Introduction to Market Failures

SECTION 3: Introduction to Market Failures Lecture 1: Introduction to Market Failures and Government Invention Market Failure is defined as a situation when the market does not allocate the appropriate level of resources to the production of that good or service. A market failure can either cause an overallocation of resources or an underallocation of resources depending on the type of market failure. But, what does it mean to overallocate or underallocate resources? The government hopes to increase firms’ profits by correcting for market failures caused by externalities. Specific taxes and legislation are two government solutions for negative externalities. The direct way to reduce negative externalities from a certain activity is to pass legislation limiting that activity The government has different ways of dealing with the under allocation of resources resulting from positive externalities. Education funding by government is an example of positive externality. Government can attempt to correct a market experiencing a positive externality by subsidizing producers and/or consumers, by government production of the product. Overallocation of Resources Suppose that a manufacturing firm produces goods made of plastic, creating a liquid waste in the process. The cost of properly disposing of the liquid waste is $1,000 per ton. The firm's manufacturing plant is near a river. It can dump the waste in the river to get dispose of it at $0 cost to them, however it does kill the fish and prevents other wildlife such as ducks and beavers from living in the area. If the firm dumps the waste into the river, they can lower the cost of production. Killing the fish in the area and preventing other wildlife from living in the area may not be a cost to the firm, but it is a cost to society. Commercial fisheries and tourism are hurt by the pollution and the production costs for these firms may increase or cause them to close their businesses completely. The cost of the pollution may be external to the plastic manufacturer, but not to society as a whole. The lower cost of production for the plastic manufacturer causes supply the firm is willing to bring to the market at all possible prices to be higher than if they realized all costs. Back to our knowledge of demand and supply, an increased supply means the equilibrium price lower and a higher quantity. The lower cost leads to too much of the good being produced -- society is allocating too many scarce resources toward the production of this good. If the firm had to pay the full cost of production, including the price of properly disposing of the waste, they would supply less to the market, the price would rise and quantity would be reduced The optimal allocation of resources occurs where the firm pays the full cost of properly disposing of the waste. When the firm decides to pollute there is an overallocation of resources in the market. An overallocation of resources means that society is spending too many scarce resources on the production of the good or service. This situation occurs any time firms do not feel the full cost burden of production. There are costs are external to the firm but society, consumers, other businesses, or others, experience the additional costs. An overallocation of resources is also known as a supply side market failure since the failure to allocate resources results from costs paid by producers. Underallocation of Resources An underallocation of resources is the opposite situation, when society allocates too few resources toward the production of a good or service. This situation will occur when consumers do not feel the full benefit of their decision. Vaccinations and other preventative health care measures are examples of goods that experience an underallocation of resources. In the market for the flu vaccine there are some consumers who are not willing and able to purchase the vaccination at the current price. However, if you sit next to me in class or in the workplace, or even use a computer at the library before me, I want you to take every measure possible to prevent getting sick. If you are less likely to get sick, I am less likely to get sick. I may even be willing to pay for a portion of your flu shot to prevent you from getting sick! If I were to give you some money to get a flu shot it may reduce the cost enough to make you willing and able to make the purchase. Moving to the economy, society as a whole is better off when people are not sick, there are less people calling out of work (production is higher) and school (knowledge that is lost from not attending). Society should be willing to paying for more people to take preventative actions, such as the getting the flu shot, to prevent them from getting sick. In the case of vaccines and other preventative actions there are benefits to society, outside the direct consumer, that others may be willing and able to contribute funds to. If the consumer had the extra funds, they would be more willing and able to consume the good. Since we do not pay our classmates and coworkers to get flu shots, demand is less than the optimal level. The higher cost for the direct consumer of the vaccination causes the demand to be lower than if society was willing to help bear part of the price burden. Back to our knowledge of demand and supply, a reduced demand means the equilibrium price is lower and a lower quantity. The lower demand leads to too little of the good being consumed -- society is allocating too few scarce resources toward the consumption of this good. If the individual were to be compensated for purchasing the product demand would increase, as a result the quantity bought and sold would increase. The 2 options available to government to correct spillover benefits or the underallocation or resources: Government provision of public goods, subsides to buyers, Subsides to producers. Government provision refers to the government providing a public good in order to correct for positive externalities where the positive externality is extremely large. What are some of the problems with taxation based upon the benefitsreceived principle? - The benefits-received principle can’t to be applied to finance some programs like safety net programs. - Benefits of public goods are widespread and diffuse. With the ability-to-pay principle of taxation, individuals and business with higher income should pay more taxes in absolute and relative terms than those with lower incomes. The ability-to-pay principle is based upon that idea that each additional dollar of income yields a smaller marginal utility when it is spent. When government gives money to a college student, this an example of consumer subsidies. Dollars paid in taxes by a poor person represents a greater unit sacrifice than the dollars taken from a rich person therefore to balance the sacrifice imposed by taxes, taxes are apportioned according to the income revised by the taxpayer. Which of the following happens when a market does not reflect consumers full willingness to pay for a good or service? Demand-side market failure. Which of the following are subsidies to consumers to correct for an underallocation of resources by producers? - Discount coupon to inoculate children against classic childhood diseases - Tax credit for purchasing an electric car When government subsidizes consumer in order to correct an underallocation of resources in a market, government is attempting to: shift demand curve to the right When government subsidizes producers, it is attempting to: shift to the right When government acts to correct a market which is experiencing a positive externality, what could happen in the market? - The demand for the good causing the externality would rise resulting in the demand curve outward - The supply for the good causing the externality would rise resulting in the supply curve shifting outward What type of tax structure does the state and local tax system tend to represent? Regressive Political realities such as particular constituencies and lack of profit incentives describe why the economic role of government is not always perfectly carried out Which of the following represents a demand-side market failure? Fireworks displays Which is an example of a good that is financed based upon the benefits-received principle? Gas taxes used to fiancé road construction and repairs. Which of the following terms is used to describe economically inefficient outcomes caused by shortcoming in the public sector? Government failure The optimal allocation of resources occurs where all individuals who benefit from the consumption contribute to the price. Since we typically do not compensate others for something that benefits ourselves there is an underallocation of resources. An underallocation of resources means that society is spending too few scarce resources on the production of the good or service. This situation occurs any time there are benefits of consumption that are outside the direct consumer. An underallocation of resources is also known as a demand side market failure since the failure to allocate resources results from benefits received by consumers. Optimal Allocation of Resources The question now becomes where is the optimal allocation of resources? The optimal allocation of resources occurs where all costs of production are fully realized by the firm and the consumer is compensated for all benefits, whether to them or to others. There are many goods and services where the optimal allocation of resources occurs without any intervention in the market. For instance, the market for haircuts. The seller of the hair cut realizes the full cost of providing the service, you receive the full benefit of the haircut. In this market there is no failure of the market to allocate the appropriate level of resources, the market is operating at its efficient level. There are two types of efficiency that must hold for a market to be considered efficient. They are productive efficiency and allocative efficiency: - Productive efficiency is producing the good or service at the lowest cost of production. If firms in the market are using the lowest costs of production (for society as a whole) the