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Market Failure An Exploration into the Dark Side Join me and together we will OWN the Universe! Too late, Vader…I already do!

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Presentation on theme: "Market Failure An Exploration into the Dark Side Join me and together we will OWN the Universe! Too late, Vader…I already do!"— Presentation transcript:

1 Market Failure An Exploration into the Dark Side Join me and together we will OWN the Universe! Too late, Vader…I already do!

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

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

4 Market Inconsistency Markets are a constant battleground for customers, resources, and profit. Markets are a constant battleground for customers, resources, and profit. Firms never act in the interest of anyone or anything but themselves 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 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 Public goods are not necessarily government owned Two characteristics Two characteristics Rivalry – use of the good prevents its use by another Rivalry – use of the good prevents its use by another Excludability – use of good requires some sort of mechanism for distribution: price system Excludability – use of good requires some sort of mechanism for distribution: price system Private Goods: Rivalrous and Excludable Private Goods: Rivalrous and Excludable Public Goods: Non-rivalrous and non-excludable Public Goods: Non-rivalrous and non-excludable Private Goods: Rivalrous and Excludable Private Goods: Rivalrous and Excludable Markets will not provide public goods…so who should? Markets will not provide public goods…so who should? Government? Private companies forced? Government? Private companies forced?

6 Public Goods A public good is one that cannot, by definition, profit directly from its existence 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. 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… Take it easy! Take it easy! That is a good song but really bad for economists! That is a good song but really bad for economists! The problem of the free-rider 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 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. 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 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 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 As Willingness to Pay Person Bs 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? MC = MR, right? WRONG! WRONG! MB = MC, stupid! MB = MC, stupid! Sorry, I get mad sometimes. Sorry, I get mad sometimes. When deciding HOW much of a public good to provide, the government needs to know the marginal cost of the good. 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! 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 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. 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 little of a public good? Can the government provide too much of a public good? Can the government provide too much of a public good? Big problem: how do you measure the social benefit accurately? Big problem: how do you measure the social benefit accurately? In Charlotte, we could analyze the costs of the light rail system vs. its marginal benefit… In Charlotte, we could analyze the costs of the light rail system vs. its marginal benefit… –Costs? –Benefits?

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

13 Positive Externalities Merit Goods Merit Goods –Any private good that has positive externalities Examples: Health care, education, entertainment Examples: Health care, education, entertainment –Markets do not always provide merit goods in large enough quantities Government intervention 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? 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 Beneficial to those who are not part of the market structure –Examples Colleges, Universities, Free museums Colleges, Universities, Free museums Natural resources, tourist attractions Natural resources, tourist attractions Art in public places 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. 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 I Cant Get No… Satisfaction… Satisfaction… The problem with positive externalities is that we, the consumer, cant get enough of them…but the market has no incentive to provide large enough quantities of merit goods to satisfy this desire. The problem with positive externalities is that we, the consumer, cant get enough of them…but the market has no incentive to provide large enough quantities of merit goods to satisfy this desire. Hence, Hence, –Merit goods will always be underallocated

16 Positive Externality Graph The positive externality provides society with benefits that it does not pay for. The positive externality provides society with benefits that it does not pay for. Hence, we say that there are spillover benefits from merit goods. Hence, we say that there are spillover benefits from merit goods. P QtQt D = MPB D t = MSB Spillover Benefits S = MPC QeQe Underallocation

17 Negative Externalities Costs of economic activity not born by the producer of the good or service 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

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

19 Dont 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. 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. Because these costs are paid for by society, we would say that there is an overallocation of demerit goods.

20 Negative Externality Graph The negative externality is not paid for by the producing firm or consumer of the good. It is a cost that is inflicted on society. The negative externality is not paid for by the producing firm or consumer of the good. It is a cost that is inflicted on society. Hence, we say that there are spillover costs from demerit goods. Hence, we say that there are spillover costs from demerit goods. S = MPC S t = MSC D = MPB Spillover Costs Overallocation QeQe QtQt P

21 Problems in Measuring Externalities Subjectivity of 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 Source of externalities and regulation –international environmental degradation Estimation of values of externalities 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 Future externalities are less of an issue for us today…less likely to consider

22 Responses to Externalities We will discuss more completely the responses that can be made to externalities later. We will discuss more completely the responses that can be made to externalities later. But keep this in mind: But 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.

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

24 Abuse of Monopoly Power Concentration of power is the goal of firms Concentration of power is the goal of firms Monopoly power does not allow the economy to function most efficiently…(my commentary) Monopoly power does not allow the economy to function most efficiently…(my commentary) Government anti-trust or anti-monopoly laws help eliminate monopoly power… Government anti-trust or anti-monopoly laws help eliminate monopoly power… But is Bill Gates all that bad…??? But is Bill Gates all that bad…???

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

26 Central Planning Characteristics Characteristics –Planners appointed to allocate resources Which resources is dependent upon the country 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 Grow the economy Equalize the economy Equalize the economy

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


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