OUTLINE -- Lessons 5a and 5b - The Public Sector (Government)

5a - Government Interference in Markets and Market Failures (Negative Externalities)
 

The Economic Role of Government and the 5 Es

I. REVIEW

A. The Market System and Efficiency
See: The supply and demand model and allocative efficiency
1. WHAT WE GET:
a. Goal of businesses: Maximize Profits
b. Therefore,they will produce where:
  • the Market Equilibrium quantity
  • the quantity where Qs=Qd
  • the is "what we get"

 

  • Graphically:

c. Assumptions: pure capitalism (for what is capitalism see: chapter 2)

2. WHAT WE WANT: ALLOCATIVE EFFICIENCY

a.. Review :
(1) Allocative Efficiency
definition - using our limited resources to produce:
  • The quantity of goods and services that maximizes society's satisfaction
  • using resources to produce more CDs that people want and fewer cassette tapes that they don't want
  • no shortages and no surpluses

(2) Benefit-Cost Analysis

definition -
the selection of ALL possible alternatives where the marginal benefits are greater than the marginal cost

select all where: MB > MC
up to where: MB = MC
but never where: MB < MC

B. Allocative Efficiency is achieved where:

1. MSB=MSC
a. define Marginal Social Benefits (MSB)

b. define Marginal Social Costs (MSC)

c. therfore if society gets

all quantities where: MSB > MSC
up to where: MSB = MSC
but never where: MSB < MSC

this will be the quantity where society's Satisfaction will be maximized or the allocatively efficient quantity

2. Graphically:

 

C. THEREFORE:

1. Businesses will produce the profit maximizing or market equilibrium quantity - the quantity where Qd=Qs

2. Society wants the allocatively efficient quantity - the quantity where MSB=MSC

3. WHAT WE GET = WHAT WE WANT if:

b. Market Demand = Marginal Social Benefits (D=MSB)
1. law of diminishing marginal utility
2. assuming no positive externality (or spillover benefit)s D=MSB

c. Market Supply = Marginal Social Costs (S=MSC)

1. law of increasing costs
2. assuming no negative externality (or spillover cost)s S=MSC

D. Competitive Markets and Allocative Efficiency (MSB=MSC)

1. if there are no negative externality (or spillover cost)s, then S = MSC,

2. if there are no positive externality (or spillover benefit)s, then D = MSB,

3. Graphically:

4. Then: WHAT WE GET = WHAT WE WANT and market economies achieve allocative efficiency

 

In a market economy with no positive externality (or spillover benefit)s and no negative externality (or spillover cost)s:

the profit maximizing or market equilibrium quantity
(what we get)

WILL BE THE SAME AS

the allocative efficient quantity
(what we want)
D. Preview of Lessons 5a and 5b - 2 Parts:
1. Governments Causing Allocative Inefficiency
2. Markets Causing Allocative Inefficiency and the Role of Government

II. Governments Causing Allocative Inefficiency

A. Price Ceilings and Allocative Inefficiency
1. definition
2. graphically
3. effects
4. examples
a. World War II price controls
b. rent controls
c. credit card interest rates
d. anti-price gouging laws (plywood after a hurricane)
e. food price controls in LDCs

B. Price Floors (Supports) and Allocative Inefficiency

1. definition
2. graphically
3. effects
4. examples
a. farm price supports
b. minimum wage

III. Economic Functions of Government

A. Two Main Roles:

1. Help the Market Achieve the 5 E's
2. Correcting the Markets when they don't achieve the 5 E's

B. Five Reasons for Government Involvement

  1. Provide a legal and social framework in which the economy can operate
  2. Maintain Competition
    (Captitalism achieves efficiency only if there is competition)
  3. Redistribution of income
    (correcting the market's failure to achieve equity)
  4. Reallocation of resources
    (correcting the market's failure to achieve efficiency)
    • spillovers
    • public goods
  5. Stabilizing unemployment and inflation and promoting economic growth