market is said to have productive efficiency. Productive efficiency is important because: more resource are available to produce other good and the good is produced in the least-costly way. - Productive efficiency is achieved when production costs are minimized - Allocative efficiency is that society is producing the mix of goods that are most highly valued. The goods and services that are most preferred by society is the mix of goods and services that are actually produced by firms. For a market to be efficient both conditions must be met. However, there are many markets where failures occur. In the follow lectures we will begin discussing the failures and the impact they have on the price and quantity produced in the market. Government subsides decrease producers’ costs, shifting the supply curve to the right, and correcting the underallocation of resources by producers. The effect of subsides on consumers in correcting for positive externalities are: - The subsidy reduces the price of purchasing the good - An increase in demand illustrated as a shift outward of the demand curve. - The quantity of the product purchased would rise to the economically optimal output eliminating the under-allocation of resources. With a progressive tax, the burden falls more heavily on the rich households while regressive taxes place a heavier burden on the poor households. The first dollars of income are usually spent on those high-urgency goods which yield the greatest marginal utility. Dispersant of the payment of taxes among citizens refers to: the apportionment of the tax burden Lecture 2: Classification of Goods Our discussion of market failures will start by identifying ways to classify goods based on the way they are purchased and consumed. Goods can be classified in two ways. Are they excludable? and Are they rival? We will discuss these two classifications and identify goods that fall into both categories. Market failures in competitive markets can be classified into demand-side and supply-side. Consequences of supply-side market failure? - There is a greater number of units produced - For some units produced, the costs are greater than the benefits - Less output is desirable A competitive market allocates resources efficiently, a competitive market makes private goods available to consumers. How does competition result in an efficient use of resources? – producers must use the right of resources, lower-cost producers will drive high-cost producers out of business, producers must use the best technology. Excludability A good is said to be excludable if sellers can prevent people who do not pay for the product from obtaining the benefits from consuming it. In other words, if you don't pay for it you don't get it. At first thought you may assume that all goods are excludable, but have you ever received the benefit of a good but had someone else purchase the good. Have you used a public park in an area you don't pay taxes? Have you watched a firework display or concert without actually entering the paid area? If so, you have experienced goods that are non-excludable. The majority of goods and services in our economy are excludable, if you do not pay for a meal at a restaurant, a pair of shoes at a store, or your cell phone bill, you cannot consume those products. The seller can prevent you from consuming the product. To determine whether a good is excludable you will want to think about the ability of the seller to prevent those from benefiting from the good unless they have paid for the good. A good is excludable, when a seller can prevent people who did not pay for a product from obtaining its benefits. Goods that are nonexcludable: street lighting, environmental protection A externality is a cost or a benefit accruing to an individual or group, a third party, that is external to a market transaction. Rival The second classification of goods are whether it is rival. A good is considered to be rival if when one person buys and consumes the good, it is not available for other people to buy and consume. Example: tickets to a movie. Again, at first thought it may seem as though all goods are rival. If I buy something, a sweatshirt, an ice cream cone, a textbook, then you cannot buy and consume the same one. However, when we begin to think about the digital world there are more goods that become non-rival. Both, you and I, can watch the same show on Netflix at the same time in different houses and lessen the consumption for others. This is also true of online news articles, such as ones published on CNN.com or other news websites. Other examples of non-rival goods would include public works of art or an open highway in rural areas. We can both consume the goods at the same time without interfering with one another. There are exceptions to these rules, if it is the first day the art is displayed and so many people attend that I must stand behind you, your consumption may stop mine. Or a highway during rush hour or when an accident occurs the highway may become more rival. In general, these goods can be consumed by many at the same time without one individual interfering with the consumption of others. Classifications Now that we have discussed the two classifications goods, excludable and rival, we will examine how to classify goods into one of four types based on these classifications. The situation when people can receive the benefits from a good without having to pay for it is called the free-rider problem. The free-rider problem makes it impossible for private firms to gather resources and profitably provide public goods. The government can provide the efficient amount of a public good by adhering to which of the following rules? Marginal benefit equals marginal cost. If Adam expects to receive $3 in extra benefit from a public good, then what is the highest price Adams would be willing to pay for the public good? $3 Lecture 3: Types of Goods Excludable and Rival As mentioned in the previous lecture most goods are considered to be excludable and rival. A good that is excludable, and rival implies that producers can restrict the consumption to only consumers who pay for the product and only one consumer is able to consume a unit of the good, we cannot both consume the same unit at the same time. This classification of good is known as a private good. Many of the goods we purchase are rival goods, from clothing, to groceries, to many services we receive. The supply and demand models that we have discussed so far have focused on the assumption that the goods are private. There are no external benefits to individuals who do not pay for the good. This means, based on the classification alone, there are no market failures present. We will see this is not the case for all goods as we move through our discussion. Private goods exhibit two consumption characteristics, rivalry and excludability. A private good that displays rival characteristics means that when someone buys and consumers that good, it is not available for someone else to buy and consume. A private goods are produced through the market system. Private goods include: personal computers, household appliances, automobiles Goods that are provided by competitive market, on the grounds that they are expected to generate profits, are known as private goods. Market failures in competitive markets can be classified into demand-side failures and supply-side market failures. A market failure arises because it is: not possible for the market to correctly weigh costs and benefits A supply-side market failure occurs when a market does not reflect the full cost of producing a good or service. A demand-side market failure occurs when a market does not reflect consumers full willingness to pay for a good or service. A demand-side market failure arises because it is impossible in certain cases to charge consumers what they are willing to pay for a product A supply-side market failure arises in situations in which: a firm does not have the full cost of producing its output. What is it called when demand fails to account for the buyer’s full willingness to pay? Demand side market failure Which of the following justifies government intervention in the economy? Market Failures The average tax rate is the total tax paid as a percentage of income. The marginal tax rate is the rate paid on each additional dollar of income. What - are the consequences of a supply-side market failure? Less output is desirable The amount of output produced is too low There is a greater number of units produced Why aren’t outdoor fireworks displays provided by private firms? - People do not have to pay to enjoy the fireworks - It is impossible to raise enough revenue to cover the costs of the displays Excludable and Non-Rival Some goods are excludable, as in only individuals who pay are able to consume the good, but also non-rival, meaning we both can consume the same good at the same time without interfering with one another's consumption. An example of this would be an arena sport game. You and I can both attend a college basketball game. The only way to see the game live is to pay for a ticket. If you do not pay for a ticket you cannot watch the game live. However, you and I can both watch the game at the same time and enjoy the same benefit without interfering with one another's consumption. (Unless you have less fun because your instructor is sitting next to you talking about economics the whole time. Or you sit in front me with your big foam finger and I cannot see the court). Goods that are excludable, but non-rival are called club goods. Other examples of club goods would be paid online subscriptions to Netflix or the Wallstreet Journal or membership to a gym. Again, there may be times at the gym where a piece of equipment or a class is rival in consumption (busy times or a popular class), but in general a gym membership would be considered a club good. Non-Excludable and Rival Our third category consists of goods that are non-excludable, we cannot prevent anyone from consuming the good, but rival, your consumption interferes with others. An example of a good that is non-excludable, and rival is a public park on a nice summer day. The park is non-excludable. Even