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:

Video:

The most inefficient man on TV:

Two Clicker Questions Next

Q5.1 When economists say that an activity meets the criterion for economic efficiency, they mean a majority of citizens favor the activity. the benefits that result from the activity exceed the costs. the number of people who gain from the activity exceeds the number on whom costs are imposed. the costs that result from the activity exceed the benefits.

Q5.2 Eliminating all pollution would be a desirable public policy objective. I agree with this statement I disagree with this statement

Eliminating all pollution would be a desirable public policy objective. Class Activity: Why do you agree or disagree with this statement?

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

Video of violating efficiency (viewer discretion advised):

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

Market failure When the market process of supply and demand, the invisible hand, and the price system produce an inefficient outcome, it is referred to as “market failure.” Market failure doesn’t mean the market stop working entirely, it simply means an inefficient outcome was reached.

(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 Class Activity: Economics is Everywhere 18.4

A tradition at the University of Michigan and a few Ivy League schools is the annual “Naked Mile,” in which students run through campus naked to welcome the arrival of spring. At Michigan (where “spring” arrives late in April), participation in the Naked Mile has decreased sharply over the last few years. This is partly because the university has tried to discourage potential participants with warnings and also by arrests of some participants for indecent exposure. The real problem for the low turnout, however, is that the Naked Mile is a public good. Everyone can enjoy watching it without bearing the cost of participating- consumption is nonrival and the good is nonexcludable. It is not surprising that the event creates a serious free-rider problem. Q: What could the organizers of the Naked Mile do to encourage more people to participate?

(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) Class Activity: Name at least two public goods

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

Illustration of public good: Recall, each question on the next exam is worth $10 For $9.90, I will sell the answer to one question. Which one of you will pay me? One pays $9.90 and everyone receives $10.

Clicker Question Next

Q5.3 Which one of you will pay me? I will No, I’ll free ride

Class Activity: Economics is Everywhere 18.1

One of the teaching assistants pointed out a neat free-rider problem One of the teaching assistants pointed out a neat free-rider problem. A friend of hers was getting married. That was one of a number of weddings that took place in the church over a weekend. There was no time to put in new flowers before each wedding, so the brides were asked to chip in for the flowers. Several brides said no; those who said yes paid for the flowers (presumably the private benefit to each was large enough to exceed the flowers’ cost), and the flowers were installed. The other brides paid nothing but had the free-rider benefit of the flowers. Q: What could the individual brides have done to get the others to pay a “fair share” of the costs of the flowers? Is there any way the free-rider brides could have been compelled to pay?

Two Clicker Questions Next

Q5.4 Which of the following is true? Consumption of a public good by one individual reduces the availability of the good for others. It is extremely difficult to limit the benefits of a public good to only the people who pay for it. Public goods are free to a society when they are produced by the government. From an efficiency standpoint, a market economy will generally supply too much of a public good.

Q5.5 A competitive market economy is unlikely to provide an efficient quantity of some public goods because only the government has the vast resources necessary to produce public goods. the nature of public goods makes it difficult for producers to withhold them from nonpaying consumers. the technology involved in the production of public goods makes it difficult for private firms to produce them even though, once produced, they could be marketed efficiently. private production of public goods generally results in a large amount of profit, which is difficult for a firm to effectively pay out to shareholders.

(4) Presence of externalities Externalities are also referred to as spillover effects and neighborhood effects Not all costs and benefits will be used in decision making (external costs and benefits are typically ignored)

(4) Presence of externalities With an external cost, too many units are produced and price is too low In other words, actual output is more than the efficient output while actual price is less than the efficient price With an external benefit, too few units are produced and price is too low In other words, actual output is less than the efficient output while actual price is less than the efficient price

Video of Negative Externality:

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

Class Activity: Identify one negative and one positive externality you’ve been involved with

Example of negative externality:

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

Two Clicker Questions Next

Q5.6 Suppose the actions of the producers of a good impose an external cost which results in the actual market price of $25 and market output of 1,000 units. How does this outcome compare to the efficient, ideal equilibrium? The efficient price would be higher than $25 while the efficient output would be less than 1,000 units. The efficient price would be higher than $25 while the efficient output would be greater than 1,000 units. The efficient price would be lower than $25 while the efficient output would be less than 1,000 units. The efficient price would be lower than $25 while the efficient output would be greater than 1,000 units.

