Part A ******** general equilibrium The condition that exists when all markets in an economy are in simultaneous equilibrium.

Transcription

1 1 Chapter 3- Market and Market Failure Part A Page 1 Syllabus-Market adjustment to changes in demand, efficiency of perfect competition, allocative efficiency and perfect competition, sources of market failure: imperfect markets, public goods, externalities, imperfect information; evaluating the market mechanism. ******** Partial equilibrium analysis- The process of examining the equilibrium conditions in individual markets and for households and firms separately. general equilibrium The condition that exists when all markets in an economy are in simultaneous equilibrium. efficiency The condition in which the economy is producing what people want at least possible cost. MARKET ADJUSTMENT TO CHANGES IN DEMAND Fig 12.3 ( in PPT and in book also) Economic theorists have struggled with the question of whether a set of prices that equates supply and demand in all markets simultaneously can actually exist when there are literally thousands and thousands of markets. If such a set of prices were not possible, the result could be continuous cycles of expansion, contraction, and instability. Efficiency of perfect competition We defines efficiency in pareto sense, it is also called pareto efficiency. Pareto efficiency says that allocation α is Pareto efficient if no change is possible that will make some members of society better off without making some other members of society worse off. To demonstrate that the perfectly competitive system leads to an efficient, or Pareto optimal allocation of resources, we need to show that no changes are possible that will make some people better off without making others worse off. Specifically perfect competition is Pareto efficient if 1. There is efficient allocation of resources among firms 2. There is efficient distribution of outputs among households

2 2 Chapter 3- Market and Market Failure 3. There is efficient mix of output: Producing what people want (Allocative efficient) Page 2 Efficient allocation of resources among firms The assumptions that factor markets are competitive and open, that all firms pay the same prices for inputs, and that all firms maximize profits lead to the conclusion that the allocation of resources among firms is efficient. Efficient distribution of outputs among households We all know that people have different tastes and preferences, and that they will buy very different things in very different combinations. As long as everyone shops freely in the same markets, no redistribution of final outputs among people will make them better off. If you and I buy in the same markets and pay the same prices, and I buy what I want and you buy what you want, we cannot possibly end up with the wrong combination of things. Free and open markets are essential to this result. Efficient mix of output: Producing what people want or Allocative efficiency of Perfect competition Society will produce the efficient mix of output if all firms equate price and marginal cost. We can think prices in terms of social benefits. If consumer is ready to pay higher prices then it means that marginal gain by each more unit is higher than its cost. If P x > MC X then society gain values by producing more X If P x < MC X then society gain values by producing less X So P x = MC X is condition for allocative efficiency, i.e. allocative efficiency is occurs when sum of consumer surplus and producer surplus is maximum. Px SUPPLY= MC CS PS

3 3 Chapter 3- Market and Market Failure DD=Marginal benefits X Page 3 The Sources of Market Failure Market failure Occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost value. There are four important sources of market failure: (1) imperfect market structure, or noncompetitive behavior, (2) the existence of public goods, (3) the presence of external costs and benefits, and (4) imperfect information. IMPERFECT MARKETS imperfect condition An industry in which single firms have some control over price and competition. Imperfectly competitive industries give rise to an inefficient allocation of resources. monopoly An industry composed of only one firm that produces a product for which there are no close substitutes and in which significant barriers exist to prevent new firms from entering the industry. In all imperfectly competitive industries, output is lower the product is underproduced and price is higher than it would be under perfect competition. The equilibrium condition P = MC does not hold, and the system does not produce the most efficient product mix. PUBLIC GOODS public goods, or social goods Goods or services that bestow collective benefits on members of society. Generally, no one can be excluded from enjoying their benefits. The classic example is national defense. private goods Products produced by firms for sale to individual households. Private provision of public goods fails. A completely laissez-faire market system will not produce everything that all members of a society might want. Citizens must band together to ensure that desired public goods are produced, and this is generally accomplished through government spending financed by taxes.

