Chapter 5: Market Failure: A Role for Government

Market Failure A market failure occurs when the competitive market system (1) does not allocate any resources whatsoever to the production of certain goods, or (2) either underallocates or overallocates resources to the production of certain goods. When private markets fail, government involvement may arise.

Private Goods Private goods are those that people individually buy and consume and that private firms can profitably provide because they keep people who do not pay from receiving the benefits. Two characteristics of private goods are: Rivalry (in consumption) Excludability

Efficient Allocation Competition among firms to produce the private goods that consumers demand forces them to use the best technology and the right combination of productive resources. This results in productive efficiency: the production of a good in the least cost way. Firms that are not productively efficient face competition from lower cost firms.

Efficient Allocation Competitive markets also produce allocative efficiency: the production of the “right” mix of products (minimum-cost production assumed). Firms will produce goods and services that are highly valued by society ensuring that resources are allocate efficiently.

Public Goods Public goods are those that everyone can simultaneously consume and from which no one can be excluded, even if they do not pay. Two characteristics of public goods are: Nonrivalry (in consumption) Nonexcludability

Public Goods Nonrivalry and nonexcludability create a free-rider problem; once a producer has provided a public good, everyone including nonpayers can obtain the benefit. This makes it impossible for firms to gather resources and profitably provide the good. In order to have the good, society must direct the government to provide it. Surveys and public votes may be used to determine the demand for a public good.

Comparing Marginal Benefit to Marginal Cost Determining the “right” amount of a public good will depend on the marginal benefit and the marginal cost of providing it. Marginal benefit (MB) is the added benefit or utility from the production of one more unit. Marginal cost (MC) is the extra cost of producing one more unit. The optimal quantity occurs when the MB equals the MC of the last good provided.

Externalities An externality occurs when some of the costs or the benefits of a good are passed on to or “spill over to” someone other than the immediate buyer or seller. Externalities can be positive or negative and can affect production or consumption.

Negative Externalities Negative externalities, or spillover costs, are production or consumption costs that affect a third party without compensation. When negative externalities occur, the producers’ supply curve lies to the right of the full-cost supply curve. The equilibrium output is greater than the optimal output; resources are overallocated to the production of this commodity.

Positive Externalities Positive externalities are spillover production or consumption benefits conferred on third parties without compensation from them. When positive externalities occur, the market demand curve lies to the left of the full-benefits demand curve. The equilibrium output is less than the optimal output; the market fails to produce enough of the good.

Externalities

Individual Bargaining: The Coase Theorem According to the Coase Theorem, private solutions can remedy positive or negative externalities without government involvement if: (1) private property is clearly defined (2) the number of people involved is small (3) bargaining costs are negligible

Liability Rules and Lawsuits When property rights are clearly established but private negotiations to an externality problem are not possible, government can protect private property from damage through liability laws, and the damage recovery system through which they give rise. Parties suffering from negative externalities done by other parties can sue for compensation.

Government Intervention When externalities affect large numbers of consumers, government intervention may be needed to achieve economic efficiency. For negative externalities, direct controls (pass legislation limiting an activity) and specific taxes can be used to counter the spillover costs. For positive externalities, government can provide subsidies to buyers or sellers or provide the product for free or for a minimal charge.

Government Intervention Direct controls and taxes raise the marginal cost of production of firms. This causes the supply curve to shift to the left, thus correcting the overallocation of resources cause by negative externalities. Output is reduced to its optimal level.

Government Intervention

Government Intervention There are three options to correct the underallocation of resources: Subsidies to buyers Subsidies to sellers Government provision of quasi-public goods Subsidizing consumers causes the demand curve to shift rightward whereas subsidies to producers shifts the supply curve rightward.

Government Intervention

A Market-Based Approach A market-based approach is one that limits government action and creates a market for externality rights.

Financing the Public Sector: Taxation In order to make available public and quasi-public goods, government must free up resources from the production of private goods. By levying taxes on households and businesses, thus reducing their incomes and spending, the private demand for products decreases, as does the private demand for resources. Taxes shift resources from private to public use.

Appropriating the Tax Burden The “tax burden” is the total cost of taxes imposed on society. Government must determine how to appropriate the tax burden among the citizens. Two basic principles on how the economy’s tax burden should be assigned include: Benefits-Received Ability to Pay

Benefits Received versus Ability to Pay The benefits-received principle is the idea that people who receive the benefit from government-provided goods and services should pay the taxes required to finance them. The ability-to-pay principle is the idea that people who have greater income should pay a greater proportion of it as taxes than those who have less income.

Progressive, Proportional, and Regressive Taxes Taxes are classified as progressive, proportional, or regressive, depending on the relationship between average tax rate (total tax paid as a percentage of income) and marginal tax rate (the rate paid on each additional dollar of income).

Progressive, Proportional, and Regressive Taxes A progressive tax is one whose average tax rate increases as the taxpayer’s income increases. A regressive tax is a tax whose average tax rate decreases as the taxpayer’s income increases. A proportional tax is a tax whoa average tax rate remains constant as the taxpayer’s income increases.

Progressive, Proportional, and Regressive Taxes In general, progressive taxes fall relatively more heavily on high-income households while regressive taxes are those that fall relatively more heavily on the poor.

Tax Progressivity in the U.S. The majority view of economists is as follows: The Federal tax system is progressive. The state and local tax structures are largely regressive. A general sales tax and property taxes are regressive with respect to income. The overall U.S. tax system is slightly progressive.

Government’s Role: A Qualification In addition to correcting externalities and providing public goods, government also sets the rules and regulations for the economy, redistributes income when desirable, and takes macroeconomic actions to stabilize the economy.