Slide 17-1 Copyright © 2000 Pearson Education Canada Inc. Lecture 13: Market Failure and Government Action Readings: Chapters 13 ( pp.313-315 ), 16, 17

Slide 17-1Copyright © 2000 Pearson Education Canada Inc.

Lecture 13: Market Failure Lecture 13: Market Failure and Government Actionand Government Action

Readings: Chapters 13 (Readings: Chapters 13 (pp.313-315pp.313-315), 16, 17), 16, 17


• Markets can fail to be efficient:Markets can fail to be efficient:

• Insufficient CompetitionInsufficient Competition

• ExternalitiesExternalities

• Public goodsPublic goods

• And Markets can be unfair:And Markets can be unfair:

• InequalityInequality

• PovertyPoverty

Market FailuresMarket Failures


• Q: How do governments intervene in Q: How do governments intervene in markets which have insufficient markets which have insufficient competition?competition?

• A: The main policy instruments are:A: The main policy instruments are:

• RegulationRegulation

• Public ownershipPublic ownership

• Anti-combine lawAnti-combine law

Insufficient CompetitionInsufficient Competition


• Q: How does government supply regulation?Q: How does government supply regulation?

• A: Regulatory agencies vary in size and A: Regulatory agencies vary in size and scope. But there are certain features common scope. But there are certain features common to all agencies. to all agencies.

• Government appoints the senior bureaucrats who Government appoints the senior bureaucrats who are the key decision makers.are the key decision makers.

• Each agency adopts a set of practices or operating Each agency adopts a set of practices or operating rules for controlling prices, product standards, and rules for controlling prices, product standards, and other aspects of economic performance.other aspects of economic performance.

• Agency certifies firms to serve a particular market.Agency certifies firms to serve a particular market.



• Q: What determines government Q: What determines government provision of regulation?provision of regulation?

• A: It is a product of the political A: It is a product of the political process, and hence will reflect a process, and hence will reflect a political equilibrium.political equilibrium.

• In recent years, the equilibrium has In recent years, the equilibrium has shifted towards de-regulation (a reduction shifted towards de-regulation (a reduction in the provision of regulation)in the provision of regulation)



• Q: Why has there been a move towards de-Q: Why has there been a move towards de-regulation?regulation?

• A: There has been growing evidence that A: There has been growing evidence that regulation to protect the public frequently regulation to protect the public frequently only succeeds in protecting the regulated only succeeds in protecting the regulated firms from competition.firms from competition.


Capture theoryCapture theory says that regulations are says that regulations are supplied to satisfy the demand of supplied to satisfy the demand of producers to maximize economic profit.producers to maximize economic profit.


• Q: Why have regulation at all?Q: Why have regulation at all?

• A: If a firm has diminishing average costs, A: If a firm has diminishing average costs, it will be a natural monopoly. With no it will be a natural monopoly. With no competition, there will be severe under-competition, there will be severe under-supply and prices will be dramatically supply and prices will be dramatically higher than marginal costs.higher than marginal costs.

• Regulation is one way of forcing output Regulation is one way of forcing output up and prices down.up and prices down.



EconomicEconomicprofitprofit

DeadweightDeadweightlossloss

ConsumerConsumersurplussurplus

Natural Monopoly:Natural Monopoly:Profit MaximizationProfit Maximization

Quantity (millions of households)Quantity (millions of households)

1515

3030

00 22 44 66 1010

DD

Pri

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2525

2020

1010

88

ATCATC

1818

MRMR

MCMC


TotalTotalsurplussurplus

Natural Monopoly:Natural Monopoly:Marginal Cost PricingMarginal Cost Pricing


1515

3030

00 22 44 66 1010

DD

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2525

2020

1010

88

ATCATC

Loss perLoss perhouseholdhousehold

MCMC


Natural Monopoly:Natural Monopoly:Average Cost PricingAverage Cost Pricing

ProducerProducersurplussurplus

ConsumerConsumersurplussurplus


1515

3030

00 22 44 66 1010

DD

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2525

2020

1010

88

DeadweightDeadweightlossloss

ATCATC

MCMC


• Q: Does price regulation reduce the Q: Does price regulation reduce the excess burden from natural excess burden from natural monopoly?monopoly?

