Market Failure and the
Role of Government
Capitalism Review
2
Characteristics of Capitalism
1. Private property
2. Freedom of choice
3. Self-interest
4. Competition
5. Prices, not bureaucrats, guide decisions
6. Limited Government
3
Heritage Foundation’s 2014 Index of Economic
Freedom
4
Bottom 10
5
Freedom creates wealth!
6
North
Korea
South
Korea
7
Does the free market
always work perfectly?
Can economic efficiency
ever be improved by
government intervention?
8
Market Failure
A situation in which the free
market fails to satisfy
society’s needs and wants
efficiently
9
Types of Market Failures
1. Public Goods
2. Externalities
3. Monopolies
4. Income Inequality
10
Public Goods
Video: Free Market Fire
Department
11
Market Failure #1:
PUBLIC GOODS
Why is the free market
bad at providing public
goods?
Free Riders!
People who benefit from
something without paying
for it
13
Free Rider
Good Citizen
14
The Free Rider
Problem
Examples:
1. People who download music illegally
2. People who watch a street performer
and don’t pay
3. Teenagers that live at home and don’t
have a job
15
Does anyone free ride off you?
•Canadian
Military
Spending:
1% of GDP
•US Military
Spending:
4.4% of GDP
Why doesn’t
Canada
spend more
on defense?
16
17
What’s Wrong With Free Riders?
Free Riding
Less
Less revenue
potential profit
Less incentive to
Firms produce less than the
produce
socially optimal quantity
Possible solutions:
1. Punish free-riders
2. Have government provide the good
18
Trimester Grades
•I’m willing to give everyone an A if
you guys give me $500
•Everyone in the class will get an A
- even those who don’t contribute
anything
•Who’s willing to pay?
19
Public Goods
Defined
20
Definition
True public goods meet two criteria:
1. Non-excludable
•Impossible to exclude people from
enjoying its benefits (even if they don’t
pay). Example: National Defense
2. Non-rival
•One person’s consumption doesn’t
affect anyone else’s
•Example: A Fireworks Show
21
Identify which of the following are
TRUE public goods
(have non-exclusion and non-rival
consumption):
1. Hamburgers
2. Satellite TV
3. The Grand Canyon
4. A house
5. Street lights
6. Highways
22
National defense is an example of a public
good because
A) it requires tax revenues to fund any
production
(B) one person’s use of it will decrease
another person’s ability to use it
(C) it is nonexcludable and nonrival
(D) the private market typically produces the
socially efficient level of output
(E) the public is protected from invasion
National defense is an example of a public
good because
A) it requires tax revenues to fund any
production
(B) one person’s use of it will decrease
another person’s ability to use it
(C) it is nonexcludable and nonrival
(D) the private market typically produces the
socially efficient level of output
(E) the public is protected from invasion
Could the federal government…
1.Stop most illegal immigration?
2.Make sure everyone in the US has
a job?
3.Build a research station on Mars?
It probably could!
Then why doesn’t it?
The costs outweigh the benefits
26
How should the
government decide how
much of a public good to
produce?
Weigh the Costs and Benefits!
27
In Theory…
A good’s Marginal Social Benefit curve
is equal to its demand curve (based on
individuals’ willingness to pay for it)
A good’s Marginal Social Cost curve is
its marginal cost curve plus any
externalities
Video: Dam Tragedy
Demand for a New Park
Marginal willingness to pay higher taxes
# of
Parks
1
2
3
4
5
Adam is
Jill is
willing to willing to
pay
pay
$4
$3
$2
$1
$0
$5
$4
$3
$2
$1
Society’s
Assume: Marginal
Demand
1. There areCost
only
(MSB)
two people in
$9
society. $5
2. $7
Each
$5
additional park
$5
costs $5 $5
$3
$5
How many parks
$1should$5
be
made?
Demand for a New Park
Marginal willingness to pay (higher taxes)
# of
Parks
1
2
3
4
5
Adam is
Jill is
Society’s Marginal
willing to willing to Demand
Cost
pay
pay
(MSB)
$4
$3
$2
$1
$0
$5
$4
$3
$2
$1
$9
$7
$5
$3
$1
$5
$5
$5
$5
$5
Demand for a New Park
Marginal willingness to pay higher taxes
# of
Parks
1
2
3
4
5
Adam is
Jill is
Society’s Marginal
willing to willing to Demand
Cost
pay
pay
(MSB)
$4
$3
$2
$1
$0
$5
$4
$3
$2
$1
$9
$7
$5
$3
$1
$5
$5
$5
$5
$5
Supply and Demand for Public Parks
The Demand is the
equal to the
marginal benefit to
society
Price
$9
7
5
3
1
D=MSB
0
1
2
3
4
Quantity of Parks
5
Supply and Demand for Public Parks
1. What if the government
made 1 park?
