Slide 17-1 Copyright © 2000 Pearson Education Canada Inc. Lecture 13: Market Failure and Government Action Readings: Chapters 13 ( pp.313-315 ), 16, 17.

2 Copyright © 2000 Pearson Education Canada Inc. Markets can fail to be efficient: Markets can fail to be efficient: Insufficient Competition Insufficient Competition Externalities Externalities Public goods Public goods And Markets can be unfair: And Markets can be unfair: Inequality Inequality Poverty Poverty Market Failures

3 Copyright © 2000 Pearson Education Canada Inc. Q: How do governments intervene in markets which have insufficient competition? Q: How do governments intervene in markets which have insufficient competition? A: The main policy instruments are: A: The main policy instruments are: Regulation Regulation Public ownership Public ownership Anti-combine law Anti-combine law Insufficient Competition

4 Copyright © 2000 Pearson Education Canada Inc. Q: How does government supply regulation? Q: How does government supply regulation? A: Regulatory agencies vary in size and scope. But there are certain features common to all agencies. A: Regulatory agencies vary in size and scope. But there are certain features common to all agencies. Government appoints the senior bureaucrats who are the key decision makers. Government appoints the senior bureaucrats who are the key decision makers. Each agency adopts a set of practices or operating rules for controlling prices, product standards, and other aspects of economic performance. Each agency adopts a set of practices or operating rules for controlling prices, product standards, and other aspects of economic performance. Agency certifies firms to serve a particular market. Agency certifies firms to serve a particular market. Insufficient Competition

5 Copyright © 2000 Pearson Education Canada Inc. Q: What determines government provision of regulation? Q: What determines government provision of regulation? A: It is a product of the political process, and hence will reflect a political equilibrium. A: It is a product of the political process, and hence will reflect a political equilibrium. In recent years, the equilibrium has shifted towards de-regulation (a reduction in the provision of regulation) In recent years, the equilibrium has shifted towards de-regulation (a reduction in the provision of regulation) Insufficient Competition

6 Copyright © 2000 Pearson Education Canada Inc. Q: Why has there been a move towards de-regulation? Q: Why has there been a move towards de-regulation? A: There has been growing evidence that regulation to protect the public frequently only succeeds in protecting the regulated firms from competition. A: There has been growing evidence that regulation to protect the public frequently only succeeds in protecting the regulated firms from competition. Insufficient Competition Capture theory says that regulations are supplied to satisfy the demand of producers to maximize economic profit.

7 Copyright © 2000 Pearson Education Canada Inc. Q: Why have regulation at all? Q: Why have regulation at all? A: If a firm has diminishing average costs, it will be a natural monopoly. With no competition, there will be severe under-supply and prices will be dramatically higher than marginal costs. A: If a firm has diminishing average costs, it will be a natural monopoly. With no competition, there will be severe under-supply and prices will be dramatically higher than marginal costs. Regulation is one way of forcing output up and prices down. Regulation is one way of forcing output up and prices down. Insufficient Competition

8 Copyright © 2000 Pearson Education Canada Inc. Economicprofit Deadweightloss Consumersurplus Natural Monopoly: Profit Maximization Quantity (millions of households) 15 30 024610 D Price and cost (dollars per household per month) 25 20 10 8 ATC 18 MR MC

9 Copyright © 2000 Pearson Education Canada Inc. Totalsurplus Natural Monopoly: Marginal Cost Pricing Quantity (millions of households) 15 30 024610 D Price and cost (dollars per household per month) 25 20 10 8 ATC Loss per household MC

10 Copyright © 2000 Pearson Education Canada Inc. Natural Monopoly: Average Cost Pricing Producersurplus Consumersurplus Quantity (millions of households) 15 30 024610 D Price and cost (dollars per household per month) 25 20 10 8 Deadweightloss ATC MC

11 Copyright © 2000 Pearson Education Canada Inc. Q: Does price regulation reduce the excess burden from natural monopoly? Q: Does price regulation reduce the excess burden from natural monopoly? A: Capture theory predicts that the producer will get the regulator to set rules that allow it to charge the same price and produce the same output as an unregulated monopoly. Firms can do this by exaggerating their costs. A: Capture theory predicts that the producer will get the regulator to set rules that allow it to charge the same price and produce the same output as an unregulated monopoly. Firms can do this by exaggerating their costs. Insufficient Competition

