market failure and the role of government. capitalism review 2
TRANSCRIPT
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Market Failure and the Role of Government
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Capitalism Review
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Characteristics of Capitalism
1. Private property
2. Freedom of choice
3. Self-interest
4. Competition
5. Prices, not bureaucrats, guide decisions
6. Limited Government
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Heritage Foundation’s 2014 Index of Economic Freedom
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Bottom 10
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Freedom creates wealth!
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South Korea
North Korea
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Does the free market always work perfectly?
Can economic efficiency ever be improved by government intervention?
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Market Failure
A situation in which the free market fails to satisfy society’s needs and wants efficiently
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Types of Market Failures
1. Public Goods
2. Externalities
3. Monopolies
4. Income Inequality
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Public Goods
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Video: Free Market Fire Department
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Market Failure #1: PUBLIC GOODS
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Why is the free market bad at providing public goods?
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Free Riders!People who benefit from something without paying for it
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Good Citizen
Free Rider
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The Free Rider Problem
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Examples: 1. People who download music illegally2. People who watch a street performer
and don’t pay 3. Teenagers that live at home and don’t
have a job
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• Canadian Military Spending: 1% of GDP
• US Military Spending:
4.4% of GDP
Why doesn’t Canada
spend more on defense?
Does anyone free ride off you?
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Possible solutions:1. Punish free-riders2. Have government provide the good
What’s Wrong With Free Riders?
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Free Riding Less revenue
potential profit Less incentive to
Firms produce less than the
Less
produce
socially optimal quantity
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Trimester Grades
•I’m willing to give everyone an A if you guys give me $500
•Everyone in the class will get an A - even those who don’t contribute anything
•Who’s willing to pay?
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Public Goods Defined
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True public goods meet two criteria:
1. Non-excludable
Definition
2. Non-rival
• Impossible to exclude people from enjoying its benefits (even if they don’t pay). Example: National Defense
•One person’s consumption doesn’t affect anyone else’s
•Example: A Fireworks Show21
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Identify which of the following areTRUE public goods
(have non-exclusion and non-rival consumption):
1. Hamburgers2. Satellite TV 3. The Grand Canyon4. A house5. Street lights6. Highways
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National defense is an example of a public good because
A) it requires tax revenues to fund any production(B) one person’s use of it will decrease another person’s ability to use it(C) it is nonexcludable and nonrival(D) the private market typically produces the socially efficient level of output(E) the public is protected from invasion
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National defense is an example of a public good because
A) it requires tax revenues to fund any production(B) one person’s use of it will decrease another person’s ability to use it(C) it is nonexcludable and nonrival(D) the private market typically produces the socially efficient level of output(E) the public is protected from invasion
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Could the federal government…
1.Stop most illegal immigration?
2.Make sure everyone in the US has a job?
3.Build a research station on Mars?
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It probably could!
Then why doesn’t it?
The costs outweigh the benefits
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How should the government decide how much of a public good to
produce?
Weigh the Costs and Benefits!
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In Theory…
A good’s Marginal Social Benefit curve is equal to its demand curve (based on individuals’ willingness to pay for it)
A good’s Marginal Social Cost curve is its marginal cost curve plus any externalities
Video: Dam Tragedy
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Demand for a New ParkMarginal willingness to pay higher taxes# of
ParksAdam is willing to
pay
Jill is willing to
pay
Society’s Demand (MSB)
Marginal Cost
1 $4 $5 $9 $52 $3 $4 $7 $53 $2 $3 $5 $54 $1 $2 $3 $55 $0 $1 $1 $5
Assume:1. There are only
two people in society.
2. Each additional park costs $5
How many parks should be
made?
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Demand for a New ParkMarginal willingness to pay (higher taxes)# of
ParksAdam is willing to
pay
Jill is willing to
pay
Society’s Demand (MSB)
Marginal Cost
1 $4 $5 $9 $52 $3 $4 $7 $53 $2 $3 $5 $54 $1 $2 $3 $55 $0 $1 $1 $5
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Demand for a New ParkMarginal willingness to pay higher taxes# of
ParksAdam is willing to
pay
Jill is willing to
pay
Society’s Demand (MSB)
Marginal Cost
1 $4 $5 $9 $52 $3 $4 $7 $53 $2 $3 $5 $54 $1 $2 $3 $55 $0 $1 $1 $5
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Price
Quantity of Parks
$ 9 7
5
3
1
0 1 2 3 4 5
D=MSB
Supply and Demand for Public ParksThe Demand is the
equal to the marginal benefit to
society
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$ 9 7
5
3
1
0 1 2 3 4 5
The supply is the public
good’s marginal cost to society
S=MSC
D=MSB
Supply and Demand for Public ParksPrice
Quantity of Parks
MSB = MSC
1. What if the government made 1 park?
2. What if the government made 4 parks?
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A side effect of an economic action that is felt by an unrelated third party
What is an externality?
