1. Market Failure Dr. G. Loth

2. Objectives Explain market failure. Identify the conditions under which market failure may occur. Compare Public and Private goods Calculate the optimal provision of a public good. Evaluate the provision of public transportation Respond to the provision of health care offered in major health care plans Explain the economists definition of an externality Describe real-world conditions for externalities Evaluate solutions (pigovian tax, Coase theorem) for externalities

3. How do markets fail? Market inconsistency – the bumpy road Lack of provision of public goods Existence of externalities Inequality of income and wealth distribution Monopoly power concentrated into the hands of a few

4. Market Inconsistency Markets are a constant battleground for customers, resources, and profit. Firms never act in the interest of anyone or anything but themselves Consequence: The consumer and laborer faces firms entering and exiting markets, jobs being created and lost, and price flucuations

5. Public vs. Private Public goods are not necessarily government owned Two characteristics Rivalry – use of the good prevents its use by another Excludability – use of good requires some sort of mechanism for distribution: price system Private Goods: Rivalrous and Excludable Public Goods: Non-rivalrous and non-excludable Private Goods: Rivalrous and Excludable Markets will not provide public goods…so who should? Government? Private companies forced?

6. Public Goods A public good is one that cannot, by definition, profit directly from its existence – Fees could be charged for the view of a statue, for example, but if there is no means of stopping someone from viewing the statue for free, it would reason that many people would look at the statue for free Public goods are plagued by the problem of free riders. – Free riders are those people who, when not required to pay for a good or service, do not!

7. Free Ride… That is a good song but really bad for economists! The problem of the free-rider – Demand for a public good is not expressed by the market – No profit-maximizing firm, in turn, would be willing to produce a public good – Yet many in the market may greatly desire the public good – So, the government will step in and provide the good… The government, however, cannot know what the demand for a public good is, so it must guess In estimating the demand for a public good, the government would need to poll people and ask them how much they would be willing to pay marginally for an additional unit of the public good. – How much would you pay for a 1 lane road? 2 lane road? 4 lanes?

8. Marginal Benefit When we add up how much individuals would be willing to pay marginally for a new road, we can create a “demand” or “willingness to pay” curve for a this public good In this example, the “marginal collective willingness to pay” could be called the Marginal Benefit because it reflects how much value each person (and society as a whole) has for each unit of the public good Military Divisions Person A’s Willingness to Pay Person B’s Willingness to Pay Social Willingness to Pay 1$4$5$9 2$3$4$7 3$2$3$5 4$1$2$3 5$0$1$1

9. Optimum Provision of Public Goods MC = MR, right? WRONG! MB = MC,! When deciding HOW much of a public good to provide, the government needs to know the marginal cost of the good. At the point where the marginal benefit and marginal cost curve intersect the optimum quantity of a public good is found and results in allocative efficiency!

10. Optimum Provision - Graphically Where MB = MC, the optimum net marginal benefit exists Hence, government should produce a public good at this quantity to maximize the net marginal benefit. Military Divisions Marginal Benefit (D) Marginal Cost (S) Net Marginal Benefit 1$9$1$8 2$7$3$12 3$5$5$12 4$3$7$8 5$1$9$0 MC = S MB = D Optimum Q

11. Impact of Optimum Provision Can the government provide too little of a public good? Can the government provide too much of a public good? Big problem: how do you measure the “social” benefit accurately?

12. Externalities Benefits and costs that affect those outside of private market models When not considered in the market model, ignores pushes and pulls that may drive prices If these are significant enough they must be considered Difficult to measure in dollars

13. Positive Externalities Merit Goods – Any private good that has positive externalities Examples: Health care, education, entertainment – Markets do not always provide merit goods in large enough quantities Government intervention – Increase demand for the merit good – Lower or eliminate the price, supply the product directly – Subsidize its production and increase the supply Question: What is the cost of government intervention? – Higher tax rates – Waste and inefficiency – Political interference with delivery

14. Positive Externalities Beneficial to those who are not part of the market structure – Examples Colleges, Universities, Free museums Natural resources, tourist attractions Art in public places I might be able to sell my house for a higher price than I paid if someone built a nice park next to it. – In this example, I do not pay for the park, but I benefit from it.

15. Satisfaction… The problem with positive externalities is that we, the consumer, can’t get enough of them…but the market has no incentive to provide large enough quantities of merit goods to satisfy this desire. Hence, – Merit goods will always be underallocated

16. Negative Externalities Costs of economic activity not born by the producer of the good or service – Not reflected in the supply of the good – Society becomes responsible for the costs

17. Negative Externalities Demerit Goods – Private goods that have negative externalities Examples: Alcohol, Drugs, Cars, etc. – The market has a tendency to produce many of these goods Government intervention: – Reduce demand for goods (reduce demand) – Tax the production of the good (reduce supply) – Outlaw the good Consequences of government interference…

18. Don’t Tread On Me! The problem with negative externalities is that there is little incentive for private firms to reduce the production of goods that have external costs. Because these costs are “paid for” by society, we would say that there is an overallocation of demerit goods.

