Public Sector Economics (EC218)

Lecture 1

Terrence Kairiza
Bindura University of Science Education
1
 Outline
• Definition of Public Sector Economics
• The Social Welfare Function
– Alternative Social Welfare Functions
• Pareto Optimality
• Welfare Theorems
– First Welfare Theorem
• Implications of the First Welfare Theorem
– Second Welfare Theorem
• Implications of the Second Welfare Theorem
2
 Introduction
• The subject matter of public sector economics revolves around
questions such as:
– When should a society forgo the economic freedom of markets and rely on
the public finance and public policy of the government? [Normative
question]
– What do we predict will be the outcome when voters and taxpayers
delegate responsibilities to governments through public finance and public
policy? [Positive question]
• It basically deals with:
– the raising and spending of funds by the government
– the comparison of alternative economic states in terms of efficiency and
distribution or equity (social objectives).
• Encompasses the social welfare function as a measure of the total
wellbeing of the society
3
 The Social Welfare Function
• A mathematical representation of the combined utilities of all
economic agents
• Utility of an individual is represented as follows:
• Ui = Ui (x)
• Where:
– Ui : Utility of the ith individual.
– Xj : A vector of commodities consumed

• The issue that arises then is to translate the individual’s utility

function into a social welfare function [which the benevolent
dictator can maximize]
• The social welfare function is therefore some kind of aggregating
function of the individual utility functions:
– W=W(U1 ( x).., Un( x))

4
 Alternative Social Welfare Functions
1. Classical Utilitarian/Benthamite SWF
• SWF is the sum of the individual utility functions:
– W(u)=∑ui
• Impersonality: same weights are given to all people
regardless of personal characteristics
• A slight generalization of this form is the Weighted Sum-of-
Utilities SWF:
– W(u)=∑ ai ui
– ai is a number indicating the importance of agent i’s utility to the
overall social welfare (value judgements of the social planner).
– It is natural to take each a as being positive.
– Problem with coming up with the weights
5
 Alternative Social Welfare Functions
2. Bergsonian SWF
• Considers the welfare of society to be reliant on
certain measurable variables that directly impact
on the wellbeing of citizens.
• All these variables define the state of the world
• The social welfare function is thus specified as:
– W = W (s) = W [V1 (s);V2 (s);........;Vn ] Where: W is the
welfare of the society.
– Vi(s) is the value of some measurable variable i in state
of the world s that is relevant for measuring collective
or social welfare.
6
 Alternative Social Welfare Functions
3. Rawlsian SWF
• Distributive justice is biased by our position in life
– rich: will never favour re-distribution policies
– poor: you will always do so
• Overcome bias to reach socially desirable outcome
– make decisions through a “veil of ignorance”
– as if people do not know their true position in the
income distribution and how that might affect future
outcomes
• Risk-averse: social welfare = utility of worst-off
– W=min[u1; u2;……. un]
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 Pareto Optimality
• An economic situation is Pareto efficient if there is no
way to make any person better off without hurting
anybody else
• Assumptions
– There are only two commodities in the economy and the
commodities are X and Y.
– There are two individuals in the economy, A and B
– Total endowment in the economy of X and Y are known to R
and S, respectively
• We can represent the ICs in an Edgeworth box as
follows:
8
9
 Pareto Optimality
• A Pareto efficient allocation can be described as an
allocation where:
– 1. There is no way to make some individual better off
without making someone else worse off; or
– 2. All of the gains from trade have been exhausted;
• These are points that lie on the tangency of the
indifference curves
– A curve connecting those points is know as the contract
curve
• On those points the MRS of the two individuals are
equal
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 Welfare Theorems:
First Welfare Theorem
• The first welfare theorem provides a set of conditions under which we
can be assured that a market economy will achieve a Pareto optimal;
– The formal expression of Adam Smith’s claim about the “invisible hand” of the
market.
• If there is a competitive equilibrium such that:
– all goods can be assigned property rights;
– if no individual and no firm can affect the prices;
– if producers are maximizing their profits and if consumers are maximizing their
utilities and
– if all markets clear,
• then the resulting allocation of resources is Pareto optimal.
• Such an allocation may not have any other desirable properties, but it will
necessarily be efficient.
– Particularly it says nothing about distribution

11
 Welfare Theorems:
Second Welfare Theorem (1)
• Under the same set of conditions as the first welfare theorem, plus:
– convexity and continuity conditions,
• Then all Pareto optimal outcomes can in principle be implemented
through the market mechanism by appropriately redistributing wealth
and then “letting the market work.”
• under certain conditions, every Pareto efficient allocation can be
achieved as a competitive equilibrium
• Implies that the problems of distribution and efficiency can be separated
• Whatever Pareto efficient allocation you want can be supported by the
market mechanism.
• The market mechanism is distributionally neutral; whatever your criteria
for a good or a just distribution of welfare, you can use competitive
markets to achieve it.

12
 Welfare Theorems:
Second Welfare Theorem (2)
• Prices play two roles in the market system: an
allocative role and adistributive role.
– The allocative role of prices is to indicate relative scarcity;
– the distributive role is to determine how much of
different goods different agents can purchase.
• The Second Welfare Theorem says that these two
roles can be separated: we can redistribute
endowments of goods to determine how much
wealth agents have, and then use prices to indicate
relative scarcity
13
 Public Sector Economics (EC405)

Lecture 2

Terrence Kairiza
Bindura University of Science Education
14
 Outline
• Definition of Market Failure
• Causes of market failure

15
 Market Failure
• Refers to a situation whereby the market
mechanism fails to achieve pareto efficiency
• Economic justification for public finance and
public policy
• Several reasons give rise to market failure
– Imperfect markets (existence of monopolies and
oligopolies)

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 Monopoly
Learning Objectives
• What is monopoly?
• What are the barriers to entry?
• How is the demand curve for a monopoly?
• How does a monopoly decide quantity of
output to produce?
• What are the social costs of monopoly?
• What is price discrimination?

