Consider a tax charged per-unit in a specific market; e.g., 10 cents per avocado

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1 Efficiency and Market Imperfection Notes, page 1, 2001; Bruce Brown I. Important Expressions Regarding Tax. raise revenue = government collect tax money from taxpayers levies a tax = government starts to collect tax (passes a law requiring payment of tax, or institutes a tax) bears the burden = to really pay the tax, to by hurt by the tax (compare post-tax price paid by buyer or received by seller with what they would have paid or received without a tax) impact of the = the effect of the tax (on price paid by buyers, received by sellers; and quantity bought and sold or transacted ) a tax wedge = separates the price buyers pay from the price sellers receive (after tax) II. Crucial Points Regarding a Per-Unit Tax Consider a tax charged per-unit in a specific market; e.g., 10 cents per avocado 1) an excise tax legally on sellers will shift upward the supply curve 2) a sales tax legally on buyers will shift down the demand curve 3) to see who really pays the tax, (i.e., to determine the economic incidence of the tax), one should compare the prices after the tax is imposed, to those which would exist without the tax. 4) Economic incidence does not depend on legal incidence. That is, in theory the effect charging buyers 10 cents per avocado bought (shown by parallel downward shift in demand) is exactly the same as charging sellers 10 cents per avocado sold (shown by parallel upward shift in supply). The only difference is whether the posted price (on the sign or on the price tag) includes the tax or not. For example, the previous two situations are economically identical. The only difference is whether the sticker price includes the tax (e.g., as with gasoline tax) or not (e.g., as with the ordinary sales tax). Suppose the price of an avocado is $1, and that a 10-cent-per-avocado sales tax exists. In this example the tax is legally on the buyers. The sticker price reflects what the seller actually receives ($1.00 per avocado), and the actual price buyers pay, after tax, is $1.10 per avocado. A 10 cent wedge exists between the price the buyer pays and that which the seller receives. Realize, that in order to find the economic incidence of the tax (find who really pays the tax) we must consider what the price would be if there were no tax. Theory suggests that in a world without a tax, the market equilibrium price of avocados would have been between $1.10 and $1.00 per avocado. Suppose it would have been $1.07. Realize without a tax, the posted price would reflect both the amount paid by buyers, and received by sellers. Then the economic incidence of the 10 per avocado tax is: 3 cents per avocado on the buyers ( ), and 7 cents per avocado on the sellers ( ). In this example we can visualize the tax as shifting down demand by 10 cents. If the tax were officially collected from the sellers (an excise tax, where the sticker price includes the tax) this could be visualized by shifting up the supply curve by 10 cents. Perhaps the most straightforward general way to depict that effect of a tax on a good is to simply use the original pre-tax supply and demand curves and show the tax as driving a wedge between the height of the demand and supply curves (prices which buyers pay and sellers receive). III. In theory, a free market with no government implies ALLOCATIVE EFFICIENCY (Allocative Efficiency means the efficient quantity of the good is produced) Assume: a) buyers and sellers have full (perfect) information b) there are many buyers and sellers who behave competitively c) there are no external benefits or costs d) the good is a pure private good that is has no characteristics of a public good e) property rights are clearly defined and enforced

2 Efficiency and Market Imperfection Notes, page 2, 2001; Bruce Brown Then: -- Height of demand curve = marginal social benefit (MSB) = marginal private benefit (MPB) to the consumer consuming the good. -- Height of supply curve = marginal social cost (MSC) = marginal private cost (MPC) to the firm producing the good. Allocative Efficiency in a market can be seen one of two ways: 1) the MSB = MSC for the last unit produced (for all units produced MSB is greater than or equal to MSC) -or- 2) the sum, consumer surplus plus producer surplus, is maximized Price Supply Curve s Height = Marginal Social Cost MSC, which also equals Marginal Private Cost MPC experienced by the firm Demand Curve s Height = Marginal Social Benefit MSB, which also equals Marginal Private Benefit MPB experienced by the consumer Q * efficient Quantity If for some reason, Q * is not transacted (bought and sold) in this market, inefficiency is implied. Government may be able to increase efficiency by causing a quantity closer to Q * to be transacted. IV. Five Efficiency-based Reasons for Government Intervention in Markets: 1. Imperfect Competition, Monopoly Power If there are a small number of producers, they may collude to restrict