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Externalities
Consumers and firms sometimes fail to consider the external costs and benefits of their actions – i.e. how their actions will affect other people
As a result, the free market may fail to produce the “socially optimal” quantity of some goods
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Negative Externalities
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Costs resulting from aneconomic action that are felt byan unrelated third party
Negative Externalities (aka: Spillover Costs)
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Example: Whistle Tips
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Zoram Pharmaceutical Co. pollutes the air when it manufactures Spazoprolam, a new drug that helps you dance better
Zoram only considers its INTERNAL costs (ignores the social cost of pollution)
If Zoram had to pay all costs, it would produce less
Example 2
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P
Q
D=MSB
Supply = Marginal
Private Cost
QFree Market 40
Market for SpazoprolamThe marginal private cost doesn’t
include the costs to society
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P
Q
D=MSB
Supply = Marginal
Private Cost
QFree Market 41
Supply = Marginal
Social Cost
What will MC/Supply look like when EXTERNAL cost are factored in?
QOptimal
Market for Spazoprolam
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P
Q
D=MSB
S=MPC
QFree Market 42
S =MSC
QOptimal
At QFM the MSC is greater than the MSB. Too much is being produced
Overallocation
Market for Spazoprolam
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P
Q
D=MSB
QFree Market 43
What should the government do to fix a negative externality?
QOptimal
S=MPC
S =MSC
Solution: Tax the amount of the
externality(Per Unit Tax)
Market for Spazoprolam
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P
Q
D=MSB
QFree Market 44
What should the government do to fix a negative externality?
QOptimal
S=MPC
S =MSC
Solution: Tax the amount of the
externality(Per Unit Tax)
=MPC
MSB = MSC
Market for Spazoprolam
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Positive Externalities
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Positive Externalities (aka: Spillover Benefits)
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Benefits from an economic action that are enjoyed by an unrelated third party.
(E.g.: Vaccines, Education, Home Renovation)
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• Mom only looks at the INTERNAL benefits (the reduced risk of her own daughter getting sick)
• If parents considered the social benefits (the reduced likelihood that her daughter will spread diseases to other children), demand would be greater
Example: A mom decides to get the MMR vaccine for her child
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P
Q
D=Marginal Private Benefit
S = MSC
QFree Market 48
Market for MMR vaccineThe marginal private benefit doesn’t
include the additional benefits to society.
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P
QQFM 49
What will the MB/D look like when EXTERNAL benefits are factor in?
QOptimal
D=Marginal Private Benefit
S = MSC
D=Marginal Social Benefit
Market for MMR vaccine
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P
Q
D=MSB
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If the market produces QFM why is it a market failure?
S = MSC
D=Marginal Social Benefit
QFM QOptimal
Market for MMR vaccine
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P
Q 51
Underallocation
S = MSC
D=Marginal Social Benefit
QFM QOptimal
At QFM the MSC is less than the MSB.
Too little is being produced
Market for MMR vaccine
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P
QQFM 52QOptimal
D=MPB
S = MSC
D=MSB
What should the government do to fix a negative externality?
Subsidize the amount of the externality (Per Unit Subsidy)
=MPB
Market for MMR vaccine
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Seating Chart!
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“I’m writing you a
prescription for pecan pie”
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The Tragedy of the Commonsa.k.a. The Common Pool Problem
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Why are public bathrooms so nasty?• No one who uses them has an
incentive to keep them clean!• This problem – called the “Tragedy of
the Commons” or the “Common Pool Problem,” applies to any non-excludable good• e.g. The air, the oceans, rivers, etc.
What can be done
about this?
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Market Failure #3
Monopolies
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D
MR
$9
8
7
6
5
4
3
2
MCATC
58 1 2 3 4 5 6 7 8 9 10 Q
P
UnregulatedSocially Optimal
Fair Return
Monopoly
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Government in Action:
Antitrust Laws
Legislative Executive Judicial
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Anti-Trust Laws
Laws designed to break up monopolies and promote competition.•Prompted by growth of Standard Oil and Carnegie Steel
Why are monopolies a Market Failure?
