chapter 8 market and government failures. copyright © 2008 pearson addison wesley. all rights...

Chapter 8

Market and Government Failures

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 32-2

Did You Know That...

• Every decision involving the environment involves a tradeoff?

• The economic way of thinking about endangered species requires considering the costs of protecting them?

• Economists want to help us opt for informed policies that have maximum net benefits?


Private versus Social Costs

• Private Costs

Costs borne solely by the individuals who incur them

Also called internal costs


Private versus Social Costs (cont'd)

• Social Costs

The full costs borne by society whenever a resource use occurs

Measured by adding internal to external costs



• Environmental issues occur when social costs exceed private cost.

• The cost of polluted air—consider both private and social costs

• Question What if you had to pay the social cost of

driving a car?



• Externality

A situation in which a private cost (or benefit) diverges from a social cost (or benefit)

A situation in which the costs (or benefits) of an action are not fully borne (or gained) by the two parties engaged in a scarce-resource-using activity


Correcting for Externalities

• An externality arises when there is a divergence between private cost and social cost.

• The remedy is to change the signal for decision making.

• In the case of industrial pollution, the firm must be forced to internalize the cost of the environmental damage.


Figure 32-1 Reckoning with Full Social Costs


Correcting for Externalities (cont'd)

• The polluters’ choice

1. Install pollution abatement equipment or change production techniques

2. Reduce pollution-causing activity

3. Pay the price to pollute


Correcting for Externalities (cont'd)

• Is a uniform tax appropriate?

It may be appropriate to levy a uniform tax, as external costs might vary from location to location.

We must establish the amount of economic damages; we have to come up with a measure of economic costs.


Policy Example: Belgian Governments Forgo a Uniform Tax and Kill Off Jobs

• In 2004, DHL announced plans to expand its operations in Brussels.

• The expansion correlated with an increase in late-night flights.

• National and regional Belgian governments objected.

• DHL moved 1,300 jobs to Leipzig, Germany.


Pollution

• Question How much pollution is too much?

• Answer The optimal quantity is determined by a

comparison of marginal costs and benefits.


Figure 32-2 The Optimal Quantity of Air Pollution

The optimal quantityof pollution occurswhere MC = MB


Pollution (cont'd)

• Optimal Quantity of Pollution

The level of pollution for which the marginal benefit of one additional unit of pollution abatement just equals the marginal cost of that additional unit


International Policy Example: Canada Confronts a High Marginal Cost of Pollution Abatement

• Under the Kyoto protocol, Canada promised that it would reduce emissions of global warming gasses.

• Since signing the treaty, Canada’s emissions have actually increased by 1.5% per year.


International Policy Example: Canada Confronts a High Marginal Cost of Pollution Abatement (cont'd)

• Canada’s government continues to promise that the nation will reach its promised level of emissions.

• Although the estimated explicit and opportunity costs to the entire Canadian economy would be at least $30 billion per year.


Common Property

• Private Property Rights

Exclusive rights of ownership that allow the use, transfer, and exchange of property


Common Property (cont'd)

• Common Property

Property that is owned by everyone and therefore by no one

Examples are air and water



• Question What do you think: Why does

pollution occur when property rights are poorly defined?

• Answer When no one owns a particular resource,

no one has any incentive (conscience aside) to consider misusing it.



• Voluntary agreement and transactions costs

Is it possible for externalities to be internalized via voluntary agreement?

What are the costs incurred by the parties who seek to negotiate an agreement?




Voluntary agreements: contracting

Opportunity cost always exists, whoever has property rights.




Transaction Costs

All costs associated with making, reaching, and enforcing agreements

Must be low relative the expected benefits



• Changing property rights

Closing the gap between private costs and social costs

Taxation

Subsidization

Regulation



• Are there alternatives to pollution-causing resource use?

Why aren’t we shifting to solar panels and electric cars?

Could manufacturing solar panels cause pollution?


Example: Profiting by Generating Electricity from Thin Air in Ireland

• The northern portion of Ireland abounds with farmland.

• Although the extreme northern tip of the country is too rugged to farm.

• Yet numerous landowners in this part of Ireland generate revenues.


Example: Profiting by Generating Electricity from Thin Air in Ireland (cont'd)

• The source of the landowner’s earnings is not the land itself, but the steady winds that blow across it.

• Several companies now harness the winds to power turbines that generate electricity.


Wild Species, Common Property, and Trade-Offs

• One of the most distressing common property problems involves endangered species.

• Virtually all species not endangered are private property (dogs, cats, cattle, sheep and horses).