17
 Monopoly
• A pure monopoly is a firm without any competition.
• Pure monopolies do not exist in the real world.
• The fewer the substitutes there are for a firm’s
products, the more monopolistic the firm is.
• A monopolist can earn long term profits if it keeps
other firms from entering its market.
• Entry barriers stop firms from entering a market and
destroying monopoly profits.

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 Monopoly
Barriers To Entry
The Government:
• Licenses: By limiting entry licenses allow
members of protected professions to earn
monopoly profits, e.g. lawyers.
• Outlawing competition: Government can outlaw
competition to a monopolist e.g. ZETDC
• State religion: Government can create religious
monopolies.

19
 Monopoly
Barriers To Entry
Unions:
• Unions are organization of workers.
• Unions engage in collective bargaining with
employers.

Control of a vital resource:

• Firms can maintain a monopoly by controlling
a vital resource, e.g. Mbadasilk in ancient
China, alum in the Ottoman empire.

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 Monopoly
Barriers To Entry
Incompatibility:
• By making its products incompatible with the
complementary goods of its rival, a firm can create
and maintain its monopoly.
– Software: Incompatibility-based barriers to entry are a
prime source of Microsoft’s riches.
– Sports leagues: Incompatibility provides a strong barrier
to entry, protecting all professional sports leagues.

21
 Monopoly
Barriers To Entry
Economies of scale:
• If in an industry average total Costs

costs decrease as output Average Total Costs

increases, then a new firm’s
costs are extremely high
compared to the monopolist’s
costs. The new firm
would be here with
• In industries with significant high average total
costs.
economies of scale, it is difficult
The monopolist is
for a new firm to challenge a here with low
monopoly. average total costs.

• Monopolies based on
economies of scale are called
“natural monopolies,” e.g. utility Output Per Month
companies.

22
 Monopoly
Barriers To Entry
Intellectual property:
• Owning intellectual property gives legal right to
demand payment from all who would use that
property.
• Copyrights: No one but the copyright’s holder can
legally sell the copyright-protected work.
• Patents: A patent gives one exclusive right to sell
the invention. Patents confer a benefit on
innovators proportional to the social benefits of
their innovation.
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 Monopoly
Monopolist Pricing
• A monopolist can set its own price.
• The Law of Demand constraints a monopolist’s
price-setting powers.
• If a monopolist wants to increase sales, it must
lower its price.
• Unlike a firm in perfect competition,
monopolist’s output influences the market
price.

24
 Marginal Revenue
and Monopolist Pricing
Marginal Revenue
= The increase in total revenue a firm receives
by selling one more good.
For a competitive firm:
• Marginal Revenue = Price
For a monopolist:
• Marginal Revenue ≠Price
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 Monopolist’s Profit Maximization
• If Marginal Revenue >
Marginal Cost, Profits Price
This intersection between

will increase by marginal revenue and marginal

cost determines the monopolist’s

producing more. optimal price and quantity.

The price
• If Marginal Revenue < the
monopolist
Marginal Cost

Marginal Cost, Profits will choose.

will increase by
$14

producing less. $8
• Profits are maximum
when Marginal Marginal
Demand

Revenue = Marginal Revenue

Cost. 100
The output the
Quantity

monopolist will choose.

26
 The Social Cost of Monopolies
• Monopolists do not produce at the lowest possible average
total cost.
• Monopolies usually produce output below the level that
maximizes the wealth of society.
$
Marginal Cost

Average Total Cost

The monopolist
sets output where
marginal cost
intersects Demand
marginal revenue.

The monopolist’s
average total cost.

Marginal Revenue

27
 Deadweight Loss of Monopoly
If the monopolist produces 150 units.
• A monopolist will produce The monopolist will not produce this
much output.
until Marginal cost = Price

marginal revenue.
Marginal
• The wealth maximizing level Cost

of output is where Marginal CS

cost = demand. $14

• Adam Smith’s invisible hand $12 D

breaks down. PS

Demand

Quantity
100

150
Marginal
Revenue

28
 Ways to Reduce Deadweight Loss
• Competition
• Price discrimination
• Antitrust laws

29
 Competition and
Deadweight Loss of Monopoly
• Competition lowers prices and expands output,
thereby reducing deadweight loss.
For example:
– Zimpost and fax, email, FedEx.
– Microsoft and Linux.
– ZBC and satellite television.
• Even the mere threat of potential competition can
induce a monopolist to expand output and reduce
deadweight loss.

30
 Price Discrimination
• Price discrimination occurs when a firm charges
separate customers different prices.
• With price discrimination, a firm can charge its old
customers high prices, but still attract new customers
by selling to them at lower prices.
• For economists, price discrimination is beneficial
because it increases the wealth of society.

31
 Price Discrimination
Perfect price discrimination:
• The monopolist charges every customer the maximum they
are willing to pay.
• The total consumer surplus becomes zero.
• The deadweight loss of monopoly is completely eliminated.

Imperfect price discrimination:

• Monopolists separate customers into groups and then charge
separate groups different price.
• The deadweight loss of monopoly is reduced but not
completely eliminated, e.g. student discounts, financial aid,
airline tickets.

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 Price Discrimination
To profitably price discriminate for and against different
groups, a monopolist must overcome three challenges:
• It must determine the value each group places on the
monopolist’s product.
• It must figure out how to sell to separate groups at different
prices.
• It must prevent customers who paid a low price from
reselling the good to those customers who paid a high
price.

