Government Policy and Market
Failures
Chapter 15
Introduction
• Should the government intervene in
the market?
– The framework presented might be called
the invisible hand framework.
– Invisible hand framework – perfectly
competitive lead individuals to make
voluntary choices that are in society’s
interest.
Market Failures
• A market failure occurs when the
invisible hand pushes in such a way that
individual decisions do not lead to
socially desirable outcomes.
Market Failures
• Any time a market failure exists, there
is a reason for possible government
intervention into markets to improve
the outcome.
Market Failures
• Because the politics of implementing
the solution often leads to further
problems, government intervention may
not necessarily improve the situation.
Externalities
• Externalities are the effect of a
decision on a third party that is not
taken into account by the decisionmaker.
• Externalities can be both positive and
negative.
Externalities
• Negative externalities occur when the
effect of a decision on others that is
not taken into account by the decisionmaker is detrimental to the third
party.
• Examples include second-hand smoke,
water pollution, and congestion.
Externalities
• Positive externalities occur when the
effect of a decision on others that is
not taken into account by the decisionmaker is beneficial to others.
• Examples include innovation,
education, and new business
formation.
Negative Externalities
• When negative externalities ensue
third parties are hurt.
• Marginal social cost is greater than
marginal private cost.
Negative Externalities
• Marginal social cost includes all the
marginal costs borne by society.
Negative Externalities
• Marginal social cost is calculated by
adding the negative externalities
associated with production to the
marginal private costs of that
production.
The Effect of a Negative Externality
Marginal social cost
Cost
Marginal private cost
Marginal cost
from externality
P1
P0
Marginal social
benefit
0
Q1 Q0
Quantity
Positive Externalities
• Private trades can benefit third
parties not involved in the trade.
• Marginal social benefit equals the
marginal private benefit of consuming
a good or service plus the positive
externalities resulting from consuming
that good or service.
A Positive Externality
S = Marginal private and social cost
Cost
P1
D1 = Marginal social benefit
Marginal benefit of an externality
P0
D0 = Marginal private benefit
0
Q0 Q1
Quantity
Alternative Methods of Dealing with
Externalities
• Externalities can be dealt with via
direct regulation, incentive policies,
and voluntary solutions.
Direct Regulation
• A program of direct regulation is
where the amount of a good people are
allowed to use is directly limited by
the government.
Direct Regulation
• Economists do not like this solution
since it does not achieve the desired
end as efficiently (at the lowest cost
possible in total resources without
consideration as to who pays those
costs) and fairly as possible.
Direct Regulation
• Direct regulation is inefficient
because it achieves a goal in a more
costly manner than necessary.
Incentive Policies
• Incentive programs are more efficient
than direct regulatory policies.
• The two types of incentive policies are
either taxes or market incentives.
Tax Incentive Policies
• A tax incentive program uses a tax to
create incentives for individuals to
structure their activities in a way that
is consistent with the desired ends.
• Often the tax yields the desired end
more efficiently than straight
regulation.
Tax Incentive Policies
• This solution embodies a measure of
fairness about it – the person who
conserves the most pays the least tax.
Tax Incentive Policies
• Another way to handle a negative
externality is through a pollution tax
or effluent fees.
• Effluent fees – charges imposed by
government on the level of pollution
created.
Regulation Through Taxation
Marginal social cost
Cost
Marginal private cost
P1
Efficient tax
P0
Marginal social
benefit
0
Q1 Q0
Quantity
Market Incentive Policies
• An alternative to direct regulation is
some type of market incentive
program.
• Market incentive program – a plan
requiring market participants to
certify total consumption – their own
or other’s – has been reduced by a
specified amount.
Market Incentive Policies
• A market incentive program is similar
to the regulatory solution in that the
amount of the good used is reduced.
Market Incentive Policies
• A market incentive program differs
from a regulatory solution in that
individuals who reduce consumption by
more than the required amount are
given a marketable certificate that can
be sold to someone else.
Voluntary Reductions
• Voluntary reductions leave individuals
free to choose whether to follow what
is socially optimal or what is privately
optimal.
• Economists are dubious of voluntary
solutions.
Voluntary Reductions
• A person’s social conscience and
willingness to do things for the good of
society generally depend on his or her
belief that others will also be helping.
Voluntary Reductions
• If a socially conscious person comes to
believe a large number of other people
will not contribute, he or she will often
lose their social conscience.
• This is another example of a free
rider problem – individuals’
unwillingness to share in the cost of a
public good.
The Optimal Policy
• An optimal policy is one in which the
marginal cost of undertaking the policy
equals the marginal benefit of that
policy.