if you did not pay for the park, or offer a donation upon your visit, you can still enjoy the public park. However, on a nice summer day the park may begin to fill up. The playground area may have an abundance of kids and there is a line for the slide. The picnic tables may be full and all shady spaces under the trees are filled with blankets and people. This is an example of a rival good. Now the consumption of one individual begins to interfere with the consumption of others. These goods are called common goods. No one can be excluded from consuming a common good, but it is rival in consumption. Other examples of common goods include hunting and fishing, seating at an outdoor concert in a park, and bike racks in front of a popular college building. No one can prevent someone from consuming these goods, but at times we may see the good become rival. The non-excludable nature of a common good can create a market failure. Since a seller cannot prevent someone who does not pay for the good from consuming the good they may have a difficult time earning revenue and making profit on the good. This will reduce their willingness and ability to supply the product until the good is completely taken off the market. In the case of fishing or hunting, the resources may become over hunted and the rival nature of the good, may cause the wildlife resources to become depleted. Market failures in these markets can be difficult to manage, but we will examine them in Lecture 10 as well as the supplemental video if you are interested in learning more about the Tragedy of the Commons. Non-Excludable and Non-Rival Our final type of good is a good that is non-excludable and non-rival. It is this type of good where market failures are most common to appear. National defense is an example of a good that is non-excludable and non-rival. If you never pay taxes to the United States government but reside within the borders of the U.S., you will receive the benefit of national defense. It is not possible for the government to put a sign on your door that says this person did not pay for the defense so you can attack here, but nowhere else. Since this is not an option national defense is nonexcludable. National defense is also non-rival. You and I are both consuming national defenses right now. Your consumption of the defense is not stopping me from consuming it or limiting the amount I consume, so consuming is non-rival. This type of good, non-excludable, non-rival is known as a public good. A public good is the opposite of a private good. They are often difficult for anyone consumer to provide since anyone else can consume them. Since sellers cannot stop you from consuming the good if you do not pay for, they may be unwilling to supply the good to the market. Public goods are an example of when markets typically fail, and government intervention is necessary to improve the market outcome. Other examples of public goods include public art and parks and fireworks displays. Characteristics of a pure private good include: Rivalry, Excludability A private good that displays rival characteristics mean when someone buys and consumes that good, it is not available for someone else to buy and consume. How do consumers express their desire to buy a good? By purchasing the good. Public goods are financed through government tax revenue. Which of the following diverts purchasing power for private spenders to government, thereby removing resources from private use? Taxation Fuzzy Areas As mentioned throughout this lecture, at times there are grey areas, there are circumstances that may change causing the good to move from one type of good to another. A rural highway may be typically seen as a public good, non-excludable and non-rival. But if an accident occurs and traffic becomes congested, your consumption of the road may begin to hinder mine as this occurs the good moves from a public good to a common good. The same can be said for the gym membership, typically it is a club good. However, on a busy day the machines may become crowded and you may need to wait for your desired piece of equipment, moving it from a club good to a private good. On the worksheet and exam there will be questions asking you to classify goods. Think about the case in general and do not over think the situation. If you start your sentence out with "well sometimes this might happen" you are overthinking it. If the question asks about a specific scenario such as "a busy time" or "a rainy day" then you may want to take that as a hint, but do not assume times are busy or all days are rainy if that is not typically the case. That being said, if you do have a question or require further clarification on a problem be sure to ask. If you believe an answer should be something other than what is listed, you can complete a form discussing what you believe is the correct answer and why. Be sure to ask if you have any questions before the due dates and have any issues cleared up before the exam. A cost or a benefit accruing to an individual or group, a third party, that is external to a market transaction is known as an externality. An externality causes some of the benefits or costs of a market transaction to be passed on to a third party. Lecture 4: Negative Externalities Negative Externality The next type of market failure is an externality. An externality occurs anytime there is a third party that is affected by the market transaction. Someone other than the buyer or seller who is impacted by the transaction. We began our discussion of this concept in the introduction lecture and will continue our discussion here. Negative Externality 1. The first type of externality is a negative externality, or external cost. A negative externality occurs when there is a cost to someone other than the seller/producer of a product. We call these cost spillover costs. Spillover costs are costs of production that are not fully realized by the producer but felt by someone external to the transaction. A negative externality is an example of a supply side failure. We will use our demand and supply diagram to analyze the idea of the supply side failure and the overallocation of resources that occurs as a result of the spillover costs. A market failure that occurs when a third party to a transaction experiences uncompensated costs is called a negative externality, or spillover cost. A negative externality occurs when: an overproduction of product occurs and there is an overallocation of resources to this product. Recall our discussion of supply side failures. When the seller does not experience the full cost of production their costs are lower than if they were to pay the full cost. The lower cost of production means supply is higher than it should be, a greater amount of supply means the price is lower than the efficient outcome and the quantity bought and sold in the market is higher. The higher quantity means that society is over allocating resources toward the production of this good. Examples of negative externalities occur any time there are costs that are outside of the direct market participants. These can include pollution by firms, smoking in a crowded public area, and dogs barking or other loud noises in the neighborhood. The result of positive externalities is that the market produces too few units of a product that could benefit society, resulting in producers under allocating resources to that product. Negative externalities such as pollution reduce the utility of people and the communities they live and work in, rather than increase it. Negative externalities (or spillover costs) result in a overallocation of resources to the production of the good. Graphically Now let's examine this idea of negative externality graphically. In the graph below the supply curve S reflects the supply curve where sellers do not realize the full cost of production. Going back to our plastic manufacturer example, the firm is dumping the waste in the river rather than properly disposing of it at supply curve S. We can see the equilibrium between supply curve S and demand curve D the equilibrium price is P and the equilibrium quantity is Q. However, if the firm were to realize the full cost of disposing of the waste the supply curve would be reduced. The amount of the reduction would be based on the additional cost of properly disposing of the waste. When the firm's costs increase the amount, the firm is willing and able to supply is reduced. We can see this as a reduction in supply from supply curve S to supply curve S1. The reduced supply has caused the equilibrium price to increase to P1 and the equilibrium quantity be reduced to Q1. The difference between Q and Q1 represents the overallocation of resources that occurs when the full costs of production are not realized. Takeaways The market will operate at supply curve S where firms are polluting, or external costs are not fully realized unless there is some intervention. The intervention could be taken by the government, we will talk about this in later lectures or maybe society has decided that they will not purchase products by firms who are polluting. Social preferences can shift business behaviors away from polluting and engaging in other activities that may have costs to society. Identify policies for coping with the overallocation of resources caused by negative externalities: - Direct controls - Direct controls - Liability rules and lawsuits - Specific taxes - Private bargaining - Markets for externality rights When a producers marginal cost of supply curve is to the right of (or below) the full cost marginal cost curve, this represents the fact that: its supply curve does not capture all the costs legitimately associated with the production of its goods. Lecture 5: Positive Externalities Positive Externality The next type of externality is a positive externality, or external benefit. A positive externality occurs when there is a benefit to someone other than the consumer of the product. These external benefits mean there are benefits to society as a whole, that are not considered when examining the traditional demand and supply market. A positive externality is an example of a demand side failure. We will use our