2. Describe specifically how your economic thinking has been affected by this course and how you can best make use [apply] the central principles and theories which were studied. What is the main outcome(s) from the course for you? (~ 2 pages)

Introduction

0. Learning objectives – After reading this chapter, students should be able to:

0. Differentiate between demand-side market failures and supply-side market failures.

0. Explain the origin of both consumer surplus and producer surplus, and explain how properly functioning markets maximize their sum, total surplus, while optimally allocating resources.

0. Describe free riding and public goods, and illustrate why private firms cannot normally produce public goods.

0. Explain how positive and negative externalities cause under- and overallocations of resources.

0. Show why we normally won’t want to pay what it would cost to eliminate every last bit of a negative externality such as air pollution.

0. (Appendix) Describe how information failures may justify government intervention in some markets.

0. Everyone uses goods and services that are provided by government.

0. The questions to be answered are: why doesn’t the private sector provide these goods and services efficiently, and what is the role of government in bringing about a better allocation of resources?

Market Failures in Competitive Markets

0. Market failures can occur in competitive markets.

Demand-side market failures:

3. Occur because at times it’s impossible to charge people what they’re willing to pay.

3. Fireworks are an example.

3. There’s no way to prevent people who didn’t pay to see fireworks from watching them.

3. Private firms therefore are not willing to produce the fireworks.

Supply-side market failures:

3. Occur because the producer fails to pay the full cost of production.

3. Pollution is an example.

3. The firm pays for all of the resources it uses, but it doesn’t pay for the pollution it creates.

3. The firm therefore produces more electricity and pollution than the firm would produce if they paid for the pollution they emit.

Efficiently Functioning Markets

0. To be efficient:

4. Demand must fully reflect consumers’ willingness to pay.

4. Supply must fully reflect all costs of production.

0. Consumer Surplus

5. Definition – the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price.

5. The surplus, measurable in dollar terms, reflects the extra utility gained from paying a lower price than what is required to obtain the good.

5. Maximum price a consumer is willing to pay depends on the opportunity cost of goods and services he must forego.

5. Consumer surplus can be measured by calculating the difference between the maximum willingness to pay and the actual price for each consumer, and then summing those differences.

5. Consumer surplus is measured and represented graphically by the area under the demand curve and above the equilibrium price. (Figure 4.1)

5. Consumer surplus and price are inversely related – all else equal, a higher price reduces consumer surplus.

0. Producer Surplus

6. Definition – the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price.

6. Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences.

6. A producer’s minimum acceptable price is based on his marginal cost and the opportunity cost of using resources to produce other goods.

6. Producer surplus is measured and represented graphically by the area above the supply curve and below the equilibrium price. (Figure 4.2)

6. Producer surplus and price are directly related – all else equal, a higher price increases producer surplus.

Efficiency Revisited and Efficiency Losses

0. Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized. (Figure 4.3)

7. Consumers receive utility up to their maximum willingness to pay, but only have to pay the equilibrium price.

7. Producers receive the equilibrium price for each unit, but it only costs the minimum acceptable price to produce.

7. Allocative efficiency occurs at quantity levels where three conditions exist:

2. MB = MC (as represented by demand and supply).

2. Maximum willingness to pay = minimum acceptable price.

2. Combined consumer and producer surplus is at a maximum.

0. Efficiency (Deadweight) Losses

8. Underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity. (Figure 4.4a)

8. Overproduction causes inefficiency because past the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to pay. (Figure 4.4b)

Public Goods

0. Private goods are produced and sold in competitive markets, and have two characteristics:

9. Rivalry in consumption – when one person buys and consumes a good, it is not available to others.

9. Excludability – Sellers can restrict the benefits to those who pay for the good.

0. Market demand for private goods is found by horizontally summing the individual demand schedules.

0. Private markets allocate goods and resources efficiently – those willing to pay to obtain goods get them. Sellers produce goods to satisfy consumer wants, and consumer buying behavior tells them whether to produce more or less of any particular good.

0. Unlike private goods, public goods are those goods that are nonrival and nonexcludable.

0. Public goods suffer from the free-rider problem, where a consumer can enjoy the benefit of the good without having to pay for it.

