What is the Free Market?•A economic structure where supply and demand allocate resources. There is little to no government intervention.
What is the Invisible Hand?The concept that society’s goals will be met as individuals seek their own self-interest.Competition and self-interest act as an invisible
hand that regulates the free market.
Example: People love the green shirts that a firm is making…..
What is a Free Market Failure?
•When the free-market system fails to satisfy society’s wants.•Private markets do not efficiently bring about the allocation of resources.
What’s the result…The government must step in to
satisfy society’s wants.
Four Market Failures
1. Public Goods2. Externalities 3. Monopolies4. Unfair distribution of income
In each of the above situations, the government MUST step in to fix the
problem.
Why must the public sector provide goods and services?
•It is impractical for the free-market to provided these goods because there is no opportunity to earn profit.• This is due to the Free-Rider Problem
•Free Riders are individuals that benefit without paying.
PUBLIC GOODS
•Free-Riders keep firms from making profits.•If left to the free market, essential services would be under produced.
What’s wrong with Free Riders?
Two criteria of public goods:1. Nonexclusion
PUBLIC GOODS
2. Shared Consumption (nonrivalry)
•Everyone can use the good.•Cannot exclude benefits of the good for those who will not pay.•Ex: National Defense
•One person’s consumption of a good does not reduce the usefulness to others.
•Ex: Kit Carson Park
Can there every be too much of a public good?
Can there be too many parks?
How does the government determine what quantity of public goods to produce?
They use Supply and Demand
Demand for Public Goods-The Marginal Social Benefit of the good determined by citizens willingness to pay.
Supply of Public Goods- The Marginal Social Cost of providing each additional quantity.
Marginal Willingness to Pay Higher Taxes
Quantity
Adams’Willingness
to pay (price)
Benson’sWillingness
to pay (price)
Society’sWillingness
to pay (price)
1 $4 $5 $9+ =
DEMAND FOR A NEW HIGHWAY
Quantity
Adams’Willingness
to pay (price)
Benson’sWillingness
to pay (price)
12
$4 3
$5 4
$9 7
++
==
Society’sWillingness
to pay (price)
DEMAND FOR A NEW HIGHWAYMarginal Willingness to Pay Higher
Taxes
Quantity
Adams’Willingness
to pay (price)
Benson’sWillingness
to pay (price)
123
$4 3 2
$5 4 3
$9 7 5
+++
===
Society’sWillingness
to pay (price)
DEMAND FOR A NEW HIGHWAYMarginal Willingness to Pay Higher
Taxes
Quantity
Adams’Willingness
to pay (price)
Benson’sWillingness
to pay (price)
1234
$4 3 2 1
$5 4 3 2
$9 7 5 3
++++
====
Society’sWillingness
to pay (price)
DEMAND FOR A NEW HIGHWAYMarginal Willingness to Pay Higher
Taxes
Quantity
Adams’Willingness
to pay (price)
Benson’sWillingness
to pay (price)
12345
$4 3 2 1 0
$5 4 3 2 1
$9 7 5 3 1
+++++
=====
Society’sWillingness
to pay (price)
DEMAND FOR A NEW HIGHWAYMarginal Willingness to Pay Higher
Taxes
Price
Quantity of Highways
$ 9 7
5
3
1
0 1 2 3 4 5
D=MSB
OPTIMAL AMOUNT OF A PUBLIC GOOD
The Demand is the equal to the marginal benefit
to society
P
Q
$ 9 7
5
3
1
0 1 2 3 4 5
The public good’smarginal cost
S=MSC
OPTIMAL AMOUNT OF A PUBLIC GOOD
D=MSB
P
Q
$ 9 7
5
3
1
0 1 2 3 4 5
D=MSB
S=MSC
OPTIMAL AMOUNT OF A PUBLIC GOOD
Theoptimum amount
of the public good
MSB = MSC
Why shouldn’t 2 highways be made?
Why shouldn’t 4 highways be made?
•An externality is a third-person side effect.•Externalities are when there are either EXTERNAL benefits or external costs to someone other than the original decision maker. Why are Externalities Market Failures?•The free market fails to include external costs or external benefits causing misallocation of resources. Example: Smoking Cigarettes.•The free market assumes that the cost of smoking is fully paid by people who smoke. •The government recognizes external costs and makes policies to limit smoking.
What are Externalities?
•Decisions that result in a cost for a different person other than the original decision maker.•The costs “spillover” to other people or society.
EX: Zoram is a chemical company that pollutes the air when it produces its good. •Zoram only looks at its INTERNAL costs.•The firms ignores the social cost of pollution•So, the firm’s marginal cost curve is its supply curve•When you factor in EXTERNAL costs, Zoram is producing too much of its product.•The government recognizes this and limits their production.
Negative Externalities (aka: Spillover Costs)
P
Q
D=MSB
0
Supply = Marginal
Private Cost
Qe
The marginal cost doesn’t include the costs to society.
