The Role of Government • Capitalism is associated with limited government, but government is necessary for three reasons: • Establish and maintain legal system to protect property rights. • Promote equity in the distribution of income and wealth. • Correct inefficiencies that arise from markets (externalities, public goods, and monopoly power). • Public Finance/Choice is the area of economics that studies the public sector. • Incentives are different in markets versus political sphere– in capitalism preference are revealed with purchases versus votes.
Another Look at Efficiency • Efficiency in competitive markets occurs where MB=MC. Where MB= private (max.) willingness to pay and MC= private (min.) willingness to sell. • More correctly, society will see the outcome as efficiency where marginal social benefits = marginal social costs. • Externalities drive a wedge between private and social benefits and private and social costs.
Supply (private cost) Equilibrium MB=MC Demand (private value) QMARKET Figure 1 The Market for Aluminum Price of Aluminum Quantity of 0 Aluminum
Externalities • Externalities are benefits (costs) received (borne) by neither the seller or the buyer but by third parties. • Private benefits + external benefits = social benefits • Private costs + external costs = social costs • Since external benefits and costs are not perceived by buyers and sellers they are not captured in markets. • Therefore, markets may fail to allocate resources inefficiently.
Negative externalities • Marginal social costs are greater than marginal private costs. • Pollution is a cost that may not be borne by sellers, but it is a cost nonetheless to society. • Private markets will overproduce (devote too many resources) to the production of goods with negative externalities. • External costs and the supply curve. • Missing the extra costs, markets generate an outcome where MSC > MSB, signal that decreasing output will increase net social benefits. • Is zero pollution efficient?
Social Cost =MSC Cost of pollution Supply (private cost) =MPC Optimum Equilibrium Demand (private value) MPB=MPB QOPTIMUM QMARKET Figure 2 Pollution and the Social Optimum Price of Aluminum MSC MSC MSB MSB Quantity of 0 Aluminum
Positive externalities • Marginal social benefits are greater than marginal private benefits. • Education is a benefit not only to the individual but to society in general. • Private markets will underproduce (devote too few resources) to the production of goods with positive externalities. • External benefits and the demand curve. • Missing the extra benefits, markets generate outcomes where MSB > MSC, a signal that increasing production will increase net social benefits.
Supply (private cost) Social value Demand (private value) QOPTIMUM QMARKET Figure 3 Education and the Social Optimum Price of Education MSB The market does too little MSB>MSC MSC Quantity of 0 Education
Internalizing or Correcting Externalities • Efficiency versus who ought to modify their behavior? • Moral and Ethical Codes • Non-governmental organizations or Charities • Integrating certain activities (bee keepers and fruit growers) • Contract between parties • Coase Theorem – if negotiation costs are zero, private parties can resolve the problem of externalities. • An optimal compensatory payment (bribe) = one that makes both parties better off. • Initial distribution of rights does not affect the efficient outcome, but it does determine who will pay whom. • Example of heating the apartment in Santiago
Government policies • Regulation • Limits to pollution • Specific technology requirements • Government production • Regulation and least cost solutions • Taxes and Subsidies • Who should pay the tax or receive the subsidy? • Tax /subsidy incidence is the same • External costs, supply (demand) and the optimal tax. • External benefits, demand (supply) and the optimal subsidy.
Tradeable Pollution Permits • The higher costs of avoiding pollution, i.e. the higher the benefits from polluting, the more a firm is willing to pay. • Criticism of Economic Solutions to Pollution • To live is to pollute • Natural carrying capacity
The Invisible Hand and Invisible Benefits and Costs • Externalities are “invisible” to buyers and sellers in markets. In some cases, government action may be needed to make them visible and ensure they are included in economic decision-making. • The efficient allocation of resources occurs where: MSB=MSC
Public Goods and Common Resources • Certain kinds of goods or services are underproduced in markets because the market does not contain sufficient incentives to produce them in efficient amounts. • Certain kinds of resources are overused because they are owned collectively or people cannot prevent them from being used.
Classifying Different Kinds of Goods and Services • Exclusion or non-exclusion– can individuals be excluded from consuming the good or the resource. (e.g. hamburger, houses, physical examination versus fireworks, national defense, and the ocean outside of territorial waters)? • Rival or non-rival – does one person’s use of the good or resource affect another persons use. (e.g. hamburger versus lighthouse, uncongested versus congested highway)
• Ice-cream cones • Fire protection • Clothing • Cable TV • Congested toll roads • Uncongested toll roads • Fish in the ocean • Tornado siren • The environment • National defense • Congested nontoll roads • Uncongested nontoll roads Figure 1 Four Types of Goods Rival? Yes No Private Goods Natural Monopolies Yes Excludable? Common Resources Public Goods No
Private Good – excludable and rival (hamburger) • Public Good – not excludable and non-rival (lighthouse, warning siren) • Common Resource – rival but not excludable (ocean, old days pasture land) • Natural Monopoly – excludable but non-rival (protecting another house – MC is small)
Public Goods • Examples are fireworks, national defense, basic research, alleviating poverty) • Free-rider problem – another example of revealed preference. If people cannot be excluded, they have no little incentive to pay for the good or service). • Free-riders make it difficult for private providers to provide the optimal amount of a public good. • Voluntary exchange does not work efficiently and efficiency may be provided by government coercion.
Government Provision versus Production of Public Goods • The government must perform cost-benefit analysis to decide if it is worthwhile to provide the good and determine how much should be produced (valuing a life). • Stoplights • Highways – public or private, uncongested or congested • Taxes are then imposed to provide for the good.
Tragedy of the Commons • Boston Commons – overuse of a rival resource where individuals were not purposively not excluded. • Ocean Fishing • Bison versus Cattle – the importance of property rights • Pricing in national parks
Summary • Efficiency and the market system • Market failures • Government failures