Government Policy and

Market Failures

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Laugher Curve
Q. How many economists does it take to
screw in a light bulb?
A. Eight. One to screw it in and seven to
hold everything else constant.

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Introduction

Economists use the invisible hand

framework to determine whether the
government should intervene in the
market.
Invisible

hand framework perfectly

competitive markets lead individuals to
make voluntary choices that are in
societys interest.

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Market Failures

Market failure the invisible hand

pushes in such a way that individual
decisions do not lead to socially desirable
outcomes.

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Market Failures
When a market failure exists, government
intervention into markets to improve the
outcome is justified.
Government failure occurs when
government intervention does not improve
the situation.

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Externalities
Externalities are the effect of a decision
on a third party that is not taken into
account by the decision-maker.
Externalities can be either positive or
negative.

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Externalities

Negative externalities occur when the

effects of a decision not taken into account
by the decision-maker are detrimental to
others.

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Externalities

Positive externalities occur when the

effects of a decision not taken into account
by the decision-maker is beneficial to
others.

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A Negative Externality
Example

When there is a negative externality,

marginal social cost is greater than
marginal private cost.
A

steel plant benefits the owner of the

plant and the buyers of steel.
The plants neighbors are made worse
off by the pollution caused by the plant.

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A Negative Externality
Example

Marginal social cost includes all the

marginal costs borne by society.
It

is the marginal private costs of

production plus the cost of the negative
externalities associated with that
production.

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A Negative Externality
Example

When there are negative externalities, the

competitive price is too low and equilibrium
quantity too high to maximize social
welfare.

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A Negative Externality
S1 = Marginal social cost

Cost

S = Marginal private cost

Marginal cost
from externality

P1
P0

0
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Q1 Q0

D = Marginal
social benefit
Quantity
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A Positive Externality
Example

Private trades can benefit third parties not

involved in the trade.
A

person who is working and taking

night classes benefits himself directly,
and his co-workers indirectly.

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A Positive Externality
Example

Marginal social benefit equals the

marginal private benefit of consuming a
good plus the positive externalities
resulting from consuming that good.

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A Positive Externality
S = Marginal private and social cost

Cost
P1

D1 = Marginal social benefit

Marginal benefit of an externality

P0

D0 = Marginal private benefit

0
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Q0 Q1

Quantity
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Alternative Methods of
Dealing with

Externalities
Externalities can be dealt with via:
Direct

regulation.
Incentive policies.
Voluntary solutions.

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Direct Regulation

Direct regulation the amount of a good

people are allowed to use is directly limited
by the government.

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Direct Regulation

Direct regulation is inefficient, not efficient.

Inefficient

achieving a goal in a more

costly manner than necessary.
Efficient achieving a goal at the lowest
cost in total resources without
consideration as to who pays those
costs.

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Incentive Policies
Incentive policies are more efficient than
direct regulatory policies.
The two types of incentive policies are
either taxes or market incentives.

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Tax Incentive Policies

A tax incentive program uses a tax to
create incentives for individuals to
structure their activities in a way that is
consistent with the desired ends.
The tax often yields the desired end more
efficiently than straight regulation.

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Tax Incentive Policies

This solution embodies a measure of

fairness about it the person who
conserves the most pays the least tax.

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Tax Incentive Policies

A way to handle pollution is through a tax
called an effluent fee.
Effluent fees charges imposed by
government on the level of pollution
created.

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Regulation Through
Taxation
Marginal social cost

Cost

Marginal private cost

P1

Efficient tax

P0

Marginal social
benefit
0
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Q1 Q0

Quantity
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Market Incentive Policies

Market incentive program market

participants certify they have reduced total
consumption their own and/or others
by a specified amount.

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Market Incentive Policies

A market incentive program is similar to
the regulatory solution.
The amount of the good consumed is
reduced.

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Market Incentive Policies

A market incentive program differs from a
regulatory solution.
Individuals who reduce consumption by
more than the required amount receive
marketable certificates that can be sold to
others.

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Voluntary Reductions
Voluntary reductions allow individuals to
choose whether to follow what is socially
optimal or what is privately optimal.
Economists are dubious of voluntary
solutions.

