Published on April 20, 2014
Unit 6: Market Failures and the Role of the Government 1 Length 2 1/2 Weeks TOTAL Assignments Problem Set #6
What is the Free Market? (Capitalism) 2
5 Characteristics of Free Markets 1. Little government involvement in the economy. (Laissez Faire = Let it be) 2. Individuals OWN resources and determine what and how to produce, and who gets what’s produced. 3. The opportunity to make PROFIT gives people INCENTIVE to produce quality items efficiently. 4. Wide variety of goods available to consumers. 5. Competition and Self-Interest work together to regulate the economy. 3 The government’s job is to enforce contracts, secure property rights, and defend the country.
Example of the INVISIBLE HAND of the free market: If society wants computers and people are willing to pay high prices then… •Businesses have the INCENTIVE to start making computers to earn PROFIT. •This leads to more COMPETITION…. •Which means lower prices, better quality and more product variety. •To maintain profits, firms find most efficient way to produce goods and services. Government doesn’t need to get involved because the needs of society are automatically met. 4
Does the Free Market ever FAIL to meet society’s needs? 5
What is a Market Failure? •A situation in which the free-market system fails to satisfy society’s wants. (When the invisible hand doesn’t work.) •Private markets do not efficiently bring about the allocation of resources. What’s the result… The government must step in to satisfy society’s wants. Circular Flow Model Review 6
How does the free market FAIL? 8
The Four Market Failures We will focus on four different market failures: 1. Public Goods 2. Externalities (third-person side effects) 3. Monopolies 4. Unfair distribution of income In each of the above situations, the government steps in to allocate resources more efficiently. 9
Market Failure #1: PUBLIC GOODS
If there was no government, how would schools, parks and freeways be different? Would there be enough to meet our needs? Public Goods 11 Video: Fire Department
Why must the government provide public goods and services? •It is impractical for the free-market to provide these goods because there is little opportunity to earn profit. •This is because of the Free-Rider Problem Free Riders are individuals who benefit without paying. Public Goods 12
What’s wrong with this picture? 13
The Free Rider Problem 14 Examples: 1. People who download music illegally 2. People who watch a street performer and don’t pay 3. Teenagers who live at home and don’t have a job
15 •Canadian Military Spending: $21.8 Billion •U.S. Military Spending: $660 Billion Why doesn’t Canada spend more on its military? Does anyone free ride off you?
•Free Riders keep firms from making profits. •If left to the free market, essential services would be under-produced. To solve the problem, the government can: 1. Find new ways to punish free riders. 2. Use tax dollars to provide the service to everyone. What’s wrong with Free Riders? 16
The Final Exam •I am willing to give 100% on the final exam to whichever class gives me $1,000. •Everyone in the class will get 100% even if they don’t pay. •Who is willing to pay? •What about those who refuse to pay? Solution? EVERYONE pays a mandatory tax and all receive the same benefits. 17
Definition of Public Goods 18
To be considered a true public good, it must meet two criteria: 1. Nonexclusion Definition of Public Goods 2. Shared Consumption (Nonrivalry) •Everyone can use the good. •Cannot exclude benefits of the good for those who will not pay. •Ex: National Defense •One person’s consumption of a good does not reduce the usefulness to others. •Ex: Ron Feist Park 19
Identify which of the following are TRUE public goods (have non-exclusion and non-rival consumption): 1. Hamburgers 2. Cable TV 3. Free Public Education 4. Homes 5. Street lights 6. Highways 20
When should the government get involved in the economy? 21 Worker Safety Laws Barber Shop Licenses Every society needs to decide how much government involvement is desirable Bank Bailouts
Unit 6: Market Failures and the Role of the Government 22
Review 1. List the characteristics of the Free Market. 2. Define Market Failure. 3. What is the “invisible hand”? 4. List the 4 Market Failures. 5. Why must the government provide public goods? 6. Define Free Rider. 7. What is wrong with having free riders? 8. List 10 streets in Roseville/Granite Bay. 23
Why doesn’t the free market provide them? There is little opportunity to earn profit. Why NOT? Individuals benefit without paying. Market Failure #1 PUBLIC GOODS 24
How do we decide how many public goods we need? 25
Can the government… 1. Prevent wild fires in Placer County forever? 2. Ensure that no one ever speeds on the freeway? 3. Create a research station on Mars? 4. Stop pollution from fossil fuels? 5. Completely stop illegal immigration? 6. Make sure everyone in the U.S. has a job? YES! But the costs outweigh the benefits. How does the government decide how many public goods to provide?