2. What if the government
made 4 parks?
Price
$9
7
MSB = MSC
S=MSC
5
The supply is
the public
good’s marginal
cost to society
3
1
0
1
2
3
D=MSB
4
Quantity of Parks
5
What is an externality?
A side effect of an
economic action that
is felt by an unrelated
third party
34
Externalities
Consumers and firms sometimes fail
to consider the external costs and
benefits of their actions – i.e. how
their actions will affect other people
As a result, the free market may fail
to produce the “socially optimal”
quantity of some goods
Negative Externalities
36
Negative Externalities
(aka: Spillover Costs)
Costs resulting from an
economic action that are felt by
an unrelated third party
37
Example: Whistle Tips
38
Example 2
Zoram Pharmaceutical Co. pollutes the
air when it manufactures Spazoprolam, a
new drug that helps you dance better
Zoram only considers
its INTERNAL costs
(ignores the social cost
of pollution)
If Zoram had to pay all costs, it would
produce less
Market for Spazoprolam
The marginal private cost doesn’t
include
the
costs
to
society
P
Supply =
Marginal
Private Cost
D=MSB
QFree Market
Q
40
Market for Spazoprolam
What will MC/Supply look like when EXTERNAL
cost are factored in?Supply =
P
Marginal
Social Cost
Supply =
Marginal
Private Cost
D=MSB
QOptimal QFree Market
Q
41
Market for Spazoprolam
At QFM the MSC is greater than the MSB. Too
much is being produced
P
S =MSC
S=MPC
Overallocation
D=MSB
QOptimal QFree Market
Q
42
Market for Spazoprolam
What should the government do to fix a
negative externality?
P
S =MSC
S=MPC
Solution: Tax the
amount of the
externality
(Per Unit Tax)
D=MSB
QOptimal QFree Market
Q
43
Market for Spazoprolam
What should the government do to fix a
negative externality?
P
S =MSC =MPC
MSB = MSC
S=MPC
Solution: Tax the
amount of the
externality
(Per Unit Tax)
D=MSB
QOptimal QFree Market
Q
44
Positive Externalities
45
Positive Externalities
(aka: Spillover Benefits)
Benefits from an economic
action that are enjoyed by an
unrelated third party.
(E.g.: Vaccines, Education,
Home Renovation)
46
Example: A mom
decides to get the MMR
vaccine for her child
• Mom only looks at the INTERNAL
benefits (the reduced risk of her own
daughter getting sick)
• If parents considered the social
benefits (the reduced likelihood that her
daughter will spread diseases to other
children), demand would be greater
Market for MMR vaccine
The marginal private benefit doesn’t
include
the
additional
benefits
to
society.
P
S = MSC
QFree Market
D=Marginal
Private
QBenefit 48
Market for MMR vaccine
What will the MB/D look like when
P EXTERNAL benefits are factor in?
S = MSC
QFM
QOptimal
D=Marginal
Social
Benefit
D=Marginal
Private
QBenefit 49
Market for MMR vaccine
If the market produces QFM why is it a market
failure?
P
S = MSC
D=Marginal
Social
Benefit
D=MSB
QFM
QOptimal
Q
50
Market for MMR vaccine
P
At QFM the MSC is less than the MSB.
Too little is being produced
S = MSC
Underallocation
QFM
QOptimal
D=Marginal
Social
Benefit
Q
51
Market for MMR vaccine
What should the government do to fix a
negative externality?
P
Subsidize the amount of the
externality (Per Unit Subsidy)
S = MSC
D=MSB =MPB
D=MPB
QFM
QOptimal
Q
52
Seating Chart!
53
“I’m writing
you a
prescription
for pecan pie”
The Tragedy of the Commons
a.k.a. The Common Pool Problem
Why are public bathrooms so nasty?
• No one who uses them has an
incentive to keep them clean!
• This problem – called the “Tragedy of
the Commons” or the “Common Pool
Problem,” applies to any nonexcludable good
• e.g. The air, the oceans, rivers, etc.
What can
be done
about this?
Market Failure #3
Monopolies
57
Monopoly
Socially
UnregulatedOptimal
P $9
8
7
6
MC
Fair
Return
5
4
3
2
ATC
D
MR
1 2 3 4 5 6 7 8 9 10 Q
58
Government in Action:
Antitrust Laws
Legislative
Executive
Judicial
59
Anti-Trust Laws
Laws designed to break up monopolies
and promote competition.
•Prompted by growth of Standard Oil and
Carnegie Steel
Why are monopolies a Market Failure?
