Chapter 8 Market and Government Failures. Copyright © 2005 Pearson Addison-Wesley. All rights...

Chapter 8

Market and Government Failures

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8-2

Learning Objectives

• Distinguish between private and social costs and explain their relationship to negative externalities.

• Identify the two characteristics of public goods.

• Contrast economic and social regulation and give examples of both.

• List three important antitrust acts.

• Compare and contrast proportional, progressive, and regressive taxation systems.


Market Failure

• Sometimes the price system does not generate the most beneficial results to society. There might be too few or too many resources going to specific activities. Such situations are called market failures.

• Market failure offers one of the strongest arguments in favor of government intervention.


Some Sources of Potential Market Failures

• While there may be numerous ways in which supply and demand do not lead to the optimal resource use in our society, we will focus mainly on three sources: Externalities, Public Goods and Excessive Market Power.


Externalities

• When you drive a car, you take account of the cost of gas, maintenance, and insurance. These are some of the private costs of driving.

• In contrast, when a cost is associated with your actions, but you do not have to consider that cost, we say that it is external to your decision-making process. This cost is an example of an externality.


Externalities

• An externality in an economic side effect or by-product that affects an uninvolved third party.

• Negative Externalities are the result of a production or consumption activity that imposes costs on third parties; for example, pollution from a factory and congestion from driving.


Examining External Costs

• The supply curve in panel (a) of Figure 8-1 (next) is labeled S1. It reflects those private costs just mentioned. The demand curve is D. The equilibrium is at E.

• If the steel mill owner were required to take into account negative externalities (for instance, all of the health costs associated with increased pollution) the supply curve would shift to S2.


Figure 8-1(a): External Costs


How Could Government Take Account of Negative Externalities?

• It is possible, and indeed it actually happens, that governments charge companies for the amount of pollution they generate.

• Alternatively, governments can seek to simply regulate the amount of pollution each company can generate.


Positive Externalities

• Consider inoculations against communicable diseases. Those individuals who do not get inoculated obtain benefits. That is because epidemics of communicable diseases will not occur because of mass inoculations. The total demand curve is therefore D1 in panel (b) of Figure 8-1.


Figure 8-1(b): External Benefits


External Benefits (cont.)

• If purchasers of inoculations take account of external benefits, the demand curve will shifted to D2. The equilibrium quantity of inoculations per year would increase to Q2.

• The vertical difference between demand curve D1 and demand curve D2 is a measure of the marginal external benefits from inoculations.


How the Government Might Correct Positive Externalities

• The government can finance such activities or it can even produce them, such as governments often do for inoculations.

• Alternatively, governments can subsidize the production or the consumption of a good or service.

• In addition, the government can impose regulations.


Private Goods

• Up until now, we have implicitly been talking about private goods.

• With a private good, when I use them, you cannot and vise versa. This is called the principle of rival consumption. By definition this principle applies to all private goods.


Public Goods

• A key characteristic of public goods is that many individuals can consume them jointly simultaneously. When you partake in the use or benefit of a public good, you do not necessarily take away from anyone else’s share of these goods.


Characteristics of Public Goods

1. Additional users of public goods do not deprive others of any of the services of the goods.

For the continental United States, when more people benefit from national defense, others do not receive less of it.


Characteristics of Public Goods (cont.)

2. It is difficult to design a collection system for a public good based on how much individuals use it.

Because everyone benefits from national defense, it would hard to figure out who benefits more, and therefore who should be charged more.


The Private Sector and Public Goods

• If the production and sale of a purely public good does not yield profits in the private sector, the purely public good will not get produced.

• This is where the government steps in to provide purely public goods, such as national defense.


Economic Regulation

• When government regulatory agencies determine prices, acceptable levels of profits, and/or rates of output in a particular industry, we say that the government is engaged in economic regulation.

• The goal of economic regulation has been to prevent firms from making monopoly profits, and from engaging in aggressive forms of competition.


Social Regulation

• When the government regulates for the benefit of public welfare—health, safety, and environment—across all industries, this is called social regulation.

• Social regulation at both the federal and state levels involves imposing occupational, health, and safety rules for a wide variety of employers.


The Rationale of Antitrust Laws

• While competition generally benefits consumers, producers and sellers certainly would prefer the easier life of monopoly.

• The federal government decided a long time ago that monopolies and attempts to monopolize are not beneficial to the economy.

• Consequently, the federal government has passed a variety of antitrust laws.


Important Antitrust Acts

• The first national antitrust law was the Sherman Antitrust Act, passed in 1890, which made illegal every contract and combination in the form of a trust in restraint of trade.

• The Clayton Act, passed in 1914, made price discrimination and interlocking directorates illegal.


Important Antitrust Acts (cont.)

• The Federal Trade Commission Act of 1914 and its 1938 Amendment established the Federal Trade Commission—charged with the power to investigate unfair competitive practices.


Government Financing

• As you have seen, the government is involved in regulation, antitrust activities, national defense, and literally hundreds of thousands of other activities.

• The first question we have to answer is how we pay for government. We do so, for the most part, via taxation.


Marginal and Average Tax Rates

Change in taxes dueMarginal tax rate =

Change in taxable income

Total taxes dueAverage tax rate =

Total taxable income


Taxation Systems

• Proportional Taxation—means that regardless of an individual’s income, taxes comprise exactly the same proportion.

• The marginal tax rate is always equal to the average tax rate. If every dollar is taxed at 20 percent, then the average tax rate is 20 percent, as is the marginal tax rate.


Taxation Systems (cont.)

• Progressive Taxation—Under progressive taxation, as a person’s taxable income increases, the percentage of income paid in taxes increases.

• The marginal tax rate is above the average tax rate.


Taxation Systems (cont.)

• Regressive Taxation—With regressive taxation, a smaller percentage of taxable income is taken in taxes as taxable income increases.

• The marginal rate is below the average rate. As income increases, the marginal tax rate falls, and so does the average tax rate.


Government Failures

• When the government engages in activities that reduce social welfare or economic efficiency, we call this situation one of government failure.

• Types of government failures: actions that reduce competition, especially from abroad; improper pricing of health care, particularly through Medicare; and inefficient methods of regulation.


Key Terms and Concepts

• antitrust laws • economic regulation

• government failure • marginal tax rate • market failures • negative

externalities • positive externality • private costs

• private goods • progressive taxation

• proportional taxation

• public goods • regressive taxation • regulation • social regulation

Chapter 8 Market and Government Failures. Copyright © 2005 Pearson Addison-Wesley. All rights...

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