The Optimal Policy
• Should pollution be totally eliminated?
• Some environmentalists say “yes.”
• Economists would answer that doing
so is costly so marginal costs should
be balanced against marginal benefits.
The Optimal Policy
• The point where MC = MR is called the
optimal level of pollution.
• Optimal level of pollution – the
amount of pollution at which the
marginal benefit of reducing pollution
equals the marginal cost.
Public Goods
• A public good is one that is
nonexclusive (no one can be excluded
from its benefits) and nonrival
(consumption by one does not preclude
consumption by others.
Public Goods
• There are no pure examples of a public
good.
– The closest example is national defense.
• Technology can change the public
nature of goods.
– Roads are an example.
Public Goods
• Once a pure public good is supplied to
one individual, it is simultaneously
supplied to all.
• A private good is only supplied to the
individual who bought it.
Public Goods
• With public goods, the focus is on
groups.
• With private goods, the focus is on
the individual.
Public Goods
• In the case of a public good, the social
benefit of a public good is the sum of
the individual benefits.
Public Goods
• Adding demand curves vertically is
easy to do in textbooks, but not in
practice.
• This is because individuals do not buy
public goods directly so that their
demand is not revealed in their
actions.
The Market Value of a Public Good
Price
1.00
.80
0.50
.60
.40
0.10
0.60
0.40
0.50
.20
1
Market demand
DB
2
DA
0.10
3
Quantity
Informational Problems
• Perfectly competitive markets assume
perfect information.
• Real-world markets often involve
deception, cheating, and inaccurate
information.
Informational Problems
• When there is a lack of information,
buyers and sellers do not have equal
information, markets may not work
properly.
Informational Problems
• Economists call such market failures
adverse selection problems.
• Adverse selection problems –
problems that occur when a buyer or
a seller have different amounts of
information about the good for sale.
Policies to Deal with Informational
Problems
• One policy alternative to deal with
information market failures is to
regulate the market and see that
individuals provide the correct
information.
Policies to Deal with Informational
Problems
• Another alternative is for the
government to license individuals in the
market and require them to provide
full information about the good being
sold.
Policies to Deal with Informational
Problems
• Regulatory solutions may be overly slow
or costly.
A Market in Information
• A market in information is one solution
to the information problem.
• Information is valuable, and is an
economic product in its own right.
A Market in Information
• Left on their own, markets will develop
to provide information that people
need and are willing to pay for it.
A Market in Information
• Economists who do not like government
interference point out that
informational problems are not a
problem of the market; it is a problem
of government regulation.
Licensing of Doctors
• Licensing of doctors is a debate that is
motivated by information problems.
• Currently all doctors practicing
medicine are required to be licensed –
this was not always so.
• Licensing of doctors is justified by
informational problems.
Licensing of Doctors
• Some economists argue that licensing
is as much a problem of restricting
supply as it is to help the consumer.
Licensing of Doctors
• Why, if licensed medical training is so
great, do we even need formal
restrictions to keep other types of
medicine from being practiced?
Licensing of Doctors
• Whom do these restrictions benefit:
the general public or the doctors who
practice mainstream medicine?
• What have the long-term effects of
licensure been?
An Informational Alternative to
Licensure
• As an alternative, the government
could provide the public with
information about which treatments
work and which do not.
– This would give rise to consumer
sovereignty – the right of the individual
to make choices about what is consumed
and produced.
An Informational Alternative to
Licensure
• In this scenario, the government would
provide such information as:
–
–
–
–
–
–
Grades in college.
Grades in medical school.
Success rate for various procedures.
References.
Medical philosophy.
Charges and fees.
An Informational Alternative to
Licensure
• This information alternative would
provide much more useful information
to the public than the present licensing
procedure.
An Informational Alternative to
Licensure
• Here are some words of caution about
the informational alternative.
– To get a true picture of whether the
present system is best would require
experts on real-life practices and
institutions.
– The problem is that the experts may
have a vested interest in keeping things
just the way they are.
Government Failures and Market
Failures
• Market failures should not
automatically call for government
intervention.
• Why? Because governments fail too.
Government Failures and Market
Failures
• Government failure occurs when the
government intervention in the market
to improve the market failure actually
makes the situation worse.
Reasons for Government Failures
• Governments do not have an incentive
to correct the problem.
• Governments do not have the
information to deal with the problem.
• Intervention in the markets is almost
always more complicated than it
initially looks.
Reasons for Government Failures
• Government intervention does not allow
fine-tuning, and so, when the problems
change, the government solution often
responds far more slowly.
• Government intervention leads to
more government intervention.
Government Policy and Market
Failures
End of Chapter 15