Chapter 9:
Government Intervention
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Market Failure
o The market mechanism may fail to provide
the optimal mix of output.
o The optimal mix of output is the most
desirable combination of output attainable
with existing resources, technology, and
social values.
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LO-1
The Nature of Market Failure
o Market failure is an imperfection in the
market mechanism that prevents optimal
outcomes:
o Market mechanism–the use of market prices
and sales to signal desired outputs (or
resource allocations).
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LO-1
The Nature of Market Failure
o Market failure implies that the forces of supply
and demand have
not led to the
best point on
the production
possibilities
curve.
o It also establishes
a basis for
government
intervention.
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LO-1
Sources of Market Failure
o There are four specific sources of microeconomic market failure:
o Public goods
o Externalities
o Market power
o Inequity
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LO-1
Public Goods
o The market mechanism works efficiently
only if the benefits of consuming the good
or service are available only to the
individuals who purchase it.
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LO-2
Joint Consumption
o A public good is a good or service whose
consumption by one person does not
exclude consumption by others.
o Examples include national defense and flood
control dams.
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LO-2
Joint Consumption
o A private good is a good or service
whose consumption by one person
excludes consumption by others.
– Examples include donuts and soda.
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LO-2
The Free-Rider Dilemma
o A free rider is an individual who reaps
direct benefits from someone else’s
purchases (consumption) of a public
good.
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LO-2
Exclusion
o The distinction between public goods and
private goods is based on the nature of
the goods, not who produces them.
o The free rides associated with public
goods upsets the customary practice of
paying for what you get.
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LO-2
Underproduction
o If public goods were marketed like private
goods, everyone would wait for someone
else to pay.
o The market tends to underproduce public
goods and overproduce private goods.
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LO-2
Externalities
o Externalities are costs (or benefits) of a
market activity borne by a third party:
o The difference between the social and private
costs (benefits) of a market activity.
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LO-3
Externalities
o The market will under produce goods that
yield external benefits.
o The market will overproduce goods that
generate external costs.
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LO-3
Consumption Decisions
o In trying to maximize their own
satisfaction, consumers often do not
consider how their consumption affects
the well-being of others.
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LO-3
External Costs
o Market demand expresses only the anticipated private benefits of consumption.
o External costs must be taken into account
to fully account for collective well-being.
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LO-3
Social Demand
o Social demand includes not only private
benefits but also accounts for any
externalities:
Social demand = market demand + externalities
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LO-3
Social Demand versus Market Demand
o If the externality
is a negative,
the activity
reflects external
costs.
o Whenever
external costs
exist, market
demand overstates
social demand.
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LO-3
External Benefits
o An external benefit augments private
demand.
o Whenever external benefits exist, the
social demand exceeds the market
demand.
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LO-3
Production Decisions
o When external costs exist, firms will
produce more of the good than is socially
desirable.
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LO-3
Profit Maximization
o A producer has an incentive to continue
polluting
using
cheaper
technology
as long as
doing so is
more
profitable.
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LO-3
Profit Maximization
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LO-3
External Cost
o People tend to maximize their personal
welfare, balancing private benefits against
private costs.
o When external costs exist, a private firm
will not allocate its resources and operate
its plant in such a way as to maximize
social welfare.
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LO-3
Social versus Private Costs
o Social costs are the full resource costs of
an economic activity, including
externalities.
o Private costs are the costs of an
economic activity directly borne by the
immediate producer or consumer
(excluding externalities).
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LO-3
External Costs
o External costs are equal to the difference
between social and private costs:
External costs = social costs – private costs
o If pollution costs are external, firms will
produce too much of a polluting good.
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LO-3
Market Failure
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LO-3
Policy Options
o The goal is to discourage production and
consumption activities that impose
external costs on society.
o We can do this in one of two ways:
o Alter market incentives.
o Bypass market incentives.
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LO-3
Emission Fees
o Market incentives can be altered via
emission charges:
o An emission charge is a fee imposed on
polluters, based on the quantity of pollution.
o An emission fee increases private
marginal cost and thus encourages lower
output.
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LO-3
Regulation
o Market incentives can be bypassed
through direct regulation.
o Government specifies the required
outcome and the process by which it is to
be achieved.
o The Clean Air Act of 1970 mandated
fewer auto emissions and the processes
to reduce those emissions.
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LO-3
Regulation
o Excessive process regulation may raise
the costs of environmental protection and
discourage cost-saving innovation.
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LO-3
Market Power
o Market power is the ability to alter the
market price of a good or service.
o The response to price signals, rather than
the signals themselves, may be flawed.
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LO-4
Restricted Supply
o Market power results from restricted
supply due to:
o Copyrights
o Patents
o Control of resources
o Restrictive production agreements
o Efficiencies of large-scale production
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LO-4
Restricted Supply
o The direct consequence of market power
is that one or more producers attain
discretionary power over the market’s
response to price signals.
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LO-4
Antitrust Policy
o The goal of government intervention is to
prevent or dismantle concentrations of
market power.
o Antitrust policy–government intervention
to alter market structure or prevent abuse
of market power.
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LO-5
The Sherman Act (1890)
o Prohibits “conspiracies in restraint of
trade,” including mergers, contracts, or
acquisitions that threaten to monopolize
an industry.
o Violators are subject to fines up to $1
million.
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LO-5
The Clayton Act (1914)
o Outlaws specific antitrust behavior not
covered by the Sherman Act.
o Principal aim of the Act was to prevent the
development of monopolies.
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LO-5
The Federal Trade Commission Act (1914)
o Created an agency to study industry
structures and behavior so as to identify
anticompetitive practices.
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LO-5
Antitrust Decisions
o Antitrust legislation has been used to
break up:
o The steel and tobacco monopolies in the
early 1900s.
o The AT&T monopoly in the 1980s.
o Recently has been used against Microsoft.
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LO-5
Inequity
o Equity concerns the FOR WHOM
question.
o Is the distribution of goods and services
generated by the market “fair”?
o Government intervention may be needed
to redistribute income if the market fails to
reflect our notion of fairness.
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LO-5
Inequity
o The government alters the distribution of
income with taxes and transfers.
o Income transfers–payments to
individuals for which no current goods or
services are exchanged.
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LO-5
Income Transfers
o Examples of income transfers include
Social Security, welfare, and
unemployment benefits.
o Social Security is the largest transfer
program.
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LO-5
Macro Instability
o Micro failures of the marketplace differ
from macro failures.
o Micro failures concern producing at the
wrong point on the production-possibilities
curve or inequitably distributing the output
produced.
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LO-5
Macro Instability
o The goals of macro intervention:
o To foster economic growth.
o To get us on the production-possibilities
curve (full employment).
o To maintain a stable price level (price
stability).
o To increase our capacity to produce (growth).
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LO-5
Trust in Government?
o The potential micro and macro failures of
the marketplace justify government
intervention.
o Can we trust the government to fix the
shortcomings of the market?
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LO-5
Information and Vested Interests
o Government intervention typically entails
a lot of groping in the dark for better, if not
optimal, outcomes.
o Vested interests often try to steer the
government away from the social
optimum.
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LO-5
Government Failure
o Government intervention might worsen,
rather than improve market outcomes:
o Government failure–government intervention
that fails to improve economic outcomes.
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LO-5
Government Failure
o The challenge for public policy is to decide
when any government intervention is
justified, then intervene in a way that
improves outcomes in the least costly way.
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LO-5
Government
Intervention
End of Chapter 9
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