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Voluntary Reductions

A persons willingness to do things for the

good of society generally depends on the
belief that others will also be helping.

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Voluntary Reductions

The socially conscious will often lose their

social conscience when they believe a
large number of other people are not
contributing.
This

is example of a free rider

problem individuals unwillingness to
share in the cost of a public good.

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The Optimal Policy

An optimal policy is one in which the

marginal cost of undertaking the policy
equals the marginal benefit of that policy.

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The Optimal Policy

Resources are being wasted if a policy

isnt optimal.
What

is saved by reducing the program

is worth more than what is lost from the
reducing the program.

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The Optimal Policy

Some environmentalists want to totally
eliminate pollution.
Economists want to reduce pollution to the
point where marginal costs of reducing
pollution equals the marginal benefits.

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The Optimal Policy

Optimal level of pollution the amount

of pollution at which the marginal benefit of
reducing pollution equals the marginal
cost.

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Public Goods

A public good is nonexclusive and

nonrival.
Nonexclusive

no one can be excluded

from its benefits.
Nonrival consumption by one does not
preclude consumption by others.

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Public Goods

There are no pure examples of a public

good.
The

closest example is national

defense.

Technology can change the public

nature of goods.
Roads

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Public Goods
Once a pure public good is supplied to one
individual, it is simultaneously supplied to
all.
A private good is only supplied to the
individual who bought it.

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Public Goods
With public goods, the focus is on groups.
With private goods, the focus is on the
individual.

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Public Goods

In the case of a public good, the social

benefit of a public good is the sum of the
individual benefits.

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Public Goods
Adding demand curves vertically is easy to
do in textbooks, but not in practice.
This is because individuals do not buy
public goods directly so that their demand
is not revealed in their actions.

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The Market Value of a

Public Good
Price

1.00
.80

0.50

.60
.40
.20

0.10
0.60

1
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0.40

0.50
2

Market demand
DB
DA
0.10
3
Quantity

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Informational Problems
Perfectly competitive markets assume
perfect information.
Real-world markets often involve
deception, cheating, and inaccurate
information.

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Informational Problems

When there is a lack of information, buyers

and sellers do not have equal information,
markets may not work properly.

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Informational Problems
Economists call such market failures
adverse selection problems.
Adverse selection problems problems
that occur when a buyer or a seller have
different amounts of information about the
good for sale.

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Policies to Deal with

Informational Problems
Regulate the market and see that
individuals provide the correct information.
Government licenses individuals in the
market and requires them to provide full
information about the good being sold.

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A Market in Information
Information is valuable, and is an
economic product in its own right.
Left on their own, markets will develop to
provide information that people need and
are willing to pay for it.

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A Market in Information

If the government regulates information,

then markets for information will not
develop.

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Licensing of Doctors
Currently all doctors practicing medicine
are required to be licensed.
Licensing of doctors is justified by
informational problems.

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Licensing of Doctors

Some economists argue that licensure

laws were established to restrict supply,
not to help the consumer.
Instead

of licensing doctors, the

government could give the public
information about which treatments
work and which do not.

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Licensing of Doctors

Providing information rather than licensing

would give rise to consumer sovereignty.
Consumer

sovereignty the right of

the individual to make choices about
what is consumed and produced.

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An Informational
Alternative to Licensure

In this scenario, the government would

require doctors to post their:
Grades

in college.
Grades in medical school.
Success rate for various procedures.
References.
Medical philosophy.
Charges and fees.
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An Informational
Alternative to Licensure

This information alternative would provide

much more useful information to the public
than the present licensing procedure.

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Government Failures and

Market Failures
Market failures should not automatically
call for government intervention.
Why? Because governments fail too.

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Government Failures and

Market Failures

Government failure occurs when the

government intervention in the market to
improve the market failure actually makes
the situation worse.

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Reasons for Government

Failures
Governments do not have an incentive to
correct the problem.
Governments do not have the information
to deal with the problem.
Intervention in the markets is almost
always more complicated than it initially
looks.

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Reasons for Government

Failures
The bureaucratic nature of government
intervention does not allow fine tuning.
Government intervention leads to more
government intervention.

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THANK YOU

End of Presentation

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