12 Copyright © 2000 Pearson Education Canada Inc. ATC (inflated ) Natural Monopoly: Inflating Costs Quantity (millions of households) 15 30 024610 D Price and cost (dollars per household per month) 25 20 10 8MC Economicprofit MR 18 Profit is maximized ATC

13 Copyright © 2000 Pearson Education Canada Inc. Q: Is regulatory capture a real problem? Q: Is regulatory capture a real problem? A: A test of whether natural monopoly regulation is in the public interest or producer interest by measuring rates of return in regulated monopolies. A: A test of whether natural monopoly regulation is in the public interest or producer interest by measuring rates of return in regulated monopolies. Many natural monopolies in Canada earn higher rates of return than the economy average. (i.e. cable television service; telephone service) Many natural monopolies in Canada earn higher rates of return than the economy average. (i.e. cable television service; telephone service) Insufficient Competition

14 Copyright © 2000 Pearson Education Canada Inc. Q: What is the alternative to regulation? Q: What is the alternative to regulation? A: Formation of crown corporations: A: Formation of crown corporations: Canada Post, Ontario Hydro, etc. Canada Post, Ontario Hydro, etc. Q: Are crown corporations efficient? Q: Are crown corporations efficient? A: With a public subsidy, a crown corporation can supply the market at marginal cost and achieve the efficient output level. A: With a public subsidy, a crown corporation can supply the market at marginal cost and achieve the efficient output level. Insufficient Competition

15 Copyright © 2000 Pearson Education Canada Inc. Crown Corporation: Efficient Outcome 0 24 6 8 10 2 6 8 10 4 Consumer surplus Tax payment DMC ATC Subsidy per tonne: efficient output 8 2 Quantity (billions of tonnes per year) Price and cost (dollars per tonne)

16 Copyright © 2000 Pearson Education Canada Inc. Q: Have Crown Corporations served the public interest? Q: Have Crown Corporations served the public interest? A: Over time, a different sort of capture may set in. Managers will tend inflate costs, and make themselves the residual claimants. A: Over time, a different sort of capture may set in. Managers will tend inflate costs, and make themselves the residual claimants. Insufficient Competition

17 Copyright © 2000 Pearson Education Canada Inc. Crown Corporation: Budget Maximization 0 24 6 8 10 2 6 8 10 4 DMC ATC Subsidy per tonne: efficient output but maximizing budget 82 ATC (inflated) Quantity (billions of tonnes per year) Price and cost (dollars per tonne)

18 Copyright © 2000 Pearson Education Canada Inc. Q: Are crown corporations inefficient? Q: Are crown corporations inefficient? A: Case study: A: Case study: CN had costs 14% higher than CP. CN had costs 14% higher than CP. Ontario Hydro routinely pays its workers wages above the market rate. Ontario Hydro routinely pays its workers wages above the market rate. In recent years, there has been a move to privatize publicly owned corporations. In recent years, there has been a move to privatize publicly owned corporations. Petro-Canada (1991), Ontario Hydro (2002) Petro-Canada (1991), Ontario Hydro (2002) Insufficient Competition

19 Copyright © 2000 Pearson Education Canada Inc. Q: What are externalities? Q: What are externalities? A: Externalities are costs or benefits that arise from economic transactions that fall on people who do not participate in the transaction. When externalities exist, the parties to the transaction consider only their own costs and benefits, and not those social costs accruing to third parties. A: Externalities are costs or benefits that arise from economic transactions that fall on people who do not participate in the transaction. When externalities exist, the parties to the transaction consider only their own costs and benefits, and not those social costs accruing to third parties.Externalities

20 Copyright © 2000 Pearson Education Canada Inc. There are two types of Externalities: A negative externality occurs whenever a person’s well being or a firm’s production capability is directly harmed by the actions of other consumers or firms. A negative externality occurs whenever a person’s well being or a firm’s production capability is directly harmed by the actions of other consumers or firms. A positive externality occurs whenever a person’s well being or a firm’s production capability is directly improved by the actions of other consumers or firms. A positive externality occurs whenever a person’s well being or a firm’s production capability is directly improved by the actions of other consumers or firms.Externalities

