1. Prepared by: Jamal Husein C H A P T E R 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Failure: Spillovers and Imperfect Information

2. 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Rationale for the Existence of Government  Certain goods and services would not exist unless we make a collective effort to produce them.  The government can help make collective decisions about paying for goods that generate spillover benefits.

3. 3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Spillover Benefits & Public Goods  When there are spillover benefits ;  When there are spillover costs ; and  When there is imperfect information. There are three cases under which markets fail to allocate resources Efficiently:

4. 4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Spillover Benefits & Public Goods  A market with spillover benefits is inefficient, so there is an opportunity for government to promote efficiency. Spillover PRINCIPLE For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume. Spillover PRINCIPLE For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.

5. 5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Spillover Benefits: An Example Number of people100,000 Benefit per person$5 Total benefit of dam (100,000 x $5) $500,000 Assumed total cost of dam (greater than personal benefit of $5) $200,000 Tax per person$2 Tax revenue (100,000 x $2) $200,000  In this example, if each person considers only the personal benefit relative to the cost of the dam, no dam will be built.  Since everyone will support a tax per person that is less than the benefit per person, the government can use its taxing power to provide a good that would otherwise not be provided.

6. 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Public Goods  A public good is a good available for everyone to consume, regardless of who pays and who doesn’t.  A private good is consumed by a single person or household.

7. 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Public Goods  Public goods are nonrival in consumption (available for everyone to consume) and nonexcludable (it is impractical to exclude people who don’t pay).  Private goods are rival in consumption (only one person can consume the good), and excludable (it is possible to exclude a person who does not pay for the good).

8. 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Public Goods  National defense  Law enforcement  Space exploration  Preservation of endangered species  Protecting the earth’s ozone layer  Fireworks display Examples of public goods:

9. 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Free-rider Problem  The problem with using voluntary contributions to support public goods is the free- rider problem. Each person will try to get the benefits of a public good without paying for it.

10. 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Overcoming the Free-rider Problem  Give contributors something in return  Arrange matching contributions  Appeal to people’s sense of civic or moral responsibility Techniques to encourage people to contribute:

11. 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Private Goods With Spillover Benefits  workplace spillover benefits; and  Civic spillovers benefits ■ Thus, the government should adopt policies to encourage people to become educated. ■ Local governments provide free primary and secondary education. States subsidize higher education, and the federal government provides financial aid to students in private and public schools. A good such as education generates:

12. 12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Spillover Costs  Just as the government has a role in markets with spillover benefits, the government also plays a role in markets with spillover costs (or externality). Spillover PRINCIPLE For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume. Spillover PRINCIPLE For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.

13. 13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Advantages of a Pollution Tax  The economist’s response to a pollution problem is to impose a pollution tax (internalize the pollution externality).  A pollution tax that is equal to the spillover cost per unit of waste forces firms to pay for the waste they generate, causing firms to produce less of the polluting good.  The tax also encourages firms to spend money to abate pollution.

14. 14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Firm’s Response to a Pollution Tax  This table shows the hypothetical cost per ton of paper with varying amounts of pollution.  Tax per gallon of waste = $4 Waste per Ton (gallons) Production Cost per Ton Tax Cost per Ton Total Cost per Ton 5$60$20$80 4611677 3641276 271879 186490 01160  As the firm decreases its waste, the cost of production rises because additional efforts to decrease waste become progressively more expensive.

15. 15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Firm’s Response to a Pollution Tax  As the firm continues to decrease the volume of waste, the production cost increases while the tax cost decreases. Waste per Ton (gallons) Production Cost per Ton Tax Cost per Ton Total Cost per Ton 5$60$20$80 4611677 3641276 271879 186490 01160  The total cost per ton of paper is minimized at $76 and 3 gallons of waste.  The typical firm will decrease its waste from 5 to 3 gallons. This result is consistent with the marginal principle.

16. 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Firm’s Response to a Pollution Tax  As long as the marginal benefit ($4 savings in taxes per gallon of waste reduced) exceeds the marginal cost (or extra production cost from cutting back a gallon of waste), the firm should continue to scale back its waste. Waste per Ton (gallons) Production cost per Ton Tax cost per Ton Total Cost per Ton 5$60$20$80 4611677 3641276 271879 186490 01160  Beyond 3 gallons, the additional production cost exceeds the additional tax savings.

