UNIT 6.1-6.2

Supply and demand results in efficient outcomes with no deadweight loss

free market-capitalism

5 Characteristics of Free Markets:

1. Little government involvement in the economy. (Laissez Faire = Let it be)  

2. Individuals OWN resources and determine what to produce, how to produce, and who gets it.

3. The opportunity to make PROFIT gives people INCENTIVE to produce quality items efficiently.

4. Wide variety of goods available to consumers. 

5. Competition and Self-Interest work together to regulate the economy.

The government’s job is to enforce contracts, secure property rights, and defend the country.

Example of the “Invisible Hand” of the Free Market:

If society wants computers and people are willing to pay high prices then… 

• Businesses have the INCENTIVE to start making computers to earn PROFIT.

• This leads to more competition with lower prices, better quality, and more product variety. 

• To maintain profits, firms find most efficient way to produce goods and services. 

• The free market satisfies society’s wants and needs.

The government doesn’t need to get involved since the needs of society are automatically met.

What is a Market Failure?

• 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 do not efficiently bring about the allocation of resources. 

What’s the result…

The government might be called upon to attempt to satisfy society’s wants.

The Four Market Failures:

We will focus on four different market failures:

1.  Public Goods (6.3)

   2.   Externalities - third person side effects (6.2)

   3.   Imperfect Competition - monopolies (6.4)

   4.   Unequal distribution of income (6.5)

In each of the above situations,

the government may step in to attempt to

allocate resources efficiently 

Supply and demand is great for determining how many pizzas to produce, but what about goods that are not sold in markets like aircraft carriers and parks? 

We still use supply and demand 

The demand is the Marginal Social Benefit of the good and its usefulness to society. 

The supply is the Marginal Social Cost of providing each additional quantity.

Socially optimal quantity: MSB = MSC

The Demand is equal to the marginal benefit to society

Market Failure #2: externalities

what are externalities?

• An externality is a third-person side effect.

• There are EXTERNAL benefits or external costs to someone other than the original decision maker. 

  Why are Externalities Market Failures?

• The free market fails to include external costs or external benefits.

• With no government involvement there would be too much of some goods and too little of others.

Example: Smoking Cigarettes.

• The free market assumes that the cost of smoking is fully paid by people who smoke. 

• The government recognizes external costs and makes policies to limit smoking.

Negative Externalities

ituation that results in a COST for a different person other than the original decision maker.

The costs “spillover” to other people or society.

Example: Zoram is a chemical company that pollutes the air when it produces its good. 

• Zoram only looks at its INTERNAL costs.

• The firms ignores the social cost of pollution

• So, the firm’s marginal cost curve is its supply curve

• When you factor in EXTERNAL costs, Zoram is producing too much of its product.

• The government might limit its production

Notice that on the previous slide the deadweight loss (DWL) is different than on other graphs.  Usually a DWL results from units of a good NOT being produced for which the MB > MC. In this case there is a DWL result from TOO MANY units being produced: units for which the MSB < MSC.  Remind students that there is deadweight loss any time the quantity produced is not same as the socially optimal quantity.

Positive Externalities:

Situations that result in a BENEFIT for someone other than the original decision maker.

The benefits “spillover” to other people or society.

(EX: Flu Vaccines, Education, Home Renovation)

Example: A mom decides to get a flu vaccine for her child

• Mom only looks at the INTERNAL benefits.

• She ignores the social benefits of a healthier society.

• So, her private marginal benefit is her demand  

• When you factor in EXTERNAL benefits the marginal benefit and demand would be greater.

• The government recognizes this and subsidizes flu shots.

The Economics of Pollution

Why are public bathrooms so gross?

The Tragedy of the Commons 

(AKA: The Common Pool Problem)

• Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted since no one has the incentive to keep them clean. 

• There is no monetary incentive to use them efficiently.

• Result is high spillover costs.

Example: Overfishing in the ocean

Perverse Incentives

1. In 1970, the government tried to protect endangered woodpeckers by requiring land developers to report nests on their land to the EPA.

The population of these bird decreased. Why? 

Land owners would kill the birds or else risk lengthy production delays. (Known as “Shoot, Shovel, and Shut Up”) 

2. Assume the government wanted to limit a firm from polluting. They tell them they will inspect them twice and they must reduce pollution by 5%. 

The amount of pollutants would increase. Why?

This firm will have the incentive to pollute more prior to inspection.

Are there “market solutions” to these problems?