• Endangered species (spotted owls, bighorn sheep and condors) are typically common property.


Wild Species, Common Property, and Trade-Offs (cont'd)

• In 1973, the federal government passed the Endangered Species Act in an attempt to keep species from dying out.

• As more and more species were put on the endangered list, a trade-off became apparent.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8-29

Public Goods

• A key characteristic of public goods is that many individuals can consume them jointly simultaneously. When you partake in the use or benefit of a public good, you do not necessarily take away from anyone else’s share of these goods.


Characteristics of Public Goods

1. Additional users of public goods do not deprive others of any of the services of the goods.

For the continental United States, when more people benefit from national defense, others do not receive less of it.


Characteristics of Public Goods (cont.)

2. It is difficult to design a collection system for a public good based on how much individuals use it.

Because everyone benefits from national defense, it would hard to figure out who benefits more, and therefore who should be charged more.


The Private Sector and Public Goods

• If the production and sale of a purely public good does not yield profits in the private sector, the purely public good will not get produced.

• This is where the government steps in to provide purely public goods, such as national defense.


Introduction

In 1997, the U.S. government ruled out a proposed merger between two companies.

Only eight years later, the two companies, AT&T and SBC, were allowed to merge. To understand this shift in the government’s view, you will have to learn more about antitrust policy.


Forms of Industry Regulation

• The U.S. government began regulating social and economic activity early in the nation’s history.

• The amount of government regulation began increasing in the twentieth century.


Figure 28-1 Regulation on the Rise


Forms of Industry Regulation (cont'd)

• There are two basic types of government regulation.

1. Economic regulation of natural monopolies and nonmonopolistic industries

2. Social regulation which covers all industries



• Economic regulation of natural monopolies Initially, most economic regulation in

the United States was aimed at controlling prices in industries considered natural monopolies.

Over time, federal and state governments have sought to influence products and processes of firms in a variety of industries.



• Economic regulation of nonmonopolistic industries

Securities (SEC)

Banking (Fed, FDIC, Comptroller)

Transportation (FAA)

Communications (FCC)



• Social regulation

The aim is better quality of life

Improved products

Less pollution

Better working conditions


Table 28-1 Federal Agencies Engaged in Social Regulation


Regulating Natural Monopolies

• Theory of natural monopoly regulation includes our understanding

Unregulated natural monopoly

Impracticality of marginal cost pricing

Average cost pricing


Regulating Natural Monopolies (cont'd)

• Recall

Natural monopoly is a monopoly arising from the peculiar production characteristics in an industry.

It usually arises when there are large economies of scale relative to the industry’s demand.

One firm can produce at a lower average cost than can be achieved by multiple firms.


Figure 28-2 Profit Maximization and Regulation Through Marginal Cost Pricing, Panel (a)

Max profits at point A where marginal cost equals marginal revenue


Figure 28-2 Profit Maximization and Regulation Through Marginal Cost Pricing, Panel (b)

Losses eventually drive the natural monopolist out of business


Profit Maximization and Regulation Through Marginal Cost Pricing

Average Cost PricingRegulatory goal: P = ATC

• Set price at P1 where ATC = D

• Output = Q2

• P = ATC

• Normal rate of return



• Methods of rate regulation

Cost-of-Service RegulationRegulation based on allowing prices to reflect

only the actual cost of production and no monopoly profits

Rate-of-Return RegulationRegulation that seeks to keep the rate of return

in the industry at a competitive level by not allowing excessive prices to be charged



• Question Are natural monopolies a thing of the past?

• Before answering consider Electricity and natural gas: separating

production from delivery

Telecommunications services meet the Internet


International Policy Example: Time to Break Up the Irish Cellphone Duopoly?

• Vodafone and mm02 have accounted for more than 95% of all sales of cellphone services in Ireland.

• Effectively, therefore, these two firms constitute a cellphone duopoly.

• Ireland’s regulators proposed they open their networks, and their fees would be regulated to ensure a “fair” rate of return.


Regulating Nonmonopolistic Industries

• Protecting consumer interests has been the main rationale for governmental regulatory functions.

• The Latin phrase caveat emptor, “let the buyer beware,” was once the operative principle, but no more.


Regulating Nonmonopolistic Industries (cont'd)

• Rationales for government oversight in nonmonopolistic industries

Market failure arising from externalities

The need for consumer protection arising from asymmetric information



• Lemons Problem

The potential for asymmetric information to bring about a general decline in product quality in an industry

Credence goods such as pharmaceuticals, health care, and professional services are vulnerable to the lemons problem.



