Unit 6:

Market Failures and the

Role of the Government
Length
2 1/2 Weeks TOTAL
Assignments
Problem Set #6
1
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.

The government’s job is to enforce contracts,

secure property rights, and defend the country.
3
 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
7
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
 Public Goods
If there was no government, how would
schools, parks and freeways be different?
Would there be enough to meet our needs?

Video: Fire Department

11
 Public Goods
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.

12
What’s wrong with this picture?

13
 The Free Rider
Problem
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
14
 Does anyone free ride off you?
•Canadian
Military
Spending:
$21.8 Billion

•U.S. Military
Spending:
$660 Billion

Why doesn’t
Canada spend
more on its
military?
15
What’s wrong with Free Riders?
•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.
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
 Definition of Public Goods
To be considered a true public good, it
must meet two criteria:
1. Nonexclusion
•Everyone can use the good.
•Cannot exclude benefits of the good for
those who will not pay.
•Ex: National Defense
2. Shared Consumption (Nonrivalry)
•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?

Worker Safety Laws Barber Shop Licenses Bank Bailouts

Every society needs to decide how much

government involvement is desirable
21
 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
 Market Failure #1
PUBLIC GOODS
Why doesn’t the free market
provide them?
There is little opportunity to earn
profit.

Why NOT?
Individuals benefit without paying.
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 Adam is Jill is Society’s
Assume:Marginal
Parks 1. There are
willing to willing to Demand only
Cost
pay pay for Parks
two people in
1 $4 $5 society. $5
$9
2. Each additional
2 $3 $4 $7 $5
park costs $5
3 $2 $3 $5 $5
How many parks
4 $1 $2 $3 $5
should be made?
5 $0 $1 $1 $5
 Demand for a New Park
Marginal willingness to pay higher taxes
# of Adam is Jill is Society’s Marginal
Parks willing to willing to Demand Cost per
pay pay (MSB) 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 Adam is Jill is Society’s Marginal
Parks “Optimal”
willing to willingamount
to Demand Social
pay pay good
of a public (MSB) Cost
1 $4 is where
$5 $9 $5
2 MSB
$3 =$4MSC!
$7 $5
3 $2 $3 $5 $5
4 $1 $2 $3 $5
5 $0 $1 $1 $5
 Supply and Demand for Public Parks
Price
$9 The Demand is
equal to the
7 marginal benefit
to society
5

1 D=MSB

0 1 2 3 4 5
Quantity of Parks
 Supply and Demand for Public Parks
Price 1. What if the government
$9 made 1 park?
2. What if the government
made 4 parks?
7
MSB = MSC
5 S=MSC

The supply is the

3 public good’s
marginal cost to
1 society D=MSB

0 1 2 3 4 5
Quantity of Parks
Market Failure #2:
EXTERNALITIES

33
 What are Externalities?
•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.
34
Negative Externalities

35
 Negative Externalities
(aka: Spillover Costs)
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.
36
Video- Whistle Tips

37
 Market for Cigarettes
The marginal private cost doesn’t include the
P
costs to society.

Supply =
Marginal
Private Cost

D=MSB
QFree Market Q 38
 Market for Cigarettes
What will the MC/Supply look like when EXTERNAL
costs are factored in? Supply =
P
Marginal
Social Cost
Supply =
Marginal
Private Cost

D=MSB
QOptimal QFree Market Q 39
 Market for Cigarettes
If the market produces QFM why is it a market
P failure?
S =MSC

S=MPC

At QFM the MSC is

greater than the MSB.
Too much is being
produced
Overallocation
D=MSB
QOptimal QFree Market Q 40
 Market for Cigarettes
What should the government do to fix a negative
P externality?
S =MSC

S=MPC

Solution: Tax the

amount of the
externality
(Per Unit Tax)

D=MSB
QOptimal QFree Market Q 41
 Market for Cigarettes
What should the government do to fix a negative
P externality? S =MSC =MPC2
Supply curve shifts left (yellow);
amount of tax is the vertical distance
between MPC1 and MSC (black)
MSB = MSC
S=MPC1

Solution: Tax the

amount of the
externality
(Per Unit Tax)

D=MSB
QOptimal QFree Market Q 42
43
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
 Market for Flu Shots
The marginal private benefit doesn’t include
P
the additional benefits to society.

