Unit VI: Market Failures

What is the Invisible Hand? What is the Free Market? A economic structure where supply and demand allocate resources. There is little to no government intervention. What is the Invisible Hand? The concept that society’s goals will be met as individuals seek their own self-interest. Competition and self-interest act as an invisible hand that regulates the free market. Example: People love the green shirts that a firm is making…..

What is a Free Market Failure? When the free-market system fails to satisfy society’s wants. Private markets do not efficiently bring about the allocation of resources. What’s the result… The government must step in to satisfy society’s wants.

Four Market Failures Public Goods 2. Externalities 3. Monopolies 4. Unfair distribution of income In each of the above situations, the government MUST step in to fix the problem.

Market Failure #1: PUBLIC GOODS

PUBLIC GOODS Why must the public sector provide goods and services? It is impractical for the free-market to provided these goods because there is no opportunity to earn profit. This is due to the Free-Rider Problem Free Riders are individuals that benefit without paying.

What’s wrong with Free Riders? Free-Riders keep firms from making profits. If left to the free market, essential services would be under produced.

PUBLIC GOODS 1. Nonexclusion 2. Shared Consumption (nonrivalry) Two criteria of public goods: 1. Nonexclusion Everyone can use the good. Cannot exclude benefits of the good for those who will not pay. Ex: National Defense 2. Shared Consumption (nonrivalry) One person’s consumption of a good does not reduce the usefulness to others. Ex: Kit Carson Park

HOW MUCH PUBLIC GOODS?

They use Supply and Demand Can there every be too much of a public good? Can there be too many parks? How does the government determine what quantity of public goods to produce? They use Supply and Demand Demand for Public Goods- The Marginal Social Benefit of the good determined by citizens willingness to pay. Supply of Public Goods- The Marginal Social Cost of providing each additional quantity.

DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 $4 + $5 = $9

DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 $4 3 + $5 4 = $9 7

DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 3 $4 3 2 + $5 4 3 = $9 7 5

DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 3 4 $4 3 2 1 + $5 4 3 2 = $9 7 5 3

DEMAND FOR A NEW HIGHWAY Marginal Willingness to Pay Higher Taxes Adams’ Willingness to pay (price) Benson’s Willingness to pay (price) Society’s Willingness to pay (price) Quantity 1 2 3 4 5 $4 3 2 1 + $5 4 3 2 1 = $9 7 5 3 1

$ 9 7 5 3 1 0 1 2 3 4 5 OPTIMAL AMOUNT OF A PUBLIC GOOD Price The Demand is the equal to the marginal benefit to society D=MSB 0 1 2 3 4 5 Quantity of Highways

OPTIMAL AMOUNT OF A PUBLIC GOOD S=MSC $ 9 7 5 3 1 The public good’s marginal cost D=MSB Q 0 1 2 3 4 5

$ 9 7 5 3 1 MSB = MSC 0 1 2 3 4 5 OPTIMAL AMOUNT OF A PUBLIC GOOD P S=MSC $ 9 7 5 3 1 Why shouldn’t 2 highways be made? The optimum amount of the public good MSB = MSC Why shouldn’t 4 highways be made? D=MSB Q 0 1 2 3 4 5

Market Failure #2: EXTERNALITIES

What are Externalities? Why are Externalities Market Failures? An externality is a third-person side effect. Externalities are when there are either EXTERNAL benefits or external costs to someone other than the original decision maker. Why are Externalities Market Failures? The free market fails to include external costs or external benefits causing misallocation of resources. Example: Smoking Cigarettes. The free market assumes that the cost of smoking is fully paid by people who smoke. The government recognizes external costs and makes policies to limit smoking.

Negative Externalities

Negative Externalities (aka: Spillover Costs) Decisions that result in a cost for a different person other than the original decision maker. The costs “spillover” to other people or society. EX: Zoram is a chemical company that pollutes the air when it produces its good. Zoram only looks at its INTERNAL costs. The firms ignores the social cost of pollution So, the firm’s marginal cost curve is its supply curve When you factor in EXTERNAL costs, Zoram is producing too much of its product. The government recognizes this and limits their production.

The marginal cost doesn’t include the costs to society. P Supply = Marginal Private Cost D=MSB Q Qe

What will the MC look like when EXTERNAL cost are factor in? P Spillover costs Supply = Marginal Private Cost D=MSB Q Qe

This is the REAL supply curve Supply = Marginal Social Cost P Supply = Private Cost D=MSB Q Qe

Compare MSB and MSC at Qe Is too much or too little being produced? S=MSC S= Private D=MSB Overallocation Q QOptimal Qe

Positive Externalities

Positive Externalities (aka: Spillover Benefits) Decisions that result in a benefit for someone other than the original decision maker. The benefits “spillover” to other people or society. (EX: Flu Vaccines, Education, Home Renovation) Example: A mom decides to get a flu vaccine for her child Mom only looks at the INTERNAL benefits. She ignores the social benefits of a healthier society. So, her private marginal benefit is her demand When you factor in EXTERNAL benefits the marginal benefit and demand would be greater. The government recognizes this and subsidizes flu shots.

