Chapter 8: Market Failure Versus Government Failure

McGraw-Hill/IrwinCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter GoalsExplain what an externality is and show how it affects the market outcomeDefine public good and explain the problem with determining the value of a public good to societyDescribe three methods of dealing with externalitiesExplain how informational and moral hazard problems can lead to market failureExplain why market failure is not necessarily a reason for government interventionMarket FailuresGovernment failures are when the government intervention actually makes the situation worseA market failure is a situation in which the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomesExternalitiesPublic goodsImperfect informationExternalitiesExternalities are the effects of a decision on a third party that are not taken into account by the decision-makerNegative externalities occur when the effects are detrimental to othersEx. Second-hand smoke and carbon monoxide emissionsPositive externalities occur when the effects are beneficial to othersEx. EducationAlternative Methods of Dealing with ExternalitiesDirect regulation is when the government directly limits the amount of a good people are allowed to use Incentive policiesTax incentives are programs using a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired endsMarket incentives are plans requiring market participants to certify that they have reduced total consumption by a certain amountVoluntary reductionsMarket Incentive PoliciesA market incentive plan is similar to direct regulation in that the amount of the good consumed is reducedA market incentive plan differs from direct regulation because individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to othersIncentive policies are more efficient than direct regulatory policiesVoluntary ReductionsVoluntary reductions allow individuals to choose whether to follow what is socially optimal or what is privately optimalThe socially conscious will often become discouraged and quit contributing when they believe a large number of people are free ridingFree rider problem is individuals’ unwillingness to share the cost of a public goodThe Optimal PolicyAn optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policyResources are being wasted if a policy isn’t optimalFor example, the optimal level of pollution is not zero pollution, but the amount where the marginal benefit of reducing pollution equals the marginal costPublic GoodsA public good is nonexclusive and nonrivalNonexclusive: no one can be excluded from its benefitsNonrival: consumption by one does not preclude consumption by othersThere are no pure public goods; national defense is the closest exampleMany goods provided by the government have public good aspects to themPublic GoodsA private good is only supplied to the individual who bought itOnce a pure public good is supplied to one individual, it is simultaneously supplied to allIn the case of a public good, the social benefit of a public good (its demand curve) is the sum of the individual benefits (value on the vertical axis)To create market demand, private goods: sum demand curves horizontallypublic goods: sum demand curves verticallyInformational and Moral Hazard ProblemsPerfectly competitive markets assume perfect informationIn the real world, buyers and sellers do not usually have equal information, and imperfect information can be a cause of a market failureAn adverse selection problem is a problem that occurs when buyers and sellers have different amounts of information about the good for saleA moral hazard problem is a problem that arises when people don’t have to bear the negative consequences of their actionsInformational and Moral Hazard ProblemsSignaling may offset information problemsSignaling refers to an action taken by an informed party that reveals information to an uninformed party that offsets the false signal that caused the adverse selection in the first placeSelling a used car may provide a false signal to the buyer that the car is a lemonThe false signal can be offset by a warrantyPolicies to Deal with Informational ProblemsRegulate the market and see that individuals provide the correct informationLicense individuals in the market and require them to provide full information about the good being soldAllow markets to develop to provide information that people need and will buyGovernment Failures and Market FailuresAll real-world markets in some way failMarket failures should not automatically call for government intervention because governments fail, tooGovernment failure occurs when the government intervention in the market to improve the market failure actually makes the situation worseReasons for Government Failures Government doesn’t have an incentive to correct the problemGovernment doesn’t have enough information to deal with the problemIntervention in markets is almost always more complicated than it initially seemsThe bureaucratic nature of government intervention does not allow fine-tuningGovernment intervention leads to more government interventionChapter Summary An externality is the effect of a decision on a third party that is not taken into account by the decision makerPositive externalities provide third-party benefits and markets for these goods produce too little for too great a priceNegative externalities impose third-party costs, and markets produce too much for too low a priceEconomists generally prefer incentive-based programs, such as a tax on the producer of a good with a negative externality, because incentive-based programs are more efficient than regulatory programs.Chapter Summary Voluntary solutions are difficult to maintain because people have an incentive to be free ridersAn optimal policy is one in which the marginal cost of the undertaking equals its marginal benefitPublic goods are nonexclusive and nonrival Adverse selection occurs when buyers or sellers withhold information causing the market for the good to disappearLicensure and full disclosure are solutions to the information problemChapter Summary Government failure occurs because:Governments don’t have an incentive and/or enough information to correct the problemIntervention is more complicated than it initially seemsThe bureaucratic nature of government precludes fine-tuningGovernment intervention often leads to more government intervention