Chapter 15: Externalities, Public Goods and Social Choice

Market failure Occurs when resources are misallocated or allocated inefficiently. In addition to the market failures (imperfect markets: monopoly, oligopoly, and monopolistic competition) discussed earlier, externalities, public or social costs, and imperfect information will be discussed next.

Market failure (cont.) Governments increase efficiency by promoting competition, limiting externalities like pollution, and providing public goods. Governments promote equity by using tax and expenditure programs to redistribute income toward particular groups. Government foster macroeconomic stability and growth – reducing unemployment and inflation while encouraging economic growth – through fiscal policy (i.e. taxing and spending) and monetary regulation (i.e. interest rates and credit conditions).

Externalities and Environmental Economics Externality A cost or benefit imposed or bestowed on an individual or a group that is outside, or external to, the transaction. Externalities are sometimes called spillovers or neighbourhood effects. Inefficient decisions result when decision makers fail to consider social costs and benefits. Examples include air, water, land, sight and sound pollution (including acid rain); traffic congestion; automobile accidents; abandoned housing; nuclear accidents; and second-hand smoke.

Externalities and Environmental Economics (cont.) Marginal Social Cost and Marginal-Cost Pricing Marginal social cost (MSC) the total cost to society of producing an additional unit of a good or service. MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production. Acid Rain and the Clean Air Act Other Externalities

Externalities and Environmental Economics (cont.)

Externalities and Environmental Economics (cont.) Internalizing Externalities (1) Government imposed taxes and subsidies, Measuring Damages Reducing Damages to an Efficient Level The Incentive to Take Care and to Avoid Harm (2) Private bargaining and negotiation, (3) Legal rules and procedures Injunction A court order forbidding the continuation of behaviour that leads to damages. Liability rules Laws that require A to compensate B for damages imposed. (4) sale or auctioning of rights to impose externalities (5) direct government regulation

Public (Social) Goods public goods (social or collective goods) Goods that are no rival in consumption and/or their benefits are no excludable. In an unregulated market economy with no government to see that they are produced, public goods would at best be produced in insufficient quantity and at worst not produced at all. The Characteristics of Public Goods No rival in consumption No excludable Drop-in-the-bucket problem Free-rider problem

Public (Social) Goods (cont.) Income Distribution as a Public Good? Public Provision of Public Goods Because private provision of public goods is generally insufficient, the government must step in to encourage the production of public goods. By casting sufficient amounts of money in certain directions, it causes resources to flow there. All levels of government – city, state, and federal – collect taxes to pay for their spending.

Public (Social) Goods (cont.) Optimal Provision of Public Goods Economist Paul Samuelson demonstrated that there exists an optimal, or a most efficient, level of output for every public good. Samuelson’s Theory An efficient economy produces what people want. Private producers, whether perfect competitors or monopolists, are constrained by the market demand for their products. If they cannot sell their products for more than it costs to produce them, they will be out of business. Because private goods permit exclusion, firms can withhold their products until households pay. Buying a product at a posted price reveals that it is “worth” at least that amount to you and to everyone who buys it. Optimal level of provision for public goods The level at which society’s total willingness to pay per unit is equal to the marginal cost of producing the good. The Problems of Optimal Provision One major problem exists. To produce the optimal amount of each public good, the government must know something that it cannot possibly know— everyone’s preferences. Mixed Goods Mixed goods that are part public goods and part private goods. Education is a key example.

Imperfect Information Adverse Selection: Asymmetric Information Moral Hazard It is impossible to know everything about behaviour and intentions. If a contract absolves one party of the consequences of its action, and people act in their own self- interest, the result is inefficient. Market Solutions Like consumers, profit-maximizing firms will gather information as long as the marginal benefits from continued search are greater than the marginal costs.

Social Choice social choice The problem of deciding what society wants. The process of adding up individual preferences to make a choice for society as a whole. The Voting Paradox The most common social decision-making mechanism is majority rule – but it is not perfect. Impossibility theorem A proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent, no arbitrary results. Voting paradox A simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem. Logrolling A problem of majority-rule voting. Occurs when congressional representatives trade votes, agreeing to help each other get certain pieces of legislation passed.

Social Choice (cont.) Government Inefficiency: Theory of Public Choice Rent-Seeking Revisited Theory may suggest that unregulated markets fail to produce an efficient allocation of resources. This should not lead you to the conclusion that government involvement necessarily leads to efficiency. There are reasons to believe that government attempts to produce the right goods and services in the right quantities efficiently may fail. Government and the Market