17. 17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Firm’s Response to a Pollution Tax  The tax shifts the supply curve leftward.  The tax is partially shifted to consumers in the form of a higher price, and they respond by consuming less.  The price of paper increases from $60 to $68 per ton. 76

18. 18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Firm’s Response to a Pollution Tax  The pollution tax affects the total volume of waste dumped in two ways:  Abatement: there is less waste per ton of paper—3 instead of 5 gallons per ton  Lower output: the industry produces less paper—80 instead of 100 tons per day

19. 19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Traditional Regulation: Command and Control  An alternative to a pollution tax is a system of regulations that control the amount of pollution generated by each firm.  The label for a traditional regulatory policy is a command-and-control policy.  In the paper example, the government would simply mandate firms to produce no more than, say, 4 gallons of waste per ton of paper.

20. 20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Traditional Regulation: Command and Control  A single abatement technology is likely to be efficient for some firms but not for others.  There is no incentive to cut the volume of waste below the maximum volume, or develop better abatement technologies. A problem with the regulatory policy is that the mandated abatement technology is unlikely to be the most efficient for two reasons:

21. 21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Global Warming and a Carbon Tax  Carbon dioxide is by far the most important greenhouse gas.  In the last century, we have blown out more carbon than plants have been able to suck in, and the volume of carbon dioxide in the atmosphere has increased by 25%.  A carbon tax is a tax based on fuel’s carbon content

22. 22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Global Warming and a Carbon Tax A carbon tax would decrease greenhouse emissions for three reasons :  The tax will increase the price of energy and increase the cost of producing energy intensive goods;  Some energy producers will switch to noncarbon energy sources, i.e., the wind, the sun, and geothermal sources  Energy producers will improve the efficiency of carbon based fuels, squeezing out more energy per ton of coal or oil.

23. 23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Global Warming and a Carbon Tax  The destruction of tropical rain forests affects the volume of carbon dioxide in the atmosphere because: When trees and plants are burned, the carbon stored in these plants is converted into carbon dioxide Once the forest is cleared, there is less plant material to convert carbon dioxide into stored carbon

24. 24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Coase Bargaining  A spillover problem can be solved through bargaining among affected parties;  A solution “Coase bargaining solution” can be reached when;  There is a small number of affected parties; and  Transaction costs of bargaining are relatively low.

25. 25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Coase Bargaining: An example  Consider a lake shared by a steel mill and a fishing firm;  The mill initially dumps 5 tons of waste into the lake which reduces the fish harvest;  The marginal cost of abatement increases with the level of abatement (from h to m);  The marginal benefit of abatement by the fishing firm decrease (increases) as the level of Abatement increases (decreases) as indicated by the movement from b to g.

26. 26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Coase Bargaining: An example Marginal Cost of abatement Marginal benefit of abatement 2323 1414 3232 5 Abatement (tons) 0 Waste (tons) 4141 1 5 7 9 11 13 17 $ The MB of pollution abatement Equals the increase in the fish harvest, While the MC equals the additional abatement cost. Using the marginal principle, the efficient level is 3 tons. Coase bargaining generates the efficient abatement level. If the steel mill owns the lake, the fishing firm will pay the steel mill to abate 3 tons. If the fishing firm owns the lake, the steel mill will pay the fishing firm no to abate more than 3 tons. b c e f g m k i h

27. 27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Consequences of Global Warming  A doubling of atmospheric carbon dioxide in about 60 years will increase global temperatures, although it is unclear by how much.  Most scientists expect total rainfall to increase, with an overall negative effect on agriculture because less rainfall is expected in areas with fertile soil and more rainfall in areas with less productive soil.  Glaciers will melt, raising sea levels and inundating the amount of land available for agriculture or living space.

28. 28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin A Carbon Tax  The economist’s response to the accumulation of greenhouse gases is to impose a tax on fossil fuels.  The carbon tax for a particular fuel would be determined by the fuel’s carbon content.

29. 29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Effects of a Carbon Tax on the Market for Coal  A carbon tax will add to the expenses incurred by coal producers. So some suppliers will leave the market.  The supply of coal shifts to the left and the coal tax results in an increase in the price per ton of coal and a smaller quantity produced.

30. 30 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Imperfect Information and Disappearing Markets  A mixed market is a market where low-quality goods and high-quality goods are mixed together.  A market will break down, or the high-quality goods will tend to disappear, if either buyers or sellers are unable to distinguish between low-quality goods and high-quality goods.

31. 31 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Asymmetric Information  In the model of supply and demand, the efficiency of markets is based on the assumption that buyers and sellers are fully informed.  If one side of the market, either buyers or sellers, has better information than the other, we say that there is asymmetric information in that market.

32. 32 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Mixed Market for Used Cars— Lemons and Plums  If buyers cannot distinguish between lemons (low-quality cars) and plums (high-quality cars), both will be sold together, in a mixed market, for the same price.  In such a market, the odds of getting a plum are small. The high-quality goods will tend to disappear, and in the extreme case, will be completely nonexistent.