4 4 Chapter 3- Market and Market Failure EXTERNALITIES externality A cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction. Page 4 The market does not always force consideration of all the costs and benefits of decisions. Yet for an economy to achieve an efficient allocation of resources, all costs and benefits must be weighed. IMPERFECT INFORMATION imperfect information The absence of full knowledge concerning product characteristics, available prices, and so forth. The conclusion that markets work efficiently rests heavily on the assumption that consumers and producers have full knowledge of product characteristics, available prices, and so forth. The absence of full information can lead to transactions that are ultimately disadvantageous. EVALUATING THE MARKET MECHANISM Freely functioning markets in the real world do not always produce an efficient allocation of resources, and this result provides a potential role for government in the economy.

5 5 Chapter 3- Market and Market Failure Part B Syllabus-Externalities, marginal cost pricing, internalizing externalities, Public goods, Imperfect Information: adverse selection, moral hazard, social Choice, government inefficiency. Page 5 ****** When there are large numbers of buyers and sellers, all with full information, exchanging similar (if not identical) goods, markets can be efficient. There are circumstances that interfere with the efficiency of these markets and when these circumstances occur, there is a market failure. In the last two chapters, we examined the effect of market failure resulting from not having enough sellers. It was then seen how the government and the market serve to remedy this failure. In this chapter, our examination will continue into the causes of market failure by studying externalities, public goods, imperfect information, and governmental failure. Externalities An externality exists when the actions or decisions of one person or group impost a cost or bestow a benefit on second or third parties. Externalities are sometimes called spillovers or neighborhood effects. Inefficient decisions result when decision makers fail to consider social costs and benefits. The study of externalities is a major concern of environmental economics. As societies become more urbanized, externalities become more important when we live closer together, our actions are more likely to affect others. REALITY CHECK: A good example of an externality is cigarette smoke. When a person smokes a cigarette, the smoke affects others. We call this second hand smoke and it is a good example of how one person s consumption can spillover to affect someone else. Marginal Social Cost and Marginal-Cost Pricing Private Choices and External Effects Internalizing Externalities Marginal Social Cost and Marginal-Cost Pricing Profit-maximizing perfectly competitive firms will produce output up to the point at which price is equal to marginal cost (P = MC). As a result, competitive markets produce and efficient mix of output.

6 6 Chapter 3- Market and Market Failure But if the production of the firm s product imposes external costs on society, producing at that point will not be efficient. If the firm does not take those additional costs into account, it is likely to overproduce. This is illustrated Figure Page 6 The top two panels of the figure illustrate the perfectly competitive firm in a situation where there are no externalities. Production at q* is efficient. In the lower two panels, external costs have been included, but the firm is ignoring them. The curve labeled MSC, marginal social cost, is the sum of the marginal costs of producing the product (MC) plus the correctly measured damage costs imposed in the process of production. Production at q* is no longer efficient. Acid Rain and the Clean Air Act Acid rain is an excellent example of an externality and the issues and conflicts in dealing with externalities. Manufacturing firms and power plants in the Midwest burn coal with high sulfur content. When the smoke from these plants mixes with moisture in the atmosphere, the result is a dilute acid that is windblown north to Canada and east to New York and New England, where it falls to earth in the rain. The acid rain imposes enormous costs where it falls; estimates of damage from fish kills, building deterioration, and deforestation range into the billions of dollars. But if the power plants were forced to consider these costs, electric bills would rise in the Midwest, which would raise production costs and perhaps result in a loss of jobs. The case of acid rain highlights the fact that efficiency analysis ignores the distribution of gains and losses. To establish efficiency, we need only to demonstrate that the total value of the gains exceeds the total value of the losses. After many years of debate, Congress passed and President Bush signed the Clean Air Act of 1990, which includes strict air emissions standards and uses tradable pollution rights (to be discussed later in this chapter). Other Externalities Not all externalities are negative. Restoring an abandoned house in an urban neighborhood makes the area better and adds value to the neighbors homes. Private Choice and External Effects Suppose that there are two people who live in a dormitory, Harry (who has a really expensive stereo system) and Jake (who lives next door to Harry). Harry (who has impaired hearing) plays his favorite music very loud, and Jake can hear it through the very thin walls. Jake doesn t like the same music as Harry, anyway.

