Government Goals & Policy Government Intervention: 1) Market Failure 2) When the market fails to perform in line with the goals that we have for performance then there is a role for government policy Eg) equitable distribution of income when markets fail to achieve social goals for equity, government policy is called for; eg, government redistribution programs 6

Measuring Economic Inequality Poverty: is a situation where a family’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. is a relative concept. In Canada, poverty is measured by using a low-income cutoff. low-income cutoff is the income level at which a family spends 54.7 percent of its income on food, shelter, and clothing.

The Sources of Economic Inequality The combination of higher demand and lower supply for high-skilled workers relative to low-skilled workers creates a higher equilibrium wage rate for those workers who have attained greater levels of human capital.

Income Redistribution In Canada, governments use three main ways to redistribute income to reduce the degree of economic inequality: Income taxes Income maintenance programs Social security programs Employment Insurance program Welfare programs Subsidized services. education Fight the caricature of capitalism as unfair/heartless Emphasize that there are no societies where income or wealth is equally distributed. There are two concerns: prosperity and equality. Private enterprise (capitalist) societies are, in general, more prosperous, and are in most cases (but not all) no less equal than socialist societies. Ask which is better for a family, to be the poorest in a rich but unequal society or equal with everyone else in a poor society. We vote for redistribution. Emphasize that we vote for policies that redistribute and we get the redistribution that the majority wants. To get more redistribution, we would need to change the rules about votes and give those who want more redistribution a bigger voice. That idea raises deep and serious questions.

Income Redistribution: Leads to “The Big Tradeoff” between equity and efficiency Income redistribution can be inefficient for three reasons: The process of redistribution uses resources Taxes create deadweight loss Taxes weaken the incentive to work, save, and invest The Big Tradeoff Emphasize that there is an opportunity cost to redistributing income in any society—when a dollar is taken from a rich person, a poor person receives less than a dollar. The size of the economic pie shrinks because: • Productive resources are used to implement the program rather than produce goods and services, • Redistribution requires taxations, which imposes a dead weight loss to society, and • The incentives facing the recipient of supplemental income are altered, delaying re-entry into the work force.

Government Goals & Policy Ensure an equitable distribution of income when markets fail to achieve social goals for equity, government policy is called for; eg, government redistribution programs Ensure the legal framework Provide a legal system Define property rights Establish legal rules of behaviour Ensure economy wide stability & growth Macro economic policy 6

Economic Functions of Government Ensure efficiency Markets sometimes fail to achieve “efficiency” in the use and allocation of society’s resources  Government policy action when….. Markets Fail: 1.) Imperfect Competition Market failure occurs if markets are not competitive  regulation of monopoly  anti-combines legislation 7

Market Failure: 2.) Public Goods Market failure occurs when markets fail to provide Public Goods Private Goods: can be consumed by only one individual at a time: are both rival and excludable Public goods: can be consumed simultaneously by everyone, that is, no one can be excluded once the good is produced, & no one’s consumption reduces the amount available for another.

Market Failure: Public Goods 1) Nonrival Consumption by one person does not decrease consumption by another. Television show 2) Nonexcludable It is impossible, or extremely costly, to prevent someone from benefiting from the good once it is produced. National defence

Market Failure: Public Goods Since people enjoy the benefits without paying, markets fail to produce public goods  government provision e.g.fireworks non excludable  free riders a free rider is a person who receives the benefit of a good but avoids 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?

Public Goods The marginal benefit of a public good to an individual is the increase in total benefit that results from a one-unit increase in the quantity provided. The marginal benefit of a public good diminishes with the level of the good provided. Everyone can consume each unit of a public good, which means the marginal benefit for the economy is the sum of marginal benefits of each person at each quantity.

Benefits of a Public Good Lisa's Marginal Benefit Figure shows how the marginal benefits of a public good are summed at each quantity of the good provided. Part (a) shows Lisa’s marginal benefit. Part (b) shows Max’s marginal benefit. 10 MBL Marginal benefit$ 8 6 4 1 2 3 4 5 Quantity (number of fireworks displays) Marginal benefit$ Max's Marginal Benefit 8 MBM 6 4 1 2 3 4 5 Quantity (number of fireworks displays) 22

Benefits of a Public Good Economy's Marginal Benefit The economy’s marginal benefit of a public good is the sum over the individuals at each quantity of the good provided. The economy’s marginal benefit curve for a public good is the vertical sum of each individual’s marginal benefit curve. 18  MB 14 Marginal benefit $ 10 1 2 3 4 5 Quantity (number of fireworks displays) 26

Market Failure: Public Goods Efficient Provision Government should provide the efficient quantity of a public good: up to the point where : MB = MC, ie. MSB=MSC At the efficient quantity, the marginal social benefit for the community is equal to the marginal social cost for the community.

