Market Failure and the Allocation Function of Govt:
(“Economics” – Chapter 10)
Recall, free market outcomes are often efficient…
 But, even in a market oriented economy (e.g., U.S.),
government plays a substantial role in the economy
 One way to see how much the government is doing is to
look at Government Spending as a Percentage of Gross
Domestic Product (GDP)
Government Expenditures as a Percentage of GDP:
Sweden
Finland
France
Germany
Canada
Spain
Ireland
Japan
U.S.
Korea
1991
61.4
56.7
50.6
46.1
52.3
44.3
44.5
31.6
37.8
19.9
1994
68.4
63.7
54.2
47.9
49.7
46.7
44.0
35.5
37.0
20.0
1997
60.7
56.2
54.1
48.3
44.3
41.6
36.7
35.7
35.4
21.3
2000
57.0
48.3
51.6
45.1
41.1
39.1
31.5
39.0
34.2
22.6
2003
56.0
50.1
53.2
48.4
41.2
38.4
33.4
38.4
36.8
29.2
2006
52.9
48.6
52.7
45.3
39.4
38.5
34.0
36.2
36.5
28.4
Mean from
1991-2006
60.58
54.58
53.02
47.92
44.90
41.66
37.30
36.91
36.32
23.23
Government spending in U.S. as a % of GDP:
 Has consistently increased over time
1792 to 1901 (just Federal)
1902 to 1917
1918 to 1967
1968 to 2007
2008 to 2015
mean median min
2.744182 2.305 1.05
7.9525
7.99
6.64
24.3988 23.825 11.24
36.7395 37.12 32.03
43.40875 43.325 40.47
max
13.27
9.86
53.44
39.86
46.49
max
year
1865
1915
1945
1992
2009
1
 During the period from 1918 to 1967, this figure
 increased steadily
 was abnormally high from 1943 to 1946
1943 47.17
1944 50.51
1945 53.44
1946 36.27
 If we re-create the table above, but do not include the
years from 1943 to 1946…
1792 to 1901 (just Federal)
1902 to 1917
1918 to 1967 (not 43-46)
1968 to 2007
2008 to 2015
mean median min
2.744182 2.305 1.05
7.9525
7.99
6.64
22.44674 22.61 11.24
36.7395 37.12 32.03
43.40875 43.325 40.47
max
13.27
9.86
31.65
39.86
46.49
max
year
1865
1915
1967
1992
2009
 For each of the last three rows, the “minimum value”
is greater than the “maximum value” from the row
above
 Before 2008, government spending was never above
40% of GDP (except in 1943, 1944, and 1945)
2008
2009
2010
2011
40.47
46.49
45.03
44.16
2012
2013
2014
2015
43.99
42.66
42.25
42.22
 If markets are so great (i.e., efficient), then why would
we want government playing such a large role in the
economy?
2
Government Intervention in markets and the economy is
most often justified by arguing for government to serve one
of the three following functions:
1. Allocation Function – government production of goods
or regulation of business, aimed at improving the
allocative efficiency of the economy (i.e., getting the
“right mix” of products produced, each in the “ideal
quantity” and at the “ideal quality”).
2. Distribution Function – government policies aimed at
changing the final distribution of goods/services across
consumers, usually with the intention of realizing a
“fairer” apportionment of consumption/income/wealth.
3. Stabilization Function – attempts by government to
minimize fluctuations in overall macroeconomic activity
For the remainder of this topic, we will focus on the
“Allocation Function” of Government
3
Government intervention may be able to improve upon the
allocation of resources in the presence of “market failure”
 Market Failure – a situation in which the “free
market outcome” is inefficient, in that there is a
positive Deadweight-Loss at the resulting “free market
level of trade.”
Recall, for market outcomes to be efficient several
conditions must be met. If these conditions are not met,
then the market outcome will not be efficient (Positive
Deadweight-Loss).
 In the presence of Market Failure, government
intervention may be able to improve the outcome (i.e.,
have us realize an outcome with a smaller
Deadweight-Loss).
Four common phenomena leading to Market Failure:
I. Market Power
II. Public Goods
III. Externalities
IV. Lack of Information
4
I.
Market Power.