21 Copyright © 2000 Pearson Education Canada Inc. Q: How do negative externalities affect social outcomes? Q: How do negative externalities affect social outcomes? A: Negative externalities include: A: Negative externalities include: Acid Rain Acid Rain Ozone layer Depletion Ozone layer Depletion Smog alerts Smog alerts Global Warming Global Warming Bacterial ground water contamination (Walkerton) Bacterial ground water contamination (Walkerton) heavy metal and persistent toxic chemical contamination of land and ground-water, etc. heavy metal and persistent toxic chemical contamination of land and ground-water, etc.Externalities

22 Copyright © 2000 Pearson Education Canada Inc. Q: Has economic growth doomed the environment? Q: Has economic growth doomed the environment? A: It has put tremendous pressure on it, but at the same time higher incomes has lead to the increased demands for a clean environment. A: It has put tremendous pressure on it, but at the same time higher incomes has lead to the increased demands for a clean environment.Externalities

24 Copyright © 2000 Pearson Education Canada Inc. Q: Why do negative externalities occur? Q: Why do negative externalities occur? A: An absence of property rights. A: An absence of property rights.Externalities Property rights are social arrangements that govern the ownership, use, and disposal of productive resources and goods and services.

25 Copyright © 2000 Pearson Education Canada Inc. Q: How does an absence of property rights create environmental problems? Q: How does an absence of property rights create environmental problems? A: Because no one owns the air, the rivers, and the oceans, they are available for free use with no restriction. Users consider only their private interest in deciding how to use the productive resource. A: Because no one owns the air, the rivers, and the oceans, they are available for free use with no restriction. Users consider only their private interest in deciding how to use the productive resource.Externalities

26 Copyright © 2000 Pearson Education Canada Inc. Externality Impact Quantity of waste (tonnes per week) 50 100 150 200 0246 8 Cost and benefit of waste (dollars per tonne) MB …when factory maximizes its benefit by dumping waste MSC Fishing club bears large cost...

27 Copyright © 2000 Pearson Education Canada Inc. Q: What can the government do to correct market failures? Q: What can the government do to correct market failures? A: The government has two options: A: The government has two options: 1. It can assert sole ownership over the commons resource and limit use: 1. It can assert sole ownership over the commons resource and limit use: 1.1) pollution controls and standards 1.1) pollution controls and standards 1.2) emission charges and taxes 1.2) emission charges and taxes 2. It can distribute private property rights: 2. It can distribute private property rights: 2.1) Common law rights 2.1) Common law rights 2.2) Marketable emission permits 2.2) Marketable emission permitsExternalities

28 Copyright © 2000 Pearson Education Canada Inc. Q: Do standards work? Q: Do standards work? A: Economists have been concerned that standards have largely failed to be implemented effectively. Political equilibrium is susceptible to special interest group manipulation. A: Economists have been concerned that standards have largely failed to be implemented effectively. Political equilibrium is susceptible to special interest group manipulation. Even when they have been implemented, they are not usually the most efficient method for reducing pollution. Even when they have been implemented, they are not usually the most efficient method for reducing pollution.Externalities

29 Copyright © 2000 Pearson Education Canada Inc. Q: What’s the problem with standards? Q: What’s the problem with standards? A: Suppose the government decides that pollution should be reduced by 25% and orders all firms to reduce their pollution from current levels by 25%. Some firms may find this extremely expensive and close. Others could reduce their pollution by 75% at very little cost but are only required to reduce pollution by 25%. A: Suppose the government decides that pollution should be reduced by 25% and orders all firms to reduce their pollution from current levels by 25%. Some firms may find this extremely expensive and close. Others could reduce their pollution by 75% at very little cost but are only required to reduce pollution by 25%.Externalities

30 Copyright © 2000 Pearson Education Canada Inc. Q: Can government policy force firms to distribute the burden of reduction in the most efficient manner possible? Q: Can government policy force firms to distribute the burden of reduction in the most efficient manner possible? A: Emission charges: The government regulator sets a charge per unit of pollution. The efficient emission charge is set so that the marginal social cost of pollution is equal to its marginal social benefit. A: Emission charges: The government regulator sets a charge per unit of pollution. The efficient emission charge is set so that the marginal social cost of pollution is equal to its marginal social benefit.Externalities