• A: Capture theory predicts that the A: Capture theory predicts that the producer will get the regulator to set producer will get the regulator to set rules that allow it to charge the same rules that allow it to charge the same price and produce the same output as price and produce the same output as an unregulated monopoly. Firms can an unregulated monopoly. Firms can do this by exaggerating their costs.do this by exaggerating their costs.



ATCATC (inflated (inflated))

Natural Monopoly:Natural Monopoly:Inflating CostsInflating Costs


1515

3030

00 22 44 66 1010

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Pri

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2525

2020

1010

88

MCMC

EconomicEconomicprofitprofit

MRMR

1818

Profit isProfit ismaximizedmaximized

ATCATC


• Q: Is regulatory capture a real problem?Q: Is regulatory capture a real problem?

• A: A A: A testtest of whether natural monopoly of whether natural monopoly regulation is in the public interest or regulation is in the public interest or producer interest by measuring rates of producer interest by measuring rates of return in regulated monopolies.return in regulated monopolies.

• Many natural monopolies in Canada earn higher Many natural monopolies in Canada earn higher rates of return than the economy average. (i.e. rates of return than the economy average. (i.e. cable television service; telephone service)cable television service; telephone service)



• Q: What is the alternative to regulation?Q: What is the alternative to regulation?

• A: Formation of crown corporations:A: Formation of crown corporations:

• Canada Post, Ontario Hydro, etc.Canada Post, Ontario Hydro, etc.

• Q: Are crown corporations efficient?Q: Are crown corporations efficient?

• A: With a public subsidy, a crown corporation A: With a public subsidy, a crown corporation can supply the market at marginal cost and can supply the market at marginal cost and achieve the efficient output level.achieve the efficient output level.



Crown Corporation: Crown Corporation: Efficient OutcomeEfficient Outcome

00 22 44 66 88 1010

22

66

88

1010

44

Consumer Consumer surplussurplus

Tax paymentTax payment

DDMCMC

ATCATC

Subsidy per tonne: Subsidy per tonne: efficient output efficient output

88

22

Quantity (billions of tonnes per year)Quantity (billions of tonnes per year)

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• Q: Have Crown Corporations served Q: Have Crown Corporations served the public interest?the public interest?

• A: Over time, a different sort of A: Over time, a different sort of capture may set in. Managers will capture may set in. Managers will tend inflate costs, and make tend inflate costs, and make themselves the residual claimants.themselves the residual claimants.



Crown Corporation: Crown Corporation: Budget MaximizationBudget Maximization

00 22 44 66 88 1010

22

66

88

1010

44

DDMCMC

ATCATCSubsidy per tonne: Subsidy per tonne: efficient output efficient output but maximizing but maximizing budgetbudget

88

22

ATCATC ( (inflatedinflated))

Quantity (billions of tonnes per year)Quantity (billions of tonnes per year)

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• Q: Are crown corporations inefficient?Q: Are crown corporations inefficient?

• A: Case study: A: Case study:

• CN had costs 14% higher than CP.CN had costs 14% higher than CP.

• Ontario Hydro routinely pays its workers wages above Ontario Hydro routinely pays its workers wages above the market rate.the market rate.

• In recent years, there has been a move to In recent years, there has been a move to privatize publicly owned corporations.privatize publicly owned corporations.

• Petro-Canada (1991) , Ontario Hydro (2002)Petro-Canada (1991) , Ontario Hydro (2002)



• Q: What are externalities?Q: What are externalities?

• A:A: ExternalitiesExternalities are costs or benefits that are costs or benefits that arise from economic transactions that fall on arise from economic transactions that fall on people who do not participate in the people who do not participate in the transaction. When externalities exist, the transaction. When externalities exist, the parties to the transaction consider only their parties to the transaction consider only their own costs and benefits, and not those social own costs and benefits, and not those social costs accruing to third parties.costs accruing to third parties.