Self selection of customers:

• Firms induce different groups of consumers to take different
visible actions. By inducing customers to voluntarily self-
select into separate groups, firms can price discriminate e.g.
coupons, airline tickets.
33
 Antitrust Laws
• Antitrust laws regulate, restrict and punish
monopolies.
• Antitrust laws rely on the government, not the
market, to reduce the harm on monopolies.

34
 Innovation and Monopoly
• Because it does not have to share its benefits,
a monopolist gets great monetary rewards
from innovation. Hence, monopolies
encourage innovations.
• However, strong entry barriers protect a
monopoly even without innovation. A
monopolist’s employees may not have
incentives to work hard to innovate.

35
 Do You Know?
• How can economies of scale create barriers to entry?
Economies of scale means average total costs decrease as
output increases. Since its costs are extremely high compared
to the monopolist’s costs, it is difficult for a new firm to
challenge a monopoly.

• Why must a monopolist who can’t price discriminate give a

discount to old customers if it wants to sell to new customers?
The Law of Demand constraints a monopolist’s price-setting
powers. As consumers buy more only at lower price
monopolist must lower its price to increase sales.

36
 Do You Know?
• How can price discrimination reduce the deadweight loss of a
monopolist?
A monopolist creates deadweight loss by producing less
output. Price discrimination allows a monopolist to charge
different prices to different consumers to produce and sell
more output.

• Why are coupons a form of price discrimination?

Coupons induce consumers to self-select into two groups:
price-sensitive and price-insensitive. Coupons allow price-
sensitive consumers to trade time for money.

37
 Summary
• A pure monopoly is a firm without any competition.
• The fewer the substitutes there are for a firm’s products, the
more monopolistic the firm is.
• Entry barriers stop firms from entering a market and
destroying monopoly profits such as government regulations,
unions, control of vital resource, incompatibility, economies
of scale and intellectual property.
• If a monopolist wants to increase sales, it must lower its
price.
• Monopolist’s profits are maximum when marginal revenue =
marginal cost.

38
 Summary
• Monopolies usually produce output below the level
that maximizes the wealth of society and creates
deadweight loss.
• Competition, price discrimination and antitrust laws
can reduce the social cost of monopolies.
• Price discrimination occurs when a firm charges
separate customers different prices.
• Price discrimination is beneficial because it increases
the wealth of society.

39
 Oligopolies
Learning Objectives
• What is oligopoly?
• What is the Prisoners’ Dilemma?
• How do oligopolistic firms find themselves in the
pricing Prisoners’ Dilemma?
• How do oligopolists escape the pricing Prisoners’
Dilemma?
• How do colluding oligopolists harm a society?
• Why do oligopolists have incentives to innovate?
• How do antitrust laws affect the society?

40
 Oligopoly
• Oligopolistic markets are in between a monopoly (where there is just
one firm) and perfect competition (where there are a large number of
firms).
– E.g. ????

41
 In The Quest Of An Oligopoly
• Antitrust laws prevent firms colluding on price as well as
monopolies from forming.
• An implicit agreement to raise prices: sending a clear but legal
signal through consecutive change of price.
• The challenge of maintaining high prices: each firm has an
incentive to cheat by undercutting the implicit agreement.
• The challenge of international competition.
• The attempts of product differentiation and complicated
pricing.
• Incompatibility and lock-in.

42
 Oligopoly
• Economists are not sure when oligopolistic
firms will compete and when they will
cooperate.
• There is no reliable theory that tells when
oligopolists will succeed cooperation.
• Prisoners’ Dilemma refers to forces that
thwart oligopolists’ efforts at cooperation.

43
 Prisoners’ Dilemma
• Two criminals are arrested.
• The only way to know they’re serious is to
establish at least one of them has confessed.
• By separating them, the police create
incentives for the prisoners to turn on each
other.

44
 Prisoners’ Dilemma
• Adam and Ben both Ben
simultaneously decide Confess Stay Silent
whether to confess or
stay silent. The two
prisoners end up in the
Adam gets life Adam goes free.
box corresponding to in prison.
their choices. Ben gets life in Ben is executed.
Confess
• In the Prisoners’ prison.
Dilemma game, each Adam and Ben will end
person is individually Adam up here.

better off confessing.

So if both Ben and Adam gets one
Adam is executed.
Adam are rational and year in prison.
Stay Silent
self-interested, they Ben goes free.
will both confess and Ben gets one year
spend their lives in in prison.
prison.
45
 Athlete's Steroid Dilemma
If winning is more important than
avoiding health problems then
both athletes will individually
always be better off using Athlete Two
steroids. Yet the athletes are in
a Prisoners’ Dilemma game Don’t Use Steroids
because they are both better off
Use Steroids
if neither uses steroids than if
both use steroids.
Both athletes have an
Athlete One wins.
equal chance of winning.
Use Steroids Athlete One suffers health
Both athletes suffer problems.
health problems.

Athlete One

Athlete Two wins. Both athletes have an

equal chance of winning.
Don’t Use Steroids Athlete Two suffers health
problems.

46
 The Pricing Prisoners’ Dilemma
• Oligopolists are often in a
Prisoners' Dilemma with
respect to pricing. Firm Two

• Each firm’s pricing actions Set a Low Price Set a High Price

affect the other firm. Firm One earns

zero profit.
Firm One earns
an extremely

• If the two firms play the Set a Low Price

Firm Two earns
high profit.

Firm Two earns a

game just once, they each zero profit. negative profit.

Firm One
have an incentive to Firm One earns a Firm One earns a

charge low prices.

negative profit. high profit.

Set a High Price Firm Two earns

an extremely Firm Two earns a
high profit. high profit.

