Market Failure

Market Failure When the market does not efficiently

allocate resources Either too much or too little is produced

Monopoly Externalities Public goods Imperfect Information

Justification for government

intervention?

Externalities Occur when decision makers do not consider all

costs (or benefits) of their actions

Two views

A.C. Pigou(1877-1959)

Ronald Coase(1910)

“Spillover effects”

All pollution should be eliminated.

a) b) c) d) e)

0% 0% 0%0%0%

a) Strongly Agreeb) Agreec) Neutrald) Disagreee) Strongly Disagree

Pigouvian ApproachSocial Cost = Private Cost + External Cost

Drinking Alcohol

Price of beerHangover

Damage to othersBoorish behavior

Pollution

Free Market: P1, Q1

Optimal Outcome: P2, Q2

steel

$

D1

Sprivate

Q1

P1

P2

Q2

Ssocial

External cost

How can society achieve social optimum?

Impose tax = marginal external cost

Free market overproduces goodsthat generate a negative externality

Internalize the externality!

“Pigou tax”

$1.00

$1.25

$1.50

$1.75

$2.00

$2.25

$2.50

$2.75

$3.00

$3.25

$3.50

$3.75

$4.00

$4.25

$4.50

$4.75

$5.00

$5.25

$5.50

$5.75

$6.00

$6.25

0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

Tuna (tons)

Pri

ce

D

Sprivate

Ssocial

Sorry, Charlie

The efficient output will be less than the free market output when:a) Marginal social cost and marginal

private cost are equalb) Marginal social cost is greater

than marginal private costc) Marginal social benefit and

marginal private benefit are equal

d) Marginal social benefit is greater than marginal private benefit

Education

Free Market: P1, Q1

Optimal Outcome: P2, Q2

Years ofCollege

$

Dprivate

S1

Q1

P1

P2

Q2

Dsocial

External benefit

How can society achieve social optimum?

Provide subsidy = marginal external benefit

Free market underproduces goodsthat generate a positive externality

If there is a positive externality, the:

a) social benefits will be greater than the private benefits

b) external benefits will be greater than the social benefits

c) social benefits will be equal to the private benefits

d) private benefits will be greater than the social benefits

a) social benefits will be greater than the private benefits

b) external benefits will be greater than the social benefits

c) social benefits will be equal to the private benefits

d) private benefits will be greater than the social benefits

Coasian Approach Externalities are due to incomplete

property rights assignment

Externalities are due to incomplete property rights assignment

“It takes two to tango”

Coasian Approach

Coase TheoremIf property rights are well-defined and transactions costsare low enough, then private bargaining can result in anefficient allocation of resources.

CorollaryAllocation of resources does not depend on initial assignment of property rights.

Externalities are due to incomplete assignment of property rights

Externalities are due to incomplete assignment of property rights

Cheshire, Ohio v. AEP

AEP paid $20 million to buy the 221-resident town in 2002

Pollution Worksheet Optimal pollution for Marietta-Parkersburg

area is 60,000 units of emissions Abatement Cost

Cars: $5 Utilities: $10 Factories: $20

Controlling pollution through: Standards Taxes Tradable Permits

Cap and Trade Program

permits

$

$20

$10

$5

40 70 90

F

U

C

D

S

60

Abatement Cost

P = $10Q = 60,000

“$200,000 Solution”

Acid Rain Market: SO2

2010 Spot Auction

2010 7-yr Advance Auction

Source: http://www.epa.gov/airmarkt/progress/ARP_1.html

Characteristics of Goods Excludability: can you be excluded from consuming the good?

Rivalry: does my consumption hinder your consumption?

Rival Non-rival

Excludable

Non-Excludable

Private GoodsArtificially Scarce Goods

orNatural Monopoly

Common Resources

Public Goods

Government Provided Goods and Services

Schools Roads Police Courts Fire Department Water Library Health Care Transportation

Schools Roads Police Courts Fire Department Water Library Health Care Transportation

National Defense Social Security Medicare Postal Service FBI, CIA, SEC, FTC,

FCC, NSF, FDA, ARC, FDIC, NLRB, HUD

National Defense Social Security Medicare Postal Service FBI, CIA, SEC, FTC,

FCC, NSF, FDA, ARC, FDIC, NLRB, HUD

National Defense Federal Government spent $779b on defense in 2009

537,2$000,000,307

000,000,000,779$

How do we pay for this?

Taxes!

Per capita expenditure

Public Goods “free-rider” problem

Under-provision by free market

Social Optimum requires: MSB = MSC Output can only be provided at one level for all Must find some way to aggregate individual MB

Fireworks in Marietta

Quantity

Gretchen’s MB

Cort’sMB

Yanan’s MB

ΣMB MC Total Benefit

Total Cost

Net Benefits

10 $8 $5 $9 $22 $10 $22 $10 $12

20 $7 $4 $8 $19 $10 $41 $20 $21

30 $6 $3 $6 $15 $10 $56 $30 $26

40 $5 $2 $4 $11 $10 $67 $40 $27

50 $4 $1 $2 $7 $10 $74 $50 $24

60 $3 $0 $1 $4 $10 $78 $60 $18

a) 0b) 1c) 2d) 3e) 4f) 5

The table below shows the marginal benefit from submarines for the only two citizens of a country. Submarines are a public good. If submarines cost $145 a piece to produce, what is the efficient quantity of submarines?

