1. Market Failure

2. Justification for government intervention?
Market Failure
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
“Spillover effects”
A.C. Pigou
( )
Ronald Coase
(1910)

4. All pollution should be eliminated.
Strongly Agree
Agree
Neutral
Disagree
Strongly Disagree

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

6. Pollution How can society achieve social optimum? Free Market: P1, Q1
Ssocial $
Sprivate
Free Market: P1, Q1
Optimal Outcome: P2, Q2 P2 P1
External cost
Free market overproduces goods
that generate a negative externality D1 Q2 Q1
steel
How can society achieve social optimum?
 Impose tax = marginal external cost
“Pigou tax”
Internalize the externality!

7. Sorry, Charlie
Ssocial
Sprivate D

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

9. Education How can society achieve social optimum? Free Market: P1, Q1$ S1
Free Market: P1, Q1
Optimal Outcome: P2, Q2 P2
External benefit P1
Free market underproduces goods
that generate a positive externality
Dsocial
Dprivate Q1 Q2
Years of
College
How 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 benefits
external benefits will be greater than the social benefits
social benefits will be equal to the private benefits
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.
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 Approach
Externalities are due to incomplete assignment of property rights
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.

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 S D “$200,000 Solution” $ F U C $20
Abatement Cost
P = $10
Q = 60,000 U
$10 C $5 D 40 60 70 90
permits
“$200,000 Solution”

17. Acid Rain Market: SO2 2010 Spot Auction 2010 7-yr Advance Auction
Source:

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

19. Government Provided Goods and Services
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

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

21. Public Goods “free-rider” problem Social Optimum requires: MSB = MSC
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 10 $8 $5 $9 $22 $10 $12 20 $7 $4 $19 $41 $20 $21
Quantity
Gretchen’s MB
Cort’s MB
Yanan’s
ΣMB MC
Total Benefit
Total Cost
Net Benefits 10 $8 $5 $9
$22
$10
$12 20 $7 $4
$19
$41
$20
$21 30 $6 $3
$15
$56
$30
$26 40 $2
$11
$67
$40
$27 50 $1
$74
$50
$24 60 $0
$78
$60
$18

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?
Katie
Youtian
Marginal benefit
(dollars per sub)
Quantity --
100 1
150 75 2 50 3 25 4 10 5 1 2 3 4 5

24. Common Resources “Tragedy of the commons” Non-excludable
Rival in consumption
African Elephant
1980: 1.3m
1990: 0.6m
Fish in the sea
Bison in America
“Tragedy of the commons”
CITES
Campfire
"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 $ PM MC D MR QM
Drugs QC

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.
Factory
Nets: $3250
Filter: $4100
Damage: $5000
What 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?

27. Health Care Reform

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

30. Information Asymmetry
Moral Hazard (Hidden actions)
Insurance markets
Employer-Employee relationship
Adverse Selection (Hidden characteristics)
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 (can’t deny for pre-existing condition)
Prohibit lifetime limits on coverage
Dependent children on parent’s 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 don’t 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: http://www.cms.hhs.gov/NationalHealthExpendData/

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 selection
Moral hazard
Screening
Signaling

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

35. Median Voter D1 D2 D3 V R3 R2 R1
In a two-party race, candidates have incentive to move toward the middle
Positioning
Coalition building

36. Popular Vote Cast for US President
Year
Winner %
Loser
Margin
1960
Kennedy
49.7
Nixon
49.5
0.2
1964
Johnson
61.1
Goldwater
38.5
22.6
1968
43.4
Humphrey
42.7
0.7
1972
60.7
McGovern
37.5
23.2
1976
Carter
50.1
Ford
48.0
2.1
1980
Reagan
50.7
41.0
9.7
1984
58.5
Mondale
40.6
17.9
1988
Bush I
53.4
Dukakis
45.6
7.8
1992
Clinton
43.0
Bush
38.0
5.0
1996
49.2
Dole
40.7
8.5
2000
Bush II
47.9
Gore
48.4
-0.5
2004
51.0
Kerry
3.0
2008
Obama
52.9
McCain
45.7
7.2

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

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
Condorcet’s Paradox
Arrow’s Impossibility Theorem
Chandler
Phoebe
Monica
First Choice
CSI
Glee
True Blood
Second Choice
Third Choice
CSI v Glee: CSI wins
Glee v True Blood: Glee wins
CSI v True Blood: True Blood wins