47
 Escaping the Prisoners’ Dilemma Through
Collusion
• If a Prisoners’ Dilemma is played repeatedly, the
participants can sometimes successfully collude.
Cartels:
• These are organizations of producers who explicitly
collude to charge high prices.
• Organization of Petroleum Exporting Countries
(OPEC)
• Criminal cartels

48
 Antitrust Laws and Collusion
• Explicit agreements to charge high prices is a
violation of antitrust laws.
• A major purpose of antitrust laws is to keep firms in a
pricing Prisoners’ Dilemma.
• Firms often have difficulty using implicit collusion to
escape a pricing Prisoners’ Dilemma.
• Mistrust and greed can easily destroy implicit
agreements to maintain high prices.

49
 Using “Pro-Consumer” Policies to Promote
Collusion
“Most favored customer” promise:
• Under this promise, the seller legally promises that
the price the customer is paying is not higher than
the price for any other customer.

Price matching:
• The seller promises to match all its rival’s prices.
• “Most favored customer” and price matching can
prevent firms from lowering prices.

50
 The Social Harm of Collusion
• By the Law of Demand, when oligopolists
maintain high prices, they reduce sales.
• When oligopolists collude, they raise prices
above marginal costs.
• As a result, some consumers go without
buying the good even when they value it
higher than marginal costs.
• Colluding oligopolists reduce wealth of
society.

51
 Escaping the Prisoners’ Dilemma
Product differentiation:
• Firms resort to product differentiation when they cannot
escape a pricing Prisoners’ Dilemma through collusion.
• When consumers base their choice on more than just price,
oligopolists do not have the pressure to sell for the lowest
price.
• Oligopolists sometimes use style rather than quality to
differentiate their products.

Advertising and brand names:

• Firms also have to inform consumers about the differences
between their product and rivals’ products.

52
 Escaping the Prisoners’ Dilemma
Using confusing prices:
• Complication reduces the damage of price
competition.
• With complicated pricing, customers cannot easily
discern which firm is charging less.
• Complicated pricing reduces the incentive for firms
to cut prices as well as the harm to one firm of its
rival’s price cut, e.g. long distance phone services,
frequent-flyer programs of airlines.

53
 Oligopolies and Innovation
• Oligopolies have greater incentives to
innovate than any other type of firm.
• Firms in oligopoly face direct competition and
so must innovate to survive.
• Oligopolies primarily engage in disruptive
innovations.

54
 Disruptive Innovation in Oligopolies
• Disruptive innovation reduces the value of existing
products or services.
• Firms are willing to develop innovations that harm
rival firms but not themselves.
• Though disruptive innovation can reduce the value of
individual firms, it usually increases the wealth of
society by giving it better products.
• Example firms are Expedia

55
 Prisoners’ Dilemma
and Disruptive Innovation
• Oligopolists sometimes collude to avoid
disruptive innovation.
• Oligopoly firms benefit from colluding to
reduce innovation expenditure.
• However, colluding to suppress innovation is
far more dangerous than colluding to set high
prices.

56
 Antitrust Laws
• Antitrust laws prohibit firms from colluding or
attempting to acquire monopolies.
• They can reduce the deadweight loss caused
by monopolies and oligopolies.
• However, antitrust laws are enacted and
interpreted by imperfect government agent
and hence can destroy society’s wealth.

57
 Antitrust Laws and Predatory Pricing
• Antitrust laws prevent predatory pricing.
• Predatory pricing litigation always seeks to punish firms when
they charge low prices.
• According to predatory pricing theory, firms initially charge
low prices to drive other firms out of their market. Then,
when the predatory firm becomes a monopolist it raises
prices, thereby damaging consumers.
• However, economists have never found any successful
examples of predatory pricing.
• Some firms can be expected to return to the market when the
predatory firm starts charging high prices.

58
 Do You Know?
• How do both criminals confess in the Prisoners’
Dilemma?
Each person is individually better off confessing
regardless of what the person does. So, each criminal
confesses for his own good.

• How can oligopolistic collusion destroy wealth?

When oligopolists collude, they maintain prices
higher than marginal costs and reduce sales. Since
some consumers go without buying the good, it
destroys society’s wealth.

59
 Do You Know?
• Why do oligopolistic firms often try to differentiate their
products?
When consumers base their choice on more than just price,
oligopolists do not have the pressure to sell for the lowest
price. Hence, oligopolists try to convince consumers that their
product is different from their rivals.

• Why do oligopolies have tremendous incentives to innovate?

Oligopolistic firms face direct competition, so they must
innovate to survive. They have greater incentive to innovate
to differentiate their products from their rivals.

60
 Summary
• Oligopolistic markets are in between a monopoly and perfect
competition.
• Through cooperation and collusion, oligopolists maintain high
prices and increase profits.
• Oligopolists are often in a Prisoners' Dilemma with respect to
pricing. where each firm’s pricing actions affect the other
firms.
• Generally, those stuck in Prisoners’ Dilemma take an action
that is either selfish or altruistic.
• Though each player is individually better off being selfish, all
players are better off if everyone is altruistic.

61
 Summary
• Firms can cooperate and escape the pricing
Prisoners' Dilemma by “most favored customer” and
price matching.
• Product differentiation, advertising and brand
names, and complicated pricing are the other ways
to escape the pricing Prisoners' Dilemma.
• Colluding oligopolists reduce wealth of society.
• Oligopolies have greater incentives to innovate and
primarily engage in disruptive innovations.
• Antitrust laws prohibit firms from colluding or
attempting to acquire monopolies.
62
 Challenge To Market Effectiveness 3:
Externalities And The Environment

63
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All
 Learning Objectives
• What are negative and positive externalities?
• What is the pollution problem?
• What are the methods of reducing the pollution
problem?
• What is the challenge of global warming?
• What are the methods of reducing traffic jams?
• What role does politics play in externalities?
• What are the environmental problems caused by the
government?
• What are technological spillovers?