C. Legal and Social Framework

providing the legal foundation and a social environment conducive to the effective operation of the market system

D. Maintaining Competition

1. review competition
a. large numbers
b. free entry and exit

2. the problem with monopolies

a. higher prices
b. smaller quantities

3. role of government

a. preventing monopolies -- antitrust laws
b. regulating monopolies -- natural monopolies

E. Correcting Market Failure to Achieve Equity

1. define equity
2. examples of income distribution

3. role of government

a. transfer payments
b. market intervention
c. progressive income taxes

F. Correcting Market Failure to Achieve Allocative Efficiency

1. negative externality (or spillover cost)s (negative externalities)
a. definition
TEXTBOOK: A cost imposed without compensation on third parties by the production or consumption of sellers or buyers.

CLASS: A negative externality (or spillover cost) occurs if some of the costs of producing and consuming a product "spillover" onto a third party who does not benefit.

  • not just the buyer
  • not just the seller,
  • but someone else must pay some of the costs of production

Example: A paper manufacturer dumps toxic chemicals into a river killing the fish sport fishers seek.

  • buyer = purchaser of paper
  • seller = paper manufacturer
  • third party = people who fish, or live, downstream

b. examples

a) pollution
b) cigarettes
c) alcohol
d) gasoline and pollution
d) party in dorm room and you're not invited

c. markets and inefficiency:

ON A GRAPH SHOW:

1) S and D for a product

2) MSC when there are NO negative externality (or spillover cost)s (producer pays ALL costs)

  • Show the profit maximizing quantity
  • Show the allocatively efficient quantity
    (assume D=MSB, i.e. no positive externality (or spillover benefit)s)

3) What happens to S if there ARE negative externality (or spillover cost)s (the producer can AVOID some costs)

4) What happens to P, Q, and efficiency WITH negative externality (or spillover cost)s?

  • what happens to the profit maximizing P and Q? (Show on gragh)
  • what is the allocatively efficient quantity? (Show on graph)

5) RESULT:

  • Does the market achieve allocative efficiency when ther are negative externality (or spillover cost)s?
  • Is there an OVERallocation of resources OR an UNDERallocation of resources?
  • without the government would TOO MUCH or TOO LITTLE be produced?

 

Negative Externalities and Allocative Inefficiency:

Benefit-Cost Analysis Approach
Negative Externalities and Allocative Inefficiency:

Consumer and Producer Surplus Approach

Overallocation of Resources: MSB < MSC

Overallocation of Resources: Deadweight Loss

 

d. correcting for negative externality (or spillover cost)s: What can the government do?

1) GOAL: to reduce production and get closer to the allocatively efficient quantity

2) policies

  • specific (excise) taxes on products with negative externality (or spillover cost)s

 

  • legislation/regulation (Direct Controls)
    • gov't sets the amount
    • gov't decides who

     

  • market for pollution rights (MORE BELOW)
    • gov't sets the amount
    • market decides who
    • RESULT:
      • same amount of pollution as with direct controls
      • but MORE output from the same amount of resources

       

e. Other ways to correct for negative externality (or spillover cost)s

1) Individual Bargaining: Coase Theorem
The idea first stated by economist Ronald Coase that spillover problems may be resolved through private negotiations of the affected parties.

Gov't may not be needed to achieve allocative efficiency

(1) IF: property rights are clearly defined
(2) IF: few people involved
(3) IF: negligible bargaining costs

2) Liability Rules and Lawsuits

(1) gov't may not be needed to achieve allocative efficiency
(2) IF: property rights are clearly defined
(3) property rights protected in court

f. Another type of negative externality (or spillover cost): Failure to provide for the future

a) explanation
b) role of government
c) example: space exploration

5b - Market Failures Continued (Positive Externalities and Public Goods)

2. Positive Externality (or spillover benefit)
a. definition
TEXTBOOK: A benefit obtained without compensation by third parties from the production or consumption of sellers or buyers.