7 7 Chapter 3- Market and Market Failure If we assume that there are no further external costs or benefits to anyone other than these two individuals, the figure below illustrates the decision process that they face. Page 7 Harry s marginal benefits and marginal cost curves are shown in blue (his MPC would reflect the cost of electricity, for example) and the red curves are the marginal damage cost to Jake (the loud music affects him negatively) and the marginal social cost (found by adding Harry s marginal cost to the marginal damage cost). If Harry considers only his private costs, he will play his stereo for a number of hours that is inefficient from the society s point of view. It is generally true that when economic decisions ignore external costs, whether those costs are borne by one person or by society, those decisions are likely to be inefficient. Internalizing Externalities A number of mechanisms are available to provide decision makers with incentives to weigh the external costs (and benefits) of their decisions, a process called internalization. Five approaches have been taken to solving the problem of externalities: Taxes and subsidies Bargaining and negotiation Legal rules and procedures Selling or auctioning pollution rights Direct regulation of externalities Taxes and Subsidies

8 8 Chapter 3- Market and Market Failure The government could tax the party who is imposing the externality, as shown in the figure below: Page 8 This is the same figure we saw earlier, except that the firm pays the damage costs in the form of a per-unit tax (the tax = the MDC). As a result, the firm s marginal cost is now the same as the marginal social cost. The efficient level of output is changed, as is the price. The biggest problem with this approach is measuring damages. While economists have some tools to help approximate some of these costs and benefits, the reality is that they are very difficult to determine. Moreover, the tax will not eliminate the damage; it will only force the producer to consider the costs. A polluter, for example, will continue to pollute because its revenue will cover the costs of resources used to produce and to compensate for those damaged by production. Taxes do provide firms with an incentive to use the most efficient technology for dealing with damage, and so will provide an incentive to reduce damages to an efficient level. Sometimes the most efficient solution to an externality problem is for the damaged party to avoid the damage. However, if the damager pays full compensation, damaged parties may not have an incentive to do so. Just as ignoring social costs can lead to inefficient decisions, so too, can ignoring social benefits. Bargaining and Negotiation The bargaining solution to the externality problem is based upon an article by Ronald Coase. The Coase theorem says that bargaining can solve externality problems, but only when three

9 9 Chapter 3- Market and Market Failure conditions hold. First, there must be a clear rule that establishes whose rights are being infringed upon. Second, the bargaining must not be difficult or costly. Lastly, there can be a few people involved in the bargaining. Page 9 REALITY CHECK: Consider the negotiations between the cigarette industry and the government. Cigarettes cause negative externalities in terms of second-hand smoke, insurance rates, medical expenses, lower productivity, and so on. In theory, the agreed-to settlement means that cigarette companies are paying to compensate society for the externality. The Coase theorem is limited in its applicability. The three conditions that must hold for the theorem to be true rarely hold completely. Typically, external costs like pollution involve many people and bargaining costs are very high. Furthermore, there is not always a clear assignment of rights to base the bargaining upon. The usefulness of the theorem is to see how the problem of an externality arises from the act of one party infringing on the rights of another party. Legal Rules and Procedures Legal rules and procedures can also help to mitigate externality problems. If the government can see that a certain behavior is causing external costs, the government can prohibit that behavior through the use of an injunction, or it can require that the offending party compensate the party that has had to bear the external cost (liability rules). Legal rules and procedures do not necessarily stop the offending action; they only punish it when it has been made public. Pollution is a byproduct of production and, for the moment, polluting cannot be made illegal. Therefore, the problem then becomes, how is it known when there is too much pollution? The legal rules and procedures require the government to be able to assess how much is too much. Selling or Auctioning Pollution Rights Selling or auctioning pollution rights is a relatively new and fascinating solution to the externality problem. The idea behind this solution is that the government sets a fixed amount of pollutants that it will allow in a given time period. Assume, as an example, that the maximum amount of annual pollution the government will allow is 10 tons of sulfur. The government then prints up 10 coupons, each of which will allow the holder of the coupon to release one ton of sulfur into the environment. These coupons then get auctioned off to the highest bidder. The companies that will end up with the coupons are the ones who have the highest cost of cutting their sulfur emission. The companies who lose the auction are the ones with the lowest cost of cutting sulfur emission, and they are the ones that will have to cut their emissions. This is a far more efficient way to reduce pollution than requiring each and every firm to reduce emissions, since some firms would find the reduction prohibitively expensive. By making firms pay to pollute, the government is imposing the external costs of their pollution back on the firm. This also gives the firms an incentive to go to the pollution control market to reduce pollution. Also, if

