12 The Market Mechanism: Shortcomings and Remedies When she was good She was very, very good, But when she was bad She was horrid. HENRY WADSWORTH LONGFELLOW

12The Market Mechanism:

Shortcomings and Remedies

When she was good

She was very, very good,

But when she was bad

She was horrid.

HENRY WADSWORTH LONGFELLOW

● What Does the Market Do Poorly?

● Efficient Resource Allocation: A Review

● Externalities: Getting the Prices Wrong

● Provision of Public Goods

● Allocation of Resources Between Present and Future

● Market Failure and Government Failure

● What Does the Market Do Poorly?

● Efficient Resource Allocation: A Review

● Externalities: Getting the Prices Wrong

● Provision of Public Goods

● Allocation of Resources Between Present and Future

● Market Failure and Government Failure

ContentsContents

Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

● The Cost Disease of the Service Sector

● Some Other Sources of Market Failure

● The Market System on Balance

● Epilogue: The Unforgiving Market, Its Gift of Abundance, and Its Dangerous Friends

● The Cost Disease of the Service Sector

● Some Other Sources of Market Failure

● The Market System on Balance

● Epilogue: The Unforgiving Market, Its Gift of Abundance, and Its Dangerous Friends

Contents (continued)Contents (continued)



What Does the Market Do Poorly? What Does the Market Do Poorly?

● Deals poorly with the side effects of many economic activities

● Cannot readily provide public goods, such as national defense

● May do a poor job of allocating resources between the present and the future

● Deals poorly with the side effects of many economic activities

● Cannot readily provide public goods, such as national defense

● May do a poor job of allocating resources between the present and the future


What Does the Market Do Poorly?What Does the Market Do Poorly?

● Makes public and personal services increasingly expensive

● Not all market failures are considered in this chapter--other chapters consider: ♦ Business fluctuations

♦ Inequitable income distribution

♦ Monopoly power

● Makes public and personal services increasingly expensive

● Not all market failures are considered in this chapter--other chapters consider: ♦ Business fluctuations

♦ Inequitable income distribution

♦ Monopoly power


Efficient Resource Allocation: A ReviewEfficient Resource Allocation: A Review

● An efficient allocation of resources requires that price equal marginal cost for each commodity (P = MC).

● An efficient allocation of resources requires that price equal marginal cost for each commodity (P = MC).

FIGURE 12-1 The Economy’s PPF for the Production of Two Goods

FIGURE 12-1 The Economy’s PPF for the Production of Two Goods


Nu

mb

er o

f B

ackp

acks

P

rod

uce

d

Number of Jeans Produced

A

C

100 80 60 40 20 0

2

4

6

8

10

K

B


● Beneficial externality = an incidental benefit of an economic activity

● Detrimental externality = an incidental cost of an economic activity

● Beneficial externality = an incidental benefit of an economic activity

● Detrimental externality = an incidental cost of an economic activity

Externalities: Getting the Prices WrongExternalities: Getting the Prices Wrong


● Externalities and Inefficiency♦ Detrimental externalities marginal social

cost > marginal private cost■Too much is produced

♦ Beneficial externalities marginal social cost > marginal private cost ■Too little output is produced

● Externalities and Inefficiency♦ Detrimental externalities marginal social

cost > marginal private cost■Too much is produced

♦ Beneficial externalities marginal social cost > marginal private cost ■Too little output is produced


FIGURE 12-2 Equilibrium of a Firm with Detrimental Externality

FIGURE 12-2 Equilibrium of a Firm with Detrimental Externality


Marginal private cost

Marginal revenue

Marginal social cost

B A

100

Mar

gin

al C

os

t an

d R

eve

nu

e

Thousands of Tons of Paper per Year

35 0

FIGURE 12-3 Externalities, Market Equil., & Resource Allocation

FIGURE 12-3 Externalities, Market Equil., & Resource Allocation


Electricity Output in Kilowatt-Hours

Tu

lip O

utp

ut

in D

oze

ns

0

K

B

E

T


Externalities: Getting the Prices Wrong Externalities: Getting the Prices Wrong

● Externalities are Everywhere♦ These problems are found throughout the

economy.

