Chapter 10 Economic Efficiency and the Role of Government

Chapter 10 Economic Efficiency and the Role of Government

Economic Efficiency and the Role of Government
Virtually every disagreement about the economy ultimately leads to government Some disagreements start there as well All these disagreements tend to obscure a remarkable degree of agreement about the economy, and government’s role in it Vast majority of goods and services that you buy in stores, over the internet, or obtain in other ways Are provided by private firms—and almost everyone agrees that’s how it should be Widespread agreement that certain goods and services should be provided by government Such as general police protection, the court system, and national defense Much of this agreement is based on ideas about economic efficiency Lieberman & Hall; Introduction to Economics, 2005

The Meaning of Efficiency
What, exactly, does efficiency mean? Economic efficiency is achieved when there is no way to rearrange the production or allocation of goods in a way that makes one person better off without making anybody else worse off A limited concept in that An efficient economy is not necessarily a fair economy Why do economists put so much stress on efficiency, rather than fairness? Issues of fairness must be resolved politically Economics can make a major contribution to our material well being by Helping us understand the preconditions for economic efficiency, Teaching us how we can bring about those preconditions Lieberman & Hall; Introduction to Economics, 2005

Pareto Improvements A trade in which both parties are made better off, and no one is harmed Named after Italian economist, Vilfredo Pareto ( ) First systematically explored the issue of economic efficiency Helps us arrive at a formal definition of economic efficiency Achieved when every possible Pareto improvement is exploited Alternatively, we can look at the economy as a whole If we discover remaining Pareto improvements that are not occurring then we would deem the economy economically inefficient Perfectly competitive markets tend to be economically efficient, and Well-functioning market economics tend to lie close to the economically efficient end of the spectrum Lieberman & Hall; Introduction to Economics, 2005

Side Payments and Pareto Improvements
There are more complicated situations in which a Pareto improvement will come about Only if one side makes a special kind of payment to the other—called a side payment Situations in which action will benefit one group and harm another If an action creates more total benefits for gainers than total harm to losers Than a side payment exists which—if transferred from gainers to losers—would make the action a Pareto improvement Important implication for economic efficiency If there is an action that benefits some more than it harms others, and if an appropriate side payment can be easily arranged Than not taking the action is a waste of an opportunity to make everyone better off When a side payment cannot be made—or for any reason is not made—then even of action might create greater gain than harm, it might not be considered fair Lieberman & Hall; Introduction to Economics, 2005

Markets and Economic Efficiency
In a market system, firms and consumers are largely free to produce and consume as they wish, without anyone orchestrating the process from above Can we expect such unsupervised trading to be economically efficient? Yes—as long as trading takes place in perfectly competitive markets To demonstrate this, we’ll return to the tools we’ve used to analyze competitive markets Demand and supply curves But we’ll look at them in a slightly different way Lieberman & Hall; Introduction to Economics, 2005

Reinterpreting the Demand Curve
Figure 1 shows a market demand curve for guitar lessons Quantity demanded per week at each price Also indicates who would be taking each lesson Standard way of thinking about a market demand curve But we can also view the curve in a different way Maximum price someone would be willing to pay for each unit of good Tells us how much that unit is worth to the person who buys it Each guitar lesson in the market has a different value In part, this is because consumers differ in their incomes and tastes But also—for each individual—value of additional lessons declines as more lessons are taken Height of market demand curve at any quantity shows us value—to someone—of last unit of good consumed Lieberman & Hall; Introduction to Economics, 2005

Figure 1: The Value of Another Guitar Lessons
While the first lesson is worth $25 to some consumer (Flo) . . . Price Number of Lessons per Week $25 Flo Joe $23 the second lesson is worth only $ $21 Flo (again) $19 Bo Zoe $17 and the third is worth $21. Demand 1 2 3 4 5 Lieberman & Hall; Introduction to Economics, 2005

