Market Failure Market Failure When the market does

Market Failure

Market Failure When the market does not efficiently allocate resources p Either too much or too little is produced p n Monopoly n Externalities n Public goods Justification for government intervention? n Imperfect Information

Externalities p p Occur when decision makers do not consider all costs (or benefits) of their actions Two views “Spillover effects” A. C. Pigou Ronald Coase (1877 -1959) (1910)

All pollution should be eliminated. a) b) c) d) e) Strongly Agree Neutral Disagree Strongly Disagree

Pigouvian Approach Social Cost = Private Cost + External Cost Price of beer Hangover Damage to others Boorish behavior Drinking Alcohol

Pollution p Free Market: P 1, Q 1 p Optimal Outcome: P 2, Q 2 Ssocial $ Sprivate P 2 P 1 External cost Free market overproduces goods that generate a negative externality How can society achieve social optimum? Impose tax = marginal external cost Internalize the externality! D 1 Q 2 Q 1 “Pigou tax” steel

Sorry, Charlie Ssocial Sprivate D

The efficient output will be less than the free market output when: a) b) c) d) Marginal social cost and marginal private cost are equal Marginal social cost is greater than marginal private cost Marginal social benefit and marginal private benefit are equal Marginal social benefit is greater than marginal private benefit

Education p Free Market: P 1, Q 1 p Optimal Outcome: P 2, Q 2 $ S 1 P 2 External benefit P 1 Free market underproduces goods that generate a positive externality Dsocial Dprivate How can society achieve social optimum? Provide subsidy = marginal external benefit Q 1 Q 2 Years of College

If there is a positive externality, the: a) b) c) d) social benefits will be greater than the private benefits external benefits will be greater than the social benefits will be equal to the private benefits will be greater than the social benefits

Coasian Approach p Externalities are due to incomplete property rights assignment “It takes two to tango”

Coasian Approach p Externalities are due to incomplete assignment of property rights Coase Theorem If property rights are well-defined and transactions costs are low enough, then private bargaining can result in an efficient allocation of resources. Corollary Allocation of resources does not depend on initial assignment of property rights.

Cheshire, Ohio v. AEP paid $20 million to buy the 221 -resident town in 2002

Pollution Worksheet p p Optimal pollution for Marietta-Parkersburg area is 60, 000 units of emissions Abatement Cost n Cars: $5 n Utilities: $10 n Factories: $20 p Controlling pollution through: n Standards n Taxes n Tradable Permits

Cap and Trade Program S $ $20 F Abatement Cost P = $10 Q = 60, 000 U $10 C $5 D 40 60 70 90 permits “$200, 000 Solution”

Acid Rain Market: SO 2 2010 Spot Auction 2010 7 -yr Advance Auction Source: http: //www. epa. gov/airmarkt/progress/ARP_1. html

Characteristics of Goods p Excludability: can you be excluded from consuming the good? p Rivalry: does my consumption hinder your consumption? Excludable Non. Excludable Rival Non-rival Private Goods Artificially Scarce Goods or Natural Monopoly Common Resources Public Goods

Government Provided Goods and Services p p p p p Schools Roads Police Courts Fire Department Water Library Health Care Transportation p p p National Defense Social Security Medicare Postal Service FBI, CIA, SEC, FTC, FCC, NSF, FDA, ARC, FDIC, NLRB, HUD

National Defense p Federal Government spent $779 b on defense in 2009 Per capita expenditure How do we pay for this? Taxes!

Public Goods p “free-rider” problem n Under-provision by free market p Social Optimum requires: MSB = MSC n Output can only be provided at one level for all n Must find some way to aggregate individual MB

Fireworks in Marietta Quantity Gretchen’s MB Cort’s MB Yanan’s MB ΣMB MC Total Benefit Total Cost Net Benefits 10 $8 $5 $9 $22 $10 $12 20 $7 $4 $8 $19 $10 $41 $20 $21 30 $6 $3 $6 $15 $10 $56 $30 $26 40 $5 $2 $4 $11 $10 $67 $40 $27 50 $4 $1 $2 $7 $10 $74 $50 $24 60 $3 $0 $1 $4 $10 $78 $60 $18

The table below shows the marginal benefit from submarines for the only two citizens of a country. Submarines are a public good. If submarines cost $145 a piece to produce, what is the efficient quantity of submarines? Katie a) b) c) d) e) f) 0 1 2 3 4 5 Youtian Marginal benefit (dollars per sub) Quantity Marginal benefit (dollars per sub) -- 0 -- 100 1 150 75 2 100 50 3 50 25 4 10 0 5 0

Common Resources Non-excludable p Rival in consumption p “Tragedy of the commons” n African Elephant § 1980: 1. 3 m § 1990: 0. 6 m CITES Campfire n Fish in the sea n Bison in America "Why would I tolerate living or coexisting with an elephant that is so destructive? " says the village chief. "It destroys our crops, our fields, our trees, our environment. It is because of the value associated with the elephant that makes us coexist with it. "

