Case Econ08 Ppt 15

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & Yvonn Quijano

15Chapter

Externalities, Public Goods,Imperfect Information,and Social Choice

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2 of 35© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Chapter Outline

15Externalities, Public Goods,Imperfect Information,

and Social Choice Externalities and Environmental EconomicsMarginal Social Cost and Marginal-Cost PricingPrivate Choices and External EffectsInternalizing ExternalitiesPublic (Social) GoodsThe Characteristics of Public GoodsMixed GoodsIncome Distribution as a Public Good?Public Provision of Public GoodsOptimal Provision of Public GoodsLocal Provision of Public Goods: Tiebout HypothesisImperfect InformationAdverse Selection: Asymmetric InformationMoral HazardMarket SolutionsGovernment SolutionsSocial ChoiceThe Voting ParadoxGovernment Inefficiency: Theory of Public ChoiceRent-Seeking RevisitedGovernment and the Market

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EXTERNALITIES, PUBLIC GOODS, IMPERFECT INFORMATION, AND SOCIAL CHOICE

market failure Occurs when resources aremisallocated or allocated inefficiently.

The existence of externalities, public goods, and imperfect information are examples of market failure.

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EXTERNALITIES AND ENVIRONMENTAL ECONOMICS

externality A cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction. Sometimes called spillovers or neighborhood effects.

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marginal social cost (MSC) The total cost to society of producing an additional unit ofa good or service. MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damagecosts involved in the process of production.

MARGINAL SOCIAL COST AND MARGINAL-COST PRICING

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FIGURE 15.1 Profit-Maximizing Perfectly Competitive Firms Will Produce Up to the Point That Price Equals Marginal Cost (P = MC)

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Acid Rain and the Clean Air Act

Acid rain is an excellent example of an externalityand of the issues and conflicts in dealing with externalities.

The case of acid rain highlights the fact that efficiency analysis ignores the distribution of gains and losses. That is, to establish efficiency we need only to demonstrate that the total value of the gains exceeds the total value of the losses.

Other Externalities

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PRIVATE CHOICES AND EXTERNAL EFFECTS

FIGURE 15.2 Externalities in a College Dormitory

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marginal damage cost (MDC) The additional harm done by increasing the level of an externality-producing activity by one unit. If producing product X pollutes the water in a river, MDC is the additional costimposed by the added pollution that results from increasing output by one unit of X perperiod.

When economic decisions ignore external costs, whether those costs are borne by oneperson or by society, those decisions are likely to be inefficient.

marginal private cost (MPC) The amount that a consumer pays to consume anadditional unit of a particular good.

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INTERNALIZING EXTERNALITIES

Five approaches have been taken to solving the problem of externalities:

(1) government-imposed taxes and subsidies,

(2) private bargaining and negotiation,

(3) legal rules and procedures,

(4) sale or auctioning of rights to imposeexternalities, and

(5) direct government regulation.

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Taxes and Subsidies

FIGURE 15.3 Tax Imposed on a Firm Equal to Marginal Damage Cost

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Bargaining and Negotiation

Coase theorem Under certain conditions, when externalities are present, privateparties can arrive at the efficient solution without government involvement.

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Legal Rules and Procedures

injunction A court order forbidding the continuation of behavior that leads to damages.

liability rules Laws that require A to compensate B for damages imposed.

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Selling or Auctioning Pollution Rights

Singapore is known for its many laws designed to reduce negative externalities. Littering, chewing gum in public, eating on a subway car, failing to flush a toilet, andvandalizing public property are all considered serious offenses that are punishable by imprisonment, fines, and/or public chastisement.

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Direct Regulation of Externalities

Taxes, subsidies, legal rules, and public auction are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against their benefits.

Direct regulation of externalities takes place at the federal, state, and local level.

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PUBLIC (SOCIAL) GOODS

public goods (social or collective goods) Goods that are nonrival in consumptionand/or their benefits are nonexcludable.

In an unregulated market economy with no government to see that they are produced,public goods would at best be produced in insufficient quantity and at worst not producedat all.

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nonrival in consumption A characteristic of public goods: One person’s enjoyment of the benefits of a public good does not interfere with another’s consumption of it.

THE CHARACTERISTICS OF PUBLIC GOODS

nonexcludable A characteristic of most public goods: Once a good is produced,no one can be excluded from enjoying its benefits.

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free-rider problem A problem intrinsic to public goods: Because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them.

drop-in-the-bucket problem A problem intrinsic to public goods: The good or service is usually so costly that its provision generally does not depend on whether or not any single person pays.

Consumers acting in their own self-interest have no incentive to contribute voluntarily to the production of public goods. Some will feel a moral responsibility or social pressure to contribute, and those people indeed may do so. Nevertheless, the economic incentive is missing, and most people do not find room in their budgets for many voluntary payments.

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MIXED GOODS

mixed goods Goods that have characteristics that are part public and part private.

INCOME DISTRIBUTION AS A PUBLIC GOOD?

