1. Government & Market Failure
Chapter 17
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2. Public Goods A good or service provided by government
Once a producer has provided a public good, it cannot bar those who don’t pay from obtaining the benefits.
Demand for the good gets understated
Firms lack a profit incentive to offer it for sale.
Examples: public highways, national defense
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3. Free-Rider Problem
People who don’t pay for a good or service can still obtain benefit or satisfaction.
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4. Demand for Public Goods
Consumers do not need to reveal their true demand for public good
This makes it difficult to determine overall demand.
Government can do surveys or public votes.
See Table 17-1… Market demand is determined by adding the prices that people are willing to pay for the last unit of the public good at each possible quantity demanded.
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5. Optimal Quantity
Optimal quantity of a public good occurs where marginal benefit equals marginal cost or where the two curves intersect.
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6. Cost-Benefit Analysis1 2 3 4 5 6
Plan
Total Cost of Project
Marginal Cost
Total Benefit
Marginal Benefit
Net Benefit (4)-(2)
No New Construction
---
Widen existing highways
New 2-lane highways 10 13 8
New 4-lane highways 18 23
New 6-lane highways 28 26 -2
Use the marginal-cost-marginal-benefit rule tells us which plan provides the maximum benefit or satisfaction.
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7. Externalities (Spillovers)
A benefit or cost from production or consumption, to an individual or group (3rd party) that is external to a market transaction.
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8. Negative externality… Spillover Cost - the cost of breathing polluted air
Positive externality… Spillover Benefit - Your neighbor improves the appearance of his house
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9. Coase Theorem
Government is not needed to resolve spillover costs or benefits when…
Property ownership is clearly defined
# of people involved is small
Bargaining costs are negligible
Government should confine its role to bargaining between affected individuals or groups.
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10. Government Intervention
Direct Controls – force firm to incur costs
Specific Taxes – to firms who create a negative externality
Subsidies & Government Provision
Subsidies to buyers – help offset costs
Subsidies to producers
Government provision
Direct controls force the offending firms to incur the actual costs of the offending activity (I.e. pollution)
Government can tax firms who chose to conduct business where a negative externality can result.
A) I.e. government could give each new mother in the u.s. a discount coupon to be used to obtain a series of inoculations for her child.
3b) government can provide subsidies to doctors who can provide these inoculations to consumers which would make it cheaper for doctors to conduct this activity. As a result, supply would increase.
3c)
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11. Inadequate information involving buyers
Moral hazard problem
Adverse selection problem
Workplace safety
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12. Moral Hazard Problem
Tendency of one party to a contract to alter their behavior, after the contract is signed, in ways that could be costly to the other party.
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13. Moral hazard cont.
The moral hazard problem is also illustrated in the following statements:
Drivers may be less cautious because they have car insurance.
Medical malpractice insurance may increase the amount of malpractice.
Guaranteed contracts for professional athletes may reduce the quality of their performance.
Government insurance on bank deposits may encourage banks to make risky loans.
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14. Adverse Selection Problem
When information known by the first party to a contract is not known by the second
The second party incurs major costs.
Arises at the time a person signs a contract.
i.e. those in the poorest health will seek to buy the most generous health insurance policies… or… a person planning to hire an arsonist to “torch” his failing business has an incentive to buy fire insurance.
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15. Workplace Safety
Employers have an incentive to provide safe workplaces.
Reduces the amount of disruption of the production process created by job accidents
Lowers the cost of recruiting & training a new replacement worker.
Reduces a firm’s worker compensation insurance premium.
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16. Safe workplaces are expensive.
However…
Safe workplaces are expensive.
Workers will avoid employers having unsafe workplaces.
Serious problems arise when workers do not know that particular jobs or workplaces are unsafe.
1) Safe equipment, protective gear, and a slower work pace all entail costs. The firm will decide how much safety to provide by comparing the marginal cost & benefit of providing a safer workplace.
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17. How does government solve this problem?
Directly provide information to workers about the injury experience of various employers.
It can require firms to provide information to workers about known workplace hazards.
Establish standards of workplace safety and enforce them through inspections & penalties.
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