Chapter 12- Market Failures and the Role of Government

Market Failure

The failure of a market to provide a good/service or to allocate goods/services in a socially optimal manner. Market failure may result from inadequate competition, from externalities, from information advantages on the part of the buyer or seller, or from other causes.

When do market failures happen?

When a market does not allocate or distribute goods or services efficiently, or when markets fail to provide certain goods or services

Externality

Either a positive or negative side-effect of production and/or consumption. Costs incurred by those who do not produce the product and benefits that accrue to those who are not the purchasers are both examples or externalities.

Externalities

Are unintended side effects of the production and consumption of a good or service

Positive Externality

A side effect of production or consumption of a good or service which provides a benefit to someone other than the consumer or the producer. Positive externalities tend to result in underproduction of the good or service in question.

Example of positive externality

Flu Vaccines: When doctor and nurses (producers) "give" (sell) full shots to their patients (consumers), both the producers and the consumers benefit. Other people who have not consumed the flu vaccine still receive benefits because as more people pay and get flu shots, the risk of getting the flu goes down for everybody.

Marginal Private Benefit

The private benefit of consuming an additional unit of a good or service; benefit obtained by the consumer only.

Marginal Social Benefit

The cost to society of consuming an additional unit of a good or service. This includes marginal private benefit and the external benefits that are captured by non-buyers.

If a good or service creates positive externality, then its marginal benefit

Then its marginal benefit to society (MSB) is greater than its marginal benefit to just the consumers, (MPB). Marginal private benefit is the market demand and in this case understates the true benefit the product provides.

Market for Flu vaccine (Positive externality)

Figure 12.1

Figure 12.1 analysis

Notice the difference between the market equilibrium price (P) and quantity (Q) and the socially optimal price (P) and quantity (Q). The socially optimal price and quantity are allocatively efficient because the MSB=MC

Socially optimal

The market condition that is met when the marginal social benefit equals the marginal social cost. Also known as the allocatively efficient level of output.

Why does positive externality create deadweight loss?

Because the private market for the vaccine does not produce the allocatively efficient quantity at the market equilibrium, MSB>MC, indicating an underproduction of the good

Negative externality

A negative externality happens when somebody other than the producer or consumer is forced to bear some of the costs of production.

Example of negative externality

Air pollution. Many power plants burn coal in order to produce electricity and this creates air pollution. Others who neither produce more consume the electricity are left with costs such as damage from acid rain, and medical bills from asthma

Marginal Social Cost

The cost to society of producing an additional unit of output. This includes marginal private costs and those external costs that are incurred by third parties.

Marginal Private Cost

The private cost of producing an additional unit of output; costs incurred by the producer only.

If a good or service creates a negative externality, then its marginal

Then its MSC that its MPC. Marginal private cost is the market supply and thus understates the true cost of making the product in question.

Market for electricity graph (negative externality)

Figure 12.2

Figure 12.2 Analysis

Notice the differencce between the market equilibrium price (p) and quantity (q) and the socially optimal price (p) and quantity (q). The socially optimal price and quantity are allocatively efficient because the MSC=MB

Why is there deadweight loss in negative externality

It creates deadweight loss because the private market for electricity does not produce the allocatively efficient quantity at the market equilibrium MSC>MB, indicating overproduction.

SUBSECTION- Remedies

Where do remedies for externalities come from?

The government

Remedy for postive externality

The government can provide a per-unit subsidy to either the producer or consumer in order to achieve the socially optimal quantity of output

Subsidy

A payment from the government that is made to either a consumer or producer of a good/service. Subsidies function like a negative tax: they encourage production and/or consumption of a good by reducing their production cost.

Model market with flu vaccine after subsidy

Figure 12.3

Analysis of figure 12.3

Notice that the subsidy increases demand for the vaccine so that MPB=MSB and allocative efficiency in the market is achieved

Remedy for negative externality

Governments can asses a per-unit tax on producers in order to bring about the socially optimal price and quantity.

Model for electricity with tax

Figure 12.4

Analysis of 12.4

Notice that the tax raises the marginal private costa every level of output (acting as a decrease in supply) of producing electricity so that the MPC=MSC and allocative efficiency in the market is again achieved.

Coase Theorem

Says that an allocatively efficient outcome can be reached without government involvement.

If the cost is 0 and private-property rights are clearly defined, then (in the case of a negative-externality) the producer and the party victim can negotiate a payment to address the externality. Either the victim can pay the producer to not produce, or the producer can the victim so as to offset the cost of the externality

Section C-Public Goods

Public Good

A good or service that is provided by the government. Goods tend to work best as public goods if they are non-rival and non-excludable.

Why is a public good necessary?

Most goods and services are provided by markets, but sometimes they fail to provide certain goods.

Non-Excludable

The condition in which the benefit of a good or service cannot be withheld if a consumer does not pay for it. Non-excludability often leads to the free rider problem in which people who would otherwise buy a good choose not to and end up receiving most or all of the benefit anyway.