Reinterpreting the Supply Curve
Now let’s look at supply side of the market Figure 2 shows supply curve for guitar lessons—quantity offered each week at various prices Indicates who would be supplying each lesson But supply curve also tells us the minimum price a seller must get in order to supply that lesson Why does it take higher prices to get more lessons? Because offering lessons is costly to guitar teachers As any one teacher devotes more and more time to giving lessons, opportunity cost of his time will rise Giving more lessons means less time left for other activities As leftover time becomes scarcer, value of each remaining hour rises Height of market supply curve at any quantity shows additional cost—to some producer—of each unit of good supplied Lieberman & Hall; Introduction to Economics, 2005

Figure 2: The Additional Costs of Guitar Lessons
Price Number of Lessons per Week Supply The smallest cost for this first lesson is $ $21 McCollum $19 Martin (again) $17 Gibson but it's $15 for the second . . . $15 Martin (again) $13 and $17 for the third. Martin 1 2 3 4 5 Lieberman & Hall; Introduction to Economics, 2005

The Efficient Quantity of a Good
Figure 3 combines supply and demand curves for guitar lessons Whenever—at some quantity—demand curve is higher than supply curve Value of last unit to consumer is greater than its additional cost to some producer Whenever demand curve lies above supply curve, producing the lesson is a Pareto improvement Whenever demand curve lies below supply curve, producing the lesson cannot be a Pareto improvement Efficient quantity of guitar lessons—the quantity at which all Pareto improvements are exploited—is where the demand curve and supply curve intersect At this quantity, value of the last good produced will be equal to—or possibly a tiny bit greater than—the cost of providing it Efficient quantity of a good is quantity at which market demand curve and market supply curves intersect Lieberman & Hall; Introduction to Economics, 2005

Figure 3: Efficiency In The Market For Guitar Lessons
Price Number of Lessons per Week 1. Joe would pay as much as $23 for the second lesson . . . $25 Flo Supply Joe $23 $21 Flo McCollum $19 Bo Martin $17 3. Four lessons is the equilibrium and the efficient quantity. Zoe Gibson $15 Martin $13 Martin Demand 2. while Martin would offer it for as little as $15. 1 2 3 4 5 Lieberman & Hall; Introduction to Economics, 2005

Perfect Competition and Efficiency
In a well-functioning, perfectly competitive market, equilibrium quantity is also efficient quantity If we leave producers and consumers alone to trade with each other as they wish Market will exploit every opportunity to make someone better off that doesn’t harm anyone else As long as market is working well, and it’s perfectly competitive Types of goods produced in competitive markets will reflect consumer preferences If a good has such low value—relative to its cost—that demand curve lies below supply curve at all quantities, it will not be provided Lieberman & Hall; Introduction to Economics, 2005

Perfect Competition and Efficiency
The notion that perfect competition—where many buyers and sellers each try to do the best for themselves—actually delivers an efficient economy is one of the most important ideas in economics Adam Smith coined term ‘invisible hand’ to describe the force that leads a competitive economy relentlessly and automatically toward economic efficiency Recognize the end promoted by invisible hand as economically efficient outcome Lieberman & Hall; Introduction to Economics, 2005

The Efficiency Role of Government
When a well-functioning, perfectly competitive market is permitted to reach its equilibrium, the outcome is efficient No opportunities for mutual gain remain unexploited Any government intervention that changes the market quantity (say, a price ceiling or a price floor) will create inefficiency—a welfare loss But government can—and does—contribute to the economic efficiency of markets Provides infrastructure that permits markets to function Physical infrastructure—bridges, airports, waterways, and buildings Institutional infrastructure—laws, courts, and regulatory agencies Stepping in when markets are not working properly When they leave Pareto improvements unexploited and therefore fail to achieve economic efficiency Lieberman & Hall; Introduction to Economics, 2005