How does the government determine what quantity of public goods to produce? It uses (surprise!) Supply and Demand Demand for Public Goods- The Marginal Social Benefit of the good as determined by citizens’ willingness to pay. Supply of Public Goods- The Marginal Social Cost of providing additional quantities/amounts of the good. Video: Dam Tragedy
Demand for a New Park Marginal willingness to pay higher taxes # of Parks Adam is willing to pay Jill is willing to pay Society’s Demand for Parks Marginal Cost 1 $4 $5 $9 $5 2 $3 $4 $7 $5 3 $2 $3 $5 $5 4 $1 $2 $3 $5 5 $0 $1 $1 $5 Assume: 1. There are only two people in society. 2. Each additional park costs $5 How many parks should be made?
# of Parks Adam is willing to pay Jill is willing to pay Society’s Demand (MSB) Marginal Cost per Park 1 $4 $5 $9 $5 2 $3 $4 $7 $5 3 $2 $3 $5 $5 4 $1 $2 $3 $5 5 $0 $1 $1 $5 Demand for a New Park Marginal willingness to pay higher taxes
# of Parks Adam is willing to pay Jill is willing to pay Society’s Demand (MSB) Marginal Social Cost 1 $4 $5 $9 $5 2 $3 $4 $7 $5 3 $2 $3 $5 $5 4 $1 $2 $3 $5 5 $0 $1 $1 $5 Demand for a New Park Marginal willingness to pay higher taxes “Optimal” amount of a public good is where MSB = MSC!
Price Quantity of Parks $ 9 7 5 3 1 0 1 2 3 4 5 D=MSB Supply and Demand for Public Parks The Demand is equal to the marginal benefit to society
$ 9 7 5 3 1 0 1 2 3 4 5 The supply is the public good’s marginal cost to society S=MSC D=MSB Supply and Demand for Public Parks Price Quantity of Parks MSB = MSC 1. What if the government made 1 park? 2. What if the government made 4 parks?
Market Failure #2: EXTERNALITIES 33
•An externality is a third-person side effect. •When there are EXTERNAL benefits or costs to someone OTHER than the original decision maker. Why are Externalities Market Failures? •The free market fails to include external costs or external benefits. •With no government involvement, there would be too much of some goods and too little of others. Example: Smoking Cigarettes. •The free market assumes that the cost of smoking is fully paid by people who smoke. •The government recognizes external costs and makes policies to limit smoking. What are Externalities? 34
Negative Externalities 35
Situation that results in a COST for a different person other than the original decision maker. The costs “spill over” to other people or society. Example: Zoram is a chemical company that pollutes the air when it produces its good. •Zoram only looks at its INTERNAL costs. •The firm ignores the social cost of pollution •So, the firm’s marginal cost curve is its supply curve •When you factor in EXTERNAL costs, Zoram is producing too much of its product. •The government recognizes this and limits production. Negative Externalities (aka: Spillover Costs) 36
Video- Whistle Tips 37
P Q D=MSB Supply = Marginal Private Cost QFree Market 38 Market for Cigarettes The marginal private cost doesn’t include the costs to society.
P Q D=MSB Supply = Marginal Private Cost QFree Market 39 Market for Cigarettes Supply = Marginal Social Cost What will the MC/Supply look like when EXTERNAL costs are factored in? QOptimal
P Q D=MSB S=MPC QFree Market 40 Market for Cigarettes S =MSC QOptimal At QFM the MSC is greater than the MSB. Too much is being produced If the market produces QFM why is it a market failure? Overallocation
P Q D=MSB QFree Market 41 Market for Cigarettes What should the government do to fix a negative externality? QOptimal S=MPC S =MSC Solution: Tax the amount of the externality (Per Unit Tax)
P Q D=MSB QFree Market 42 Market for Cigarettes What should the government do to fix a negative externality? QOptimal S=MPC1 S =MSC Solution: Tax the amount of the externality (Per Unit Tax) =MPC2 MSB = MSC Supply curve shifts left (yellow); amount of tax is the vertical distance between MPC1 and MSC (black)
Positive Externalities 44
Positive Externalities (aka: Spillover Benefits) Situations that result in a BENEFIT for someone other than the original decision maker. The benefits “spill over” to other people or society. (EX: Flu Vaccines, Education, Home Renovation) Example: A mom decides to get a flu vaccine for her child •Mom only looks at the INTERNAL benefits. •She ignores the social benefits of a healthier society. •So, her private marginal benefit is her demand •When you factor in EXTERNAL benefits, the marginal benefit and demand would be greater. •The government recognizes this and subsidizes flu shots. 45
P Q D=Marginal Private Benefit S = MSC QFree Market 46 Market for Flu Shots The marginal private benefit doesn’t include the additional benefits to society.
