Market Failure

1
Market Failure
Ch 4 Public Sector

• Our goal is to produce the optimal mix of output,
  the most desirable combination of output
  attainable with existing resources, technology
  and social values.

• Market failure occurs when an imperfection in the
  market mechanism prevents optimal outcomes.

2
Market Failure
Production possibilities
X (Optimal mix)
M (Market mix)
3
Causes of Market Failure

• Four specific sources of market failure
• Public goods
• Externalities
• Market power
• Equity

4
Public Goods

• Public good - good or service whose consumption
  by one person does not exclude consumption by
  others.
• Free rider - an individual who reaps direct
  benefits from someone elses purchase
  (consumption) of a public good.

5
Public Goods

• Markets tend to under-produce public goods and
  over-produce private goods.
• If we want more public goods, we need a
  non-market force government intervention to
  get them.

6
Externalities

• Externalities - costs (or benefits) of a market
  activity borne by a third party.

• When externalities are present, market prices
  arent a valid measure of a goods value to
  society.

• The market will under-produce goods that yield
  external benefits and over-produce those that
  generate external costs.

7
External Costs

• Social demand equals market demand plus
  externalities the externality is subtracted if
  it is an external cost.
• The optimal production mix is where the social
  demand curve intersects the supply curve.

8
Externalities
9
Market Power

• When a firm has market power it has the ability
  to alter the market price of a good or service.
• Producer can maximize profits rather than produce
  the optimal mix of output.

10
Market Power - Monopoly

• Monopoly - firm that produces the entire market
  supply of a particular good or service.

• Government follows an antitrust policy when it
  intervenes to alter market structure or prevent
  abuse of market power.

11
Market Power - Natural Monopoly

• Natural monopoly - industry in which one firm can
  achieve economies of scale over the entire range
  of market supply.

• The government may have to regulate the behavior
  of a natural monopoly to ensure that consumers
  get the benefits of its cost efficiency.

12
Equity

• The distribution of goods and services generated
  by the marketplace is not necessarily fair.

• Transfer payments are made to individuals for
  which no current goods or services are exchanged,
  like Social Security, welfare, unemployment
  benefits.

13
Public-Sector Spending (percentage of total
output)
14
Government Growth
15
Income Taxes
Tax Structures

• Progressive As incomes increase, of income
  paid toward tax increases.
• Proportional All incomes pay same of income
  toward tax.
• Regressive As incomes increase, of income
  paid toward tax decreases.

16
Excise Taxes

• Excise taxes - imposed on certain goods and
  services examples include liquor, gasoline,
  cigarettes, and telephone service.
• Excise taxes discourage production and
  consumption of these goods.

17
Federal Taxes
18
State and Local Tax Sources
19
Government Failure

• Governments, like markets, can fail.
• Government failure occurs when government
  intervention fails to improve economic outcomes.

20
Cost-Benefit Analysis

• Additional public-sector activity is desirable
  only if the benefits from that activity exceed
  its opportunity costs.

• The value of public services must be estimated
  because they dont have (reliable) market prices.

21
Ballot-Box Economics

• Voting mechanisms substitute for the market
  mechanism in allocating resources to the public
  sector and deciding how to use them.

• We do not know what the real demand for public
  goods is, and votes alone do not reflect the
  intensity of individual demands.