14. Market Failures and the Potential Role for GovernmentIn this chapter you will learn:

About the problems of the private market system. These include:The widening of the income distribution;Monopoly exploitation;Uncertainty;Goods the private sector cannot provide, Public Goods;Actions that harm others or benefit others outside the market: Externalities;The Coase solution to externalities;Solving social problems.

14.1 Problems with the market outcome: income distribution.The income distribution is the outcome of a complicated process. Millions of people buy and sell a broad variety of products and services on numerous markets and this generates economic activity and hence income. This process also generates the distribution of income across people. If the process changes over time, then the distribution will change.

To describe the distribution we can separate the population into groups and calculate how much income each group has. For example, split the population into groups of 20%, and calculate how much income the bottom 20% has, how much income the next lowest 20% has, and so on. As a simple example, suppose there are two people, A and B, there is a total of $5 available in the economy, and A gets $4 and B gets $1. Then the top 50% of the population (person A) has 80% of the income and the bottom 50% (person B) has only 20% of the income. We can split the population up any way we want. One popular way is to compare the top 1% against the bottom 99%.

Typically, the top 10% in most countries receives a lot more than 10% of the income generated by the economy. Around World War One the top 10% of the income distribution in the US received about 45% of the country’s income. However, this fell dramatically during the Great

1

Depression to less than 35%, and stayed there until about 1980 when it started rising again. It is now above where it was in 1930. This pattern was true for most advanced countries.

It appears that income is more skewed toward the top earners now and some have suggested that the middle class is shrinking as more income shifts to income earners at the top of the distribution. This same phenomenon is occurring in other countries in Europe, Asia, and Latin America as well. So this is a worldwide phenomenon, not just isolated to one country.

Most issues involving the income distribution inevitably involve fairness, the rules under which transactions take place, global competition, education and training across the population, discrimination, and a broad variety of other factors. A person’s view about the income distribution is conditioned by a number of these factors. Consider the following scenario.

Suppose we have $1 to divvy up between two people. How should we do it? Without any further information, most will answer: 50 – 50, as fairness would suggest. Next, suppose person A is rich and person B is poor. How should we divvy up the $1? Many will say give 75¢ to the poor person and 25¢ to the rich person. So the initial wealth of the recipients will matter. Third, suppose the poor person will probably spend some of whatever he gets on cheap wine, or drugs. Many will then say that the poor person should only get 5¢ and the other person should get the rest. So the expected consumption of the transfer will matter. Fourth, suppose the poor person is mentally challenged and cannot work as a result. Many will transfer more of the dollar, e.g., 95¢, to that person so those with perceived challenges may receive more. On the other hand, suppose the poor person doesn't like work and chooses not to work. Most will transfer less to such a person. So the recipient's perceived reason for not working will matter in deciding on a transfer. Finally, suppose, the poor person must use the money to buy medicine for a sick child. Now, many will respond by giving the $1 entirely to the person with the sick child. The allocation of the $1 will depend on whether or not a child is the ultimate recipient.

Summarizing, people will generally condition their feelings about the income distribution and the help society should give to people on a number of factors such as whether the recipient of a transfer is poor because of their own unwillingness to work or whether they are incapable of working, what they will spend the money on, whether children will receive the aid or not, and a number of other factors. And views on welfare programs have changed dramatically in the last thirty or forty years. Some analysts believe that people were more willing to transfer to the poor during the 1960's than now in the 2000s.

Should we care about these changes in the income distribution? One could argue that we don’t know enough about this complicated process to adjust it with policy. One could go a step further and argue that imperfect policies could make the problem worse. On the other hand, when the income distribution becomes more unequal, crime rates soar, drug and alcohol abuse increase, there is more domestic violence, and the divorce rate increases. These negative outcomes impose a huge cost on society, but may be alleviated by programs that redistribute income and provide other forms of assistance, e.g., job training, student loan programs. However, there are tradeoffs.

First, consider the goal of redistribution. The initial endowment point in the diagram is point E. Person A has most of both goods and trading leads to an equilibrium at A where person A is clearly a rich person consuming most of both goods and person B is poor. Some would want to redistribute the endowment from point E to point E', and then allow trading to take place. The new equilibrium at point A' is more egalitarian than point A; the goods are more evenly distributed between the two agents at A' than at point A. This type of redistribution occurs in many countries. It is more extreme in Scandinavian countries and much less so in Latin America.

2

This is complicated by the possibility there might be a tradeoff between equity and the efficiency of production. Consider the following Edgeworth Box with the associated competitive equilibrium with production at point P and consumption at point C. At C one person receives most of everything and so would be considered a rich person while the other person is really poor. Society might view this unfavorably and consider redistributing from the rich to the poor. This policy would lead to different trading and different relative prices and a new allocation point like C'. Clearly, the poor are better off and the rich are worse off. Unfortunately, there is no way to make an objective comparison between C and C', only subjective comparisons based on opinions can be made. Most people choosing between the two before knowing if they would be rich or poor in such a society would choose the more egalitarian outcome, C’.

However, this is not the end of the story. When the government redistributes income from one person to another it must use a particular policy. For example, it may use a progressive tax system, which taxes the wealthy at higher rates than the poor, and it will typically transfer to the poor through welfare programs like the school lunch program, food stamps, and college loan subsidies. Taxes may reduce the incentive to work and save at the margin and anti-poverty programs may also reduce the incentive to work. Therefore, less will be produced when such programs exist and the PPF will shift in as depicted, where x* > x** and y* > y**.

3

This shrinking of production is the loss in efficiency the economy experiences when it tries to redistribute income from one group to another, e.g., from the young to the old through social security, from the rich to the poor through the income tax or welfare programs, from the middle class to wealthy defense contractors through defense spending, and so on. This depicts a tradeoff between equity and efficiency. The more equity we want to achieve, the more we will have to give up in production efficiency.

There have been a number of explanations as to why income is becoming more unequally distributed and many of the explanations are similar to those given as to why the economy is growing less quickly now than in the 1990s or 1960s. Most of the explanations involve changes in the economic environment that affect people in the middle or the lower end of the distribution. They are the following.