demand and supply diagram to analyze the concept of demand side failure and the underallocation of resources that occurs as a result of external benefits. Going back to our discussion of demand side failures, we know the buyer is not the only one who benefits from the purchase. When the buyer is not only one who feels benefit of consumption the demand curve is lower than the optimal level. A lower demand means the price and quantity are lower than the efficient level. Since quantity is less than optimal society is under allocating resources toward the production of the good. Example of a Positive Externality: Suppose you decide to purchase a home in an older part of town. The house is in a residential area and there are few local businesses nearby. However, a city investment project fixes up a set of retail buildings in the neighborhood. This causes a variety of new stores to open locations in the neighborhood, including restaurants, coffee shops, and boutiques. The increased number of businesses within walking distance to your home has driven up the value of your home. In less than two years since purchasing the home the value of your home has increased 10 percent. The increased value of your home has come at no direct cost to you. A positive externality has an uncompensated spillover benefit. A positive externality (or spillover benefit) resulting in an underallocation of resources to the market is a type of market failure. Examples of markets that are more likely to experience positive externalities: immunizations, education Graphically Now that we have determined what a positive externality is, we will examine underallocation of resources graphically. In the graph below the demand curve D reflects the demand curve where only the benefit of the direct consumers of the product is taken into account. We can see the equilibrium between the demand curve D and the supply curve S has an equilibrium price of P and equilibrium quantity Q. However, we know that there are others who benefit from the transaction other than the direct consumer. Adding the external benefits to the direct consumer's benefits our demand curve increases to D1. The increased demand curve causes the price and quantity to rise to P1 and Q1. The difference between Q and Q1 show the underallocation of resources caused by the positive externality. When positive external benefits occur, the market demand curve lies to the left of, or below the full-benefits demand curve. The market demand curve for positive externalities reflects only the direct, private benefits to those who demand and use the product. Takeaways Even though the efficient outcome occurs at Q1, the market will not operate at this level of output unless there is an intervention in the market. Positive externalities, like public goods, are difficult to provide at the optimal level without government intervention. We will talk about how governments can work to incentivize consumption to move the economy toward the efficient allocation of resources and optimal quantity. The optimal quantity of a public good will be where marginal benefit equals marginal cost. When the marginal benefit exceeds the marginal cost, additional abatement (reduction) of a community problem may move society toward economic efficiency. When demand curves underreport how much consumers are willing and able to pay for a good this represents: a demand-side market failure. Lecture 6: Price Ceiling A price celling is the maximum legal price a seller may charge for a product or service. With a price ceiling, the quantity of a product demanded will exceed quantity supplied, resulting in a persistent shortage of the product. When a price ceiling is established, the new price and quantity are now at disequilibrium. At any price above the equilibrium price, such as with a price floor, quantity supplied will be greater than the quantity demanded, resulting in a persistent excess supply or surplus of the product. Price controls or ceilings mandated in the apartment rental market benefit the consumer by establishing a price below the free market equilibrium price. When a price ceiling is enacted, the new price is established below the old equilibrium price, quantity demanded rises and quantity supplied falls thus creating disequilibrium. The function and purpose of enacting a price ceiling is: to enable consumers to obtain some “essential good or service they could not afford at the equilibrium price. Now that we have examined the common types of market failures, goods at that are non-excludable such as public goods and common goods, and negative and positive externalities, we will examine the ways that governments intervene to move the market toward more efficient outcomes. Before we start with government intervention, let's quickly review the initial outcomes of these types of failures and the desired level of quantity. Public Goods Without government intervention public goods may not be provided at all. The non-excludable nature of the good typically means that no consumer is willing and able to provide the good to all others in society. The non-excludable, non-rival nature of the good means the product is often under produced and resources are under allocated toward its production. The optimal quantity would be higher than the initial quantity. Common Goods Common goods too are non-excludable, but also rival. This means that often times consumption of these goods is too high. Since no one can be excluded from consuming the good many people attempt to consume the product. The overconsumption begins to deplete the good, since it is rival in nature. Without more production, which suppliers may not be willing or able to do, since it is difficult to make a profit from a non-excludable good, the good will fully deplete and no more of the good will be left in the market. The optimal quantity is less than the quantity that is initially bought and sold in the market. Negative Externalities Negative externalities occur in markets with spillover costs. These costs cause supply to be greater than the optimal level. The higher level of supply means the quantity produced in the market is larger than optimal and resources are overallocated. Positive Externalities Positive externalities occur in markets with external benefits. Since individuals other than the buyer experience the benefit of consumption, the optimal demand is larger than the initial demand. The since the optimal demand should be higher than the initial level, the quantity produced in the market is less than optimal and resources are under allocated. Now that we have revisited the ideal level of output that each type of market failure, we can begin to look at corrections that the government may use to move the economy toward the optimal, efficient level. The first set of government interventions are price controls. Price controls are government set prices that will influence the quantity demanded and quantity supplied in the market. This lecture will focus on price ceiling and the next will examine price floors. Price Ceilings – a government set price maximum. Price above the price ceiling = illegal. A price ceiling is a government set maximum price for the market. Firms in the market can charge no more than the amount of the price ceiling. If a firm attempted to charge a price above the price ceiling it would be an illegal price. For example, if the government set a price ceiling of $4 in a market and a firm was charging $3 for the good, there would be no effect on the market. The firm would continue to charge $3 and the price would be legal. However, if the firm was charging $5 for the good, the price is illegal. The government has stepped in and said any price above $4 is illegal, you cannot charge $5. The firm would need to lower their price to $4 in order to comply with the law. If the market price is above the price ceiling the government action is said to be binding, or a binding price ceiling is present. If the price in the market is at or below equilibrium the price ceiling is not binding and will have no effect on the market. Let's look at example of a price ceiling graphically. The graph below depicts a normal demand and supply curve. Before beginning let's determine the equilibrium price and quantity. The equilibrium occurs at a price of $4 and a quantity of 40 units. If the price was set above $4, such as $5 the market would not be in equilibrium, surpluses would exist. Market forces would push the price down toward equilibrium attempting to eliminate all surpluses. If the price was set below $4, say $2 the market would also not be in equilibrium, shortages would exist. Market forces would push the price up toward equilibrium attempting to eliminate all shortages. This will hold true for any market -- the market will always attempt to move toward the equilibrium. However, suppose the government has decided this market has a market failure associated with it and decides to intervene in the market with a price ceiling. A price ceiling is the maximum price a firm can charge, any price above the price ceiling is illegal. Price Ceiling Above Equilibrium If the price ceiling is set above the equilibrium price there will be no effect on the market. For example, if the government decides to place the price ceiling at $6 any price above $6 would be illegal, prices of $7, $8... would all be illegal. However, firms are currently selling the good for $4, a price that is legal under the price ceiling law. Firms will continue to sell the product at $4, they will not increase the price to $6 as a result of the price control. Increasing the price to $6 would result in a surplus and market forces would move the price back toward equilibrium. A price ceiling above the equilibrium is not binding. The market will remain in equilibrium. Price Ceiling Below Equilibrium If a price ceiling is set below the equilibrium price the equilibrium will become an illegal price. For example, if the government decides to place a price ceiling of $2 on the market, any price above $2 would be illegal. Prices of $3, $4, $5… would all be illegal. Since firms are currently selling the good for $4, the price becomes illegal. Firms will be unable to sell their