12 The Market Mechanism Shortcomings and Remedies When

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12 The Market Mechanism: Shortcomings and Remedies When she was good She was very,

12 The Market Mechanism: Shortcomings and Remedies When she was good She was very, very good, But when she was bad She was horrid. HENRY WADSWORTH LONGFELLOW

Contents ● What Does the Market Do Poorly? ● Efficient Resource Allocation: A Review

Contents ● What Does the Market Do Poorly? ● Efficient Resource Allocation: A Review ● Externalities: Getting the Prices Wrong ● Provision of Public Goods ● Allocation of Resources Between Present and Future ● Market Failure and Government Failure Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Contents (continued) ● The Cost Disease of the Service Sector ● Some Other Sources

Contents (continued) ● The Cost Disease of the Service Sector ● Some Other Sources of Market Failure ● The Market System on Balance ● Epilogue: The Unforgiving Market, Its Gift of Abundance, and Its Dangerous Friends Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

What Does the Market Do Poorly? ● Deals poorly with the side effects of

What Does the Market Do Poorly? ● Deals poorly with the side effects of many economic activities ● Cannot readily provide public goods, such as national defense ● May do a poor job of allocating resources between the present and the future Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

What Does the Market Do Poorly? ● Makes public and personal services increasingly expensive

What Does the Market Do Poorly? ● Makes public and personal services increasingly expensive ● Not all market failures are considered in this chapter--other chapters consider: ♦ Business fluctuations ♦ Inequitable income distribution ♦ Monopoly power Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Efficient Resource Allocation: A Review ● An efficient allocation of resources requires that price

Efficient Resource Allocation: A Review ● An efficient allocation of resources requires that price equal marginal cost for each commodity (P = MC). Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

12 -1 The Economy’s PPF for the Production of Two Goods Number of Backpacks

12 -1 The Economy’s PPF for the Production of Two Goods Number of Backpacks Produced FIGURE 10 C B 8 K 6 4 2 0 20 40 60 80 A 100 Number of Jeans Produced Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Externalities: Getting the Prices Wrong ● Beneficial externality = an incidental benefit of an

Externalities: Getting the Prices Wrong ● Beneficial externality = an incidental benefit of an economic activity ● Detrimental externality = an incidental cost of an economic activity Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Externalities: Getting the Prices Wrong ● Externalities and Inefficiency ♦ Detrimental externalities marginal social

Externalities: Getting the Prices Wrong ● Externalities and Inefficiency ♦ Detrimental externalities marginal social cost > marginal private cost ■Too much is produced ♦ Beneficial externalities marginal social cost > marginal private cost ■Too little output is produced Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

12 -2 Equilibrium of a Firm with Detrimental Externality FIGURE Marginal Cost and Revenue

12 -2 Equilibrium of a Firm with Detrimental Externality FIGURE Marginal Cost and Revenue Marginal social cost 0 B A 35 100 Marginal private cost Marginal revenue Thousands of Tons of Paper Year Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

12 -3 Externalities, Market Equil. , & Resource Allocation Tulip Output in Dozens FIGURE

12 -3 Externalities, Market Equil. , & Resource Allocation Tulip Output in Dozens FIGURE T B K 0 E Electricity Output in Kilowatt-Hours Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Externalities: Getting the Prices Wrong ● Externalities are Everywhere ♦ These problems are found

Externalities: Getting the Prices Wrong ● Externalities are Everywhere ♦ These problems are found throughout the economy. ♦ Both market economies and centrally-planned economies wrestle with externality problems. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Externalities: Getting the Prices Wrong ● Government Policy and Externalities ♦ Governments can promote

Externalities: Getting the Prices Wrong ● Government Policy and Externalities ♦ Governments can promote efficiency by moving private costs closer to social costs. ♦ They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Provision of Public Goods ● A good is public when: ♦ it is not

Provision of Public Goods ● A good is public when: ♦ it is not depleted by repeated use. ♦ people cannot be excluded from access to it. ● The market tends to underprovide public goods. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Provision of Public Goods ● It is usually not possible to charge a price

Provision of Public Goods ● It is usually not possible to charge a price for a pure public good because people cannot be excluded from enjoying its benefits. ● It may also be undesirable to charge a price for it because that would discourage some people from benefiting, even though using a public good does not deplete its supply. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Provision of Public Goods ● Conclusion: If public goods are to be produced, the

Provision of Public Goods ● Conclusion: If public goods are to be produced, the government must do it. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Allocation of Resources Between Present and Future ● A production possibilities frontier can be

Allocation of Resources Between Present and Future ● A production possibilities frontier can be used to analyze the allocation of resources between the present and the future. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Allocation of Resources Between Present and Future ● The Role of the Interest Rate

Allocation of Resources Between Present and Future ● The Role of the Interest Rate ♦ Allocate resources between present and future ♦ Represents the opportunity cost of money Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Allocation of Resources Between Present and Future ● How Does It Work in Practice?