♦ Both market economies and centrally-planned economies wrestle with externality problems.

● Externalities are Everywhere♦ These problems are found throughout the

economy.

♦ Both market economies and centrally-planned economies wrestle with externality problems.



● Government Policy and Externalities♦ Governments can promote efficiency by

moving private costs closer to social costs.

♦ They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities.

● Government Policy and Externalities♦ Governments can promote efficiency by

moving private costs closer to social costs.

♦ They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities.


Provision of Public GoodsProvision of Public Goods

● A good is public when:♦ it is not depleted by repeated use.

♦ people cannot be excluded from access to it.

● The market tends to underprovide public goods.

● A good is public when:♦ it is not depleted by repeated use.

♦ people cannot be excluded from access to it.

● The market tends to underprovide public goods.


● It is usually not possible to charge a price for a pure public good because people cannot be excluded from enjoying its benefits.

● It may also be undesirable to charge a price for it because that would discourage some people from benefiting, even though using a public good does not deplete its supply.

● It is usually not possible to charge a price for a pure public good because people cannot be excluded from enjoying its benefits.

● It may also be undesirable to charge a price for it because that would discourage some people from benefiting, even though using a public good does not deplete its supply.



● Conclusion: If public goods are to be produced, the government must do it.

● Conclusion: If public goods are to be produced, the government must do it.



● A production possibilities frontier can be used to analyze the allocation of resources between the present and the future.

● A production possibilities frontier can be used to analyze the allocation of resources between the present and the future.

Allocation of Resources Between Present and FutureAllocation of Resources Between Present and Future



● The Role of the Interest Rate♦ Allocate resources between present and future

♦ Represents the opportunity cost of money

● The Role of the Interest Rate♦ Allocate resources between present and future

♦ Represents the opportunity cost of money



● How Does It Work in Practice?♦ Since interest rates are manipulated for many

purposes, there is little reason to think that they represent a good evaluation of the future.

♦ The market tends to devote too many resources to immediate consumption since today’s population may not be good judges of future needs.

● How Does It Work in Practice?♦ Since interest rates are manipulated for many

purposes, there is little reason to think that they represent a good evaluation of the future.

♦ The market tends to devote too many resources to immediate consumption since today’s population may not be good judges of future needs.



● How Does It Work in Practice?♦ The inherent risk of investment projects means

that investment for the future may fall short of the socially optimal amount.

♦ It may not be in society’s best interests to allow the market to make irreversible decisions about the future.

● How Does It Work in Practice?♦ The inherent risk of investment projects means

that investment for the future may fall short of the socially optimal amount.

♦ It may not be in society’s best interests to allow the market to make irreversible decisions about the future.


Market Failure and Government FailureMarket Failure and Government Failure

● The market has many failures, but remember that it has many strengths as well, and that governments are also subject to failure.

● Some market failures are best left alone and, in some cases, the best action by the government is to reinforce the best aspects of the market, not to replace the market.

● The market has many failures, but remember that it has many strengths as well, and that governments are also subject to failure.

● Some market failures are best left alone and, in some cases, the best action by the government is to reinforce the best aspects of the market, not to replace the market.


● The service sector includes such huge industries as education and health care.

● Services can be public or private.● Costs for services have risen more rapidly

than other costs.● Although not strictly a market failure, this

often leads to government action that threatens general welfare.

● The service sector includes such huge industries as education and health care.

● Services can be public or private.● Costs for services have risen more rapidly

than other costs.● Although not strictly a market failure, this

often leads to government action that threatens general welfare.

