Government and the MarketThe Role of GovernmentAnother Look at EfficiencyFigure 1 The Market for AluminumExternalitiesNegative externalitiesFigure 2 Pollution and the Social OptimumPositive externalitiesFigure 3 Education and the Social OptimumInternalizing or Correcting ExternalitiesPowerPoint PresentationSlide 12The Invisible Hand and Invisible Benefits and CostsPublic Goods and Common ResourcesClassifying Different Kinds of Goods and ServicesFigure 1 Four Types of GoodsSlide 17Public GoodsGovernment Provision versus Production of Public GoodsTragedy of the CommonsSummaryGovernment and the MarketThe Role of GovernmentCapitalism is associated with limited government, but government is necessary for three reasons:Establish and maintain legal system to protect property rights.Promote equity in the distribution of income and wealth.Correct inefficiencies that arise from markets (externalities, public goods, and monopoly power).Public Finance/Choice is the area of economics that studies the public sector.Incentives are different in markets versus political sphere– in capitalism preference are revealed with purchases versus votes.Another Look at EfficiencyEfficiency in competitive markets occurs where MB=MC. Where MB= private (max.) willingness to pay and MC= private (min.) willingness to sell.More correctly, society will see the outcome as efficiency where marginal social benefits = marginal social costs.Externalities drive a wedge between private and social benefits and private and social costs.Figure 1 The Market for AluminumCopyright © 2004 South-WesternQuantity ofAluminum0Price ofAluminumEquilibrium MB=MCDemand(private value)Supply(private cost)QMARKETExternalitiesExternalities are benefits (costs) received (borne) by neither the seller or the buyer but by third parties.Private benefits + external benefits = social benefitsPrivate costs + external costs = social costsSince external benefits and costs are not perceived by buyers and sellers they are not captured in markets.Therefore, markets may fail to allocate resources inefficiently.Negative externalitiesMarginal social costs are greater than marginal private costs.Pollution is a cost that may not be borne by sellers, but it is a cost nonetheless to society.Private markets will overproduce (devote too many resources) to the production of goods with negative externalities.External costs and the supply curve.Missing the extra costs, markets generate an outcome where MSC > MSB, signal that decreasing output will increase net social benefits.Is zero pollution efficient?Figure 2 Pollution and the Social OptimumCopyright © 2004 South-WesternEquilibriumQuantity ofAluminum0Price ofAluminumDemand(private value)MPB=MPBSupply(private cost)=MPCSocialCost =MSCQOPTIMUMOptimumCost ofpollutionQMARKETMSCMSBMSCMSBPositive externalitiesMarginal social benefits are greater than marginal private benefits.Education is a benefit not only to the individual but to society in general.Private markets will underproduce (devote too few resources) to the production of goods with positive externalities.External benefits and the demand curve.Missing the extra benefits, markets generate outcomes where MSB > MSC, a signal that increasing production will increase net social benefits.Figure 3 Education and the Social OptimumCopyright © 2004 South-WesternQuantity ofEducation0Price ofEducationDemand(private value)SocialvalueSupply(private cost)QMARKETQOPTIMUMInternalizing or Correcting ExternalitiesEfficiency versus who ought to modify their behavior?Moral and Ethical CodesNon-governmental organizations or CharitiesIntegrating certain activities (bee keepers and fruit growers)Contract between partiesCoase Theorem – if negotiation costs are zero, private parties can resolve the problem of externalities.An optimal compensatory payment (bribe) = one that makes both parties better off.Initial distribution of rights does not affect the efficient outcome, but it does determine who will pay whom.Example of heating the apartment in SantiagoGovernment policies Regulation Limits to pollutionSpecific technology requirementsGovernment productionRegulation and least cost solutionsTaxes and Subsidies Who should pay the tax or receive the subsidy? Tax /subsidy incidence is the sameExternal costs, supply (demand) and the optimal tax.External benefits, demand (supply) and the optimal subsidy.Tradeable Pollution PermitsThe higher costs of avoiding pollution, i.e. the higher the benefits from polluting, the more a firm is willing to pay.Criticism of Economic Solutions to PollutionTo live is to polluteNatural carrying capacityThe Invisible Hand and Invisible Benefits and CostsExternalities are “invisible” to buyers and sellers in markets. In some cases, government action may be needed to make them visible and ensure they are included in economic decision-making.The efficient allocation of resources occurs where:MSB=MSCPublic Goods and Common ResourcesCertain kinds of goods or services are underproduced in markets because the market does not contain sufficient incentives to produce them in efficient amounts.Certain kinds of resources are overused because they are owned collectively or people cannot prevent them from being used.Classifying Different Kinds of Goods and ServicesExclusion or non-exclusion– can individuals be excluded from consuming the good or the resource. (e.g. hamburger, houses, physical examination versus fireworks, national defense, and the ocean outside of territorial waters)?Rival or non-rival – does one person’s use of the good or resource affect another persons use. (e.g. hamburger versus lighthouse, uncongested versus congested highway)Figure 1 Four Types of GoodsCopyright © 2004 South-WesternRival?YesYes• Ice-cream cones• Clothing• Congested toll roads• Fire protection• Cable TV• Uncongested toll roadsNoPrivate Goods Natural MonopoliesNoExcludable?• Fish in the ocean• The environment• Congested nontoll roads• Tornado siren• National defense• Uncongested nontoll roadsCommon Resources Public GoodsPrivate Good – excludable and rival (hamburger)Public Good – not excludable and non-rival (lighthouse, warning siren)Common Resource – rival but not excludable (ocean, old days pasture land)Natural Monopoly – excludable but
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