13. As a result of free-riders government must provide the good.

13. Government doesn’t prevent free-riders, but government can finance production of the good through taxes.

13. Sometimes public goods can be subsidized through private related goods and therefore provided by private firms.

0. Consider This … Street Entertainers

14. Street entertainers regularly appear in popular tourist areas in major cities. Even though some people pay when the “hat is passed,” many benefit from the shows without contributing to the cost (free-riding).

14. Because local businesses benefit from the customers attracted by these performers, the businesses or local government will sometimes pay these entertainers.

14. Even when government is not contributing to the cost of street entertainers, a public good is still being provided.

0. The demand for public goods differs from the market demand for private goods.

15. It is a “phantom” demand since the consumers will not be making individual purchases.

15. To find the collective demand schedule for a public good, we add the prices people collectively are willing to pay for the last unit of the public good at each quantity demanded (Table 4.3).

15. Figure 4.5 is a graphical illustration of this table. A collective demand curve is the vertical sum of the individual demand curves for the public who want that good.

15. Recall that the market demand for a private good was a horizontal summation of the individual demand curves.

0. The supply curve for any good is its marginal cost curve. As with private goods, the law of diminishing returns applies to the supply of public goods.

0. The optimal quantity of a public good can be determined by comparing the collective demand curve with the supply (marginal cost) curve to determine their point of intersection or by looking at the demand and supply (marginal cost) schedules to see at what price and quantity marginal benefit equals marginal cost (Figure 4.5c).

0. Cost-benefit analysis is a technique for decision making in the public sector.

18. The concept involves comparing the benefit of providing incremental units of public goods with the costs of providing these additional units. Note that the comparison is a marginal one, i.e., the comparison is made between the costs and benefits of additional amounts of a public good or service.

18. Table 4.4 illustrates this concept in determining the scope of a national highway construction project. Four possible phases of projects are considered, with costs and benefits compared. By comparing the marginal costs and benefits as one moves from the least expensive phase to the mostexpensive phase, we see Plan C is the optimal choice.

18. The rule for this decisionmaking technique is to use the marginal benefit = marginal cost rule; if the marginal cost exceeds the marginal benefit, that part of the project should not be included.

18. The problem with this technique is the difficulty in measuring costs and benefits. Benefits are particularly difficult to estimate, because there are many related aspects that are not easily calculated. Nevertheless, the method is widely used.

0. Quasipublic goods are those that have large positive externalities, so government will sponsor their provision. Otherwise, they would be underproduced. Medical care, education, and public housing are examples.

0. Resources are reallocated from private to public use by levying taxes on households and businesses, thus reducing their purchasing power and using the proceeds to purchase public and quasipublic goods. This can bring about a significant change in the composition of the economy’s total output.

0. Consider This … Responding to Digital Free-riding

21. The music industry struggles with digital piracy. In this example four friends start a rock band and eventually get signed by a major record label. However, since people can download their music for free they have a difficult time making a living.

21. To overcome this problem the band provides the free music downloads to increase their popularity (they do not fight the public goods nature of their music). However, they now charge a higher price to attend their concerts, which is still a private good.

Externalities

0. Externalities occur when costs or benefits accrue to an individual who is external to the market transaction.

0. Figures 4.6a and 4.6b, respectively, illustrate that an overallocation of resources occurs when negative externalities are present and an underallocation of resources occurs when positive externalities are present.

23. Negative externalities occur when producers are able to shift some of their costs onto the community.

23. Positive externalities occur when the benefits of a good are received by others in the community although they did not pay for them. These benefits are not reflected in the individual demand curve.

0. Consider This…The Fable of the Bees

24. The Coase theorem, named after Nobel prizewinning economist Ronald Coase, suggests that government is not always needed to remedy external costs and benefits.

24. With the right conditions, externalities can be solved with a market approach to individual bargaining.

24. Bees provide many positive externalities to farmers by pollinating their crops.

2. Farmers and beekeepers used individual bargaining to determine payment, avoiding government intervention.

2. All farmers in an area hire beekeepers simultaneously, avoiding free-riders.

2. Farmers willingly pay the beekeepers to maintain their services because without the bees the farmers’ crops would be devastated.

24. Government’s role should be to encourage bargaining wherever possible, rather than to get involved in direct restrictions or subsidies.