64
 The Pollution Problem
• Without government assistance, Adam Smith’s
invisible hand does little to reduce pollution.
• As pollution is created by imperfect markets
and regulated by imperfect governments,
there is no ultimate pollution solution.

65
 Externalities
Negative Externalities:
• A negative externality is a cost paid by people other than the
buyer or seller of a good.
• Self-interested buyers and sellers don’t take into account
negative externalities in their decision-making, e.g. pollution
and smoking.

Positive Externalities:
• Positive externalities are benefits received by people other
than the buyer and seller of a good.
• Self-interested individuals will buy less than the socially
optimal number of positive externality goods, e.g. vaccine and
perfumes.

66
Externalities and Anti-Theft Devices
• The Club is a metal “club” that locks through a steering
wheel, preventing a thief from turning the wheel.
• One car owner’s use of The Club therefore decreases
the chance of his car getting stolen, but increases the
chance of another car being pilfered: Negative
externality.

• LoJack is a tiny electronic locator. When a car with

LoJack is stolen, the locator is activated, signaling the
car’s location to the police.
• Widespread use of LoJack makes it less likely that
thieves will steal any car since they don’t know which
car has LoJack: Positive externality.

67
Methods of Reducing the Harm of Pollution

Forbidding all pollution:

• Many valuable economic activities create
pollution. If the government banned all
types of pollution, it would drastically
reduce economic production.

68
Methods of Reducing the Harm of Pollution
Command and control approach:
• The government tells each firm how much it can pollute and
what kind of pollution-reducing technologies it must employ.

This approach suffers from two problems:

1. Information Deficiencies
• Markets excel at gathering and organizing information
whereas government bureaucrats tend to be informationally
challenged.
2. Governmental Corruption
• Self-interested politicians are most often motivated to
protect their supporters rather than enacting socially optimal
pollution regulation.

69
 Methods of Reducing
the Harm of Pollution
Pigouvian taxes:
• According to Arthur Pigou, governments should tax goods that create
negative externalities.
• Such “Pigouvian taxes” reduce individual’s incentives to use such goods.

The advantages of Pigouvian taxes over command and control

approach:
• Taxation allows firms to pick their own level of pollution.
• Firms have an incentive to reduce their pollution since less pollution
means lower taxes.
• Taxation gives firms flexibility in deciding how to reduce pollution.
Pollution taxes create incentives for firms to use the most cost efficient
pollution-reducing methods.
• Taxation creates incentives for pollution technological innovation.

70
 Supply, Demand, and Pigouvian Taxes
• Externalities, by definition,
don’t affect consumers or Pollution externality =$3
producers directly. $

• Externalities don’t have any Pigouvian tax =$3

direct effect on supply and Supply
demand curves. with tax
$13
• However, externalities
create deadweight loss. $10
Supply

• The Pigouvian tax reduces

amount of pollution. Demand

491 870 Quantity

71
 Externality and Pigouvian Taxes
• Pigouvian taxes force people and firms to internalize any
externalities they cause.
• Internalizing Externalities means forcing someone to fully take
into account the harm his externalities cause when deciding
how much of the product to use.
• By forcing the creators of externalities to pay a tax equal to
the harm caused to others by their activity, Pigouvian taxes
cause consumers and firms to engage in externality-causing
activities only when the benefit of the activity exceeds the
total social cost of the activity.
• However, the government can’t set limits on the total amount
of pollution with Pigouvian taxation. Pigouvian taxation works
best when the harm of pollution is always proportional to the
amount of pollution.

72
Methods of Reducing the Harm of Pollution
Tradable permits:
• Under this system, firms are given permits to pollute only
up to the amount covered by the permits.
• A firm can use its permit, buy permits from other firms or
sell its permits to other firms.

The advantages of tradable permits are identical to those of

Pigouvian taxes.
• They give tremendous flexibility to firms in deciding how to
combat pollution.
• They ensure that only firms that place a relatively high value
on pollution end up polluting.
• They create a market for pollution-reduction innovations.

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 Tradable Permits vs. Pigouvian Taxation
• Only tradable permits allow the government to set the total
amount of pollution that will be generated.
• If the government can determine the optimal level of
pollution, then tradable permits are socially superior to
Pigouvian taxes.
• If the government doesn’t know the optimal level of pollution,
then the government should use Pigouvian taxes to allow the
market to set the optimal level of pollution.
• A tradable permit system allows environmentalists to buy and
then not use pollution permits.

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 Methods of Reducing
the Harm of Pollution
The Coase Theorem:
• The government should do nothing and allow the Coase
Theorem to work.
• According to the Coase Theorem, if parties can negotiate
without any barriers, they will always be able to eliminate
wealth-destroying negative externalities.
• However, there are often many barriers to negotiation.
• The Coase Theorem indicates that only when a small group
of people are harmed by an externality they can remedy
the situation through negotiations.

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 Technological Spillovers
• Innovation is the primary cause of economic growth.
• On an average, around 80% of the gain from innovations goes
to people other than the innovators.
• Most of the wealth that people in rich countries have is due to
these technological spillovers.
• Even when firms succeed in profiting greatly from their
innovations, they still create enormous spillovers.
• Because innovation creates such enormous positive
externalities, firms engage in less than the socially optimal
level of innovation.

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 Do You Know?
• Why are products with negative externalities overused?
A negative externality is a cost paid by people other than the
buyer or seller of a good. Self-interested buyers and sellers
don’t take into account negative externalities in their
decision-making and hence overuse the those products.

• What are Pigouvian taxes?

Pigouvian taxes are taxes on creating negative externalities.
These taxes such as pollution taxes force people and firms to
internalize any externalities they cause.