The Efficient Quantity of a Public Good The marginal benefit curve, MB, is the one we derived = MSB. The marginal cost curve, MC, is just like the MC curve for a private good. The efficient quantity is where marginal benefit equals marginal cost. Marginal Benefit & Marginal Cost MC=MSC  MB=MSB Marginal benefit Efficient use of resources MB 1 Quantity (number of fireworks displays 38

Market Failure: 3.) Externaility Market failure occurs when all the relevant costs and benefits are not registered by the market Externality: Cost or Benefit resulting from some activity or transaction that is imposed on parties outside the activity or transaction; that is not registered by the market

Externalities: Positive and Negative Market transactions reflect individual consumer and firm marginal private benefits and marginal private costs respectively. Efficiency requires: the marginal social benefit and the marginal social cost be equalized. If MPC¹MSC &/or MPB¹MSB, then markets will fail to achieve efficiency

Market Failure: External Benefits With external benefits: 1) More shots are given at a higher price 2) Demand shifts to D2 D2 S D1 D1 P2 Q2 E1 P1 Q1 E Without external benefits registered: 1) Too few influenza shots are given 2) Demand = D1 Price of Flu Shots Quantity of Flu Shots per Year Too little is produced, price too low when external benefits are not accounted for in the market 4

Market Failure: External Costs MSC MPC MSB A Q2 P2 E1 Internalize external cost: 1) Steel mill pays the the cost of pollution 2) Supply shifts to S2 Price of Steel per Tonne P1 E Q1 Private costs only 1) Residents incur cost of pollution 2) Supply = S1 Quantity of Steel per Year Too much produced, price too low when external costs are not accounted for in the market: third parties bear part of the costs 3

Negative Externalities: Pollution Pollution is an old problem and is faced by both rich industrial countries and poor developing countries. It is an economic problem that is coped with by balancing benefits and costs, using policies that internalize the external costs of production.

Negative Externalities: Pollution Public Policy For Externalities in the case of Pollution  1.)Regulation (command and control) 2.)Taxes (negative externalities) 3) Subsidies (positive externalities) Tax equal to the marginal external costs. In equilibrium then P = MSC. The company with the lowest cost of reducing pollution, will choose to reduce, to avoid the tax

Public Policy: Tax = External Cost S2 SMC (including externalities) Supply of Good X when costs = social cost S1 = SMC (excluding externalities) D P1 Q1 Tax=External Cost of Pollution Q2 P2 Price of Good X per Unit Supply of Good X when costs include only internal costs Quantity of Good X per Time Period In the case of a negative externality, the efficient amount of production is achieved through a tax=external costs

External Costs: Public Policy: Tax Taxes provide incentives for producers or consumers to cut back on an activity that creates external costs. Taxing an externality does not eliminate all pollution. Taxes force decision makers to consider the full costs of their decisions: internalize the externality.

External Costs: Public Policy: Tax Taxes, have two advantages over regulation because of their incentive effects: they give owners an economic incentive to reduce pollution – avoid the tax, they bring about a given amount of pollution reduction in the most efficient – least costly – way possible.

Public Policy: 3.) Emission Charges MSC 15 MB At an emission level of 15MTonnes MSC($15) > MB($7) Cost and benefit of waste (dollars per tonne) 10 Efficient price $10 per tonne at efficient qn of 10M Tonnes/yr 7 5 10 15 20 Emissions (millions of tonnes per year)

External Costs: Public Policy: Marketable Permits 4)Tradable Pollution Rights Trading pollution rights in essence creates a new scarce resource - pollution permits. The price will be set by the forces of demand and supply. The firms that can reduce pollution only at high cost will be willing to pay the most for pollution permits, others will reduce pollution for less cost. P r i c e of o l t n $ Supply Pollution Permits D Pollution Permits Qn (pollution)

Optimal Amount of Pollution MSC 15 MSB Society’s MSC & MSB of Pollution Abatement Optimal (social) amount of pollution 10 Efficient Price 7 20 40 60 80 Amount of pollution abatement %