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Chapter 16

Chapter 16.docx

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ECON 110
Ian James Cromb

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Chapter 16 – Market Failures and Government Intervention  The operative choice is not between an unhampered free-market economy and a full centralized command economy. It is rather the choice of which mix of markets and government intervention best suits people’s hopes and dreams  When the government’s monopoly of violence is secure and functions with effective restrictions against its arbitrary use, citizens can safely carry out their ordinary economic and social activities.  Informal defence of free markets is based on three central arguments o Free markets provide automatic coordination of the actions of decentralized decision makers o The pursuit of profits in free markets provides a stimulus to innovation and rising material lining standards o Free markets permit a decentralization of economic power  Market failure: describes a situation in which the free market, in the absence of government intervention, fails to achieve allocative efficiency  Externality: an effect on parties not directly involved in the production or use of a commodity. Also called third-party effects.  Private cost the value of the best alternative use of resource 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  Discrepancies between private cost and social cost occur when there are externalities. The presence of eternities, even when all markets are perfectly competitive, leads to allocative inefficient outcomes.  With positive externality, a competitive free market will produce too little of the good. With a negative externality a competitive free market will produce too much of the good.  See figure 16-1 pg. 391 for diagram  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.  Goods that are both rivalrous and excludable - private goods - pose no particular problem for public policy.  Goods that are rivalrous and non-excludable are called common-property resources. They tend to be overused by private firms and consumers.  To avoid inefficient exclusions, the government often provides for free non-rivalrous but excludable goods and services.  Because of the free-rider problem, private markets will not always provide public goods. In such situations, public good must be provided by government.  The optimal quantity of a public good is such that the marginal cost of the good equals the sum of all users’ marginal benefits of the good. o Figure 16-2 pg.396 Excludable Non-excludable Private Goods Common-Property Resources  DVDs  Fisheries Rivalrous  A seat on an airplane  Rivers and streams  An hour of legal advice  Wildlife  Clean air Non-Rivalrous Public Goods (up to capacity)  Art galleries  National defence  Roads  Public information  Bridges  Public production  Cable or satellite TV signal  Regular TV signal  Asymmetric information: a situation in which one party to a transaction has more or better relevant information about the transaction than the other party  Moral Hazard: a situation in which an individual or a firm takes advantage of special knowledge while engaging in socially inefficient behavior.  Adverse selection: self-selection, within a single risk category, of persons of above- average risk.  Summary of market failures; the following four situations result in market failures and, at least in principle, provide a rationale for government interventions. o Firms with market power will charge a price greater than marginal cost. The level of output in these cases is less than the allocative efficient level. o When there are externalities, social and private marginal costs are not equal. If there is a negative externality, output will be greater than the allocative efficient level. If there is a positive externality, output will be less than the allocative efficient level. o Common-property resources will be overused by priva
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