0. Direct government controls or taxes may be needed to reduce negative externalities, or provide subsidies or government provision where positive externalities exist.

25. Direct controls place limits on the amount of the offensive activity that can occur. Clean air and water legislation are examples. The effect is to force the offenders to incur costs associated with pollution control. This should shift the product supply curve leftward and reduce the equilibrium quantity. Therefore, it should reduce the resource allocation in a socially optimal way. (See Figure 4.7a)

25. Pigovian taxes can be levied on polluters. The tax payment will increase costs to the producer, shifting the product supply curve leftward, and reducing resource allocation to this type of production as desired and increasing the equilibrium price. (See Figure 4.7b)

25. Subsidies and government provision suggest three options.

2. Buyers may be subsidized. For example, new parents may be given coupons to receive inoculations at reduced prices for their children. This would increase the number of vaccinations and eliminate the underallocation of resources. (See Figures 4.8a and 4.8b)

2. Producers could be subsidized so that producers’ costs are reduced, thus shifting the supply curve rightward, increasing equilibrium output, and eliminating the underallocation. (See Figure 4.8c)

2. The government could provide the product as a public good where spillover benefits are extremely large. An example would be administering free vaccines to all children in India to end smallpox.

0. Table 4.5 reviews the methods for correcting externalities.

Society's Optimal Amount of Externality Reduction

0. Society’s optimal amount of externality reduction is not necessarily total elimination.

27. To determine the correct amount of negative externalities like pollution, it’s necessary to find the point where the MC of cleaning it up equals the MB of cleaner air.

27. The cost of reducing spillover costs increases with each additional unit of reduction. The benefit received from each additional unit of reduction decreases due to diminishing marginal utility.

27. When MC=MB, society has found its optimal amount of pollution abatement (Figure 4.9).

27. In reality it is difficult to measure benefits as well as costs, but this analysis demonstrates that some degree of pollution may be socially efficient.

0. Government's Role in the Economy:

28. Identifying and correcting for market failures can be difficult, time consuming, and costly.

28. Introducing politics into the equation complicates the situation even more and can lead to undesirable economic outcomes.

28. In the political environment, there can be over- and underregulation.

28. Public and quasi-public goods may be produced because of powerful politicians, not because the benefits of the good exceed its costs.

28. Without a profit incentive, government is often inefficient.

Last Word…Carbon Dioxide Emissions, Cap-and-Trade, and Carbon Taxes

0. An owner of a landfill has full property rights and charges people to dump their garbage.

0. The payment that the landowner receives fails to account for the negative externalities from pollution.

0. It is possible to use cap-and-trade systems where government sets a limit on the total amount of a particular pollutant allowed then issues permits to firms, enabling them to emit a certain amount of the pollutant.

0. Firms can then trade permits with each other.

32. Smokestack Toys might have a permit for 100 tons of carbon dioxide that can be used to produce toys that will generate a profit of $100,000.

32. A power plant could use the 100 tons of carbon dioxide to produce energy and generate $1 million in profit.

32. Smokestack Toys can sell its permit for more than $100,000 to the power plant who will willingly buy it for up to $1 million (its expected profit).

32. Society benefits because when the energy company emits the carbon dioxide, society gets greater net benefits from it than it would from the production of toy cars as implied by the much greater profits without any change in the total amount of pollution.

0. Cap-and-trade systems are ineffective when it’s difficult for regulators to verify that firms are following the standards like the problems with the European Union’s cap-and-trade system for carbon dioxide.

0. Cap-and-Trade has been very effective in the U.S. for sulfur dioxide emissions because there are very few firms emitting this pollutant so regulators can easily verify that firms are not exceeding their limit.

0. To control carbon dioxide, economists recommend a carbon tax.

Appendix to Chapter 4

This appendix discusses another potential market failure. Since different individuals have different information about products, health etc… markets may fail to develop or operate on a limited basis. For example, the buyer of a used car knows less about the quality of the used car than the seller. Thus, the two may not be able to agree on a price.

1. Information failures are another form of market failure.

0. Information is often asymmetric – buyers and sellers don’t have the same information about the good, service, or resource being sold, and the cost of obtaining better information is often prohibitive.

