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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Market Failures Chapter 18.

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Presentation on theme: "McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Market Failures Chapter 18."— Presentation transcript:

1 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Market Failures Chapter 18

2 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve Q.How many economists does it take to screw in a light bulb? A.Eight. One to screw it in and seven to hold everything else constant.

3 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Economists use the invisible hand framework to determine whether the government should intervene in the market. l Invisible hand framework – perfectly competitive markets lead individuals to make voluntary choices that are in societys interest.

4 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Failures n Market failure – the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes.

5 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Failures n When a market failure exists, government intervention into markets to improve the outcome is justified. n Government failure occurs when government intervention does not improve the situation.

6 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities n Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. n Externalities can be either positive or negative.

7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities n Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others.

8 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities n Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others.

9 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Negative Externality Example n When there is a negative externality, marginal social cost is greater than marginal private cost. l A steel plant benefits the owner of the plant and the buyers of steel. l The plants neighbors are made worse off by the pollution caused by the plant.

10 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Negative Externality Example n Marginal social cost includes all the marginal costs borne by society. l It is the marginal private costs of production plus the cost of the negative externalities associated with that production.

11 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Negative Externality Example n When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare.

12 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Negative Externality D = Marginal social benefit S = Marginal private cost S 1 = Marginal social cost Cost Quantity0 Q0Q0 P0P0 Q1Q1 P1P1 Marginal cost from externality

13 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Positive Externality Example n Private trades can benefit third parties not involved in the trade. l A person who is working and taking night classes benefits himself directly, and his co- workers indirectly.

14 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Positive Externality Example n Marginal social benefit equals the marginal private benefit of consuming a good plus the positive externalities resulting from consuming that good.

15 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Positive Externality Cost Quantity0 Marginal benefit of an externality D 0 = Marginal private benefit D 1 = Marginal social benefit Q0Q0 P0P0 Q1Q1 P1P1 S = Marginal private and social cost

16 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Alternative Methods of Dealing with Externalities n Externalities can be dealt with via: l Direct regulation. l Incentive policies. l Voluntary solutions.

17 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Direct Regulation n Direct regulation –the amount of a good people are allowed to use is directly limited by the government.

18 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Direct Regulation n Direct regulation is inefficient, not efficient. l Inefficient – achieving a goal in a more costly manner than necessary. l Efficient achieving a goal at the lowest cost in total resources without consideration as to who pays those costs.

19 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Incentive Policies n Incentive policies are more efficient than direct regulatory policies. n The two types of incentive policies are either taxes or market incentives.

20 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tax Incentive Policies n A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends. n The tax often yields the desired end more efficiently than straight regulation.

21 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tax Incentive Policies n This solution embodies a measure of fairness about it – the person who conserves the most pays the least tax.

22 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tax Incentive Policies n A way to handle pollution is through a tax called an effluent fee. n Effluent fees – charges imposed by government on the level of pollution created.

23 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation Through Taxation Marginal social benefit Marginal private cost Marginal social cost Cost Quantity0 Q0Q0 P0P0 Q1Q1 P1P1 Efficient tax

24 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Incentive Policies n Market incentive program – market participants certify they have reduced total consumption – their own and/or others – by a specified amount.

25 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Incentive Policies n A market incentive program is similar to the regulatory solution. n The amount of the good consumed is reduced.

26 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Incentive Policies n A market incentive program differs from a regulatory solution. n Individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others.

27 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Voluntary Reductions n Voluntary reductions allow individuals to choose whether to follow what is socially optimal or what is privately optimal. n Economists are dubious of voluntary solutions.

28 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Voluntary Reductions n A persons willingness to do things for the good of society generally depends on the belief that others will also be helping.

29 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Voluntary Reductions n The socially conscious will often lose their social conscience when they believe a large number of other people are not contributing. l This is example of a free rider problem – individuals unwillingness to share in the cost of a public good.

30 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Optimal Policy n An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.

31 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Optimal Policy n Resources are being wasted if a policy isnt optimal. l What is saved by reducing the program is worth more than what is lost from the reducing the program.

32 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Optimal Policy n Some environmentalists want to totally eliminate pollution. n Economists want to reduce pollution to the point where marginal costs of reducing pollution equals the marginal benefits.

33 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Optimal Policy n Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.

34 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods n A public good is nonexclusive and nonrival. l Nonexclusive – no one can be excluded from its benefits. l Nonrival – consumption by one does not preclude consumption by others.

35 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods n There are no pure examples of a public good. l The closest example is national defense. n Technology can change the public nature of goods. l Roads are an example.

36 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods n Once a pure public good is supplied to one individual, it is simultaneously supplied to all. n A private good is only supplied to the individual who bought it.

37 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods n With public goods, the focus is on groups. n With private goods, the focus is on the individual.

38 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods n In the case of a public good, the social benefit of a public good is the sum of the individual benefits.

39 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public Goods n Adding demand curves vertically is easy to do in textbooks, but not in practice. n This is because individuals do not buy public goods directly so that their demand is not revealed in their actions.

40 The Market Value of a Public Good 0.50 Price 123Quantity.80.60.40.20 1.00 Market demand DBDB DADA 0.10 0.40 0.10 0.60 0.50 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

41 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Informational Problems n Perfectly competitive markets assume perfect information. n Real-world markets often involve deception, cheating, and inaccurate information.

42 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Informational Problems n When there is a lack of information, buyers and sellers do not have equal information, markets may not work properly.

43 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Informational Problems n Economists call such market failures adverse selection problems. n Adverse selection problems – problems that occur when a buyer or a seller have different amounts of information about the good for sale.

44 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Policies to Deal with Informational Problems n Regulate the market and see that individuals provide the correct information. n Government licenses individuals in the market and requires them to provide full information about the good being sold.

45 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Market in Information n Information is valuable, and is an economic product in its own right. n Left on their own, markets will develop to provide information that people need and are willing to pay for it.

46 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Market in Information n If the government regulates information, then markets for information will not develop.

47 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Licensing of Doctors n Currently all doctors practicing medicine are required to be licensed. n Licensing of doctors is justified by informational problems.

48 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Licensing of Doctors n Some economists argue that licensure laws were established to restrict supply, not to help the consumer. l Instead of licensing doctors, the government could give the public information about which treatments work and which do not.

49 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Licensing of Doctors n Providing information rather than licensing would give rise to consumer sovereignty. l Consumer sovereignty – the right of the individual to make choices about what is consumed and produced.

50 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. An Informational Alternative to Licensure n In this scenario, the government would require doctors to post their: l Grades in college. l Grades in medical school. l Success rate for various procedures. l References. l Medical philosophy. l Charges and fees.

51 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. An Informational Alternative to Licensure n This information alternative would provide much more useful information to the public than the present licensing procedure.

52 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Failures and Market Failures n Market failures should not automatically call for government intervention. n Why? Because governments fail too.

53 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Failures and Market Failures n Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse.

54 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Government Failures n Governments do not have an incentive to correct the problem. n Governments do not have the information to deal with the problem. n Intervention in the markets is almost always more complicated than it initially looks.

55 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Government Failures n The bureaucratic nature of government intervention does not allow fine tuning. n Government intervention leads to more government intervention.

56 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Market Failures End of Chapter 18

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