay for education because it is important C.Let the market deal with the issue: potential students will find a way to finance their education if it is really valuable D.Publically financed colleges should be created to lower the costs to students since education has large external benefits

Clicker  If the market for textbooks has dramatic external benefits, what government policy might help solve the market failure? A.An extra sales tax could be imposed on textbooks to internalize the benefit B.Higher tax rates on publishing enterprises could compensate for the extraordinary benefit C.Textbook content could be more carefully regulated to increase their value D.The government could provide subsidies to students for textbook purchases E.The government could reduce tuition costs at public colleges

Clicker  The FTC (Federal Trade Commission) must approve any mergers or acquisition among the nation’s airline companies. Assuming this is an attempt to compensate for a market failure, which market failure would it be addressing? A.Business Cycles B.Common Property Goods C.External Costs D.Lack of Competition E.Public Goods

Clicker  The Pacific Red Snapper became a very popular seafood in the 1990s. Today the Red Snapper has been fished to the brink of extinction. Which market failure explains the plight of the Red Snapper? A.Common Property Goods B.External Benefits C.Imperfect Information D.Indifference E.Public Goods

Clicker  The Pacific Red Snapper became a very popular seafood in the 1990s. Today the Red Snapper has been fished to the brink of extinction – a result of the Common Property problem. What solution would Public Choice Economists be most likely to suggest? A.Hold an auction and sell private ownership of schools of Red Snapper to winning bidders B.Create publically funded Red Snapper hatcheries the replenish the supply C.Impose a ban on Red Snapper fishing D.Issue licenses for Red Snapper fishing with strict limits on quantities E.Launch an information campaign to raise awareness of the plight of the Red Snapper.

3.2 Public Goods A public good is a good for which the cost of exclusion is prohibitive and for which the marginal cost of another user is zero. A private good is a good for which exclusion is possible and for which the marginal cost of another user is positive. Free riders are people or firms that consume a public good without paying for it.

3.4 Common Property Resources Common property resources are resources for which no property rights have been defined The difficulty with common property resources –Individuals may not have adequate incentives to engage in efforts to preserve or protect them