good for $4 and will now be forced to lower their prices. Market forces will move the price as close to equilibrium as possible, to maintain the smallest shortage possible. The highest possible price that firms will be able to charge is $2. At $2, the quantity demanded is 50 units (the demand curve at a price of $2). At $2 the quantity supplied is 20 units (the supply curve at a price of $2). This will result in a shortage. Even though the market will want to move up to $4 to eliminate the shortage, it is not possible based on the government set price. The binding price control will result in a shortage for the market. A price ceiling below the equilibrium is binding. The market will experience a shortage. Binding Price Ceilings A binding price ceiling means the price has been restricted to below the equilibrium price. There is a greater quantity demanded than quantity supplied. So how will the market respond. In the example above the quantity demanded was 50 units and the quantity supplied was 20 units. For simplicity let's assume each buyer wishes to buy one unit (so there are 50 buyers each wanting to purchase one unit) and each seller wishes to sell one unit (so there are 20 sellers each wanting to sell one unit). We know there is a shortage of 30 units, but what does this mean for the market? Since there are only 20 units for sale, the quantity that is bought and sold in the market is 20 units. The binding price ceiling has caused the quantity to be reduced from 40 units to 20 units. A price ceiling can be an effective tool in reducing the quantity when a market failure has caused an overallocation of resources. If a market failure is causing the market to produce too much, a binding price ceiling can be effective in reducing the quantity that is bought and sold in the market. But at what cost? The quantity that is bought and sold in the market has been reduced, but at what cost? An equilibrium is efficient because the goods are consumed by the buyers who value the goods the most highly and produced by the sellers who can do so at the lowest cost. The binding price ceiling will maintain that the sellers with the lowest cost will remain in the market. The reduced price (from $4 to $2) has caused only sellers who are willing and able to produce the good for $2 to remain in the market. Sellers with a higher cost of production will no longer participate. Now, what about the buyers? At $4, only buyers who were willing and able to purchase the product for $4 were included in the market. But as the price falls to $2 the law of demand tells us the quantity demanded will increase. We see this as an increase in the quantity demanded from 40 units to 50 units. The additional 10 buyers in the market have a lower willingness and ability to purchase the product, but are now able to join the market due to the lower price. There are 20 units of the good for sale and 50 people who wish to purchase the good. How does the market decide which consumers purchase the good and which are left wanting to purchase, but unable to find a seller? The market is unable to solve this problem. Market forces will attempt to drive up prices, but will be unsuccessful due to the price ceiling. Other mechanisms must be used to determine which consumers get the goods. They may include discrimination, black markets, long lines, etc. However, it may no longer be the case that the consumers who most highly value the good are the ones that consume the good. This brings about a different inefficiency to the market when the government is attempting to correct a failure. Lecture 7: Price Floor A price floor in the wheat market benefits producers and is nonbeneficial for consumers. Price floors are invoked when a society feels that the free market has no provided sufficient income for resource suppliers or producers. Now that we have examined the government set maximum price, we will focus our attention on minimum price controls. Whereas in the last lecture we used a demand and supply diagram we will use a demand and supply schedule in this lecture to get experience using both methods. You should be able to determine the effect of a price control using both methods. Price Floors A price floor is a government set minimum price for the market. Firms in the market must receive at least the amount of the price floor. Any firm attempting to provide the good for a price below the price floor it would be providing it at an illegal price. Let's look at an example, if the government set a price floor of $10 in a market and a firm was charging $13 for the good, there would be no effect on the market. The firm would continue to charge $13 and the price would be legal. However, if the firm was charging $7 for the good, that price is illegal. The government has stepped in and said any price below $10 is illegal, you cannot charge $7. The firm would need to increase their price to $10 in order to comply with the law. If the market price is below the price floor the government action is said to be binding, or a binding price floor is present. If the price in the market is at or above equilibrium, the price floor is not binding and will have no effect on the market. Price Floor – a government set price minimum. Any price below the price floor is illegal. Next, let's examine a price floor using a demand and supply schedule. The schedule below depicts demand for a good based on the law of demand and supply for a good based on the law of supply. Before beginning let's determine the equilibrium price and quantity. We know the equilibrium price and quantity occurs when the quantity demanded is equal to the quantity supplied. This occurs at a price of $10 and 60 units. We also know that market forces will push the market toward equilibrium. If the price were to fall below $10 a shortage would occur. Sellers would respond to the shortage by increasing prices until all of the units produced were sold. If the price were above $10 a surplus would exist. Sellers would respond to the excess supply but reducing prices until the quantity supplied is exactly equal to the quantity demanded. When the market is left alone, market forces move prices and quantities to equilibrium. However, let's suppose that the government has decided there is a market failure associated with this market and a price floor must be put in place. Remember, price floors are price minimums and any price below the price floor has been declared illegal by the government. Price Floors Below Equilibrium If the price floor is set below the equilibrium price there will be no effect on the market. For example, if the government decides to place the price floor at $5 any price below $5 would be illegal, prices of $4, $3, $2,... would all be illegal. However, firms are currently selling the good for $10, a price that is legal under the price floor law. Firms will continue to sell the product at $10, they will not reduce the price to $5 as a result of the price control. Reducing the price to $5 would result in a shortage and market forces would move the price back to equilibrium. A price floor at or below the equilibrium is not binding. The market will remain in equilibrium. Price Floor Above Equilibrium If a price floor is set above the equilibrium price the equilibrium will become an illegal price. For example, if the government decides to place a price floor of $20 on the market, any price below $20 would be illegal. Prices of $15, $10, $5,... would all be illegal. Since firms are currently selling the good for $10, the price becomes illegal. Firms will be unable to sell their good for $10 and must increase their prices. Market forces will move the price as close to equilibrium as possible, to maintain the smallest surplus possible. The lowest possible price that firms will be able to charge is $20. At $20, the quantity demanded is 20 units and the quantity supplied is 100 units. This will result in a surplus of 80 units. Even though the market will want to reduce the price to $10 to eliminate the surplus, it is not possible based on the government set price. The binding price control will result in a surplus for the market. A price floor above the equilibrium is binding. The market will experience a surplus. Binding Price Floors You may be thinking, sellers would love to sell their output at a higher price. They would much rather sell their goods at a price of $20 rather than $10, and you are correct. They would like to sell their goods for the highest possible price, however if they cannot find any buyers for those goods, they are not able to make the sale. Let's examine work though the effect of the binding price floor on the market, which sellers produce the good and which buyers consume the good. We have already established that a binding price floor occurs above the equilibrium price, so at $20 there would be a binding price floor. The law of supply tells us that sellers are happier about the situation. The quantity supplied has increased as a result of the binding price floor, from 60 units at $10 to 100 units at $20. The higher price has caused sellers who were not willing and able to supply the product at $10 to enter into the market at $20. Higher cost producers are now in the market, as well as the original low-cost producers. The higher prices had the opposite effect on buyers, the law of demand tells us the higher price will cause the quantity demanded in the market to fall. This is what happens as the quantity demanded falls from 60 units to 20 units. Since consumers only wish to purchase 20 units that is the amount that is bought and sold in the market. Even though sellers would happily provide the market with 100 units, they are only able to sell 20 units. While the higher price may make producers happier, they are not happy about the reduction in the number of buyers. If they cannot find buyers for their goods, they are unable to earn revenues and a sitting a on a surplus of the good, unable to sell the product. Market forces attempt to reduce the price, but the price floor does not allow the price to drop. Again, in an efficient market the buyers that most highly value the good are the ones consuming the goods and the sellers that produce the good at the lowest