Market Failure and the Role of Government

Capitalism Review 2

Characteristics of Capitalism 1.Private property 2.Freedom of choice 3.Self-interest 4.Competition 5.Prices, not bureaucrats, guide decisions 6.Limited Government 3

4 Heritage Foundation’s 2014 Index of Economic Freedom

5 Bottom 10

6 Freedom creates wealth!

7 South Korea North Korea

8 Does the free market always work perfectly? Can economic efficiency ever be improved by government intervention?

Market Failure A situation in which the free market fails to satisfy society’s needs and wants efficiently 9

Types of Market Failures 1.Public Goods 2. Externalities 3. Monopolies 4. Income Inequality 10

Public Goods 11 Video: Free Market Fire Department

Market Failure #1: PUBLIC GOODS

Why is the free market bad at providing public goods? 13 Free Riders! People who benefit from something without paying for it

14 Good Citizen Free Rider

The Free Rider Problem 15 Examples: 1.People who download music illegally 2.People who watch a street performer and don’t pay 3.Teenagers that live at home and don’t have a job

16 Canadian Military Spending: 1% of GDP US Military Spending: 4.4% of GDP Why doesn’t Canada spend more on defense? Does anyone free ride off you?

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Possible solutions: 1. Punish free-riders 2. Have government provide the good What’s Wrong With Free Riders? 18 Free Riding Less revenue potential profitLess incentive to Firms produce less than the Less produce socially optimal quantity

Trimester Grades I’m willing to give everyone an A if you guys give me $500 Everyone in the class will get an A - even those who don’t contribute anything Who’s willing to pay? 19

Public Goods Defined 20

True public goods meet two criteria: 1. Non-excludable Definition 2. Non-rival Impossible to exclude people from enjoying its benefits (even if they don’t pay). Example: National Defense One person’s consumption doesn’t affect anyone else’s Example: A Fireworks Show 21

Identify which of the following are TRUE public goods (have non-exclusion and non-rival consumption): 1. Hamburgers 2. Satellite TV 3. The Grand Canyon 4. A house 5. Street lights 6. Highways 22

National defense is an example of a public good because A) it requires tax revenues to fund any production (B) one person’s use of it will decrease another person’s ability to use it (C) it is nonexcludable and nonrival (D) the private market typically produces the socially efficient level of output (E) the public is protected from invasion

National defense is an example of a public good because A) it requires tax revenues to fund any production (B) one person’s use of it will decrease another person’s ability to use it (C) it is nonexcludable and nonrival (D) the private market typically produces the socially efficient level of output (E) the public is protected from invasion

Could the federal government… 1.Stop most illegal immigration? 2.Make sure everyone in the US has a job? 3.Build a research station on Mars?

26 It probably could! Then why doesn’t it? The costs outweigh the benefits

27 How should the government decide how much of a public good to produce? Weigh the Costs and Benefits!

In Theory… A good’s Marginal Social Benefit curve is equal to its demand curve (based on individuals’ willingness to pay for it) A good’s Marginal Social Cost curve is its marginal cost curve plus any externalities Video: Dam Tragedy

Demand for a New Park Marginal willingness to pay higher taxes # of Parks Adam is willing to pay Jill is willing to pay Society’s Demand (MSB) Marginal Cost 1$4$5$9$5 2$3$4$7$5 3$2$3$5 4$1$2$3$5 5$0$1 $5 Assume: 1.There are only two people in society. 2.Each additional park costs $5 How many parks should be made?

Demand for a New Park Marginal willingness to pay (higher taxes) # of Parks Adam is willing to pay Jill is willing to pay Society’s Demand (MSB) Marginal Cost 1$4$5$9$5 2$3$4$7$5 3$2$3$5 4$1$2$3$5 5$0$1 $5

Demand for a New Park Marginal willingness to pay higher taxes # of Parks Adam is willing to pay Jill is willing to pay Society’s Demand (MSB) Marginal Cost 1$4$5$9$5 2$3$4$7$5 3$2$3$5 4$1$2$3$5 5$0$1 $5

Price Quantity of Parks $ D=MSB Supply and Demand for Public Parks The Demand is the equal to the marginal benefit to society

$ The supply is the public good’s marginal cost to society S=MSC D=MSB Supply and Demand for Public Parks Price Quantity of Parks MSB = MSC 1.What if the government made 1 park? 2.What if the government made 4 parks?