The Institutional Infrastructure of a Market Economy
Americans take their institutional infrastructure almost completely for granted In some countries Police are more likely to steal from citizens than to protect them from thievery People have no effective rights to their own property If a person is injured by a drunk driver, there may be no system for compensating her or punishing the driver Powerful mafias exist that extort protection money by threatening to shut down businesses or physically harm their owners In nations with highly developed and stable legal infrastructures, such incidents are the exception When countries are divided into three groups, according to the quality of their institutional infrastructure There is a strong relation between infrastructure and output per worker Lieberman & Hall; Introduction to Economics, 2005

Figure 4: Government Infrastructure and Output per Worker
Low Quality of Infrastructure Medium High Average Output per Worker 2,000 6,000 10,000 14,000 $18,000 Lieberman & Hall; Introduction to Economics, 2005

The Legal System: Criminal Law
The backbone of a market economy’s institutional infrastructure is the legal system Criminal law While criminal law has important moral and ethical dimensions Central economic function is to limit exchanges to voluntary ones By making most involuntary exchanges illegal, criminal law helps to channel our energies into exchanges and productive activities that benefit all parties involved—Pareto improvements In this way, criminal law contributes to economic efficiency Lieberman & Hall; Introduction to Economics, 2005

Property Law Property law gives people precisely defined, enforceable rights over things they own When property rights are poorly defined Much time and energy are wasted in disputes about ownership People spend time trying to capture resources from others Time that could have been spent producing valuable goods and services Property law contributes to economic efficiency by increasing total production Raising total benefits that markets can provide by reducing disputes about property Channeling resources into production Lieberman & Hall; Introduction to Economics, 2005

Contract Law In countries in which contract law is less well defined or less strictly enforced, investors would worry that they would not be able to collect their share A contract is a mutual promise Often one party does something first and the other party promises to do something later Contracts play a special role in a market economy Without them, only Pareto improvements involving simultaneous exchange could take place You get a bag of apples from a farmer and simultaneously hand over some money Lieberman & Hall; Introduction to Economics, 2005

Contract Law Contracts enable us to make exchanges that take place over time and in which one person must act first In this way, contracts help society enjoy the full benefits of specialization and exchange Legal enforcement of contacts is not the only force that makes people keep promises Parents, religious organizations, and schools teach people that keeping promises is a moral obligation A reputation for failing to keep promises would be harmful to a business or a person While socialization and concern over reputation are important, contracts and the infrastructure for enforcing them play vital role in making economy more efficient Because of contract law, people are more willing to take a chance with a new business Since they know that they have a law behind them if new business reneges on a deal Lieberman & Hall; Introduction to Economics, 2005

Tort Law Deals with interactions among strangers or people not linked by contracts Specifically, a tort is a wrongful act—such as manufacturing an unsafe product—that causes harm to someone, and for which the injured person can seek remedy in court Tort law defines types of harm for which someone can seek legal remedy And what sorts of compensation the injured person can expect When people and business are held responsible for injuries they cause, they act more carefully Also protects against fraud In which a seller of something—a product, a business, shares of stock—lies to the buyer in order to make the sale Lieberman & Hall; Introduction to Economics, 2005

Antitrust Law Designed to prevent business from making agreements or engaging in other behavior that limits competition and harms consumers Operates in three areas Agreements among competitors U.S. antitrust law—expressed in Section 1 of Sherman Act—prohibits “contracts, combinations, or conspiracies” among competing firms that would harm consumers by raising prices Monopolization Section 2 of Sherman Act Makes it illegal to monopolize or attempt to monopolize a market Mergers In a merger, two firms combine to form one new firm The result is to increase the danger of higher prices from oligopoly or monopoly Mergers of this type are often blocked by U.S. government based on Section 7 of Clayton Act Lieberman & Hall; Introduction to Economics, 2005

Regulation Important part of the institutional infrastructure that supports a market economy Under regulation, a government agency—such as the Food and Drug Administration (FDA), the Environmental Protection Agency (EPA), or a state public utilities commission—has power to direct business to take specific actions In addition to protecting public safety and health Regulation is also used to help markets function more efficiently Regulation differs from use of legal procedures in a fundamental way Regulators reach deep into the operations of business to tell them what to do While legal procedures typically result in fines or other penalties if businesses do something wrong Lieberman & Hall; Introduction to Economics, 2005

