The Government’s Role

What can the Government do for less cost? Economic Efficiency and the Role of Government or What can the Government do for less cost?

What does Efficiency mean? efficiency - the maximum value/benefit of output from the cost. 2 conditions necessary for ideal efficiency: All activities with more benefits than costs must be undertaken. No activities that provide benefits less than costs should be undertaken.

Efficiency Graphed Marginal (or Additional) Cost to Provide Marginal Benefit Provided to Society. Price Marginal Cost Q1 too little Q3 too much Q1 just right Marginal Benefit Quantity/time Q1 Q2 Q3

Functions of Government 1. Protection of individuals and their property against acts of aggression. Including prosecution of aggressors 2. Provision of goods difficult to supply through the market. Also a stable monetary and financial environment

and Shortcomings of the The Role of Government and Shortcomings of the Invisible Hand

4 Reasons the Invisible Hand May Fail to Allocate Resources Efficiently Lack of Competition Externalities Public Goods Poor Information

(1) Lack of Competition Sellers may restrict output and raise price. Too few units will be produced. Price S2(restricted supply) S1(competitive supply) P2 P1 D Quantity/time Q2 Q1

(2) Externalities (Spillovers) Externalities - the market fails to register fully costs and benefits. External costs: When the actions of an individual or group incur a cost to 3rd party. External benefits: Present when the actions of an individual or group generate benefits for 3rd parties.

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External Cost (Spillover) All of the costs of production are not fully registered, so the supply curve understates the true cost of production. (Shifts left) Price S2(including external costs) Ideal price and output S1 P2 Actual price and output Actual price and output P1 D Quantity/time Q2 Q1 Too many units are produced. Pollution problems are often a side effect.

External Benefit The demand curve understates the total value of the output. Price D2(including external benefits) S1 Ideal price and output P2 Actual price and output P1 D1 Quantity/time Q1 Q2 From the viewpoint of efficiency, too few units may be produced.

Why the Invisible Hand May Fail (3) Public Goods Public goods are: 1. jointly consumed – Individuals can simultaneously enjoy consumption of same product or service If a public good is made available to one, it is simultaneously made available to others.

Characteristics of a Public Good 2. non-excludable – Consumption of the good is not able to be restricted to the customers who pay for it Because those who do not pay can not be excluded, no one has much of an incentive to pay for such goods; each has an incentive to become a free rider. Free rider: – a person who receives the benefits of the good without helping to pay for its cost. When a lot of people become free riders, too little of the good is produced.

Examples of public goods: national defense radio and television broadcast signals clean air.

Question for Thought: Which of the following are public goods? (using the definition of a public good.) a. An anti-missile system surrounding Washington. a. An anti-missile system surrounding Washington. b. A fire department. c. Tennis courts. d. Shenandoah National Park. e. Elementary schools

(4) Poor Information A minimal problem if the item is purchased regularly. Problems can arise if goods are: difficult to evaluate on inspection and seldom repeatedly purchased from the same producer, or, potentially capable of serious and lasting harmful side effects that cannot be predicted by a lay person.

(4) Poor Information Market responses to poor information: Consumer information publications Provide expert evaluation and unbiased information Brand names and franchises Provide standardized quality and dependability Warranties Supplier promises to repair possible problems

The Opportunity Cost of Government Opportunity cost of resources used to produce goods supplied through the public sector. Cost of resources expended in the collection of taxes and the enforcement of government mandates. Excess burden (deadweight loss) of taxation.

Which of the following is the most fundamental function of government? protection of individuals and their property imposing progressive taxes to fund income-transfer programs regulating prices and wages provision of postal services and garbage collection 2. Economic efficiency requires that a. individuals produce at their maximum level. b. only long-lasting, high-quality products be produced without regard to cost. c. income be distributed equally among consumers. d. all economic activity generating more benefits than costs be undertaken

3. When production of a good generates external costs, the a. demand curve for the good will overstate the true social benefits from consumption of the good. b. demand curve for the good will understate the true social benefits from consumption of the good. c. supply curve for the good will overstate the true social cost of producing the good. d. supply curve for the good will understate the true social cost of producing the good. 4. From the viewpoint of economic efficiency, when competitive forces in an industry are weak, market allocation will often lead to a. an output of the product that exceeds the amount consistent with ideal economic efficiency. b. an output of the product that is less than the amount consistent with ideal economic efficiency. c. an output of the product that equals the amount consistent with ideal economic efficiency. d. product prices that are below the cost of production.

5. Competitive markets generally give consumers and producers correct incentives when a. externalities are present in the market. b. property rights are well-defined and enforced. c. the good being produced and consumed is a pure public good. d. there is a substantial lack of information on the part of either buyers or sellers. 6. Which of the following correctly describes the external benefit resulting from an individual’s purchase of a winter flu shot? The flu shot is cheaper than the cost of treatment when you get the flu. The income of doctors increases when you get the flu shot. The flu shot reduces the likelihood others will catch the flu. The flu shot reduces the likelihood you will miss work as the result of sickness; therefore, you will earn more income.

7. Which of the following is the best example of a public good? a. a government-run health care system b. the Walt Disney World amusement park c. national defense d. long-distance telephone service 8. Markets may have difficulty providing the proper quantity of a public good because individuals will tend to become free riders, and private firms will have difficulty generating enough revenue to produce an efficient quantity of the good. the good generally has a very large value to consumers relative to its cost of production. the good is one that tends to benefit a large number of people. the large profit involved in the production of a public good is generally too much for private firms to effectively pay out to shareholders.

c. consumer ratings magazines d. all of the above 9. Suppose paper pulp mills are permitted to emit harmful pollutants, free of charge, into the air. How will the price and output of paper in a competitive market compare with their values under conditions of ideal economic efficiency? a. The price will be too high, and the output will be too large. b. The price will be too low, and the output will be too large. c. The price will be too low, and the output will be too small. d. The price will be too high, and the output will be too small. 10. Which of the following is a source of information that helps consumers acquire information about the quality of a good or service? a. brand names b. franchising c. consumer ratings magazines d. all of the above