Market Failure & the Role of Government

Key Questions What are externalities, and how do they affect markets? What is a monopoly? Why will monopoly often result in economic inefficiency? Why are public goods difficult for markets to allocate efficiently? When external costs are present, how will the price and output of a good compare with that associated with ideal economic efficiency? What are externalities, and how do they affect markets? What are private goods and public goods? Why does the government provide public goods?

A wise and frugal government, which shall restrain men from injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvements, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government. Thomas Jefferson In 2016 federal, state, and local governments spent $6.72 trillion dollars out of the $18.46 trillion in spending throughout the economy.

Monopoly Def: A market structure in which only one producer sells a product for which there are no close substitutes. Characteristics Only one seller Restricted or regulated market Control of prices

Monopoly A monopoly is characterized by the absence of competition, which can lead to high costs for consumers, inferior products and services, and corrupt behavior. Not all monopolies are harmful and some are actually encouraged. Monopolies do not have any competition due to a barrier to entry – something that stops other businesses from entering the market

Types of Monopolies Natural Government Technological Geographic The cost of production lowest when only one company provides output Government Some level of government owns or authorizes one producer Technological One company owns technology, invention, manufacturing method Geographic No other sellers/producers in region

Protective & Productive Roles of Government Government serves a protective function when it – Creates, upholds and maintains a legal framework Protects and enforces the rights of individuals to their person and property Government promotes economic progress by protecting the rights of individuals and supplying a few goods that are difficult to provide through markets. Government provides a productive function when it – Supplies goods that are difficult to supply efficiently through markets National defense and regional flood control projects provide examples

Private Goods vs. Public Goods Externalities often reflect a divide between the way markets operate and the social optimum. Why? Usually related to property rights (private goods). Property Rights give the owner the ability to exercise control over a resource. When not clearly defined, problems occur. One way to minimize externalities is to establish well-defined private property rights. With exclusive ownership there are incentives to maintain, protect, and conserve property and trade with others.

The Coase Theorem If there is no government interference and property rights are clear, interested parties will bargain privately (although not always successfully) to correct any externalities.

Providing Public Goods In our economic system, most production decisions are made in the marketplace through interactions between buyers and sellers. If people who are not part of a marketplace interaction benefit from it or do not pay part of the costs, there is market failure (inefficiency). When market failures occur, the government sometimes provides the good or service, known as a public good.

Characteristics of Public Goods Public goods are funded with taxes collected by the government. People cannot be excluded from the benefits of the product even though they do not pay for it. One person’s use of the product does not reduce its usefulness to others. Examples: Street lighting, national defense, Mozilla Firefox

Free Riders Some people will not voluntarily pay for a public good, as they can receive benefit from it whether they pay or not. Because of these “free riders,” there is no incentive for businesses to produce public goods. Classical musician Joshua Bell performing in the DC Metro. The night before he sold out a concert at $100 a ticket. In the Metro he made $30 total…

Market failure Def: any situation where the individual incentives for rational behavior do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but those prove to be the wrong decisions for the group. “Markets fail. A legitimate purpose of public policy is to intervene in markets to prevent market failure. Public policy has a necessary role in protecting the environment, human rights, labor rights, education and public health, managing growth, regulating markets, and managing global trade.” Stan Sorscher The four biggest market failures, so far: -Climate change: $40 trillion, so far -Health care in America: trillions per year, ongoing -The housing-financial asset bubble: at least $8 trillion -Free trade: $8 trillion, so far According to the chief economist for the World Bank, Nicholas Stern, climate change is the greatest market failure in human history. Greenhouse gas emissions are a classic externality, where everyone on earth subsidizes oil companies and consumers of fossil fuels. Fossil fuels are under-priced by $40 trillion — a rough estimate of the cost that future generations will pay for damage we’re doing to the Earth.

Managing Externalities One type of market failure occurs when market transactions cause externalities. An externality is a side effect of a transaction that affects someone other than the producer or buyer. Negative Externality Creates a negative effect, or cost for people not involved. Sometimes known as “social costs.” Positive Externality A positive effect, or benefit for people who were not involved in the original economic activity.

Examples Negative Externality Positive Externality Dow Chemical discharges pollution into the Detroit River, resulting in a loss of fish for the fishermen. If you drive a car you create pollution and cause congestion. Positive Externality Childhood immunizations can prevent outbreaks of disease. A farmer who grows apple trees provides a benefit to a beekeeper.