Unit 6 Notes

invisible hand of free markets

invisible hand of free markets

government doesn’t need to get involved since the needs of society are met by firms seeking to make a profit

market failure

a situation in which the free-market system fails to satisfy society’s wants

when the invisible hand doesn’t work

• private markets don’t efficiently bring about allocation of resources

• govt may be called to satisfy society’s wants

four market failures

• public goods

• externalities

• imperfect competition

• unequal distribution of income

marginal social benefit

demand

marginal social cost

supply

socially optimal quantity

MSB = MSC

externality

third person side effect

why externalities are market failures

• free market doesn’t include external costs or benefits

• no govt involvement would mean too much or too little of something

negative externalities

• situation that results in a cost for a different person other than the original decision maker

• overallocation

negative externality deadweight loss

• between MSC and S = MPC, above D = MSB

• flat side facing right

positive externalities

• situations that result in a benefit for someone other than the original decision maker

• underallocation

positive externality deadweight loss

• opposite triangle

• flat side facing left

• left of equilibrium

govt handles negative externalities with

per unit tax (the amount of externality)

govt handles positive externalities

subsidy to consumer or producer (per unit)

consumer → demand right

producer → supply right

tragedy of the commons

goods available to everyone are often polluted because nobody has incentive to keep them clean

• no monetary incentive to use them efficiently

• result is high spillover cost

perverse incentives

regulations are put in place and firms try to avoid this and has additional negative impact (ex: if this species is found, it is protected land → farmers kill the species when they find it)

public sector

part of economy primarily controlled by the govt

private sector

part of economy run by private individuals and companies that seek profit

free riders

• individuals that benefit without paying

• keep firms from making profits

• if left to free market, essential services will be underproduced

non exclusionary

cannot exclude people from enjoying the benefits

non rivalrous (shared consumption)

one person’s consumption of a good does not reduce the usefulness to others

public goods

non exclusionary and non rivalrous

private goods

excludable and rivalrous

club goods

excludable but non rivalrous

common goods

non excludable but rivalrous

antitrust laws

laws designed to prevent monopolies and promote competition

why regulate monopolies

• keep prices low

• make monopolies efficient

• regulate with price ceilings

• not w/ taxes bc will limit supply

allocative efficiency / socially optimal price

P = MC

normal profit / fair return price / break even

P = ATC

natural monopoly

one firm can produce the socially optimal quantity at the lowest cost due to economies of scale

if govt sets price ceiling to get socially optimal quantity

firm makes a loss and requires a subsidy

why averages aren’t useful

they don’t show anything about income distribution

lorenz curve

• shows the degree of income inequality

• straight line is perfect equality

• lorenz curve is actual distribution (bowed out to bottom right)

gini coefficient

• statistical measurement of income distribution

• area inside banana divided by triangle banana is in

• higher number → more inequality

• lower number → less inequality

welfare provides a ---- for citizens

safety net

taxes

mandatory payments made to the government to cover costs of goverment

• finance govt operations

• influence economic behavior of firms and individuals

progressive taxes

takes a larger percent of income from high income groups (current federal income tax system)

proportional taxes (flat rate)

takes the same percent of income from all income groups

regressive taxes

takes a larger percentage from low income groups (sales tax, consumption tax)