The Government’s Role

1. The Government’s Role

2. Market Failures vs Government Failures • A market failure - a situation where individual decisions do not lead to socially desirable outcomes • Externalities • Public goods • Imperfect information • Government failures are when the government intervention actually makes the situation worse

3. Economic Efficiency and the Role of Government or What can the Government do for less cost?

4. What does Efficiency mean? • efficiency - the maximum value/benefit of output from the cost. • 2 conditions necessary for ideal efficiency: • All activities with more benefits than costs must be undertaken. • No activities that provide benefits less than costs should be undertaken.

5. Efficiency Graphed • Marginal Benefit Provided to Society. • Marginal (or Additional) Cost to Provide Price Marginal Cost Q1 too little Q3 too much Q1 just right Marginal Benefit Quantity/time Q1 Q2 Q3

6. The Role of Government and Shortcomings of the Invisible Hand

7. 4 Reasons the Invisible Hand May Fail to Allocate Resources Efficiently Lack of Competition Externalities Public Goods Poor Information

8. S2(restricted supply) (1) Lack of Competition • Too few units will be produced. • Sellers may restrict output and raise price. Price S1(competitive supply) P2 P1 D Quantity/time Q1 Q2

9. (2) Externalities (Spillovers) • Externalities - the market fails to register fully costs and benefits. • External costs: • When the actions of an individual or group incur acost to 3rd party. • External benefits: • Present when the actions of an individual or group generate benefits for3rd parties.

10. Externalities • Externalities are the effects of a decision on a third party that are not taken into account by the decision-maker • Negative externalities occur when the effects are detrimental to others • Ex. Second-hand smoke and carbon monoxide emissions • Positive externalities occur when the effects are beneficial to others • Ex. Education or vaccinations

11. sweater factory beach brewery

12. S2(including external costs) Actual price and output Actual price and output Ideal price and output External Cost (Spillover) • All of the costs of production are not fully registered, so the supply curve understates the true cost of production. (Shifts left) Price S1 P2 P1 D Quantity/time Q1 Q2 • Too many units are produced. • Pollution problems are often a side effect.

13. Actual price and output Ideal price and output D2(including external benefits) External Benefit • The demand curve understates the total value of the output. Price S1 P2 P1 D1 Quantity/time Q1 Q2 • From the viewpoint of efficiency, too few units may be produced.

14. A Negative Externality Example Cost, P If there are no externalities, P0Q0 is the equilibrium S1 = Marginal Social Cost If there are externalities, the marginal social cost differs from the marginal private cost, and P0 is too low and Q0 is too high to maximize social welfare S0 = Marginal Private Cost P1 Cost of externality P0 Government intervention may be necessary to reduce production D = Marginal Social Benefit Q Q1 Q0

15. A Positive Externality Example If there are no externalities, P0Q0 is the equilibrium Cost, P If there are externalities, the marginal social benefit differs from the marginal private benefit, and both P0 and Q0 are too low to maximize social welfare S = Marginal Private Cost Benefit of externality P1 P0 D1= Marginal Social Benefit Government intervention may be necessary to increase consumption D0= Marginal Private Benefit Q Q0 Q1

16. Methods of Dealing with Externalities • Direct regulation is when the government directly limits the amount of a good people are allowed to use • Incentive policies • Tax incentives are programs using a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends • Market incentives are plans requiring market participants to certify that they have reduced total consumption by a certain amount • Voluntary solutions

17. Why the Invisible Hand May Fail (3) Public Goods • Public goods are: • 1. jointly consumed– Individuals can simultaneously enjoy consumption of same product or service • If a public good is made available to one, it is simultaneously made available to others.

18. Characteristics of a Public Good • 2. non-excludable– Consumption of the good is not able to be restricted to the customers who pay for it • Because those who do not pay can not be excluded, no one has much of an incentive to pay for such goods; each has an incentive to become afree rider. • Free rider:– a person who receives the benefits of the good without helping to pay for its cost. • When a lot of people become free riders, too little of the good is produced.

