Government Policy and Market Failures Chapter 15

Introduction Should the government intervene in the market? The framework presented might be called the invisible hand framework. Invisible hand framework – perfectly competitive lead individuals to make voluntary choices that are in society’s interest.

Market Failures A market failure occurs when the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes.

Market Failures Any time a market failure exists, there is a reason for possible government intervention into markets to improve the outcome.

Market Failures Because the politics of implementing the solution often leads to further problems, government intervention may not necessarily improve the situation.

Externalities Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. Externalities can be both positive and negative.

Externalities Negative externalities occur when the effect of a decision on others that is not taken into account by the decision-maker is detrimental to the third party. Examples include second-hand smoke, water pollution, and congestion.

Externalities Positive externalities occur when the effect of a decision on others that is not taken into account by the decision-maker is beneficial to others. Examples include innovation, education, and new business formation.

Negative Externalities When negative externalities ensue third parties are hurt. Marginal social cost is greater than marginal private cost.

Negative Externalities Marginal social cost includes all the marginal costs borne by society.

Negative Externalities Marginal social cost is calculated by adding the negative externalities associated with production to the marginal private costs of that production.

The Effect of a Negative Externality Cost Quantity Marginal social cost Marginal social benefit Marginal private cost Marginal cost from externality Q1 P1 Q0 P0

Positive Externalities Private trades can benefit third parties not involved in the trade. Marginal social benefit equals the marginal private benefit of consuming a good or service plus the positive externalities resulting from consuming that good or service.

A Positive Externality D0 = Marginal private benefit D1 = Marginal social benefit S = Marginal private and social cost Cost Quantity Q1 P1 Marginal benefit of an externality Q0 P0

Alternative Methods of Dealing with Externalities Externalities can be dealt with via direct regulation, incentive policies, and voluntary solutions.

Direct Regulation A program of direct regulation is where the amount of a good people are allowed to use is directly limited by the government.

Direct Regulation Economists do not like this solution since it does not achieve the desired end as efficiently (at the lowest cost possible in total resources without consideration as to who pays those costs) and fairly as possible.

Direct Regulation Direct regulation is inefficient because it achieves a goal in a more costly manner than necessary.

Incentive Policies Incentive programs are more efficient than direct regulatory policies. The two types of incentive policies are either taxes or market incentives.

Tax Incentive Policies A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends. Often the tax yields the desired end more efficiently than straight regulation.

Tax Incentive Policies This solution embodies a measure of fairness about it – the person who conserves the most pays the least tax.

Tax Incentive Policies Another way to handle a negative externality is through a pollution tax or effluent fees. Effluent fees – charges imposed by government on the level of pollution created.

Regulation Through Taxation Cost Quantity Marginal social cost Marginal social benefit Marginal private cost Q1 P1 Efficient tax Q0 P0

Market Incentive Policies An alternative to direct regulation is some type of market incentive program. Market incentive program – a plan requiring market participants to certify total consumption – their own or other’s – has been reduced by a specified amount.

Market Incentive Policies A market incentive program is similar to the regulatory solution in that the amount of the good used is reduced.

Market Incentive Policies A market incentive program differs from a regulatory solution in that individuals who reduce consumption by more than the required amount are given a marketable certificate that can be sold to someone else.

Voluntary Reductions Voluntary reductions leave individuals free to choose whether to follow what is socially optimal or what is privately optimal. Economists are dubious of voluntary solutions.

Voluntary Reductions A person’s social conscience and willingness to do things for the good of society generally depend on his or her belief that others will also be helping.

Voluntary Reductions If a socially conscious person comes to believe a large number of other people will not contribute, he or she will often lose their social conscience. This is another example of a free rider problem – individuals’ unwillingness to share in the cost of a public good.

The Optimal Policy An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.

The Optimal Policy Should pollution be totally eliminated? Some environmentalists say “yes.” Economists would answer that doing so is costly so marginal costs should be balanced against marginal benefits.

The Optimal Policy The point where MC = MR is called the optimal level of pollution. Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.

Public Goods A public good is one that is nonexclusive (no one can be excluded from its benefits) and nonrival (consumption by one does not preclude consumption by others.

Public Goods There are no pure examples of a public good. The closest example is national defense. Technology can change the public nature of goods. Roads are an example.

Public Goods Once a pure public good is supplied to one individual, it is simultaneously supplied to all. A private good is only supplied to the individual who bought it.

Public Goods With public goods, the focus is on groups. With private goods, the focus is on the individual.

Public Goods In the case of a public good, the social benefit of a public good is the sum of the individual benefits.

Public Goods Adding demand curves vertically is easy to do in textbooks, but not in practice. This is because individuals do not buy public goods directly so that their demand is not revealed in their actions.

The Market Value of a Public Good Price 1 2 3 Quantity .80 .60 .40 .20 1.00 0.50 Market demand 0.10 0.60 DB DA 0.50 0.40 0.10

Informational Problems Perfectly competitive markets assume perfect information. Real-world markets often involve deception, cheating, and inaccurate information.

Informational Problems When there is a lack of information, buyers and sellers do not have equal information, markets may not work properly.

Informational Problems Economists call such market failures adverse selection problems. Adverse selection problems – problems that occur when a buyer or a seller have different amounts of information about the good for sale.

Policies to Deal with Informational Problems One policy alternative to deal with information market failures is to regulate the market and see that individuals provide the correct information.

Policies to Deal with Informational Problems Another alternative is for the government to license individuals in the market and require them to provide full information about the good being sold.

Policies to Deal with Informational Problems Regulatory solutions may be overly slow or costly.

A Market in Information A market in information is one solution to the information problem. Information is valuable, and is an economic product in its own right.

A Market in Information Left on their own, markets will develop to provide information that people need and are willing to pay for it.

A Market in Information Economists who do not like government interference point out that informational problems are not a problem of the market; it is a problem of government regulation.

Licensing of Doctors Licensing of doctors is a debate that is motivated by information problems. Currently all doctors practicing medicine are required to be licensed – this was not always so. Licensing of doctors is justified by informational problems.

Licensing of Doctors Some economists argue that licensing is as much a problem of restricting supply as it is to help the consumer.

Licensing of Doctors Why, if licensed medical training is so great, do we even need formal restrictions to keep other types of medicine from being practiced?

Licensing of Doctors Whom do these restrictions benefit: the general public or the doctors who practice mainstream medicine? What have the long-term effects of licensure been?

An Informational Alternative to Licensure As an alternative, the government could provide the public with information about which treatments work and which do not. This would give rise to consumer sovereignty – the right of the individual to make choices about what is consumed and produced.

An Informational Alternative to Licensure In this scenario, the government would provide such information as: Grades in college. Grades in medical school. Success rate for various procedures. References. Medical philosophy. Charges and fees.

An Informational Alternative to Licensure This information alternative would provide much more useful information to the public than the present licensing procedure.

An Informational Alternative to Licensure Here are some words of caution about the informational alternative. To get a true picture of whether the present system is best would require experts on real-life practices and institutions. The problem is that the experts may have a vested interest in keeping things just the way they are.

Government Failures and Market Failures Market failures should not automatically call for government intervention. Why? Because governments fail too.

Government Failures and Market Failures Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse.

Reasons for Government Failures Governments do not have an incentive to correct the problem. Governments do not have the information to deal with the problem. Intervention in the markets is almost always more complicated than it initially looks.

Reasons for Government Failures Government intervention does not allow fine-tuning, and so, when the problems change, the government solution often responds far more slowly. Government intervention leads to more government intervention.

Government Policy and Market Failures End of Chapter 15