ExternalitiesExternalities


There are two types of Externalities:There are two types of Externalities:

• A A negative externalitynegative externality occurs whenever a occurs whenever a person’s well being or a firm’s production person’s well being or a firm’s production capability is directly harmed by the actions of other capability is directly harmed by the actions of other consumers or firms.consumers or firms.

• A A positive externalitypositive externality occurs whenever a occurs whenever a person’s well being or a firm’s production person’s well being or a firm’s production capability is directly improved by the actions of capability is directly improved by the actions of other consumers or firms.other consumers or firms.



• Q: How do negative externalities affect Q: How do negative externalities affect social outcomes?social outcomes?

• A: Negative externalities include:A: Negative externalities include:

• Acid RainAcid Rain

• Ozone layer Depletion Ozone layer Depletion

• Smog alerts Smog alerts

• Global WarmingGlobal Warming

• Bacterial ground water contamination (Walkerton)Bacterial ground water contamination (Walkerton)

• heavy metal and persistent toxic chemical heavy metal and persistent toxic chemical contamination of land and ground-water, etc.contamination of land and ground-water, etc.



• Q: Has economic growth Q: Has economic growth doomed the environment?doomed the environment?

• A: It has put tremendous A: It has put tremendous pressure on it, but at the pressure on it, but at the same time higher incomes same time higher incomes has lead to the increased has lead to the increased demands for a clean demands for a clean environment. environment.



Externalities: Air PollutionExternalities: Air Pollution


• Q: Why do negative externalities occur?Q: Why do negative externalities occur?

• A: An absence of property rights.A: An absence of property rights.


Property rightsProperty rights are social are social arrangements that govern the arrangements that govern the ownership, use, and disposal of ownership, use, and disposal of productive resources and goods and productive resources and goods and services.services.


• Q: How does an absence of property Q: How does an absence of property rights create environmental problems?rights create environmental problems?

• A: Because no one owns the air, the A: Because no one owns the air, the rivers, and the oceans, they are rivers, and the oceans, they are available for free use with no available for free use with no restriction. Users consider only their restriction. Users consider only their private interest in deciding how to use private interest in deciding how to use the productive resource.the productive resource.



Externality ImpactExternality Impact

Quantity of waste (tonnes per week)Quantity of waste (tonnes per week)

5050

100100

150150

200200

00 22 44 66 88

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MBMB

……when factorywhen factorymaximizes its benefitmaximizes its benefitby dumping wasteby dumping waste

MSCMSC

Fishing clubFishing clubbears largebears largecost...cost...


• Q: What can the government do to Q: What can the government do to correct market failures?correct market failures?

• A: The government has two options:A: The government has two options:

• 1. It can assert sole ownership over the 1. It can assert sole ownership over the commons resource and limit use:commons resource and limit use:

• 1.1) pollution controls and standards1.1) pollution controls and standards

• 1.2) emission charges and taxes1.2) emission charges and taxes

• 2. It can distribute private property rights:2. It can distribute private property rights:• 2.1) Common law rights2.1) Common law rights

• 2.2) Marketable emission permits2.2) Marketable emission permits



• Q: Do standards work?Q: Do standards work?

• A: Economists have been concerned that A: Economists have been concerned that standards have largely failed to be standards have largely failed to be implemented effectively. Political equilibrium implemented effectively. Political equilibrium is susceptible to special interest group is susceptible to special interest group manipulation.manipulation.

• Even when they have been implemented, they Even when they have been implemented, they are not usually the most efficient method for are not usually the most efficient method for reducing pollution.reducing pollution.



• Q: What’s the problem with standards?Q: What’s the problem with standards?

• A: Suppose the government decides that A: Suppose the government decides that pollution should be reduced by 25% and pollution should be reduced by 25% and orders all firms to reduce their pollution orders all firms to reduce their pollution from current levels by 25%. Some firms from current levels by 25%. Some firms may find this extremely expensive and may find this extremely expensive and close. Others could reduce their pollution close. Others could reduce their pollution by 75% at very little cost but are only by 75% at very little cost but are only required to reduce pollution by 25%.required to reduce pollution by 25%.



