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Topic 15 - The Role of Government.pdf

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James Pesando

Topic 15 – The Role of Government th (Jan 24 ) Outline: 1. Overview; 2. Public and Private Goods; 3. Example: Lighthouse; 4. Excise Taxes and Allocative Efficiency; 5. Regulating a natural monopoly 6. Distribution of Income  Overview Role of Government in a market economy -- Improve Efficiency if “Market Failure”; -- Monopoly (Natural Monopoly) – where there is no point for a lot of firms present in the market; -- Externalities; -- Public Goods; -- Alter Distribution of Income; -- Tax/Transfer programs;  Public and Private Goods; 1. Two Characteristics of Goods -- Excludability: a person can be excluded from using the goods; -- Rivalness: one person’s use of good diminishes other people’s use; 2. Pure Private Goods -- Excludable and Rival; -- e.g. ice cream sundae; Pure Public Goods: -- Non-excludable and Non-rival; -- e.g. national defense; criminal justice system key result: private market cannot produce public goods; (because market failure & free rider problems)  Example: Lighthouse -- light house is a public good: non-excludable & non-rival; -- Suppose: - Value to each ship owner: $5,000; - Number of ship owners: 2,000; - Total value: $10M; - Cost: $1M Total Value > Cost  efficient to build; 1. Lighthouse built in Private Market -- Entrepreneur requires $500 ($1M/2,000) from each owner; -- Yet no owner will pay, since cannot be excluded from benefit of lighthouse, once built (so not paying is considered a rational decision); This is the free rider problem. 2. Lighthouse built by government -- Force charges $500 to each owner (licensing fees/special tax); -- Each owner enjoys surplus of $4,500 ($5,000-$500) -- Government can solve the free rider problem, therefore can produce public goods.  Exercise Tax and Allocative Efficiency Q: How to determine allocatively efficient output of public good (the lighthouse is atypical example: it’s either 1 or 0; what about other goods?) A: Produce output where sum of marginal benefit to each individual = marginal cost; John 6 The market MB is the Vertical sum of individual MB schedule. e.g. (left) assume John and Joan are the only two firms Joan in the market. 3 9 Market
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