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Chapter 16

Economics 101: Chapter 16

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University of British Columbia
ECON 101
Robert Gateman

Economics 101: Principles of Microeconomics Chapter 16  Governments are necessary to provide law and order and to define property rights  Allowing decentralized decision making is more desirable that a centralized planning body  There are some areas of the economy that can benefit from government intervention  The operative choice is the choice of which mix of markets and government intervention best suits people's hopes and needs 16.1 Basic Function of Government  The government has a monopoly on violence (incarceration, judicial system) o There are systems in place to make sure the government is acting adequately as well o Some countries do not have these monopolies in place and it leads to violence o Without checks for the system, there may be the misuse of power  When government monopolies of violence are secure and function with effective restrictions against its arbitrary use, citizens can safely carry on their ordinary economic/social activities  Property rights enforce the rights and obligations of corporations, organization etc.  More stable and representative political structures lead to stronger economies  Institution building: taking the form of political rather than economic assistance 16.2 The Case for Free Markets  Free markets function and distribute wealth without a central form of leadership  Modern market economies are able to innovate and increase living standards  Formal defence: if all markets were perfectly competitive, and governments allowed prices to be determined by supply/demand, then price would equal marginal cost o The economy would therefore be allocatively efficient  Informal defence: markets are an effective mechanism for coordinating the decisions of decentralized decision makers o Free markets provide coordination of the actions of decentralized decision makers o Pursuit of profits provides free markets with innovation and rising standards o Free markets permit a decentralization of economic power Automatic Coordination:  Some economists believe free market economies are able to adjust more quickly to changes  Centralized governments force the same patterns on everyone (price-fixing, rationing etc.)  It is difficult to quickly adjust quotas/allocations and there will be shortages/surpluses  In a market system suppliers do not need to understand how the market works o There is coordination without anyone understanding how the market system works Innovation and Growth:  Successful entrepreneurs are able to gauge the market and create a product that is needed  A market economy allows for risk taking and innovation to exploit opportunities  Centralized systems have to guess what innovations will be strongly demanded o Could choice correctly and advance the economy o If they choice wrongly, all resources have been dedicated to an idea that did not work Economics 101: Principles of Microeconomics Decentralization of Power:  Large firms and labour unions have substantial economic power  Creative destruction: market power constrained my competition, new firms and products  Coercion creates opportunities for bribery, allocation and corruption o Allocate scarce resources to individuals/firms that pay the largest bribes  Economic freedom: the ability to allocate resources through private markets o Essential to the maintenance of political freedom (Milton Friedman) 16.3 Market Failures  The failure of the market economy to achieve an efficient allocation of resources  Firms that face downward sloping demand curves, have price exceeding MC at equilibrium o No real market economy has ever achieved perfect allocative efficiency o Efficiency is often only used as a benchmark to compare the economy  Market failures in the free market, in the absence of government intervention, fails to achieve allocative efficiency  Allocative efficiency is a positive statement, that is not a value statement Market Power:  In some industries there is only room for a few firms to operate efficiently  In some industries firms sell differentiated products and have the ability to set prices  Firms that innovate with new products/production methods have a temporary monopoly o Firms with market power, maximize profit at output when price exceeds MC o The result is allocative inefficiency even though there are new innovations  Governments must scale advantages of imperfect markets without controlling them Externalities:  Individual consumers are interested in their own benefit not the benefits of others  Externality: whenever actions taken by firms/consumers impose costs/benefits on others o The third part effect (parties other than the buyer/seller are affected)  Private cost: the cost faced by the private decision maker (production, advertising etc.)  Social cost: private cost and costs imposed on third parties o Similar distinction between private and social benefit  Discrepancies between private cost and social cost occur when there are externalities o Presence of externalities leads to allocatively inefficient outcomes  A positive externality in a competitive free market will produce too little of a good o Governments may impose a subsidy for these types of externalities  A negative externality in a competitive free market will produce too much of the good o Creates a justification for government intervention o Impose a tax levy on pollution or other restrictions on negative externalities Non-rivalrous and Non-excludable Goods:  Rivalrous (good/service): if one person's consumption of one unit of a good, means that no one else can also consume that unit  Excludable (good/service): if people can be prevented from consuming it Economics 101: Principles of Microeconomics Private Goods:  Most goods/services consumer are both rivalrous and excludable  Private goods: goods that are both rivalrous and excludable o Pose no particular problem for public policy Common-Property Resources:  Goods that are rivalrous but non-excludable pose a challenge to public policy  Common property resources: fisheries, common grazing land, wildlife  Private users will tend to overuse a product that has zero price (ex. Water) o Will be some positive marginal cost to society for using the resource  Tragedy of the commons: social cost associated with the overuse of common resources  Goods that are rivalrous and non-excludable are called common-property resources o Tend to be overused by private firms and consumer Excludable but Non-Rivalrous Goods:  Goods that are excludable but not rivalrous (typically provided by government) o Non-rivalry means the marginal cost of providing one extra is zero  If the marginal cost is zero, the price must also be zero (allocative efficiency) o When there is congestion this is no longer true  Imposes costs of those already using the good/service  To avoid inefficient exclusion, governments often provide free non-rivalrous but excludable goods/services  Governments that provide goods with high demand must charge to ration the good Public Good:  Public goods: neither excludable nor rivalrous o Sometimes called collective consumption goods (national defence) o All Canadians are equally provided with national defence  Information is also often a public good (disclosure, recalls, public warnings, defects etc.) o Once the good is produced it is impractical to make people pay for it o Free markets may fail to produce public goods at all  The free-rider problem in the private markers will not always provide public goods o Public goods must be provided by the government in these situations  Governments should continue providing until marginal benefit is just equal to marginal cost  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 Asymmetric Information:  One party in a transaction has special knowledge o Take advantage of the special knowledge in way that change the natural of the transaction o Even when information is not a public good, markets for expertise are prone to failures Economics 101: Principles of Microeconomics Moral Hazard:  Exists when one party has incentive and the ability to shift costs onto the other party o Market failure arises because the action by the insured raises the total cost for society o May reduce the cost of an individual but increase the cost for others  May be codes, professional ethics, licensing, certification process etc. o Government policies may also create moral hazards Adverse Selection:  Tendency of people more or less at risk to buy/reject insurance o Insurance companies can limit risk through exams, age requirements etc. o Rates change between different categories and ages  Someone that is high risk, but pays a low rate, imposes low private cost but high social costs  Someone that is low risk, but pays a high rate, imposes high private cost but low social costs Summary:  Following are market failure that provide rationale for government intervention  Firms with market power will charge a price greater than marginal cost o Level of output is less than the allocativ
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