• Q: Can government policy force firms to Q: Can government policy force firms to distribute the burden of reduction in the distribute the burden of reduction in the most efficient manner possible?most efficient manner possible?

• A: Emission charges:A: Emission charges: The government The government regulator sets a charge per unit of regulator sets a charge per unit of pollution. The efficient emission charge pollution. The efficient emission charge is set so that the marginal social cost of is set so that the marginal social cost of pollution is equal to its marginal social pollution is equal to its marginal social benefit. benefit.



Externalities: Emission ChargesExternalities: Emission Charges

77

1010

1515

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MBMB

MSCMSC

Emissions (millions of tonnes per year)Emissions (millions of tonnes per year)

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Efficient priceEfficient priceper tonneper tonne

At $7/tonne, At $7/tonne, MSCMSC > > MBMB


• Q: What if emission charges cannot be assessed Q: What if emission charges cannot be assessed (ie noise pollution).(ie noise pollution).

• A: The government could introduce a A: The government could introduce a Pigouvian Pigouvian TaxTax which discourages the activity that has the which discourages the activity that has the negative externality associated with it.negative externality associated with it.

• Q: What is the correct Pigouvian tax?Q: What is the correct Pigouvian tax?

• A: If the tax is set equal to the external marginal A: If the tax is set equal to the external marginal cost, then efficient outcome will be achieved.cost, then efficient outcome will be achieved.



S = PMCS = PMC

Competitive markets oversupply Competitive markets oversupply if there is pollutionif there is pollution

Quantity (kilometres)Quantity (kilometres)

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MSC = PMC + EMCMSC = PMC + EMC

PP11

CC11

QQ11 QQ00

PP00

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CompetitiveCompetitiveequilibriumequilibrium

Point ofPoint ofallocativeallocativeefficiencyefficiency

EMCEMC


S = MCS = MC

External Cost at Competitive EquilibriumExternal Cost at Competitive Equilibrium


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ExternalExternalcostcost


S = MCS = MC

Pigouvian TaxPigouvian Tax


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Point ofPoint ofallocativeallocativeefficiencyefficiency


• Q: What are the problems with Q: What are the problems with government asserting ownership over government asserting ownership over the commons?the commons?

• A: There are several:A: There are several:

• Political equilibrium may not be efficient.Political equilibrium may not be efficient.

• Business will resist the huge transfer to Business will resist the huge transfer to government implied by the government government implied by the government solution. (ie carbon tax resistance)solution. (ie carbon tax resistance)



• Q: What are the private property Q: What are the private property solutions to pollution?solutions to pollution?

• A: The government can clarify and A: The government can clarify and extend common law rights, or it can extend common law rights, or it can establish and distribute marketable establish and distribute marketable emission permits.emission permits.



• Q: How does extending common law Q: How does extending common law property rights solve the externality property rights solve the externality problem?problem?

• A: Many problems occur because when no A: Many problems occur because when no one owns a resource, everyone thinks they one owns a resource, everyone thinks they own it. Extending property rights would own it. Extending property rights would clarify who owns the resource. The owner clarify who owns the resource. The owner could then set about limiting use of the could then set about limiting use of the resource.resource.



• Q: If common law property rights are Q: If common law property rights are extended, does it matter who gets extended, does it matter who gets them?them?

• A: According to the A: According to the Coase theoremCoase theorem::

• 1. If transaction costs are low, the 1. If transaction costs are low, the (common law) assignment of property (common law) assignment of property rights will solve the externality.rights will solve the externality.

• 2. It will not matter who receives the 2. It will not matter who receives the property right.property right.



• Q: How does this work: Q: How does this work:

• A: It will depend on who receives the A: It will depend on who receives the property right:property right:

• If the polluted party is given control of the If the polluted party is given control of the environment, they can force the polluter to environment, they can force the polluter to reduce pollution.reduce pollution.

• If the polluter is given control of the If the polluter is given control of the environment, the polluted party may choose environment, the polluted party may choose to pay the polluter to reduce pollution.to pay the polluter to reduce pollution.