10 10 Chapter 3- Market and Market Failure the reduction in pollution has a value to the public, the public can buy a coupon and destroy it, as was recently done. Page 10 This is still a relatively new technique and still requires the government to determine the socially optimal amount of emissions in the first place. Direct Regulation of Externalities The final solution is direct regulation, which is simply having the government establish permissible pollution levels and then enforce those rules. Direct regulation is not easy, however. It is impossible to monitor the output of all firms, not to mention cars and other household pollutants. Furthermore, the determination of appropriate levels of pollution is left to Congress, which (as will be discussed later in this chapter) may not be representing the best interests of society. The success of direct regulation in the U.S. has been limited, but measurable. The Clean Air Act and Clean Water Act have had a dramatic effect on effluents. Public (Social) Goods The second source of market failure is in markets for public (or social) goods, which are also called collective goods. A public good is a good that benefits everyone in the society. The Characteristics of Public Goods To be called a public good, a good must exhibit two traits: there must be no way to exclude anyone from consuming it (nonexcludability), and one person s consumption of the good must not diminish another person s ability to consume the good (nonrivalry). Classic examples of public goods are lighthouses and the national defense. There are some problems that are associated with the providing of these particular goods, though. 1. Free Rider Problem- Suppose the government decided that anyone who wanted to benefit from national defense would therefore have to pay for it. What would be the incentive to pay? The problem is that people would recognize that there is no way the government could prevent them from benefiting from the national defense if they did not pay for it. As a result, many people would consume the service (take advantage of national defense) without paying for it. This situation is called the free-rider problem (Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them.) 2. Drop in the bucket Problem- The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays. Since the producer of the good does not get enough money to pay for all of the goods used due to these two problems, the good will therefore get underproduced.

11 11 Chapter 3- Market and Market Failure Public Provision of Public Goods Page 11 Since private firms would never want to provide public goods, because they cannot get paid for what they produce, the responsibility falls upon the government to provide for public goods. The government can force people to pay for these goods through taxation and then hire a private firm to produce the good. The debate about government provision of public goods exists at three levels: first, what goods truly are public goods; second, how does the government determine how much of the good to produce; and third, how can it be insured that the government will provide the good efficiently? The determination of what goods are public goods is difficult. With the exception of the national defense, there is no unanimity of opinion. In an extreme sense, most goods could be made excludable, police could refuse to help people who do not have a badge that says they paid for their police protection. In an extreme sense, everything in the world is rivalrous, even national defense. Eventually, if there were enough people in the U.S., it might become impossible to defend them all. There are some goods that tend to look more like public goods than others do. Police and fire protection are good examples of semi-public goods, since they are both rivalrous and excludable. These goods are close enough to a pure public good to warrant the government choosing to provide them. Other goods are not so clearly public. There is an ongoing debate over which goods the government should provide. From public schools to public parks, there are a variety of opinions. Optimal Provision of Public Goods What is the optimal amount of a public good that the government should provide? Paul Samuelson looked at this problem and argued that the market demand for a public good was derived in a distinctly different way than the market demand for a private good. Samelson s Theory In the early 1950, economist Paul Samuelson demonstrated that there exists an optimal or a most efficient level of output for every public good. Once the market demand for a public good was accurately derived, then the optimal amount of the public good to produce is where the demand crosses the marginal cost curve. The method to determine the market demand for a private good is done by finding the amount that people are willing to buy at each price and then adding the quantities up. The total amount that everyone is willing to buy at that price is a point on the market demand curve. This is equivalent to adding each demand curve horizontally (see Fig 15.4) For a public good, the demand curves are added differently. The summation of the demand curve for the private good reflects the fact that one person s consumption of a good prevents another person from consuming the good. A public good does not have this quality. This is illustrated in Figure 14.5.