S = MSC

D=Marginal
Private Benefit
QFree Market Q 46
 Market for Flu Shots
What will the MSB/D look like when
P EXTERNAL benefits are factored in?

S = MSC

D=Marginal
Social Benefit

D=Marginal
Private Benefit
QFM QOptimal Q 47
 Market for Flu Shots
If the market produces QFM why is it a market
P failure?

S = MSC

D=Marginal
Social Benefit

D=MSB
QFM QOptimal Q 48
 Market for Flu Shots
At QFM the MSC is less than the MSB.
Too little is being produced
P

S = MSC

D=Marginal
Social Benefit
Underallocation

QFM QOptimal Q 49
 Market for Flu Shots
What should the government do to address a
positive externality?
P
Subsidize the amount of the
externality (Per Unit Subsidy)
S = MSC
Subsidy shifts MSB/D right (yellow);
amount of subsidy is vertical distance
between MB curves (black)

D=MSB =MPB

D=MPB
QFM QOptimal Q 50
 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
Assume the lake can
naturally absorb 500 100
gallons of pollutants
each year

The Gov’t sells each 200

firm the right to
pollute a set number
of gallons 100

Now what does each

50
firm have the incentive 50
to do?
2010 Practice FRQ

57
 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
 Monopoly
Socially
Unregulated Optimal
P $9
MC
8 ATC
7
Fair
6 Profit =$5
Return
5
4 D
3
2
MR
1 2 3 4 5 6 7 8 9 10 Q 60
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
64
 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

Net
Worth
over $2.3
billion

66
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
 The Lorenz Curve
100

80
Percent of Income

Perfect Equality
60

40

20

0
20 40 60 80 100
Percent of Families 72
 The Lorenz Curve
100
Lorenz Curve
(actual distribution)
80
Percent of Income

Perfect Equality
60

55

40

30

20
15

5
0
20 40 60 80 100
Percent of Families 73
 The Lorenz Curve
100
Lorenz Curve
(actual distribution)
80
Percent of Income

Perfect Equality
60

55

40

30 The size of the

banana shows
20
15 the degree of
income inequality.
5
0
20 40 60 80 100
Percent of Families 74
 The Lorenz Curve
100

After Distribution
80
Percent of Income

Perfect Equality
60

55

40

30 The banana gets

smaller when the
20
15 government re-
distributes income
5
0
20 40 60 80 100
Percent of Families 75
(retirement, unemployment, workers comp, health,
etc.)
BUT, what are some possible downsides?

Where does the government get

the money for welfare?
76
Taxes

77
 What are Taxes?
Taxes – mandatory payments made to the
government to cover costs of governing.
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. 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
2. Proportional Taxes (flat rate) –takes the same
percent of income from all income groups.
Ex: 20% flat income tax on all income groups
3. Regressive Taxes – takes a larger percentage
from low income groups (takes more from poor
people).
Ex: Sales tax; any consumption tax.
79
 Three Types of Taxes
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
 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 LAST micro graph to
learn!!!!
The Laffer Curve
Shows relationship between tax
rate and tax revenue.
What would happen if the highest tax
bracket was 75%?
83
 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
If the government
increase taxes rates
% Tax tax revenue will
Rate increase

If the tax rate

becomes too high, tax
revenue will fall since
workers have no
incentive to work
harder

Tax Revenue 85
GREAT NEWS…

YOU ARE DONE WITH

MICRO!!!!
86
Practice FRQs

87
2005, #2 88
2003, #1 89