CLASS: A positive externality (or spillover benefit) occurs if some of the benefits of producing or consuming a product "spillover" onto a third party who does not have to pay

  • not just the buyer
  • not just the seller,
  • but someone else benefits

Example: A beekeeper benefits when a neighboring farmer plants clover.

  • buyer = purchaser of clover
  • seller = farmer
  • third party = beekeeper

b. examples

a) education
b) Ski Areas and Ski Shops
c) parks

c. markets and inefficiency:

 

ON A GRAPH SHOW:

a) MSB and alloc eff. P and Q with NO positive externality (or spillover benefit)s

  • what is the profit maximizing quantity?
  • what is the allocatively efficient quantity?

b) What happens to D if there are positive externality (or spillover benefit)s and a consumer can benefit without paying?

c) So what happens to P, Q, and efficiency WITH positive externality (or spillover benefit)s?

  • what is the profit maximizing quantity?
  • what is the allocatively efficient quantity?

d) RESULT: an UNDERallocation of resources

  • too little would be produced without the government

 

Positive Externalities and Allocative Inefficiency:

Benefit-Cost Analysis Approach
Positive Externalities and Allocative Inefficiency:

Consumer and Producer Surplus Approach

Underallocation of Resources: MSB > MSC

Underallocation of Resources: Deadwieght Loss

 

d. Correcting for positive externality (or spillover benefit)s - What can the government do?

1) GOAL: increase the quantity

2) HOW?

  • increase demand (subsidize consumers)
  • increase supply (subsidize suppliers)
  • provide goods via the government

3. Public goods and services

a. definition
A good or service which is indivisible and to which the exclusion principle does not apply

1) exclusion principle does not apply

The exclusion principle is: The ability to exclude those who do not pay for a product from receiving its benefits.

2) free-rider problem

because exclusion principle does not apply

The inability of potential providers of an economically desirable but indivisible good or service to obtain payment from those who benefit because the exclusion principle is not applicable.

3) indivisible good / nonrival

b. examples

1) lighthouse
2) national defense
3) immunizations
4) street lights
5) insect and flood control

c. markets and inefficiency

RESULT:
  • an UNDERallocation of resources
  • too little (none) will be produced without the government

d. role of government:
allocating resources to public goods

e. Are the following public goods? If not why does the government provide them?

1) public education
2) public parks
3) public libraries

G. Stabilization

1. unemployment and inflation
2. role of government

 

IV. A Market for Externality Rights: Buying Pollution Permits

What is "cap and trade" and why is it used to reduce pollution?

Getting California Business to Clean Up Its Act
http://www.npr.org/templates/story/story.php?storyId=5744852

All Things Considered, August 31, 2006 · Melissa Block talks with Fred Krupp, director of the nonprofit group Environmental Defense. Krupp explains how California's new climate-change initiative will be implemented.

California's carbon cap-and-trade

Marketplace, February 17, 2006

http://marketplace.publicradio.org/shows/2006/02/17/AM200602179.html

The Golden State plans to limit carbon emissions from private utilities and open a carbon market where companies can buy and sell carbon credits. As Sarah Gardner reports, California is the largest in a growing number of states experimenting with cap-and-trade.

Schwarzenegger, Democrats reach landmark global warming deal

Posted on Wed, Aug. 30, 2006
http://www.mercurynews.com/mld/mercurynews/news/local/states/california/northern_california/15399900.htm

1. The old way: gov't forces all producers to reduce pollution by the certain amount

 

2. Cap and Trade

a. CAP: Government sets (caps) the AMOUNT of pollution allowed
(1) NOT elimination of pollution
(2) gov't sets the amount of permits allowed
(3) Gov't sells pollution permits
(4) vertical Supply curve for pollution permits

b. TRADE: The market decides WHO pollutes

c. RESULT: More goods produced than if gov't forced all producers to reduce pollution

V. Society's Optimal Amount of Externality Reduction

A. Benefit-Cost Analysis
B. Shifts in Locations of Curves