Law and Regulation in Perspective
Invisible hand of market system cannot operate on its own Legal system, along with regulatory agencies, creates an environment in which invisible hand can do its job Almost every Pareto improvement that we can think of relies on legal and regulatory infrastructure But what about cases where law and regulation don’t seem to be working perfectly? Does this mean that our institutional infrastructure is failing us? Lieberman & Hall; Introduction to Economics, 2005

Law and Regulation in Perspective
Yes…and no While instances like these are never welcome, society has chosen not to eliminate them entirely Must balance benefits—safer products, reduced crime—against costs A legal and regulatory system that ensured the complete elimination of crime, unsafe products, and other unwelcome activities would be less efficient than a system that tolerated some amount of these activities An efficient infrastructure must consider the costs, as well as the benefits, of achieving our legal and regulatory goals Lieberman & Hall; Introduction to Economics, 2005

Market Failures Another vitally important role for government
To intervene in situations of market failure When a market equilibrium—even with the proper institutional support—is economically inefficient General types of market failures to which economists have devoted a lot of attention Monopoly power Externalities Public goods While economists and policy-makers agree in theory on what causes a market failure Dealing with real-world market failures remains one of the most controversial aspects of government policy Lieberman & Hall; Introduction to Economics, 2005

Monopoly and Monopoly Power
A firm has monopoly power when it can influence the price that it charges for its product A market with just one seller, or a few oligopolists who cooperate and behave as a monopoly, is a more serious market failure Monopoly and imperfectly competitive markets—in which firms charge a price greater than marginal cost—are generally inefficient Price is too high, and output is too low, to create the efficient outcome What can government do to make this monopoly market more efficient? Lieberman & Hall; Introduction to Economics, 2005

Figure 5: The Inefficiency of Monopoly
2. A monopoly charges a higher price than a competitive market . . . MC Number of Lessons per Week Dollars 4. Lessons with greater value than their costs are not provided. $22 1. A competitive efficient market for guitar lessons would provide 4,000 at a price of $19. $19 E D MR 3. and produces a lower quantity. 2,500 4,000 Lieberman & Hall; Introduction to Economics, 2005

Anti-trust Law as a Remedy
In the case of the guitar-lesson monopoly, there may be a solution Since this market would function very well under competitive conditions, the government could use anti-trust law to break the monopoly into several competing firms But breaking up a monopoly would not make sense when the market would perform even worse with more competition Monopolies that arise from patents and copyrights, provide an incentive for artistic creations and scientific discovery Monopoly power that arises from network externalities offers benefits that would be hard to achieve under more competitive conditions When a monopoly arises as a natural monopoly Using anti-trust law to break it up or even to prevent its formation in the first place is a poor remedy Lieberman & Hall; Introduction to Economics, 2005

The Special Case of Natural Monopoly
A natural monopoly exists when, due to economies of scale, one firm can produce for the entire market at a lower cost per unit than can two or more firms If government steps aside, such a market will naturally evolve toward monopoly If breaking up a natural monopoly is not advisable, what can government do to bring us closer to economic efficiency? One option is public ownership and operation Public takeover of private business is rare, except when certain conditions are present That leaves one other option Regulation Lieberman & Hall; Introduction to Economics, 2005

Figure 6: Regulating A Natural Monopoly
Number of Households Served Dollars Unregulated monopoly "Fair rate of return" production A $60 Efficient production (requires subsidy) C $29 LRATC F $15 MC B MR D 50,000 100,000 85,000 Lieberman & Hall; Introduction to Economics, 2005

Regulation of Natural Monopoly
Under regulation, a government agency digs deep into the operations of a business and takes some of the firm’s decisions under its own control In the case of a natural monopoly, regulators are interested in achieving economic efficiency, which they do by telling the firm what price it can charge At first glance, you might think that natural monopoly regulators have an easy job Unfortunately, it’s not that easy There is the matter of information Regulators must be able to trace out firm’s MC curve as well as market demand curve Lieberman & Hall; Introduction to Economics, 2005

