A situation in which the free-market system fails to satisfy society s wants.

Transcription

1 A situation in which the free-market system fails to satisfy society s wants. 1. Monopolies 2. Unfair distribution of income 3. Externalities 4. ublic Goods In each of the above situations, the government steps in to allocate resources more efficiently

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3 A situation where some of the costs or benefits from an activity fall on someone other than the people directly involved in the activity. aka spillover costs/benefits and third-party costs/benefits WHY ARE EXTERNALITIES MARKET FAILURES? The free market fails to include external costs or external benefits. Without government involvement there would be too much of some goods and too little of others.

4 Situation that results in a COST for a different person other than the original decision maker. The costs spillover to other people or society. Example: smoking cigarettes. The smoker pays for his/her pack of cigarettes but ignores the costs of secondhand smoke to the other people s health. The government recognizes external costs and makes policies to limit smoking. 9

5 Situations that result in a BENEFIT for someone other than the original decision maker. The benefits spillover to other people or society. Example: A parent gets a flu vaccine for her child Mom only looks at the INTERNAL benefits. She ignores the social benefits of a healthier society. When you factor in EXTERNAL benefits the marginal benefit and demand should be greater. The government recognizes this and subsidizes flu shots. 10

6 The exhaust from automobiles is a negative externality because it creates smog that other people have to breathe. As a result of this externality, drivers tend to pollute too much. The federal government attempts to solve this problem by setting emission standards for cars. It also taxes gasoline to reduce the amount that people drive. Research into new technologies provides a positive externality because it creates knowledge that other people can use. Because inventors cannot capture the full benefits of their inventions, they tend to devote too few resources to research. The federal government addresses this problem partially through the patent system, which gives inventors an exclusive use over their inventions for a period of time.

7 GRAHING EXTERNALITIES The demand curve shows the marginal private benefit(mb) to those consuming the good or service. If there are no positive externalities associated with the activity, then MB is equal to marginal social benefit (MSB) The supply curve shows the marginal private cost(mc) to those producing the good or service. If there are no negative externalities associated with the activity, then MC is equal to marginal social cost (MSC). In terms of benefits and costs S = MC D=MB 12

8 GRAHING EXTERNALITIES In terms of benefits and costs S = MC = MSC Equilibrium MB = MC MSB = MSC D=MB = MSB If there are no externalities, the output is also socially optimal as MSB = MSC. The market is producing the right amount of the product. 13

9 GRAHING EXTERNALITIES In terms of benefits and costs D=MB S = MC BUT in most cases, externalities exists and so MB MS and MC MSC ositive Externality Marginal private benefit (MB) + marginal external benefit (MEB) = Marginal social benefit (MSB) Negative Externality Marginal private cost (MC) + marginal external costs (MEC) = Marginal social cost (MSC).

10 GRAHING EXTERNALITIES MC In terms of benefits and costs Free Market Optimal MB MSB MEB

11 GRAHING EXTERNALITIES In terms of benefits and costs MSC MC MEC Optimal Free Market MB

12 MARKET FOR CIGARETTES The marginal private cost doesn t include the costs to society. Supply = MC D=MSB Free Market

13 MARKET FOR CIGARETTES What will the MC/supply curve look like when EXTERNAL cost are factored in? Supply = MSC Supply = MC D=MSB Optimal Free Market

14 MARKET FOR CIGARETTES If the market produces FM why is it a market failure? DWL since overallocation is done at the expense of society S=MSC S=MC **notice DWL is above the demand curve Overallocation Optimal Free Market At FM the MSC is greater than the MSB. Too much is being produced D=MSB

15 MARKET FOR FLU SHOTS The marginal private benefit doesn t include the additional benefits to society. S = MSC Free Market D=Marginal rivate Benefit

16 MARKET FOR FLU SHOTS What will the MB/demand curve look like when EXTERNAL benefits are factor in? S = MSC D=Marginal Social Benefit FM Optimal D=Marginal rivate Benefit

17 MARKET FOR FLU SHOTS If the market produces FM why is it a market failure? S = MSC D=Marginal Social Benefit D=MSB FM Optimal

18 MARKET FOR FLU SHOTS At FM the MSC is less than the MSB. Too little is being produced S = MSC D=Marginal Social Benefit Underallocation D=MSB FM Optimal

19 rivate decision makers produce where MB = MC Society wants a market to produce where MSB = MSC As long as MEB and MEC are zero, the market quantity will be the socially optimal quantity. If MEB and/or MEC is not zero, we have a market failure.

20 Consumers and producers compare their marginal costs and benefits but ignore external costs. To change behavior, the government can manipulate those costs and benefits with Taxes and Subsidies (aka igouvian) er-unit -a fixed amount for eachunit of a good or service sold or produced. Lump-sum -a fixed amount

21 er-unit vs Lump-sum MC ATC 1 MR 1 Costs (dollars) AVC AFC 1 uantity

22 Taxes er-unit taxes increase the marginal cost for a firm and shifts all cost curves upward and decrease the quantity to be produced. What impact would a lump-sum tax have? No effect as this tax only changes the fixed costs and thus the firm will continue to produce the same quantity. Subsides er-unit subsidies shift the marginal cost curve down, encouraging a greater quantity to be produced. ***Treat taxes and subsidies as incentives. Taxes decrease output and subsidies increase output.

23 MARKET FOR CIGARETTES What should the government do to fix a negative externality? S=MSC S=MC Solution: Impose a per -unit tax in the amount of the externality (for C market) Optimal Free Market D=MSB

24 MARKET FOR CIGARETTES What should the government do to fix a negative externality? S=MSC =MC MSB = MSC S=MC Solution: Impose a per -unit tax in the amount of the externality (for C market) Optimal Free Market D=MSB

25 MARKET FOR CIGARETTES What should the government do to fix a negative externality? The DWL is eliminated MSB = MSC S=MSC =MC Solution: Impose a per -unit tax in the amount of the externality (for C market) D=MSB Optimal Free Market

26 CA $2.87 effective as of 4/1/17

27 MARKET FOR FLU SHOTS What should the government do to fix a positive externality? Subsidize the amount of the externality (per-unit subsidy) S = MSC D=MSB=MB D=MB FM Optimal