A. Foreign competition has eliminated many manufacturing jobs in the US and many jobs, even some white-collar jobs, are being outsourced.

B. Fewer workers are in labor unions. Unions can more effectively negotiate with a large corporation than a single worker can and can protect a worker’s rights to breaks, health care, and capricious firing. Unionization has fallen from 39% in 1945 to less than 12%.

C. There has been a shift from manufacturing to services and service jobs typically experience low productivity growth and low pay as a result.

D. Many firms are substituting capital (robots and computers, etc.) for labor. This has occurred in a number of industries, e.g., jet aircraft, autos, steel, paint, tires. It serves to keep wages down.

E. Many people lack basic computer skills and skills in more advanced areas like robotic repair, high end lab work, and statistical quality control, that pay well, and they have difficulty financing additional training.

F. Government Regulations reduce efficiency since it is costly for private business to comply. In particular, two laws are very costly to comply with, the Environmental Protection Act of 1970 and the Americans with Disabilities Act. These laws have tremendous benefits to society but also have some costs.

We can ask how the US compares to other countries. As you can see from the map, most countries have less inequality than the US (blue versus purple).1 1 The gini coefficient for each country is depicted in the map. The gini coefficient is a measure of income inequality. It is between zero and one and the higher it is the less equal the income distribution is. For example, if country A has a gini coefficient of 0.23 and country B has a coefficient of 0.49, country A has a more equal distribution of income. And, if the gini coefficient is increasing over time it means that income is becoming less equally distributed in that country.

4

In data on the countries in the OECD, which comprises the industrial economies of the world (Europe, North America, and Japan), inequality has increased in almost all of these countries since 1980. The shift of income to the top in a lot of countries since the late 1970s and early 1980s is a worldwide phenomenon. One explanation that is supported by some evidence, is the Capital Skilled Labor Complementarity Hypothesis, or CSC hypothesis for short. Suppose output is produced using capital, skilled labor, and unskilled labor, Y = F(K, S, U), where K is capital, S is skilled labor, and U is unskilled labor. Suppose capital and skilled labor are complements in production and capital and unskilled labor are substitutes. What would happen if more capital is accumulated over time? As capital accumulates, the demand for skilled workers increases if S and K are complements, while the demand for unskilled workers would fall if U and K are substitutes. This means that the income of skilled workers would increase over time, while the income of unskilled workers would fall. This would cause a widening of the distribution of income to occur over time.

14.2 Problems with the market outcome: market power and monopoly.Another problem with the private market system is monopoly, and more generally, market power. Large firms like Apple, JP Morgan Chase, Dow Chemical, Walmart, and United, do not behave as a small firm does under perfect competition. They don’t take price as given. They advertise and innovate to get ahead. And they pursue policies designed to increase their market share. The monopolist is the extreme case. Large firms under imperfect competition or monopoly, choose output where MR = MC, and p > MR = MC. This is not optimal since as we have seen, optimality requires p = MC. So the existence of monopoly, or firms with market power, can lead to an outcome where output is too low and price is too high.

However, there is some tension here as mentioned in Chapter 10. A monopoly is created when someone has a new idea and receives a patent for it. This is where new products come from and clearly consumers demand such products. So it seems appropriate that we provide people with an incentive to produce new ideas and new products from those ideas. So we need to distinguish between the actions of a firm with market power that generate new products consumers obtain utility from and other actions taken by such a firm that are designed to rig the market in their favor, e.g., mergers, price fixing, and false advertising.

5

A caveat is in order. Market power does not last forever. A firm will not be able to maintain a monopoly advantage for long even if it has a patent. It is certainly possible to alter a patent enough to allow a competitor to produce its own version of a product. And new technologies can threaten old monopolies. The cell phone would surely have driven AT&T out of business. Some of Apple’s products like the iPad with its iOS have effectively challenged Microsoft’s monopoly over the operating system of a computer. And Samsung has in turn challenged the dominance of Apple’s iPhone. And now Walmart is feeling intense competitive pressure from Amazon.

14.3 Problems with the market outcome: uncertainty and imperfect insurance markets.Sometimes a market doesn’t function properly, and in the extreme, may fail to exist altogether, despite the demand for the product. For example, an incoming freshman would like to buy an insurance product that would insure her against not having a job within six months of graduation. Unfortunately, no such insurance contract exists despite the possible demand for it. Why? To answer that question we need to take a look at how people respond to uncertainty.

In many situations one side of the market has more information about the product than the other side. Whenever this is true, we say the information is asymmetric. Usually the supply side of the market knows more about the product than the demand side. GM and Toyota know more about the safety of their cars than the buyers do. Goldman Sachs knows more about the riskiness of its derivative bonds than the investor does. And you know more about whether you are a good worker or not than your employer.

There are two problems that always arise in situations involving uncertainty when information is asymmetric, moral hazard and adverse selection. Moral hazard is any situation where the existence of insurance increases the probability of the bad state of nature occurring. Having auto insurance may cause people to drive less safely and cause more accidents to occur, the bad state of nature being an accident. The existence of flood insurance may cause more people to move to a flood plain increasing the payout if there is a flood. People with health insurance see the doctor more. When moral hazard exists people change their behavior because of the insurance.

Adverse selection is a situation where the people who are the bad risks want to buy the insurance more than the people who are the good risks. If only the bad risks want the insurance the market will collapse. For example, bad drivers are more likely to buy collision insurance than good drivers. Sick people are more likely to buy health insurance than healthy people. Lazy people are more likely to buy unemployment insurance, than workaholics.

One general rule is that the good risks subsidize the bad risks. The insurance company collects premiums from all drivers, but only pays out when someone has an accident. More of the bad risks will have accidents than the good risks. Some of the good risks won't have any accidents at all, yet, will still pay premiums for their insurance coverage. So the good risks subsidize the bad risks. The insurance company would like to have more good risks than bad risks but risk is not something they can calculate perfectly. They will usually try to charge the bad risks more for their insurance than the people who are good risks, once the company has discovered a person is a bad risk.

