ECON 1000 Contemporary Economic Issues (Summer 2018) Market Failure and the Allocation Function of Government Relevant Readings from the Required Textbooks: Chapter 10, Market Failure Definitions and Concepts: Three primary functions of government in the economy: allocation function, distribution function, and stabilization function allocation function government production of goods or regulation of business, aimed at improving the allocative efficiency of the economy (i.e., getting the right mix of products produced, each in the ideal quantity and at the ideal quality ). distribution function government policies aimed at changing the final distribution of goods/services across consumers, usually with the intention of realizing a fairer apportionment of consumption/income/wealth. stabilization function attempts by government to minimize fluctuations in overall macroeconomic activity. market failure a situation in which the free market outcome is inefficient, in that there is a positive Deadweight-Loss at the resulting free market level of trade. four common sources of market failure: (1) profit maximization by a firm with market power, (2) market provision of public goods, (3) market provision of goods generating externalities, and (4) lack of information by market participants market power A firm has market power if they have some control over the price of their output, in that they: (i) can increase price without losing all customers and (ii) must decrease price in order to increase sales monopoly market structure in which there is one single seller of a unique good with no close substitutes. The polar opposite of perfect competition. The demand curve facing a monopolist is the market demand curve. They can choose any price/quantity combination along the market demand curve. profit the difference between revenues and costs of production marginal revenue the amount by which revenue changes as the firm s quantity of output is increased by a unit marginal costs of production the amount by which production costs change as the firm s quantity of output is increased by a unit non-rival good a good for which consumption by one person does not diminish the quantity or quality of consumption by others rival good a good for which consumption by one person does diminish the quantity or quality of consumption by others non-excludable good a good for which it is difficult (or very costly) to prevent consumption by those who do not pay excludable good a good for which it is easy to prevent consumption by those who do not pay private good a good that is excludable and rival in consumption.
e.g., Big Mac from McDonald s; market provision is typically efficient public good a good that is non-excludable and non-rival in consumption e.g., national defense club good a good that is excludable and non-rival in consumption e.g., satellite radio or television broadcast common good a good that is non-excludable and rival in consumption e.g., stock of fish in the ocean free rider problem if a public good were supplied in a free market, the amount traded would be less than the efficient quantity, since many people would attempt to enjoy the benefits of units purchased by others, while not purchasing any units themselves externality a benefit or cost that is realized by someone who is not directly engaging in an activity negative externality a cost of an activity borne by someone not engaging in the activity. examples: pollution, noise from low-flying aircraft, speeding on a highway, installation of The Club in a car positive externality a benefit from an activity realized by someone not engaging in the activity examples: vaccines, installation of smoke detector in an attached apartment, installation of Lojack in a car Market provision of a good for which there is an externality is inefficient: Negative externality => free markets provide more than the optimal amount (i.e., too much) of the good Positive externality => free markets provide less than the optimal amount (i.e., not enough) of the good Potential policies to reduce the DWL associated with a negative externality 1. ban the activity entirely ( illegal to emit any pollution ) 2. establish minimum compliance standards for manufacturers ( can only pollute up to a certain level ) 3. cap and trade issue a certain number of pollution permits for society as a whole, and allow people to trade these permits amongst themselves 4. offer subsidies to manufacturers that reduce pollution ( pay the polluter to reduce their level of pollution ) 5. charge manufacturers a fee for each unit of pollution emitted ( polluter must pay for the right to pollute ) internalizing an externality policies which introduce a cost (or foregone gain) that is realized if the person continues to generate a negative externality
Coasian solution to the problem of externalities Ronald Coase (1910-2013; Noble Prize in 1991; Professor Emeritus at Univ. of Chicago Law School) argued that problems of externalities are at their core due to undefined property rights and can be address by the following approach: i. clearly and fully define property rights ii. make individuals pay compensation if they infringe upon the property rights of others iii. allow parties to negotiate with one another regarding infringements on property rights caused by the externality Coase showed that regardless of which party is given the property right, negotiation between the parties will result in the efficient level of the externality (so long as the costs of negotiation and enforcement are low enough) defining property rights and allowing parties to negotiate essentially internalizes the externality market failure due to lack of information for some goods consumers may have difficulty knowing their true reservation price => especially common for goods purchased infrequently or for which quality is difficult to observe (e.g., house, car, education, medical procedure, meal at a restaurant) when consumers lack accurate information about costs or benefits of