31 Copyright © 2000 Pearson Education Canada Inc. Externalities: Emission Charges 7 10 15 05101520 MB MSC Emissions (millions of tonnes per year) Cost and benefit of waste (dollars per tonne) Efficient price per tonne At $7/tonne, MSC > MB

32 Copyright © 2000 Pearson Education Canada Inc. Q: What if emission charges cannot be assessed (ie noise pollution). Q: What if emission charges cannot be assessed (ie noise pollution). A: The government could introduce a Pigouvian Tax which discourages the activity that has the negative externality associated with it. A: The government could introduce a Pigouvian Tax which discourages the activity that has the negative externality associated with it. Q: What is the correct Pigouvian tax? Q: What is the correct Pigouvian tax? A: If the tax is set equal to the external marginal cost, then efficient outcome will be achieved. A: If the tax is set equal to the external marginal cost, then efficient outcome will be achieved.Externalities

33 Copyright © 2000 Pearson Education Canada Inc. S = PMC Competitive markets oversupply if there is pollution Quantity (kilometres) Cost, price, and benefit (dollars per kilometre) 0 D = MB MSC = PMC + EMC P1P1P1P1 C1C1C1C1 Q1Q1Q1Q1 Q0Q0Q0Q0 P0P0P0P0 SC 0 Competitiveequilibrium Point of allocativeefficiency EMC

34 Copyright © 2000 Pearson Education Canada Inc. S = MC External Cost at Competitive Equilibrium Quantity (kilometres) Cost, price, and benefit (dollars per kilometre) 0 D = MB MSC P1P1P1P1 C1C1C1C1 Q1Q1Q1Q1 Q0Q0Q0Q0 P0P0P0P0 SC 0 Competitiveequilibrium Externalcost

35 Copyright © 2000 Pearson Education Canada Inc. S = MC Pigouvian Tax Quantity (kilometres) Cost, price, and benefit (dollars per kilometre) 0 D = MB MSC P1P1P1P1 C1C1C1C1 Q1Q1Q1Q1 Q0Q0Q0Q0 SC 0 S + T Point of allocativeefficiency

36 Copyright © 2000 Pearson Education Canada Inc. Q: What are the problems with government asserting ownership over the commons? Q: What are the problems with government asserting ownership over the commons? A: There are several: A: There are several: Political equilibrium may not be efficient. Political equilibrium may not be efficient. Business will resist the huge transfer to government implied by the government solution. (ie carbon tax resistance) Business will resist the huge transfer to government implied by the government solution. (ie carbon tax resistance)Externalities

37 Copyright © 2000 Pearson Education Canada Inc. Q: What are the private property solutions to pollution? Q: What are the private property solutions to pollution? A: The government can clarify and extend common law rights, or it can establish and distribute marketable emission permits. A: The government can clarify and extend common law rights, or it can establish and distribute marketable emission permits.Externalities

38 Copyright © 2000 Pearson Education Canada Inc. Q: How does extending common law property rights solve the externality problem? Q: How does extending common law property rights solve the externality problem? A: Many problems occur because when no one owns a resource, everyone thinks they own it. Extending property rights would clarify who owns the resource. The owner could then set about limiting use of the resource. A: Many problems occur because when no one owns a resource, everyone thinks they own it. Extending property rights would clarify who owns the resource. The owner could then set about limiting use of the resource.Externalities

39 Copyright © 2000 Pearson Education Canada Inc. Q: If common law property rights are extended, does it matter who gets them? Q: If common law property rights are extended, does it matter who gets them? A: According to the Coase theorem : A: According to the Coase theorem : 1. If transaction costs are low, the (common law) assignment of property rights will solve the externality. 1. If transaction costs are low, the (common law) assignment of property rights will solve the externality. 2. It will not matter who receives the property right. 2. It will not matter who receives the property right.Externalities

40 Copyright © 2000 Pearson Education Canada Inc. Q: How does this work: Q: How does this work: A: It will depend on who receives the property right: A: It will depend on who receives the property right: If the polluted party is given control of the environment, they can force the polluter to reduce pollution. If the polluted party is given control of the environment, they can force the polluter to reduce pollution. If the polluter is given control of the environment, the polluted party may choose to pay the polluter to reduce pollution. If the polluter is given control of the environment, the polluted party may choose to pay the polluter to reduce pollution.Externalities

