Economics for Educators
Lesson 8 and 5E Model
Revised Edition
Robert F. Hodgin, Ph.D.
Texas Council on Economic Education
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Economics for Educators, Revised
Copyright © 2012
Texas Council on Economic Education
All Rights Reserved
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Lesson 8: Economic Justifications for Government
Market Failure and Government
In theory, with perfect information and clearly defined property rights, a competitive free-market will efficiently allocate private goods.
But what about cases where there is imperfect information (for example, a food buyer has less information about the quality of food
safety than the meatpacker) or property rights are not clearly defined (for example, who owns the right to odor-free air around your
home, you or the local paper mill?). In these cases, there is market failure in terms of not attaining the desired efficient outcome for
all concerned.
The US government has a constitutional right to coerce certain actions, such as the payment of taxes and enforcement of anti-trust
laws, to help correct market inefficiencies. An economically efficient outcome does not necessarily mean that it is socially equitable
or preferred. More, while government can correct for market failure in specific cases, proper and useful policies must be in place.
Even then, no policy is perfect and policy applications often spawn unintended consequences. So if government is to pursue a nonmarket solution, it should weigh the expected benefits of the policy against the expected costs to individuals and society.
Cases where markets fail to efficiently allocate goods
9 Public goods–goods where use by one person does not reduce the good’s availability to society, and some people to
“ride free” at the expense of others, causing such goods to be under-produced by private markets
9 Natural monopoly–a single firm provides services at a lower cost than two or more competing organizations
9 Common resources–natural resources where overuse by one or more individuals reduces the availability to society, and
high transactions costs with ill-defined property rights, hinder efficient allocation for society
9 Externalities—where benefits or costs from the consumption or production of a private good unintentionally affect others
not a party to the private good’s consumption or production
Defining the types of goods produced and consumed in society is a first step. The characteristics used to distinguish them are rivalry
and excludability.
Rival good—one person’s consumption reduces the amount of the good available to others.
Nonrival good—consumption by any person(s) does not reduce the amount of the good available to others.
Excludable good—others can be excluded from consuming the good, usually because it has been consumed already.
Nonexcludable good—preventing others from consuming the good is too expensive.
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Economic Good Types
Good is Nonexcludable
Good is Excludable
Good is Nonrival
Public goods
(national defense, fireworks shows)
Natural Monopoly
(cable television, water and sewer)
Good is Rival
Common resources
(ocean fisheries, irrigation systems)
Private goods
(apples, cars, airline flights, haircuts)
Government Provision of Public Goods
Consider the voluntary provision of national defense. National defense is a public good because individuals cannot be excluded from
consuming it and consumption of national defense by one individual does not reduce the amount available to others. Caring people
may contribute funds to national defense, but persons self-interested in maximizing their wealth have an incentive to “ride free”,
letting others pay for the service while they also receive the benefits. Because of the incentive to ride-free and the inability to exclude
non-payers, national defense would be under-provided if left to the private sector. So government uses tax revenue to fund national
defense for the benefit of society.
Government Regulation of Monopoly
Let’s consider a water company, which has characteristics of natural monopoly whereby the larger it gets the lower the cost of its
output. Also, potential competitors are not eager to build a second network of pipes for a chance to compete, a “barrier to market
entry.” Sufficient water means that its consumption is nonrival. An unregulated profit-maximizing monopolist would restrict quantity to
charge higher prices, resulting in an inefficient level of water provision and economic losses. But if government owned the water
supply, it can behave in a social-enhancing way rather than a profit-maximizing way and sell the water at cost. Or, if the water supply
were privately owned, the government could regulate the price charged.
Government Regulation of Common Resources
The Tragedy of the Commons occurs when individuals, acting in their own self-interest, exhaust a common resource even though it
was in no one’s long-term interest to do so. Consider a public fishery, where the fish population doubles each year until it reaches a
level that the ecology can support. Because users cannot be excluded from fishing, and the fish are a rival good (the fish one person
catches is a fish another person cannot catch), the incentive is to catch as many fish as possible before others do so.
