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ECON 208 (113)
Chapter 16

Chapter 16 Market Failures and Government Intervention.docx

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Department
Economics (Arts)
Course Code
ECON 208
Professor
Mayssun El- Attar Vilalta

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Chapter 16 Market Failures and Government Intervention  Govts necessary to provide law and order and define and enforce property rights  The operative choice is not between an unhampered free-market economy and a fully centralized command economy. It is rather the choice of which mix of markets and government intervention best suits people’s hopes and needs 16.1 Basic Functions of Government  Monopoly of violence: violent acts can be conducted by the military and the civilian police arms of govt and thru its judicial system the govt can deprive ppl of their liberty by incarcerating them or executing them ->this fcn has not changed. So need to keep the govt’s monopoly directed to the general good rather than to the good of a narrow govt circle – importance of having checks on the govt’s arbitrary use of its monopoly (dictators misuse power)  When the govt’s monopoly of violence is secure and functions with effective restrictions against its arbitrary use, citizens can safely carry on their ordinary economic and social activities  Adam smith: “1 duty of sovereign is that of protecting the society from the violence of other independent nd societies; 2 is protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it”  Govt activity: provide security of property; govt defines/enforces property rights to give ppl secure claim  Local corruption, powerful warlords, lack of basic political infrastructure combine to make official development aid less effective than it would be in countries w/ more stable and representative political structures.  Institution building: Growing share of official assistance to developing countries is taking the form of political rather than economic assistance 16.2 The Case for Free Markets  Free markets: consumer tastes and producer’s costs generate price signals that coordinate separate decisions taken by independent agents pursuing own self-interest, allocating the nation’s resources without conscious central direction. Distribution of income also determined by markets by establishing prices of factors of production which provide incomes for their owners. Modern markets produce better goods more cheaply, generate technological changes that have raised avg living standards thru competition.  “formal defence” of free markets-AE-if all markets were perfectly competitive and if govts allowed all prices to be determined by D and S, then p=MC for all products and AE (meaning resources are used in such a way that total surplus to society is maximized)  Informal defence – applies to all market economies – markets are an effective mechanism for coordinating the decisions of decentralized decision makers. Not laid out in a formal model of an economy but it does follow from some hard reasoning and subject to much intellectual probing  The informal defence of free markets is based on 3 central arguments:  1) Free markets provide automatic coordination of the actions of decentralized decision markers.  2) The pursuit of profits in free markets provides a stimulus to innovation and rising material living standards  3) Free markets permit a decentralization of economic power Automatic Coordination  Decentralized market system is more flexible and adjusts more quickly to changes; fast rxn to price change  ^oil price -> decentralized: ppl adjust however they want. Centralized: rationing/regulating/limiting  Quotas, allocations, rationing schemes -> hard to adjust in price change 1  Market provides automatic signals as a situation develops so that not all of the consequences of an economic change have to be anticipated and allowed for by a group of central planners.  Market system allows for coordination without anyone needing to understand how the whole system works Innovation and Growth  Technology, taste and resource availability constant change – profits sought by entrepreneurs who correctly read the market and perceive a D for some product may exist or be created  Market economy – ppl risk their time+money in to earn profits: trial and error. Allocates resources to what [roce to be successful innovations  Centralized system-planners have to guess which innovations will be productive and which goods will be strongly demanded -> inability to encourage the experimentation and innovation that have proven to be the friving forces behind LR growth in advanced market economies. Decentralization of Power  Free-market economy decentralizes power and requires less coercion of individuals than any other type of economy.  Markets diffuse power, but large firms/labour unions have/exercise ^economic power but it is constrained by competition of other large entities and by the emergence of new products and firms = creative destruction; but even this private power is less than govt power  Govts must coerce if markets aren’t allowed to allocate people to jobs and goods to consumers. ->opportunity for bribery, corruption, allocation according to central administrator preferences, and coercion regarded as arbitrary  Milton Friedman: economic freedom – the ability to allocate resources thru private markets – is essential to the maintenance of political freedom.  Free market has more diffusion of power than centrally planned ones 16.3 Market Failures  Market failures: failure of the unregulated market system to achieve allocative efficiency  Firms have some market power since –vely sloped (not horizontal) D curves for their products p>MC (not perfectly AE)  Market failure describes a situation in which the free market, in the absence of govt intervention, fails to achieve allocative efficiency.  Economy is AE -> positive statement (w/o value judgement); AE not desirable in normative sense: an economy may be AE but distribution of income is judged by some to be undesirable  4 situations: free market fails to achieve complete AE 1)Market Power  a)Industries economies of scale are such that there is room for only a few firms to operate efficiently, each having some ability to influence market conditions  b)in many industries, firms sell differentiated products and thus have some ability to set their prices  c)firms that innovate with new products/production processes gain a temporary monopoly until other firms learn what the innovator knows; firms w/ market power maximize profits at output where p>MC = AiE  d)govt policymakers take the dynamic view of competition -> conflict between achieving AE and encouraging economic growth. Don’t try to make imperfectly competitive industries into perfectly competitive ones or try to induce such forms to produce where MC=p. impossible due to persuasiveness of oligopoly and monop 2 competition and undesirable since much innovation and productivity growth comes from firms w/ MP. Instead govts seek to prevent monopolistic practices that would permit firms to avoid behaving competitively wrt one another. Economic policy challenge is to accept monopolistic and oligopolistic imperfect competition for the rance of choices and scale advantages they provide, while keeping firms in active competition with one another so as to gain the economic growth that results from their innovative practices. 