MSCMSC

The Coase TheoremThe Coase Theorem

Quantity of waste (tonnes per week)Quantity of waste (tonnes per week)

5050

100100

150150

200200

00 22 44 66 88

MBMB

Efficient levelEfficient levelof wasteof wasteC

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• Q: Can we rely on Coasian bargains to Q: Can we rely on Coasian bargains to resolve all negative externalities?resolve all negative externalities?

• A: No! Transaction costs are frequently A: No! Transaction costs are frequently high because:high because:

• 1) There are many affected parties1) There are many affected parties

• 2) people bargain strategically, and fail to 2) people bargain strategically, and fail to agree on a price.agree on a price.



• Q: How does a system of marketable Q: How does a system of marketable emission permits work?emission permits work?

• A: A maximum allowable amount of A: A maximum allowable amount of pollution is determined. Permits which sum pollution is determined. Permits which sum to this total are distributed to current to this total are distributed to current polluters. polluters.

• A firm is permitted to only pollute up to the A firm is permitted to only pollute up to the amount of the permits held.amount of the permits held.

• A firm can either buy or sell its permits.A firm can either buy or sell its permits.



• Q: Why is this system efficient?Q: Why is this system efficient?

• A: It will be expected that firms that A: It will be expected that firms that can easily abate pollution will choose can easily abate pollution will choose to sell their permits to firms that find it to sell their permits to firms that find it expensive to abate. The result is that expensive to abate. The result is that the least cost method distribution of the least cost method distribution of abatement will automatically be found.abatement will automatically be found.



• Q: What sorts of positive externalities Q: What sorts of positive externalities are there?are there?

• A: There are many, among which A: There are many, among which include:include:

• LandscapingLandscaping

• InoculationsInoculations

• EducationEducation



• Q: In what way does education Q: In what way does education have a positive externality have a positive externality associated with it?associated with it?

• A: External benefits:A: External benefits:

• Citizens who can better Citizens who can better communicate and interactcommunicate and interact

• Good ideas/inventions can be Good ideas/inventions can be copiedcopied



• Q: Does this create a market failure?Q: Does this create a market failure?

• A: Education and research and A: Education and research and development decisions are made by development decisions are made by comparing private marginal costs and comparing private marginal costs and private marginal benefits. When private marginal benefits. When decision-makers neglect external decision-makers neglect external benefits there will be underinvestment in benefits there will be underinvestment in education and R&D without government education and R&D without government intervention.intervention.



• Q: How does the government solve this Q: How does the government solve this market failure?market failure?

• A: The government has three main A: The government has three main policy instruments to correct the market policy instruments to correct the market failure:failure:

• SubsidiesSubsidies

• Below-cost provisionBelow-cost provision• Patents and copyrightsPatents and copyrights



AA subsidysubsidy is a payment made by the is a payment made by the government to producers that depends government to producers that depends on the level of output.on the level of output.

Providing a subsidy to producers Providing a subsidy to producers reduces their private marginal reduces their private marginal cost.cost.

If a subsidy is provided equal to If a subsidy is provided equal to the external benefit, an efficient the external benefit, an efficient outcome will be achieved.outcome will be achieved.



MSBMSB

DD = = MPBMPB

The Efficient QuantityThe Efficient Quantityof Educationof Education

Quantity (thousands of students per year)Quantity (thousands of students per year)

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Efficient allocationEfficient allocation

ExternalExternalbenefitbenefit


Instead of offering subsidies to private Instead of offering subsidies to private schools, the government can provide its schools, the government can provide its own schools that provide schooling own schools that provide schooling below cost.below cost.

It may still charge tuition equal to the marginal It may still charge tuition equal to the marginal private benefit of education.private benefit of education.

It can also establish its own research It can also establish its own research facilities.facilities.

In education, direct provision is larger; in In education, direct provision is larger; in R&D, subsidies are main tool.R&D, subsidies are main tool.



• Q: Is there a private property solution?Q: Is there a private property solution?