consuming a good, they may fail to make efficient choices in the marketplace Further note, information is often a club good (non-rival in consumption and excludable). o Once a club good is produced, the additional cost of providing it to the next person is essentially zero => to maximize social surplus, everyone who has a positive value for the information should be able to access it o Additionally, as long as the information is accurate, total costs to society are minimized if the information is only generated once (e.g., it is a waste of resources to have both the National Weather Service and AccuWeather come up with weather forecasts) In such cases, have government license, inspect, and/or regulate providers of such goods in order to: i. provide people with the important information needed to make good decisions in markets and ii. minimize the costs to society of providing the information o e.g., Cobb and Douglas Public Health inspects restaurants and assigns letter grades based upon compliance with health codes => government regulates product and provides information
Government Expenditures as a % of GDP across countries: Cuba 64.6% Norway 44.0% Australia 35.6% Finland 57.5% New Zealand 42.4% South Korea 31.8% France 57.0% Japan 42.3% China 29.3% Italy 51.0% Argentina 40.3% Mexico 28.1% Ukraine 48.1% United States 38.9% India 27.0% United Kingdom 45.1% Brazil 38.6% Singapore 18.2% Germany 44.3% Russia 38.2% Hong Kong 17.6% Government spending as a % of GDP in U.S. over time: mean median min max max year 1820 to 1917 5.94 6.01 3.12 14.83 1865 1918 to 1966 23.72 23.12 11.14 52.22 1945 1967 to 2007 35.48 35.96 30.57 38.67 1992 2008 to 2020 40.78 39.94 38.88 45.13 2009 Jumped from 4.12% in 1861 to 10.41% in 1862; Jumped from 9.45% in 1917 to 21.93% in 1918 1943: 46.13%... 1944: 49.44%... 1945: 52.22%... Abnormally high in 1862-65, 1918-19, 1942-46 If we re-create the table above, but do not include the years from 1862-65, 1918-19, 1942-46 mean median min max 1820 to 1917 (not 1862-65) 5.69 5.93 3.12 9.76 1918 to 1966 (not 1918-19, 1942-46) 21.44 21.27 11.14 30.52 1967 to 2007 35.48 35.96 30.57 38.67 2008 to 2020 40.78 39.94 38.88 45.13 For each row, the minimum value is greater than the maximum value from the row above Before 2008, government spending was never above 38.67% of GDP (except in 1943, 1944, and 1945). Values since 2008 (projected out to 2020): 2008 2009 2010 2011 2012 2013 2014 39.52 45.13 43.89 43.55 41.38 39.94 38.88 2015 2016 2017 2018 2019 2020 38.93 39.66 39.50 39.53 40.00 40.26
Problem: 1. The production of phosphate fertilizers results in substantial pollution. The graph below illustrates Marginal Private Benefits, Marginal Private Costs, and Marginal Social Costs for different levels of trade in this market. Answer the questions below based upon the information conveyed in this graph. $ Marginal Social Costs = (Marginal Private Costs) + (Marginal External Costs) 28.85 24.60 Supply = (Marginal Private Costs) 19.40 16.25 13.10 8.60 0 Demand = (Marginal Private Benefits) quantity 0 3,100 4,750 5,625 1A. Focusing on the 3,100 th unit of output, what is the value of the external cost of producing this unit? Explain. 1B. Continuing to focus on the 3,100 th unit of output, would producing/trading this unit increase or decrease Total Social Surplus? Explain. 1C. Without any intervention in this market, what level of trade would result (i.e., what is the free market level of trade )? 1D. Determine the efficient or Total Social Surplus maximizing level of production/trade in this market. 1E. Would the free market lead to too much trade, too little trade, or just the right amount of trade? Explain. 1F. Is the best level of pollution zero pollution? Explain. Multiple Choice Questions: 1. Market Failure can be described as a situation in which A. a single seller of a good has substantial control over the price of the good. B. the free market outcome is NOT efficient. C. government intervention leads to a greater Deadweight-Loss than does the free market outcome. D. government imposes progressive taxes, in order to indirectly redistribute income.
2. Government spending as a percentage of GDP is greatest in which of the following countries? A. Finland B. United States C. Singapore D. Hong Kong 3. Which of the following is a common source of Market Failure? A. Pricing by firms with market power. B. Market provision of private goods. C. Market provision of a good which generates an externality. D. More than one (perhaps all) of the above answers are correct. 4. Focusing on government spending as a percentage of GDP in the U.S., we observed that: (i) between 1820 and 1917 this figure was never larger than 9.76% and (ii) before 2008 this value was above 38.67% in only three single years (1943, 1944, and 1945). In every single year since 2008, government spending in the U.S. as a percentage of GDP has been A. below 9.76%. B. between 10% and 20%. C. between 20% and 30%. D. above 38.67%. 5. Jim lives in a country in which military output is not provided by the government, but rather is supplied by profit maximizing firms and purchased by individual consumers in a free market. Jim chooses to enjoy the benefits of national security which result from military output purchased by others in society, while purchasing zero units of military output of his own. This example illustrates A. Joseph Schumpeter s account of a gale of creative destruction. B. the Free Rider Problem. C. the Coasian Solution to the problem of externalities. D. Adam Smith s Invisible Hand. 6. The function of government can be described as government production of goods or regulation of business, aimed at getting the right mix of products produced, each in the ideal quantity and at the ideal quality. A. Taxation B. Allocation C. Distribution D. Stabilization 7. A 4 th of July Fireworks display in downtown Atlanta is A. easily Excludable. B. perfectly Rival in Consumption. C. very Non-Rival in Consumption. D. More than one (perhaps all) of the above answers is correct.