One solution is to privatize the resource. In the case of fisheries, government might restrict the size of the catch or length of time
catching is allowed (through fishing season definitions) to avoid depleting the resource, or it can tax the catch or act of fishing to
reduce the benefits of fishing and the quantity caught.
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Private Goods with External Effects
Private markets trading private goods often do achieve a socially optimal solution, without government intervention. So under what
circumstances should government intervene in markets for private goods?
Externality Types and Market Consequences
Externality Type
Production:
Positive
Production:
Negative
Supply of Good
from Society’s View
Society wants more of
the good than is
produced by sellers
(e.g. R&D)
Society wants less of
the good than is
produced by sellers
(e.g. coal power)
Externality Type
Consumption:
Positive
Consumption:
Negative
Demand for Good from
Society’s View
Society wants more of
the good than is
consumed by buyers
(e.g. vaccinations)
Society wants less of
the good than is
consumed by buyers
(e.g. heroin)
Private goods, when produced or when consumed, may unintentionally impose benefits or costs on a party that is neither the
purchaser nor the producer. In short, externalities affect someone external to the transaction. For example, if Mary buys a pack of
cigarettes from a machine in a restaurant and smokes it, the smoke is a negative externality imposed on other diners. Or, if Robert
pays landscapers to plant a beautiful garden in his front lawn, the garden is a positive externality enjoyed by his neighbors.
A now famous proposition put forth by Ronald Coase at the University of Chicago, says that if property rights are clearly defined, the
transactions costs of bargaining are zero, and the affected parties are willing to bargain, efficient market-based resolutions can be
achieved when the parties negotiate compensation or agreed upon restrictions.
The Coase Theorem—states that if private parties can bargain without cost about how to allocate resources, then they can
resolve the externality problem on their own.
Property rights—limits on the use of private property, goods and services that help define the limits of social behavior.
Transactions costs—the costs of negotiating a transaction with all relevant parties.
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Real limitations hinder Coase’s theorem in practice. An externality’s impact does not always lend itself to negotiation with the
affected parties if the parties are difficult to locate, there are too many to easily bargain with or the property rights are too vague.
Imagine fifty thousand residents of a city bargaining with a local coal plant over acid rain caused by sulfur emissions. If the private
market solution cannot be made to work, government may play a role.
Air pollution, a negative production externality, is such a case. Air pollution has several known detrimental effects on public health.
Identifying and negotiating with companies individually or even in groups can be costly. Government has alternatives such as
1) limiting the pollutant volume, 2) taxing polluter or 3) providing tradable pollution rights. Although the idea of selling “pollution
permits” strikes non-economists as strange, it is an efficient allocation mechanism. Once the air pollution goal, say parts per million
per geographic area, has been set, each company is allowed to “trade” its allotted “rights” to pollute with other companies for a
negotiated price. If one company can achieve better than its mandated target, it can “sell” its remaining pollution limit to another
company that cannot meet its requirement. Through this process, the overall pollution goal is attained and individual firms get to
make economically efficient benefit-cost decisions on how to comply with the pollution regulation.
Notice that no approach above would reduce pollution to zero. Achieving that goal would likely mean closing down the companies
generating the pollution. Society then is denied all benefits from the company’s private production. Economic solutions most often
try to balance benefits against costs at the margin, maximizing total (net) benefits or minimizing total (net) costs.
Constitutional Right to Tax
An economist would argue that any government with such a constitutional privilege can, and in many ways should, act in an
economic manner—first weighing social costs and benefits at the margin. While some taxes are economically justifiable, no tax is
popular. On the other hand, should informed citizens not recognize the personal and collective value of supporting a public good or
using a common resource and willingly submit some value to authorities?