• A: Since knowledge is productive and A: Since knowledge is productive and creates external benefits, it is necessary creates external benefits, it is necessary to use public policies to ensure that to use public policies to ensure that there are incentives to develop new there are incentives to develop new ideas. Intellectual property rights provide ideas. Intellectual property rights provide the creators of knowledge with property the creators of knowledge with property rights to their discoveries.rights to their discoveries.



PatentsPatents or or copyrightscopyrights are are government-sanctioned exclusive government-sanctioned exclusive rights granted to the inventor or a rights granted to the inventor or a good, service, or productive process.good, service, or productive process.

Obtaining a patent allows the developer of Obtaining a patent allows the developer of the new idea to prevent others from the new idea to prevent others from benefiting from the invention for a number benefiting from the invention for a number of years. of years.

To obtain the patent, the inventor must make To obtain the patent, the inventor must make knowledge of the invention public.knowledge of the invention public.



The economic cost of patent protection The economic cost of patent protection is the deadweight loss of monopoly.is the deadweight loss of monopoly.

But without patents, the effort to But without patents, the effort to develop new goods, services, or develop new goods, services, or process is diminished, and the flow of process is diminished, and the flow of new inventions would slow.new inventions would slow.

Patent protection trades off the benefits Patent protection trades off the benefits of more invention against costs of of more invention against costs of monopoly over a limited time.monopoly over a limited time.



• Q: What are public goods?Q: What are public goods?

• A: A: Public goodsPublic goods are goods or are goods or services that are consumed services that are consumed simultaneously by everyone and simultaneously by everyone and from which no one can be from which no one can be excluded.excluded.

Public GoodsPublic Goods


Public GoodsPublic Goods1) Nonrivalry1) Nonrivalry

The consumption by one The consumption by one person does not decrease person does not decrease the consumption by another.the consumption by another.

• Television showTelevision show

2) Nonexcludable2) Nonexcludable

It is impossible, or extremely costly, to prevent It is impossible, or extremely costly, to prevent someone from benefiting from a good.someone from benefiting from a good.

• National defenceNational defence


Public Goods and Public Goods and Private GoodsPrivate Goods

Fish in the oceanFish in the ocean

AirAir

Nonexcludable & rivalNonexcludable & rival

FoodFood

CarCar

HouseHouse

Pure private goodsPure private goods Excludable & nonrivalExcludable & nonrival

Cable televisionCable television

BridgeBridge

HighwayHighway

Pure public goodsPure public goods

LighthouseLighthouse

National defenceNational defence


Public Goods and Public Goods and The Free-Rider ProblemThe Free-Rider Problem

AA free riderfree rider is a person who consumes a is a person who consumes a good without paying for it.good without paying for it.

Public goods create a free-Public goods create a free-rider problem because the rider problem because the quantity of the good that a quantity of the good that a person is able to consume person is able to consume is not influenced by the is not influenced by the amount the person pays for amount the person pays for the good...so why pay the good...so why pay anything at all?anything at all?


• Q: What is the social value of another unit of a Q: What is the social value of another unit of a public good ?public good ?

• A: As everyone will jointly consume this A: As everyone will jointly consume this additional unit of the public good, its total social additional unit of the public good, its total social value (its social marginal benefit) is the value (its social marginal benefit) is the sumsum of of every persons maximum willingness to pay. every persons maximum willingness to pay.

• Social Marginal Benefit = Social Marginal Benefit = sumsum of each individual’s of each individual’s marginal willingness to pay.marginal willingness to pay.

• The social marginal benefit at each provision level can The social marginal benefit at each provision level can be derived by vertically summing each individual’s be derived by vertically summing each individual’s demand for the public good. demand for the public good.



Benefits of a Public Benefits of a Public GoodGood

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Lisa's Marginal BenefitLisa's Marginal Benefit

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Max's Marginal BenefitMax's Marginal Benefit

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• Contrast this with a private good. Only one Contrast this with a private good. Only one person gets to consume a private good, so the person gets to consume a private good, so the social marginal benefit of one unit of the private social marginal benefit of one unit of the private good is the marginal benefit (maximum good is the marginal benefit (maximum willingness to pay) of the person who gets to willingness to pay) of the person who gets to consume the good. consume the good.