Allocation of Resources Between Present and Future ● How Does It Work in Practice? ♦ Since interest rates are manipulated for many purposes, there is little reason to think that they represent a good evaluation of the future. ♦ The market tends to devote too many resources to immediate consumption since today’s population may not be good judges of future needs. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Allocation of Resources Between Present and Future ● How Does It Work in Practice?

Allocation of Resources Between Present and Future ● How Does It Work in Practice? ♦ The inherent risk of investment projects means that investment for the future may fall short of the socially optimal amount. ♦ It may not be in society’s best interests to allow the market to make irreversible decisions about the future. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Market Failure and Government Failure ● The market has many failures, but remember that

Market Failure and Government Failure ● The market has many failures, but remember that it has many strengths as well, and that governments are also subject to failure. ● Some market failures are best left alone and, in some cases, the best action by the government is to reinforce the best aspects of the market, not to replace the market. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● The service sector includes such huge

The Cost Disease of the Service Sector ● The service sector includes such huge industries as education and health care. ● Services can be public or private. ● Costs for services have risen more rapidly than other costs. ● Although not strictly a market failure, this often leads to government action that threatens general welfare. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

w ay or ai n Sp n nd la Ire Ja pa at es

w ay or ai n Sp n nd la Ire Ja pa at es St tr ia us A Ita ly ce Fr an N y lia tr a an gd om in d K te ni U te d ni U us A m G er ad a an C nd s la he r et N Average Annual Growth Rates (percentage) 12 -4 Real per-Capita Health-Care Expenditures FIGURE 6 5 4 3 2 1 0 Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

12 -5 Real per-Pupil Education Costs FIGURE Average Annual Growth Rates 12% 10 9.

12 -5 Real per-Pupil Education Costs FIGURE Average Annual Growth Rates 12% 10 9. 67 8 7. 25 6 4 2. 72 2 3. 42 4. 32 0 – 2 – 4 – 1. 55 United Kingdom United States Canada Germany Japan France Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● Why Are Some Personal Services Getting

The Cost Disease of the Service Sector ● Why Are Some Personal Services Getting Worse but Costing More? ♦ The “cost disease” of personal services stems from their labor-intensive nature. ♦ Competition forces wages in the service sector to grow as rapidly as wages in manufacturing. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● Why Are Some Personal Services Getting

The Cost Disease of the Service Sector ● Why Are Some Personal Services Getting Worse but Costing More? ♦ Productivity grows more rapidly in manufacturing than services. ♦ If wage growth cannot be accommodated by productivity growth, prices must rise. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● A Future of More Goods, but

The Cost Disease of the Service Sector ● A Future of More Goods, but Fewer Services: Is It Inevitable? ♦ As the society becomes richer, it becomes more difficult, not less, to provide services such as health care, teaching, and the performing arts. ♦ If we value services sufficiently, we can have more and better services--at some sacrifice in the growth rate of manufactured goods. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● Government May Make the Problem Worse

The Cost Disease of the Service Sector ● Government May Make the Problem Worse ♦ The market does give the appropriate price signals, but government is likely to misunderstand these signals and to make decisions that do not promote the public interest most effectively. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● Government May Make the Problem Worse

The Cost Disease of the Service Sector ● Government May Make the Problem Worse ♦ This problem is not a market failure, but government attempts to deal with it may distort the market in inefficient ways. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Cost Disease of the Service Sector ● Government May Make the Problem Worse

The Cost Disease of the Service Sector ● Government May Make the Problem Worse ♦ In many cases, price controls are proposed for sectors of the economy affected by the cost disease. ♦ But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Some Other Sources of Market Failure ● Imperfect information ● Rent-seeking behavior ● Moral

Some Other Sources of Market Failure ● Imperfect information ● Rent-seeking behavior ● Moral hazard Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

The Market System on Balance ● While the market mechanism is virtually irreplaceable, the

The Market System on Balance ● While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Epilogue: The Unforgiving Market ● The market system produces growth and prosperity as no

Epilogue: The Unforgiving Market ● The market system produces growth and prosperity as no other system has been able to do. ● At the same time, it allocates its rewards in ways that many people believe to be unjust. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.

Epilogue: The Unforgiving Market ● Sometimes the proposals of alleged friends of the free

Epilogue: The Unforgiving Market ● Sometimes the proposals of alleged friends of the free market are just as dangerous to its long-term health as are the attacks of its enemies. Copyright© 2003 South-Western/Thomson Publishing. All rights reserved.