2 Justification for government intervention? Market FailureWhen the market does not efficiently allocate resourcesEither too much or too little is producedMonopolyExternalitiesPublic goodsImperfect InformationJustification for government intervention?
3 ExternalitiesOccur when decision makers do not consider all costs (or benefits) of their actionsTwo views“Spillover effects”A.C. Pigou( )Ronald Coase(1910)
4 All pollution should be eliminated. Strongly AgreeAgreeNeutralDisagreeStrongly Disagree
5 Social Cost = Private Cost + External Cost Pigouvian ApproachSocial Cost = Private Cost + External CostPrice of beerHangoverDamage to othersBoorish behaviorDrinking Alcohol
6 Pollution How can society achieve social optimum? Free Market: P1, Q1 Ssocial$SprivateFree Market: P1, Q1Optimal Outcome: P2, Q2P2P1External costFree market overproduces goodsthat generate a negative externalityD1Q2Q1steelHow can society achieve social optimum? Impose tax = marginal external cost“Pigou tax”Internalize the externality!
8 The efficient output will be less than the free market output when: Marginal social cost and marginal private cost are equalMarginal social cost is greater than marginal private costMarginal social benefit and marginal private benefit are equalMarginal social benefit is greater than marginal private benefit
9 Education How can society achieve social optimum? Free Market: P1, Q1 $S1Free Market: P1, Q1Optimal Outcome: P2, Q2P2External benefitP1Free market underproduces goodsthat generate a positive externalityDsocialDprivateQ1Q2Years ofCollegeHow can society achieve social optimum? Provide subsidy = marginal external benefit
10 If there is a positive externality, the: social benefits will be greater than the private benefitsexternal benefits will be greater than the social benefitssocial benefits will be equal to the private benefitsprivate 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.greater; greater.greater; less.less; less.less; greater.
12 Coasian Approach “It takes two to tango” Externalities are due to incomplete property rights assignment“It takes two to tango”
13 Coasian ApproachExternalities are due to incomplete assignment of property rightsCoase TheoremIf property rights are well-defined and transactions costsare low enough, then private bargaining can result in anefficient allocation of resources.CorollaryAllocation of resources does not depend on initialassignment of property rights.
14 Cheshire, Ohio v. AEPAEP paid $20 million to buy the 221-resident town in 2002
15 Pollution WorksheetOptimal pollution for Marietta-Parkersburg area is 60,000 units of emissionsAbatement CostCars: $5Utilities: $10Factories: $20Controlling pollution through:StandardsTaxesTradable Permits
16 Cap and Trade Program S D “$200,000 Solution” $ F U C $20 Abatement CostP = $10Q = 60,000U$10C$5D40607090permits“$200,000 Solution”
18 Characteristics of Goods Excludability: can you be excluded from consuming the good?Rivalry: does my consumption hinder your consumption?RivalNon-rivalExcludableNon-ExcludableArtificially Scarce GoodsorNatural MonopolyPrivate GoodsCommonResourcesPublic Goods
20 Taxes! National Defense How do we pay for this? Federal Government spent $779b on defense in 2009Per capitaexpenditureHow do we pay for this?Taxes!
21 Public Goods “free-rider” problem Social Optimum requires: MSB = MSC Under-provision by free marketSocial Optimum requires: MSB = MSCOutput can only be provided at one level for allMust find some way to aggregate individual MB
23 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 $145 a piece to produce, what is the efficient quantity of submarines?KatieYoutianMarginal benefit(dollars per sub)Quantity--100115075250325410512345
24 Common Resources “Tragedy of the commons” Non-excludable Rival in consumptionAfrican Elephant1980: 1.3m1990: 0.6mFish in the seaBison in America“Tragedy of the commons”CITESCampfire"Why would I tolerate living or coexisting with an elephant that is so destructive?" says the village chief."It destroys our crops, our fields, our trees, our environment. It is because of the value associated with the elephant that makes us coexist with it."
25 Artificially Scarce Goods ExcludableNon-RivalDigital infoMoviesMusicBooksPharmaceuticalsMarginal Cost ofprovision is zero$PMMCDMRQMDrugsQC
26 A factory's production process creates sludge that pours into a river 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.FactoryNets: $3250Filter: $4100Damage: $5000What outcome would you expect under the following conditions:Transactions costs low and factory is not liable for damage?Transactions costs low and factory is liable for damage?Transactions costs high and factory is liable for damage?
29 Health Care Reform Objectives: Expand insurance coverage Lower health care costsPrivate InsuranceSocial InsuranceRevenue Provisions
30 Information Asymmetry Moral Hazard (Hidden actions)Insurance marketsEmployer-Employee relationshipAdverse Selection (Hidden characteristics)Used car marketSolutions?Signaling: Informed party takes actionScreening: Uninformed party takes actionGovernment regulation?
31 Private Insurance Reforms Insurance rulesCommunity rating (age, area, family size, and tobacco use)Guaranteed issue (can’t deny for pre-existing condition)Prohibit lifetime limits on coverageDependent children on parent’s plan until age 26Establish health insurance exchangesIndividual Health Insurance MandateTax credit subsidies up to 400% poverty$695 fine (or 2.5% income) if you don’t buyEmployer Health Insurance Mandate$2000 fine per employee for firms N > 50Tax credit subsidies to small employersHigh cost plan excise tax (t = 40%)
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:Adverse selectionMoral hazardScreeningSignaling
34 Public Choice Theory Public Interest vs Self Interest Political Actors PoliticiansVotersSpecial Interest Groups
35 Median VoterD1D2D3VR3R2R1In a two-party race, candidates have incentive to move toward the middlePositioningCoalition building
36 Popular Vote Cast for US President YearWinner%LoserMargin1960Kennedy49.7Nixon49.50.21964Johnson61.1Goldwater38.522.6196843.4Humphrey42.70.7197260.7McGovern37.523.21976Carter50.1Ford48.02.11980Reagan50.741.09.7198458.5Mondale40.617.91988Bush I53.4Dukakis45.67.81992Clinton43.0Bush38.05.0199649.2Dole40.78.52000Bush II47.9Gore48.4-0.5200451.0Kerry3.02008Obama52.9McCain45.77.2
37 Public Choice Theory Public Interest vs Self Interest Political Actors PoliticiansMedian voter hypothesisVotersRational ignorance
40 Public Choice Theory Public Interest vs Self Interest Political Actors PoliticiansMedian voter hypothesisVotersRational ignoranceSpecial Interest GroupsRent seekingConcentrated benefits and dispersed costsLabor unionsIndustry groupsAARPDairy price supports: $900 millionBenefit to farmers: $900m/65,000 = $13,846Cost to taxpayers: $900m/142m = $6.34
41 Social Choice Mechanisms Condorcet’s ParadoxArrow’s Impossibility TheoremChandlerPhoebeMonicaFirst ChoiceCSIGleeTrue BloodSecond ChoiceThird ChoiceCSI v Glee: CSI winsGlee v True Blood: Glee winsCSI v True Blood: True Blood wins