1. The Shortcomings of Free Markets

2. ●Externalities: Getting the Prices Wrong ●Provision of Public Goods ●Resource Allocation Between Present and Future ●Imperfections of Information ●The Cost Disease of the Service Sector ●Externalities: Getting the Prices Wrong ●Provision of Public Goods ●Resource Allocation Between Present and Future ●Imperfections of Information ●The Cost Disease of the Service Sector Contents Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

3. What Does the Market Do Poorly? ●We saw perfect competition leads to efficient allocation of resources ●We also saw that allocations may fail to be efficient if firms have market power ♦Recall the deadweight loss of monopoly ●There are other things that free markets are not perfect at implementing ●We saw perfect competition leads to efficient allocation of resources ●We also saw that allocations may fail to be efficient if firms have market power ♦Recall the deadweight loss of monopoly ●There are other things that free markets are not perfect at implementing

4. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●A classic example of market shortcoming is an externality - an impact on any party not involved in a given economic transaction ●Can be beneficial or detrimental ♦Beneficial externality – an incidental benefit of some economic activity ♦Detrimental externality – an incidental cost of an economic activity ●A classic example of market shortcoming is an externality - an impact on any party not involved in a given economic transaction ●Can be beneficial or detrimental ♦Beneficial externality – an incidental benefit of some economic activity ♦Detrimental externality – an incidental cost of an economic activity Externalities

5. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●There are many examples of externalities: ♦Negative examples include: ■Pollution (c.f. Guest Lecture on pollution) ■Traffic jams ■Second-hand smoking ♦ Positive ones include: ■Academic research ■Fitness ●There are many examples of externalities: ♦Negative examples include: ■Pollution (c.f. Guest Lecture on pollution) ■Traffic jams ■Second-hand smoking ♦ Positive ones include: ■Academic research ■Fitness Externalities: Examples

6. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●Detrimental externalities  marginal social cost > marginal private cost ♦Too much is produced ●Beneficial externalities  marginal social cost < marginal private cost ♦Too little output is produced ●Detrimental externalities  marginal social cost > marginal private cost ♦Too much is produced ●Beneficial externalities  marginal social cost < marginal private cost ♦Too little output is produced Externalities and Inefficiency

7. FIGURE 1: Equilibrium of a Firm with Detrimental Externality Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Marginal private cost Marginal revenue Marginal social cost BA 100 Marginal Cost and Revenue Thousands of Tons of Paper per Year 350

8. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Government Policy and Externalities ●Governments can promote efficiency by moving private costs closer to social costs ♦This is sometimes called “internalization of externality” ●They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities ●See Guest Lecture on pollution ●Governments can promote efficiency by moving private costs closer to social costs ♦This is sometimes called “internalization of externality” ●They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities ●See Guest Lecture on pollution

9. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Public Goods ●So far all the goods or services we considered were private ●A good or service is private when either: ♦It cannot be consumed by two people at once ♦Or easy to exclude others from consumption ●A cake or a concert are examples of private goods (or services) ●So far all the goods or services we considered were private ●A good or service is private when either: ♦It cannot be consumed by two people at once ♦Or easy to exclude others from consumption ●A cake or a concert are examples of private goods (or services)

10. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Public Goods ●In contrast, a good is public when: ♦it is not depleted by repeated use (non-rival) ♦people cannot be excluded from access to it ●A relevant example is snow-plowing ♦Once the snow is plowed, “consumption” of the plowed road by one driver hardly impairs the ability of others to “consume” the same plowed road ●In contrast, a good is public when: ♦it is not depleted by repeated use (non-rival) ♦people cannot be excluded from access to it ●A relevant example is snow-plowing ♦Once the snow is plowed, “consumption” of the plowed road by one driver hardly impairs the ability of others to “consume” the same plowed road

11. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●It is in general a bad idea to charge a price for access to public good: ♦It is hard to exclude people from consuming it ♦It may discourage some people from benefiting, which is inefficient ♦A so-called “collective action” problem arises – everyone must pay a lot, but enjoys only a part of the benefit, so doesn’t want to pay ●It is in general a bad idea to charge a price for access to public good: ♦It is hard to exclude people from consuming it ♦It may discourage some people from benefiting, which is inefficient ♦A so-called “collective action” problem arises – everyone must pay a lot, but enjoys only a part of the benefit, so doesn’t want to pay Provision of Public Goods

12. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●Conclusion: If public goods are to be produced, the government must do it ●It is actually the local government that provides most of the public goods ♦Like snow-plowing ●But some public goods are produced by the federal government ♦Like the U.S. army ●Conclusion: If public goods are to be produced, the government must do it ●It is actually the local government that provides most of the public goods ♦Like snow-plowing ●But some public goods are produced by the federal government ♦Like the U.S. army Provision of Public Goods

13. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Resource Allocation Between Present and Future ●Recall the model of consumer choice between two goods ●We can use it to model the choice between consumption and savings ●In this case, the relative price of consumption and savings will be the interest rate ●Recall the model of consumer choice between two goods ●We can use it to model the choice between consumption and savings ●In this case, the relative price of consumption and savings will be the interest rate

14. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Resource Allocation Between Present and Future ●Interest rate represents the opportunity cost of money. Consider an example: ♦You have $100 today, interest rate is 10% ♦Put it in a bank today – get $110 tomorrow ♦Or if you put $91 in a bank today, you get $100 tomorrow ♦So $100 today are worth the same as $91 yesterday or $110 tomorrow ●Interest rate represents the opportunity cost of money. Consider an example: ♦You have $100 today, interest rate is 10% ♦Put it in a bank today – get $110 tomorrow ♦Or if you put $91 in a bank today, you get $100 tomorrow ♦So $100 today are worth the same as $91 yesterday or $110 tomorrow

15. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Resource Allocation Between Present and Future ●In general, we can find an optimal rule for savings via our model ●But there are some issues about the model’s predictions and reality ●In general, we can find an optimal rule for savings via our model ●But there are some issues about the model’s predictions and reality

16. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Resource Allocation Between Present and Future ●How Does It Work in Practice? ♦Since interest rates are manipulated for many purposes, there is little reason to think that they represent a good evaluation of the future. ♦The market tends to devote too many resources to immediate consumption since today’s population may not be good judges of future needs. ●How Does It Work in Practice? ♦Since interest rates are manipulated for many purposes, there is little reason to think that they represent a good evaluation of the future. ♦The market tends to devote too many resources to immediate consumption since today’s population may not be good judges of future needs.

17. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Resource Allocation Between Present and Future ●How Does It Work in Practice? ♦The inherent risk of investment projects means that investment for the future may fall short of the socially optimal amount. ♦It may not be in society’s best interests to allow the market to make irreversible decisions about the future. ●How Does It Work in Practice? ♦The inherent risk of investment projects means that investment for the future may fall short of the socially optimal amount. ♦It may not be in society’s best interests to allow the market to make irreversible decisions about the future.

18. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●All our models assumed full availability of information to all parties ♦When you buy a used car, this is rarely the case ♦Usually the dealer knows much more about it ●When information is asymmetric, some mutually beneficial transactions may not occur ●All our models assumed full availability of information to all parties ♦When you buy a used car, this is rarely the case ♦Usually the dealer knows much more about it ●When information is asymmetric, some mutually beneficial transactions may not occur Asymmetric Information

19. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●A classic example is market for lemons and plums (i.e. bad and good used cars) ♦Suppose only these two types of cars are sold ♦Buyers cannot tell a lemon from a plum ♦If plums are more expensive, nobody will buy those due to the fear of buying a lemon for a high price ♦So no plums will be sold at all ●A classic example is market for lemons and plums (i.e. bad and good used cars) ♦Suppose only these two types of cars are sold ♦Buyers cannot tell a lemon from a plum ♦If plums are more expensive, nobody will buy those due to the fear of buying a lemon for a high price ♦So no plums will be sold at all Asymmetric Information

20. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●This problem occurs with almost all experience goods ♦A good that you have to use before you can determine its quality ●So sellers of high-quality goods try to disclose information about their quality: ♦Warranties ♦Money-back guarantees ●This problem occurs with almost all experience goods ♦A good that you have to use before you can determine its quality ●So sellers of high-quality goods try to disclose information about their quality: ♦Warranties ♦Money-back guarantees Asymmetric Information

21. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●Rent-seeking occurs when an individual, or firm seeks to make money by manipulating the economic and/or legal environment rather than by making a profit through trade and production of wealth ●Nowadays it usually refers to any sort of legal battles and misuse of government regulation ●Rent-seeking occurs when an individual, or firm seeks to make money by manipulating the economic and/or legal environment rather than by making a profit through trade and production of wealth ●Nowadays it usually refers to any sort of legal battles and misuse of government regulation Rent-seeking Behavior

22. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●A good example is modern Russia: ♦Due to high oil prices, it is very profitable to control an oil producing company ♦So there are many (semi)-legal battles among the Russian businessmen and top government officials for the rights of control of the major oil producing companies ♦Technically this is an inefficient waste of resources ●A good example is modern Russia: ♦Due to high oil prices, it is very profitable to control an oil producing company ♦So there are many (semi)-legal battles among the Russian businessmen and top government officials for the rights of control of the major oil producing companies ♦Technically this is an inefficient waste of resources Rent-seeking Behavior

23. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Moral Hazard ●Many people do not like risk ●So providing insurance for them is optimal ♦Suppose you are a beginner driver and decide to buy collision insurance ♦But now, knowing that you’re covered, you may start driving a bit more recklessly ♦This is a problem of moral hazard in action ●Many people do not like risk ●So providing insurance for them is optimal ♦Suppose you are a beginner driver and decide to buy collision insurance ♦But now, knowing that you’re covered, you may start driving a bit more recklessly ♦This is a problem of moral hazard in action

24. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Moral Hazard ●Problem of moral hazard is critical to insurance market ♦You buy insurance if you think you need it ♦So there is some self-selection going on (those who don’t need insurance do not buy it) ♦Hence an insurance company expects its clients to be more prone to accidents ♦As a result, companies charge higher prices ●Problem of moral hazard is critical to insurance market ♦You buy insurance if you think you need it ♦So there is some self-selection going on (those who don’t need insurance do not buy it) ♦Hence an insurance company expects its clients to be more prone to accidents ♦As a result, companies charge higher prices

25. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●Principals = owners or beneficiaries of an enterprise (i.e. a “boss”) ●Agents = hired by principals to run an enterprise (i.e. an “employee”) ●Many situations in economics are characterized by principal-agent type of relationships ●Principals = owners or beneficiaries of an enterprise (i.e. a “boss”) ●Agents = hired by principals to run an enterprise (i.e. an “employee”) ●Many situations in economics are characterized by principal-agent type of relationships Principal-Agent Problem

26. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●Agent is hired to work for the principal in order to earn profits for him ●But it can be that some actions of the agent will be more profitable for him than for the principal ●If the latter cannot perfectly monitor the actions of the agent, there is a problem ●Agent is hired to work for the principal in order to earn profits for him ●But it can be that some actions of the agent will be more profitable for him than for the principal ●If the latter cannot perfectly monitor the actions of the agent, there is a problem Principal-Agent Problem

27. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●Stock option = owners (principals) grant an individual (agent) the option to buy some of a company’s stock at a predetermined price ♦These stimulate agent to work so that company’s stock prices go up ♦But they also created incentives for the agents to illegally manipulate the stock prices ●Stock option = owners (principals) grant an individual (agent) the option to buy some of a company’s stock at a predetermined price ♦These stimulate agent to work so that company’s stock prices go up ♦But they also created incentives for the agents to illegally manipulate the stock prices Principals, Agents and Recent Stock Option Scandals

28. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Market Failure and Government Failure ●So the market has failures ●But it has many strengths as well ●And governments are also subject to failure ♦If the government can correct things, it does not mean that it actually would do that properly ●Sometimes market failures are best left alone ●In some cases best government action is to reinforce the best aspects of the market ♦And not to replace the market. ●So the market has failures ●But it has many strengths as well ●And governments are also subject to failure ♦If the government can correct things, it does not mean that it actually would do that properly ●Sometimes market failures are best left alone ●In some cases best government action is to reinforce the best aspects of the market ♦And not to replace the market.

29. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. ●The service sector includes such huge industries as education and health care ●Services can be public or private ●Costs for services have risen more rapidly than other costs ●Although not strictly a market failure, this often leads to government action that threatens general welfare ●The service sector includes such huge industries as education and health care ●Services can be public or private ●Costs for services have risen more rapidly than other costs ●Although not strictly a market failure, this often leads to government action that threatens general welfare The Cost Disease of the Service Sector

30. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. The Cost Disease of the Service Sector ●Why Are Some Personal Services Getting Worse but Costing More? ♦The “cost disease” of personal services stems from their labor-intensive nature ♦Competition forces wages in the service sector to grow as rapidly as wages in manufacturing ●Why Are Some Personal Services Getting Worse but Costing More? ♦The “cost disease” of personal services stems from their labor-intensive nature ♦Competition forces wages in the service sector to grow as rapidly as wages in manufacturing

31. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. The Cost Disease of the Service Sector ●Why Are Some Personal Services Getting Worse but Costing More? ♦Productivity grows more rapidly in manufacturing than services ♦If wage growth cannot be accommodated by productivity growth, prices must rise ●Why Are Some Personal Services Getting Worse but Costing More? ♦Productivity grows more rapidly in manufacturing than services ♦If wage growth cannot be accommodated by productivity growth, prices must rise

32. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. The Cost Disease of the Service Sector ●A Future of More Goods, but Fewer Services: Is It Inevitable? ♦As the society becomes richer, it becomes more difficult, not less, to provide services such as health care, teaching, and the performing arts ♦If we value services sufficiently, we can have more and better services – at some sacrifice in the growth rate of manufactured goods ●A Future of More Goods, but Fewer Services: Is It Inevitable? ♦As the society becomes richer, it becomes more difficult, not less, to provide services such as health care, teaching, and the performing arts ♦If we value services sufficiently, we can have more and better services – at some sacrifice in the growth rate of manufactured goods

33. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. The Cost Disease of the Service Sector ●Government May Make the Problem Worse ♦The market does give the appropriate price signals, but government is likely to misunderstand these signals and to make decisions that do not promote the public interest most effectively ♦This problem is not a market failure, but the way government attempts to deal with it may distort the market in inefficient ways ●Government May Make the Problem Worse ♦The market does give the appropriate price signals, but government is likely to misunderstand these signals and to make decisions that do not promote the public interest most effectively ♦This problem is not a market failure, but the way government attempts to deal with it may distort the market in inefficient ways

34. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. The Cost Disease of the Service Sector ●Government May Make the Problem Worse ♦In many cases, price controls are proposed for sectors of the economy affected by the cost disease ♦But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself ●Government May Make the Problem Worse ♦In many cases, price controls are proposed for sectors of the economy affected by the cost disease ♦But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself

35. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Epilogue: The Unforgiving Market ●The market system produces growth and prosperity as no other system has been able to do ●At the same time, it allocates its rewards in ways that many people believe to be unjust ●The market system produces growth and prosperity as no other system has been able to do ●At the same time, it allocates its rewards in ways that many people believe to be unjust

36. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. Epilogue: The Unforgiving Market ●While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works ●Sometimes the proposals of alleged friends of the free market are just as dangerous to its long-term health as are the attacks of its enemies ●While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works ●Sometimes the proposals of alleged friends of the free market are just as dangerous to its long-term health as are the attacks of its enemies

37. Copyright© 2006 South-Western/Thomson Publishing. All rights reserved. The End ???