2)Externalities  for AE, marginal benefit=MC  Externality: an effect on parties not directly involved in the production or use of a commodity (aka third-party effects: parties other than the two primary participants in the transaction – buyer and seller – are affected)  Private cost: the value of the best alternative use of resources used in production as valued by the producer; measures the cost faced by the private decision maker (production costs, advertising costs)  Social cost: the value of the best alternative use of resources used in production as valued by society; includes the prdvate cost (since the decision maker is a member of the society) but also includes any other costs imposed on 3 parties.  Discrepancies between private cost and social cost occur when there are externalities. The presence of externalities, even when all markets are perfectly competitive, leads to allocatively inefficient outcomes.  Negative externalities – harmful; positive externalities – beneficial; AiE even tho perfect competition  When firm ignores those parts of social cost that aren’t its won private cost (negative externalities) the firm will produce too much output relative to what is AE  Renovator ignores those parts of social benefits that aren’t her own private benefits (positive externalities), there will be too littler home renovation done relative to what is AE  With a positive externality, a competitive free market will produce too little of the good. With a –ve externality, a competitive free market will produce too much of the good  AiE caused by externalitiy = justification for govt intervention. –ve: tax on firms or consumers responsible (pollution); +ve: subsidy (-ve tax) to the firms or consumers responsible (education) 3)Non-rivalrous and Non-excludable Goods  Rivalrous: a good/service is rivalrous if, when one person consumes one unit of it, there is one less unit available for others to consume (chocolate) (not TV signal)  Excludable: a good/service excludable if its owner can prevent others from consuming it (chocolate; not TV signal, except for specialty channels; not air you breathe) Private Goods  Private goods: goods/services that are both rivalrous and excludable (pay seller for the right to own those goods/services and consumption of them reduces the amount available for others – gas, textbooks)  Common-property resource: a product that is rivalrous but no excludable  Goods that are both rivalrous and excludable – private goods – pose no particular problem for public policy Common-Property Resources  Fisheries, wildlife, rivers. Use reduces amount available for other, but no way to control access to it, so no charge for its use (zero price); w/o govt intervention, private users will tend to overuse common-property resources until the marginal benefit is zero. But there will be some +ve MC to society of using the resource  Since the MC>marginal benefit, society will be better off if less of the resource was used. The social costs associated with the overuse of CPRs is called tragedy of the commons 3  Goods that are rivalrous and non-excludable are called common-property resources. They tend to be oversued by private firms and consumers  Govt intervention of fisheries – licenses and quotas Excludable but Non-rivalrous Goods  Art galleries, roads, bridges. Provided by govt usually.  MC of providing the good to one extra person is zero, AE requires that the price also be zero. +ve price prevents some ppl from using it, but this would be inefficient.  If marginal benefit>social MC of providing the good, it is efficient for these ppl to use the good  To avoid inefficient exclusion, the govt often provides for free non-rivalrous but excludable goods and services  Positive price in art galleries to cover demonstration and other legitimate costs. And congestion – meaning MC of providing the good to one more user is no longer 0. ^congestion, providing the good to one more person imposes costs on already those already using the good. A good that is non-rivalrous when uncongested becomes rivalrous when congested (less pleasant when crowded), becoming a private good and a +ve price is efficient. And when rivalry becomes sufficient, govts that provide such goods often charge a price to help ration  Road pricing to reduce congestion and improve the efficiency of urban transportation systems Public Goods  Public goods: goods/services that can simultaneously provide benefits to a large group of people (aka collective consumption goods); neither rivalrous nor excludable. (national defense)  These raise free-rider problem since PG are not excludable, it’s impossible to prevent anyone from using them once they’re provided. If the provider charged a price, non-payers would take a free ride at the expense of those individuals with a social conscience who do pay. Private markets don’t produce efficient amounts of the PG since one it is produced, it is impractical/impossible to make ppl pay for its use. Free market may fail to produce PGs so govt provides the good from tax revenues.  Because of the free-rider problem, private markets will not always provide public goods. In such situations, public goods must be provided by govt.  Govt should provide the PG up to the point at which the sum of everyone’s individual marginal benefit from the good is =MC of providing the good. Add everyone’s individual marginal benefit to get the total MB since PG and generates value to more than one person at a time.  The optimal quantity of a public good is such that the MC of the good equals the sum of all users’ marginal benefits of the good 4)Asymmetric Info  Markets for expertise are conceptually identical to markets for any other valuable service  Information is often a public good and tends to be underproduced by a free market. Even when its not a PG, markets for expertise are prone to market failure since one party to a transaction can take advantage of special knowledge in ways that change the nature of the transaction  Asymmetric information: a situation in which one party to a transaction has more/better relevant information about the transaction than the other party; can lead to market failures(moral hazard, adverse selection) Moral Hazard  Moral hazard: a situation in which an individual or a firm takes advantage of special knowledge while engaging in socially inefficient behaviour; when one party to a transaction has both the incentive and the ability to shift costs onto the other party (don’t shovel snow, mailman falls, insurance covers) 4  If insured against loss, will often take less care to prevent that loss than they would in the absences of insurance since they don’t bear all the MC imposed by the risk, whereas they do bear all of the MC of taking action to reduce the risk. MH, MF arises since action by insured party raises total costs for society.  Professional services – dentist has financial interest in giving answers that encourage one to buy their s
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