1. Chapter 15 Government’s Role in Economic Efficiency ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2. 2 The Legal System Economic role of law Criminal law –People channel their efforts into mutually beneficial, voluntary exchanges Property law –People find the most productive uses for their property Contract law –Productive activity and exchange

3. 3 The Legal System Tort law –Protect consumers from unsafe products –Protect businesses from unreasonable liabilities Antitrust law –Prevent businesses from engaging in behavior that limits competition and harms consumers

4. 4 Regulation Directs businesses –To take some specific actions –Prohibits actions Often: case-by-case basis Protects –Buyers –Sellers –Third parties

5. 5 The Importance of Infrastructure Low Quality of Infrastructure MediumHigh Average Output per Worker 2,000 6,000 10,000 14,000 $18,000 Figure 1 Government Infrastructure and Output per Worker

6. 6 Market Failures Market that fails to take advantage of every Pareto improvement Market is economically inefficient 1.Monopoly markets 2.Externalities 3.Public goods 4.Information asymmetry

7. 7 Monopoly Antitrust Law as a Remedy –Use in markets that perform better with competition –Don’t use if the monopoly power comes from Patents and copyrights Network externalities Natural monopoly

8. 8 The Special Case of Natural Monopoly B $20 $38 A C MC $80 LRATC 50,000 DMR 85,000 100,000 Number of Households Served Dollars Unregulated monopoly "Fair rate of return" production F Efficient production (requires subsidy) Figure 2 Regulating A Natural Monopoly

9. 9 Regulation of Natural Monopoly Marginal cost pricing –Setting the price = MC Average cost pricing –Setting the price = LRATC –Fair rate of return pricing The natural monopoly –Zero economic profit –Fair rate of return –Keeps the monopoly in business

10. 10 Externalities By-product of a good or activity Affects someone not immediately involved in the transaction Negative externality –Causes harm to others Positive externality –Creates benefits for others

11. 11 The Private Solution to a Negative Externality Coase theorem –A side payment can be arranged without cost –Market will solve an externality problem on its own Conditions 1.Legal rights are clearly established 2.Legal rights can be easily transferred 3.Number of people involved is very small

12. 12 Externalities The Free Rider Problem –When the efficient outcome requires a side payment –Individual gainers will not contribute

13. 13 Government Solutions A market with a negative externality –Produce more than the efficient quantity –Creates a deadweight loss Correcting negative externalities –Taxes –Regulations –Tradable permits

14. 14 Government Solutions Taxing a Negative Externality –A tax on each unit of a good = external harm it causes –Can correct a negative externality –Bring the market to an efficient output level

15. 15 Taxing a Negative Externality 100125 D S $2.00 A MSC C $1.00 B Millions of Gallons per Period Dollars Efficient Quantity Equilibrium Quantity Figure 3a A Tax on Producers to Correct a Negative Externality

16. 16 Taxing a Negative Externality 100125 D $2.00 $1.00 B Millions of Gallons per Period Dollars $2.60 $1.60 S S After Tax A Figure 3b A Tax on Producers to Correct a Negative Externality New Equilibrium Quantity with Tax

17. 17 Regulation and Tradable Permits Regulations –Move a market closer to the efficient point Tradable permit –License that allows a company to release a unit of pollution into the environment over some period of time

18. 18 Dealing with a Positive Externality A market with a positive externality –Produce less than the efficient quantity –Creates a deadweight loss Correcting positive externalities –Subsidies A subsidy on each unit of a good = external benefits it creates, Can correct a positive externality Brings the market to an efficient output level

19. 19 Dealing with a Positive Externality 100200 D S $400 MSB A $200 Quantity of Devices (thousands) Price B Figure 4a A Subsidy for Consumers to Correct a Positive Externality

20. 20 Dealing with a Positive Externality S 100200 400 B A $200 Quantity of Devices (thousands) Price $450 250 D D After Subsidy Figure 4b A Subsidy for Consumers to Correct a Positive Externality

21. 21 Public Goods Rivalry –One person’s consumption of a unit of a good or service means that no one else can consume that unit Excludability –The ability to exclude those who do not pay for a good from consuming it Pure private good –Is both rivalrous and excludable

22. 22 Public Goods Pure public good –Nonrival and nonexcludable –Provided by government without charge Marketable public good –Excludable and nonrival –Provided by the market for a price Common Resource –Nonexcludable and rival –Free of charge

23. 23 Private, Public and Mixed Goods Nonexcludable Excludable Marketable Public Goods Software Digital Music and Video Pure Public Good National Defense Legal System Urban parks Common Resources Fish in international waters Earth’s atmosphere Pure Private Good Food Clothing Housing RivalNonrival Figure 5 Pure Private, Pure Public and Mixed Goods

24. 24 Asymmetric information One party to a transaction has relevant information not known by the other party –Adverse selection – quality –Moral hazard - lack of information about someone’s future behavior –Principal–agent problem

25. 25 Market and Government Solutions Market solutions: –Reputation –Behavior –Contingent contract Government solutions: –Regulation

26. 26 Efficiency and Government in Perspective Government failure Deadweight loss from taxes Dissatisfaction with public goods Equity

27. 27 Traffic as a Market Failure Traffic –Externality problem –Negative externalities –City streets = common resource Dealing with the market failure –Charging tolls –Auction off a limited number of license plates