P QQFM 47 Market for Flu Shots What will the MSB/D look like when EXTERNAL benefits are factored in? QOptimal D=Marginal Private Benefit S = MSC D=Marginal Social Benefit
P Q D=MSB 48 Market for Flu Shots If the market produces QFM why is it a market failure? S = MSC D=Marginal Social Benefit QFM QOptimal
P Q 49 Market for Flu Shots Underallocation S = MSC D=Marginal Social Benefit QFM QOptimal At QFM the MSC is less than the MSB. Too little is being produced
P QQFM 50 Market for Flu Shots QOptimal D=MPB S = MSC D=MSB What should the government do to address a positive externality? Subsidize the amount of the externality (Per Unit Subsidy) =MPB Subsidy shifts MSB/D right (yellow); amount of subsidy is vertical distance between MB curves (black)
Review 1. What is an Externality? When EXTERNAL benefits or external costs are on someone other than the original decision maker. 2. Why are Externalities Market Failures? The free market fails to include external costs or external benefits. 3. Explain why the graph for a Negative Externality has two supply curves. Two Costs: Private and Social 4. Explain why the graph for a Positive Externality has two demand curves. Two Benefits: Private and Social 51
The Economics of Pollution 52
Economics of Pollution Why are public bathrooms so gross? The Tragedy of the Commons (AKA: The Common Pool Problem) •Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted because no one has the incentive to keep them clean. •There is no monetary incentive to use them efficiently. •Result is high spillover costs. Example: Over fishing in the ocean 53
The Common Pool Problem 54
Perverse Incentives 1. In 1970, the government tried to protect endangered woodpeckers by requiring land developers to report nests on their land to the EPA. The population of these birds decreased. Why? Land owners would kill the birds to avoid risk of lengthy production delays. (Known as “Shoot, Shovel, and Shut Up”) 2. Assume the government wanted to limit a firm from polluting. They tell the firm it will be inspected twice and it must reduce pollution by 5%. The amount of pollutants would increase. Why? This firm will have the incentive to pollute more prior to the initial inspection. Are their “market solutions” to these problems? 55
How can markets and self interest help to limit pollution? Government can sell the right to pollute 100 200 50 50 100 Assume the lake can naturally absorb 500 gallons of pollutants each year Now what does each firm have the incentive to do? The Gov’t sells each firm the right to pollute a set number of gallons
57 2010 Practice FRQ
Market Failure #3 Monopolies 58
Monopoly Review 1. Draw a monopoly making a profit. Label price and output, and shade (or label) profit. 2. Identify three specific reasons why monopolies are bad. 3. Label the Fair Return price and output. 4. Label the Socially Optimal price and output. 5. Explain why taxing a monopoly is a bad idea. 59
D MR $9 8 7 6 5 4 3 2 MC ATC 60 1 2 3 4 5 6 7 8 9 10 Q P Profit =$5 Unregulated Socially Optimal Fair Return Monopoly
Government in Action: Antitrust Laws Legislative Executive Judicial 61
WHAT ARE ANTITRUST LAWS? Laws designed to prevent monopolies and promote competition. •After the Civil War, advances in technology and transportation led to national markets. •Eventually only a few firms began to dominate industries: railroads, steel, meatpacking, coal, etc. Why are monopolies a Market Failure? •Monopolies destroy the key ingredient of the free market system – Competition. •To fix this MARKET FAILURE, the government must get involved. 62
WHAT DOES THE GOVERNMENT DO? Legislative Branch •Passed laws designed to stop monopolies •Sherman Act of 1890- “Every person who shall monopolize …or conspire to monopolize…shall be deemed guilty of a felony.” Executive Branch •The Federal Trade Commission must approve all corporate mergers. (Like AT&T and …) •When firms use anti-competitive tactics the Department of Justice files suit against them. Judicial Branch •The courts find the firm guilty or not guilty and assign a punishment. 63
Review 1. Define Market Failure. 2. Identify the four market failures we have learned in this unit. 3. Explain why are public goods a market failure. 4. Explain why are externalities a market failure. 5. Explain why are monopolies a market failure. 6. By yourself, draw a positive externality. 7. By yourself, draw a negative externality. 8. Use graph to explain the remedy for positive externalities. 9. Use graph to explain the remedy for negative externalities. 10.Name 10 different super heroes. 65
Market Failure #4 Unfair Distribution of Wealth 66 Net Worth over $2.3 billion