There are a number of situations where private companies may have trouble offering insurance at an affordable price because of moral hazard and adverse selection. These include health, employment, old age, natural disasters, and student loans, among others. The private market might not exist or charge such a high price for the insurance that few are willing to buy it. Yet, there is still a demand for it. One potential solution to this problem is social insurance, where the government steps in with subsidies or provides the insurance itself.

6

To illustrate the basic idea, consider a student who wants to go to college, but can’t pay for it. This requires that they borrow to pay tuition and expenses. Banks will generally require some form of collateral for the loan, which is some asset the bank can seize if you do not repay the loan. What can you use as collateral to get the loan? When you buy a house or car the collateral is the house or the car. If you don’t make a loan payment the bank forecloses on the house or repossesses the car. What is your collateral for a loan to go to school? Typically, it is your future earnings after graduation. However, that won’t work; it’s too risky for the bank. You can get someone to cosign the loan in which case they take on the risk and repay the loan if you do not. Or a bank may charge you a risk premium for the loan, which is very high interest designed to compensate the bank for the extra risk in making a loan to you. But such high interest may cause some to avoid taking out a loan and either drop out, or take much longer to finish, which is socially inefficient.

Does moral hazard and adverse selection affect the student loan market? Yes. If you get the loan are you more likely, or less likely, to take more time to finish? Some may take more time since the pressure to pay bills is gone so moral hazard probably exists. Who is most likely to want to take the loan? Probably students who have incurred large bills thus making it harder to repay the loan so adverse selection also exists. These problems cause the market to work very inefficiently. So a subsidized student loan program is probably an appropriate policy response to this problem. The loan program need not be run by the government but simply financed by it, while banks in the private sector deal with the details of making the actual loans.

Unemployment, health care, retirement consumption, and natural disasters are also problems that have the same characteristics as the student loan problem. Moral hazard and adverse selection exist for each of these areas and are acute enough to make private solutions impossible to implement. This calls for some form of government intervention. Take health insurance, for example. Who are the bad risks to an insurance company? Sick people. Who is more likely to want the insurance? Sick people. Will the availability of the insurance change behavior? Probably. Private insurers will charge high premiums for such insurance and this will cause some to avoid buying the insurance. So it may be appropriate for the government to provide some form of social insurance.

There is another problem with private insurance for situations such as health care and "old age" insurance (that pays for your retirement consumption). Someone might refuse to buy private insurance when they are young, either because they want to spend their money on other things, or because they think they will be able to work as long as they like. If they become sick, or have to retire early, they would be destitute. If that were to happen, they might throw themselves on the mercy of society, who might respond by helping them out. The issue then becomes: how can we eliminate this type of situation where people take advantage of society's altruism? One answer is to force everyone to contribute to helping such people out, including those people who might take advantage of society’s altruism, by taxing everyone and then paying benefits to people who are retired, or who need health care. This is another justification for programs like social security and Medicare as a forced savings program so that everyone helps in the solution to the general problem and cannot take advantage of the system.

Therefore, private insurance markets may fail to exist or may not function properly because of moral hazard and adverse selection, which are both caused by asymmetric information. Some forms of insurance are very expensive and do not cover many situations. Some may not buy the insurance as a result because the price is too high. This may lead to a role for government to play in providing social insurance.

Application: Are some banks and large companies too big to fail? Will the economy collapse if a large company or bank goes under? If so, it may be deemed too big to fail and

7

receive a bailout from the government if it needs help. Now imagine you are running such a company. If you believe that your company is literally too big to fail, will this affect the amount of risky projects you undertake? Probably. And who is more likely to go to the government asking for a bailout, a company on the brink of bankruptcy, or a perfectly healthy company? So moral hazard and adverse selection exist under this form of insurance policy.

In 2008 our financial system literally locked up and there was the very real possibility that the entire system could crash and cause another Great Depression. The Treasury Department under Hank Paulson, Secretary of the Treasury under the Bush Administration, orchestrated a massive bailout of our largest banks to stave off a complete collapse. And the Fed essentially purchased private assets from the largest banks like Goldman, Citi, and JP Morgan Chase, in order to shore up the financial system. This was unprecedented especially for a Republican Administration.2

GM and Chrysler also came under attack during the crisis and had to be bailed out by the government. Negotiations began under the Bush Administration and were completed by the Obama Administration. The argument was that if GM went under jobs in other industries would be lost. GM is the largest customer of the steel, paint, tire, and car stereo industries. This would ripple through the entire economy causing another Great Depression. Too Big To Fail is the ultimate form of insurance.

The really interesting question is the following: if the government lets it be known they will bail out large companies who get into trouble, will this cause more large companies to take even greater risks and thus increase the likelihood of getting into trouble thus requiring a bailout? Clearly, the answer is yes and this provided the impetus for the Dodd Frank law aimed at ending this sort of “too big to fail” possibility in the financial services industry.

14.4.1 Problems with the market outcome: public goods.As it turns out there are many goods the private sector cannot provide like clean air. If people gain utility from such goods, but the private sector cannot provide them, there is a potential role for government. This does not mean the government has to actually provide the good itself.

Consider the following streetlight game. There are two neighbors, A and B, who live at the end of a cul-de-sac and there is no street lighting. They meet in the middle of the street to watch the sun go down and both remark on how dark it gets and how nice it would be if there were a streetlight. Assume the streetlight costs $100 per week and that a single family would receive a benefit measured at $80 per week from the streetlight.

What is the individual’s incentive? Clearly, family A would not provide the light by itself since the cost is greater than its own individual benefit. So the individual incentive is not to pay for the light. The problem is that if A pays for the light, B also benefits from it, but doesn’t pay for those benefits. If A pays for the light, some of the benefit "spills over" to B. And, similarly if B pays for the light; if B pays for the light some of the benefit “spills over” to A. This is not true of other commodities like an apple. When A pays for an apple and consumes it, only A benefits from the apple and B does not.

