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Part A

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.

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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

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3. There is efficient mix of output: Producing what people want (Allocative efficient)

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 Px > MCX then society gain values by producing more X

If Px < MCX then society gain values by producing less X

So Px = MCX 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

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DD=Marginal benefits

X

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.

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EXTERNALITIES

externality A cost or benefit resulting from some activity or transaction that is imposed or

bestowed on parties outside the activity or transaction.

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.

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Part B

Syllabus-Externalities, marginal cost pricing, internalizing externalities, Public goods, Imperfect

Information: adverse selection, moral hazard, social Choice, government inefficiency.

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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.

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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 15.1.

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.

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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.

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

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The government could tax the party who is imposing the externality, as shown in the figure below:

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

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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.

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

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the reduction in pollution has a value to the public, the public can buy a coupon and destroy it, as

was recently done.

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.

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Public Provision of Public Goods

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.

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Price Per Unit MC

DA+B

DA

X* Units of Ouputs

DA

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

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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

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is taking the action. An example of such a solution is profit sharing for a firm, which provides

incentives to employees.

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.

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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.

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

A B A A wins: A > B

B versus C

B B C B wins: B > C

C versus A

A C C C wins: C > A

aA > 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

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the appropriation of government spending for localized projects secured solely or primarily to

bring money to a representative's district.)

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.