Non-Rival/Shared Consumption

The condition in which one person's consumption of a good or service does not prevent another person from consuming the exact same good or service. Also known as shared consumption.

What makes some goods suitable to being produced by the government and paid by tax money rather than being allocated in the private market?

Public goods are typically non-rival and non-excludable. Examples are bridges, public highways, THPRD

Private goods can be rival or non-rival, but they are always excludable. Examples include candy bars, concerts, haircuts, cars, houses

When is a good or service rival?

When ones persons consumption prevents another person from consuming that good or service. Examples: resort booking. One aspirin pill

When is a good or service non-rival

If ones persons consumption does not diminish the ability of another person to consume the same good or service. (Jim and sarah can watch the same movie at the theatre)

When is a good or service excludable

If it can be withheld from those are either unable to unwilling to pay. Example: if you don't for the ticket, you can watch the movie.

When is a good or service non-excludable

If it cannot be withheld from those unwilling to or unable to pay. Examples: Police protection or storm siren

Section D- Antitrust Policy and Regulation

Examples of market failures

Imperfectly competitive markets (oligopoly, monopoly, monopolistic competition). They do not provide the socially optimal price and quantity for a good or service.

What does the government do with imperfectly-competitive firms?

Break them up or regulates them

Model Unregulated natural monopoly

12.5

Model regulated natural monopoly with productively efficient price

12.6

Model regulated natural monopoly with allocatively efficient price

12.7

Section E- Income distribution

What is something markets fail to do?

Allocate income equally: some households earn more income while others earn less

What are reasons for the difference in income across households?

Differences in worker productivity, changing trade patterns, price discrimination, and tax policies.

For example, an increase in demand for unskilled labor and a decrease in demand for unskilled labor results in less income equality as skilled workers income rises and unskilled falls

What measures income inequality

Lorenz Curve and Gini Coefficient

Lorenz Curve

A graph of income inequality that shows the percentage of a country's income earned by a percentage of a country's households.

Model a lorenz curve

Figure 12.8

What does the lorenz curve show?

The distribution of income

Model a lorenz curve that you could analyze

Figure 12.9

If the curve gets further away from the line of equality, what does it mean?

The income is less evenly allocated in the country than before

Analyze figure 12.9

Point A shows that 50 percent of the households earn only 33 percent of the income, which also means that the top half of households earn two-thirds of the nations income. Point B shows that 88 percent of the households earn 80 percent of the income, meaning that the riches 12% earn one-fifth of the income in society.

Gini Coefficient

The ratio of the area above the Lorenz curve to the total area below the line of equality. Gini coefficients range between 0 (perfectly distributed wealth/income) and 1 (unequally distributed wealth/income).

Gini Coefficient forumla

A/A+B (Figure 12.11)

Gini-coefficient ranges

0 to 1

Gini-coefficient of 0

Perfect income equality. Every household earns an equal amount of income and the society lorenz curve is the line of equality. Area A equals zero

Gini-coefficient of 1

Perfect income inequality. One household earn all of the income. Area B is 0, which means that the society's lorenz curve follows the x axis until 100% and then jumps vertically upward to the point (100%, 100%)

Real world ini coefficients

Gini coefficients closer to 0 mean income is more equally distributed, while gini coefficients lost one mean that income distribution is more unequal.

Section 2- Taxes

Progressive Tax definition

A tax which takes a greater percentage of income from households with high income than households with low income. The United States income tax is set up in a progressive manner because higher-income earners are in higher tax brackets.

Progressive Tax explanation

Progressive taxes are those taxes that take a higher percentage of the income of high-income earners than from low-income earners. The effect is to make the income distribution more even.

Example of progressive tax

Gift tax and estate tax

Estate Tax

A tax assessed on the total value of a person's private property after (s)he dies; often assessed only on large estates.

Gift Tax

A tax placed on gifts received from another person.

Regressive taxes definition

A tax which takes a greater percentage of income from households with low income than households with high income.

Regressive taxes effect

To make income distribution less equal.

Examples of regressive tax

Sales tax- High income earners pay tax only on the income they spend, and they save more than low income earners

Proportional Taxes definition

A tax which takes the same percentage of income from all households.

Proportional Taxes explanation

Places an equal burden on all household income levels and should not affect the distribution of income. A flat rate tax on income is a good example.

Section B- Principles of taxation

Ability to pay principle of taxation

Says that taxes should be collected from those with enough income to pay the tax. In the United States, the federal income tax is an example of taxation according to the ability-to-pay principle. Those with higher income pay the tax and those with lower income pay little or nothing at all.

Benefit Principle of taxation

Says that those who benefit from a public good or service should pay the tax for the good or service. Taxes for soccer field.

How do lump-sum taxes affect a firm's cost of production

They are a fixed cost and as such only affect AFC and ATC. Since they only affect fixed costs, they have no effect on the firm's profit-maximizing quantity of output

How do per-unit taxes affect a firm?

They are a variable cost and thus affect VC and MC. For example, a per-unit tax affects not only a firm's cost of production, but affects the profit-maximizing quantity of output because of its effect on MC.