A side effect of an economic action that is felt by an unrelated third party What is an externality? 34

Externalities Consumers and firms sometimes fail to consider the external costs and benefits of their actions – i.e. how their actions will affect other people As a result, the free market may fail to produce the “socially optimal” quantity of some goods

Negative Externalities 36

Costs resulting from an economic action that are felt by an unrelated third party Negative Externalities (aka: Spillover Costs) 37

Example: Whistle Tips 38

Zoram Pharmaceutical Co. pollutes the air when it manufactures Spazoprolam, a new drug that helps you dance better Zoram only considers its INTERNAL costs (ignores the social cost of pollution) If Zoram had to pay all costs, it would produce less Example 2

P Q D=MSB Supply = Marginal Private Cost Q Free Market 40 Market for Spazoprolam The marginal private cost doesn’t include the costs to society

P Q D=MSB Supply = Marginal Private Cost Q Free Market 41 Supply = Marginal Social Cost What will MC/Supply look like when EXTERNAL cost are factored in? Q Optimal Market for Spazoprolam

P Q D=MSB S=MPC Q Free Market 42 S =MSC Q Optimal At Q FM the MSC is greater than the MSB. Too much is being produced Overallocation Market for Spazoprolam

P Q D=MSB Q Free Market 43 What should the government do to fix a negative externality? Q Optimal S=MPC S =MSC Solution: Tax the amount of the externality (Per Unit Tax) Market for Spazoprolam

P Q D=MSB Q Free Market 44 What should the government do to fix a negative externality? Q Optimal S=MPC S =MSC Solution: Tax the amount of the externality (Per Unit Tax) =MPC MSB = MSC Market for Spazoprolam

Positive Externalities 45

Positive Externalities (aka: Spillover Benefits) 46 Benefits from an economic action that are enjoyed by an unrelated third party. (E.g.: Vaccines, Education, Home Renovation)

Mom only looks at the INTERNAL benefits (the reduced risk of her own daughter getting sick) If parents considered the social benefits (the reduced likelihood that her daughter will spread diseases to other children), demand would be greater Example: A mom decides to get the MMR vaccine for her child

P Q D=Marginal Private Benefit S = MSC Q Free Market 48 Market for MMR vaccine The marginal private benefit doesn’t include the additional benefits to society.

P Q Q FM 49 What will the MB/D look like when EXTERNAL benefits are factor in? Q Optimal D=Marginal Private Benefit S = MSC D=Marginal Social Benefit Market for MMR vaccine

P Q D=MSB 50 If the market produces Q FM why is it a market failure? S = MSC D=Marginal Social Benefit Q FM Q Optimal Market for MMR vaccine

P Q 51 Underallocation S = MSC D=Marginal Social Benefit Q FM Q Optimal At Q FM the MSC is less than the MSB. Too little is being produced Market for MMR vaccine

P Q Q FM 52 Q Optimal D=MPB S = MSC D=MSB What should the government do to fix a negative externality? Subsidize the amount of the externality (Per Unit Subsidy) =MPB Market for MMR vaccine

53 Seating Chart!

“I’m writing you a prescription for pecan pie”

The Tragedy of the Commons a.k.a. The Common Pool Problem

Why are public bathrooms so nasty? No one who uses them has an incentive to keep them clean! This problem – called the “Tragedy of the Commons” or the “Common Pool Problem,” applies to any non- excludable good e.g. The air, the oceans, rivers, etc. What can be done about this?