41 Copyright © 2000 Pearson Education Canada Inc.MSC The Coase Theorem Quantity of waste (tonnes per week) 50 100 150 200 0 2 4 6 8 MB Efficient level of waste Cost and benefit of waste (dollars per tonne)

42 Copyright © 2000 Pearson Education Canada Inc. Q: Can we rely on Coasian bargains to resolve all negative externalities? Q: Can we rely on Coasian bargains to resolve all negative externalities? A: No! Transaction costs are frequently high because: A: No! Transaction costs are frequently high because: 1) There are many affected parties 1) There are many affected parties 2) people bargain strategically, and fail to agree on a price. 2) people bargain strategically, and fail to agree on a price.Externalities

43 Copyright © 2000 Pearson Education Canada Inc. Q: How does a system of marketable emission permits work? Q: How does a system of marketable emission permits work? A: A maximum allowable amount of pollution is determined. Permits which sum to this total are distributed to current polluters. A: A maximum allowable amount of pollution is determined. Permits which sum to this total are distributed to current polluters. A firm is permitted to only pollute up to the amount of the permits held. A firm is permitted to only pollute up to the amount of the permits held. A firm can either buy or sell its permits. A firm can either buy or sell its permits.Externalities

44 Copyright © 2000 Pearson Education Canada Inc. Q: Why is this system efficient? Q: Why is this system efficient? A: It will be expected that firms that can easily abate pollution will choose to sell their permits to firms that find it expensive to abate. The result is that the least cost method distribution of abatement will automatically be found. A: It will be expected that firms that can easily abate pollution will choose to sell their permits to firms that find it expensive to abate. The result is that the least cost method distribution of abatement will automatically be found.Externalities

45 Copyright © 2000 Pearson Education Canada Inc. Q: What sorts of positive externalities are there? Q: What sorts of positive externalities are there? A: There are many, among which include: A: There are many, among which include: Landscaping Landscaping Inoculations Inoculations Education EducationExternalities

46 Copyright © 2000 Pearson Education Canada Inc. Q: In what way does education have a positive externality associated with it? Q: In what way does education have a positive externality associated with it? A: External benefits: A: External benefits: Citizens who can better communicate and interact Citizens who can better communicate and interact Good ideas/inventions can be copied Good ideas/inventions can be copiedExternalities

47 Copyright © 2000 Pearson Education Canada Inc. Q: Does this create a market failure? Q: Does this create a market failure? A: Education and research and development decisions are made by comparing private marginal costs and private marginal benefits. When decision-makers neglect external benefits there will be underinvestment in education and R&D without government intervention. A: Education and research and development decisions are made by comparing private marginal costs and private marginal benefits. When decision-makers neglect external benefits there will be underinvestment in education and R&D without government intervention.Externalities

48 Copyright © 2000 Pearson Education Canada Inc. Q: How does the government solve this market failure? Q: How does the government solve this market failure? A: The government has three main policy instruments to correct the market failure: A: The government has three main policy instruments to correct the market failure: Subsidies Subsidies Below-cost provision Below-cost provision Patents and copyrights Patents and copyrightsExternalities

49 Copyright © 2000 Pearson Education Canada Inc. A subsidy is a payment made by the government to producers that depends on the level of output. Providing a subsidy to producers reduces their private marginal cost. If a subsidy is provided equal to the external benefit, an efficient outcome will be achieved. Externalities

50 Copyright © 2000 Pearson Education Canada Inc. MSB D = MPB The Efficient Quantity of Education Quantity (thousands of students per year) Cost, price, and benefit (thousands of dollars per student per year) 5 10 15 20 01020304050 25MC Competitiveequilibrium Efficient allocation Externalbenefit

51 Copyright © 2000 Pearson Education Canada Inc. Instead of offering subsidies to private schools, the government can provide its own schools that provide schooling below cost. It may still charge tuition equal to the marginal private benefit of education. It can also establish its own research facilities. In education, direct provision is larger; in R&D, subsidies are main tool. Externalities