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 Do You Know?
• What are tradable pollution permits?
Tradable pollution permits are permits that allow firms to
pollute only up to the amount covered by the permits. A firm
can use its permit, buy permits from other firms or sell its
permits to other firms. They give tremendous flexibility to
firms in deciding how to combat pollution.

• What are technological spillovers?

Technological spillovers are the gains from innovations that go
to people other than the innovators. Technological spillovers
create positive externalities.

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Challenge To Market Effectiveness 4:
Inadequate Property Rights

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 Learning Objectives
• What are property rights?
• How do property rights create wealth?
• What is the tragedy of the commons?
• What are different categories of goods?
• What is a public good?
• Why does the market fail to produce public goods?
• What is intellectual property?
• How do real estate property rights help people?

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 Property Rights
• To have property rights in a good means one
can use the good oneself, sell it to others or
prevent others from using the good.
• A prime reason for widespread devastating
poverty is the lack of adequate property
rights.
• When property rights aren’t secure, markets
have difficulty creating wealth.

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 Pain Before Pleasure
• Businesspeople must invest their time and resources
before earning a profit.
• Without property rights, the initial pain of
investment often leads to disappointment rather
than to pleasurable profits.
• People without property rights often have no
incentive to suffer the initial pain that investment
requires.
• For example, because it lacked secure property
rights, few people invest in communist countries
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 Securing Property Rights
• Creating secure property rights is difficult.
• For property rights to be secure, they must be
respected at many levels of society.
• The central as well as local governments must refrain
from arbitrary confiscation.
• In addition, secure property rights require honest
courts that can adjudicate disputes among
businesspeople and honest police who prevent
criminal gangs from seizing property.
• Secure property rights also require families to
respect the individually owned property of their
members.
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 Property Rights
• For property rights to create wealth, they must belong to
individuals, not groups.
• The wealth-creating superiority of individual over collective
property rights was well shown by Soviet agriculture.
• Peasants had to farm the communal land without the right to
keep what was grown on it. Consequently, peasants often did
a shoddy job of farming the collectively owned land.
• The small, privately owned plots, which accounted for only 1%
of the farm land in the Soviet Union, produced one-third of all
the food grown in the country.

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 Tragedy of the Commons
• A resource is rival if one person’s use of it reduces the amount
left for other people to consume.
• A resource is excludable if people can be prevented, or
excluded, from using it.
• A non-excludable resource will continue to be used as long as
some people benefit from it. But, if the resource is rival, then
each person’s use harms other people.
• So, resources that are rival but non-excludable will (tragically)
tend to be used until they are depleted or destroyed.
• A tragedy of the commons arises when a resource is rival but
non-excludable.

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Tragedy of the Commons
The Buffalo Tragedy:
• In 19th century, any American had the right
to kill buffalo.
• Consequently, American buffaloes were
almost hunted to extinction.

Lake Commons:
• Fish are a rival resource. If anyone has the
right to fish in the lake, people will continue
to fish this lake until no fish survive to spawn
new fish.

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 Tragedy of the Commons
• When a common resource is owned by no one, each user can
benefit from using the resource.
• But, because the resource is rival, each person’s use of the
resource creates negative externalities on everyone else.
• People tend to overuse goods that have negative externalities.
• The tragedy of the commons problem arises because absent
some corrective measure, common resources are frequently
used until depletion.
• Property rights make a resource excludable and solve the
tragedy of the commons problem.

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 Public Good
• A public good is any product or service that is non-
rival and non-excludable.
• Because it’s non-rival, one person’s use of a public
good doesn’t harm other people.
• Because it’s non-excludable, anyone can benefit from
a public good regardless of whether they have
contributed to creating it.
• Consequently, people have an incentive to free-ride
off of others’ expenditures on public goods.

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 Public Good
• Because public goods are non-excludable, their
creators can’t acquire property rights in them.
• The free market does not induce self-interested
people to engage in producing public goods because
they would receive only a tiny fraction of the benefits
of their efforts.
• Adam Smith’s invisible hand of the marketplace does
not push people to take socially beneficial actions.
• Through compulsory taxes, the government can
prevent people from free riding off others and
provide public goods.

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 Charlie and the Chocolate Factory
• Using the information gathered by their spies,
other chocolate firms started selling the exact
same products that Willy Wonka produces.
• Because of the widespread theft of his chocolate
innovations, Willy Wonka has to shut down his
factory.
• Insufficient property rights cause Wonka to stop
making candy since he cannot recover his
innovation costs.

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 Intellectual Property
• Intellectual property is information rather than physical
goods, e.g. the formula for making Everlasting Gobstoppers,
the code behind a software program, the composition of
notes making up a song.
• To have secure property rights in intellectual property means
that no one can use the proprietary information without the
innovator’s permission.
• Intellectual property can sometimes be defended without
governmental help. French chefs protect their intellectual
property by ostracizing those who steal.

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 Internet Piracy
• Internet piracy has eroded intellectual property
rights in music and movies.
• The Internet has made music and movies far less
excludable.
• Such theft of property poses a significant threat to
the for-profit production of movies and music.
• Although Internet piracy is illegal in most countries,
the laws are not seriously enforced.

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Solutions to the Internet Piracy
Problem
• Increase the Moral Cost of Theft: Use of advertising to convince people
that theft of intellectual property is wrong.
• Action Figures/Concerts: Creators of intellectual property could still profit
even if everyone freely took their property by selling products based on
their intellectual property .
• Advertising: Movies, music, and books could incorporate commercials into
their plots.
• Tips: Intellectual property creators could ask for tips from consumers.
• Self-Enforcement: Intellectual property holders could use virtual weapons
to protect their stuff.
• Not-For-Profit Production: Even with rampant intellectual property theft,
amateurs will still produce movies, music, and books for pleasure and
fame.