It is easy for people to rationalize that the fruit of their labor stems solely from their own acts and that any related benefits should flow
exclusively to them. As individuals we tend to forget that we drive our cars to work on the “freeway”, or that our national defense
system protects our investments as well as our freedom. If citizens could be somehow induced to reveal the value implicit in the
public goods or common resources they use—parks, libraries, public transportation, education, trash collection, and all the rest—
honestly bargain for the price, then pay it, much less direct government taxing or policy coercion would be necessary. Unfortunately,
research has shown that surveys are unreliable in eliciting people’s values for public goods and services.
There are few simple means to get citizens to accurately reveal their true valuations for public goods and common resources. That
reality, along with a strong tendency for many people to “ride free” on the efforts and opinions of fellow citizens, invites more rather
than fewer government strictures. Among the more vexing issues that economists have undertaken is how to impose tax policies.
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Economists apply the criteria of fairness and efficiency to assess how taxes affect work incentives and the distribution of resources in
the market place. At the onset, two things are clear, taxes alter economic behavior and, ultimately, only individuals pay taxes.
Principles of Taxation
An efficiently designed tax system would let the government determine the necessary level of public goods and services. Then use
the tax system to raise the revenue in the most efficient and equitable manner possible. The two principles for designing a tax system
are the “benefits received principle” and the “ability to pay” principle. The benefits received principle of taxation says that people
should contribute taxes in some proportion to the benefits they receive from using public goods. This justification applies fairly well to
user-fees like gasoline taxes to fund highways or to public education via local property taxation.
But some public good benefits are so broad and diffuse that the benefits received principle is neither an adequate nor an appropriate
rationale. An alternative, the ability to pay principle, says that taxes should be levied based on how well the person can shoulder the
financial burden. Simply, those who earn more pay more taxes. The federal income tax system is based on this concept.
Public goods like national defense and education require tax expenditures but often it is difficult to match their use, or the option to
use them, to specific benefiting individuals or groups. For these public goods, many citizens would simply “ride free” if not for the
ability-to-pay justification to collect the tax.
A person “rides free” when they experience benefits from a public good or common resource due others’ actions, but avoids paying
for those benefits. As one small example of riding free, have you ever enjoyed visiting an historical site but ignored the voluntary
contributions box when exiting? We all ride free on some public value some of the time, but how many fewer tax dollars would have
to be coerced from us if we honestly volunteered contributions in proportion to the value received?
Fairness in Taxation
The ability to pay principle raises the issue of fairness in levying taxes. Economists apply two relative assessment criteria when
speaking of fairness, horizontal equity and vertical equity. Horizontal equity suggests that taxpayers with a similar ability to pay
should pay a similar amount in taxes. Vertical equity suggests that tax payers with greater ability to pay should pay larger relative
amounts of taxes.
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Tax Incidence Based on Annual Income
Annual
Income
$ 25,000
$ 50,000
$ 75,000
$100,000
Regressive
Tax
$1,000 = 4%
$1,000 = 2%
$1,000 = 1.3%
$1,000 = 1%
Proportional
Tax
$1,000 = 4%
$2,000 = 4%
$3,000 = 4%
$4,000 = 4%
Progressive
Tax
$1,000 = 4%
$3,000 = 6%
$6,000 = 8%
$10,000 = 10%
The table above highlights the dilemma of equitably trading-off tax dollars by count of dollars versus tax dollars as a percent of
income. Horizontal equity, while a seemingly good idea, is difficult to apply in practice. What criteria should determine the “similarity”
between individuals or households? Does the act of imposing the criteria not bear upon the personal choice of lifestyle and
expenditure pattern? For example, one simple approach is to apply the same tax rate to families with the same income level. But
that single criterion presupposes that other dimensions such as family size, family member age, and the cost of supporting a chosen
lifestyle are somehow similar.
