Markets and Government

Chapters 28 - 29

Market Failure

n The Private Sector does not provide the mix of goods society wants

n Government, as agent of society, steps in.

Market Failure

n The market’s output mix satisfies only the buyers and sellers.

n This mix might NOT be the mix society desires.

n The forces of supply and demand do not lead to society’s preferred point on the PPF.

n Because of this, government may intervene.

Market Failure: Medical Care (chart)

Government Failure: Medical Care (chart)

Government failure

n Bureaucracy is costly.

n Laws are permanent.

n The cost of government intervention ends up to be greater than the benefit received.

n Mistakes are difficult to fix.

Market Failure: two forms

n Dealing with Externalities

n Providing Public Goods

Externality

n A side effect of a market transaction that affects the well-being of third parties.

Externality

n A side effect of a market transaction that affects the well-being of third parties.

n Negative externality: Adverse side effect

n Imposes a cost to third parties

n Positive externality: Beneficial side effect

n Generates a benefit to third parties

Externalities

n The market responds only to demand and supply behavior.

n It does not include externality costs and benefits.

n Society wants all benefits and all costs included.

n Society wants to include externality costs and benefits in the decision making process.

Negative Externality

n The market produces more than society wants.

n If externality costs were included, costs increase and the supply curve shifts left.

n Less produced.

n Higher price.

Negative Externality (chart)

Positive Externality

n The market produces less than society wants.

n If externalities were included, benefits increase and the demand curve shifts right.

n More produced.

n Higher price.

Positive Externality (chart)

Externalities - summary

n These are costs or benefits of a market activity borne by a third party.

n The buyer and the seller have their own (private) costs and benefits.

n The total costs and benefits to society add third party costs and benefits to the private costs and benefits.

Externalities - summary

n Society’s ideal quantity is where the social demand curve (reflecting all benefits) intersects the social supply curve (reflecting all costs).

n The market produces a quantity reflecting only market demand and market supply (buyer’s and seller’s benefits and costs).

Positive Externality

n Example: Education

n The social demand curve is to the right of the market demand curve.

n The market will under produce this good.

n The role of government is to increase production.

Negative Externality

n Example: Pollution from waste products

n The social supply curve is to the left of the market supply curve.

n The market will overproduce this good.

n The role of government is to decrease production.

Government’s Role

n Negative Externality

n Reduce output:

n Laws Forbidding Production

n Taxes on Output

n Regulations Restricting Production

Government’s Role

n Positive Externality

n Increase output:

n Laws Requiring Consumption

n Subsidize Output

n Subsidize Consumption

Environmental Economics

n Pollution:

n The degradation of the environment

n The least cost method of getting rid of waste products

Pollution

n An externality cost:

n Keeps the costs of getting rid of waste products low

n benefits the buyer (lower prices)

n …and the seller (lower costs).

n People living in the polluted environment caused by the waste suffer an externality cost.

Technology and Pollution

n Waste is the result of an inefficient process.

n There are three costs:

n (1) the cost to acquire resources to make the waste

n (2) the cost to get rid of the waste

n (3) the externality cost.

n New technology to make the process more efficient will reduce the production of waste and reduce all three costs.

Pollution Control

n There is a MB and a MC for each unit of pollution to be cleaned up.

n As the cleanup progresses:

n the MB of cleaning the next unit decreases

n the MC of cleaning up the next unit increases

n There exists a cost-beneficial, ideal amount of cleanup.

n Society should not clean up more than that unit.

How Much Pollution Should We Clean Up?

n If MB of cleaning up a unit of pollution is greater than MC of cleaning up that unit, then commit resources to reduce pollution.

n If MB is less than MC, it is not a good idea to reduce that unit of pollution.

n If MB > MC, do it!

n If MB < MC, don’t.

Pollution Control (chart)

Standard of Living and the Environment

n The higher the standard of living, the more likely society will be concerned about its environment.

n At low incomes, first insure survival at the expense of the environment

n As incomes rise, basic wants are more easily filled. Then society begins to fill secondary wants, such as environmental cleanup

The Difference Between Private Goods and Public Goods

n Private Good: A good or service whose use by one person excludes its use by others.

n Public Good: A good or service whose use by one person does not exclude use of it by others.