Market Failure #3 Monopolies 57

D MR $ MC ATC Q P Unregulated Socially Optimal Fair Return Monopoly

Government in Action: Antitrust Laws Legislative ExecutiveJudicial 59

Anti-Trust Laws Laws designed to break up monopolies and promote competition. Prompted by growth of Standard Oil and Carnegie Steel Why are monopolies a Market Failure? They are neither productively nor allocatively efficient 60

WHAT DOES THE GOVERNMENT DO? Legislative Branch Passed Sherman Act of “Every person who shall monopolize …or conspire to monopolize…shall be deemed guilty of a felony.” Executive Branch Federal Trade Commission must approve all corporate mergers. Justice Department prosecutes anti-competitive firms Judicial Branch Federal Courts adjudicate antitrust complaints 61

Market Failure #4 Wealth Inequality 62

Wealth Inequality In 2014, the mean household income in the U.S. was $72,641 In 2014, the median household income was $51,939 How can this be? 63

The Lorenz Curve and Gini Coefficient 64

Measuring Income Distribution The process: Divide households into quintiles based on income If perfect equality, 20% of families should earn 20% of income, 40% should earn 40%...etc. Compare actual distribution (Lorenz Curve) to perfect distribution – ratio is the Gini Coefficient 65

Measuring Income Distribution Example: Group #1 (Poorest 20%) Total of $5Bn (5% of total income) Group #2 Total of $10Bn (10% of total income) Group #3 Total of $15Bn (15% of total income) Group #4 Total of $25Bn (25% of total income) Group #5 (Richest 20%) Total of $45Bn (45% of total income) 66

Percent of Families Percent of Income Perfect Equality The Lorenz Curve 67

Percent of Families Percent of Income Perfect Equality Lorenz Curve (actual distribution) 68 The Lorenz Curve

Percent of Families Percent of Income Perfect Equality Lorenz Curve (actual distribution) 69 The Lorenz Curve The size of the banana shows the degree of income inequality

Percent of Families Percent of Income Perfect Equality After Redistribution 70 The Lorenz Curve The banana gets smaller when the government re- distributes income

Percent of Families Percent of Income Perfect Equality 71 The Lorenz Curve Gini Coefficient = A/(A+B) A B

72 Government Policy to Reduce Inequality Transfer Payments (AKA “welfare”) and Taxes

Welfare provides a safety net for citizens (retirement, unemployment, workers comp, health care, etc.) What are some possible downsides? Where does the government get the money for welfare? 73

Taxes 74

What are Taxes? Two purposes: 1.Pay for government operations Public goods: highways, national defense, police, the court system Other programs: welfare, social security 2. Change economic behavior E.g. Excise tax on tobacco raises revenue AND discourages cigarette production Taxes – mandatory payments to the government 75

Three Types of Taxes 1.Progressive Taxes – higher income earners pay a higher percentage Ex: Current Federal Income Tax system 3. Regressive Taxes – lower income earners pay a higher percentage Ex: Head tax, sales tax 2. Proportional (Flat) Taxes – everyone pays the same percentage of income 76

What kind of taxes are these? (Think % of Income) 1.Toll road tax ($5 per use) 2.State income tax where richer citizens pay higher % 3.$.45 tax per pack of cigarettes 4.Medicare tax of 1.45 % on every $ earned 5.5.6% Arizona sales tax 77 Three Types of Taxes

Federal Income Tax Equal Tax of $350 per week (Regressive Tax) Income Amount of Tax % Amount to live on $200$ % - $150 ) $350$ % $0 $500$350 70% $150 $1,000$350 35%$650 $5,000$350 7%$4,650 T ax tax of 20% per week (Proportional Tax) Income Amount of Tax Amount to live on $200$40 $160 $350$70 $280 $500$100 $400 $1,000$200 $800 $5,000$1,000 $4,000 78

Federal Income Tax This is our current system. Is it fair?

The Laffer Curve Illustrates the relationship between tax rate and tax revenue 80 The final graph to learn for microeconomics…

The Laffer Curve 81 % Tax Rate Tax Revenue If government raises tax rates, revenue will increase…to a point. If the tax rate becomes too high, tax revenue will eventually fall. Why?

GREAT NEWS… WE’RE DONE WITH MICRO! 82