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Market Failure. When the market does not efficiently allocate resources Either too much or too little is produced Monopoly Externalities Public goods.

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Presentation on theme: "Market Failure. When the market does not efficiently allocate resources Either too much or too little is produced Monopoly Externalities Public goods."— Presentation transcript:

1 Market Failure

2 When the market does not efficiently allocate resources Either too much or too little is produced Monopoly Externalities Public goods Imperfect Information Justification for government intervention?

3 Externalities Occur when decision makers do not consider all costs (or benefits) of their actions Two views A.C. Pigou ( ) Ronald Coase (1910) Spillover effects

4 All pollution should be eliminated. a) Strongly Agree b) Agree c) Neutral d) Disagree e) Strongly Disagree

5 Pigouvian Approach Social Cost = Private Cost + External Cost Drinking Alcohol Price of beer Hangover Damage to others Boorish behavior

6 Pollution Free Market: P 1, Q 1 Optimal Outcome: P 2, Q 2 steel $ D1D1 S private Q1Q1 P1P1 P2P2 Q2Q2 S social External cost How can society achieve social optimum? Impose tax = marginal external cost Free market overproduces goods that generate a negative externality Internalize the externality! Pigou tax

7 D S private S social Sorry, Charlie

8 The efficient output will be less than the free market output when: a)Marginal social cost and marginal private cost are equal b)Marginal social cost is greater than marginal private cost c)Marginal social benefit and marginal private benefit are equal d)Marginal social benefit is greater than marginal private benefit

9 Education Free Market: P 1, Q 1 Optimal Outcome: P 2, Q 2 Years of College $ D private S1S1 Q1Q1 P1P1 P2P2 Q2Q2 D social External benefit How can society achieve social optimum? Provide subsidy = marginal external benefit Free market underproduces goods that generate a positive externality

10 If there is a positive externality, the: a)social benefits will be greater than the private benefits b)external benefits will be greater than the social benefits c)social benefits will be equal to the private benefits d)private benefits will be greater than the social benefits a)social benefits will be greater than the private benefits b)external benefits will be greater than the social benefits c)social benefits will be equal to the private benefits d)private benefits will be greater than the social benefits

11 A consequence of a negative consumption externality is that social benefits are ______ than private benefits, and the socially optimal level of output is ______ than the private level of output. a)greater; greater. b)greater; less. c)less; less. d)less; greater. a)greater; greater. b)greater; less. c)less; less. d)less; greater.

12 Coasian Approach Externalities are due to incomplete property rights assignment It takes two to tango

13 Coasian Approach Coase Theorem If property rights are well-defined and transactions costs are low enough, then private bargaining can result in an efficient allocation of resources. Corollary Allocation of resources does not depend on initial assignment of property rights. Externalities are due to incomplete assignment of property rights

14 Cheshire, Ohio v. AEP AEP paid $20 million to buy the 221-resident town in 2002

15 Pollution Worksheet Optimal pollution for Marietta-Parkersburg area is 60,000 units of emissions Abatement Cost Cars: $5 Utilities: $10 Factories: $20 Controlling pollution through: Standards Taxes Tradable Permits

16 Cap and Trade Program permits $ $20 $10 $ F U C D S 60 Abatement Cost P = $10 Q = 60,000 $200,000 Solution

17 Acid Rain Market: SO Spot Auction yr Advance Auction Source:

18 Characteristics of Goods Excludability: can you be excluded from consuming the good? Rivalry: does my consumption hinder your consumption? RivalNon-rival Excludable Non- Excludable Private Goods Artificially Scarce Goods or Natural Monopoly Common Resources Public Goods

19 Government Provided Goods and Services Schools Roads Police Courts Fire Department Water Library Health Care Transportation Schools Roads Police Courts Fire Department Water Library Health Care Transportation National Defense Social Security Medicare Postal Service FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC, NLRB, HUD National Defense Social Security Medicare Postal Service FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC, NLRB, HUD

20 National Defense Federal Government spent $779b on defense in 2009 How do we pay for this? Taxes! Per capita expenditure

21 Public Goods free-rider problem Under-provision by free market Social Optimum requires: MSB = MSC Output can only be provided at one level for all Must find some way to aggregate individual MB

22 Fireworks in Marietta QuantityGretchens MB Corts MB Yanans MB ΣMBMCTotal Benefit Total Cost Net Benefits 10$8$5$9$22$10$22$10$12 20$7$4$8$19$10$41$20$21 30$6$3$6$15$10$56$30$26 40$5$2$4$11$10$67$40$27 50$4$1$2$7$10$74$50$24 60$3$0$1$4$10$78$60$18

