Lecture Outlines - Week 5

Government Intervention in Markets (Ch. 9 Schiller)

Learning Objectives:

1. Under what conditions do markets fail?
2. How can government intervention help?
3. How effective is government intervention?

What is market failure?

It is a circumstance in which the market fails to yield an efficient or equitable allocation of the resource, good, or service in question. Traditionally the focus has been on efficiency, since there isn't a universal metric with which to measure equity.

Thus market failures are allocation failures. Like the story of the three bears, there is either too much or not enough of the resource, good or service.

Under what conditions do markets fail?

1. Public Goods and Common-Pool Resources:

Public goods have the following characteristics:

Common-pool resources have the following characteristics:

Contrast both with private goods, which have the following characteristics:

What are some examples of public goods?

Air, public radio, lighthouses, emergency sirens

What are some examples of common-pool resources?

Clean air, marine capture fisheries, groundwater, wildlife, the stratospheric ozone layer, urban parks

Will markets provide and properly maintain an adequate quantity of public goods and common-pool resources?

Discuss the free rider problem. Examples?

How profitable is it for a firm to produce and supply and maintain something that people can access without paying for it? If firms won't supply public goods and common-pool resources, who will?

What is the Tragedy of the Commons, and under what circumstances does it happen to common-pool resources?

==> If a single individual overuses the commons, the individual gets 100% of the benefits of her increased harvest, but all users share the cost or damage done to the commons. Therefore there is an incentive for all individuals to overuse the commons, even when the individual would rather not ("if I don't overharvest, someone else will, so I had better get mine now"). This tragedy can be averted when the commons is owned (whether by government, individuals, or a community) and thus some entity has legal authority to limit use.

What sort of government intervention in markets occurs in the context of pure public goods and common-pool resources?

What mechanism(s) assures that the government will provide and maintain an appropriate quantity of public goods and common-pool resources?

2. Externalities

2.a. Define a positive externality. If positive externalities are good things, then what's the problem?

Positive externalities are unpaid-for benefits enjoyed by "3rd parties" that are generated as a side effect of a private transaction.

What are some examples of positive externalities?

Vaccinations that avert epidemics, home upkeep that improves the lives and property values of the neighbors, education that makes people more informed citizens and voters in a democracy, etc.

What, exactly, is the market failure associated with positive externalities?

1. Market demand reflects the private benefits to the buyer.
2. When there are positive externalities, "3rd parties" receive benefits that are external to the market, and thus are not reflected in market demand.
3. Consequently, market demand is understated, and too small and amount of the good or service generating the positive externality is produced and consumed.

Thus the market failure due to positive externalities is that too small an amount of the good or service generating the external benefits is produced and consumed.

Draw the diagram. Two demand curves: One based on private benefits alone, and the other larger demand based on social benefits (private benefits + external benefits).

What government intervention might enhance the efficiency of this market? Examples? What might be some problems?

2.b. Define a negative externality to be uncompensated costs borne by "3rd parties" that are generated as a side effect of a private transaction.

What are some examples of negative externalities?

Air pollution emitted by an electricity-generating facility, watershed damage by certain types of logging and road-building practices, loss of fisheries due to hydroelectric dams, etc.

What, exactly, is the market failure associated with negative externalities?

1. Market supply reflects the private costs to the seller.
2. When there are negative externalities, "3rd parties" bear costs pr harms that are external to the market, and thus are not reflected in market supply.
3. Consequently, market supply is overstated, and too large an amount of the good or service generating the negative externality (e.g., electricity generated by burning coal) is produced and consumed.

Thus the market failure due to negative externalities is that too large an amount of the good or service generating the external costs is produced and consumed.

Draw the diagram. Two supply curves: One larger curve based on private costs alone, the other based on social costs (private costs + external costs).

What government intervention might enhance the efficiency of this market?

3. Market Power

A pure monopoly occurs when there is a single seller. A monopsony occurs when there is a single buyer (e.g., a company town with one employer).

A monopoly, or cooperative behavior among a group of firms in an industry, by itself is not illegal. What is illegal is the exercise of market power, which is the ability to manipulate market price and quantity to the detriment of consumers.

What is the market failure due to market power? Too much or too little produced?

Monopoly or cartel problems. Describe why a monopoly or cartel will produce less than if competitive conditions prevailed.

In the US, antitrust law (Sherman, Clayton Acts) makes the exercise of market power illegal. In what way does antitrust law resolve the market failure due to market power?

Some examples of antitrust actions:

• The forced breakup of Standard Oil into Unocal, Sohio, Std Oil of NJ, etc.
• The forced breakup of AT&T/Bell.
• Price fixing by international vitamin producers

4. Information Imperfection

Another source of market failure is imperfect information. If sellers can overstate quality prior to purchase, if employers can misrepresent workplace safety, etc., then there will be a market failure.

Describe them in a diagram.

Have non-government arrangements developed to resolve information imperfections?

What are some government interventions that have occurred?

5. Equity

A key problem with markets in the context of inequality is that willingness-to-pay differs from need. Consequently, goods and services do not necessarily flow to those who need them the most.

This is not reflected in an inefficiency, as in the other cases described above, and thus equity is not a traditional market failure.

Nevertheless, most all governments intervene at some level or another to resolve gross inequality.

Describe some interventions.

How might resolving equity problems lead to other forms of inequity, or to an erosion of efficiency?

6. Macroeconomic Stability

Before the development of central banks, industrial economies were subjected to boom-and-bust cycles, financial panics, etc., that made many people worse off.

As we shall see later in the course, central bank authorities can use their powers over the money supply and interest rates to stabilize the macroeconomy and foster economic growth (increases in real GDP).