1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 16 Market Failures and Government Intervention

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-2 In this chapter you will learn to 3. Explain why public goods are underprovided by private markets. 2. Define an externality and explain why they lead to allocative inefficiency. 1. Explain the “informal” defense of free markets. 4. Explain why free markets may not achieve some desirable social goals. 5. Describe the direct and indirect costs of government intervention, and some of the important causes of government failure.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-3 The operative choice is between which mix of markets and government intervention best suits people’s hopes and needs. When government’s monopoly of violence is secure and functions with restrictions against its arbitrary use, citizens can safely carry on their ordinary economic and social activities. Basic Functions of Government

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-4 Adam Smith (1723-1790) As the founder of British classical economics, Adam Smith, put it a long time ago: “The first duty of the sovereign [is] that of protecting the society from the violence and invasion of other independent societies…. The second duty of the sovereign [is] that of protecting, as far as possible, every member of society from the injustice of oppression of every other member of it.” Basic Functions of Government

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-5 The Case for Free Markets The formal case for free markets is based on the concept of allocative efficiency. The informal case is based on three central arguments: 1. Free markets coordinate actions automatically. 2. The pursuit of profits leads to innovation and rising material living standards. 3. Free markets decentralize economic power.

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-6 Automatic Coordination A decentralized market system adjusts quickly to changes. As market conditions change, prices in a market economy also change — decision makers can react continually. A market system coordinates without anyone needing to understand how the whole system works.

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-7 Firms in free markets innovate because they get to keep the rewards. Similar motives give individuals an incentive to invest in human capital. Decentralization of Power Market systems have less centralized power than planned economies. Innovation and Growth Free Markets

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-8 Market Failures Market failure: a situation in which the free market fails to achieve allocative efficiency. Market Power Firms with market power will typically reduce output below competitive levels and lead to allocative inefficiency. This is the motivation for competition policy (Chapter 12).

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-9 Externalities Externality: when actions taken by firms or consumers impose costs or confer benefits on third parties. Individual agents care about private costs. But what matters for allocative efficiency is social cost. Even if all markets were perfectly competitive, externalities would lead to allocative inefficiency.

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-10 With a negative externality, a free market produces too much of the product. Quantity Price D = MB S=MC p MC S 1 pCpC p1p1 MC S 2 p2p2 Q1Q1 QCQC Q2Q2 External cost of a negative externality External benefit of a positive externality With a positive externality, a free market produces too little of the product. Allocative Inefficiency

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-11 Nonrivalrous and Nonexcludable Goods A product is rivalrous if one person’s consumption of it means that no one else can also consume it. A product is excludable if people can be prevented from consuming it. There are four different types of goods: - private goods - public goods - common-property resources - excludable but nonrivalrous goods

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-12 Table 16.1 Four Types of Products

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-13 Figure 16.1 An Externality Leads to Allocative Inefficiency

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-14 The existence of public goods and common-property resources raises the free-rider problem. The private market will generally not produce efficient amounts of public goods because it is impractical and often impossible to make users pay. Public goods must therefore be provided by government. APPLYING ECONOMIC CONCEPTS 16.1 The World’s Endangered Fish Free-Rider Problem

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-15 Figure 16.2 The Optimal Provision of a Public Good How much of a public good should the government provide? The MB curve for society is the vertical sum of the individual MB curves. Therefore, provide the quantity where MC = MB.

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-16 Asymmetric Information Parties involved in a transaction may have asymmetric information, leading to market failure. Moral hazard exists when one party to a transaction has both the incentive and the ability to shift costs on to the other party. - often arises with insurance contracts. Adverse selection refers to the tendency for people who are more at risk than average to purchase insurance, and for those who are less at risk to reject insurance.

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-17 APPLYING ECONOMIC CONCEPTS 16.2 Public Goods Experiments in the Laboratory and in the Classroom APPLYING ECONOMIC CONCEPTS 16.3 Used Cars and the Market for “Lemons” Asymmetric Information

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-18 Summary 1. Firms with market power 2. Externalities 3. Common-property resources and public goods 4. Asymmetric information Four basic causes of market failure:

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-19 Broader Social Goals Income Distribution Even with no market failures, government may choose to intervene for other reasons. The tax-and-transfer system redistributes income, as do many policies such as employment insurance and child benefits. Policies designed to redistribute income often reduce economic efficiency.

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-20 Preferences for Public Provision Some things, like justice and police services, are viewed by most people as being better provided by government than by the private sector. Individual freedom generally does not include having the freedom to harm others. Protecting Individuals from Others Broader Social Goals

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-21 Some government policies are designed to protect people from themselves. It is generally illegal to “buy” your way out of mandatory national service or to sell one’s right to vote. Paternalism Social Responsibility Broader Social Goals

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-22 Economic Growth Growth in productivity is crucial for increases in our material living standards. Governments now routinely ask how various policies will affect the economy’s growth rate. Free markets are unlikely to generate outcomes consistent with most people’s social goals, but … … there is often a tradeoff between achieving these social goals and achieving allocative efficiency. A General Principle Broader Social Goals

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-23 Government Intervention The Tools of Government Intervention Public provision Redistribution programs Regulation Governments use cost-benefit analysis to weigh the costs and benefits of specific policies.

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-24 The Costs of Government Intervention All government intervention involves resource costs. These costs must be weighed against the potential benefits of the intervention. The costs of government intervention are of two types: - direct costs - indirect costs

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-25 changes in costs of production costs of compliance of regulations “rent-seeking” behavior Some examples of indirect costs are: Indirect Costs

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-26 Government Failure Some government failure is an inescapable cost of democratic decision making. Public choice theory examines the incentives of individual decision makers and tries to explain political and economic outcomes. Government decision makers often face political constraints that lead them to act against the broad public interest.

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-27 Results: Albert and Bob will use democracy to appropriate resources from Charlene (through taxation) while reducing economic efficiency. Table 16.2 Net Benefits from Road Construction

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-28 How Much Should Government Intervene? To evaluate the costs and benefits of government intervention, we must compare two realistic alternatives: - the free market as it actually works - government intervention as it actually works EXTENSIONS IN THEORY 16.2 A Problem with Democracy