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Real Estate Property Rights
• The ownership of every home, building, and piece of land in
most rich countries is diligently recorded by the government.
• Banks readily make collateral-backed loans because of such
careful records.
• Collateralized property loans allow many people in rich
countries to buy homes or start small businesses.
• Unfortunately, most of the real estate owned by poor people
in poor nations is not publicly recorded. They are
consequently denied the benefits of collateral-backed loans
that benefit citizens of rich nations.

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 Property in Poor Countries
• Most of the property possessed by poor people in poor
countries is only informally owned.
• Because no one officially owns the land, the property legally
belongs to the government.
• According to Hernando De Soto, informally owned property is
“dead capital.” Dead capital refers to assets that can’t be used
to create new wealth.
• Banks are extremely reluctant to give loans to people with
dead capital as collateral.
• Similarly, lack of individual property rights, which creates
dead capital, is a prime reason for Native American poverty.

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 The Story of Srey Neth
• Srey Neth was a Cambodian teenage prostitute/sex-slave. New York Times
columnist, Nicholas Kristof, purchased her freedom for $150.
• With Kristof’s help, Srey Neth started a small shop but it failed because
she lacked property rights. She could not stop her family from taking the
goods from her shop.
• Using money donated by some New York Times readers, Srey Neth
attended school to become a beautician.
• Srey Neth’s family likely possessed only dead capital that couldn’t be used
as collateral for a loan. So without charitable assistance, Srey Neth would
not have been able to pay for her education.
• Many people in poor countries have the skills to run small businesses, but
their lack of property rights and dead capital often makes this impossible.

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 Where Property Rights Are Not Needed
• The free software movement purposefully rejects property
rights to deliberately create public goods, e.g. the computer
operating system Linux and the online encyclopedia
Wikipedia.
• Both of these free software products are built by volunteers
and are freely and legally accessible to everyone.
• Since Wikipedia and Linux deliberately forsake property
rights, their tremendous success poses a challenge to the
worldview of those who believe in the importance of property
rights for wealth creation.

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 Do You Know?
 Why does collective ownership discourage wealth creation?
Collective ownership of resources does not provide individual
property rights. People without property rights often have no
incentive to suffer the initial pain that investment requires
and hence to create wealth.

 What is the “tragedy of the commons”?

The tragedy of the commons is a problem that arises when
common resources are frequently used until depletion.

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 Do You Know?
 Why doesn’t Adam Smith’s invisible hand cause self-
interested people to provide public goods?
A public good is any product or service that is non-rival and
non-excludable. Adam Smith’s invisible hand fails to push self-
interested people to engage in producing public goods
because they would receive only a tiny fraction of the benefits
of their efforts.

 What is the problem with dead capital?

Dead capital refers to property that is informally owned
without any official records. These assets can not be used to
create new wealth as banks are extremely reluctant to give
loans to people with dead capital as collateral.

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 Summary
• To have property rights in a good means one can use the good oneself,
sell it to others or prevent others from using the good.
• Without secure property rights people have no incentives to invest and
create wealth.
• The tragedy of the commons problem arises because rival but non-
excludable resources are frequently used until depletion.
• A resource is rival if one person’s use of it reduces the amount left for
other people to consume.
• A resource is excludable if people can be prevented, or excluded, from
using it.
• A public good is any product or service that is non-rival and non-
excludable.
• Market fails to produce public goods because people have an incentive to
free-ride off of others’ expenditures on public goods.

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 Summary
• To have secure property rights in intellectual property means
that no one can use the proprietary information without the
innovator’s permission.
• Theft of intellectual property poses a significant threat to the
for-profit production of movies and music.
• Because of lack of real estate property rights, many people in
poor nations are denied the benefits of collateral-backed
loans that so benefit citizens of rich nations.
• The free software movement that purposefully rejects
property rights to deliberately create public goods has been
tremendously successful.

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 Coming Up

What is incomplete information?

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 Chapter 15

Challenge To Market Effectiveness 5:

Incomplete Information

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McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All
 Learning Objectives
• How does incomplete information affect customers?
• How can brand names, money-back guarantee and eBay
ratings reduce the effects of incomplete information?
• What is adverse selection?
• How does adverse selection manifest itself in the used car
market?
• What is agency cost?
• How do consumers face agency costs?
• How does incomplete information about potential employees
affect firms?
• How does incomplete information affect health insurance
firms?

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 Incomplete Information
• If customers have incomplete information about
products’ qualities, customers don’t always get what
they want.
• Businesses sometimes use uncertainty to cheat
customers.
• Product uncertainty harms firms as well as
consumers.
• Consumers pay less for a product the less sure they
are of the product’s safety and reliability.

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 Brand Names

• Firms that can earn consumers’ trust increase the demand for
their products.
• Brand name greatly reduces the uncertainty facing
consumers.
• A well-known brand name is an asset only if customers have
positive experiences with the products.
• A brand name makes it easy for customers to associate their
negative experiences with the company.
• Not-for-profit groups sometimes use brand names to promote
their causes.

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 Value of Brands
• The value of a brand is Company Value of Brand
how much extra profit Coco-Cola $67.5 billion
over the long term a Microsoft $59.9 billion
company receives IBM $53.4 billion
because of the brand. GE $47.0 billion
Intel $35.6 billion
Nokia $26.5 billion
Disney $26.4 billion
McDonald’s $26.0 billion

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 Money-Back Guarantees
• Firms use money-back guarantees as a means
of winning customers’ trust.
• Money-back guarantees allow consumers to
recover most of the cost of buying a product if
the product proves defective.

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 eBay Ratings
• eBay is an online auction website that allows anyone to buy
and sell goods.
• Both the buyer and seller have the ability to harm each other.
• eBay has succeeded only because it has created a buyer and
seller rating system under which buyers and sellers mostly
trust each other.
• eBay’s rating system not only provides buyers and sellers with
information about each other, but also gives eBay users an
incentive to behave honestly.
• eBay represents a triumph of markets over uncertainty.