8. In the presence of a negative externality, the free market would A. provide more than the efficient amount of the good. B. provide less than the efficient amount of the good. C. have trade take place at a price of $0. D. None of the above answers are correct. For Questions 9 through 11, consider a good with Marginal Private Benefits, Marginal Private Costs, Marginal Social Benefits, and Marginal Social Costs as illustrated below. $ 21.85 15.80 13.30 11.00 a b c e (Marginal Social Costs) = (Marginal Private Costs) Marginal Social Benefits 0 d Marginal Private Benefits quantity 0 4,100 5,900 6,800 9. Based upon this graph, it appears as if A. the government is imposing a substantial per unit tax on this good. B. this good is clearly produced by a monopolist. C. production/consumption of this good generates a positive externality. D. production/consumption of this good generates a negative externality. 10. If this good were traded in a free market (without any government intervention),, although the Social Welfare Maximizing level of trade is. A. 6,800 units would be traded; 5,900 units. B. 5,900 units would be traded; 4,100 units. C. 4,100 units would be traded; 5,900 units. D. 0 units would be traded; 6,800 units. 11. At the free market outcome (without any government intervention) there would be a Deadweight-Loss equal to A. area (c). B. area (e). C. areas (a)+(b). D. areas (a)+(b)+(c).
12. Which of the following is a good example of a Pure Public Good? A. National Defense. B. Public Transportation (e.g., the subway system). C. Denny s Moons Over My Hammy breakfast sandwich. D. Mp3 files purchased from Amazon.com. For Questions 13 through 15, consider a monopolist facing Demand and with Marginal Costs and Marginal Revenue as illustrated below. $ 17.10 12.00 Marginal Costs of Production 8.40 a d b e c f h Demand 6.00 g 0 0 Marginal 2,720 Revenue 4,640 5,920 13. The efficient level of output for this good is units. A. 2,720 B. more than 2,720 but fewer than 4,640 units C. 4,640 D. 9,120 9,120 quantity 14. To maximize profit, this monopolist would A. sell 9,120 units of output, each at a price of $17.10. B. sell 4,640 units of output, each at a price of $8.40. C. sell 2,720 units of output, each at a price of $6.00. D. None of the above answers are correct. 15. When this monopolist chooses the price and quantity which maximizes profit, A. Total Consumers Surplus is equal to zero. B. Producer s Surplus (i.e., Monopoly Surplus ) is equal to areas (a)+(b)+(d)+(e)+(g). C. Deadweight-Loss is equal to areas (c)+(f). D. More than one (perhaps all) of the above answers is correct.
16. Government Spending as a Percentage of GDP in the United States is projected to A. decrease to less than 30% by 2020. B. remain at roughly 40% for the next several years. C. increase to roughly 60% by 2020. D. None of the above answers are correct. For questions 17 through 19 consider the following scenario. Company Z wants to construct a new manufacturing facility near an existing residential neighborhood. If they construct and operate the facility, they can do so at one of three different sizes: small plant, medium plant, or large plant. However, their economic activity would impose external costs from pollution on the nearby residents. The resulting profit (for Company Z ) and external costs (to residents of the adjacent neighborhood) of each possible choice are specified in the table below: no plant small plant medium plant large plant Profit $0 $400,000 $700,000 $900,000 External Costs $0 $50,000 $250,000 $650,000 17. If Company Z was able to choose its plant size without having to account for the external cost to nearby residents whatsoever, they would choose A. no plant. B. small plant. C. medium plant. D. large plant. 18. The socially efficient outcome is for Company Z to construct and operate A. no plant. B. a small plant. C. a medium plant. D. a large plant. 19. Suppose that property rights can be clearly defined, individuals must pay compensation if they infringe upon the property rights of others, and the impacted parties can negotiate with one another. We would expect the ultimate outcome to be if the homeowners are given the right to a pollution free environment and if Company Z is given the right to pollute the environment. A. no plant; large plant. B. large plant; no plant. C. small plant; small plant. D. medium plant; medium plant.