•They are neither productively nor allocatively efficient
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WHAT DOES THE GOVERNMENT DO?Legislative Branch• Passed Sherman Act of 1890-
“Every person who shall monopolize …or conspire to monopolize…shall be deemed guilty of a felony.”
Executive Branch •Federal Trade Commission must approve all corporate mergers.•Justice Department prosecutes anti-competitive firms
Judicial Branch•Federal Courts adjudicate antitrust complaints
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Market Failure #4
Wealth Inequality
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Wealth Inequality • In 2014, the mean
household income in the U.S. was $72,641
• In 2014, the median household income was $51,939
How can this be?63
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The Lorenz Curve and Gini
Coefficient
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Measuring Income Distribution The process:
• Divide households into quintiles based on income
• If perfect equality, 20% of families should earn 20% of income, 40% should earn 40%...etc.
• Compare actual distribution (Lorenz Curve) to perfect distribution – ratio is the Gini Coefficient 65
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Measuring Income Distribution Example:
Group #1 (Poorest 20%)• Total of $5Bn (5% of total income)
Group #2 • Total of $10Bn (10% of total income)
Group #3• Total of $15Bn (15% of total income)
Group #4• Total of $25Bn (25% of total income)
Group #5 (Richest 20%)• Total of $45Bn (45% of total income)
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20 40 60 80 100
100
80
60
40
20
0
Percent of Families
Per
cen
t o
f In
com
e
Perfect Equality
The Lorenz Curve
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100
80
60
55
40
30
2015
5 0
Percent of Families
Per
cen
t o
f In
com
e
Perfect Equality
Lorenz Curve (actual distribution)
68
The Lorenz Curve
20 40 60 80 100
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100
80
60
55
40
30
2015
5 0
Percent of Families
Per
cen
t o
f In
com
e
Perfect Equality
Lorenz Curve (actual distribution)
69
The Lorenz Curve
The size of the banana showsthe degree of
income inequality.
20 40 60 80 100
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100
80
60
55
40
30
2015
5 0
Percent of Families
Per
cen
t o
f In
com
e
Perfect Equality
After Redistribution
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The Lorenz Curve
The banana gets smaller when the government re-
distributes income
20 40 60 80 100
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100
80
60
55
40
30
2015
5 0
Percent of Families
Per
cen
t o
f In
com
e
Perfect Equality
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The Lorenz Curve
Gini Coefficient = A/(A+B)
20 40 60 80 100
A
B
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Government Policy to Reduce InequalityTransfer Payments (AKA
“welfare”) and Taxes
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Welfare provides a safety net for citizens(retirement, unemployment, workers comp, health
care, etc.)What are some possible downsides?
Where does the government get the money for welfare?
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Taxes
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What are Taxes?
Two purposes:1. Pay for government operations
• Public goods: highways, national defense, police, the court system
• Other programs: welfare, social security
2. Change economic behavior E.g. Excise tax on tobacco raises revenue AND
discourages cigarette production
Taxes – mandatory payments to the government
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Three Types of Taxes1. Progressive Taxes – higher income
earners pay a higher percentageEx: Current Federal Income Tax system
3. Regressive Taxes – lower income earners pay a higher percentage
Ex: Head tax, sales tax
2. Proportional (Flat) Taxes – everyone pays the same percentage of income
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What kind of taxes are these?
(Think % of Income)
1. Toll road tax ($5 per use)2. State income tax where richer citizens
pay higher % 3. $.45 tax per pack of cigarettes4. Medicare tax of 1.45 % on every $
earned 5. 5.6% Arizona sales tax
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Three Types of Taxes
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Federal Income TaxEqual Tax of $350 per week (Regressive Tax) Income Amount of Tax % Amount to live on• $200 $350 175% -$150)• $350 $350 100% $0 • $500 $350 70% $150• $1,000 $350 35% $650• $5,000 $350 7% $4,650
Tax tax of 20% per week (Proportional Tax) Income Amount of Tax Amount to live on• $200 $40 $160 • $350 $70 $280• $500 $100 $400 • $1,000 $200 $800 • $5,000 $1,000 $4,000
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Federal Income Tax
This is our current system. Is it fair?
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The Laffer CurveIllustrates the relationship
between tax rate and tax revenue
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The final graph to learn for microeconomics…
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The Laffer Curve
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% Tax Rate
Tax Revenue
If government raises tax rates,
revenue will increase…to a
point.
If the tax rate becomes too high,
tax revenue will eventually fall.
Why?
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GREAT NEWS…
WE’RE DONE WITH MICRO!
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