• By a little bit of thought you will be able to see By a little bit of thought you will be able to see that the social marginal benefit curve for a that the social marginal benefit curve for a private good is the horizontal summation of the private good is the horizontal summation of the individual demand curves (maximum willingness individual demand curves (maximum willingness to pay curves).to pay curves).



• Q: What is the efficient provision level of the Q: What is the efficient provision level of the public good?public good?

• A: The most efficient provision level is where the A: The most efficient provision level is where the social surplus is maximized. This occurs where social surplus is maximized. This occurs where the social marginal benefit (SMB) equals the the social marginal benefit (SMB) equals the marginal cost. A rational strategy for finding the marginal cost. A rational strategy for finding the efficient provision level is to:efficient provision level is to:

• increase provision if increase provision if SMB > MCSMB > MC

• reduce provision if reduce provision if SMB < MCSMB < MC

• hold provision constant if SMB = MChold provision constant if SMB = MC



MCMC

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The Efficient Provision The Efficient Provision of a Public Goodof a Public Good

MMEfficientEfficientuse ofuse ofresourcesresources

Total Benefit & Total CostTotal Benefit & Total Cost Marginal Benefit & Marginal CostMarginal Benefit & Marginal Cost

TCTC

TBTB

Net benefitNet benefit$2.0 billion$2.0 billion


• Q: Is private market provision efficient?Q: Is private market provision efficient?

• A: No! Because of the free rider problem, A: No! Because of the free rider problem, too little of the public good is provided.too little of the public good is provided.

• A private firm will not deliver the efficient quantity of A private firm will not deliver the efficient quantity of a public good. It needs to charge consumers a price a public good. It needs to charge consumers a price that will cover its costs…but once it is produced, no that will cover its costs…but once it is produced, no one has an incentive to buy.one has an incentive to buy.

• Example: Lighthouse signalExample: Lighthouse signal



• Q: Is government provision efficient?Q: Is government provision efficient?

• A: To answer this we have to examine what A: To answer this we have to examine what the political equilibrium delivers.the political equilibrium delivers.

• Political parties do a “what if” analysis before Political parties do a “what if” analysis before determining their policy regarding the provision of determining their policy regarding the provision of public goods. public goods.

• They choose the platform that maximizes their chance They choose the platform that maximizes their chance of being elected: this means they must maximize the of being elected: this means they must maximize the perceived net benefit of a winning coalition of voters.perceived net benefit of a winning coalition of voters.



Public ProvisionPublic ProvisionQ: How does political competition between parties Q: How does political competition between parties

influence the platforms on offer?influence the platforms on offer?

A: Competition for votes tends to move parties to the A: Competition for votes tends to move parties to the center. It is in the center that the median voter is center. It is in the center that the median voter is found, and hence it is in the center that winning found, and hence it is in the center that winning coalitions can be constructed. The implication is coalitions can be constructed. The implication is that all parties tend to advocate similar provision that all parties tend to advocate similar provision levels in equilibrium.levels in equilibrium.

The The principle of minimum differentiationprinciple of minimum differentiation is is the tendency for competitors to make themselves the tendency for competitors to make themselves identical to appeal to the maximum number of identical to appeal to the maximum number of clients or voters.clients or voters.


• Q: Will the winning platform be efficient?Q: Will the winning platform be efficient?

• A: The winning platform on public good A: The winning platform on public good provision will tend to appeal to the median provision will tend to appeal to the median voter’s preferences. Notice that this voter’s preferences. Notice that this equilibrium is unrelated to the calculation of equilibrium is unrelated to the calculation of the efficient provision level. We therefore the efficient provision level. We therefore cannot expect that the democratic process cannot expect that the democratic process will deliver an efficient amount of the public will deliver an efficient amount of the public good. good.



• Q: Is there anything that might complicate Q: Is there anything that might complicate the political equilibrium?the political equilibrium?