33. 33 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Ignorant Consumers and Knowledgeable Sellers  To determine the price in a mixed market we must answer these questions:  How much is the consumer willing to pay for a plum—a high-quality car?  How much is the consumer willing to pay for a lemon—a low-quality car?  What is the chance that a used car purchased in the mixed market will be a lemon?

34. 34 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Equilibrium Outcome in the Mixed Market  Suppose that a consumer believes that the chances of getting a lemon are 50% (neutral expectations).  To determine whether the actual chance of getting a lemon is greater or less than the expected chance, consider the assumptions in the following table:

35. 35 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Equilibrium Outcome in the Mixed Market  Under neutral expectations (50%), consumers will underestimate the chance of getting a lemon (80%). Neutral Expectations Assumed chance of lemon50% Willingness to pay for lemon$2,000 Willingness to pay for plum$4,000 Willingness to pay for used car (average) $3,000 Number of lemons supplied16 or 80% Number of plums supplied4 or 20% Total number of used cars20 or 100% Actual chance of lemon80%

36. 36 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Equilibrium Outcome in the Mixed Market  Under pessimistic expectations, the actual chance of getting a lemon is the same as the expected chance (100%).  The higher the chance of getting a lemon, the lower the price consumers are willing to pay.  Under pessimistic expectations, the price of used cars decreases. Pessimistic Expectations Assumed chance of lemon100% Willingness to pay for lemon$2,000 Willingness to pay for plum$4,000 Willingness to pay for used car (value of a lemon) $2,000 Number of lemons supplied9 or 100% Number of plums supplied0 Total number of used cars9 or 100% Actual chance of lemon100%

37. 37 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Supply of Used Cars  The supply of used cars is comprised of people willing to sell their cars in the used-car market.  Owners of plums ask at least $2,500 before any plums are supplied.  Owners of lemons are willing to sell at a price of $500 or more.

38. 38 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Equilibrium Outcome in the Mixed Market for Used Cars  When consumers’ expectations are consistent with their actual experiences, the equilibrium price of used cars is $2,000, and the plums will disappear from the market.

39. 39 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Adverse Selection  Adverse selection is the result of the dynamics of asymmetric information (one side has better information than the other), which generates a downward spiral of price and quantity: A decrease in price decreases the quantity of plums supplied, decreasing the price further when buyers realize that most cars are lemons, which leads to even fewer plums on the market.  The domination of the used-car market by lemons is an example of the adverse-selection problem. The quality of the goods left in the market is adverse, or undesirable.

40. 40 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Thin Market for Plums  It is possible that asymmetric information generates a thin market— one in which some high-quality goods are sold, but fewer than would be sold in a market with perfect information.

41. 41 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Thin Market for Plums  If the chance of getting a plum is 10%, buyers are willing to pay $2,200 for a used car.  The market is in equilibrium because consumers accurately assess the chances of getting a lemon.  At an equilibrium price of $2,200, 20 cars are sold, 10% of which are plums. Assumed chance of lemon90% Willingness to pay for lemon$2,000 Willingness to pay for plum$4,000 Willingness to pay for used car $2,200 Number of lemons supplied18 or 90% Number of plums supplied2 or 10% Total number of used cars20 or 100% Actual chance of lemon90%

42. 42 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Thin Market for Plums  If the supply of plums starts at $1,800, it is possible that the market will have a small number of plums when it reaches equilibrium: 2 plums and 18 lemons sold at $2,200 each.

43. 43 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin ApplicationsApplications  Baseball pitchers who are more prone to injuries tend to switch teams more often than pitchers who aren’t.  This happens because of asymmetric information and adverse selection. The new team has much less information than the old one.

44. 44 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin ApplicationsApplications  A person who buys an insurance policy knows much more about his or her risks than the insurance company.  Insurance companies must pick from an adverse or undesirable selection of customers. Buyers of insurance policies have more information than sellers.

45. 45 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin ApplicationsApplications  Careful physicians do not buy malpractice insurance because insurance companies are unable to distinguish between careful and reckless doctors.  The mixed market increases the cost of providing insurance and the price of the malpractice policy.

46. 46 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Moral Hazard  Moral hazard is a situation that encourages risky behavior.  Insurance causes people to take greater risks. They don’t buy a fire extinguisher, or tend to drive recklessly. These are unobserved actions that increase the probability of a grim outcome.

47. 47 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Moral Hazard  The moral hazard is pervasive. The availability of insurance, for example, decreases investment in prevention programs that reduce risk.  Deposit insurance causes a moral hazard problem. With insurance available, depositors are less likely to evaluate the performance and riskiness of the financial institution.