Vertical equity, too, suffers critical vagaries in the attempt to equitably apply it. While the objective is to tax less those with smaller
incomes and to tax more those with larger incomes, what should the rate be for each income level and how fast should the tax rate
rise as income rises? During Ronald Reagan’s presidency in the 1980s the marginal income tax rate—the rate applied to the last
dollar of taxable earnings—was reduced from a maximum of 70 percent on the highest income levels to 28 percent. Was vertical
equity served? The answer is not immediately obvious.
Tax Incidence and Efficiency
Economists also are concerned about who ultimately pays a given tax—the incidence of the tax—and how much a tax distorts the
allocation of goods in the market place—the efficiency of the tax. Most people, to the extent legally possible, try to avoid paying more
taxes than necessary. Business owners, to the extent allowed by the market, try to pass taxes on to their customers. This avoidance
tendency illustrates the power of taxes to alter—even distort—the allocation of resources in the market place.
Two things are almost certain to occur in the market when a new tax is applied. First, the quantity sold of the taxed good or service
will fall. A second, and not at all obvious, effect is that both the buyer and the seller share in paying the tax. The proportion of the tax
paid by each party in the transaction depends on the market’s competitiveness. The more competitive the market, the more the
seller bears the burden of the tax. The less competitive the market, the more the buyer bears the tax burden.
While it may sound strange to speak about an efficient tax, economists would favor the tax that least distorted the allocation of
goods—that is, was more efficient. To a person of limited means, a proposal to heavily tax luxury goods like yachts and fur coats
might seem appropriate. Yet wealthy individuals can simply avoid such taxes by purchasing different luxury items, and they do. The
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burden of such a tax would then inefficiently fall more on the makers and sellers of yachts and furs, via diminished sales, than on the
targeted wealthy buyers.
The type of tax that least distorts goods allocation in the market—a lump sum tax—is one where each person pays the same single
sum, regardless of income. It causes the least market distortion—is most efficient—because the amount of tax owed does not alter
people’s private market decisions. The problem with the lump sum tax is that it is regressive with respect to income. For example, a
$1,000 lump sum tax paid by someone earning $25,000 a year is a larger percentage (4%) than for someone earning $100,000 (1%)
per year.
Another aspect of tax inefficiency, apart from market allocation distortions, is the cost of tax policy administration. A prime example is
US personal income tax collection, enforcement and preparation where such costs are high and sustain one of the largest
bureaucracies in the federal government, the Internal Revenue Service.
What messages should be drawn from this discussion on taxation? Only people pay taxes. Many taxes are justifiably necessary to
fund expenditures on public goods, preserve common resources and redress externalities for the benefit of society. People often will
ride free, benefiting from a public good or common resource without paying, if they can. Taxes tend to distort both market incentives
and goods allocation because citizens and business owners work to avoid taxes where possible. No tax is both efficient and fair in
the eyes of all people or from all logical vantage points.
In Sum
9 Markets fail, operate inefficiently to some degree, when competitive forces cannot prevail.
o Government should enter the market only after carefully weighing the private and social costs and benefits
o Public goods—goods where use by one person does not reduce the good’s availability to society and no one can be
excluded from their use.
o Natural monopoly—a single firm provides a service at a lower cost than two or more firms.
o Externalities—costs or benefits accruing to other than the transacting parties are not measured when conducting
market transactions. Types and results:
ƒ Production positive—benefits others, goods are under-produced in society’s view
ƒ Production negative—imposes costs on others, goods are over-produced in society’s view
ƒ Consumption positive—benefits others, goods are under consumed in society’s view
ƒ Consumption negative—imposes costs on others, goods are over consumed in society’s view
9 Common resources—natural resources where use by one individual reduces the availability to society
9 Property rights – bounds placed on the use of private property that help define the limits of social behavior.
9 Transactions costs – the costs of negotiating a transaction with all relevant parties.
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9 Coase’s Theorem—states that if private parties can bargain without cost about how to allocate resources, then they can
resolve the externality problem on their own.
9 Tragedy of the commons—free common resource overuse, where all citizens have access but no single user directly pays,
diminishes the use value for all as the tragedy of the commons.