 When there are not “many participants” on one side
of a market, then some individuals can have
“substantial control over price”
 As a result, prices may deviate from “marginal
costs” (or “marginal benefits”), leading to an
inefficient level of trade
In a “perfectly competitive market” sellers have “no control
over price”
 “Many other sellers,” each selling an “identical
item”
 If a seller tries to charge more than the “prevailing
market price,” nobody will buy their output
 There are “so many buyers,” so that the firm can
always sell one more unit of output at the current
market price
 A firm in a perfectly competitive market faces a
demand curve that is a “horizontal line” at the
prevailing market price
$
(Prevailing market
price) = $10
Demand facing firm in
perfectly competitive market
0
quantity
0
5
Market Power – A firm has market power if they have
some “control over the price of their output,” in that they
i. can increase price without losing all customers
ii. must decrease price in order to increase sales
Monopoly – market structure in which there is one single
seller of a unique good with no close substitutes.
 The “polar opposite” of “perfect competition.”
 The demand curve facing a monopolist is the
market demand curve.
 They can choose any price/quantity combination
along the market demand curve.
Profit Maximization for a Monopolist:
 “downward sloping demand” => “marginal revenue is
below price”
$
Marginal Costs
of Production
Demand
0
quantity
0
Marginal
Revenue of
Firm
6
$
Consumers’ Surplus
Profit
Maximizing
Price
Monopoly
Surplus
Deadweight-Loss
Marginal Costs
of Production
Demand
0
0
q M  Profit Maximizing
Quantity Sold
Efficient
Quantity  q E
of Trade
quantity
Marginal Revenue
of Firm
 When maximizing profit, the monopolist only sells those
units for which “Marginal Revenue” is greater than
“Marginal Costs”
 “Profit Maximization” => trade up to q M .
 To maximize “Total Social Surplus” we would need to
trade all units for which “Buyer’s Reservation Price”
(illustrated by “Height of Demand Curve”) is greater
than “Seller’s Reservation Price” (illustrated by “Height
of Marginal Cost Curve”)
 “Efficiency” => trade up to q E .
 “Inefficiency due to underproduction” ( qM  qE )
illustrated by the gray shaded area above (positive DWL)
 “Monopoly Surplus” illustrated by orange shaded area;
Consumers’ Surplus illustrated by green shaded area
 Positive DWL is “the reason why monopoly is bad”…
7
II.
Public Goods.
Goods can differ with respect to their “excludability”
and “rivalness in consumption”:
 Non-Rival Good – a good for which
consumption by one person does not diminish the
quantity or quality of consumption by others
 Rival Good – a good for which consumption by
one person does diminish the quantity or quality
of consumption by others
 Non-Excludable Good – a good for which it is
difficult (or very costly) to prevent consumption
by those who do not pay
 Excludable Good – a good for which it is easy to
prevent consumption by those who do not pay
Private Good – a good that is excludable and rival in
consumption.
 Example: a “Big Mac” from McDonald’s.
 Rival: if I get the benefits of eating the Big
Mac, you cannot also get the benefits of eating
the Big Mac.
 Excludable: McDonald’s could easily sell a
Big Mac to me, but not to you (i.e., they could
easily exclude someone from consuming the
good if they refuse to pay for it)
 Market provision of Private Goods is generally
efficient.
8
Public Good – a good that is non-excludable and non-rival
in consumption
 Classic example: National Defense.
 Non-rival: the amount of national defense that we
are enjoying in this room right now would not
decrease if one more student had come to class
today.
 Non-excludable: there is no way to provide me with
a certain level of national defense as I am giving my
lecture, but at the same time prevent you from
enjoying the benefits of the good.
Also, define…
 Club Good – a good that is excludable and non-rival in
consumption
 e.g., satellite radio or television broadcast
 Common Good – a good that is non-excludable and
rival in consumption
 e.g., stock of fish in the ocean
Degree of
Excludability
Club Good
(Satellite TV)
Public Good
(National
Defense)
Private Good
(Big Mac)
1
Degree of
Rivalness
0
0
1
Common Good
(fish in the ocean)
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Provision of a Pure Public Good:
Example: F-22 Raptor – cost of $150 million per jet
 Consider the choice of “building the next F-22”
 Suppose that each of the 150 million U.S. households
has an “average value” of $4 for “one more F-22”
 Would the free market provide another unit?
 Is it efficient to provide another unit?
Implications of a good being a “public good”…
 non-rival: so long as the good is provided (by someone),
each person gets “all the benefits” of the good => the
“Social Benefits” of providing a unit are equal to “the
sum of the private benefits” of providing the unit
 In this example, the “Social Benefits” are $600 million
while the Social Costs are $150 million => efficient to
produce one more unit
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 non-excludable: even if someone “doesn’t contribute
any money toward paying for the good,” they still get to
“enjoy the benefits of the good” => there is in essence
no effective way to charge for the good
 Suppose we decided whether or not to produce “one
more F-22 Raptor” by
(i) asking everyone to state their “marginal benefit
for one more F-22”
(ii) producing one more unit if the stated marginal
benefits add up to more than $150 million (i.e., if
the stated Social Benefits are greater than the
Social Costs)
(iii) asking each person to pay a fraction of costs
equal to “their stated fraction of Social Benefits”
 Fixing the answers of others, I will claim “no benefit
from another F-22” (even though my benefit is $4)
 This “false answer” will almost certainly not change
whether the unit is or is not provided (i.e., it almost
certainly will not change whether the “sum of stated
values is above or below $137.5 million”), and I will
have to contribute ($0) toward paying for the good!