the quantity sold in the market (below Q * ) so as to raise the price charged customers. This may increase Producer Surplus, but reduce Consumer Surplus by a greater amount. That is, the monetary value of the gain to producers will be smaller than the monetary loss to consumers, thus implying inefficiency. Government may use anti-trust policy to prevent this reduction in the quantity sold in the market (e.g., make it illegal for firms to collude to restrict quantity). Real world application of antitrust policy may be more complicated. In a very important current case, U.S. federal (and some state) governments have filed law suits against Microsoft, the maker of MS Windows, MS Word, MS Excel, etc. Microsoft is accused of activities that will make it more difficult for other computer firms to sell their computer software. The basic idea is that with reduced competition, Microsoft will be able to charge a higher price in the future (a complication is that Microsoft may force other computer software companies out of the market by giving away their software for free now; AND if consumers may get free software now, they may benefit now; BUT with fewer competitors in the future Microsoft will be able to raise prices and hurt consumers in the future -- our model has no time, and so has difficulty describing this)

3 Efficiency and Market Imperfection Notes, page 3, 2001; Bruce Brown 2. Macroeconomic Instability - Government policy may be able to stop a recession (or depression) An economy in a recession has an inefficiently large amount of unemployed resources, (e.g., many workers are involuntary unemployed). In theory, government may stimulate an economy by lowering interest rates; increasing the money supply; encouraging banks and other financial firms to increase lending; reducing taxes and increasing government spending (increasing its fiscal budget deficit); and improving business and consumer confidence so as to increase investment and consumption spending. Note that if the macroeconomy is out of equilibrium, so may be markets for individual goods. That is the amount transacted may be below Q * in many markets. If government can increase (stimulate) spending, the quantities being bought and sold in these markets may move toward Q * - increasing efficiency. 3. Externalities spill-over costs & benefits experienced by third-parties (neither buyers or sellers) If the consumption of a good benefits people other than the buyer/direct consumer; then there is a positive externality. Then MSB > MPB in consumption - that is the MSB curve is above the demand curve. The free market quantity is below the efficient amount Q market < Q eff. Government could increase efficiency by increasing the amount bought and sold in this market. This could be done by subsidizing consumption (paying part, or all, of the consumer s cost), or by forcing consumers to spend more of their own money on this good. Examples include: i) immunizations (the use of medicines to prevent infectious diseases that can be spread from one person to another), ii) driver training classes iii) general education (which would benefit not only the student, but other individuals as well). If the production of a good generates a cost, experienced by people other than the producer/firm (or the consumer/buyer), then there is a negative externality. Then MSC > MPC in production. The MSC curve is therefore above the supply curve. The free market quantity produced and sold is larger than the efficient amount Q market > Q eff. Government could increase efficiency by reducing the amount bought and sold in this market. This could be done by taxing production (charging firms a tax which increases with output of the good), or by forcing firms to produce less (by regulation and/or legal restrictions). Examples include: i) pollution, ii) unpleasant noise. Price Positive Externality Supply = MPC = MPC MSB Demand = MPB Price Q * eff Q mkt Q Negative Externality MSC Supply = MPC Q * eff Q mkt Demand = MPB = MSB Q

4 Efficiency and Market Imperfection Notes, page 4, 2001; Bruce Brown In the previous graphs, we assume for convenience that the external cost or benefit is a constant amount for each unit produced or consumed. The Mankiw text, Ch 10, shows four possibilities: i) negative externality in production (Figure 10-2); ii) positive externalities in production (Figure 10-3); negative externality in consumption (Figure 10-4a); and positive externality in consumption (Figure 10-4b). The text s terminology is somewhat shorter and less descriptive than that used in class and in these notes: MPC = private cost ; MPB = private value ; MSC = social cost ; MSB = social value.