• Implementing consumer protection regulation

Liability laws and government licensing

Direct economic and social regulation


Incentives and Costs of Regulation

• Abiding by government regulations can be costly.

Businesses engage in activities avoiding true intent.

Try and change regulations agencies establish


Incentives and Costs of Regulation (cont'd)

• Creative response and feedback effects: results of regulation

Creative Response

Behavior on the part of a firm that allows it to comply with the letter of the law but violates the spirit, significantly lessening the law’s effects



• Creative response and feedback effects: results of regulation

Feedback effectChanging behavior after the regulation that

offset the regulation

ExampleHOV lanes added to combat air pollution have

higher accident rates


Example: How Dare You Get Ahead of Me in that HOV Lane!

• High occupancy vehicle (HOV) lanes have increased nationwide in order to combat air pollution.

• Drivers merging from HOV lanes often drive faster than traffic conditions warrant, however.

• Those in HOV lanes also face resentment from non-HOV lane users, who may make it difficult for them to merge.



• Capture Hypothesis

Predicts that the regulators will eventually be captured by the special interests of the industry being regulated



• Share-the-Gains, Share-the-Pains Theory

The regulators must take account of the demands of three groups: legislators, members of the regulated industry, and consumers of the regulated industry’s product or service



• Benefits and costs to regulation

Regulation offers many potential benefits.

Actual benefits are more difficult to measure.



• Direct costs to taxpayers

Taxpayers pay more than $40 billion per year.

Agencies employ more than 190,000 employees.


Figure 28-3 The Distribution of Federal Regulatory Spending



• The total social cost of regulation

Explicit costs of compliance in the United States is estimated to be between $500 billion and $600 billion per year.

Economists estimate the opportunity cost of complying with federal regulations may be as high as $270 billion.

Add state and municipal regulations, and consider all implicit and explicit costs, and we are over $1 trillion in total.


Antitrust Policy

• An expressed aim of the U.S. government is to foster competition.

• This is the general idea behind antitrust legislation.

• Congress has enacted four key antitrust laws; the most important is the Sherman Act.


Table 28-2 Key U.S. Antitrust Laws


Antitrust Policy (cont'd)

• Sherman Antitrust Act of 1890

Section 1

Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several states, or with foreign nations, is hereby declared to be illegal.



• Sherman Antitrust Act of 1890

Section 2

Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons to monopolize any part of the trade or commerce… shall be guilty of a misdemeanor.



• Clayton Act of 1914

Passed to remove the vagueness of the Sherman Act



• Robinson-Patman Act of 1936

Amended Section 2 of the Clayton Act

Designed to protect independent retailers and wholesalers from “unfair discrimination” by chain stores



• Exemptions from antitrust laws

All labor unions

Public utilities

Professional baseball

Cooperative activities among U.S. exporters



• Exemptions from antitrust laws

Hospitals

Public transit and water systems

Suppliers of military equipment

Joint publishing arrangement in a single city by two or more newspapers



• As more U.S. firms seek to merge with companies in other countries, the international dimensions of antitrust policy become more important.

• In the European Union, there are restrictions against any business combination that would enhance the market dominance of one firm.


Antitrust Enforcement

• Monopolization

The possession of monopoly power in the relevant market and the willful acquisition or maintenance of that power

As distinguished from growth or development as a consequence of a superior product, business acumen, or historical accident


Antitrust Enforcement (cont'd)

• Market Share Test

The percentage of a market that a particular firm supplies; used as the primary measure of monopoly power


E-Commerce Example: Microsoft’s Market Shares

• In the market for PC software, one company stands alone.

• Microsoft’s market share is over 95% for PC software.

• Their market share of office productivity software is about 94%.

• Why might it be argued that Microsoft is not a monopoly under the Sherman Act?



• The relevant market

The relevant product market

The relevant geographic market



• Determining when a firm has engaged in “willful acquisition or maintenance” of market power

• What appears as good business to some may look like antitrust violations to others.



• Versioning

Selling a product in slightly altered forms to different groups of consumers

An example is selling software in “professional” and “standard” versions



• Bundling

Offering two or more products for sale as a set



• Tie-In Sales

Purchases of one product that are permitted by the seller only if the consumer buys another good or service from the same firm


Issues and Applications: Identifying the Relevant Telecommunications Market

• In 1997, AT&T and SBC, the “Southwestern Bell,” held merger talks—an act the then FCC chief called “unthinkable.”

• Eight years later the two companies merged after all, and neither the FCC nor the U.S. antitrust authorities raised objections.

• What had happened? The answer is that the relevant market for SBC, AT&T, and other telecommunications companies expanded.