Even with perfect information about monopolist’s cost and demand curves, regulators have a serious problem Look again at Figure 6—notice that MC curve lies everywhere below LRATC curve Problem for regulators If they set the efficient price of $15 so that buyers demand efficient quantity of 100,000, firm’s cost per unit is greater than $15 Firm will suffer a loss In long-run, it will go out of business Lieberman & Hall; Introduction to Economics, 2005

Leaves regulatory agency with two alternatives Set prices to MC and subsidize the monopoly from the general budget, to make up for the loss In practice, however, regulators in market economies around the world have usually chosen a different solution Regulators determine a price that gives owners a “fair rate of return” for funds they’ve put into the monopoly Should give monopoly what economists call normal profit Profit just high enough to cover all of the owners’ opportunity costs, including the foregone interest of their own funds What price will accomplish this? A fair rate of return is already built into LRATC curve This strategy—called average cost pricing—is the most common solution chosen by regulators of natural monopolies Lieberman & Hall; Introduction to Economics, 2005

With average cost pricing, regulators strive to set price equal to cost per unit where LRATC curve crosses demand curve At this price, the natural monopoly makes zero economic profit Which provides its owners with a fair rate of return, and keeps the monopoly in business Average cost pricing is not a perfect solution Does not quite make the market efficient Provides little or no incentive for the natural monopoly to economize on capital Lieberman & Hall; Introduction to Economics, 2005

Externalities When a private action has side effects that affect other people in important ways, we have the problem of externalities By-product of a good or activity that affects someone not immediately involved in transaction Lieberman & Hall; Introduction to Economics, 2005

The Private Solution to a Negative Externality
Under certain conditions, inefficiency that would be caused by a negative externality will automatically be resolved by the parties themselves The outcome is the efficient outcome Lieberman & Hall; Introduction to Economics, 2005

The Coase Theorem What if building a theater would create $100,000 of benefits for some but $70,000 worth of harm for others? Whether the theater will or will not be built depends entirely on whether it is the efficient or inefficient outcome Regardless of who holds the legal rights Negative externality is solved by market No government intervention is required, other than the initial assignment of legal rights Rather surprising result is known as the Coase Theorem—named after economist Ronald Coase States that private market will solve externality problem on its own, always arriving at the efficient outcome When side payments can be negotiated and arranged without cost While initial distribution of legal rights will determine allocation of gains and losses among the parties, it will not affect action taken Lieberman & Hall; Introduction to Economics, 2005

The Coase Theorem Requires that side payments can be arranged without cost—or, in practice, that cost is so low relative to gains or losses at stake that it doesn’t matter This requirement is most likely to be satisfied when all of the following conditions are present Legal rights are clearly established Legal rights can be easily transferred The number of people involved is very small Unfortunately, many real world situations do not satisfy these conditions Biggest problem is applying Coase theorem to many real-world externalities is the third condition Often, a large number of people are involved When many people are involved, achieving efficiency with side payments is plagued by an often insoluble problem Free rider problem Lieberman & Hall; Introduction to Economics, 2005

The Free Rider Problem Occurs when efficient outcome requires a side payment but individual gainers—each obligated to pay a small share of the side payment—will not contribute If extensive enough—can shrink the side payment until it isn’t large enough to compensate losers and still leave gainers better off Stands in the way of many Pareto improvements One of the main reasons why we typically turn to government to deal with important externalities that affect many people Lieberman & Hall; Introduction to Economics, 2005

Market Externalities and Government Solutions
A competitive market has many buyers and sellers When a negative externality affects a market, the private solution is unlikely to work A market with a negative externality associated with producing or consuming a good will produce more than the efficient quantity Unfortunately, with so many people involved, it would take too much time and trouble for individual producers and consumers to arrange appropriate side payments and production cutbacks In any case, free rider problem would effectively destroy the arrangement Efficient outcome requires government intervention in the market Lieberman & Hall; Introduction to Economics, 2005