 When we all behave like this, zero units would be
provided (most certainly not optimal)
 Recognize that this mechanism for providing the good
is very similar to how the market would go about
providing the good => market provision of Public
Goods is generally inefficient, because of the “Free
Rider Problem”
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 Free Rider Problem – if a public good were supplied in
a free market, the amount traded would be less than the
efficient quantity, since many people would attempt to
enjoy the benefits of units purchased by others, while not
purchasing any units themselves
 i.e., many “self-interested” people would rationally try
to “free ride” on units purchased by others
 we might still expect a “positive amount to be
provided” (e.g., maybe Bill Gates and Warren Buffett
might buy “a few F-22’s”), but the amount purchased
would be “less than the efficient amount”
How to “correct” for this inefficiency? How did we, in the
United States, “decide” to put 187 F-22 Raptors into
service between 2005 and 2011?
 we did not rely on markets, but rather we relied on
government…
 a government agency supplied these goods
 through our political process we elected officials who
appointed bureaucrats and made budgetary decisions
which ultimately resulted in a “choice” of this level
 through the same process, taxes were imposed to
cover the costs of production
 note: we do not know that “187 units” is the efficient
quantity, but we do know (with certainty) that the
quantity which a free market would provide is less than
the efficient quantity (whatever the efficient quantity
happens to be)
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III. Externalities.
 Some activities result in benefits or costs for
individuals who are not “directly involved in the
activity” (i.e., an “external effect” or “externality”)
 External Cost or Negative Externality – a cost of
an activity borne by someone not engaging in the
activity.
 examples: pollution, noise from low-flying
aircraft, speeding on a highway, installation of
“The Club” in a car
 External Benefit or Positive Externality – a
benefit from an activity realized by someone not
engaging in the activity.
 examples: vaccines, installation of smoke
detector in an “attached apartment,” installation
of Lojack in a car
Note the difference between Lojack and “The Club”
 If I install Lojack, then a greater fraction of cars have
Lojack => “expected surplus” of stealing any arbitrary
car is lower => all cars are less likely to be stolen
 If I use “The Club” => “expected surplus” is lowered
for stealing my car but not changed for stealing your
car => my car is less likely to be stolen, but your car is
more likely to be stolen
Market provision of a good for which there is an externality
is inefficient:
 Negative externality => free markets provide more
than the optimal amount (i.e., too much) of the good
 Positive externality => free markets provide less than
the optimal amount (i.e., not enough) of the good
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Market Outcome in Presence of a “Negative Externality”:
(?): What is the “best level of pollution” for society?
 In general, “Marginal Social Cost” is equal to the “sum
of Marginal Costs over all people in society” => The
sum of “Marginal Private Cost” and “Marginal External
Cost” => MSC=MPC+MEC
 In the presence of a “Negative Externality” there is a
“positive Marginal External Cost,” making “Marginal
Social Cost” greater than “Marginal Private Cost” (that
is, since MEC>0 => MSC>MPC)
$
Marginal Social
Costs
Marginal
= MPC = “Supply”
Private Costs
Marginal Private
= MPB = “Demand”
Benefits
0
quantity
0
14
 If this good was traded in a free, unrestricted,
unregulated market => rational, self-interested market
participants would base their actions upon “Marginal
Private Costs” (and “Marginal Private Benefits”), not
taking into account the “Marginal External Cost.”
$
Deadweight-Loss
Efficient
amount of
Negative
Externality
Marginal Social
Costs
Marginal
= MPC = “Supply”
Private Costs
Marginal Private
= MPB = “Demand”
Benefits
0
quantity
0 Efficient Level
of Trade
Free Market
Level of Trade
 Free Market outcome results in “too much of the
activity” => positive DWL illustrated by gray area
 Positive DWL is why “market provision of a good which
generates a negative externality is bad”…
 But note that at the efficient level of trade, there is a
positive amount of the negative externality being
generated (illustrated by the purple area above)
 “Best Level of Pollution” for society is NOT ZERO!