12 12 Chapter 3- Market and Market Failure Price Per Unit MC Page 12 D A+B D A X* Units of Ouputs D A As shown, person A is willing to pay $6 for X1 units, and person B is willing to pay $3 for the same X1 units. Since these people can both simultaneously consume X1 units of a public good, the society, as a whole, is willing to pay $9 for X1 units. In other words, demand curves are added together vertically, instead of horizontally. The Problems of Optimal Provision Once added together, the marginal cost of producing the public good can be added to the market demand curve for the public good, therefore finding the optimal amount to produce. This is shown in above fig. The problem is that it is difficult to know how much each person in an economy is willing to pay for something. Since they will be able to consume the good no matter what, there is no incentive for people to reveal how much they are willing to pay for a public good. If the government does not know the amount people are willing to pay, then they cannot accurately determine the market demand curve and the optimal amount to produce. Local Provision of Public Goods: The Tiebout Hypothesis An efficient mix of public goods is produced when localland/housing prices and taxes come to reflect consumer preferences just as they do in the market for private goods. One way to get people to reveal their willingness to pay for public goods was demonstrated by Charles Tiebout (pronounced Tee-Bow). He pointed out that different communities provide

13 13 Chapter 3- Market and Market Failure Page 13 different levels of public goods. People who want a particular level of a public good will move into the community providing the level. The more that people want to move into a community, the higher the demand for housing, and consequently, the higher the price of housing. In the end, the price of housing serves as the price that people are willing to pay for the public good in that community. Since people reveal their willingness to pay for the public good by where they choose to live, this model demonstrates "voting with your feet." Mixed Goods Goods that have characteristics that are part public and part private. Education is a key example Imperfect Information The third cause of market failure is the presence of imperfect information. Information is limited, and firms make best guesses about many market features. But there are certain types of information gaps that pose unique problems for markets. There are two scenarios of imperfect information: adverse selection and moral hazard. Adverse Selection To illustrate the scenario of adverse selection, a labor market example will be used. It is difficult for employers to determine whether or not they are hiring a qualified employee. If an employer knows that a skilled employee has a marginal revenue product (MRP) of $20 an hour and an unskilled employee has an MRP of $10 an hour, then the employer will offer a wage somewhere between the two MRPs. An employer does this since they are not sure if they are getting the high MRP worker or the low skilled one. The problem is that the high MRP workers will not be willing to work for the lower wage and will not apply for the job. Thus, the only applicants will be the low skilled workers, who will be overpaid. Likewise, if a demander is unable to determine whether a good is of high quality or of low quality, the demander will hedge his or her willingness to pay. As a result, the high quality goods will be driven out of the market. The solution to this problem is to find a way for the high quality goods to demonstrate to the demander that they are of high quality. Independent labs test goods; independent employment firms screen applicants; and quality universities only give degrees to bright students. The methods of signaling this information to the demander are through things like screening applicants, college degrees, and independent lab tests of goods. Moral Hazard The moral hazard problem occurs when one party to a contract passes the costs of his or her behavior on to another party. In other words, this is when a person does not have to pay for the consequences of their actions. The moral hazard problem exists whenever the cost of someone s actions is not borne by that person. The solution to moral hazard problems is to partially shift the cost back on the person who

