Market Failure and the Role of Government

Capitalism Review

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Characteristics of Capitalism

1. Private property

2. Freedom of choice

3. Self-interest

4. Competition

5. Prices, not bureaucrats, guide decisions

6. Limited Government

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Heritage Foundation’s 2014 Index of Economic Freedom

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Bottom 10

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Freedom creates wealth!

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South Korea

North Korea

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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

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Types of Market Failures

1. Public Goods

2. Externalities

3. Monopolies

4. Income Inequality

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Public Goods

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Video: Free Market Fire Department

Market Failure #1: PUBLIC GOODS

Why is the free market bad at providing public goods?

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Free Riders!People who benefit from something without paying for it

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Good Citizen

Free Rider

The Free Rider Problem

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Examples: 1. People who download music illegally2. People who watch a street performer

and don’t pay 3. Teenagers that live at home and don’t

have a job

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• 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-riders2. Have government provide the good

What’s Wrong With Free Riders?

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Free Riding Less revenue

potential profit Less 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?

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Public Goods Defined

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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 Show21

Identify which of the following areTRUE public goods

(have non-exclusion and non-rival consumption):

1. Hamburgers2. Satellite TV 3. The Grand Canyon4. A house5. Street lights6. Highways

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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?

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It probably could!

Then why doesn’t it?

The costs outweigh the benefits

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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 ParkMarginal willingness to pay higher taxes# of

ParksAdam is willing to

pay

Jill is willing to

pay

Society’s Demand (MSB)

Marginal Cost

1 $4 $5 $9 $52 $3 $4 $7 $53 $2 $3 $5 $54 $1 $2 $3 $55 $0 $1 $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 ParkMarginal willingness to pay (higher taxes)# of

ParksAdam is willing to

pay

Jill is willing to

pay

Society’s Demand (MSB)

Marginal Cost

1 $4 $5 $9 $52 $3 $4 $7 $53 $2 $3 $5 $54 $1 $2 $3 $55 $0 $1 $1 $5

Demand for a New ParkMarginal willingness to pay higher taxes# of

ParksAdam is willing to

pay

Jill is willing to

pay

Society’s Demand (MSB)

Marginal Cost

1 $4 $5 $9 $52 $3 $4 $7 $53 $2 $3 $5 $54 $1 $2 $3 $55 $0 $1 $1 $5

Price

Quantity of Parks

$ 9 7

5

3

1

0 1 2 3 4 5

D=MSB

Supply and Demand for Public ParksThe Demand is the

equal to the marginal benefit to

society

$ 9 7

5

3

1

0 1 2 3 4 5

The supply is the public

good’s marginal cost to society

S=MSC

D=MSB

Supply and Demand for Public ParksPrice

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?

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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

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Costs resulting from aneconomic action that are felt byan unrelated third party

Negative Externalities (aka: Spillover Costs)

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Example: Whistle Tips

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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

QFree Market 40

Market for SpazoprolamThe marginal private cost doesn’t

include the costs to society

P

Q

D=MSB

Supply = Marginal

Private Cost

QFree Market 41

Supply = Marginal

Social Cost

What will MC/Supply look like when EXTERNAL cost are factored in?

QOptimal

Market for Spazoprolam

P

Q

D=MSB

S=MPC

QFree Market 42

S =MSC

QOptimal

At QFM the MSC is greater than the MSB. Too much is being produced

Overallocation

Market for Spazoprolam

P

Q

D=MSB

QFree Market 43

What should the government do to fix a negative externality?

QOptimal

S=MPC

S =MSC

Solution: Tax the amount of the

externality(Per Unit Tax)

Market for Spazoprolam

P

Q

D=MSB

QFree Market 44

What should the government do to fix a negative externality?

QOptimal

S=MPC

S =MSC

Solution: Tax the amount of the

externality(Per Unit Tax)

=MPC

MSB = MSC

Market for Spazoprolam

Positive Externalities

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Positive Externalities (aka: Spillover Benefits)

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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

QFree Market 48

Market for MMR vaccineThe marginal private benefit doesn’t

include the additional benefits to society.

P

QQFM 49

What will the MB/D look like when EXTERNAL benefits are factor in?

QOptimal

D=Marginal Private Benefit

S = MSC

D=Marginal Social Benefit

Market for MMR vaccine

P

Q

D=MSB

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If the market produces QFM why is it a market failure?

S = MSC

D=Marginal Social Benefit

QFM QOptimal

Market for MMR vaccine

P

Q 51

Underallocation

S = MSC

D=Marginal Social Benefit

QFM QOptimal

At QFM the MSC is less than the MSB.

Too little is being produced

Market for MMR vaccine

P

QQFM 52QOptimal

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

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Seating Chart!

“I’m writing you a

prescription for pecan pie”

The Tragedy of the Commonsa.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

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D

MR

$9

8

7

6

5

4

3

2

MCATC

58 1 2 3 4 5 6 7 8 9 10 Q

P

UnregulatedSocially Optimal

Fair Return

Monopoly

Government in Action:

Antitrust Laws

Legislative Executive Judicial

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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

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WHAT DOES THE GOVERNMENT DO?Legislative Branch• Passed Sherman Act of 1890-

“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

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Market Failure #4

Wealth Inequality

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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

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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)

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20 40 60 80 100

100

80

60

40

20

0

Percent of Families

Per

cen

t o

f In

com

e

Perfect Equality

The Lorenz Curve

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100

80

60

55

40

30

2015

5 0

Percent of Families

Per

cen

t o

f In

com

e

Perfect Equality

Lorenz Curve (actual distribution)

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The Lorenz Curve

20 40 60 80 100

100

80

60

55

40

30

2015

5 0

Percent of Families

Per

cen

t o

f In

com

e

Perfect Equality

Lorenz Curve (actual distribution)

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The Lorenz Curve

The size of the banana showsthe degree of

income inequality.

20 40 60 80 100

100

80

60

55

40

30

2015

5 0

Percent of Families

Per

cen

t o

f In

com

e

Perfect Equality

After Redistribution

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The Lorenz Curve

The banana gets smaller when the government re-

distributes income

20 40 60 80 100

100

80

60

55

40

30

2015

5 0

Percent of Families

Per

cen

t o

f In

com

e

Perfect Equality

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The Lorenz Curve

Gini Coefficient = A/(A+B)

20 40 60 80 100

A

B

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Government Policy to Reduce InequalityTransfer 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?

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Taxes

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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

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Three Types of Taxes1. Progressive Taxes – higher income

earners pay a higher percentageEx: 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

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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 cigarettes4. Medicare tax of 1.45 % on every $

earned 5. 5.6% Arizona sales tax

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Three Types of Taxes

Federal Income TaxEqual Tax of $350 per week (Regressive Tax) Income Amount of Tax % Amount to live on• $200 $350 175% -$150)• $350 $350 100% $0 • $500 $350 70% $150• $1,000 $350 35% $650• $5,000 $350 7% $4,650

Tax 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

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Federal Income Tax

This is our current system. Is it fair?

The Laffer CurveIllustrates the relationship

between tax rate and tax revenue

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The final graph to learn for microeconomics…

The Laffer Curve

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% 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!

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