What is the group incentive in the streetlight example? Clearly, both A and B benefit from the streetlight and the total benefit of the group is greater than the cost, $160 > $100. The group incentive is to get together and share the cost of the streetlight. The point is that self interest may not be enough to get the streetlight produced; the two individuals have to agree to share the cost. This is a case where the individual's incentive differs from the group incentive.

2 The banks receiving bailouts repaid the money plus interest very quickly so they could begin paying huge bonuses to its top employees. However, the government actually made money on the deal.

8

To continue with the streetlight example, suppose the two neighbors try to share the cost of the light and assume that if both neighbors contribute to the light they split the cost evenly. Imagine that the two neighbors agree to share the cost for the streetlight, but then must go back to their respective houses to actually write the check to the power company, who will install and maintain the light. If only one family sends a check to the power company assume the power company sends that family a bill for the rest of the cost of the light. The payoffs are given in the following table. (30 = 80 - 50, - 20 = 80 - 100 and so on.)

If the game is played once the equilibrium is where A and B both choose “don't contribute.” Each consumer tries to free ride on the other consumer hoping they will contribute. If both do this, however, the good is not provided. This is the same problem faced by the members of a cartel. The group incentive is to form a cartel to exploit the market, while the individual incentive is to cheat on the cartel. The same is true regarding the streetlight. The problem is that there is no way of enforcing the agreement unless A and B write a binding contract committing them to sharing the cost of the light. We discuss what may happen if the game is played repeatedly in the Appendix. Notice that to make the proper decision we had to sum the benefits of the streetlight and compare that to the cost. This is different from goods like apples and movie rentals on iTunes.

Other examples of public goods include national defense, lighthouses, public infrastructure like roads, bridges, highways, streets, airports, water and sewer systems, clean air and water, basic research, air traffic control, the general health of the population, police and fire protection, and satellite weather information. There are even "international public goods" like peacekeeping efforts, the information provided by Interpol about criminals who cross country borders, saving the whales, and foreign aid. The free rider problem arises in each example.

14.4.2 Public goods and private goods Imagine a lake with houses arranged around it. In the warm weather there is a mosquito problem. The problem won't be solved if one homeowner sprays for mosquitoes. Only if they all spray will they eliminate the mosquitoes. It might be difficult for the individuals to organize if there are a lot of owners. And some owners may take advantage by not spraying hoping that everyone else will and that this will control the mosquitos. So government can usefully step in, charge a small fee, and oversee the spraying. Mosquito control can be thought of as a public good. And once the mosquitoes are gone, people can enjoy picnics, sunbathing, and boating. And, the demand for picnics, or boating, is probably positively related to mosquito control.

These so-called "public goods" have certain characteristics that make them difficult, if not impossible, for the private sector to provide. First, consider a private good. A private good is a commodity that exhibits exclusion and depletion. Exclusion is where people who benefit from the existence of the good are forced to pay for the good and those who do not pay are excluded from enjoying the benefits of the good. For example, if you wish to consume an apple you must

9

pay the owner of the apple. If you don't pay, then the owner can exclude you from consuming the apple and enjoying its benefits. Paying for the good essentially transfers the property right from the owner to the buyer. Depletion, which is sometimes referred to as rivalry, means that more resources have to be used up, or depleted, to produce one more unit of the good so another consumer can enjoy the benefits of the good. To produce one more apple will cost society an additional expenditure of resources. It cannot be produced for nothing. A private good exhibits exclusion and depletion.

A pure public good exhibits non-exclusion and non-depletion. For example, "clean air" is a public good. No one can be excluded from enjoying the benefits of "clean air" once the good "clean air" has been produced (non-exclusion) and we can provide one more person with the commodity "clean air" without expending any additional resources (non-depletion or non-rivalry).

Mosquito control exhibits both non-exclusion and non-depletion. It is impossible to exclude one homeowner from enjoying the benefits of mosquito control once all the mosquitoes are eliminated, and one more homeowner can build a house and enjoy life on the lake without causing society to spend more on mosquito control. So mosquito control is a pure public good.

It is really exclusion that creates a problem for the private sector. If the owner of the good cannot exclude people who do not pay from enjoying the benefits of the good in question, then the owner has no incentive to provide the good. For example, imagine a company that produces "clean air" and tries to sell it. In order to be compensated for providing the good, the company would have to charge people for the air they breathe. How would it collect? Would people send a check to the company every month or would they "free ride?" They would probably free ride and try not to pay. But if everyone does this, the company would go bankrupt and the good "clean air” would not get provided despite the demand for it.

As another example, it is technically possible for a private company to operate a highway by charging tolls and restricting access to the road. Tolls could then be collected. There were even private companies who ran lighthouses in the 17th and 18th centuries. Every ship that sailed past the lighthouse would dock at the local harbor and would have to pay a fee to the harbormaster for sailing past the lighthouse. However, there were problems with private provision. Some toll collectors were corrupt. They would set up wealthy travelers for "highwaymen" who would rob them. And some harbormasters would seek bribes in order to look the other way when ships offloaded goods that were not on the manifest. So government provision took precedence. In addition to this, governments also realized the amount of revenue they could obtain for themselves by controlling the roads and harbors. In fact, this was a major source of tax revenue in the 18th and 19th centuries. So, control of the roads and other infrastructure passed over to the state.3

There is a symmetry between a private good and a public good. For a private good everyone pays the same price but would like to consume different quantities. For example, everyone pays the same price for an apple but consumes a different amount. For a pure public good everyone must consume the same good but would be willing to pay a different price. Why? Suppose the public good is "clean air." Presumably, anyone who breathes the air consumes the same commodity, namely, "clean air." However, because people differ, each person would be willing to pay a different amount for the good "clean air."

14.4.3 Equilibrium with public goods3 There is a technology that would place a GPS monitor inside your car’s engine that would track every road and bridge and highway you use and send you a bill at the end of the month, like a Cell phone bill with all your calls on it. Each local government would get paid based on the weight of your car and how much of their roads you used.

