Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 16 Market Failures and Government Intervention

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 16

Market Failures and Government Intervention

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-2

In this chapter you will learn to

3. Explain why public goods are underprovided by private markets.

2. Define an externality and explain why they lead to allocative inefficiency.

1. Explain the “informal” defense of free markets.

4. Explain why free markets may not achieve some desirable social goals.

5. Describe the direct and indirect costs of government intervention, and some of the important causes of government failure.


The operative choice is between which mix of markets and government intervention best suits people’s hopes and needs.

When government’s monopoly of violence is secure and functions with restrictions against its arbitrary use, citizens can safely carry on their ordinary economic and social activities.

Basic Functions of Government


Adam Smith (1723-1790)As the founder of British classical economics, Adam Smith, put it a long time ago:

“The first duty of the sovereign [is] that of protecting the society from the violence and invasion of other independent societies…. The second duty of the sovereign [is] that of protecting, as far as possible, every member of society from the injustice of oppression of every other member of it.”

Basic Functions of Government


The Case for Free Markets

The formal case for free markets is based on the concept of allocative efficiency.

The informal case is based on three central arguments:

1. Free markets coordinate actions automatically.

2. The pursuit of profits leads to innovation and rising material living standards.

3. Free markets decentralize economic power.


Automatic Coordination

A decentralized market system adjusts quickly to changes.

As market conditions change, prices in a market economy also change — decision makers can react continually.

A market system coordinates without anyone needing to understand how the whole system works.


Firms in free markets innovate because they get to keep the rewards.

Similar motives give individuals an incentive to invest in human capital.

Decentralization of Power

Market systems have less centralized power than planned economies.

Innovation and Growth

Free Markets


Market Failures

Market failure: a situation in which the free market fails to achieve allocative efficiency.

Market Power

Firms with market power will typically reduce output below competitive levels and lead to allocative inefficiency.

This is the motivation for competition policy (Chapter 12).


Externalities

Externality: when actions taken by firms or consumers impose costs or confer benefits on third parties.

Individual agents care about private costs. But what matters for allocative efficiency is social cost.

Even if all markets were perfectly competitive, externalities would lead to allocative inefficiency.


With a negative externality, a free market produces too much of the product.

Quantity

Pri

ce

D = MB

S=MCp

MCS1

pC

p1

••

• MCS2

p2

Q1 QC Q2

External cost of a negative externality

External benefit of a positive externality

With a positive externality, a free market produces too little of the product.

Allocative Inefficiency


Nonrivalrous and Nonexcludable Goods

A product is rivalrous if one person’s consumption of it means that no one else can also consume it.

A product is excludable if people can be prevented from consuming it.

There are four different types of goods:

- private goods

- public goods

- common-property resources

- excludable but nonrivalrous goods


Table 16.1 Four Types of Products


Figure 16.1 An Externality Leads to Allocative Inefficiency


The existence of public goods and common-property resources raises the free-rider problem.

The private market will generally not produce efficient amounts of public goods because it is impractical and often impossible to make users pay.

Public goods must therefore be provided by government.

APPLYING ECONOMIC CONCEPTS 16.1

The World’s Endangered Fish

Free-Rider Problem


Figure 16.2 The Optimal Provision of a Public Good

How much of a public good should the government provide?

The MB curve for society is the vertical sum of the individual MB curves.

Therefore, provide the quantity where MC = MB.


Asymmetric Information

Parties involved in a transaction may have asymmetric information, leading to market failure.

Moral hazard exists when one party to a transaction has both the incentive and the ability to shift costs on to the other party.

- often arises with insurance contracts.

Adverse selection refers to the tendency for people who are more at risk than average to purchase insurance, and for those who are less at risk to reject insurance.



Public Goods Experiments in the Laboratory and in the Classroom


Used Cars and the Market for “Lemons”

Asymmetric Information


Summary

1. Firms with market power

2. Externalities

3. Common-property resources and public goods

4. Asymmetric information

Four basic causes of market failure:


Broader Social Goals

Income Distribution

Even with no market failures, government may choose to intervene for other reasons.

The tax-and-transfer system redistributes income, as do many policies such as employment insurance and child benefits.

Policies designed to redistribute income often reduce economic efficiency.


Preferences for Public Provision

Some things, like justice and police services, are viewed by most people as being better provided by government than by the private sector.

Individual freedom generally does not include having the freedom to harm others.

Protecting Individuals from Others



Some government policies are designed to protect people from themselves.

It is generally illegal to “buy” your way out of mandatory national service or to sell one’s right to vote.

Paternalism

Social Responsibility



Economic Growth

Growth in productivity is crucial for increases in our material living standards.

Governments now routinely ask how various policies will affect the economy’s growth rate.

Free markets are unlikely to generate outcomes consistent with most people’s social goals, but …… there is often a tradeoff between achieving these social goals and achieving allocative efficiency.

A General Principle



Government Intervention

The Tools of Government Intervention

• Public provision

• Redistribution programs

• Regulation

Governments use cost-benefit analysis to weigh the costs and benefits of specific policies.


The Costs of Government Intervention

All government intervention involves resource costs.

These costs must be weighed against the potential benefits of the intervention.

The costs of government intervention are of two types:

- direct costs

- indirect costs


• changes in costs of production

• costs of compliance of regulations

• “rent-seeking” behavior

Some examples of indirect costs are:

Indirect Costs


Government Failure

Some government failure is an inescapable cost of democratic decision making.

Public choice theory examines the incentives of individual decision makers and tries to explain political and economic outcomes.

Government decision makers often face political constraints that lead them to act against the broad public interest.


Results: Albert and Bob will use democracy to appropriate resources from Charlene (through taxation) while reducing economic efficiency.

Table 16.2 Net Benefits from Road Construction


How Much Should Government Intervene?

To evaluate the costs and benefits of government intervention, we must compare two realistic alternatives:

- the free market as it actually works

- government intervention as it actually works

EXTENSIONS IN THEORY 16.2

A Problem with Democracy

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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 16 Market Failures and Government Intervention