The Free-Rider Dilemma

n A free rider looks for free access to public goods.

n A free rider reaps direct benefits from someone else’s purchase of a public good, and does not have to pay.

n If you can use it for free, then you won’t pay for it. Nobody will buy it, waiting for someone else to buy it.

The Free-Rider Dilemma.

n In the market place, everyone waits for someone else to pay.

n Result: these goods won’t be produced.

n The market fails to deliver the desired amount of public goods

n Government intervention is needed to get them.

The Free-Rider Dilemma.

n Producers will not make the good for free.

n Government becomes the buyer.

n The people get to use the good “for free”.

n These purchases are funded with tax dollars and fees for use.

Taxation

n Governments produce no wealth or income

n The primary purpose of taxation is to shift income (purchasing power) from the private sector to the public sector.

Transfer Payments

n Government makes transfer payments to shift purchasing power from one group, usually taxpayers, to groups favored by government:

n Welfare receivers

n Subsidy receivers

n Special-interest groups

Progressive tax

n Makes people with high incomes pay a larger percent of their income in taxes than those with lower incomes.

n The average tax rate rises as income rises, and vice versa.

n Example: Federal income tax

Progressive Tax System: Example (chart)

Regressive tax

n Makes people with low incomes pay a larger percent of their income in taxes than those with higher incomes.

n The average tax rate falls as income rises, and vice versa.

n Examples: Payroll tax (FICA), sales tax (with no exemptions), property tax.

Proportional tax

n All pay the same percentage of their income in tax, no matter what their income level is.

n “Flat tax”

What’s the difference?

n In each of the tax structures, the higher income person pays more dollars in tax than the lower income person.

n It is the percent of income taken in tax that is the difference between the three structures.

Public Choice

n Economic Principles applied to the Political Process

n Voting

n Special Interest Groups

n Bureaucratic Activity

Median Voter

n Political candidates will appeal to their extremes to get the party’s nomination.

n In the general election, each candidate will move to the middle to appeal to the most voters.

Median Voter

n Democrats appeal to the left and Republicans appeal to the right in primaries.

n Both move toward the political middle in the general election.

Voting

n Benefit of voting:

n Electing the candidate that you want to win.

n Costs of voting:

n Accepting the opposing candidate if your candidate loses

n Time and effort involved in acquiring information

n Time and effort involved in actually voting

Voting

n If the costs of voting exceed the benefits of voting, it is rational:

n not to follow the campaign.

n not to vote.

n Choose to be rationally ignorant.

Voting Booth vs. the Market

n Choose your candidate.

n Get who the majority selects, no matter who you voted for.

n Choose your product.

n Get your product you select, no matter what the majority prefers.

Special Interest Groups

n A group with intense preferences for or against a particular government service, activity, or policy.

n A subsidy, or a tax break.

n Usually, a small group willing to fund a lobbying campaign to get the subsidy or tax break.

Special Interest Groups

n Example:

n 100 ranchers get a subsidy of $1 million each.

n They will pay $100,000 each to insure this occurs.

n Total cost to 50 million taxpayers is $100 million, or a $2 increase in one’s taxes.

n No one would pay $2 to stop the subsidy.

Logrolling

n Members of Congress agree to support each others’ special interests in exchange for support of their own special interests.

Rent Seeking

n Rent is any payment greater than opportunity cost.

n It pays the special interest group to acquire the subsidy or tax break as they end up having more.

n It is a loss to society in general due to the cost expended to acquire the subsidy or tax break.

Bureaucracy

n Not profit driven – so inefficiency is not punished.

n Not service oriented – no competition.

n Success is measured by increasing size, responsibility, and budget.

n Nearly impossible to eliminate even if the original need has disappeared.

n Legislation required.

n Special interest groups opposed.

Bureaucracy

n Decisions are made by bureaucrats exactly like all other decisions.

n Personal value systems used.

n What’s the benefit (to me and others)?

n What’s the cost (to me and others)?

n Major factor: Preservation (or expansion) of one’s position.

n Most bureaucracies operate with diseconomies of scale.