 In order to have “zero pollution” we would have to
have: no cars, no electricity, no fire…
 Clearly the costs of the initial units of pollution are
well below the benefits of the initial units of the
activities that cause the pollution
15
Potential policies to reduce the DWL associated with a
“negative externality”
1. ban the activity entirely (“illegal to emit any
pollution”)
2. establish minimum compliance standards for
manufacturers (“can only pollute up to a certain
level”)
3. “cap and trade” – issue a certain number of “pollution
permits” for society as a whole, and allow people to
trade these permits amongst themselves
4. offer subsidies to manufacturers that reduce pollution
(“pay the polluter to reduce their level of pollution”)
5. charge manufacturers a fee for each unit of pollution
emitted (“polluter must pay for the right to pollute”)
 last three options can most easily implement the efficient
market outcome, so long as the “ideal number of permits
are issued” or the “subsidy/fee is set appropriately”
 each of these final three policies attempts to “internalize
the externality” by introducing a cost (or foregone gain)
that would be realized if the person continues to generate
the externality
 in a similar vein, another solution to the problem of
externalities was offered by Nobel Laureate Ronald
Coase (1910-; Noble Prize in 1991; Professor Emeritus
at Univ. of Chicago Law School)
 Coase began by explaining that problems of
externalities are at their core due to undefined property
rights
16
e.g., suppose a new housing development is built right next
to McCollum Field here in Kennesaw
 noisy aircraft impose an external cost on homeowners
 but, who is causing the externality? (as a parallel,
consider the old “Reese’s Peanut Butter Cups” ad:
http://www.youtube.com/watch?v=DJLDF6qZUX0)
 airport, since they are flying the noisy planes
 homeowners, since they are living next to the airport
 as the ad suggests, it takes both parties
 Should homeowners near the airport have an expectation
of “no noise” (i.e., do they have the property right)?
 Should the airport be able to create all the noise it wants
(i.e., does it have the property right)?
 Coase argued that society must first address this question
of who has the property right
Coasian Solution to the problem of externalities:
i. clearly and fully define property rights
ii. make individuals pay compensation if they infringe
upon the property rights of others
iii. allow parties to negotiate with one another
regarding infringements on property rights caused
by the externality
 Coase showed that regardless of which party is given the
property right, negotiation between the parties will result
in the efficient level of the externality (so long as the
costs of negotiation and enforcement are low enough)
 defining property rights and allowing parties to negotiate
essentially “internalizes the externality”
17
“Coasian Solution” in practice: Re-introduction of Wolves
in Western U.S.
 by 1973 the gray wolf did not exist in the wild in
Western U.S.
 re-introduction of wild wolves was supported by
environmentalists
 ranchers opposed re-introduction => concerned about
impact of “new predator” on flocks/herds
 “Coasian Solution” – clearly define property rights,
and make people compensate others if property rights
are violated
 ranchers given the “right to have flocks/herds
unattacked”
 “Defenders of Wildlife” (an environmentalist
organization) established “The Bailey Wildlife
Foundation Wolf Compensation Trust” in 1987 to
compensate ranchers for any verified livestock losses
due to wolf attacks
 fund completely financed by private donations =>
“Our goal is to shift the economic responsibility for
wolf recovery away from the individual rancher and
toward the millions of people who want to see wolf
populations restored.”
 2008: 131 payments totaling $226,891 for the killing
of 195 cattle, 238 sheep, and 22 other animals
 Since 1987: 893 payments totaling $1,368,043 for
killing of 3,832 animals
18
IV. Lack of Information.
 market decisions are based upon comparisons of
benefits and costs => to make good choices, people
must have accurate information about these values
 for some goods consumers may have difficulty
knowing their “true reservation price” => especially
common for goods purchased infrequently or for
which quality is difficult to observe (e.g., house, car,
education, medical procedure, meal at a restaurant).
 Further note, “information” is often a “club good”
(non-rival in consumption and excludable).
 Once a club good is produced, the additional cost of
providing it to the next person is essentially zero => to
maximize social surplus, everyone who has a positive
value for the information should be able to access it
 Additionally, as long as the information is accurate,
total costs to society are minimized if the information
is only generated once (e.g., it is a waste of resources
to have both the National Weather Service and
AccuWeather come up with weather forecasts)
 In such cases, have government license, inspect,
and/or regulate providers of such goods in order to:
i. provide people with the important information
needed to make good decisions in markets and
ii. minimize the costs to society of providing the
information
 e.g., “Cobb and Douglas Public Health” inspects
restaurants and assigns letter grades based upon
compliance with health codes => government
“regulates product” and “provides information”
19