9 Two categories of economic goods
o Public Good—consumption by one person does not diminish the amount available to another person, and others
cannot be excluded from its consumption.
o Private Good—only the consumer enjoys the benefits of consuming the good and the act of consumption reduces the
good’s availability to others.
9 Taxation principles
o Benefits received principle of taxation says that people should contribute taxes in some proportion to the benefits they
receive.
o Ability to pay principle, says that taxes should be levied so that those who earn more pay proportionately more.
9 Tax policy fairness
o Horizontal equity means that taxpayers with a similar ability to pay should pay a similar amount in taxes.
o Vertical equity means that tax payers with greater ability to pay should pay larger amounts of taxes.
9 Free rider —a person who receives benefits from a public good or from others’ decisions regarding a public good, but who
avoids paying for the benefit.
9 Tax incidence – the party who ultimately pays the tax, always a person or group.
9 Tax efficiency – the nature and size of the market distortion from a given tax.
9 Tax burden on income, types:
o Regressive; taxation where there is a greater percentage burden on lower income levels
o Proportional; taxation where there is an equal percentage burden on all income levels
o Progressive; taxation where there is a greater percentage burden as income level rises
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The general response would be that tourists bring money into local business
coffers, and a portion of their taxes will be based on money earned from
tourism.
After all responses are recorded, rank each of the suggestions by their likelihood to
be successful. Seek about a half dozen different ideas to consider further.
After the students have had time to record thoughts, have them call their ideas out
loud and list them on the board.
Realizing that tourism is a plus for the city, think of some ways that you might use
to restrict the littering behavior.
From the view of the local township, what are benefits of tourists visiting the
beach?
Explore
List suggestions: likely ranging from throwing them on the ground to finding
a trash receptacle to taking them hope to discard them. Focus on those who
would simply toss the bottles onto the beach. That is a negative externality in
consumption of a private good: i.e. a cost to others (unsightly trash and the
cost of cleanup by the town).
Refer to pages 42-43 of the lesson. Suppose you and a few friends are going to a
public beach—maintained by the local township--on a lovely day, and have taken
along a case of bottled water you just purchased. Once at the beach all are having
a great time but the sun is hot and much water is being consumed. Noticing that
there are no nearby trashcans, what will you and your friends do with the empty
bottles?
Engage
Lesson 8: Economic Justifications for Government, page 42
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Have the groups discuss and then write their answers with their reasons for
the choice they have made. After the groups have completed their discussion
and written explanations, the entire class discusses.
Now re-rank the most “efficient” solutions: those where the perceived benefit are
greater than the cost of enforcement AND result in a change in the behavior of the
littering parties.
Suggest that economic solutions usually do not completely eliminate an externality,
but reduce the negative aspects by imposing a cost on responsible parties.
Extend
Answers will vary. At the conclusion of the group time, ask for a class
discussion.
Have the group record what they feel the best solution would be and explain why in
writing.
Have the students work in groups of three to review the suggestions and determine
which ideas would remedy the solution and apply the cost of the littering to those
who caused it. Which solutions impact others as well?
Short of an ideal solution, governments often default into “general” solutions that
tax a larger group of citizens and use the revenue to keep the beaches clean.
The core issue is how to conceive of an efficient solution to littering without
imposing costs on others beyond the litterers! And that is not easy. The problem is
one of recognizing who those persons are and imposing an appropriate cost on
their behavior sufficient to have them cease littering.
Explain
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Have several students give their solution and reasons.
Which option achieves the most reduction in the bottle litter for the least cost. In
particular, which solution balances the additional costs with the additional benefits
for SOCIETY though not necessarily the individual? Ask the students to use the
term externality correctly in their explanation.
Have each student write a short paper discussing the top 2 or 3 option(s) from
above that might be the most economically efficient and make a good economic
case for why that is so.
Evaluate
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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the
Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices
Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to
provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better
economic & financial choices in a global economy.
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