} Realize that if a new store opens in a town, the owner of an old store may be hurt. This is NOT a negative externality in the sense discussed above. Standard economic analysis presented here does NOT provide a rational for preventing the new store from opening based on the fact that the owner of the old store will be hurt. Simple standard analysis often holds the amount of pollution cost per unit of good produced constant. With this assumption, taxing output provides identical results as taxing the actual pollution. For example, if each ton of steel produced created a constant 10 pounds of pollution, then a tax of $10 per ton of steel produced would be the same as a tax of $1 per pound of pollution. The text calls such a taxes to reduce pollution Pigouvian Taxes (after the economist A.C. Pigou). If a firm can reduce the amount of pollution per unit of output, then taxation of pollution is different than taxation of output. Realize that the real world practices of: i) charging a firm a fee based on the amount of pollution, or ii) fining a firm which creates more than an allowed amount of pollution, are somewhat different than the standard theoretical exercise of taxing output which we explicitly consider in this class. 4. Public Goods A pure public good has two characteristics: i) non-rival in consumption (it can be consumed by more than one person), and ii) it is impossible to exclude people from consuming it. The second characteristic implies that it would be difficult or impossible to sell this good in a market. A free rider problem implies people would not buy the good if they could wait for others to buy it and then consume it without paying. An (impure) public good is partially non-rival in consumption (up to a certain point, at least), and the buyer may be able to exclude the consumption by others, but it is usually costly to do so. A pure private good is rival in consumption. Only one person, the buyer, may consume it. Generally, an inefficiently small amount of goods with public good characteristics would be produced and consumed in a competitive market without government intervention. Thus an efficiency based argument exists for the government to provide items like parks, national defense, lighthouses to warn ships that the coastline is dangerous, etc. Nearly all goods are neither pure public or pure private goods; but one can approximately order goods in terms of their similarity with one, versus the other. For Example: PURE National Defense PUBLIC Lighthouse GOODS Large National Uncrowded Parks Small Crowded City Parks Police and Fire Protection Roads Publicly Broadcast Television Cable or Satellite Television (easier to exclude viewers who don t pay) Movies shown in a theater PURE Housing PRIVATE Clothing GOODS Food Note that government may provide private goods; and some public goods may be provided by markets. Whether a good is basically public or private depends on its characteristics, NOT by whether it is provided by government or private markets.

5 Efficiency and Market Imperfection Notes, page 5, 2001; Bruce Brown The notion of Public Goods may overlap that of Externalities in some cases and often there is also a connection with the provision of information. For example if a bank has a clock on its roof which people who pass by can see, one may view this as the private sector providing a public good (many people can consume the clock at the same time), or the bank s desire to bring attention to itself for advertising purposes as causing a positive externality. Note that the good in this case is information (about the current time). If there was truly perfect information, people would already know the time without looking at the clock, and would know about the existence of the bank (and the quality of its service, etc.) With perfect information, people would have no reason to look at the clock, and the bank would have no reason to place the clock on the roof, or more generally, to advertise at all. 5. Imperfect Information i. Direct Provision of Information In a number of circumstances, government can increase efficiency increasing the amount and quality of information. For example government may: i) collect and provide information about skills required by employers in the future so people can invest in the skills that will help them find jobs. ii) help match unemployed workers with job vacancies. iii) require firms to provide financial information, audited by independent CPA firms. iv) facilitate the collection of credit histories of individual consumers, making the extension of credit to buyers less risky and thus less expensive. v) create grades or quality categories of goods for which consumers have difficulty determining quality (e.g., USDA Choice, or Premium grade beef... etc.) vi) require Microsoft, the maker of the operating system MS Windows, to disclose details about how it is made (the computer codes ) so that makers of applications software (e.g., for word-processing, data manipulation, internet communication, etc.) can make compatible software. vii) require firms to be able to prove specific claims made in their advertisements. Nearly all of the seven examples above can be considered special cases of the previous four reasons for government intervention. Information may be considered a public good, under-provided without government action; or as a good which when consumed by one person, gives