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Market Failure

Ch 4 – Public Sector. Market Failure. Our goal is to produce the optimal mix of output , the most desirable combination of output attainable with existing resources, technology and social values. Market failure occurs when an imperfection in the market mechanism prevents optimal outcomes.

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Market Failure

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  1. Ch 4 – Public Sector Market Failure • Our goal is to produce the optimal mix of output, the most desirable combination of output attainable with existing resources, technology and social values. • Market failure occurs when an imperfection in the market mechanism prevents optimal outcomes.

  2. Computers (units per time period) All Other Goods (units per time period) Market Failure Production possibilities X (Optimal mix) M (Market mix)

  3. Causes of Market Failure Four specific sources of market failure: • Public goods • Externalities • Market power • Equity

  4. Public Goods • Publicgood - good or service whose consumption by one person does not exclude consumption by others. • Free rider - an individual who reaps direct benefits from someone else’s purchase (consumption) of a public good.

  5. Public Goods • Markets tend to under-produce public goods and over-produce private goods. • If we want more public goods, we need a non-market force — government intervention — to get them.

  6. Externalities • Externalities - costs (or benefits) of a market activity borne by a third party. • When externalities are present, market prices aren’t a valid measure of a good’s value to society. • The market will under-produce goods that yield external benefits and over-produce those that generate external costs.

  7. External Costs • Social demand equals market demand plus externalities — the externality is subtracted if it is an external cost. • The optimal production mix is where the social demand curve intersects the supply curve.

  8. Market supply EM External cost per pack EO Price (per pack) Market demand qO qM Social demand Quantity of Cigarettes (packs per year) Externalities

  9. Market Power • When a firm has market power it has the ability to alter the market price of a good or service. • Producer can maximize profits rather than produce the optimal mix of output.

  10. Market Power - Monopoly • Monopoly - firm that produces the entire market supply of a particular good or service. • Government follows an antitrust policy when it intervenes to alter market structure or prevent abuse of market power.

  11. Market Power - Natural Monopoly • Natural monopoly - industry in which one firm can achieve economies of scale over the entire range of market supply. • The government may have to regulate the behavior of a natural monopoly to ensure that consumers get the benefits of its cost efficiency.

  12. Equity • The distribution of goods and services generated by the marketplace is not necessarily “fair.” • Transfer payments are made to individuals for which no current goods or services are exchanged, like Social Security, welfare, unemployment benefits.

  13. 31% 28% 26% 20% 19% 19% 16% 14% 7% U.S. Israel Japan Canada Sweden Denmark Germany Switzerland Great Britain Public-Sector Spending(percentage of total output)

  14. Government Growth

  15. Income Taxes Tax Structures: • Progressive – As incomes increase, % of income paid toward tax increases. • Proportional – All incomes pay same % of income toward tax. • Regressive – As incomes increase, % of income paid toward tax decreases.

  16. Excise Taxes • Excise taxes - imposed on certain goods and services – examples include liquor, gasoline, cigarettes, and telephone service. • Excise taxes discourage production and consumption of these goods.

  17. Corporate income taxes 7% Excise taxes 4% Other Customs duties 1% taxes Estate and gift taxes 1% 8% Miscellaneous 2% Individual income tax Social 43% Security taxes 40% Federal Taxes

  18. Corporate 6% Other 5% Property 2% Other 9% Sales 18% Income Income 5% 37% Sales Property 46% 72% STATE TAX SOURCES LOCAL TAX SOURCES State and Local Tax Sources

  19. Government Failure • Governments, like markets, can fail. • Government failure occurs when government intervention fails to improve economic outcomes.

  20. Cost-Benefit Analysis • Additional public-sector activity is desirable only if the benefits from that activity exceed its opportunity costs. • The value of public services must be estimated because they don’t have (reliable) market prices.

  21. Ballot-Box Economics • Voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them. • We do not know what the real demand for public goods is, and votes alone do not reflect the intensity of individual demands.

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