The marginal benefit doesn’t include the benefits to society. P S=MC Demand=Marginal Private Benefit Q Qe

What will the demand look like when EXTERNAL benefits are factor in? P S=MC Spillover Benefits Demand=Marginal Private Benefit Q Qe

This is the REAL demand curve P S=MC Demand=Marginal Social Benefit Demand=Marginal Private Benefit Q Qe

Compare MSB and MSC at Qe Is too much or too little being produced? S=MC D=MSB D=MPB Underallocation Qe QOptimal

CORRECTING EXTERNALITIES

CORRECTING SPILLOVER COSTS (Solution: Tax the amount of the externality) S=MSC P Spillover costs S Private TAX Overallocation Corrected D Q Q0 Qe

CORRECTING SPILLOVER BENFITS (Subsidize either producers or consumers the amount of the externality) P S Spillover Benefits D=MSB D Private Underallocation Corrected Q Qe QOptimal

The Economics of Pollution

Economics of Pollution Why are public bathrooms so gross? The Tragedy of the Commons (AKA: The Common Pool Problem) Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted since no one has the incentive to keep them clean. There is no monetary incentive to use them efficiently. Result is high spillover costs.

Market Failure #3: Monopolies

Government in Action: Antitrust Laws

WHAT ARE ANTITRUST LAWS? Why are monopolies a Market Failure? Laws designed to prevent monopolies and promote competition. Why are monopolies a Market Failure? Monopolies destroy the key ingredient of the free market system- Competition. To fix this MARKET FAILURE the government must get involved. Identify the socially optimal and fair return points.

Market Failure #4 Unfair Distribution of Income

How does the government measure distribution of income? Income Inequality In 2001, the average American family made $66,863. Everyone is obviously rich. What’s wrong with using the average? Averages reveal absolutely nothing about how income is distributed. How does the government measure distribution of income?

The LAST graph to learn for Microeconomics THE LORENZ CURVE The LAST graph to learn for Microeconomics

Measuring Income Distribution Review the process: The government divides all income earning families into five equal groups (quintiles) from poorest to richest. Each groups represents 20% of the population. If there was perfect equality then 20% of the families should earn 20% of the income, 40% should earn 40% (and so on) The government compares how far the actual distribution is from perfect distribution then attempts to redistribute money fairly.

THE LORENZ CURVE Perfect Equality Percent of Income 100 80 60 40 20 Perfect Equality Percent of Income 20 40 60 80 100 Percent of Families

THE LORENZ CURVE Lorenz Curve (actual distribution) Perfect Equality 100 80 60 55 40 30 20 15 5 Lorenz Curve (actual distribution) Perfect Equality Percent of Income 20 40 60 80 100 Percent of Families

THE LORENZ CURVE Lorenz Curve (actual distribution) Perfect Equality 100 80 60 40 20 Lorenz Curve (actual distribution) Perfect Equality Percent of Income Area between the lines shows the degree of income inequality 20 40 60 80 100 Percent of Families

We have a Market Failure. Income is extremely unfairly distributed. THE LORENZ CURVE 100 80 60 40 20 Lorenz Curve (actual distribution) We have a Market Failure. Income is extremely unfairly distributed. How does this get fixed? Perfect Equality Percent of Income 20 40 60 80 100 Percent of Families

after government re-distribution THE LORENZ CURVE 100 80 60 40 20 Lorenz Curve (actual distribution) Perfect Equality Percent of Income Lorenz curve after government re-distribution 20 40 60 80 100 Percent of Families

Taxes

What kind of taxes are these? (THINK % of Income) Three Types of Taxes 1. Progressive Taxes -takes a larger percent of income as income rises (takes more from rich people) Ex: Current Federal Income Tax system 2. Proportional Taxes (flat rate) –takes the same percent of income from all income groups. Ex: 20% flat income tax on all income groups 3. Regressive Taxes –takes a larger percentage from low income groups. (takes more from poor people) Ex: Sales tax; any consumption tax. What kind of taxes are these? (THINK % of Income) Toll road tax ($1 per day) State income tax where richer citizens pay higher % $.45 excise tax on cigarettes Medicare tax of 1.45% of every dollar earned 6% California sales tax

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