Table 28-3 Shares of Industry Sales in Alternative Markets for Broadband Internet Access


Government Financing

• As you have seen, the government is involved in regulation, antitrust activities, national defense, and literally hundreds of thousands of other activities.

• The first question we have to answer is how we pay for government. We do so, for the most part, via taxation.


Marginal and Average Tax Rates

Change in taxes dueMarginal tax rate =

Change in taxable income

Total taxes dueAverage tax rate =

Total taxable income


Taxation Systems

• Proportional Taxation—means that regardless of an individual’s income, taxes comprise exactly the same proportion.

• The marginal tax rate is always equal to the average tax rate. If every dollar is taxed at 20 percent, then the average tax rate is 20 percent, as is the marginal tax rate.


Taxation Systems (cont.)

• Progressive Taxation—Under progressive taxation, as a person’s taxable income increases, the percentage of income paid in taxes increases.

• The marginal tax rate is above the average tax rate.


Taxation Systems (cont.)

• Regressive Taxation—With regressive taxation, a smaller percentage of taxable income is taken in taxes as taxable income increases.

• The marginal rate is below the average rate. As income increases, the marginal tax rate falls, and so does the average tax rate.


Government Failures

• When the government engages in activities that reduce social welfare or economic efficiency, we call this situation one of government failure.

• Types of government failures: actions that reduce competition, especially from abroad; improper pricing of health care, particularly through Medicare; and inefficient methods of regulation.


Did You Know That...

• One of every 125 U.S. residents is a “millionaire?”

• About 30,000 people possess personal wealth exceeding $30 million?

• At the other end, there are 37 million U.S. residents in poverty?


Income

• Income provides us a means of consuming and saving

Can be payment for labor

Can be payment for other factor

Can be from gifts and government transfers


Income (cont'd)

• Distribution of Income

The way income is allocated among the population


Income (cont'd)

• Lorenz Curve

A geometric representation of the distribution of income

A Lorenz curve that is perfectly straight represents complete income equality.

The more bowed a Lorenz curve, the more unequally income is distributed.


Figure 31-1 The Lorenz Curve


Income (cont'd)

• Criticisms of the Lorenz curve

1. It does not include income in kind: income received in the form of goods and services.

2. It does not account for the differences in size of households or the number of wage earners households contain.


Income (cont'd)

• Criticisms of the Lorenz curve

3. It does not account for age differences.

4. It ordinarily reflects money income before taxes.

5. It does not measure unreported income.


Figure 31-2 Lorenz Curves of Income Distribution, 1929 and 2007


Table 31-1 Percentage Share of Money Income for Households Before Direct Taxes


Example: Why it is Misleading to Examine Only Wages and Salaries

• Today, only about 52% of national income is derived from wages and salaries.

• Total compensation received has remained close to 70% of national income.


Figure 31-3 Wages and Salaries and Total Labor Compensation as Percentages of U.S. National Income


The Distribution of Wealth

• Income—a flow—can be viewed as a return on wealth—a stock.

• The distribution of income is not the same as the distribution of wealth.

• Wealth includes tangible objects and human wealth.


Figure 31-4 Measured Total Wealth Distribution


Determinants of Income Differences

• We know there are income differences; that is not in dispute.

• A more important question is why these differences occur.

• If we know, perhaps we can change policy, or better understand them.


Determinants of Income Differences (cont'd)

• We will look at four determinants of income differences

1. Age

2. Marginal productivity

3. Inheritance

4. Discrimination



• Age-Earnings Cycle

The regular earnings profile of an individual throughout his or her lifetime



• Age-earnings cycle

At age 18, earnings from wages are relatively low.

Earnings gradually rise until they peak at about age 50.

Earnings then fall until retirement, when they become zero.


Figure 31-5 Typical Age-Earnings Profile



• Marginal productivity

Talent

Experience

Training

Investment in human capital



• Inheritance 10% of inequality traced to inheritance

• Discrimination Different pay for equal MRP

Equal pay for different MRP



• Access to education

Minorities face discrimination in the acquisition of human capital.



• Doctrine of Comparable Worth

The belief that women should receive the same wages as men if the levels of skill and responsibility in their jobs are equivalent


Today

• Complete Chapter 31 Social Issues

• Discuss Homework Health Care Plans

• Chapter 32 Environmental Economics


Theories of Desired Income Distribution

• The productivity standard “To each according to what she or

he produces”Also called the contributive standard, or

referred to as the merit standard

• Equality—the egalitarian principle “To each exactly the same”


Poverty and Attempts to Eliminate It

• Throughout history mass poverty has been accepted as inevitable.