Figure 7(a): A Tax on Producers to Correct a Negative Externality
Millions of Gallons per Period Dollars 1. This market has a negative externality of $0.50 per unit. MSC C $0.50 B S 2. The efficient quantity is here . . . A 3. but the equilibrium quantity is here. $1.00 D 4. In equilibrium, units that create greater costs than benefits are produced. 100 125 Lieberman & Hall; Introduction to Economics, 2005

Figure 7(a): A Tax on Producers to Correct a Negative Externality
(b) Millions of Gallons per Period Dollars 5. A tax per unit on producers, equal to the negative externality per unit, 6. shifts the supply curve upward . . . SAfter Tax SBefore Tax B $0.50 $1.30 A 7. and moves the equilibrium to the efficient quantity. $1.00 $0.80 D 100 125 Lieberman & Hall; Introduction to Economics, 2005

Taxing a Negative Externality
Government could use a tax on producers to move gasoline market to point B Payment of the externality tax is shared between consumers and producers, as is the payment of any tax, and will depend on elasticities of supply and demand A tax on each unit of a good, equal to the external harm it causes, can correct a negative externality and bring market to an efficient output level Consider the logic of this result Tax cures the inefficiency because it forces market to internalize the externality To take account of the harm caused by gasoline Suggests that a tax on consumers of gasoline would work just as well as a tax on producers Taxes to correct negative externalities have been used in countries around the world In United States, however, taxes designed to correct negative externalities are less common Lieberman & Hall; Introduction to Economics, 2005

Regulation and Tradable Permits
A tax is not only way to correct a negative externality Government can also use regulation to move a market closer to the efficient point In last two decades, U.S. government has relied increasingly on an innovative technique to reduce several types of pollution Tradable permits License that allows a company to release a unit of pollution into the environment over some period of time Firms can trade their permits in an organized market Left to itself, a market with a negative externality will produce too much output Taxes, regulation, and tradable permits are examples of government intervention to decrease output toward efficient level Lieberman & Hall; Introduction to Economics, 2005

Dealing with a Positive Externality
What about the case of a positive externality? By-product of an activity or a service benefits other parties, rather than harms them A market with a positive externality associated with producing or consuming a good will produce less than the efficient quantity, creating a welfare loss A subsidy on each unit of a good, equal to the external benefits it creates, can correct a positive externality and bring the market to an efficient output level If a good is rivalrous, efficiency requires that people pay a price for its use In the absence of any market failure, private provision will lead to efficient level of production If a good is excludable, it can be provided by private market Lieberman & Hall; Introduction to Economics, 2005

Figure 8(a): A Subsidy for Consumers to Correct a Positive Externality
1. This market has a positive externality of $30,000 per college degree. (a) Number of Degrees per Year Dollars 2. The equilibrium quantity is here . . . S $30,000 B 3. but the efficient quantity is here. $100,000 A MSB C D 800,000 1,000,000 4. In equilibrium, units that provide more benefits than their cost are not produced. Lieberman & Hall; Introduction to Economics, 2005

Figure 8(a): A Subsidy for Consumers to Correct a Positive Externality
5. A subsidy per unit for consumers equal to the positive externality per unit . . . Number of Degrees per Year Dollars (b) 6. shifts the demand curve upward . . . 7. and moves the market to the efficient quantity S $30,000 B $114,000 $100,000 A DAfter Subsidy $84,000 DBefore Subsidy 800,000 1,000,000 Lieberman & Hall; Introduction to Economics, 2005

Public Goods Pure private good
One that is both rivalrous and excludable In absence of any significant market failure, private firms will provide these goods at close to efficient levels When a good is nonexcludable, people have an incentive to become free riders To let others pay for the good, so they can enjoy it without paying When a good is nonexcludable, private sector will generally be unable to provide it In most cases, if we want such a good, government must provide it When a good or service is nonrivalrous, market cannot provide it efficiently Rather, to achieve economic efficiency, good or service would have to be provided free of charge Pure public good One that is both nonrivalrous and nonexcludable Lieberman & Hall; Introduction to Economics, 2005

