Introduction

 Should the government intervene in the market?

 The framework presented might be called the invisible
hand framework.
 Invisible hand framework – perfectly competitive lead
individuals to make voluntary choices that are in
society’s interest.
Market Failures
 A market failure occurs when the invisible hand
pushes in such a way that individual decisions do not
lead to socially desirable outcomes.
Market Failures
 Any time a market failure exists, there is a reason for
possible government intervention into markets to
improve the outcome.
Market Failures
 Because the politics of implementing the solution
often leads to further problems, government
intervention may not necessarily improve the
situation.
Externalities
 Externalities are the effect of a decision on a third
party that is not taken into account by the decision-
maker.
 Externalities can be both positive and negative.
Externalities
 Negative externalities occur when the effect of a
decision on others that is not taken into account by
the decision-maker is detrimental to the third party.

• Examples include second-hand smoke,

water pollution, and congestion.
Externalities
 Positive externalities occur when the effect of a
decision on others that is not taken into account by
the decision-maker is beneficial to others.

• Examples include innovation,

education, and new business
formation.
Negative Externalities
 When negative externalities ensue third parties are
hurt.
 Marginal social cost is greater than marginal private
cost.
Negative Externalities
 Marginal social cost includes all the marginal costs
borne by society.
➢ Marginal social cost is calculated by adding the
negative externalities associated with production to
the marginal private costs of that production
The Effect of a Negative Externality
Cost Marginal social cost
Marginal private cost
Marginal cost
P1 from externality
P0
Marginal social
benefit
0 Q1 Q0 Quantity
Positive Externalities
 Private trades can benefit third parties not involved in
the trade.
 Marginal social benefit equals the marginal private
benefit of consuming a good or service plus the
positive externalities resulting from consuming that
good or service.
A Positive Externality
S = Marginal private and social cost
Cost
P1
D1 = Marginal social benefit
Marginal benefit of an externality
P0

D0 = Marginal private benefit

0 Q 0 Q1 Quantity
Alternative Methods of Dealing
with Externalities
 Externalities can be dealt with via

1. Direct Regulation
2. Incentive Policies
3. Voluntary Solutions.
Direct Regulation
 A program of direct regulation is where the amount
of a good people are allowed to use is directly limited
by the government.
Direct Regulation
 Economists do not like this solution since it does not
achieve the desired end as efficiently (at the lowest
cost possible in total resources without consideration
as to who pays those costs) and fairly as possible.
Direct Regulation
 Direct regulation is inefficient because it achieves a
goal in a more costly manner than necessary.
Incentive Policies
 Incentive programs are more efficient than direct
regulatory policies.
 The two types of incentive policies are either taxes or
market incentives.
Tax Incentive Policies
 A tax incentive program uses a tax to create
incentives for individuals to structure their activities in
a way that is consistent with the desired ends.
 Often the tax yields the desired end more efficiently
than straight regulation.
Tax Incentive Policies
 Another way to handle a negative externality is
through a pollution tax or effluent fees.

• Effluent fees – charges imposed by

government on the level of pollution
created.
Regulation Through Taxation
Cost Marginal social cost
Marginal private cost

P1
Efficient tax
P0
Marginal social
benefit
0 Q1 Q0 Quantity
Market Incentive Policies
 An alternative to direct regulation is some type of
market incentive program.
 Market incentive program – a plan requiring market
participants to certify total consumption – their own
or other’s – has been reduced by a specified amount.
Voluntary Reductions
 Voluntary reductions leave individuals free to choose
whether to follow what is socially optimal or what is
privately optimal.
 Economists are uncertain of voluntary solutions.
Voluntary Reductions
 A person’s social conscience and willingness to do
things for the good of society generally depend on his
or her belief that others will also be helping.
Voluntary Reductions
 If a socially conscious person comes to believe a large
number of other people will not contribute, he or she
will often lose their social conscience.

• This is another example of a free

rider problem – individuals’
unwillingness to share in the cost of a
public good.
The Optimal Policy
 An optimal policy is one in which the marginal cost
of undertaking the policy equals the marginal benefit
of that policy.
The Optimal Policy
 Should pollution be totally eliminated?

• Some environmentalists say “yes.”