10

Recall that for a private good under competition, p = MC. To obtain the market demand for a private good earlier in the course we summed horizontally. We fixed the price and determined how many units each person was willing to buy at the going price. Then we summed up horizontally across different consumers. Why horizontally? Because in a supply and demand graph price is on the vertical axis and quantity is on the horizontal axis. When we sum horizontally everyone pays the same price but consumes different quantities.

To obtain the demand for a public good, we sum vertically, rather than horizontally, because for a pure public good everyone consumes the same “good,” but is willing to pay a different price. Let’s see how this works.

Suppose there are two types of consumer, A and B. Their respective demand curves or "willingness-to-pay for the public good" curves are depicted as dA and dB. Imagine the public good is "quality of the driving experience for one trip across a bridge," and G = size of the bridge, e.g., two lanes, four lanes. Pick a level for G, say G1, and ask how much is each agent willing to pay for G1? A is willing to pay $9 while B is only willing to pay $3. Sum them to get the total willingness to pay for G1, $12, point a in the diagram. Do the same thing for G2 ($7.5 + $3 = $10.5, point b) and G3 ($6 + $3 = $9, point c) and so on. This yields society's total willingness to pay for G or its total market demand curve, D. We can then combine the market demand curve with the marginal cost curve of producing G to obtain the optimal solution for G. Apparently, the optimal level of G is given by G3 where D = MC. Note that we are summing the benefit of the public good to get the total benefit and setting that equal to the marginal cost. This is very different from a private good where the individual chooses consumption so their own benefit is equal to the price or marginal cost.

Intuitively, when a consumer consumes one more unit of x, their benefit is the marginal utility, MUx. When they give up some y they lose MUy. The ratio MUx/MUy is the benefit - cost ratio of shifting from y to x. It is literally how much y the consumer is psychologically willing to give up for one more unit of x. What do they actually have to give up? The price charged by the market, i.e., the market tradeoff, px/py. The consumer chooses their consumption of private goods where the psychological tradeoff is the same as the market tradeoff, MUx/MUy = px/py. With competition and marginal cost pricing we have the rule,

MUx/MUy = MCx/MCy.

11

Example: Suppose the consumer is willing to give up two movie rentals at iTunes for one meal at Denny’s. Then their “willingness to pay” for one meal at Denny’s is two movie rentals, MUmeal /MUrental = 2. If a meal costs $9 and a rental at iTunes is $4.50, the consumer is in equilibrium. If the market price equals marginal cost, then this is an equilibrium for society.

For a pure public good we sum the benefits because everyone benefits from the same good, G, and we ask how much of a generic private good each consumer is willing to give up for more of the public good. Let y be a generic private good. Then (MUG/MUy)A is consumer A’s willingness to pay for G, or how much y the consumer is willing to give up for G, and (MUG/MUy)B is consumer B’s willingness to pay for G. Sum to get society’s total willingness to pay for G, (MUG/MUy)A + (MUG/MUy)B. This represents the Market Demand for G. To find the equilibrium set this equal to the marginal cost. The rule is

(MUG/MUy)A + (MUG/MUy)B = MCG/MCy

where it is usually assumed the generic private good y has a marginal cost equal to one for simplicity, MCy = 1. This is known as Samuelson’s rule; at the optimal choice for the public good, the sum of benefits equals the cost at the margin.

Example: Suppose G is the bridge in the previous example and a can of Pepsi is the generic private good, which costs $1.00. Then at point c in the diagram consumer A is willing to pay 6 cans of Pepsi for a trip across the bridge, while consumer B is only willing to pay 3 cans. Sum to get 9 as the total benefit.

The question then becomes: how do we actually pay for G3? Since A and B are willing to pay different amounts it seems reasonable to charge them different amounts. Optimally, we should charge A $6 because that is her willingness to pay for G3 and we should charge B $3 because that is what he is willing to pay. This is known as Lindahl's solution after the Swedish economist who first proposed it.

For pure public goods, it is widely believed that the government must provide the good in question since the private sector has great difficulty in doing so. This is why the problem exists in the first place. Taxes must generally be imposed to pay for the good. However, some public goods are impure in that there is congestion, hence depletion, associated with the good, e.g., crowded museum. To whatever extent it can, the government should probably charge user fees to help cover the cost of an impure public good and to cut down on congestion. In fact, it is actually optimal to charge a "user" fee to reduce congestion. So people who use public docking facilities, national parks, museums, and crowded streets and highways should pay a fee and then they will economize on their visits to the public good.

Application: Student health service. How much should we charge for the student health service? At many universities students pay a fixed fee and can visit the health service as much as they wish. Sometimes the waiting room is full, i.e., there is congestion. If a nominal fee, say $10, is charged for each visit, congestion might be reduced but some students might not go to the health service. In that case, certain illnesses would become more prevalent on campus, the likelihood of contracting such illnesses would increase for many students, and additional problems might arise as the disease spreads more rapidly through the population. The quality of health for students on campus is probably a pure public good and visits to the health service contribute to it. So charging a fee to cut down on congestion might not be a good idea in this case even though there is congestion.

Application: Privately provided public goods. Sometimes a "public good" can be provided by the market. Charity is one example. Another example is when a flood threatens a town and complete strangers send money to help the flood victims and show up to fill sand bags. Volunteering time is a third example. A neighborhood watch program is a fourth example.

12

14.5 Problems with the market outcome: externalities. An externality is any situation where one agent's behavior or action affects another agent. A pecuniary externality occurs within a market. A non-pecuniary externality occurs outside a market. Externalities can also be classified as to whether they are beneficial or harmful. Sometimes these effects are called "spill over" effects because the agent's action "spills over" and affects another person.

Examples of various externalitiesExternality: Someone sneezes and you catch a cold.Non-pecuniary externality: The Exxon Valdez spilled a large amount of oil off Prince

William Sound and ruined the local habitat and killed many animals living in the Sound.Pecuniary Externality: The Exxon Valdez spilled a large amount of oil off Prince

William Sound and the resulting shortage raised gasoline prices on the west coast by about 10-15¢ per gallon.