Figure 9: Pure Private, Pure Public and Mixed Goods
More Nonexcludable More Excludable More Rival More Nonrival Mixed Good Pure Private Good Pure Public Good food, clothing, housing sold-out movie crowded highway newspaper software movie with empty seats uncrowded highway downloaded music file cable television urban park national defense, legal system police and fire protection crowded city streets fish in international waters Lieberman & Hall; Introduction to Economics, 2005

Mixed Goods Goods that appear in upper right and lower left corners of Figure 9 can be called mixed goods Share features of both public and private goods These goods are becoming increasingly important in our society Are responsible for some growing tension and controversy Lieberman & Hall; Introduction to Economics, 2005

Excludable But Nonrivalrous Goods
Goods near lower left hand corner are excludable but nonrivalrous Includes most information products Software is an essentially nonrivalrous good, but an excludable one Neither pure public nor pure private Digital music files are another example of this type of mixed good Currently, music remains somewhat excludable It is against the law to make copyrighted music available online Many people—either because of respect for the law, fear of getting caught, lack of technical expertise, or scarce time—still prefer to buy their music from a store or online shipping service Music industry is desperately looking for ways to achieve greater excludability Has not yet found a good solution Lieberman & Hall; Introduction to Economics, 2005

Nonexcludable But Rivalrous Goods
Tragedy of commons occurs when rivalrous but nonexcludable goods are overuse to detriment of all An economy with well-functioning, perfectly competitive markets tends to be economically efficient Many types of government involvement are needed to ensure that markets function well and to deal with market failures Cases of government involvement are not without controversy Debates about public education, Social Security, international trade, and immigration center on questions of proper role for government Some of the disagreement is over government’s role in bringing about a more fair economy Also debate about the government’s role in bringing about economic efficiency Lieberman & Hall; Introduction to Economics, 2005

Nonexcludable But Rivalrous Goods
Information problems While government may be able to move us closer to efficiency, it can also fall short or overshoot based on inaccurate information Incentive problems for government Government officials are agents of the general public, and are supposed to serve public interest However, they can be influenced by lobbies for special interest groups In order for government to have the funds it needs to support markets and do other things, it must raise revenue through taxes Inherent problem with provision of public goods that almost guarantees dissatisfaction about them Other important roles for government besides fostering efficiency Equity, fairness, justice, and more Anyone studying role of government in the economies is struck by one glaring fact Most economic activity is carried out among private individuals Lieberman & Hall; Introduction to Economics, 2005

Using the Theory: Traffic as a Market Failure
Almost everyone in United States has been caught in a traffic jam in some large town or city at some point in their lives Problem in most cities is getting worse Consider London, for example Traffic congestion has worsened dramatically in recent decades, especially in the historic inner city Traffic is an externality problem When you decide to take your car onto a city street, your decision is based on the costs and benefits to you Traffic can be viewed as a mixed good Can the government solve the problem? Some cities, such as New York, do charge tolls for cars that enter via bridges or tunnels But entry tolls are problematic, and are rarely set high enough to solve the problem Lieberman & Hall; Introduction to Economics, 2005

Using the Theory: Traffic as a Market Failure
A bigger problem Political damage to any elected representative who would propose a fee high enough to be efficient for a good that has traditionally been free All of this conventional political wisdom may have changed in early 2003 In early 2003, Ken Livingstone, the Mayor of London, decided to take a chance His administration established a 5£ (about $8) per day user fee on any automobile that appeared in the 8 square mile boundary of London’s inner city On the first day the fee applied, traffic dropped about 25% 60,000 fewer cars entered the area than on a normal day Officials in New York, Paris, Los Angeles, and other large cities around the world have been studying London’s success Lieberman & Hall; Introduction to Economics, 2005

Chapter 10 Economic Efficiency and the Role of Government

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