Market Failure

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?

Externalities Occur when decision makers do not consider all costs (or benefits) of their actions Two views “Spillover effects” A.C. Pigou (1877-1959) Ronald Coase (1910)

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

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

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!

Sorry, Charlie Ssocial Sprivate D

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

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

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

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.

Coasian Approach “It takes two to tango” Externalities are due to incomplete property rights assignment “It takes two to tango”

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.

Cheshire, Ohio v. AEP AEP paid $20 million to buy the 221-resident town in 2002

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

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”

Acid Rain Market: SO2 2010 Spot Auction 2010 7-yr Advance Auction Source: http://www.epa.gov/airmarkt/progress/ARP_1.html

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

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

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!

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

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

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

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."

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

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?

Health Care Reform

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

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?

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%)

Source: http://www.cms.hhs.gov/NationalHealthExpendData/

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

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

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

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

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

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

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