52 Copyright © 2000 Pearson Education Canada Inc. Q: Is there a private property solution? Q: Is there a private property solution? A: Since knowledge is productive and creates external benefits, it is necessary to use public policies to ensure that there are incentives to develop new ideas. Intellectual property rights provide the creators of knowledge with property rights to their discoveries. A: Since knowledge is productive and creates external benefits, it is necessary to use public policies to ensure that there are incentives to develop new ideas. Intellectual property rights provide the creators of knowledge with property rights to their discoveries.Externalities

53 Copyright © 2000 Pearson Education Canada Inc. Patents or copyrights are government-sanctioned exclusive rights granted to the inventor or a good, service, or productive process. Obtaining a patent allows the developer of the new idea to prevent others from benefiting from the invention for a number of years. To obtain the patent, the inventor must make knowledge of the invention public. Externalities

54 Copyright © 2000 Pearson Education Canada Inc. The economic cost of patent protection is the deadweight loss of monopoly. But without patents, the effort to develop new goods, services, or process is diminished, and the flow of new inventions would slow. Patent protection trades off the benefits of more invention against costs of monopoly over a limited time. Externalities

55 Copyright © 2000 Pearson Education Canada Inc. Q: What are public goods? Q: What are public goods? A: Public goods are goods or services that are consumed simultaneously by everyone and from which no one can be excluded. A: Public goods are goods or services that are consumed simultaneously by everyone and from which no one can be excluded. Public Goods

56 Copyright © 2000 Pearson Education Canada Inc. Public Goods 1) Nonrivalry The consumption by one person does not decrease the consumption by another. Television show Television show 2) Nonexcludable It is impossible, or extremely costly, to prevent someone from benefiting from a good. National defence National defence

57 Copyright © 2000 Pearson Education Canada Inc. Public Goods and Private Goods Fish in the ocean Air Nonexcludable & rival FoodCarHouse Pure private goods Excludable & nonrival Cable television BridgeHighway Pure public goods Lighthouse National defence

58 Copyright © 2000 Pearson Education Canada Inc. Public Goods and The Free-Rider Problem A free rider is a person who consumes a good without paying for it. Public goods create a free- rider problem because the quantity of the good that a person is able to consume is not influenced by the amount the person pays for the good...so why pay anything at all?

59 Copyright © 2000 Pearson Education Canada Inc. Q: What is the social value of another unit of a public good ? Q: What is the social value of another unit of a public good ? A: As everyone will jointly consume this additional unit of the public good, its total social value (its social marginal benefit) is the sum of every persons maximum willingness to pay. A: As everyone will jointly consume this additional unit of the public good, its total social value (its social marginal benefit) is the sum of every persons maximum willingness to pay. Social Marginal Benefit = sum of each individual’s marginal willingness to pay. Social Marginal Benefit = sum of each individual’s marginal willingness to pay. The social marginal benefit at each provision level can be derived by vertically summing each individual’s demand for the public good. The social marginal benefit at each provision level can be derived by vertically summing each individual’s demand for the public good. Public Goods

60 Copyright © 2000 Pearson Education Canada Inc. Benefits of a Public Good Quantity (number of acid-rain checks) Marginal benefit (dollars per acid-rain check) Quantity (number of acid-rain checks) Marginal benefit (dollars per acid-rain check) 0 12 34 20 40 60 80 Lisa's Marginal Benefit 0 1234 20 40 60 80 MB L MB M Max's Marginal Benefit 5 5

61 Copyright © 2000 Pearson Education Canada Inc. 20 40 60 80 100 120 Quantity (number of acid-rain checks) Marginal benefit (dollars per acid-rain check) Benefits of a Public Good 012345 140 Economy's Marginal Benefit MB

62 Copyright © 2000 Pearson Education Canada Inc. Contrast this with a private good. Only one person gets to consume a private good, so the social marginal benefit of one unit of the private good is the marginal benefit (maximum willingness to pay) of the person who gets to consume the good. Contrast this with a private good. Only one person gets to consume a private good, so the social marginal benefit of one unit of the private good is the marginal benefit (maximum willingness to pay) of the person who gets to consume the good. By a little bit of thought you will be able to see that the social marginal benefit curve for a private good is the horizontal summation of the individual demand curves (maximum willingness to pay curves). By a little bit of thought you will be able to see that the social marginal benefit curve for a private good is the horizontal summation of the individual demand curves (maximum willingness to pay curves). Public Goods