23 a) 0 b) 1 c) 2 d) 3 e) 4 f) 5 The table below shows the marginal benefit from submarines for the only two citizens of a country. Submarines are a public good. If submarines cost $145 a piece to produce, what is the efficient quantity of submarines? KatieYoutian Marginal benefit (dollars per sub) QuantityMarginal benefit (dollars per sub)

24 Common Resources Non-excludable Rival in consumption African Elephant 1980: 1.3m 1990: 0.6m Fish in the sea Bison in America CITES Campfire Tragedy of the commons "Why would I tolerate living or coexisting with an elephant that is so destructive?" says the village chief. "It destroys our crops, our fields, our trees, our environment. It is because of the value associated with the elephant that makes us coexist with it."

25 Artificially Scarce Goods Excludable Non-Rival Digital info Movies Music Books Pharmaceuticals Marginal Cost of provision is zero D MC QMQM PMPM QCQC Drugs $ MR

26 A factory's production process creates sludge that pours into a river. This sludge makes it difficult to fish in the river, increasing the costs of the local fishermen by $5000. The factory can install a water filter system for $4100, and the fishermen can utilize a weighted fishing net system (to get under the sludge) for $3250. Both systems would remedy the sludge damage to the fishermen. What outcome would you expect under the following conditions: a)Transactions costs low and factory is not liable for damage? b)Transactions costs low and factory is liable for damage? c)Transactions costs high and factory is liable for damage? Factory Filter: $4100 Nets: $3250 Damage: $5000

27 Health Care Reform

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29 Objectives: Expand insurance coverage Lower health care costs Private Insurance Social Insurance Revenue Provisions Health Care Reform

30 Information Asymmetry Moral Hazard (Hidden actions) Insurance markets Employer-Employee relationship Adverse Selection (Hidden characteristics) Insurance markets Used car market Solutions? Signaling: Informed party takes action Screening: Uninformed party takes action Government regulation?

31 Private Insurance Reforms Insurance rules Community rating (age, area, family size, and tobacco use) Guaranteed issue (cant deny for pre-existing condition) Prohibit lifetime limits on coverage Dependent children on parents plan until age 26 Establish health insurance exchanges Individual Health Insurance Mandate Tax credit subsidies up to 400% poverty $695 fine (or 2.5% income) if you dont buy Employer Health Insurance Mandate $2000 fine per employee for firms N > 50 Tax credit subsidies to small employers High cost plan excise tax (t = 40%)

32 Source:

33 Suppose you are covered under health insurance or belong to a Health Maintenance Organization (HMO), and you are insured against all or most of the costs of visits to the doctor. As a result you are likely to make greater use of medical services of all kinds. This tendency of people with insurance to change their behavior in a way that leads to more claims against the insurance company is called: a) Adverse selection b) Moral hazard c) Screening d) Signaling

34 Public Choice Theory Public Interest vs Self Interest Political Actors Politicians Voters Special Interest Groups

35 Median Voter In a two-party race, candidates have incentive to move toward the middle Positioning Coalition building VR1R1 D1D1 D2D2 D3D3 R3R3 R2R2

36 Popular Vote Cast for US President YearWinner%Loser%Margin 1960Kennedy49.7Nixon Johnson61.1Goldwater Nixon43.4Humphrey Nixon60.7McGovern Carter50.1Ford Reagan50.7Carter Reagan58.5Mondale Bush I53.4Dukakis Clinton43.0Bush Clinton49.2Dole Bush II47.9Gore Bush II51.0Kerry Obama52.9McCain

37 Public Choice Theory Public Interest vs Self Interest Political Actors Politicians Median voter hypothesis Voters Rational ignorance

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40 Public Choice Theory Public Interest vs Self Interest Political Actors Politicians Median voter hypothesis Voters Rational ignorance Special Interest Groups Rent seeking Concentrated benefits and dispersed costs Labor unions Industry groups AARP Dairy price supports: $900 million Benefit to farmers: $900m/65,000 = $13,846 Cost to taxpayers: $900m/142m = $6.34

41 Social Choice Mechanisms Condorcets Paradox Arrows Impossibility Theorem ChandlerPhoebeMonica First ChoiceCSIGleeTrue Blood Second ChoiceGleeTrue BloodCSI Third ChoiceTrue BloodCSIGlee CSI v Glee: CSI wins Glee v True Blood: Glee wins CSI v True Blood: True Blood wins


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