cost are the ones that supply the good. The limited number of buyers that remain in the market are the ones that most highly value the good, but both high-cost and lowcost sellers are in the market. Buyers will have the power to determine which sellers they will purchase from. Buyers may base their decision on a variety of different characteristics, customer service, quality, name-brand, etc. are all potential ways buyers may decide. Both price floors and price ceilings cause the quantity bought and sold in the market to fall below the equilibrium quantity. They can be useful if resources are overallocated toward the production of a good and too much is produced. Depending on the goal of the intervention, the government may desire higher prices for suppliers or lower prices for buyers. However, if the price control is binding the market will limit the quantity bought and sold in the market. But keep in mind, these policies do come at a cost to society. Note: Students often confuse a floor with below equilibrium since it seems lower and a ceiling with above equilibrium since it seems higher. This is incorrect. Be sure to write your notes carefully and fully understand the concept before moving onto the worksheet and exam. A good that could be produced by the market system (since exclusion is possible), but government provides it in order to avoid an underallocation of resources is called quasi-public good. Why aren’t outdoor fireworks displayed provided by private firms? - It is impossible to raise enough revenue to cover the costs of the displays - People do not have to pay to enjoy the fireworks A polluting producer supply curve lies father to the right than it does when the firm bears the full costs of production. In the imposition of a price floor, the quantity supplied exceeds the quantity demanded. Lecture 8: Taxes In this lecture we will examine the effect of taxes on the market. In the United States we pay many different types of taxes, some you may be more familiar with than others. Personal income taxes due each April, sales taxes on our non-grocery purchases, gas tax, property tax, payroll taxes, state and local taxes, and the list goes on. Many of these taxes are more complex than what we will be covering in this lecture, or even in this class. There are many resources available if you are interested in learning more about taxes, Marginal Revolution University and Khan Academy have some videos on these topics, Investopedia is another great tool that you can use to learn more. In this class we will be making some assumptions about taxes that limit their application to the real world, but all taxes will function in a similar manner so understanding this lecture will give you a basic understanding of how taxes work. What is it called when those who benefit the most from governmentsupplied goods or services should pay the taxes necessary to finance them? Benefits-paid principle. How is a tax classified as progressive, regressive, or proportional? – the relationship between average tax rates and taxpayer incomes Based on the relationship between average tax rates and taxyer payer incomes, what are the classifications of taxes? - Regressive - Progressive - Proportional - With Progressive tax, the average tax rate increases as income increases. When the average tax remains the same as income increase, the tax is considered – proportional What kind of income tax is the income tax of the United States considered? Progressive What factors contribute to the US tax system being less progressive than indicated by the average tax rates? deductions of interest on home mortgages and deduction of property tax A general sales tax tends to be regressive because a larger portion of low-income’s persons income is exposed to the tax. With a flat 35% corporate income tax, the federal corporate income tax tends to be proportional. Payroll taxes like Social Security and Medicare are considered regressive because the social security tax is only applied to a fixed amount of income. Payroll taxes are more regressive than indicated because they only apply to wage and salary income and ignore incomes from rents and dividends. Why are property taxes considered regressive? - Property taxes are higher in poor areas to make up for the low value of the property - Property tax represent a higher proportion of income for low-income earners. What type of tax structure does the federal tax system tend to represent? Progressive. Assumptions Before our discussion begins, we will need to clarify the assumptions that we are making. Our first assumption is the seller will be paying the tax or writing the checkout to the government. As a buyer in the market you pay for the good and the tax, but do not need to send the money to the government. This is how many taxes in the United States works, we do not see the gas tax we pay each time we purchase a gallon of gas. Unlike the gas tax, we do see the sales tax amount printed at the bottom of the receipt, but again the seller is taking care of sending the money to the government. Our second assumption, and not as common in the real world, is that our tax will be a per-unit tax or excise. When a tax is placed on the market, we will assume the tax is a dollar amount for each unit purchased rather than a percentage of the price. In the United States we commonly percentage taxes rather than per- unit taxes. For example, a sales tax is listed as a percentage, say 7%. Personal income taxes, payroll taxes, and property taxes are also a percent. This assumption will make it easier to read our graph and does not influence the takeaway. If you continue studying economics, you will move into more difficult tax concepts such as per-unit or marginal tax rates. Taxes, An Example The best way to understand the impact of taxes on the market is to work through an example. Our analysis of taxes, and subsidies, will all be completed using a demand and supply diagram. All components of the tax are easily visible this way. That being said, analyzing the market after a tax has been implemented is one of the most difficult concepts for students during the entire semester. Many students struggle with this concept and the best advice I can give is to practice and rework, practice and rework. Let's start by analyzing the market below: In this market we have an equilibrium price of $4 and 40 units are bought and sold. (If you are unable to determine the equilibrium at this point in the semester I strongly recommend reaching out for help.) Now, let's suppose that a $3.00 per unit tax is placed on the market that the seller is responsible for paying. Since the seller is responsible for the tax, we will adjust the supply curve. Recall that the tax is a per-unit tax so if you buy one unit you will pay the price of the good, plus $3 for the tax. In equilibrium we were initially paying $4. We will now need to pay $7 (price of $4 plus the tax $3). We will add three dollars to the price for each quantity point provided. - At a quantity supplied of 10 the price was $1, adding the tax it is now $4. - At a quantity supplied of 20 the price was $2, adding the tax it is now $5. - At a quantity supplied of 30 the price was $3, adding the tax it is now $6. - At a quantity supplied of 50 the price was $5, adding the tax it is now $8. - At a quantity supplied of 60 the price was $6, adding the tax it is now $9. We will use these calculations to determine our new supply curve with tax. (Plot the price and quantity supplied for a Supply tax curve.) Now that the tax has been implemented, the market faces a new supply curve. The old supply curve is no longer relevant, the price buyers pay has now gone up. We will need to calculate our new equilibrium based on the demand and Supplytax curve. The new equilibrium price is now $6 and the new equilibrium quantity is now 30 units. Why didn't the equilibrium remain at 40 units? Now that the tax has been implemented in the market buyers face higher prices. The law of demand tells us an increase in price causes the quantity demanded to fall. Our new supply curve shows that the quantity supplied remains 40 units at a new price plus tax of $7, but at $7 the buyers are only willing and able to 25 units. Our market would be in disequilibrium and a surplus would result. To eliminate the surplus sellers would reduce their price, in this case to $6. At $6 the quantity demanded is 30 units and the quantity supplied (with the tax) is 30 units. Our new equilibrium. When a tax is placed on the market there is a reduction in the quantity that is bought and sold. We have seen that buyers are unhappy about the higher price they must pay and so they reduce the quantity demanded, but what happened to the amount that sellers receive? If your initial thought is that it went up from the old equilibrium price of $4 to the new equilibrium price of $6, that is NOT correct. Remember, they must send $3.00 for each unit sold to the government. If they receive a price of $6.00 and must send $3.00 to the government, they are only left with $3.00! The price that sellers receive also went down as a result of the tax! They too are less happy with the situation. Who is happy about the situation then, or who benefits? Tax revenue is collected, so the beneficiaries of the tax do benefit from the tax revenue. When we have a perunit tax, the tax revenue is calculated as the new equilibrium quantity (intersection of demand and supply tax curves) times the amount of the tax. In our case the new equilibrium is 30 units and the amount of the tax is $3.00 so the tax revenue collect is $90. Takeaways When a tax is placed on a market the equilibrium quantity falls. The quantity bought and sold in the market falls because both buyers and sellers are worse off. The buyers pay a higher price due to the tax and the sellers receive a lower price due to the tax. Both events cause the quantity bought and sold to be reduced based on their respective laws. If everyone is worse off when taxes are placed on markets, why do we use taxes? Taxes do allow governments to collect tax revenues. This is how many governments provided goods, such as our roadways, education system, national defense, etc. are funded. Without