1. What percent of Americans are living in poverty? 2. Why is income distribution a market failure? 67
Income Inequality In 2003, the average American family made $66,863. Everyone is obviously rich. What’s wrong with using the average? Averages reveal absolutely nothing about how income is distributed. How does the government measure distribution of income? SIMULATION (Based on 2003 Information) 68
THE LORENZ CURVE SIMULATION 69
Measuring Income Distribution Review the process: • The government divides all income earning families into five equal groups (quintiles) from poorest to richest. • Each groups represents 20% of the population. • If there was perfect equality then 20% of the families should earn 20% of the income, 40% should earn 40% (and so on). • The government compares how far the actual distribution is from perfect distribution then attempts to redistribute money fairly. 70
Measuring Income Distribution Summary: Group #1 (Poorest 20%) • Total of $5 (5% of total income) Group #2 • Total of $10 (10% of total income) Group #3 • Total of $15 (15% of total income) Group #4 • Total of $25 (25% of total income) Group #5 (Richest 20%) • Total of $65 (45% of total income) 71
20 40 60 80 100 100 80 60 40 20 0 Percent of Families PercentofIncome Perfect Equality The Lorenz Curve 72
20 40 60 80 100 100 80 60 55 40 30 20 15 5 0 Percent of Families PercentofIncome Perfect Equality Lorenz Curve (actual distribution) 73 The Lorenz Curve
20 40 60 80 100 100 80 60 55 40 30 20 15 5 0 Percent of Families PercentofIncome Perfect Equality Lorenz Curve (actual distribution) 74 The Lorenz Curve The size of the banana shows the degree of income inequality.
20 40 60 80 100 100 80 60 55 40 30 20 15 5 0 Percent of Families PercentofIncome Perfect Equality After Distribution 75 The Lorenz Curve The banana gets smaller when the government re- distributes income
(retirement, unemployment, workers comp, health, etc.) BUT, what are some possible downsides? Where does the government get the money for welfare? 76
What are Taxes? Why does the government tax? Two purposes: 1. Finance government operations. • Public goods – highways, defense, employee wages • Fund Programs – welfare, social security 2. Influence economic behavior of firms and individuals. Ex: Excise tax on tobacco raises tax revenue and discourages the use of cigarettes. Taxes – mandatory payments made to the government to cover costs of governing. 78
Three Types of Taxes 1. Progressive Taxes -takes a larger percentage of income from high income groups (takes dollars at increasing rate from richer people). Ex: Current Federal Income Tax system 3. Regressive Taxes – takes a larger percentage from low income groups (takes more from poor people). Ex: Sales tax; any consumption tax. 2. Proportional Taxes (flat rate) –takes the same percent of income from all income groups. Ex: 20% flat income tax on all income groups 79
What kind of taxes are these? (THINK % of Income) 1. Toll road tax ($1 per day) 2. State income tax where richer citizens pay higher % 3. $.45 tax on cigarettes 4. Medicare tax of 1% of every dollar earned 5. 8.25% California sales tax 80 Three Types of Taxes
Federal Income Tax Debate Equal Tax of $350 per week (Regressive Tax) Income Amount of Tax % Amount to live on • $200 $350 175% -$150)[crime?] • $350 $350 100% $0 • $500 $350 70% $150 • $1,000 $350 35% $650 • $5,000 $350 7% $4,650 Flat tax of 20% per week (Proportional Tax) Income Amount of Tax Amount to live on • $200 $40 $160 • $350 $70 $280 • $500 $100 $400 • $1,000 $200 $800 • $5,000 $1,000 $4,000 81
Federal Income Tax Debate This is our current system. Is it fair? The progressive tax system is the most effective way to fight this market failure
The Laffer Curve Shows relationship between tax rate and tax revenue. What would happen if the highest tax bracket was 75%? 83 The LAST micro graph to learn!!!!
THINK ROBIN HOOD!!!!!! What was his group’s name? Merry Men What did they do? Laugh a lot … they were “Laffers.” What was his weapon of choice? Bow and Arrow What did Robin Hood do? Steal from the rich and give to the poor. What would happen to the amount of travelers through Sherwood Forest if he took 95% instead of 39% of their money? What would happen to the total amount of money he collects? 84
The Laffer Curve 85 % Tax Rate Tax Revenue If the government increase taxes rates tax revenue will increase If the tax rate becomes too high, tax revenue will fall since workers have no incentive to work harder
GREAT NEWS… YOU ARE DONE WITH MICRO!!!! 86
Practice FRQs 87
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