19. Examples of public goods: • national defense • radio and television broadcast signals • clean air.

20. Question for Thought: • Which of the following are public goods? • (using the definition of a public good.) a. An anti-missile system surrounding Washington. a. An anti-missile system surrounding Washington. b. A fire department. c. Tennis courts. d. Shenandoah National Park. e. Elementary schools

21. Public Goods • A private good is only supplied to the individual who bought it • Once a pure public good is supplied to one individual, it is simultaneously supplied to all • In the case of a public good, the social benefit of a public good (its demand curve) is the sum of the individual benefits (value on the vertical axis) • To create market demand, • private goods: sum demand curves horizontally • public goods: sum demand curves vertically

22. The Market Value of a Public Good Price A public good is enjoyed by many people without diminishing in value $1.20 $1.10 $1.00 Individual A’s demand is vertically summed with… $0.80 $0.60 Individual B’s demand to equal… Market Demand $0.40 Demand B $0.60 Market demand for a public good $0.50 $0.20 Demand A Quantity 1 2 3

23. (4) Poor Information • A minimal problem if the item is purchased regularly. • Problems can arise if goods are: • difficult to evaluate on inspection and seldom repeatedly purchased from the same producer, or, • potentially capable of serious and lasting harmful side effects that cannot be predicted by a lay person.

24. Informational Problems • Signaling may offset information problems • Signalingrefers to an action taken by an informed party that reveals information to an uninformed party that offsets the false signal that caused the adverse selection in the first place • Selling a used car may provide a false signal to the buyer that the car is a lemon • The false signal can be offset by a warranty

25. (4) Poor Information • Market responses to poor information: • Consumer information publications • Provide expert evaluation and unbiased information • Brand names and franchises • Provide standardized quality and dependability • Warranties • Supplier promises to repair possible problems

26. Government Failures and Market Failures • All real-world markets in some way fail • Market failures should not automatically call for government intervention because governments fail, too • Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse

27. Reasons for Government Failures • Government doesn’t have an incentive to correct the problem Government doesn’t have enough information to deal with the problem Intervention in markets is almost always more complicated than it initially seems The bureaucratic nature of government intervention does not allow fine-tuning Government intervention leads to more government intervention

28. Which of the following is the most fundamental function of government? • protection of individuals and their property • imposing progressive taxes to fund income-transfer programs • regulating prices and wages • provision of postal services and garbage collection 2. Economic efficiency requires that a. individuals produce at their maximum level. b. only long-lasting, high-quality products be produced without regard to cost. c. income be distributed equally among consumers. d. all economic activity generating more benefits than costs be undertaken

29. 3. When production of a good generates external costs, the a. demand curve for the good will overstate the true social benefits from consumption of the good. b. demand curve for the good will understate the true social benefits from consumption of the good. c. supply curve for the good will overstate the true social cost of producing the good. d. supply curve for the good will understate the true social cost of producing the good. 4. From the viewpoint of economic efficiency, when competitive forces in an industry are weak, market allocation will often lead to a. an output of the product that exceeds the amount consistent with ideal economic efficiency. b. an output of the product that is less than the amount consistent with ideal economic efficiency. c. an output of the product that equals the amount consistent with ideal economic efficiency. d. product prices that are below the cost of production.

30. 5. Competitive markets generally give consumers and producers correct incentives when a. externalities are present in the market. b. property rights are well-defined and enforced. c. the good being produced and consumed is a pure public good. d. there is a substantial lack of information on the part of either buyers or sellers. • 6. Which of the following correctly describes the external benefit resulting from an individual’s purchase of a winter flu shot? • The flu shot is cheaper than the cost of treatment when you get the flu. • The income of doctors increases when you get the flu shot. • The flu shot reduces the likelihood others will catch the flu. • The flu shot reduces the likelihood you will miss work as the result of sickness; therefore, you will earn more income.

31. 7. Which of the following is the best example of a public good? a. a government-run health care system b. the Walt Disney World amusement park c. national defense d. long-distance telephone service • 8. Markets may have difficulty providing the proper quantity of a public good because • individuals will tend to become free riders, and private firms will have difficulty generating enough revenue to produce an efficient quantity of the good. • the good generally has a very large value to consumers relative to its cost of production. • the good is one that tends to benefit a large number of people. • the large profit involved in the production of a public good is generally too much for private firms to effectively pay out to shareholders.

32. 9. Suppose paper pulp mills are permitted to emit harmful pollutants, free of charge, into the air. How will the price and output of paper in a competitive market compare with their values under conditions of ideal economic efficiency? a. The price will be too high, and the output will be too large. b. The price will be too low, and the output will be too large. c. The price will be too low, and the output will be too small. d. The price will be too high, and the output will be too small. 10. Which of the following is a source of information that helps consumers acquire information about the quality of a good or service? a. brand names b. franchising c. consumer ratings magazines d. all of the above