19. Problems in Measuring Externalities Subjectivity of Externalities – What is a merit good to one person/country could not be to another… – The degree of merit or demerit is highly debatable Source of externalities and regulation – international environmental degradation Estimation of values of externalities – Use of social cost benefit analysis attempts to price on externalities – In most cases, externalities do not warrant banning the good, yet often governments look to do this. Future externalities are less of an issue for us today…less likely to consider

20. Responses to Externalities Keep this in mind: – Abatement of negative externalities has a cost as does provision of positive externalities. – Hence, the marginal cost of a response to either problem has to be weighed against the marginal benefit of the response. – In turn, there can be too much response (action) and too little response (action) to externalities. In either case, we do not achieve the socially optimal quantity of response.

21. Inequality of Income and Wealth Income – The flow of economic payments: rent, wages, interest, and profit Wealth – The stock of economic goods and services owned Government intervention is better at equalizing these among people in a country… but at a cost… ……TAXES!!!!! Welfare! Transfer payments!

22. Abuse of Monopoly Power Concentration of power is the goal of firms Monopoly power does not allow the economy to function most efficiently Government anti-trust or anti-monopoly laws help eliminate monopoly power…

23. Central Planning A solution to economic inequality and abuse of power is government intervention Some forms of intervention take on a planning model -> Soviet style Planning

24. Central Planning Characteristics – Planners appointed to allocate resources Which resources is dependent upon the country – Prices for goods set to match supply – Ownership transferred from private to public – Development plans implemented Grow the economy Equalize the economy

25. Types of Planning Public Sector Planning – Occurs in market economies – Allows only for the planning of public goods and some merit goods Indicative Planning – Low impact planning that involves directing the method of the economy but not directly controlling it Central Planning – High impact planning that involves making direct decisions about the means of production Development Planning – Planning in LDCs where growth into modern economies is the chief focus.

26. Correcting Market Failure Subsidies and Taxation

27. Subsidies: – Aim to change relative prices – Given to the producer – Used to help re-distribute income – Used to help firms compete – Numerous examples – state benefits, free school meals, working tax credits, agriculture, transport, regional development, housing, employment, education

28. Subsidies and Taxation Effects of Subsidies: – Shifts supply curve to right – Reduces price to consumer – Increases output – market failure is perceived as a lack of output – Long term effects on market – distorts price signals – Who benefits – depends who gets the subsidy and how it is used! – Welfare effects: cost of the subsidy to the taxpayer minus the value of the benefits received – Impact on relative consumer and producer surplus

29. Subsidies and Taxation Price Quantity Bought and Sold D S £10 500 S + Subsidy £14 £7 700 Total cost of the subsidy First we look at the market before the subsidy The subsidy will encourage suppliers to offer more for sale at every price The amount of the subsidy is the vertical distance between the two supply curves The effect of the subsidy is to reduce prices and increase the amount available – but at what cost?

30. Subsidies and Taxation Taxation: – Specific or flat rate – amount per unit – Ad Valorem – percentage of the price – Levied on the producer – indirect tax – Examples: VAT, excise duties, tariffs, levies, duties (e.g. stamp duty) National Insurance Contributions (NICs) – a tax on employment? Incidence – who pays? – Producer/consumer – price elasticity of demand

31. Subsidies and Taxation Effects of a tax: Increases price Reduces consumption/output Welfare effects: – Burden of tax on producer and consumer – changes in producer and consumer surplus – Tax yield minus the cost of the tax

32. Subsidies and Taxation Effects of Taxation: – Distortion of the market – Influence on behaviour – Extent of the effect dependent on the degree of elasticity – number of substitutes, addictiveness of the product, proportion of income devoted, time scale – Creation of underground markets – smuggling, booze cruises, etc. – Increases business costs – competitiveness? – Raises revenue to help pay for government services

33. Incidence of a tax on petrol Price p per litre Quantity Bought and Sold (000s litres per day) D S 74 50 S + tax Amount of tax 76.8 Tax Revenue Tax burden of consumer Tax burden of producer 49.5 Petrol has an inelastic demand curve The tax effectively increases the cost of production, shifting supply to the left The amount of the tax is the vertical distance between the two supply curves Some of the tax is passed on to the consumer in the form of higher prices – this is the burden of tax The producer has to carry the rest of the burden. With an inelastic demand this may not be very much!

34. Incidence of an ad valorem tax on a product with a greater degree of price elasticity Price Quantity Bought and Sold D S £7 900 S + Tax 500 £9 Amount of the tax (£6) £3 Total Tax Paid Burden on Consumer Burden on Producer