Micro Chapter 5
Difficult Cases for the Market, and
the Role of Government
3 Learning Goals
1) Explore the details of efficiency
2) Identify factors that reduce the efficiency
of markets
3) Explain how those factors reduce
efficiency
A Closer Look at
Economic Efficiency
What does efficiency mean?
The largest net benefit is achieved
Rule: Engage in an activity so long as the
expected marginal benefit is greater than
the expected marginal cost
Graph:
Video:
The most inefficient man on TV:
Two Clicker Questions Next
Q5.1 When economists say that an activity meets
the criterion for economic efficiency, they mean
a) a majority of citizens favor the activity.
b) the benefits that result from the activity exceed
the costs.
c) the number of people who gain from the activity
exceeds the number on whom costs are
imposed.
d) the costs that result from the activity exceed the
benefits.
Q5.2 Eliminating all pollution would be a
desirable public policy objective.
a) I agree with this statement
b) I disagree with this statement
Eliminating all pollution would be a
desirable public policy objective.
Class Activity: Why do you agree or
disagree with this statement?
Have you ever said to yourself
“that’s good enough”?
When cleaning something
When studying for an exam
When completing a task
Perfection is not usually a desirable result
Video of violating efficiency (viewer
discretion advised):
Potential Shortcomings of
the Market
Markets will usually generate an
efficient outcome. Sometimes they
may not.
Four reasons why the market may
produce an inefficient outcome:
(1) A lack of competition
(2) Poor information
(3) Public goods
(4) Externalities
Market failure
When the market process of supply and
demand, the invisible hand, and the price
system produce an inefficient outcome, it
is referred to as “market failure.”
Market failure doesn’t mean the market
stop working entirely, it simply means an
inefficient outcome was reached.
(1) A lack of competition
– If there are only a few firms, then supply may
be restricted which will lower the quantity
available and raise price
(2) Poor (or no) information
– Poor information results in poor decision
making
(3) Existence of public goods
Class Activity: Economics is
Everywhere 18.4
A tradition at the University of Michigan and a few
Ivy League schools is the annual “Naked Mile,” in
which students run through campus naked to
welcome the arrival of spring. At Michigan (where
“spring” arrives late in April), participation in the
Naked Mile has decreased sharply over the last few
years. This is partly because the university has
tried to discourage potential participants with
warnings and also by arrests of some participants
for indecent exposure. The real problem for the low
turnout, however, is that the Naked Mile is a public
good. Everyone can enjoy watching it without
bearing the cost of participating- consumption is
nonrival and the good is nonexcludable. It is not
surprising that the event creates a serious free-rider
problem.
Q: What could the organizers of the Naked Mile do
to encourage more people to participate?
(3) Existence of public goods
A public good has two distinguishing
characteristics:
– (1) Many people can consume the good
simultaneously; referred to as joint consumption or nonrival
– (2) People who don’t pay for the good can still consume
it; referred to as non-excludable
Note: public goods are not necessarily provided
by the gov’t (i.e. paid with public money)
Class Activity: Name at least two public goods
Why does a public good pose a
problem?
Because of its characteristics, it will be hard to
generate funds to pay for its production
Individuals have a strong incentive to free ride –
not pay, wait for someone else to pay, then
consume the good
This typically leads to underproduction of public
goods; i.e. an inefficient amount being produced
Illustration of public good:
Recall, each question on the next exam
is worth $10
For $9.90, I will sell the answer to one
question.
Which one of you will pay me? One
pays $9.90 and everyone receives $10.
Clicker Question Next
Q5.3 Which one of you will pay me?
a) I will
b) No, I’ll free ride
Class Activity: Economics is
Everywhere 18.1
One of the teaching assistants pointed out a
neat free-rider problem. A friend of hers was
getting married. That was one of a number of
weddings that took place in the church over a
weekend. There was no time to put in new
flowers before each wedding, so the brides were
asked to chip in for the flowers. Several brides
said no; those who said yes paid for the flowers
(presumably the private benefit to each was
large enough to exceed the flowers’ cost), and
the flowers were installed. The other brides paid
nothing but had the free-rider benefit of the
flowers.
Q: What could the individual brides have done to
get the others to pay a “fair share” of the costs of
the flowers? Is there any way the free-rider
brides could have been compelled to pay?
Two Clicker Questions Next
Q5.4 Which of the following is true?
a)
b)
c)
d)
Consumption of a public good by one individual
reduces the availability of the good for others.
It is extremely difficult to limit the benefits of a public
good to only the people who pay for it.
Public goods are free to a society when they are
produced by the government.
From an efficiency standpoint, a market economy will
generally supply too much of a public good.
Q5.5 A competitive market economy is unlikely to
provide an efficient quantity of some public goods
because
a)
b)
c)
d)
only the government has the vast resources necessary to
produce public goods.
the nature of public goods makes it difficult for producers
to withhold them from nonpaying consumers.
the technology involved in the production of public goods
makes it difficult for private firms to produce them even
though, once produced, they could be marketed efficiently.
private production of public goods generally results in a
large amount of profit, which is difficult for a firm to
effectively pay out to shareholders.