taxes it would be difficult for the government to provide these goods to society. The other reason governments decide to implement taxes on markets is when they believe there is a market failure occurring. If a market is producing too much of a good, an overallocation of resources, the government can intervene by placing a tax on the market. The tax will reduce the quantity that is bought and sold in the market and move the market toward a more efficient outcome. When we initially discussed the market system, we talked about government's role was "active, but limited." We were referring to governments stepping in when a market failure exists and moving the market toward a more efficient outcome. The use of taxes is one way of doing so. In the real world you do hear politicians’ reference this. Social Security taxes exist because they government was attempting to reduce market failures associated with elderly poverty by providing a public savings program for workers. In the market for gasoline, a tax was implemented to help fund roads because no one consumer was willing or able to provide the public good and the government needed a source of revenue to fund the project. In the market for tanning (in a tanning bed) the government placed a tax on the market to reduce consumption in hopes of reducing future skin cancer diagnosis. Typically, when we hear the government discussing a new tax or an increase in an existing tax, they will discuss the reason in terms of a market failure to justify the intervention. Whether the intervention is warranted, is your decision. The answer would be a normative economic statement. Market failures can be used to justify government invention in the economy. How can the government deal with the underallocation of resources resulting from positive externalities? - By subsidizing consumers - By providing goods via government - By subsidizing suppliers Examples of experience positive externalities? - Education - immunizations Government can improve the allocation of resources in an economy by correcting for market failures caused by externalities. When producers intentionally or unintentionally pass some of the costs of production onton the community, resources for production are overallocated to the commodity, producing too much output and causing negative externalities to occur. Government can use direct controls and specific taxes to counter negative externalities and it may provide subsidies or public goods to deal with positive externalities. What are some of the obstacles that government faces when trying to correct market failures? - Identify the market failure - Adopting corrective actions - Identifying the cause of the market failure Lecture 9: Subsidies Much of our discussion on subsidies will follow that of taxes. We will make the same assumptions, the subsidy will be a per-unit subsidy and the seller will receive the subsidy, not the buyer. We will work through an example to analyze the market outcome and discuss it's uses in helping the government improve market outcomes. A subsidy to a producer is a payment from the government to decrease the producers’ cost to encourage more supply of a product beneficial to society. Government can finance the provision of public goods through taxes. Subsidies, An Example For an example of subsidy, let's use the same example that we used for the tax discussion. From there we can determine the effect of a subsidy. Recall that a subsidy is a negative tax. Instead of the seller having to mail a check to the government, they will receive money from the government. The money they will receive allows the firm to reduce the price to buyers. For example, if a subsidy of $3.00 is placed on the market, at the initial equilibrium shown below, the price would fall to $1.00, the government would pay the seller the $3.00 subsidy and the seller would receive a total of $4.00. The same as under the equilibrium with no subsidy. Using this same reasoning lets work through a $3.00 subsidy for each of the quantities provided. - At a quantity price is $0. At a quantity price is $2. At a quantity price is $3. At a quantity price is $4. At a quantity price is $5. supplied of 30, the price was $3, subtracting the subsidy the supplied of 50, the price was $5, subtracting the subsidy the supplied of 60, the price was $6, subtracting the subsidy the supplied of 70, the price was $7, subtracting the subsidy the supplied of 80, the price was $8, subtracting the subsidy the Using this information, we can plot the Supply Subsidy curve. Now that the subsidy has been implemented the market faces a new supply curve. The old supply is no longer relevant, and the price buyers pay has gone down. We can calculate the new equilibrium based on the demand and Supply Subsidy curve. The new equilibrium price is now $2, and the new equilibrium quantity is now 50 units. Similar to the change in the market after a tax, the market has changed once a subsidy has been implemented. Many times, in the media and from friends and family you will hear how consumers always feel the full pain of a tax or maybe that the seller receives all the benefit of a subsidy. Now you know that is not true. The subsidy of $3.00 that was given to sellers was partially passed on to consumers. Prior to the subsidy the buyers were paying $4. After the subsidy they are paying $2! They are better off and happier about the subsidy! As the price falls the law of demand tells us the quantity demanded will increase. We see this in our new equilibrium. But what about sellers? Why do they agree to the lower price? Recall that sellers do not just receive the $2.00 from buyers, they also receive the $3 from the government. In the end they receive a total of $5, which is better than the $4 they were receiving before the subsidy. The law of supply tells us that as the price increases the quantity supplied for sellers will also increase. So, if buyers and sellers both benefit from a subsidy, where is the downside? Why don't we subsidize all goods if buyers and sellers are both better off? The subsidy does cost someone, the government, or more specifically the taxpayers who are funding the subsidy. For every unit that is bought and sold the government must pay the sellers $3. In our market this totals $150 ($3 * 50 units). If there is a cost to taxpayers but only those engaging in the market benefit, why would the government implement a subsidy? It may be the case that there are external individuals that do benefit from the market. If there is a positive externality present in the market providing a subsidy can move the market toward a more efficient outcome. If the government can tax only those individuals who specifically benefit from the market transactions, but are not engaged in the transactions, our economy becomes more efficient. We will talk more about the role of subsidies in correcting market failures in our finial lecture. Ability-to-pay principle – when the tax burden is apportioned based upon the taxpayers’ income? The benefits-received principle means that people who benefit from government provided goods pay the taxes to finance the goods. Using the benefits-received principle can be difficult because public goods are characterized by nonrivalry and nonexcludability making the benefits widespread and diffuse. The marginal tax rate is the rate paid on each additional dollar of income (or purchases). The average tax rate is the total tax paid as a percentage of income. Suppose that the technology for pollution-control equipment improve noticeably. One would except: - The cost of pollution abatement to fall - Society’s marginal cost curve (MC) to shift rightward - The optimal quantity level of abatement to rise Lecture 10: Government Intervention The role of government in a market economy is to remain active but limited in their interventions. Under a market system, governments limit their intervention to markets where failures occur. The government interventions are intended to move the market toward a more efficient outcome. We will review the basic market failures discussed in this section and the tools governments may use to push the market toward a more efficient outcome. In the final lecture of this section we will examine the government interventions that can occur in order to improve the efficiency of a market when failure occurs. The market failures that we have discussed in this section are 1) Common Goods 2) Public Goods 3) Negative Externalities and 4) Positive Externalities. We have also discussed some forms of government intervention. We will add a couple more to our list as we go through the way's governments may improve market outcomes. Government Invention may be needed to achieve economic efficiency when positive or negative externalities affect large numbers of people or when community interests are at stake. Characteristics of public goods: non-rivalry, non-excludability. If a good is nonrival and nonexcludable then it is known as a public good. - Example of rivalrous goods: John eats an apple for lunch, Mary drinks a can of Pepsi. Excludability means that buyers who are willing and able to pay the market price for the product obtain its benefits, but those unable or unwilling to pay price do not. Examples of public goods: army helicopters, highways, fire stations, police cars, national defense. - Quasi-public goods include education, streets and highways, police and fire protection, libraries, etc; they could all be priced and provided by private firms through the market system because the free-rider problem would be minimal. But, because spillover benefits extend well beyond the individual buyer, the market system may underproduce them. Therefore, government often provides quasi-public goods. o Example: post offices, parks Governments can use direct controls and specific taxes to counter negative externalities and it may provide subsides or public goods to deal with positive externalities. Direct controls have dominated American air pollution policy? - Uniform emission standards - Limits on allowable pollution Private bargaining, markets for externality rights, specific taxes, liability rules and lawsuits, and directs controls are all examples of: how