Efficiency and Non-Market Forces Going ga-ga about markets –Review of Market EfficiencyMarket Efficiency Government’s Role in Economic EfficiencyGovernment’s Role –Provides infrastructure for economic activity Market Failures –4 reasons markets break down / do not exist Public Goods –What are they? How best to manage them?

Revisiting Some Economic Concepts Value of Free Markets (bidding mechanism) –Maximize (total social benefit - cost) Pareto Efficient –Competition drives societies to PPF –Pareto Improvements Sharing the Economic Pie –Efficiency, Growth, Better Living Standards Markets work under some assumptions

The Government: not there just to take your money! Physical Infrastructure –Networks, Lifelines Institutional Infrastructure –Legal SystemLegal System –Regulation Security –Internal; External; Preserves conditions for trade. Taxation –Pays for public goods; helps redistribute econ growth –Can increase efficiency & help create markets

Legal System Criminal Property Contract Tort Antitrust Law –Price fixing; Monopoly; Mergers

Reasons for Market Failure Why do markets fail in general? Economic: Wealth Effect /Market Power Externalities –NegativeNegative –PositivePositive Public Goods and Common Property Resources Asymmetric Information –Adverse selection (market for lemons) –Moral Hazard (risk insurance problem)

Unintended costs or benefits that are imposed on unsuspecting people and that result from the economic activity of others –Subsidize the production of an environmentally friendly good making it less expensive Externality

Price per Gallon Gasoline (Gallons) 1.00 A S Q ineff D Q eff MSC = S +tax B $1.50 Negative Externality – graph

Price Number of Bachelor’s Degrees 50,000 A S Q D MSB = D +Subsidy B $65,000 Positive Externality - graph

A market left on its own will not address the problem of negative externalities What is Market Failure

Some Environmental Terms related to Market Failure Social Cost –This cost includes both the private costs of production and the externalities cost generated by its production Free Rider –Someone who consumes a good or service without paying for it Property Rights –The right to own a good or service and the right to receive the benefits of the goods or service

Goods whose benefits are not diminished even when additional people consume it and no one is excluded from its benefits –Roads –National defense –Lighthouse Public Goods

Private / Mixed / Pure Public Goods Can limit target market.Cannot prevent anyone from consuming it. Non Excludable Excludable

Private / Mixed / Pure Public Goods One’s consumption deprives another Benefits of joint consumption Rival Non Rival

Private / Mixed / Pure Public Goods Private Good Hot Dogs, Cars, Houses Mixed Good Fishing lakes, Grazing lands Mixed Good Freeway, Bridge City Parks Pure Public Good Defense Public Radio / TV Non Excludable Excludable Rival Non Rival

The failure of the government to buy the quantity of public goods that generates maximum efficiency Government Failure

Solutions to the Externality Problem Command & Control Export (NIMBY) Convert to private goods (property rights) –Create new property forms Internalize the cost –Impose penalty taxes –Enforce standards Modern market based measures –Quantity: quotas / permits –Price:taxes

Examples of Environmental Solutions New Property Form –Giving legal title to a public beach Pollution Tax –A tax of 5 cents per kilowatt-hour levied on a firm using coal to generate electricity Standard –Mandate the use of scrubbers in smokestacks

Some Cool Environmental Buzzwords! Market Failure Externality Negative Externality Socially Optimal Output Positive Externality Internalizing Externalities Transaction Costs Coase Theorem Public Good Rivalry in Consumption Nonexcludability Excludability Free Rider Asymmetric Information Adverse Selection Moral Hazard

for the real nerds ADDITIONAL MATERIAL

Negative Externality

The Triangle

Positive Externality

A Corrective Tax Gone Wrong

Cost of Reducing Pollution - 3 Firms example

Asymmetric Information in a Product Market S1 = MPC E1 E2 0 Q2Q1Quantity D2 = MPB2 (symmetric info.) D1 = MPB1 (asymmetric info.) Price and Cost Output with Symmetric info. Output with Asymmetric Info.

Asymmetric Information in a Factor Market S1= MPC1 (asymmetric info.) E1 E2 0 Q2Q1 Quantity of Labor D1 = MPB Wage Rate Quantity of Labor with Symmetric info. Quantity of Labor with Asymmetric Info. Wage with Symmetric info. Wage with Asymmetric Info. S2= MPC2 (symmetric info.) W2 W1