(4) Presence of externalities
Externalities are also referred to as
spillover effects and neighborhood effects
Not all costs and benefits will be used in
decision making (external costs and
benefits are typically ignored)
(4) Presence of externalities
With an external cost, too many units are
produced and price is too low
In other words, actual output is more than
the efficient output while actual price is
less than the efficient price
With an external benefit, too few units are
produced and price is too low
In other words, actual output is less than
the efficient output while actual price is
less than the efficient price
Video of Negative Externality:
Another way to think of
externalities:
Negative externality – a cost imposed on
you for an activity you’re not directly
involved in and you would like to see less
of the activity
Positive externality – a benefit accrued to
you for an activity you’re not directly
involved in and you would like to see more
of the activity
Class Activity: Identify one negative and
one positive externality you’ve been
involved with
Example of negative externality:
Graph of external cost:
See handouts on Blackboard: “externality
graphs.pdf” and “externality comments.pdf”
Two Clicker Questions Next
Q5.6 Suppose the actions of the producers of a good
impose an external cost which results in the actual market
price of $25 and market output of 1,000 units. How does
this outcome compare to the efficient, ideal equilibrium?
a) The efficient price would be higher than $25 while the
efficient output would be less than 1,000 units.
b) The efficient price would be higher than $25 while the
efficient output would be greater than 1,000 units.
c) The efficient price would be lower than $25 while the
efficient output would be less than 1,000 units.
d) The efficient price would be lower than $25 while the
efficient output would be greater than 1,000 units.
Discuss your answer with a neighbor.
Then we’ll redo the question.
Q5.7 Suppose the actions of the producers of a good
impose an external cost which results in the actual market
price of $25 and market output of 1,000 units. How does
this outcome compare to the efficient, ideal equilibrium?
a) The efficient price would be higher than $25 while the
efficient output would be less than 1,000 units.
b) The efficient price would be higher than $25 while the
efficient output would be greater than 1,000 units.
c) The efficient price would be lower than $25 while the
efficient output would be less than 1,000 units.
d) The efficient price would be lower than $25 while the
efficient output would be greater than 1,000 units.
Class Activity: Economics is Everywhere
18.10
A recent news story showed how complex the interactions
that involve externalities can be. The overfishing of
Pollock in Alaskan waters has, so scientists claim,
reduced the population of seals, which eat Pollock. With
fewer seals, orca whales have lost their favorite prey and
have had to move closer to shore to prey on sea otters.
The sea otter population is down, allowing their prey- sea
urchins- to multiply rapidly and chew up the underwater
kelp forests near the shore. Since the kelp forests aren’t
there, the shorelines are more exposed to waves that
generate beach erosion and have caused an increasing
loss of shoreline housing. This six-step externality is the
most complex I’ve heard of. It illustrates how something
seemingly harmless- overfishing just one species- can
generate serious negative effects in an area that to a
layperson would seem very far removed from the action
that originally produced the externality.
Q: List one remedy that the government could introduce
to reduce the problem of beach erosion presented in this
story. Are there any potential secondary effects of your
solution?
Graph of external benefit:
See handouts on Blackboard: “externality
graphs.pdf” and “externality
comments.pdf”
Class Activity: Economics is Everywhere
18.19
One of my colleagues just returned from
vacation in the Florida Keys. He was all excited
that, at age forty-eight, he had gone scuba
diving for the first time. He remarked that,
unfortunately, the water was quite rough and
made him somewhat seasick. He felt worse and
worse, had to return to the boat, and eventually
was so ill that he “fed his lunch to the fishes.”
He noted, however, that he had at least created
a positive externality: His activity attracted a
large number of exotic fish, allowing other divers
standing on the boat much better viewing than
they otherwise would have had.
Q: If you were a tour-boat operator and read this
what might you do to make the fish-viewing trip
better for all of the people taking the trip?
Two Clicker Questions Next
Q5.8 Suppose the actions of the producers of a good
generate an external benefit which results in the actual
market price of $15 and market output of 614 units. How
does this outcome compare to the efficient, ideal equilibrium?
a) The efficient price would higher than $15 while the
efficient output would be less than 614 units.
b) The efficient price would be higher than $15 while the
efficient output would be greater than 614 units.
c) The efficient price would be lower than $15 while the
efficient output would be less than 614 units.
d) The efficient price would be lower than $15 while the
efficient output would be greater than 614 units.
Q5.9 When the consumption of a good generates
an external benefit,
a) the private benefit consumers receive from the good
will be higher than the true social benefit.
b) too much of the good will tend to be produced from the
viewpoint of economic efficiency.
c) the community generally suffers an exactly offsetting
external cost from the production of the good.
d) the market demand curve will understate the total
benefits derived from consumption of the good, and as
a result, too little of it will be produced and consumed.
Optional Assignment:
Read 2-page article titled “Leef-Society
shouldn’t pay for your education” on
Blackboard under Optional Assignments
Type your answers in a Word file to the
questions found in the document “Optional
Assignment Leef-Society shouldn’t pay for
your education”
Upload your file to Blackboard before
Exam 2
Why do externalities produce
inefficient outcomes?
With an external cost, too many units are
produced and price is too low
In other words, actual output is more than the
efficient output while actual price is less than the
efficient price
With an external benefit, too few units are
produced and price is too low
In other words, actual output is less than the
efficient output while actual price is less than the
efficient price
Why do externalities produce
inefficient outcomes?
External costs and benefits are sometimes
ignored and always difficult to measure
What causes externalities?
The primary source is lack of property
rights
How can externalities be
“fixed”?
That is, what kind of solutions can push
the market closer to efficient outcomes?
1. Clearly define and enforce property
rights
2. Taxes
– “Internalize the externality”
– A tax equal to the externality will produce an
efficient outcome
Taxes may not produce the
intended result
Video:
Extra Credit Clicker Question Next
Q5.10 Who was the original scholar to
propose “fixing it with taxes”?
a)
b)
c)
d)
e)
f)
Joe Calhoun
Adam Smith
David Ricardo
A.C. Pigou
John Locke
Ronald Coase
Clicker Question Next
Q5.11 Eliminating all pollution would be a
desirable public policy objective.
a) I agree with this statement
b) I disagree with this statement
3 Learning Goals
1) Explore the details of efficiency
2) Identify factors that reduce the efficiency
of markets
3) Explain how those factors reduce
efficiency