Artificially Scarce Goods Excludable p Non-Rival p n Digital info § Movies § Music § Books n Pharmaceuticals Marginal Cost of provision is zero $ PM MC D MR QM QC Drugs

A factory's production process creates sludge that pours into a river. This sludge makes it difficult to fish in the river, increasing the costs of the local fishermen by $5000. The factory can install a water filter system for $4100, and the fishermen can utilize a weighted fishing net system (to get under the sludge) for $3250. Both systems would remedy the sludge damage to the fishermen. Nets: $3250 Factory Filter: $4100 Damage: $5000 What outcome would you expect under the following conditions: a) Transactions costs low and factory is not liable for damage? b) Transactions costs low and factory is liable for damage? c) Transactions costs high and factory is liable for damage?

Health Care Reform

Health Care Reform p Objectives: n Expand insurance coverage n Lower health care costs v Private Insurance v Social Insurance v Revenue Provisions

Information Asymmetry p Moral Hazard (Hidden actions) n Insurance markets n Employer-Employee relationship p Adverse Selection (Hidden characteristics) n Insurance markets n Used car market p Solutions? n Signaling: Informed party takes action n Screening: Uninformed party takes action n Government regulation?

Private Insurance Reforms p Insurance rules n Community rating (age, area, family size, and tobacco use) n Guaranteed issue (can’t deny for pre-existing condition) n Prohibit lifetime limits on coverage n Dependent children on parent’s plan until age 26 n Establish health insurance exchanges p Individual Health Insurance Mandate Tax credit subsidies up to 400% poverty n $695 fine (or 2. 5% income) if you don’t buy n p Employer Health Insurance Mandate n $2000 fine per employee for firms N > 50 n Tax credit subsidies to small employers n High cost plan excise tax (t = 40%)

Share of Personal Health Care Expenditures by Source of Funds 60% 50% % of PHCE 40% Out of pocket Health Ins 30% Fed State 20% 10% 0% 1960 1970 1980 1990 2000 2010 Source: http: //www. cms. hhs. gov/National. Health. Expend. Data/

Suppose you are covered under health insurance or belong to a Health Maintenance Organization (HMO), and you are insured against all or most of the costs of visits to the doctor. As a result you are likely to make greater use of medical services of all kinds. This tendency of people with insurance to change their behavior in a way that leads to more claims against the insurance company is called: a) b) c) d) Adverse selection Moral hazard Screening Signaling

Public Choice Theory Public Interest vs Self Interest p Political Actors p n Politicians n Voters n Special Interest Groups

Median Voter D 1 p D 2 D 3 V R 3 R 2 R 1 In a two-party race, candidates have incentive to move toward the middle n Positioning n Coalition building

Popular Vote Cast for US President Year Winner % Loser % Margin 1960 Kennedy 49. 7 Nixon 49. 5 0. 2 1964 Johnson 61. 1 Goldwater 38. 5 22. 6 1968 Nixon 43. 4 Humphrey 42. 7 0. 7 1972 Nixon 60. 7 Mc. Govern 37. 5 23. 2 1976 Carter 50. 1 Ford 48. 0 2. 1 1980 Reagan 50. 7 Carter 41. 0 9. 7 1984 Reagan 58. 5 Mondale 40. 6 17. 9 1988 Bush I 53. 4 Dukakis 45. 6 7. 8 1992 Clinton 43. 0 Bush 38. 0 5. 0 1996 Clinton 49. 2 Dole 40. 7 8. 5 2000 Bush II 47. 9 Gore 48. 4 -0. 5 2004 Bush II 51. 0 Kerry 48. 0 3. 0 2008 Obama 52. 9 Mc. Cain 45. 7 7. 2

Public Choice Theory Public Interest vs Self Interest p Political Actors p n Politicians § Median voter hypothesis n Voters § Rational ignorance

Voter Participation Rates: US Presidential Elections 1924 - 2008 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1924 1932 1940 1948 1956 1964 1972 1980 1988 1996 2004

Voter Participation Rates: US House of Representatives 1960 - 2010 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Public Choice Theory Public Interest vs Self Interest p Political Actors p n Politicians § Median voter hypothesis n Voters § Rational ignorance Labor unions Industry groups AARP n Special Interest Groups § Rent seeking § Concentrated benefits and dispersed costs Dairy price supports: $900 million Benefit to farmers: $900 m/65, 000 = $13, 846 Cost to taxpayers: $900 m/142 m = $6. 34

Social Choice Mechanisms p Condorcet’s Paradox Chandler Phoebe Monica First Choice CSI Glee True Blood Second Choice Glee True Blood CSI Glee Third Choice CSI v Glee: CSI wins Glee v True Blood: Glee wins CSI v True Blood: True Blood wins p Arrow’s Impossibility Theorem