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ECON 208 Chapter Notes -Rational Ignorance, Public Health Insurance Option, Adverse Selection


Department
Economics
Course Code
ECON 208
Professor
Lee Ohanian

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Adrienne Pacini ECON 208 WEEK: November 10, 2009
MARKET FAILURES AND GOVERNMENT INTERVENTON
Chapter 16
Basic Functions of Government
- The operative choice is between which mix of markets and government intervention best
suits people’s hopes and needs
- When government’s monopoly of violence is secure and functions with restrictions against
its arbitrary use, citizens can safely carry on their ordinary economic and social activities
The Case for Free Markets
- The formal case for free markets is based on the concept of allocative efficiency
o Where society is using its resources to produce the optimal mix of goods and
services (i) at P = MC, which (ii) maximizes economic surplus, meaning (iii) all
mutually beneficial trades have been undertaken
- The informal case is based on three central arguments
o Free markets coordinate actions automatically
o The pursuit of profits leads to innovation and growth
o Free markets decentralize economic power
Automatic Coordination
- Free markets are flexible and self-correcting because economic power is decentralized
o Economic profits or losses signal firms to enter or exit an industry to alter the
allocation of the economy’s resources in the production of goods and services
o Prices respond to changes in demand and supply via the market forces of excess
demand and supply, and both firms and consumers respond to the changes in prices
- So the price mechanism in free markets coordinates the responses of the individual
economic agents (the firm and the consumer) seeking only their self-interest
o This coordinates markets:
Without any conscious planning
Without any individual consumer or producer needing to understand how
the system works
Innovation and Growth
- Profit motive creates incentives for research and development, creating new and better
products and production methods (often by trial and error)
- The biggest failure of centrally-planned economies was to hinder research and development
by:
o Not letting the market make decisions
o Not providing the incentives
- Pursuit of self-interest gives individuals an incentive to work hard and improve their stock of
human capital
Decentralization of Power
- Market systems have less centralized power than planned economies
o Probably less scope for corruption and abuse of power
- Almost all developed “command economies” have moved to much more free-market
systems:
o Rates of economic growth were too low to maintain acceptable standards of living
relative of other developed economies (lacking incentives)
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Adrienne Pacini ECON 208 WEEK: November 10, 2009
Market Failures
- Market failure: a situation in which the free market fails to achieve allocative efficiency (the
best attainable outcome)
- There are four situations in which the free market fails to achieve allocative efficiency
Market Power
- Reason for intervention: firms with market power will typically produce where P > MC
- Types of intervention: regulation; anti-trust or competition policy
- Potential problem: “the cure may be worse than the disease”
o Regulation can cause inefficient production
o Competition policy:
Can protect firms at consumers’ expense
Can prevent exploitation of economies of scale
Can reduce incentives for innovation and invention
Externalities
- A cost that is not born by the producers or consumers of the good
- When actions taken by firms or consumers impose costs or confer benefits on third parties
who neither consume nor produce the good
- Allocative efficiency rule for society: P = MCsocial = MCprivate + NX (negative externalities)
o Example: pollution
- With a negative externality, a free market produces too much of the product
o (P = MCP < MCS)
o If there are negative externalities, a monopoly may get closer to allocative efficiency
than perfect competition
- With a positive externality, a free market produces too much of the product
o (P = MCP > MCS)
- Only use society’s resources to eliminate negative externalities to the point where MC of
intervention = MB from intervention
- With a positive externality, a competitive free market will produce too little of the good (and
opposite with negative externalities)
- Example: what is MC if there is a lower life expectancy because of less medical research?
- Private cost: the value of the best alternative use of resources used in production as valued
by the producer
- Social cost: the value of the best alternative use of resources used in production as valued
by society
Non-Rivalrous and Non-Excludable Goods
- Rivalrous: a good or service is rivalrous if, when one person consumes one unit of it, there is
one less unit available for others to consume
- Excludable: a good or service is excludable if its owner can prevent others from consuming
it
- Private goods: goods or services that are both rivalrous and excludable
o These goods pose no particular problem for public policy
o Examples: consumption of food, clothing, other material objects
- Common-property resources: a product that is rivalrous but not excludable
o In the absence of government intervention, private users will tend to overuse
common-property resources
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