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Chapter 16

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ECON 110
Ian James Cromb

Chapter 16: Market Failures and Government Intervention Basic Functions of the Government  From the creation of gov’t, one function that has been maintained throughout is to provide what is called monopoly of violence o Violent acts can be conducted by the military, police, and through the judicial system (incarcerating or executing them)  These monopolies are easily abused which is why good societies have system checks and balances designed to keep the gov’t directed to the general public’s good  Gov’t are also supposed to provide security of property – through property rights o The rights include clear definition and enforcement of the rights and obligations of institutions such as corporations, religious organizations, and not-for-profit’s The Case for Free Markets  Formal Defence: Allocative efficiency – resources used such that total surplus is captured  The “informal” defence 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 for innovation and rising material standards of living o Free markets permit a decentralization of economic power Automatic Coordination  Argue that a free market system is more flexible and adjusts more quickly to changes o If the price of gas went up – people could change how much they use o If centralized, the same pattern would be forced on everyone – by price fixing, rationing the gas, regulating temperature, etc.  As market conditions continue to change, prices in a market economy will also change, and decentralized decision makers can react continually o In contrast, gov’t quotas, allocations, and rationing schemes are much more difficult to adjust – more likely to be constant shortages or surpluses Innovation and Growth  Individuals risk their time and money in the hope of earning profits – not many succeed o The market system works by trial and error to sort them out and then allocates resources to those who prove to be as successful innovations  In contrast, planners in more centralized systems have to guess which innovations will be productive and which goods will be strongly demanded – they may guess wrong o One of the biggest failures was their inability to encourage experimentation and innovation that have proven to be the driving forces of long-run growth Decentralization of Power  Free market economies tend to decentralize power, thus requiring less coercion of individuals than any other type of economy – although power is not distributed evenly  Though the market power of a large corporation is not negligible, tends to be constrained both by competition and by the emergence of new products & firms – creative destruction o Supporters say that this private power is less substantial than the gov’t power  Gov’ts must coerce if markets are not allowed to allocate people to jobs and gods to consumers – such coercion creates opportunities for bribery, corruption, etc. Market Failures  Market failure: The failure of the market economy to achieve allocative efficiency  Market failure happens when firms in the industry have negatively sloped demand curves and can set price higher than marginal cost o These market failures provide gov’t opportunities to improve allocative efficiency  There are four situations in which free market fails to reach allocative efficiency o Market power, externalities, non-rivalrous, and non-excludable Market Power  Market power is inevitable in any market economy for three reason o In many industries, economies of scale are such that only a few firms operate efficiently, each having some ability to influence market conditions o Firms sell differentiated products & therefore have some ability to set their prices o Firms that innovate with new products or production processes gain a temporary monopoly until other firms learn what the innovator knows  As we already know, firms with market power will maximize profits by operating where price exceeds marginal cost – allocatively inefficient  When gov’ts intervene, all they do is prevent monopolistic practices that would permit firms to avoid behaving competitively with respect to one another – active competition Externalities  An externality occurs whenever actions taken by firms or consumers directly impose costs or confer benefits on others – also called third-party effects  Private Cost measures the cost faced by the private decision maker including production costs, advertising costs, and so on – similar distinction of private benefit  Social Cost includes the private cost (since they are a part of society) but also includes any other costs imposed on third parties – similar distinction to social benefit  Negative Externalities: When externalities are harmful to third-parties  Positive Externalities: When externalities are beneficial to third-parties  When there is an externality, either too little (+) or too much (-) of a good is produced Non-Rivalrous and Non-Excludable Goods  Economists classify goods/services based on the rivalry & the excludability of the good  A good/service is said to be rivalrous if one person’s consumption of one unit of the good means no one else can consume that same unit  A good/service is said to be excludable if people can be prevented from consuming it Private Goods  These are goods and services that are both rivalrous and excludable  Most goods that we consumer fall into this category – no problem for public policy Common-Property Resources  This is a product that is rivalrous but not excludable – challenge for public policy o Fisheries, wildlife, clean air – no way to make someone pay for it; zero price  In the absence of gov’t intervention, private users overuse common-property resources o Faced with a zero price, private users will use resource until marg benefit = zero o Will be some positive marginal cost to society – society would be better off if less resources were used these social costs are referred to as tragedy of the commons Excludable but Non-Rivalrous Goods  Examples include art galleries, roads, and bridges  Non-rivalry means that the marg cost of providing these goods to one extra person is zero  If marginal cost to society of providing one more unit of the good is zero, then allocative efficiency requires that the price be zero - any price could prevent people from using it o As long as their marginal benefit exceeds the social marginal cost of providing this good, it is efficient for these people to use the good Public Goods  These are goods/services that can simultaneously provide benefits to a large group of people – also called collective consumption goods  ex. National defence  Public goods cause rise to what is called the Free-Rider Problem o Since public goods can be used by anyone, non-payers of a good can free-ride its use at the expense of the individuals with the social conscience who do pay o Because of free-riders the private market won’t produce efficient amounts of the public goods because once produced, it’s impossible to get people to pay to use it Asymmetric Information  This is a situation in which one party to a transaction has more or better relevant information about the transaction than the other party Moral Hazard  This is a situation in which an individual or a firm takes advantage of special knowledge while engaging in socially inefficient behaviour  This would happen if the individual does not bear all of the marginal cost imposed by the risk – raises total cost for society  Ex. You get people to do/not do something for your benefit by not telling them the truth Adverse Selection  Refers to the tendency for people more at risk to purchase insurance and those who are less at risk, to reject insurance – if you have a heart condition, you seek life insurance  People getting the insurance know more about themselves than the company selling the insurance – although they can do tests/credit checks o Therefore different people are charged different prices for insurance  Resources get allocated inefficiently because the marginal private benefit of the action is not equal to the marginal social cost Broader Social Goals  Even if markets were completely competitive and allocatively efficient and there were no problems of externalities, market power, public goods, or asymmetric information, the gov’t would still have to intervene  The following are broader social goals that would still require gov’t intervention Income Distribution  People whose services are in large demand relative to supply have large incomes, whereas those not in heavy demand earn much less  As discussed in ch. 13, these can be temporary or equilibrium differentials  Free-market systems reward certain groups and penalize others o Is it fair that people starve if they lose their job? – there are many charities and gov’t policies concerned with modifying the distribution of income Preferences for Public Provision  Police protection and justice could, in principle, be provided by a private-market mechanism (security guards,
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