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Final

Topic 15: The Role of Government 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


Department
Economics
Course Code
ECO101H1
Professor
James Pesando
Study Guide
Final

Page:
of 4
Topic 15 The Role of Government
(Jan 24th)
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 persons use of good diminishes other peoples 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: its either 1 or 0; what about other goods?)
A: Produce output where sum of marginal benefit to each individual = marginal cost;
The market MB is the Vertical sum of individual MB
schedule.
e.g. (left) assume John and Joan are the only two firms
in the market.
6
3
9
John
Joan
John
Market
Market MB = sum of individuals MB
SS=MC
-- At q<q*, MB >MC increase quantity of public good;
-- At q>q*, MB <MC decrease quantity of public good;
-- At q=q*, MB =MC efficient level of production;
Taxes, which raise revenues for governments, crease deadweight or welfare loss;
Input into Government policy:
1) Design of the tax system
2) Trade-off between redistribution and economic efficiency;
Excise (Sales) Tax: Paid by seller
q1 q
Regulating a Natural Monopoly
1. Natural Monopoly
High fixed cost + low marginal cost MC < ATC over relevant range
e.g. gas pipeline;
2. Regulation
SS=MC
-- At q1, price (value to buyers) > marginal cost not allocatively efficient;
-- Intuition: market shrinks and gains from trade are not fully realized;
SS+t
DD
Q Quantity
Price
PPrice
ee
DD
ATC
MC
MR
Choice 1:
-- P=MC;
Allocative Efficiency: P (value to buyers) = cost;
Monopoly suffers economic loss:
P<ATC requires government subsidy;
Q Quantity
Price
PPrice
ee
DD
ATC
MC
MR
Choice 2:
-- P=ATC (the actual approach)
Allocative Inefficiency: P (value to buyers) > MC;
Monopoly earns normal profits;