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 Hidden Information
• Firms sometimes attempt to deliberately increase
consumer uncertainty by hiding information.
• “Sound of silence” has strong applications to
consumer product markets.
• Silence signals that the situation is very bad because
if it wasn’t, the firm would have an incentive to say
something.
• Consumers may not benefit from mandatory
disclosure laws.

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 Adverse Selection
• Distrust created by uncertainty is sometimes
magnified by adverse selection.
• Adverse Selection occurs when one attracts
those with whom one least wants to interact.

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 Used Cars and Adverse Selection
• When buying a used car, Car’s quality Car’s value
buyers most want to attract to buyer
sellers of high quality cars. High $10,000
• Sellers would most want to
part with vehicles of low Low $3,000
quality.
• Current owners know their • The price of used cars will
car’s quality, but be far below $10,000
prospective buyers don’t. because of adverse
selections.
• This low price for used
cars means that owners
As adverse selection of excellent cars will be
lowers the price of used even less willing to sell
cars, fewer used cars of them.
high quality are sold.
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 Countering Adverse Selection
in Used Car Markets
• The cure for adverse selection is additional
information.
• An independent mechanic can verify the car’s quality.
• A warranty by the seller can reduce hidden
information.
• An association with brand names can reduce adverse
selection, e.g. “certified pre-owned BMW.”

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 Incomplete Information
About Employee Activities
• When employees make decisions for their employers, they act
as agents.
• These agents have an interest in maximizing their own
welfare, not the welfare of their employer.
• Agency Costs = The harm suffered by employers when
employees makes decisions that help themselves but harm
their employers.
• Agency costs arise because firms have incomplete information
about their employees’ activities, e.g. bribes and gifts to
managers, frequent flyer miles for business travelers.

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 Agency Costs and Consumers
Agency costs also affect consumers:
• Stockbrokers have an incentive to recommend that
their customers engage in an excess amount of stock
trading.
• Real estate agents serve their own self-interests by
pushing their clients to make quick purchasing
decisions.
• Doctors can serve their own self-interests while
determining prescription drugs for their patients.

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 Incomplete Information
About Potential Employees
• Firms don’t have complete information about potential
employees and hence must guess based upon signals.
• Resume omission can damage job applicants.
• On average, job candidates who would be the happiest with
the salary offered are the candidates of the lowest quality
since the marketplace values them the least.
• Incomplete information can result in firms engaging in
statistical discrimination in hiring decisions.
• Statistical discrimination occurs when someone is
discriminated against for being in a group whose members
have some undesirable quality.

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 Incomplete Information
About Politicians
• Adverse selection contaminates most revolutions
because the only types of people capable of
acquiring power in revolutionary environments are
those skilled at murder and betrayal.
• The unique success of the American Revolution is
due to its escaping adverse selection.
• Voters always have incomplete information about
presidential candidates.

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 Incomplete Information
About Insurance Customers
• Adverse selection creates potential problems for health insurance
companies.
• The people who most want to buy health insurance are the people whom
the health insurance companies least want to insure.
• Health insurance companies escape adverse selection by not providing
coverage for preexisting conditions.
• Unchecked adverse selection will drive healthy customers out of the
market, resulting in only sickly people buying insurance.
• Governments sometimes prevent insurance companies from fighting
adverse selection.
• Genetic testing would create tremendous adverse selection problems for
the health insurance industry.

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 Incomplete Information
About Romantic Dates
• You want to date someone with high qualities.
Unfortunately, the higher someone’s qualities, the
better they will do in the dating market and the less
interest they will have in you.
• Uncertainty makes dating markets difficult to
navigate.
• Dating market participants are willing to pay money
to reduce uncertainty resulting in many Internet
dating services.
• Silence can also send signals in online dating.

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 Do You Know?
• How do brand names reduce uncertainty?
By building reputation for quality and consistency, brand
names reduce uncertainty for customers.

• Why is it difficult for firms to hide information if they are

forbidden to lie but have the option of not releasing
information?
Even silence speaks for itself. Silence signals that the situation
is very bad because if it wasn’t, the firm would have an
incentive to say something.

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 Do You Know?
• Why would unfettered adverse selection cause almost all used
cars for sale to be of low quality?
Since prospective buyers don’t know the quality of used cars,
they are willing to pay only a low price. As adverse selection
lowers the price of used cars, fewer used cars of high quality
are sold.

• How do agency costs harm firms?

Agency costs arise because firms have incomplete information
about their employees’ activities. Firms’ employees have an
interest in maximizing their own welfare and not the welfare
of their employer.

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 Summary
• Incomplete information about product harms firms as well as
consumers.
• Brand name greatly reduces the uncertainty facing
consumers.
• Firms use money-back guarantees as a means of winning
customers’ trust.
• Through its rating system, eBay represents a triumph of
markets over uncertainty.
• “Sound of silence” has strong applications to consumer
product markets.
• Adverse Selection occurs when one attracts those with whom
one least wants to interact.
• As adverse selection lowers the price of used cars, fewer used
cars of high quality are sold.

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 Summary
• When firms have incomplete information about their
employees, these employees have an interest in maximizing
only their own welfare.
• Consumers also face agency costs in dealing with
stockbrokers, real estate agents and doctors.
• Firms don’t have complete information about potential
employees and hence must guess based upon signals.
• Adverse selection contaminates most political revolutions.
• Adverse selection creates potential problems for health
insurance companies.
• Uncertainty makes dating markets difficult to navigate.
• The cure for adverse selection is additional information.

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 Coming Up

What is inequality?

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