The Cost Disease of the Service SectorThe Cost Disease of the Service Sector

FIGURE 12-4 Real per-Capita Health-Care Expenditures

FIGURE 12-4 Real per-Capita Health-Care Expenditures


6

5

4

3

2

Norway

Spain

Italy

Irela

nd

Japan

United S

tate

s

Austria

France

United K

ingdom

Austra

lia

Germ

any

Canad

a

Nether

lands

Ave

rag

e A

nn

ual

Gro

wth

Rat

es (

per

cen

tag

e)

1

0

FIGURE 12-5 Real per-Pupil Education Costs

FIGURE 12-5 Real per-Pupil Education Costs


– 1.55

United Kingdom

4.32

Germany

2.72

United States

9.67

France

3.42

Canada

7.25

Japan

Ave

rag

e A

nn

ual

Gro

wth

Rat

es

12%

10

8

6

4

2

0

– 2

– 4



● Why Are Some Personal Services Getting Worse but Costing More?♦ The “cost disease” of personal services stems

from their labor-intensive nature.

♦ Competition forces wages in the service sector to grow as rapidly as wages in manufacturing.

● Why Are Some Personal Services Getting Worse but Costing More?♦ The “cost disease” of personal services stems

from their labor-intensive nature.

♦ Competition forces wages in the service sector to grow as rapidly as wages in manufacturing.



● Why Are Some Personal Services Getting Worse but Costing More?♦ Productivity grows more rapidly in

manufacturing than services.

♦ If wage growth cannot be accommodated by productivity growth, prices must rise.

● Why Are Some Personal Services Getting Worse but Costing More?♦ Productivity grows more rapidly in

manufacturing than services.

♦ If wage growth cannot be accommodated by productivity growth, prices must rise.



● A Future of More Goods, but Fewer Services: Is It Inevitable?♦ As the society becomes richer, it becomes

more difficult, not less, to provide services such as health care, teaching, and the performing arts.

♦ If we value services sufficiently, we can have more and better services--at some sacrifice in the growth rate of manufactured goods.

● A Future of More Goods, but Fewer Services: Is It Inevitable?♦ As the society becomes richer, it becomes

more difficult, not less, to provide services such as health care, teaching, and the performing arts.

♦ If we value services sufficiently, we can have more and better services--at some sacrifice in the growth rate of manufactured goods.



● Government May Make the Problem Worse♦ The market does give the appropriate price

signals, but government is likely to misunderstand these signals and to make decisions that do not promote the public interest most effectively.

● Government May Make the Problem Worse♦ The market does give the appropriate price

signals, but government is likely to misunderstand these signals and to make decisions that do not promote the public interest most effectively.



● Government May Make the Problem Worse♦ This problem is not a market failure, but

government attempts to deal with it may distort the market in inefficient ways.

● Government May Make the Problem Worse♦ This problem is not a market failure, but

government attempts to deal with it may distort the market in inefficient ways.



● Government May Make the Problem Worse♦ In many cases, price controls are proposed for

sectors of the economy affected by the cost disease.

♦ But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself.

● Government May Make the Problem Worse♦ In many cases, price controls are proposed for

sectors of the economy affected by the cost disease.

♦ But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself.


● Imperfect information

● Rent-seeking behavior

● Moral hazard

● Imperfect information

● Rent-seeking behavior

● Moral hazard

Some Other Sources of Market FailureSome Other Sources of Market Failure


● While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works.

● While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works.

The Market System on BalanceThe Market System on Balance


Epilogue: The Unforgiving MarketEpilogue: The Unforgiving Market

● The market system produces growth and prosperity as no other system has been able to do.

● At the same time, it allocates its rewards in ways that many people believe to be unjust.

● The market system produces growth and prosperity as no other system has been able to do.

● At the same time, it allocates its rewards in ways that many people believe to be unjust.


Epilogue: The Unforgiving MarketEpilogue: The Unforgiving Market

● Sometimes the proposals of alleged friends of the free market are just as dangerous to its long-term health as are the attacks of its enemies.

● Sometimes the proposals of alleged friends of the free market are just as dangerous to its long-term health as are the attacks of its enemies.

Documents

12 The Market Mechanism: Shortcomings and Remedies When she was good She was very, very good, But when she was bad She was horrid. HENRY WADSWORTH LONGFELLOW