If we accept the idea that redistributing income generates a public good, private endeavors may fail to do what we want them to do, and government involvement may be called for.

PUBLIC PROVISION OF PUBLIC GOODS

When members of society get together to form a government, they do so to provide themselves with goods and services that will not be provided if they act separately.

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OPTIMAL PROVISION OF PUBLIC GOODSSamuelson’s Theory

FIGURE 15.4 With Private Goods, Consumers Decide What Quantity to Buy; Market Demand Is the Sum of Those Quantities at Each Price

The price mechanism forces people to reveal what they want, and it forces firms to produceonly what people are willing to pay for, but it works this way only because exclusionis possible.

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FIGURE 15.5 With Public Goods, There Is Only One Level of Output, and Consumers Are Willing to Pay Different Amounts for Each Level

For private goods, market demand is the horizontal sum of individual demandcurves—we add the different quantities that households consume (as measured on thehorizontal axis). For public goods, market demand is the vertical sum of individualdemand curves—we add the different amounts that households are willing to pay to obtain each level of output (as measured on the vertical axis).

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FIGURE 15.6 Optimal Production of a Public Good

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optimal level of provision for public goods The level at which resources are drawn from the production of other goods and services only to the extent that people want the public good and are willing to pay for it. At this level, society’s willingness to pay per unit is equal to the marginal cost of producing the good.

At the optimal level, society’s total willingness to pay per unit is equal to the marginal cost of producing the good.

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The Problems of Optimal Provision

To produce the optimal amount of each public good, the government must know something that it cannot possibly know—everyone’s preferences.

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Tiebout hypothesis An efficient mix of public goods is produced when localland/housing prices and taxes come to reflect consumer preferences just as they do in the market for private goods.

LOCAL PROVISION OF PUBLIC GOODS: TIEBOUT HYPOTHESIS

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IMPERFECT INFORMATION

adverse selection Can occur when a buyer or seller enters into an exchange with another party who has more information.

ADVERSE SELECTION: ASYMMETRIC INFORMATION

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moral hazard Arises when one party to a contract passes the cost of its behavior on to the other party to the contract.

MORAL HAZARD

It is impossible to know everything about behavior and intentions. If a contract absolves one party of the consequences of its action, and people act in their own self-interest, the result is inefficient.

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MARKET SOLUTIONS

Like consumers, profit-maximizing firms will gather information as long as the marginalbenefits from continued search are greater than the marginal costs.

GOVERNMENT SOLUTIONS

Information is essentially a public good and is nonrival in consumption.

When information is very costly for individuals to collect and disperse, it may be cheaper for government to produce it once for everybody.

There is an efficient quantity of information production.

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SOCIAL CHOICE

social choice The problem of deciding what society wants. The process of adding up individual preferences to make a choice for society as a whole.

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SOCIAL CHOICE

THE VOTING PARADOX

impossibility theorem A proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent,nonarbitrary results.

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SOCIAL CHOICE

FIGURE 15.7 Preferences of Three Top University Officials

TABLE 15.1 Results of Voting on University’s Plans: The Voting Paradox

VOTES OF:

Vote VP1 VP2 Dean Result a

A versus B A B A A wins: A > BB versus C B B C B wins: B > CC versus A A C C C wins: C > A

aA > B is read “A is preferred to B.”

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SOCIAL CHOICE

voting paradox A simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistentresults. A commonly cited illustration of the kind of inconsistency described in theimpossibility theorem.

logrolling Occurs when congressional representatives trade votes, agreeing tohelp each other get certain pieces of legislation passed.

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SOCIAL CHOICE

GOVERNMENT INEFFICIENCY: THEORY OF PUBLIC CHOICE

To understand the way government functions, we need to look less at the preferences ofindividual members of society and more at the incentive structures that exist around publicofficials.

RENT-SEEKING REVISITED

Theory may suggest that unregulated markets fail to produce an efficient allocation of resources. This should not lead you to the conclusion that government involvementnecessarily leads to efficiency. There are reasons to believe that government attempts to produce the right goods and services in the right quantities efficiently may fail.

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GOVERNMENT AND THE MARKET

GOVERNMENT INEFFICIENCY: THEORY OF PUBLIC CHOICE

There is no question that government must be involved in both the provision of public goods and the control of externalities.

The question is not whether we need government involvement. The question is how much and what kind of government involvement we should have.

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adverse selectionCoase theoremdrop-in-the-bucket problemexternalityfree-rider problemimpossibility theoreminjunctionliability ruleslogrollingmarginal damage cost

(MDC)marginal private cost (MPC)marginal social cost (MSC)

REVIEW TERMS AND CONCEPTS

market failure

mixed good

moral hazard

nonexcludable

nonrival in consumption

optimal level of provision for public goods

public goods (social or collective goods)

social choice

Tiebout hypothesis

voting paradox

Case Econ08 Ppt 15

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Transcript of Case Econ08 Ppt 15