•They are neither productively
nor allocatively efficient
60
WHAT DOES THE GOVERNMENT DO?
Legislative Branch
•Passed Sherman Act of 1890“Every person who shall monopolize …or
conspire to monopolize…shall be deemed
guilty of a felony.”
Executive Branch
•Federal Trade Commission must approve all
corporate mergers.
•Justice Department prosecutes anti-competitive
firms
Judicial Branch
•Federal Courts adjudicate antitrust complaints
61
Market Failure #4
Wealth Inequality
62
Wealth Inequality
• In 2014, the mean
household income in the
U.S. was $72,641
• In 2014, the median
household income was
$51,939
How can this be?
63
The Lorenz Curve
and Gini
Coefficient
64
Measuring Income
The process: Distribution
• Divide households into quintiles based on
income
•
If perfect equality, 20% of families should
earn 20% of income, 40% should earn
40%...etc.
• Compare actual distribution (Lorenz
Curve) to perfect distribution – ratio is the
Gini Coefficient
65
Measuring Income
Distribution
Example:
Group #1 (Poorest 20%)
• Total of $5Bn (5% of total income)
Group #2
• Total of $10Bn (10% of total income)
Group #3
• Total of $15Bn (15% of total income)
Group #4
• Total of $25Bn (25% of total income)
Group #5 (Richest 20%)
• Total of $45Bn (45% of total income)
66
The Lorenz Curve
Percent of Income
100
80
Perfect Equality
60
40
20
0
20
40
60
80
Percent of Families
100
67
The Lorenz Curve
Percent of Income
100
Lorenz Curve
(actual distribution)
80
Perfect Equality
60
55
40
30
20
15
5
0
20
40
60
80
Percent of Families
100
68
The Lorenz Curve
Percent of Income
100
Lorenz Curve
(actual distribution)
80
Perfect Equality
60
55
40
The size of the
banana shows
the degree of
income inequality.
30
20
15
5
0
20
40
60
80
Percent of Families
100
69
The Lorenz Curve
100
Percent of Income
After Redistribution
80
Perfect Equality
60
55
40
The banana gets
smaller when the
government redistributes
income
30
20
15
5
0
20
40
60
80
Percent of Families
100
70
The Lorenz Curve
Percent of Income
100
80
Perfect Equality
60
A
55
40
Gini Coefficient =
A/(A+B)
B
30
20
15
5
0
20
40
60
80
Percent of Families
100
71
Government Policy to
Reduce Inequality
Transfer Payments (AKA
“welfare”) and Taxes
72
Welfare provides a safety net for citizens
(retirement, unemployment, workers comp, health
care, etc.)
What are some possible downsides?
Where does the government
get the money for welfare?
73
Taxes
74
What are Taxes?
Taxes – mandatory payments to the
government
Two purposes:
1. Pay for government operations
• Public goods: highways, national defense,
police, the court system
• Other programs: welfare, social security
2. Change economic behavior
E.g. Excise tax on tobacco raises revenue AND
discourages cigarette production
75
Three Types of Taxes
1. Progressive Taxes – higher income
earners pay a higher percentage
Ex: Current Federal Income Tax system
2. Proportional (Flat) Taxes – everyone
pays the same percentage of income
3. Regressive Taxes – lower income earners
pay a higher percentage
Ex: Head tax, sales tax
76
Three Types of Taxes
What kind of taxes are these?
(Think % of Income)
1. Toll road tax ($5 per use)
2. State income tax where richer citizens
pay higher %
3. $.45 tax per pack of cigarettes
4. Medicare tax of 1.45 % on every $
earned
5. 5.6% Arizona sales tax
77
Federal Income Tax
Equal Tax of $350 per week (Regressive Tax)
Income
Amount of Tax %
Amount to live on
• $200
$350
175%
-$150)
• $350
$350
100%
$0
• $500
$350
70%
$150
• $1,000
$350
35%
$650
• $5,000
$350
7%
$4,650
Tax tax of 20% per week (Proportional Tax)
Income
Amount of Tax
Amount to live on
• $200
$40
$160
• $350
$70
$280
• $500
$100
$400
• $1,000
$200
$800
• $5,000
$1,000
$4,000
78
Federal Income Tax
This is our current system. Is it
fair?
The final graph to learn
for microeconomics…
The Laffer Curve
Illustrates the relationship
between tax rate and tax revenue
80
The Laffer Curve
% Tax
Rate
If government
raises tax rates,
revenue will
increase…to a
point.
If the tax rate
becomes too high,
tax revenue will
eventually fall.
Why?
Tax Revenue
81
GREAT NEWS…
WE’RE DONE WITH
MICRO!
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