Non-pecuniary externality: An outbreak of salmonella, a deadly bacteria, in peanut butter originating at the Peanut Corporation of America, caused a dramatic drop in sales of Skippy, Jif, and Peter Pan, even though salmonella was not found among those name brands.

Beneficial Externality: Research that finds a cure for cancer.Harmful Externality: Pollution.

It is widely believed that the government should only intervene in important cases involving non-pecuniary externalities, where the externality occurs outside the market. Markets essentially allocate goods across potential buyers and sellers. If the price is high, few will wish to buy. If the price is low, more will want to buy the good. When a "shock" hits the market, the price will rise or fall. If it rises, fewer people will be able to afford the good. If it falls instead, more will. Obviously, consumers are happier when the price falls than when the price rises. The government should interfere with this process as little as possible. As we have seen in other circumstances like price controls, when the government does intervene it can make the markets function less efficiently and a misallocation of resources can easily result.

For example, during the Christmas shopping season there always seems to be a toy children have to have. Effective advertising essentially creates a demand and parents frantically scurry around trying to fulfill that demand. The price of the toy rises and desperate parents will pay the price. Some won't. The market will allocate the good across all of those potential consumers. Should the government intervene and pass a law stating that every family that wants one should get the toy?

The only exception to the rule of only intervening in the case of an important non-pecuniary externality is when the shock to the market in question adversely affects the income distribution. For example, home heating oil prices increased dramatically during the Gulf War. The Gulf War caused a shortage of oil, and thus gasoline and home heating oil, causing prices to increase. Home heating oil is very expensive and an increase in its price can create a hardship for poor people.

What policy should the government pursue in the case of an externality that occurs outside the market? This depends on the individual situation. However, in general, it should pursue policies aimed at having economic agents face the social marginal cost of their actions. This includes the private marginal cost we have been studying all along this semester. In addition, it also includes any additional positive or negative externality costs the agent may perpetrate on others at the margin. Consider the following example.

Example: Suppose there is a chemical producer that builds a new factory and begins dumping toxic waste into a river. Further suppose there is a fishing village downstream. The

13

toxic waste reduces the number of fish and thus raises the cost of fishing to the fishing village. Essentially, the chemical producer's action affects the fishing village adversely and it is outside the normal market system so it is a harmful or negative, non-pecuniary, externality. Also assume that both the chemical producer and the fishing village behave competitively so each takes the price in its market as given. In the diagram below the chemical producer faces the private marginal cost (PMC) of producing its product but not the social marginal cost (SMC) of its actions which includes the damage to the fishing village. It produces at point a, where Pc = PMC, which maximizes its profit. The fishing village produces at point a' where Pf = MC before

the chemical plants opens up because this is where it maximizes its profit. After the chemical plant opens, pollution increases and it becomes more costly to catch fish so the fishing village's cost curve shifts up. Given the increase in its cost, output drops from a' to b' and people are laid off and some fisher people will go out of business. Under competition, the chemical producer is at point a and the fishing village is at point b' after chemical production starts and the pollution problem begins. Too much is being produced by the chemical producer because the chemical producer is not facing the social marginal cost of production and not enough is being produced by the fishing village relative to the optimal levels of production at points b and a', respectively. The problem is that the chemical producer is not taking into account the impact it has on the fishing village.

The social marginal cost curve, SMC, includes all social costs of production including the costs associated with the pollution damage. Y*c is the optimal level of chemical production since this is where Pc = SMC. The problem is how to get the chemical producer to face the SMC curve rather than the PMC curve. The optimal response of the government is to impose a tax or fine per unit of output on the chemical company for creating pollution. This raises its private marginal cost curve until it equals the social marginal cost curve. When the chemical producer faces the SMC curve because of the tax, it will choose the optimal level of production at b. The increase in the PMC curve is the tax rate imposed on the chemical company. Optimally, a producer should always face the social marginal cost of production, SMC. The government can impose a tax or fine on a polluter in order to force the polluter to face the SMC instead of the PMC. If the polluter faces the SMC, its decisions will be socially optimal.

As another example, consider a researcher who produces basic research, upon which applied research later can be based. There is a demand for basic research and a marginal cost of producing basic research. The PMC curve depicted below is the private marginal cost of producing basic research and the SMC curve is the social marginal cost. In a competitive equilibrium, the output of research will occur where D = PMC at point A. However, the socially

14

efficient level of basic research occurs at point B instead because of the possible beneficial externality effects associated with basic research.

How does this work? There are enormous benefits to doing basic research that spill over and help others. A scientific break through published in an academic journal anyone can read and study can have an enormous impact on a variety of different companies. If basic research is done and made available to everyone, then each private firm doesn't have to do the basic research itself, i.e., each firm doesn't have to "reinvent the wheel" itself, the wheel need only be invented once by the basic researcher. Each private firm can instead focus on applied research based on the basic research. This is an example of a beneficial non-pecuniary externality. Basic research increases the productivity of the private sector at the margin. This is an extra benefit of basic research not really reflected in the private marginal cost curve. In fact, basic research actually reduces a private firm's marginal cost making it easier for private firms to produce private goods. Thus, the social marginal cost of producing basic research is lower than the private cost because of these beneficial externality effects. This means that it is socially optimal to produce more research than the market outcome, Goptimal > G*, as depicted at point B.

A solution to this problem is to subsidize basic research. A subsidy shifts the private cost curve down until it is equal to the social marginal cost. The subsidy rate is the distance between the two cost curves, PMC - SMC. The idea is that the researcher in a competitive world faces the PMC curve. However, only G* will be produced in that case and this is suboptimal. A subsidy that lowers the researcher's marginal cost from PMC to SMC will induce the researcher to produce more research, G-optimal, and this is socially efficient.

In general, the government should subsidize those who create a beneficial non-pecuniary externality and tax those who cause a harmful non-pecuniary externality so that they face the social marginal cost of their actions. SMC < PMC when there is a beneficial externality and the appropriate subsidy is PMC - SMC. If SMC > PMC, then there is a harmful externality being generated and the tax is SMC - PMC because the SMC curve is above the PMC curve. This is known as the Pigouvian tax-subsidy policy after A. C. Pigou, the British economist who first worked it out.