off positive externalities; or as related to the restriction of competition (as in the Microsoft example); or as related to prevention of recessions (during recessions, individual errors sometimes based on incorrect information, can be thought of as an important factor which prevents the economy from moving to a full-employment equilibrium). In general, there is a good deal of overlap between these five categories. They are not mutually exclusive. ii. Asymmetric Information Asymmetric information exists when buyer and seller have different information about product characteristics. This asymmetry may prevent efficiency increasing trades from taking place. Good examples include: i) An individual selling his/her used car is likely to have more information about the car s quality and how it was maintained, etc., than will the buyer (who may obtain his/her information only by inspecting the car). ii) A buyer of health insurance is likely to have better information about their health and medical history than the insurance company who will sell the policy. iii) A borrower has better information about the chance that they will not repay a loan than does the lender. Consider automobile insurance. Insurance companies would like to charge risky drivers higher premiums (the price of buying insurance) because the chance of them filing a claim (e.g., having an accident which requires the insurance company to pay money to fix the car), is higher. The firm s problem can be partially resolved by basing the premiums charged to individuals on a number of observable factors. This problem can be divided into two categories:

6 Moral Hazard (MH) - (behavior is changed after the insurance contract is made) Efficiency and Market Imperfection Notes, page 6, 2001; Bruce Brown Once a driver gets insurance, they have an incentive to drive less cautiously. If a driver has insurance which covers his/her car being broken into, then they will be more likely to park in a dangerous place. Adverse Selection (AS) - (those who are more risky have a greater incentive to buy insurance) Those who know they typically park in dangerous areas (either with or without insurance) will have an incentive to purchase comprehensive insurance which covers a car broken into while parked. Various practices of auto insurance companies may be thought of as a response to either MH or AS. For example if premiums are: i) higher for drivers with a history of accidents. MH is reduced since if you drive dangerously and get into an accident, you will pay higher premiums in the future. AS is reduced since naturally bad drivers are more likely to have had accidents in the past. ii) higher for young males who are not married. AS is reduced since young unmarried males tend to have more accidents. iii) lower for people who have a higher deductible (amount of money which the driver must pay to repair their car -- e.g., if there is a $500 deductible, then a driver whose car was damaged must pay the first $500 of the repair cost, with the insurance company paying the rest). MH is reduced - drivers will behave more cautiously with a higher deductible, since a smaller portion of repair costs will be covered by insurance if an accident occurs AS is reduced - drivers who know they are naturally safe drivers will accept insurance policies with higher deductibles and lower premiums. In certain circumstances with asymmetric information, efficiency may be increased if government forces a group of firms to sell (or provide insurance, or lend...), or a group of consumers to buy. For example, consider health insurance for people within a particular group. Suppose individuals have much better information about their health than insurance companies (in the real world, companies reduce this problem by requiring customers to pass a physical examination, by not covering pre-existing conditions, etc.). Suppose people are in one of three categories: i) sickly, ii) average, or iii) very healthy. Suppose individuals know which of these categories they are in, but insurance companies do not; and so they charge the same premium to individuals in different groups. If very healthy people choose not to buy insurance, the premium required for the insurance company to earn a normal profit (constrained by competition, assumed to exist in the insurance market) will be higher. This higher premium could cause people with average health not to buy insurance. If only sickly people buy insurance, the premium will have to be very high. If instead, government forced everyone to buy insurance, the required premium would be much lower. In fact, it may be so low that average people would buy it voluntarily. That is, government may cause transactions which benefit society to occur, where they would not have occurred unless government required everyone to buy insurance (wealth will also be transferred from very healthy to sickly people, and this may be desirable, but this is NOT the reason for government intervention in this example which focuses on efficiency).