0. Inadequate information about sellers—two examples:

37. Assume that the gasoline market exists in an absurd situation in which there is no system of weights and measures established by law. In such a world, the station could advertise highoctane gas that was actually lowoctane gas; pumps could register more gallons than were actually being pumped. Without government regulation, one could imagine some incentive for some stations to cheat in such ways. Government intervenes in such markets to prevent such cases of market failure. This provides reliable information to buyers and also helps sellers through enforcement of fair sales practices.

37. Licensing of surgeons is another example in which the consumer would find it difficult to gather information about a physician’s expertise without government licensing standards. Such rules set minimum standards for competence. There will still be physicians of varying abilities, but the consumer can be confident that basic standards were met.

0. Inadequate information about buyers may lead to potential problems for sellers.

38. The moral hazard problem occurs when there is a tendency of one party to a contract to alter his/her behavior in ways that are costly to the other party. Examples include the driver who behaves more recklessly after obtaining insurance; guaranteed contracts for athletes, which may reduce their performance; unemployment compensation insurance, which may discourage incentives to work.

38. The adverse selection problem arises when information known by the first party to a contract is unknown to the second and, as a result, the second party incurs major costs. Examples include those in poor health who take out health insurance, the person planning an arson attempt who takes out fire insurance and the person whose marriage is failing who takes out the book’s hypothetical “divorce” insurance. In areas where insurance is traditionally underprovided, the government has provided insurance or subsidized insurance.

38. Qualification: There are private methods of overcoming lack of information problems.

2. Product warranties overcome lack of information about the seller or product.

2. Franchising helps set uniform standards, so that most McDonalds or Holiday Inns have similar quality.

2. Firms have specialized in providing information to buyers and sellers; consumer reports, travel guides, and credit-checking agencies are some examples.

QUIZ

Consumer surplus arises in a market because:

At the market price, quantity supplied is greater than quantity demanded

At the current market price, quantity demanded is greater than quantity supplied

Some consumers are willing to pay more than the equilibrium price but do not need to do so

Some consumers are willing to pay less than the equilibrium price but do not need to do so

Answer: C

Negative externalities arise:

1. when firms pay more than the opportunity cost of resources.

when the demand curve for a product is located too far to the left.

when firms "use" resources without being compelled to pay for their full costs.

only in capitalistic societies.

Answer: C

Rivalry and excludability are the main characteristics of:

1. capital goods.

private goods.

public goods.

consumption goods.

Answer: B

The market system does not produce public goods because:

1. there is no need or demand for such goods.

private firms cannot stop consumers who are unwilling to pay for such goods from benefiting from them.

public enterprises can produce such goods at lower cost than can private enterprises.

their production seriously distorts the distribution of income.

Answer: B

A demand curve for a public good is determined by:

1. summing vertically the individual demand curves for the public good.

summing horizontally the individual demand curves for the public good.

combining the amounts of the public good that the individual members of society demand at each price.

multiplying the per-unit cost of the public good by the quantity made available.

Answer: A

Cost-benefit analysis attempts to:

1. compare the real worth, rather than the market values, of various goods and services.

compare the relative desirability of alternative distributions of income.

determine whether it is better to cut government expenditures or reduce taxes.

compare the benefits and costs associated with any economic project or activity.

Answer: D

At the optimal quantity of a public good:

1. marginal benefit exceeds marginal cost by the greatest amount.

total benefit equals total cost.

marginal benefit equals marginal cost.

marginal benefit is zero.

Answer: C

An important problem in evaluating public projects through the use of cost-benefit analysis is that:

1. real costs cannot be stated in monetary terms.

one must decide whether to compare total costs and total benefits or marginal costs and marginal benefits.

positive and negative externalities associated with such projects may be difficult to measure.

the funding of such projects is inherently inflationary.

Answer: C

From the economist's perspective, "market failures" basically arise when:

1. The quantity demanded for a good or service is greater than the quantity supplied of the good or service

The quantity supplied of a good or service is greater than the quantity demanded for a good or service

Demand and supply do not accurately reflect all the benefits and all the costs of production

The market system is unable to adapt to or to accommodate change

Answer: C

When the production of a product creates external costs greater than external benefits, a market economy will:

1. Not produce the product without government intervention

Produce a socially optimal allocation of resources

Allocate too few resources to production of the product

Allocate too many resources to production of the product

Answer: D