• Sustained economic growth has wiped out mass poverty in many countries.

• How can there be so much poverty in a nation of such abundance?


Figure 31-6 Official Number of Poor in the United States, Panel (a)

Source: U.S. Department of Labor


Figure 31-6 Official Number of Poor in the United States, Panel (b)

Source: U.S. Department of Labor


Poverty and Attempts to Eliminate It (cont'd)

• Defining poverty

Official poverty level in 2007 for an urban family of four around $21,000

Adjusted based on CPI

Does not include cash and non-cash transfer payments

• Absolute poverty not the same as relative poverty

In a relative sense, poverty will always exist even if absolute poverty eliminated.


Source: Bureau of Labor Statistics; U.S. Bureau of the Census

Figure 31-7 Relative Poverty: Comparing Household Income and Household Spending



• Attacks on poverty: major income maintenance programs

Social Security which has been called OASDI

90% of all employed persons covered

In 2007, 49 million people received checks averaging $960 a month.



• Supplemental Security Income (SSI)

Minimum income for the

Aged

Blind

Disabled



• Temporary Assistance to Needy Families (TANF)

State administered program financed in part by federal grants

The program provides aid to families in need.



• Food stamps

Government-issued coupons (or e-debit cards) that can be used to purchase food

In 1964, some 367,000 Americans received food stamps.

In 2007, one in nine citizens received food stamps.


Policy Example: What are Food Stamps Worth?

• Recipients qualify for food stamps because they have low incomes.

• There are times when these recipients need cash more than food stamps.

• Diane Whitmore of the University of Chicago sought to determine value.


Policy Example: What are Food Stamps Worth? (cont'd)

• She found 20 to 30% purchased more food (than if they received cash).

• This group placed an average cash value of 80 cents per $1 in food stamps.

• She found that stamps trade in the underground market for 65 cents per $1.



• Earned Income Tax Credit Program (EITC)

Designed to provide rebates to low- income workers

Each year federal government grants $36 billion in benefits.

Over one-fifth of all tax returns claim an EITC.



• No apparent reduction in poverty

1973: 11%

1983: 15%

1990: 13.1%

Since fallen to 12%


Health Care

• Health care is intimately related to the distribution of income and poverty


Health Care (cont'd)

• America’s health care situation

Portion of national income spent on health care has risen steadily since 1965.

16% of U.S. real GDP is devoted to spending on health care.

Per capita spending greater than anywhere else in the world


Source: U.S. Department of Commerce; U.S. Department of Health and Human Services; Deloitte and Touch LLP; VHA, Inc.

Figure 31-8 Percentage of Total National Income Spent on Health Care in the United States



• Question Why have health care costs risen

so much?

• Answers The age-health care expenditure equation

New technologies

Third-party financing



• Third Parties

Parties who are not directly involved in a given activity or transaction

Fees may be paid by third parties (insurance companies, government)


Source: Health Care Financing Administration; U.S. Department of Health and Human Services

Figure 31-9 Third-Party versus Out-of-Pocket Health Care Payments



• Price, quantity demanded, and moral hazard

Large percent of medical services payments made by third parties

Price to the consumer drops and the quantity demanded increases

An individual with a zero deductible may engage in a less healthful lifestyle


Figure 31-10 The Demand for Health Care Services

At P1 quantitydemanded is Q1

If the price falls to zero, quantity demanded increases to Q2



• Moral hazard as it affects physicians and hospitals

Due to third-party payments, patients do not have to worry about the cost of operations and medical procedures.

Physicians and hospitals order more of them since they are reimbursed on the basis of medical procedures.



• Medicare expenditures are one of the most serious problems facing the federal government today.

• The number of beneficiaries has increased from 19.1 million in 1966 to more than 40 million in 2007.

• Federal spending on Medicare has increased about 10% a year, adjusted for inflation.


Figure 31-11 Federal Medicare Spending



• Is national health insurance the answer?

Over 40 million Americans are uninsured at some point during the year.

Federal spending might increase from $60 to $100 billion.



• Countering the moral hazard problem: Health Savings Account (HSA)

A tax-exempt health care account

To which individuals can pay on a regular basis

And out of which medical care expenses can be paid


Key Terms and Concepts

• antitrust laws

• economic regulation

• government failure

• marginal tax rate

• market failures

• negative externalities

• positive externality

• private costs

• private goods

• progressive taxation

• proportional taxation

• public goods

• regressive taxation

• regulation

• social regulation

chapter 8 market and government failures. copyright © 2008 pearson addison wesley. all rights...

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