Discuss your answer with a neighbor. Then we’ll redo the question.

Q5.7 Suppose the actions of the producers of a good impose an external cost which results in the actual market price of $25 and market output of 1,000 units. How does this outcome compare to the efficient, ideal equilibrium? The efficient price would be higher than $25 while the efficient output would be less than 1,000 units. The efficient price would be higher than $25 while the efficient output would be greater than 1,000 units. The efficient price would be lower than $25 while the efficient output would be less than 1,000 units. The efficient price would be lower than $25 while the efficient output would be greater than 1,000 units.

Class Activity: Economics is Everywhere 18.10

A recent news story showed how complex the interactions that involve externalities can be. The overfishing of Pollock in Alaskan waters has, so scientists claim, reduced the population of seals, which eat Pollock. With fewer seals, orca whales have lost their favorite prey and have had to move closer to shore to prey on sea otters. The sea otter population is down, allowing their prey- sea urchins- to multiply rapidly and chew up the underwater kelp forests near the shore. Since the kelp forests aren’t there, the shorelines are more exposed to waves that generate beach erosion and have caused an increasing loss of shoreline housing. This six-step externality is the most complex I’ve heard of. It illustrates how something seemingly harmless- overfishing just one species- can generate serious negative effects in an area that to a layperson would seem very far removed from the action that originally produced the externality. Q: List one remedy that the government could introduce to reduce the problem of beach erosion presented in this story. Are there any potential secondary effects of your solution?

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

Class Activity: Economics is Everywhere 18.19

One of my colleagues just returned from vacation in the Florida Keys One of my colleagues just returned from vacation in the Florida Keys. He was all excited that, at age forty-eight, he had gone scuba diving for the first time. He remarked that, unfortunately, the water was quite rough and made him somewhat seasick. He felt worse and worse, had to return to the boat, and eventually was so ill that he “fed his lunch to the fishes.” He noted, however, that he had at least created a positive externality: His activity attracted a large number of exotic fish, allowing other divers standing on the boat much better viewing than they otherwise would have had. Q: If you were a tour-boat operator and read this what might you do to make the fish-viewing trip better for all of the people taking the trip?

Two Clicker Questions Next

Q5.8 Suppose the actions of the producers of a good generate an external benefit which results in the actual market price of $15 and market output of 614 units. How does this outcome compare to the efficient, ideal equilibrium? The efficient price would higher than $15 while the efficient output would be less than 614 units. The efficient price would be higher than $15 while the efficient output would be greater than 614 units. The efficient price would be lower than $15 while the efficient output would be less than 614 units. The efficient price would be lower than $15 while the efficient output would be greater than 614 units.

Q5.9 When the consumption of a good generates an external benefit, the private benefit consumers receive from the good will be higher than the true social benefit. too much of the good will tend to be produced from the viewpoint of economic efficiency. the community generally suffers an exactly offsetting external cost from the production of the good. the market demand curve will understate the total benefits derived from consumption of the good, and as a result, too little of it will be produced and consumed.

Optional Assignment: Read 2-page article titled “Leef-Society shouldn’t pay for your education” on Blackboard under Optional Assignments Type your answers in a Word file to the questions found in the document “Optional Assignment Leef-Society shouldn’t pay for your education” Upload your file to Blackboard before Exam 2

Why do externalities produce inefficient outcomes? With an external cost, too many units are produced and price is too low In other words, actual output is more than the efficient output while actual price is less than the efficient price With an external benefit, too few units are produced and price is too low In other words, actual output is less than the efficient output while actual price is less than the efficient price

Why do externalities produce inefficient outcomes? External costs and benefits are sometimes ignored and always difficult to measure

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

How can externalities be “fixed”? That is, what kind of solutions can push the market closer to efficient outcomes? 1. Clearly define and enforce property rights 2. Taxes “Internalize the externality” A tax equal to the externality will produce an efficient outcome

Taxes may not produce the intended result Video:

Extra Credit Clicker Question Next

Q5.10 Who was the original scholar to propose “fixing it with taxes”? Joe Calhoun Adam Smith David Ricardo A.C. Pigou John Locke Ronald Coase

Clicker Question Next

Q5.11 Eliminating all pollution would be a desirable public policy objective. I agree with this statement I disagree with this statement

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