14.6 The Coase Solution.We should note that it will not always be optimal for the government to intervene in an externality situation. Two remarks are in order. First, the benefits of intervening must outweigh the costs. When an oil tanker runs aground and spills thousands of barrels of oil thus destroying natural wildlife areas and fouling the water for miles around, clearly, the benefits of intervening outweigh the costs. However, one can imagine smaller situations where government intervention is not required. For example sneezing on someone giving them your cold is a harmful, non-pecuniary externality. Optimally, the government should impose a tax on the Sneezer or a

15

subsidy for the Sneezee. However, the costs associated with figuring out who should pay the tax or receive the subsidy clearly outweigh the benefits from doing so.

Second, the private sector might find a solution itself thus making government intervention unnecessary. Ronald Coase is credited with this idea and it partly won him the Nobel prize in economics. He argued that most externality situations really involve only two people, the person who creates the externality and the recipient or person affected by the externality. Coase argued that if the two agents involved can bargain with one another, they will reach an optimal solution.

Consider the classic example put forth by Coase. A rancher allows his herd to graze freely and sometimes some of his animals trample the farmer's fence and get into his corn. Under the Pigouvian solution to the problem, the rancher would be taxed. However, Coase argued that the two can bargain and the bargain will be based on the definition of the property rights involved. Suppose the farmer has the property right to not have his crops trampled. If the rancher's cattle trample the corn, the rancher and the farmer can come to a settlement privately without any government intrusion. Coase argued that most externality conflicts can be privately settled.The counter argument to Coase is that he ignored bargaining costs. If there are significant bargaining costs, private negotiation may not resolve the conflict. Many important externality situations involve a large number of people and the greater the number of people involved in the bargaining the higher the bargaining costs will be. Consider a defect in a car. Literally thousands, if not millions, of car owners would be affected and would have to negotiate with GM, for example. This would be very costly. The greater the bargaining costs involved, the lower the likelihood that private bargaining will solve the problem. As another example, it would be impossible for car owners to negotiate with Toyota in Japan if a defect were found in their Camry. Finally, who would negotiate on behalf of a wilderness area if a tanker spills millions of barrels of oil, as occurred in the Exxon Valdez case?

The conclusion is that many externality situations involving low bargaining costs can be privately resolved without government intervention. However, in cases where the bargaining costs are large, some form of government intervention will usually be called for. So the Coase solution is not a general panacea but will work in "small" cases.

14.7 Can the private sector solve "social" problems?In his 1988 acceptance speech at the Republican convention, George H. W. Bush used the phrase, written by speechwriter Peggy Noonan, a "thousand points of light" to denote people in the private sector solving social problems. Each point of light was one person solving a problem in their local community.

Many social problems have a "prisoner's dilemma" structure. The structure of the payoffs was discovered by Merrill Flood and Melvin Dresher, two researchers at RAND, a private think tank, in 1950. Albert Tucker came up with a story about two prisoners and prison sentence payoffs and also provided the name of the "Prisoner's Dilemma." (John Nash from the movie "A Beautiful Mind" was a student of Tucker's.) Imagine two criminals have been caught at the scene of a crime. The police have them on a minor charge but take them back to the station to interrogate them separately hoping to get one or both to confess to a more serious crime by cutting a deal with the police. The individual incentive is for each prisoner to cut a deal with the police. However, it is in the interest of each as a group to refuse to talk. This has the same structure as the streetlight game: replace "contribute" with "don't talk to the police" and "don't contribute" with "talk to the police," and the fishing game: replace "fish a lot" with "talk to the police" and "fish a little" with "don't talk to the police."

If both prisoner's talk, the police have enough evidence to get a sentence of 10 years for each prisoner. If A talks and cuts a deal and B does not talk, A only gets 1 year and B gets 12. If

16

neither talk they get a sentence on a minor charge of 2 years. The payoffs are depicted in the figure. The individual incentive is to talk while the group incentive is to not talk. The Nash equilibrium if the game is played once is for both prisoner's to talk.

As we have seen in the earlier games, the Nash equilibrium in the one-shot game is where both players follow their individual incentive and don't contribute, fish a lot, and in the Prisoner's Dilemma game talk to the police, whereas the group's incentive is to contribute, fish a little, and not talk to the police. It is also possible to find a trigger strategy that will support the group incentive, which in many cases is socially optimal, or at least preferred to the outcome when individuals follow the individual incentive.

In some cases the social problem exists because the private sector has been unable to solve it. This can be the case when there is a Prisoner's Dilemma type of structure to the interaction. Firms can pollute or not, but if they pollute it may be cheaper to produce and compete, for example, than if they spend some of their profits cleaning up the pollution. In such cases, some sort of government policy is called for. For example, fining (taxing) polluters and forcing them to clean up their own pollution is one such response.

In other cases, the private sector tries to solve the problem but cannot do so completely. For example consider a charity and two donors A and B, Each cares about a private good x and charity C. Utility is UA(xA, C) and UB(xB, C). Let d be a donation to charity. Then C = dA + dB, i.e., total charity spending is equal to the sum of individual donations by A and B. This is a classic example of an externality. Substitute for C, UA(xA, dA + dB) and UB(xB, dA + dB). A's utility partly depends on B's donation and B's utility depends on A's donation, i.e., there is an externality. We might observe donations to charity and so it looks like the private sector is "solving" the externality problem. However, most likely, donor A will ignore the impact his donation has on donors B, D, E, F, and so on, for all who donate to the charity. This means that too little charity will occur. Why? If A took his impact on B and so on into account, he would give more. Since he does not, in general, he will not give more and so too little charity is produced.

A simple solution is for the government is to allow a tax write off for charitable donations. This is an indirect subsidy for charity. Some, like Martin Feldstein of Harvard, have argued that we should rely on private sector alternatives to public programs and simply subsidize private efforts through the income tax code.