14 14 Chapter 3- Market and Market Failure is taking the action. An example of such a solution is profit sharing for a firm, which provides incentives to employees. Page 14 Market and Government Solutions Market Solutions As with any other goods, there is an efficient quantity of information production. Information is produced by consumers and producers themselves in the process called market search. The rapid development of the Internet has had an enormous effect on the availability of information to consumers. Firms also spend time and resources searching for information. Like consumers, profit-maximizing firms will gather information as long as the marginal benefits from a continued search are greater than the marginal costs. Government Solutions Information is essentially a public good. When information is costly for individuals to collect and disperse, it may be cheaper for the government to produce it for everybody. Social Choice One view of government or the public sector, holds that it exits to provide things that society wants. A society is collection of individual, and each has a unique set of preferences. Defining what society wants, therefore, becomes a problem of social choice. (Social choice- the problem of deciding what society wants.) To understand we must understand the incentives facing politicians and public servants, as well as the difficulties of aggregating the preferences of the member of a society. The Voting Paradox Democratic societies use ballot procedures to determine aggregate preferences and to make the social decisions that follow from them. The most common social decision making mechanism is majority rule-but it is not perfect. The voting Paradox-A simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem.

15 15 Chapter 3- Market and Market Failure In 1951, Kenneth Arrow proved his impossibility theorem. This theorem (Arrow Impossibility theorem) says that no system of putting together the wills of a whole society will yield consistently socially optimal outcomes. Page 15 The voting paradox highlights the problem with majority rule voting. Suppose that, faced with a decision about the future of the institution, the president of a major university opts to let its three top administrators vote on the following options. Should the university A-Increase the number and hire more faculty B-maintain the current size of faculty and student body C-cut back on faculty and reduce the student body? Table 15.1 shows the result of the vote. TABLE 15.1 Results of Voting on University s Plans: The Voting Paradox VOTES OF: Vote VP1 VP2 Dean Result a A versus B B versus C A B A A wins: A > B B B C B wins: B > C C versus A A C C C wins: C > A a A > B is read A is preferred to B. If A is better than B and B is better than C, how could C be better than A? This inconsistency is called the voting paradox. Thus, even when a government action is taken based on a decision made by majority rule, there is no certainty that the decision is the most desired option for the society. Another problem with majority-rule voting is that it leads to logrolling, which occurs when representatives trade votes (I vote for your program if you vote for mine). It is not clear whether any bill could get through any legislature without logrolling. It is also not clear whether logrolling is, on balance, a good thing or a bad thing from the standpoint of efficiency. It may turn out beneficial legislation, or it may turn out unjustified pork barrel legislation. (Pork barrel is

16 16 Chapter 3- Market and Market Failure the appropriation of government spending for localized projects secured solely or primarily to bring money to a representative's district.) Page 16 A number of other problems result from voting as a mechanism for public choice. Voters do not have much of an incentive to become well informed, because the apparent costs may outweigh the apparent benefits. Also, choices are almost always limited to bundles of public goods, and we vote infrequently. Government Inefficiency Government does not compete and does not need to make a profit; hence, it has little incentive to provide goods and services efficiently. Ultimately, social choice theory argues that government, like households, acts to maximize its utility. That utility may come from re-election or from bringing certain government-sponsored projects to the home state of the Congress member. Assuming that government is able to determine all the costs and benefits that would allow it to solve the market problems discussed in this chapter, it is not obvious that government has the incentive to solve the problem. Elected and appointed officials represent many people with many different views. Furthermore, these officials are also self-interested to the extent that their budgets and re-election prospects may drive them to make socially sub-optimal decisions. Rent-Seeking Revisited Special interest groups can and do spend resources to influence the legislative process. Any group that benefits from a government policy has an incentive to use its resources to lobby for that policy. In the absence of well-informed and active voters, special-interest groups assume an important and perhaps critical role. Government and the Market There is no question that government must be involved in both the provision of public goods and the control of externalities. A strong case can also be made for government actions to increase the flow of information. The question is not whether we need government involvement; the question is how much and what kind of government involvement we should have.