Katie YoutianMarginal

benefit (dollars per

sub)

Quantity

Marginal benefit (dollars per sub)

-- 0 --

100 1 150

75 2 100

50 3 50

25 4 10

0 5 0a) b) c) d) e) f)

0% 0% 0%0%0%0%

Common Resources

Non-excludable Rival in consumption

African Elephant 1980: 1.3m 1990: 0.6m

Fish in the sea Bison in America

CITES

Campfire

“Tragedy of the commons”

"Why would I tolerate living or coexisting with an elephant that is so destructive?" says the village chief."It destroys our crops, our fields, our trees, our environment. It is because of the value associated with the elephant that makes us coexist with it."

Artificially Scarce Goods Excludable Non-Rival

Digital info Movies Music Books

Pharmaceuticals

Marginal Cost of provision is zero

DMC

QM

PM

QC

Drugs

$

MR

A factory's production process creates sludge that pours into a river. This sludge makes it difficult to fish in the river, increasing the costs of the local fishermen by $5000. The factory can install a water filter system for $4100, and the fishermen can utilize a weighted fishing net system (to get under the sludge) for $3250. Both systems would remedy the sludge damage to the fishermen.

What outcome would you expect under the following conditions:a) Transactions costs low and factory is not liable for damage?b) Transactions costs low and factory is liable for damage?c) Transactions costs high and factory is liable for damage?

Factory Filter: $4100Nets: $3250

Damage: $5000

Health Care Reform

Objectives: Expand insurance coverage Lower health care costs

Private Insurance Social Insurance Revenue Provisions

Health Care Reform

Information Asymmetry Moral Hazard (Hidden actions)

Insurance markets Employer-Employee relationship

Adverse Selection (Hidden characteristics)

Insurance markets Used car market

Solutions? Signaling: Informed party takes action Screening: Uninformed party takes action Government regulation?

Private Insurance Reforms Insurance rules

Community rating (age, area, family size, and tobacco use) Guaranteed issue (can’t deny for pre-existing condition) Prohibit lifetime limits on coverage Dependent children on parent’s plan until age 26 Establish health insurance exchanges

Individual Health Insurance Mandate Tax credit subsidies up to 400% poverty $695 fine (or 2.5% income) if you don’t buy

Employer Health Insurance Mandate $2000 fine per employee for firms N > 50 Tax credit subsidies to small employers High cost plan excise tax (t = 40%)

1960 1970 1980 1990 2000 20100%

10%

20%

30%

40%

50%

60%

Share of Personal Health Care Expenditures by Source of Funds

Out of pocketHealth InsFedState%

of

PH

CE

Source: http://www.cms.hhs.gov/NationalHealthExpendData/

Suppose you are covered under health insurance or belong to a Health Maintenance Organization (HMO), and you are insured against all or most of the costs of visits to the doctor. As a result you are likely to make greater use of medical services of all kinds. This tendency of people with insurance to change their behavior in a way that leads to more claims against the insurance company is called:

a) b) c) d)

0% 0%0%0%

a) Adverse selectionb) Moral hazardc) Screening d) Signaling

Public Choice Theory Public Interest vs Self Interest Political Actors

Politicians

Voters

Special Interest Groups

Median Voter

In a two-party race, candidates have incentive to move toward the middle Positioning Coalition building

V R1D1 D2 D3 R3 R2

Popular Vote Cast for US President

Year Winner % Loser % Margin

1960 Kennedy 49.7 Nixon 49.5 0.2

1964 Johnson 61.1 Goldwater 38.5 22.6

1968 Nixon 43.4 Humphrey 42.7 0.7

1972 Nixon 60.7 McGovern 37.5 23.2

1976 Carter 50.1 Ford 48.0 2.1

1980 Reagan 50.7 Carter 41.0 9.7

1984 Reagan 58.5 Mondale 40.6 17.9

1988 Bush I 53.4 Dukakis 45.6 7.8

1992 Clinton 43.0 Bush 38.0 5.0

1996 Clinton 49.2 Dole 40.7 8.5

2000 Bush II 47.9 Gore 48.4 -0.5

2004 Bush II 51.0 Kerry 48.0 3.0

2008 Obama 52.9 McCain 45.7 7.2

Public Choice Theory Public Interest vs Self Interest Political Actors

Politicians Median voter hypothesis

Voters Rational ignorance

1924 1932 1940 1948 1956 1964 1972 1980 1988 1996 20040%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Voter Participation Rates: US Presidential Elections1924 - 2008

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 20080%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Voter Participation Rates: US House of Representatives1960 - 2010

Public Choice Theory Public Interest vs Self Interest Political Actors

Politicians Median voter hypothesis

Voters Rational ignorance

Special Interest Groups Rent seeking Concentrated benefits and dispersed costs

Labor unionsIndustry groupsAARP

Dairy price supports: $900 millionBenefit to farmers: $900m/65,000 = $13,846Cost to taxpayers: $900m/142m = $6.34

Social Choice Mechanisms Condorcet’s Paradox

Arrow’s Impossibility Theorem

Chandler Phoebe Monica

First Choice CSI Glee True Blood

Second Choice Glee True Blood CSI

Third Choice True Blood CSI Glee

CSI v Glee: CSI winsGlee v True Blood: Glee winsCSI v True Blood: True Blood wins