20. A government policy that attempts to Internalize an Externality can be generally described as A. a policy which completely bans an activity that generates an externality. B. a policy which introduces a cost (or foregone gain) that would be realized by a decision maker who generates an externality. C. a policy which mandates the exact level of an activity that decision makers must engage in. D. None of the above answers are correct. 21. Widgets are non-rival in consumption and non-excludable. As a result, if widgets were simply sold in the marketplace, we should expect A. less than the efficient amount of widgets to be traded. B. exactly the efficient amount of widgets to be traded. C. more than the efficient amount of widgets to be traded. D. None of the above answers are necessarily correct (since we need to know something about costs of production in order to be able to determine whether the resulting level of trade will be more than, less than, or exactly equal to the efficient level of trade). 22. Which of the following was discussed in lecture to illustrate how something akin to the Coasian Solution to Externalities has been implemented in practice? A. How total social welfare (on a global level) was likely decreased by President Barack Obama flying to Copenhagen in order to lobby the International Olympic Committee on behalf of Chicago s bid to host the 2012 Summer Olympics. B. How the Defenders of Wildlife established the Bailey Wildlife Wolf Compensation Trust in order to facilitate the re-introduction of the gray wolf into the wild in the western United States. C. Why efficiency dictates that any activity which generates a negative externality should be completely banned. D. Why a free market would tend to provide less than the efficient amount of national defense. 23. Which of the following policies could likely reduce Deadweight-Loss in the presence of a negative externality, such as pollution? A. Establish minimum compliance standards for manufacturers in the industry (allowing them to generate only a certain amount of the negative externality). B. Do nothing (i.e., just let the market allocate the good as is currently the case, with no deliberate government action whatsoever). C. Offer subsidies to manufacturers for reducing the amount of the negative externality that they generate. D. More than one (perhaps all) of the above answers is correct
24. On September 11, 2010, former heavyweight boxing champion Wladimir Klitschko defeated Samuel Peter by knockout in Frankfurt, Germany. This fight was only available in the U.S. on Pay Per View. The broadcast of this bout on Pay Per View is excludable but non-rival, and was therefore a A. Public Good. B. Private Good. C. Club Good. D. Common Good. 25. A firm operating in a Perfectly Competitive Market has No Market Power, which implies that the firm A. would lose all its customers if it attempted to increase price above the prevailing market price. B. must decrease its price in order to increase the quantity of output sold. C. faces a horizontal demand curve for its output. D. More than one (perhaps all) of the above answers is correct. 26. A good is non-excludable if A. consumption by one person does not diminish the quantity/quality of consumption by others. B. consumption by one person does diminish the quantity/quality of consumption by others. C. it is difficult (or very costly) to prevent consumption by those who do not pay for the good. D. it is easy (or relatively costless) to prevent consumption by those who do not pay for the good.
Answer to Problem: 1A. Since Social Costs are equal to the sum of Private Costs and External Costs, it follows that External Costs could be thought of as the difference between Social Costs and Private Costs. Focusing on just the 3,100 th unit, the External Cost of producing/trading this unit is the difference between the Marginal Social Cost of producing/trading this unit and the Marginal Private Cost of producing this unit. From the graph we see that this difference is: (13.10)-(8.60)=(4.50). 1B. In general, the Social Surplus from trading any particular unit is equal to the difference between the Marginal Social Benefits and the Marginal Social Costs of trading the unit. In this market there is no positive externality, so that Marginal Social Benefits are simply equal to Marginal Private Benefits. Therefore, from the graph we see that producing/trading this unit would generate a Social Surplus of: (28.85)-(13.10)=(15.75). Since this difference is positive, Total Social would be increased by producing/trading this unit. 1C. Without any intervention in the market, self-interested buyers would base their purchasing decisions upon their Marginal Private Benefits and self-interested sellers would base their supply decisions upon their Marginal Private Costs. Market forces would ensure that trade would occur on all units for which Marginal Private Benefits are greater than Marginal Private Costs. Thus, we see from the graph that (5,625) units would be traded. 1D. In order to maximize Total Social Surplus we should only produce/trade those units for which Marginal Social Benefits are greater than Marginal Social Costs. Again, since there is no positive externality in this market, it follows that Marginal Social Benefits are simply equal to Marginal Private Benefits. Therefore, we see from the graph that Total Social Surplus is largest when (4,750) units are traded. 1E. From the answers to parts (1c) and (1d), it follows that in the presence of this negative externality, the free market would lead to too much trade (since 5,625 is greater than 4,750). 1F. No, the best level of pollution (that is, the amount of pollution generated at the efficient level of production/trade) is not equal to zero. In order to generate zero pollution, society would have to refrain from producing/trading any units for which there was a positive Marginal External Cost. From the graph it is clear that there is a positive Marginal External Cost from every unit produced. However, from the standpoint of society, it is clear that the Social Benefits are greater than the Social Costs for each of the initial 4,750 units produced/traded in this market. Answers to Multiple Choice Questions: 1. B 2. A 3. D 4. D 5. B
6. B 7. C 8. A 9. C 10. C 11. C 12. A 13. C 14. D 15. D 16. B 17. D 18. C 19. D 20. B 21. A 22. B 23. D 24. C 25. D 26. C