14.8 Government failureEven though we as economists can prescribe a remedy for a perceived problem that exists with the functioning of the market system, there is no guarantee the government can or will

17

implement the proposed solution. We have already seen the problems that arise when the government attempts to regulate monopolists.

Political failure may take many forms. There may be what is known as "gridlock," where nothing can be accomplished even though the country faces some pretty obvious problems because the President and the Congress are posturing. On other occasions, the two branches of government seem to be able to work together. In general, we can model this interaction as a "game of chicken." In the now famous movie "Rebel without a Cause" James Dean and another young man race their cars to the edge of a cliff to prove who is more courageous. The first one who stops is "chicken" and loses face in front of everyone. Similarly with the Congress and the President. In fact, gridlock under the Bush Administration severely limited the ability of the government to pass legislation and attempt to solve the country's problems. The problem got much worse in the early part of the Clinton Administration and the federal government was forced to shut down several times.

Consider the following game between the President and Congress. We obtain different outcomes depending on the values for a and b.

A. a = b = 0. There is one equilibrium : (don't back down, don't back down) with associated payoffs of (0, 0). This is the case of gridlock. Neither the President, nor Congress is chicken.

B. a = b = -5. Now there are two equilibria : (don't back down, back down) and (back down, don't back down). In the first equilibrium, Congress is "chicken." In the second equilibrium, it is the President who is "chicken."

C. a = - 5, b = 1. There is one equilibrium : (back down, don't back down). Notice that "don't back down" is a dominant strategy for Congress.

D. Opposite of case #3. (a = 1, b = - 5.) The equilibrium is (don't back down, back down). "Don't back down" is now a dominant strategy for the President.

Many times the players engage in what is known as tough talk before the game begins. This can be interpreted as an effort to get the other player to change his belief about the payoffs in the table. When the President talks tough, he is trying to convince the Congress that a = 1 and that he won't back down. When the Congress talks tough, it is trying to get the President to believe that b =1. If both are convincing, gridlock occurs and the government is possibly shut down. Of course, some might think that is not necessarily a bad thing.

AppendixWhat happens if the streetlight game is played repeatedly? A strategy must tell the player

what to do under every circumstance so a strategy is more complex than an action. If the game is played over an infinite number of periods, the strategy "never contribute" is an equilibrium if both players decide to play it. (Check your understanding of this. The payoff from playing this

18

strategy is 0/(1 - ) = 0, where is the discount factor. However, if A deviates on the first move and then goes back to playing the strategy, her payoff is - 20 + 0/(1 - ) = - 20. So deviating reduces her total payoff.) On the other hand, the strategy "always contribute" is not an equilibrium. This is because cheating on every move yields a higher payoff than playing the strategy "always contribute," 80/(1 - ) > 30/(1 - ).

We can design a trigger strategy that can support contributing as an equilibrium. The strategy is ST = 1.) Choose "contribute" at t = 1; 2a.) For t > 1, choose "contribute" if the opponent chose "contribute" at t-1; 2b.) For t > 1, choose "don't contribute" forever after if the opponent chose "don't contribute" at t-1. The payoff for the pair (ST, ST) is 30/(1 - ). Suppose A deviates on the first move. She gets 80 at t=1. At t=2, she is punished and gets 0 forever after for a total payoff of 80. If 30/(1 - ) > 80, she should choose "contribute." Why 0 forever? Because player B punishes by choosing don't contribute at t = 2 and so for t = 3 part 2b of the trigger strategy kicks in for A and she chooses not to contribute forever after. Rearrange the inequality,

30 > 80 - 80, or, > 5/8. If satisfies the inequality condition, then both players will stick with the trigger strategy and not deviate. For example, if = .5, then compare 30/(1-) = 60 with 80 and obviously she will deviate so (ST, ST) is not an equilibrium. If = .75, then compare 30/(1-) = 120 with 80, and she will choose not to deviate.

Important ConceptsIncome distribution

equity - efficiency tradeoffMonopolyUncertainty

moral hazard, adverse selection. social insurancePublic Goods

horizontal versus vertical summationcan the private sector solve social problems?Samuelson's rule for a pure public goodLindahl's solution

Externalitiespecuniary versus non-pecuniaryharmful versus beneficialSolutions: Pigou, Coase

The Prisoner’s Dilemma problem.Can governments solve problems?

Review Questions1. Explain the equity - efficiency tradeoff using the Edgeworth Box.2. What is moral hazard? Why is it a problem? What is adverse selection? Why is

it a problem? What is social insurance? Why do we need it?3. What is a private good? What is a public good? What are exclusion and

depletion?4. Will the private market supply public goods? Can the private sector solve social

problems?5. What is an externality? Explain the different types. Are there any solutions to the

externality problem?6. What is government failure?

19

7. Can governments solve problems in a global economy?

Practice Questions1. Is there a deadweight loss if a monopolist charges P = MC?

a. Yes.b. No.

2. Under Samuelson's rulea. a private good is produced where P = MC.b. a private good is produced where MR = MC.c. a public good is produced where P = MC.d. a public good is produced where the sum of marginal benefits is equal to

the MC.

3. Social insurance cannot be provided by the market.a. True.b. False.

4. Bad drivers are charged a higher premium for auto insurance than goods drivers. This is an example of

a. sound profit maximizing behavior.b. adverse selection.c. moral hazard.d. social insurance.e. a public good.

5. An operating system is a set of instructions that guide the basic functions of a computer. It is useful if there is only one operating system because then software developers know how to program their application, e.g., spreadsheet, word processing, graphics production. A single operating system for desktop publishing is an example of

a. an externality.b. a private good.c. a public good.d. exclusion.e. moral hazard.

6. Consider the provision of a public good. Suppose there are two consumers with the same demand and a single person’s demand is d in the diagram. Find the aggregate demand curve for the public good.

20

7. Given the supply curve which reflects marginal cost, MC, find the optimal level for the public good. Redraw your result from the last question.

21

Answers 1. b.2. d.3. a.4. a.5. c.6.

The demand for one person is d. To find D, the intercept is 2 x 4 = 8 and at G3 d = 1 so 2 x 1 = 2 for D.

7.

22