63 Copyright © 2000 Pearson Education Canada Inc. Q: What is the efficient provision level of the public good? Q: What is the efficient provision level of the public good? A: The most efficient provision level is where the social surplus is maximized. This occurs where the social marginal benefit (SMB) equals the marginal cost. A rational strategy for finding the efficient provision level is to: A: The most efficient provision level is where the social surplus is maximized. This occurs where the social marginal benefit (SMB) equals the marginal cost. A rational strategy for finding the efficient provision level is to: increase provision if SMB > MC increase provision if SMB > MC reduce provision if SMB < MC reduce provision if SMB < MC hold provision constant if SMB = MC hold provision constant if SMB = MC Public Goods

64 Copyright © 2000 Pearson Education Canada Inc.MCMB Quantity (number of acid-rain checks) Total benefit and total cost (billions of dollars) Quantity (number of acid-rain checks) Marginal benefit (billions of dollars per acid-rain check) 0 1234 1.5 3.5 5.0 7.5 01234 1.0 2.0 55 The Efficient Provision of a Public Good M Efficient use of resources Total Benefit & Total Cost Marginal Benefit & Marginal Cost TCTB Net benefit $2.0 billion

65 Copyright © 2000 Pearson Education Canada Inc. Q: Is private market provision efficient? Q: Is private market provision efficient? A: No! Because of the free rider problem, too little of the public good is provided. A: No! Because of the free rider problem, too little of the public good is provided. A private firm will not deliver the efficient quantity of a public good. It needs to charge consumers a price that will cover its costs…but once it is produced, no one has an incentive to buy. A private firm will not deliver the efficient quantity of a public good. It needs to charge consumers a price that will cover its costs…but once it is produced, no one has an incentive to buy. Example: Lighthouse signal Example: Lighthouse signal Public Goods

66 Copyright © 2000 Pearson Education Canada Inc. Q: Is government provision efficient? Q: Is government provision efficient? A: To answer this we have to examine what the political equilibrium delivers. A: To answer this we have to examine what the political equilibrium delivers. Political parties do a “what if” analysis before determining their policy regarding the provision of public goods. Political parties do a “what if” analysis before determining their policy regarding the provision of public goods. They choose the platform that maximizes their chance of being elected: this means they must maximize the perceived net benefit of a winning coalition of voters. They choose the platform that maximizes their chance of being elected: this means they must maximize the perceived net benefit of a winning coalition of voters. Public Goods

67 Copyright © 2000 Pearson Education Canada Inc. Public Provision Q: How does political competition between parties influence the platforms on offer? A: Competition for votes tends to move parties to the center. It is in the center that the median voter is found, and hence it is in the center that winning coalitions can be constructed. The implication is that all parties tend to advocate similar provision levels in equilibrium. The principle of minimum differentiation is the tendency for competitors to make themselves identical to appeal to the maximum number of clients or voters.

68 Copyright © 2000 Pearson Education Canada Inc. Q: Will the winning platform be efficient? Q: Will the winning platform be efficient? A: The winning platform on public good provision will tend to appeal to the median voter’s preferences. Notice that this equilibrium is unrelated to the calculation of the efficient provision level. We therefore cannot expect that the democratic process will deliver an efficient amount of the public good. A: The winning platform on public good provision will tend to appeal to the median voter’s preferences. Notice that this equilibrium is unrelated to the calculation of the efficient provision level. We therefore cannot expect that the democratic process will deliver an efficient amount of the public good. Public Goods

69 Copyright © 2000 Pearson Education Canada Inc. Q: Is there anything that might complicate the political equilibrium? Q: Is there anything that might complicate the political equilibrium? A: Politics is the art of the possible. Politicians rely heavily on the advice of bureaucrats as to what is possible, and the costs of these possibilities. A: Politics is the art of the possible. Politicians rely heavily on the advice of bureaucrats as to what is possible, and the costs of these possibilities. A bureaucrat’s interests are different from the interests of vote maximizing politicians. A bureaucrat’s interests are different from the interests of vote maximizing politicians. Public Goods

