Chapter 16. Market Failures and Government Intervention. In this chapter you will learn to. Basic Functions of Government

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1 Chapter 16 Market Failures and Government Intervention In this chapter you will learn to 1. Explain the informal defense of free markets. 2. Define an externality and explain why they lead to allocative inefficiency. 3. Explain why public goods are underprovided by private 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 Basic Functions of Government 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

2 Basic Functions of Government Adam Smith ( ) 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 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

3 Free Markets Innovation and Growth 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 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

4 Price Allocative Inefficiency External cost of a negative externality p 1 p C p 2 MC S 1 S=MC p MC 2 S External benefit of a positive externality D = MB Q 1 Q C Q 2 Quantity With a negative externality, a free market produces too much of the product. With a positive externality, a free market produces too little of the product 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

5 Figure 16.1 An Externality Leads to Allocative Inefficiency Free-Rider Problem APPLYING ECONOMIC CONCEPTS 16.1 The World s Endangered Fish 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 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

6 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 Asymmetric Information APPLYING ECONOMIC CONCEPTS 16.2 Public Goods Experiments in the Laboratory and in the Classroom APPLYING ECONOMIC CONCEPTS 16.3 Used Cars and the Market for Lemons Summary Four basic causes of market failure: 1. Firms with market power 2. Externalities 3. Common-property resources and public goods 4. Asymmetric information

7 Broader Social Goals Even with no market failures, government may choose to intervene for other reasons. Income Distribution 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 Broader Social Goals 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. Protecting Individuals from Others Individual freedom generally does not include having the freedom to harm others Broader Social Goals Paternalism Some government policies are designed to protect people from themselves. Social Responsibility It is generally illegal to buy your way out of mandatory national service or to sell one s right to vote

8 Broader Social Goals 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. A General Principle 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 Government Intervention Governments use cost-benefit analysis to weigh the costs and benefits of specific policies. The Tools of Government Intervention Public provision Redistribution programs Regulation 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

9 Indirect Costs Some examples of indirect costs are: changes in costs of production costs of compliance of regulations rent-seeking behavior 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 Table 16.2 Net Benefits from Road Construction Results: Albert and Bob will use democracy to appropriate resources from Charlene (through taxation) while reducing economic efficiency

10 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