Difficult Cases for the Market, and the Role of Government Micro Chapter 5 Difficult Cases for the Market, and the Role of Government

3 Learning Goals Explore the details of efficiency Identify factors that reduce the efficiency of markets Explain how those factors reduce efficiency

A Closer Look at Economic Efficiency

What does efficiency mean? The largest net benefit is achieved Rule: Engage in an activity so long as the expected marginal benefit is greater than the expected marginal cost

Graph:

Have you ever said to yourself “that’s good enough”? When cleaning something When studying for an exam When completing a task Perfection is not usually a desirable result

Potential Shortcomings of the Market

Markets will usually generate an efficient outcome Markets will usually generate an efficient outcome. Sometimes they may not. Four reasons why the market may produce an inefficient outcome: (1) A lack of competition (2) Poor information (3) Public goods (4) Externalities

(1) A lack of competition If there are only a few firms, then supply may be restricted which will lower the quantity available and raise price (2) Poor (or no) information Poor information results in poor decision making

(3) Existence of public goods A public good has two distinguishing characteristics: (1) Many people can consume the good simultaneously; referred to as joint consumption or non-rival (2) People who don’t pay for the good can still consume it; referred to as non-excludable Note: public goods are not necessarily provided by the gov’t (i.e. paid with public money)

Why does a public good pose a problem? Because of its characteristics, it will be hard to generate funds to pay for its production Individuals have a strong incentive to free ride – not pay, wait for someone else to pay, then consume the good This typically leads to underproduction of public goods; i.e. an inefficient amount being produced

(4) Presence of externalities Not all costs and benefits will be used in decision making (external costs and benefits are typically ignored) With an external cost, too many units are produced and price is too low With an external benefit, too few units are produced and price is too low

Another way to think of externalities: Negative externality – a cost imposed on you for an activity you’re not directly involved in and you would like to see less of the activity Positive externality – a benefit accrued to you for an activity you’re not directly involved in and you would like to see more of the activity

Graph of external cost: See handouts on BB: “externality graphs.pdf” and “externality comments.pdf”

Graph of external benefit: See handouts on BB: “externality graphs.pdf” and “externality comments.pdf”

Why do externalities produce inefficient outcomes? With an external cost, too many units are produced and price is too low With an external benefit, too few units are produced and price is too low External costs and benefits are ignored, difficult to measure, or hard to distribute to affected parties

What causes externalities? The primary source is lack of property rights