Untitled Flashcards Set

• Three primary functions of government in the economy: allocation function, distribution function, and

stabilization function

• allocation function – government production of goods or regulation of business, aimed at improving the

allocative efficiency of the economy (i.e., getting the “right mix” of products produced, each in the “ideal

quantity” and at the “ideal quality”).

• distribution function – government policies aimed at changing the final distribution of goods/services

across consumers, usually with the intention of realizing a “fairer” apportionment of

consumption/income/wealth.

• stabilization function – attempts by government to minimize fluctuations in overall macroeconomic

activity.

• market failure – a situation in which the “free market outcome” is inefficient, in that there is a positive

Deadweight-Loss at the resulting “free market level of trade.”

• four common sources of market failure: (1) profit maximization by a firm with market power, (2) market

provision of public goods, (3) market provision of goods generating externalities, and (4) lack of

information by market participants

• market power – A firm has market power if they have some “control over the price of their output,” in that

they: (i) can increase price without losing all customers and (ii) must decrease price in order to increase

sales

• monopoly – market structure in which there is one single seller of a unique good with no close substitutes.

 The “polar opposite” of “perfect competition.”

 The demand curve facing a monopolist is the market demand curve.

 They can choose any price/quantity combination along the market demand curve.

• profit – the difference between revenues and costs of production

• marginal revenue – the amount by which revenue changes as the firm’s quantity of output is increased by a

unit

• marginal costs of production – the amount by which production costs change as the firm’s quantity of

output is increased by a unit

• non-rival good – a good for which consumption by one person does not diminish the quantity or quality of

consumption by others

• rival good – a good for which consumption by one person does diminish the quantity or quality of

consumption by others

• non-excludable good – a good for which it is difficult (or very costly) to prevent consumption by those who

do not pay

• excludable good – a good for which it is easy to prevent consumption by those who do not pay

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• private good – a good that is excludable and rival in consumption.

 e.g., Big Mac from McDonald’s; market provision is typically efficient

• public good – a good that is non-excludable and non-rival in consumption

 e.g., national defense

• club good – a good that is excludable and non-rival in consumption

 e.g., satellite radio or television broadcast

• common good – a good that is non-excludable and rival in consumption

 e.g., stock of fish in the ocean

• free rider problem – if a public good were supplied in a free market, the amount traded would be less than

the efficient quantity, since many people would attempt to enjoy the benefits of units purchased by others,

while not purchasing any units themselves

• externality – a benefit or cost that is realized by someone who is not directly engaging in an activity

• negative externality – a cost of an activity borne by someone not engaging in the activity.

 examples: pollution, noise from low-flying aircraft, speeding on a highway, installation of “The Club” in

a car

• positive externality – a benefit from an activity realized by someone not engaging in the activity

 examples: vaccines, installation of smoke detector in an “attached apartment,” installation of Lojack in a

car

• Market provision of a good for which there is an externality is inefficient:

 Negative externality => free markets provide more than the optimal amount (i.e., too much) of the good

 Positive externality => free markets provide less than the optimal amount (i.e., not enough) of the good

• Potential policies to reduce the DWL associated with a “negative externality”

1. ban the activity entirely (“illegal to emit any pollution”)

2. establish minimum compliance standards for manufacturers (“can only pollute up to a certain level”)

3. “cap and trade” – issue a certain number of “pollution permits” for society as a whole, and allow people

to trade these permits amongst themselves

4. offer subsidies to manufacturers that reduce pollution (“pay the polluter to reduce their level of

pollution”)

5. charge manufacturers a fee for each unit of pollution emitted (“polluter must pay for the right to

pollute”)

• internalizing an externality – policies which introduce a cost (or foregone gain) that is realized if the

person continues to generate a negative externality

• Coasian solution to the problem of externalities – Ronald Coase (1910-2013; Noble Prize in 1991;

Professor Emeritus at Univ. of Chicago Law School) argued that problems of externalities are at their core

due to undefined property rights and can be address by the following approach:

i. clearly and fully define property rights

ii. make individuals pay compensation if they infringe upon the property rights of others

iii. allow parties to negotiate with one another regarding infringements on property rights caused by the

externality

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 Coase showed that regardless of which party is given the property right, negotiation between the parties

will result in the efficient level of the externality (so long as the costs of negotiation and enforcement are

low enough)

 defining property rights and allowing parties to negotiate essentially “internalizes the externality”

• market failure due to lack of information – for some goods consumers may have difficulty knowing their

“true reservation price” => especially common for goods purchased infrequently or for which quality is

difficult to observe (e.g., house, car, education, medical procedure, meal at a restaurant)

 when consumers lack accurate information about costs or benefits of consuming a good, they may fail to

make efficient choices in the marketplace

 Further note, “information” is often a “club good” (non-rival in consumption and excludable).

 Once a club good is produced, the additional cost of providing it to the next person is essentially

zero => to maximize social surplus, everyone who has a positive value for the information should be

able to access it

 Additionally, as long as the information is accurate, total costs to society are minimized if the

information is only generated once (e.g., it is a waste of resources to have both the National Weather

Service and AccuWeather come up with weather forecasts)

• In such cases, have government license, inspect, and/or regulate providers of such goods in order to:

i. provide people with the important information needed to make good decisions in markets and

ii. minimize the costs to society of providing the information

 e.g., “Cobb and Douglas Public Health” inspects restaurants and assigns letter grades based upon

compliance with health codes => government “regulates product” and “provides information”