• Economists would answer that doing
so is costly so marginal costs should
be balanced against marginal benefits.
The Optimal Policy
 The point where MC = MR is called the optimal level
of pollution.

• Optimal level of pollution – the

amount of pollution at which the
marginal benefit of reducing pollution
equals the marginal cost.
Public Goods
 A public good is one that is nonexclusive (no one can
be excluded from its benefits) and nonrival
(consumption by one does not preclude consumption
by others.
Public Goods
 There are no pure examples of a public good.

– The closest example is national defense.

• Technology can change the public
nature of goods.
– Roads are an example.
Public Goods
 With public goods, the focus is on groups.

• With private goods, the focus is on

the individual.
Public Goods
 In the case of a public good, the social benefit of a
public good is the sum of the individual benefits.
Public Goods
 Adding demand curves vertically is easy to do in
textbooks, but not in practice.

• This is because individuals do not buy

public goods directly so that their
demand is not revealed in their
actions.
The Market Value of a Public Good
Price

1.00
0.50
.80
.60 0.10 Market demand
.40 DB
0.60 0.40
0.50
.20
DA
0.10
1 2 3 Quantity
Informational Problems
 Perfectly competitive markets assume perfect
information.
 Real-world markets often involve deception, cheating,
and inaccurate information.
Informational Problems
 When there is a lack of information, buyers and sellers
do not have equal information, markets may not work
properly.
Informational Problems
 Economists call such market failures adverse selection
problems.

• Adverse selection problems –

problems that occur when a buyer or
a seller have different amounts of
information about the good for sale.
Policies to Deal with Informational
Problems
 One policy alternative to deal with information market
failures is to regulate the market and see that
individuals provide the correct information.
Policies to Deal with Informational
Problems
 Another alternative is for the government to license
individuals in the market and require them to provide
full information about the good being sold.
Policies to Deal with Informational
Problems
 Regulatory solutions may be overly slow or costly.
A Market in Information
 A market in information is one solution to the
information problem.
 Information is valuable, and is an economic product in
its own right.
A Market in Information
 Left on their own, markets will develop to provide
information that people need and are willing to pay for
it.
A Market in Information
 Economists who do not like government interference
point out that informational problems are not a
problem of the market; it is a problem of government
regulation.
Licensing of Doctors
 Licensing of doctors is a debate that is motivated by
information problems.
 Currently all doctors practicing medicine are required
to be licensed – this was not always so.
 Licensing of doctors is justified by informational
problems.
Licensing of Doctors
 Some economists argue that licensing is as much a
problem of restricting supply as it is to help the
consumer.
Licensing of Doctors
 Why, if licensed medical training is so great, do we
even need formal restrictions to keep other types of
medicine from being practiced?
Licensing of Doctors
 Whom do these restrictions benefit: the general public
or the doctors who practice mainstream medicine?

• What have the long-term effects of

licensure been?
An Informational Alternative to
Licensure
 As an alternative, the government could provide the
public with information about which treatments work
and which do not.
 This would give rise to consumer sovereignty – the
right of the individual to make choices about what is
consumed and produced.
An Informational Alternative to
Licensure
 In this scenario, the government would provide such
information as:

– Grades in college.
– Grades in medical school.
– Success rate for various procedures.
– References.
– Medical philosophy.
– Charges and fees.
An Informational Alternative to
Licensure
 This information alternative would provide much
more useful information to the public than the present
licensing procedure.
An Informational Alternative to
Licensure
 Here are some words of caution about the
informational alternative.

– To get a true picture of whether the

present system is best would require
experts on real-life practices and
institutions.
– The problem is that the experts may
have a vested interest in keeping things
just the way they are.
Government Failures and Market
Failures
 Market failures should not automatically call for
government intervention.
 Why? Because governments fail too.
Government Failures and Market
Failures
 Government failure occurs when the government
intervention in the market to improve the market
failure actually makes the situation worse.
Reasons for Government Failures
 Governments do not have an incentive to correct the
problem.
 Governments do not have the information to deal with
the problem.
 Intervention in the markets is almost always more
complicated than it initially looks.
Reasons for Government Failures
 Government intervention does not allow fine-tuning,
and so, when the problems change, the government
solution often responds far more slowly.

• Government intervention leads to

more government intervention.