70 Copyright © 2000 Pearson Education Canada Inc. Q: How do bureaucratic interests alter the political equilibrium? Q: How do bureaucratic interests alter the political equilibrium? A: There are a number of theories. The simplest suggests that many bureaucrats may seek to maximize the size of their bureau so as to increase their pay and prestige. Such a bureaucrat will thus seek methods to influence the political equilibrium in a way that increases the size of the budget that they control. A: There are a number of theories. The simplest suggests that many bureaucrats may seek to maximize the size of their bureau so as to increase their pay and prestige. Such a bureaucrat will thus seek methods to influence the political equilibrium in a way that increases the size of the budget that they control. Public Goods

71 Copyright © 2000 Pearson Education Canada Inc. TC Bureaucratic Overprovision Quantity (number of acid-rain checks) Total benefit and total cost (billions of dollars) 0 1234 1.5 3.5 5.0 7.5 5 TB Efficientprovision Goal of bureaucracy

72 Copyright © 2000 Pearson Education Canada Inc. Q: How do bureaucrats influence the political equilibrium? Q: How do bureaucrats influence the political equilibrium? A: Bureaucrats controls information about the costs and benefits of proposed public goods. If they exaggerate the benefits or underestimate the costs of a public good, they might be able to get a politician to adopt and implement a platform that promotes a larger provision level than is efficient. A: Bureaucrats controls information about the costs and benefits of proposed public goods. If they exaggerate the benefits or underestimate the costs of a public good, they might be able to get a politician to adopt and implement a platform that promotes a larger provision level than is efficient. Example: Missile Defense Example: Missile Defense Public Goods

74 Copyright © 2000 Pearson Education Canada Inc. Q: Are bureaucrats the only group who wish to manipulate the political equilibrium? Q: Are bureaucrats the only group who wish to manipulate the political equilibrium? A: No special interests who have a private stake in public good provision are very active in attempting to manipulate political outcomes. A: No special interests who have a private stake in public good provision are very active in attempting to manipulate political outcomes. Public Goods

75 Copyright © 2000 Pearson Education Canada Inc. Q: How do special interest groups manipulate the political equilibrium? Q: How do special interest groups manipulate the political equilibrium? A: By manipulating information. Politicians and voters are uninformed about the costs and benefits of public goods, and interest groups will use advertising and political contributions to influence platforms. A: By manipulating information. Politicians and voters are uninformed about the costs and benefits of public goods, and interest groups will use advertising and political contributions to influence platforms. Example: Softwood lumber dispute. Example: Softwood lumber dispute. Public Goods

76 Copyright © 2000 Pearson Education Canada Inc. Q: Why might democracy be easily manipulated by special interests? Q: Why might democracy be easily manipulated by special interests? A: Rational ignorance. A: Rational ignorance. Rational ignorance is the decision not to acquire information because the cost of doing so exceeds the expected benefit. Public Goods

77 Copyright © 2000 Pearson Education Canada Inc. Q: What are the most expensive public goods provided by government in wealthy countries? Q: What are the most expensive public goods provided by government in wealthy countries? Concern for poor families and poor children has led to desire for the community to do something to help alleviate suffering. Concern for poor families and poor children has led to desire for the community to do something to help alleviate suffering. One response is to create social norms that laud charitable giving. This is found in virtually all religions of the world. One response is to create social norms that laud charitable giving. This is found in virtually all religions of the world. A modern response is to get the State to provide a social safety net of welfare services. A modern response is to get the State to provide a social safety net of welfare services. This is a public good, because the benefit (relief that something is being done to help the poor) is shared communally, but the cost is subject to free riding. This is a public good, because the benefit (relief that something is being done to help the poor) is shared communally, but the cost is subject to free riding. Public provision financed by taxation solves under-supply problem. Public provision financed by taxation solves under-supply problem. Public Goods

Slide 17-1 Copyright © 2000 Pearson Education Canada Inc. Lecture 13: Market Failure and Government Action Readings: Chapters 13 ( pp.313-315 ), 16, 17.

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Slide 17-1 Copyright © 2000 Pearson Education Canada Inc. Lecture 13: Market Failure and Government Action Readings: Chapters 13 ( pp.313-315 ), 16, 17.

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Presentation on theme: "Slide 17-1 Copyright © 2000 Pearson Education Canada Inc. Lecture 13: Market Failure and Government Action Readings: Chapters 13 ( pp.313-315 ), 16, 17."— Presentation transcript:

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