1. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Intervention

2. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Failure The market mechanism may fail to provide the optimal mix of output. –The optimal mix of output is the most desirable combination of output attainable with existing resources, technology and social values.

3. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. M (market outcome) X (optimal mix) ALL OTHER GOODS (units per time period) Too many computers COMPUTERS (units per time period) Too few other goods Market Failure

4. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Nature of Market Failure Market failure is an imperfection in the market mechanism that prevents optimal outcomes. –Market mechanism — use of market prices and sales to signal desired outputs (or resource allocations).

5. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Nature of Market Failure The forces of supply and demand have not led to the best point on the production possibilities curve.

6. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Nature of Market Failure Market failure establishes the basis for government intervention.

7. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Sources of Market Failure There are four specific sources of microeconomic market failure: –Public goods –Externalities –Market power –Equity considerations

8. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods The market mechanism works efficiently if the benefits of consuming the good or service are available only to individuals who purchase it.

9. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Joint Consumption A public good is a good or service whose consumption by one person does not exclude consumption by others. –Examples include national defense and flood control dams.

10. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Joint Consumption A private good is a good or service whose consumption by one person excludes consumption by others. –Examples include donuts, soda, etc.

11. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Free-Rider Dilemma A free rider reaps direct benefits from someone else’s purchases (consumption) of a public good.

12. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Exclusion The distinction between public goods and private goods is based on the nature of the goods, not who produces them.

13. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Exclusion The free ride associated with public goods upsets the customary practice of paying for what you get.

14. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Underproduction If public goods were marketed like private goods, everyone would wait for someone else to pay.

15. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Underproduction The market tends to under-produce public goods and over-produce private goods.

16. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. B (market outcome) A (optimal outcome) PUBLIC GOODS (units per time period) PRIVATE GOODS (units per time period) Underproduction of Public Goods

17. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities Externalities are costs (or benefits) of a market activity borne by a third party. The difference between the social and private costs (benefits) of a market activity.

18. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities Market will under-produce goods that yield external benefits. Market will over-produce goods that generate external costs.

19. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Consumption Decisions In trying to maximize their own satisfaction, consumers often do not consider how their consumption affects the well-being of others.

20. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. External Costs Market demand expresses only the anticipated private benefits of consumption.

21. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. External Costs External costs must be taken into account to account fully for collective well-being.

22. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social Demand Social demand includes not only private benefits but also accounts for any externalities. Social demand = market demand + externalities

23. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social Demand If the externality is a negative, the activity reflects external costs.

24. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social Demand Whenever external costs exist, market demand overstates social demand.

25. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social vs. Market Demand Market demand qmqm qsqs dmdm Social demand dsds External costs QUANTITY (cars per year) PRICE (per car) p1p1

26. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. External Benefits An external benefit augments private demand. Social demand exceeds market demand whenever external benefits exist.

27. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Decision When external cost exists, firms will produce more of the good than is socially desirable.

28. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Maximization A producer has an incentive to continue polluting using cheaper technology as long as doing so is more profitable.

29. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Price = (MR) Profit A MC 1 ATC 1 1,000 0 QUANTITY (kilowatt-hours per day) PRICE OR COST (dollars per kilowatt-hour) (a) Using cheap but polluting process Profit Maximization in Electric Power Production

30. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Prior Profit Price = (MR) A MC 1 ATC 1 1,0000 QUANTITY (kilowatt-hours per day) PRICE OR COST (dollars per kilowatt-hour) (b) Using more expensive but less-polluting process MC 2 ATC 2 B Profit Profit Maximization in Electric Power Production

31. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. External Cost People tend to maximize their personal welfare, balancing private benefits against private costs.

32. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. External Cost When external costs exists, a private firm will not allocate its resources and operate its plant to maximize social welfare.

33. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social vs. Private Costs Social costs are the full resource costs of an economic activity, including externalities.

34. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social vs. Private Costs Private costs are the costs of an economic activity directly borne by the immediate producer or consumer (excluding externalities).

35. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Social vs. Private Costs External costs are the difference between social and private costs. External costs = social costs – private costs

36. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities If pollution costs are external, firms will produce too much of a polluting good.

37. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. A B Price = (MR) Private MCSocial MC qsqs qpqp 0 PRICE OR COST (dollars per unit) QUANTITY (units per time period) External cost Market Failure

38. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Policy Options The goal is to discourage production and consumption activities that impose high external costs on society.

39. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Policy Options Policy options can accomplish goals by: –Altering market incentives. –Bypassing market incentives.

40. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Emission Fees Market incentives can be altered via emission charges. An emission charge is a fee imposed on polluters, based on the quantity of pollution.

41. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Emission Fees An emission fee increases private marginal cost and thus encourages lower output.

42. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Fee = t MC + fee Private MC Price QUANTITY (units per time period) q1q1 q0q0 PRICE OR COST (dollars per unit) Emission Fees

43. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation Market incentives can be bypassed through regulation. Government specifies the required outcome and the process by which it is to be achieved.

44. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation The Clean Air Act of 1970 mandated fewer auto emissions and the processes to reduce those emissions.

45. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation Excessive process regulation may actually raise costs of environmental protection.

46. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power The ability to alter the market price of a good or service. The response to price signals, rather than the signals themselves, are flawed.

47. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Restricted Supply Market power results from restricted supply: –Copyrights –Patents –Control of an essential resource –Restrictive production agreements –Economies of scale

48. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Restricted Supply The direct consequence of market power is that one or more producers attain discretionary power over the market’s response to price signals.

49. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Antitrust Policy The goal of government policy is to prevent or dismantle concentrations of market power. Antitrust — government intervention to alter market structure or prevent abuse of market power.

50. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Sherman Act (1890) Prohibits “conspiracies in restraint of trade.” Violators subject to fines up to $1 million.

51. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Clayton Act (1914) Outlaws specific antitrust behavior not covered by Sherman Act. Prevention of the development of monopolies.

52. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Trade Commission Act (1914) Created agency to study industry structures and behavior.

53. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Antitrust Decisions Antitrust legislation has been used to break up: –Steel and tobacco monopolies in the 1900s. –AT&T monopoly in the 1980s. –It is currently being used against Microsoft.

54. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity Equity concerns the FOR WHOM question. Is the distribution of goods and services generated by the market fair?

55. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity Government intervention may be needed to redistribute income if the market fails to reflect our notions of fairness.

56. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity Transfer payments – payments to individuals for which no current goods or services are exchanged. –Examples include social security, welfare, and unemployment benefits.

57. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity To the extent it benefits the public at large, the relief of misery can be thought of as a public good.

58. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Macro Instability Micro failures of the marketplace differ from macro failures. Micro failures concern producing at the wrong point on the production- possibilities curve or inequitably distributing the output produced.

59. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Macro Instability The goals of macro intervention: –Foster economic growth. –Get on the production-possibilities curve (full employment). –Maintain stable price level. –Increase our capacity to produce (growth).

60. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Trust in Government? Potential micro and macro failures of the marketplace justify government intervention. Can we trust government to fix market shortcomings?

61. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Information Government intervention typically entails a lot of groping in the dark for better, if not optimal, outcomes.

62. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Vested Interests Vested interests often try to steer the government away from the social optimum.

63. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Failure Government intervention might worsen rather than improve market outcomes. –Government failure — government intervention that fails to improve economic outcomes.

64. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Failure The challenge for public policy is to decide when intervention is justified. Then intervene in a way that improves outcomes in the least costly way.

65. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Intervention End of Chapter 9