• A: Politics is the art of the possible. A: Politics is the art of the possible. Politicians rely heavily on the advice of Politicians rely heavily on the advice of bureaucrats as to what is possible, and the bureaucrats as to what is possible, and the costs of these possibilities.costs of these possibilities.

• A bureaucrat’s interests are different from A bureaucrat’s interests are different from the interests of vote maximizing politicians.the interests of vote maximizing politicians.



• Q: How do bureaucratic interests alter the Q: How do bureaucratic interests alter the political equilibrium?political equilibrium?

• A: There are a number of theories. The A: There are a number of theories. The simplest suggests that many bureaucrats may simplest suggests that many bureaucrats may seek to maximize the size of their bureau so seek to maximize the size of their bureau so as to increase their pay and prestige. Such a as to increase their pay and prestige. Such a bureaucrat will thus seek methods to bureaucrat will thus seek methods to influence the political equilibrium in a way influence the political equilibrium in a way that increases the size of the budget that they that increases the size of the budget that they control.control.



TCTCBureaucratic OverprovisionBureaucratic Overprovision


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• Q: How do bureaucrats influence the Q: How do bureaucrats influence the political equilibrium?political equilibrium?

• A: Bureaucrats controls information about A: Bureaucrats controls information about the costs and benefits of proposed public the costs and benefits of proposed public goods. If they exaggerate the benefits or goods. If they exaggerate the benefits or underestimate the costs of a public good, underestimate the costs of a public good, they might be able to get a politician to they might be able to get a politician to adopt and implement a platform that adopt and implement a platform that promotes a larger provision level than is promotes a larger provision level than is efficient.efficient.

• Example: Missile DefenseExample: Missile Defense



TCTCBureaucratic ExaggerationBureaucratic Exaggeration


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• Q: Are bureaucrats the only group who Q: Are bureaucrats the only group who wish to manipulate the political wish to manipulate the political equilibrium?equilibrium?

• A: No special interests who have a A: No special interests who have a private stake in public good provision private stake in public good provision are very active in attempting to are very active in attempting to manipulate political outcomes. manipulate political outcomes.



• Q: How do special interest groups Q: How do special interest groups manipulate the political equilibrium?manipulate the political equilibrium?

• A: By manipulating information. Politicians A: By manipulating information. Politicians and voters are uninformed about the costs and voters are uninformed about the costs and benefits of public goods, and interest and benefits of public goods, and interest groups will use advertising and political groups will use advertising and political contributions to influence platforms.contributions to influence platforms.

• Example: Softwood lumber dispute.Example: Softwood lumber dispute.



• Q: Why might democracy be easily Q: Why might democracy be easily manipulated by special interests?manipulated by special interests?

• A: Rational ignorance.A: Rational ignorance.

Rational ignoranceRational ignorance is the decision is the decision notnot to acquire information because the cost of to acquire information because the cost of doing so exceeds the expected benefit.doing so exceeds the expected benefit.



• Q: What are the most expensive public goods Q: What are the most expensive public goods provided by government in wealthy countries?provided by government in wealthy countries?

• Concern for poor families and poor children has led to desire for the Concern for poor families and poor children has led to desire for the community to do something to help alleviate suffering.community to do something to help alleviate suffering.

• One response is to create social norms that laud charitable giving. One response is to create social norms that laud charitable giving. This is found in virtually all religions of the world. This is found in virtually all religions of the world.

• A modern response is to get the State to provide a social safety net of A modern response is to get the State to provide a social safety net of welfare services. welfare services.

• This is a public good, because the benefit (relief that something is This is a public good, because the benefit (relief that something is being done to help the poor) is shared communally, but the cost is being done to help the poor) is shared communally, but the cost is subject to free riding. subject to free riding.

• Public provision financed by taxation solves under-supply problem. Public provision financed by taxation solves under-supply problem.



ENDEND

Documents

Slide 17-1 Copyright © 2000 Pearson Education Canada Inc. Lecture 13: Market Failure and Government Action Readings: Chapters 13 ( pp.313-315 ), 16, 17