P
Q0
Spillovercosts
Qe
What will the MC look like when EXTERNAL cost are factor in?
Supply = Marginal
Private Cost
D=MSB
P
Q0 Qe
Supply = Marginal
Private Cost
Supply = Marginal
Social Cost
This is the REAL supply curve
D=MSB
P
Q0
S=MSC
S= Private
Overallocation
QOptimal Qe
Compare MSB and MSC at Qe
Is too much or too little being produced?
D=MSB
Positive Externalities (aka: Spillover Benefits)
•Decisions that result in a benefit for someone other than the original decision maker.•The benefits “spillover” to other people or society.(EX: Flu Vaccines, Education, Home Renovation)
Example: A mom decides to get a flu vaccine for her child•Mom only looks at the INTERNAL benefits.•She ignores the social benefits of a healthier society.•So, her private marginal benefit is her demand •When you factor in EXTERNAL benefits the marginal benefit and demand would be greater.•The government recognizes this and subsidizes flu shots.
P
Q0 Qe
S=MC
Demand=Marginal Private Benefit
The marginal benefit doesn’t include the benefits to society.
P
Q0
SpilloverBenefits
Qe
What will the demand look like when EXTERNAL benefits are factor in?
Demand=Marginal Private Benefit
S=MC
P
Q0 Qe
This is the REAL demand curve
Demand=Marginal Private Benefit
S=MC
Demand=Marginal Social Benefit
P
0 Qe
D=MPB
S=MC
D=MSB
Compare MSB and MSC at Qe
Is too much or too little being produced?
UnderallocationQOptimal
P
Q
CORRECTING SPILLOVER COSTS
D
0
Spillovercosts
S=MSC
S Private
TAX
OverallocationCorrected
Q0 Qe
(Solution: Tax the amount of the externality)
P
Q
CORRECTING SPILLOVER BENFITS
0 QOptimalQe
D Private
S
D=MSB
SpilloverBenefits
UnderallocationCorrected
(Subsidize either producers or consumers the amount of the externality)
Economics of PollutionWhy are public bathrooms so gross?
The Tragedy of the Commons (AKA: The Common Pool Problem)•Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted since no one has the incentive to keep them clean. •There is no monetary incentive to use them efficiently.•Result is high spillover costs.
WHAT ARE ANTITRUST LAWS?Laws designed to prevent monopolies and promote competition.
Why are monopolies a Market Failure?
•Monopolies destroy the key ingredient of the free market system- Competition. •To fix this MARKET FAILURE the government must get involved.•Identify the socially optimal and fair return points.
Income Inequality In 2001, the average American family made $66,863. Everyone is obviously rich.
What’s wrong with using the average?
Averages reveal absolutely nothing about how income is distributed.
How does the government measure distribution of income?
Measuring Income Distribution Review the process:• The government divides all income earning
families into five equal groups (quintiles) from poorest to richest.
• Each groups represents 20% of the population.• If there was perfect equality then 20% of the
families should earn 20% of the income, 40% should earn 40% (and so on)
• The government compares how far the actual distribution is from perfect distribution then attempts to redistribute money fairly.
20 40 60 80 100
100
80
60
40
20
0
Percent of Families
Per
cen
t o
f In
com
ePerfect Equality
THE LORENZ CURVE
20 40 60 80 100
100
80
60
55
40
30
2015
5 0
Percent of Families
Per
cen
t o
f In
com
e
THE LORENZ CURVE
Perfect Equality
Lorenz Curve (actual distribution)
20 40 60 80 100
100
80
60
40
20
0
Percent of Families
Per
cen
t o
f In
com
ePerfect Equality
Lorenz Curve (actual distribution)
Area betweenthe lines shows
the degree ofincome inequality
THE LORENZ CURVE
20 40 60 80 100
100
80
60
40
20
0
Percent of Families
Per
cen
t o
f In
com
e Perfect Equality
Lorenz Curve (actual distribution)
THE LORENZ CURVE
We have a Market Failure.Income is extremely unfairly
distributed.How does this get fixed?
20 40 60 80 100
100
80
60
40
20
0
Percent of Families
Per
cen
t o
f In
com
e Perfect Equality
Lorenz Curve (actual distribution)
THE LORENZ CURVE
Lorenz curveafter government
re-distribution
Three Types of Taxes
What kind of taxes are these? (THINK % of Income)1. Toll road tax ($1 per day)2. State income tax where richer citizens pay higher % 3. $.45 excise tax on cigarettes4. Medicare tax of 1.45% of every dollar earned 5. 6% California sales tax
1. Progressive Taxes -takes a larger percent of income as income rises (takes more from rich people) Ex: Current Federal Income Tax system
3. Regressive Taxes –takes a larger percentage from low income groups. (takes more from poor people) Ex: Sales tax; any consumption tax.
2. Proportional Taxes (flat rate) –takes the same percent of income from all income groups. Ex: 20% flat income tax on all income groups
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