to cope with the over allocating of resources caused by negative externalities Direct controls on pollution raise the marginal cost of production because: the firms must purchase, operate and maintain pollution control equipment A policy approach to negative externalities is for government: to levy taxes or fines specifically on the related goods As pollution continues to be reduced: the marginal cost to firms and society rises. If the cost to a community to completely eliminate waste from an old landfill which has been cleaned up to meat EPA standards is very expensive but would benefit some community members economically, then the community should consider not doing the project. Under what circumstances would government intervene and prevent prices from rising or falling to their equilibrium levels? - Prices are too high for consumers - Prices are too low for firms Which of the following causes shortages or surpluses, distortions in resource allocation, and negative side effects? Government-control prices Underallocation of Resources Both public goods and positive externalities cause an underallocation of resources in the market. For the government to improve the market outcome they would need to incentivize greater production and consumption of goods in these markets to move the economy toward a more efficient outcome. For public goods, there are times that the good is not produced at all due to the non-excludable nature of the good. Since sellers are unable to prevent individuals who do not pay from consuming the good, it can be difficult to make the good profitable. If no firm is willing to supply the good the supply curve will remain at a 0 quantity for all price levels. Positive externalities also face the problem of underallocation of resources, or too little produced, but in most cases, there is some level of production. Positive externalities do not necessarily face the same challenge of non- excludability that public goods do. Positive externalities can occur in any types of market, for example vaccinations are considered a private good. The graph below is the one we used to describe a market where a positive externality is present. The underallocation can be seen as the difference between Q1 and Qe. The most efficient level of production would be Q1, however the economy is currently operating at Qe. For a public good the initial quantity may fall all the way to zero. So, the question becomes how can the government improve the market outcome? One way is to introduce a subsidy on the market. Our analysis of a subsidy examined only a subsidy provided to producers, but a subsidy to consumers will result in the same outcome, a greater allocation of resources. If the government is able to determine the level of subsidy that would push the equilibrium quantity to Q1, they would move the market toward a more efficient market. Even if the government was unable to exactly predict the amount of subsidy required, it is likely they will move the market toward a more efficient outcome and begin to reduce the problem of under allocated resources. A subsidy can also be used in the case of a public good. However, it may need to be very large to be effective in bringing producers into the market to supply the good. The producers would need to cover all costs associated with production with the subsidy since individuals do not necessarily need to pay for the good in order to consume it. Another method for improving the underallocation of resources in markets with a public good or positive externality is by directly providing the good. If the government were to provide the good, like in the case of national defense or roadways, they can move an economy toward an efficient outcome. Governments can work to improve market failures of under production through the use of subsidies, either for buyers or sellers, or direct provision of the good or service. The use of resources is only efficient if all benefits and costs are fully reflected in the market demand and supply curves. The market demand for a private good is the horizontal summation of the individual demand schedules. When a demand curve reflects none of its consumers’ willingness to pay the good will be a public good. What is it called when demand fails to account for the buyers full willingness to pay? Demand side market failure In determining the market demand for a public goods: we vertically sum the prices that people are willing to pay for the last unit of the public good at each possible quantity demanded. In determining the market demand for a private good: we horizontally add the quantities demanded at each possible price. The government will provide a public good where there are positive externalities and the externalities are large. Overallocation of Resources Common goods and negative externalities cause too much production or consumption of a good. For the government to improve the market outcome they would need to incentivize less production and consumption in these markets to move the economy toward a more efficient outcome. For common goods, there are times that the good is consumed until the point of depletion. This is sometime the case for natural resources and wildlife. Negative externalities also face the problem of overallocation of resources, or too much produced. Negative externalities do not necessarily face the same challenge depletion that common goods do, but the overconsumption of the good has a negative impact on society as a whole. The graph below is the one we used to describe a market where a negative externality is present. The overallocation can be seen as the difference between Q and Q1. The most efficient level of production would be Q1, however the economy is currently operating at Q. In this case the government will need to reduce the quantity that is bought and sold in the market. One way to do this is through the use of taxes, specifically Pigouvian taxes. These taxes are placed on markets were inefficiencies occur in hopes of moving the market toward a more efficient outcome. In order to move the market to the most efficient allocation, Q1, the government would need to determine the exact size of the tax that shifts the supply curve to S1. However, even if the government is unable to know the exact amount needed, they can still move the market toward a more efficient outcome by placing a tax on the market. We also discussed price ceilings and price floors as mechanisms for reducing the quantity bought and sold in the market. While these do not provide the government with tax revenue, they can adjust prices to further help the buyer or seller. A binding price ceiling lowers the price that buyers must pay for the good, while reducing the quantity bought and sold in the market. A binding price floor increases the price sellers receive. Depending on which party the government wishes to help will determine which price control the government places on the market. The final method that governments may employ for reducing production is through direct controls. A government may decide to set the maximum quantity that can be produced by sellers in the market. If the government knows the optimal level, they can state that amount as the direct control. However, reducing the quantity produced in any way will move the economy toward a more efficient outcome by pushing the economy back toward the socially optimal level of output. Since the total profit from the sale of five bottles of water is $1.00, representing a 20% profit margin, this a reason to “tap the market”. The collective demand curve measures society’s marginal benefit of each unit of a particular good. When does it mean when the demand curve which represents all of the benefits of a good lies above the supply curve representing all of the costs? The marginal benefit exceeds marginal cost of each of these goods. Which of the following explains how the government provides the optimal quantity of a public good? It compares the marginal benefit of an added unit of the good against the governments marginal cost of providing it. Which of the following help highlight the reasons why the law of diminishing marginal returns may make it undesirable to completely eliminate pollution? - Cleaning up the second 10% of pollutants from an industrial smokestack normally is more costly than cleaning up the first 10% - Cleaning up the last 10% of pollutants from an industrial smokestack normally is the most costly reduction of all. - Cleaning up the third 10% of pollutants from an industrial smokestack normally is more costly than cleaning up the second 10% Which of the following subsides to producers to correct for an underallocation of resources caused by a lack of consumer demand for a product beneficial to society? - Tax credit to vaccine drug makers - Cash payments from government to pharmaceutical firms making vaccines A less direct action than passing legislation to correct a negative externality is levy a specific tax on the producers of the related good. A specific tax applied to the producer of a good in order to correct a negative externality will cause what change to the market for that good? Supply curve shifts left. Which of the following is one of the major requirements of the Clean Air Act of 1990? Forced factories and business to install advanced pollution control technology to reduce emissions. A form of economic efficiency called allocative efficiency is achieved when the quantity of output at equilibrium is produced. When all benefits and costs are fully reflected in the market demand and supply curves of a product, then resource us is considered: efficient Government may place legal limits on prices when it is determined that prices are unfairly high for buyers or unfairly low for sellers. These explain why economists “sound the alarm” when politicians advocate government-control prices such as price ceiling or price floors? - Government-controlled prices may cause potential environmental damage - Government-controlled price distort resource allocation - Government-control prices causes surpluses - Government-controlled prices cause shortages Government-controlled prices cause: - Surpluses - Distortions in resource allocation - Shortages