Government and public sector: market failure, rents, externalities, public goods, efficiency

This chapter falls from the knowledge of the function of the market system and its ability, at least in its design, to allocate resources efficiently. Indeed most of the definitions of economic efficiency manifest themselves best, if not only, in competitive markets. However not all people and satisfied, in normative judgements, with the outcomes of a market system. This outcomes include some differences among groups with respect to income and wealth distribution. Also, there is market failure when buyers and sellers do not come to terms, when the sale is not consummated, for instance. In other words, the market cannot determine the terms of exchange - price, quantity, location, service, financing, etc. - and/or one party is not willing or able to pay the price. The market fails. In both of these situations, we have possible functions for the government. Also, the presence of externalities, negative and positive, can be the basis of government taxation or subsidies to the market to more efficient or equitable position. With respect to the efficient position, remember the market role of efficiency - but if the market fails or there are externalities, the market will not be the vehicle for efficiency. The government may then intervene to promote a desirable social outcome.

There are certain important concepts on market failures topic:

1. Externalities.

In an externality, either the buyer or the seller does not "capture" all of the benefits or costs of the transaction that is some of the benefits; that is, some of the benefits or costs accrue to the public as social costs and benefits. So the question arises itself; "how can the government

react to a positive or to a negative externality?"

The right answer in terms of positive externality would be the granting of a subsidy to private producers in order to continue production for this positive externality.

Conversely, there is an negative externality - the government might impose a tax to improve economic efficiency. The situation of a negative externality is often used in the context of a pollution by firm.

Often, the tax will vary directly as the pollution by the firm varies. Thus, the more the pollution and as a subsequent tax rises, the greater the incentive by the firm to control pollution.

Also, with respect to negative externalities, the private market will determine a price that is relatively low; a relatively low price encourages more sales, more production and more negative externalities. Here, attacks on the producer might be considered a factor or determinant of a shift to the left of supply (a decrease in supply), which would cause a higher price and reduce output or production of the good. Conversely, with respect to positive externalities, the price of the product would be a relatively high. A government subsidy would cause an increase in supply (shift to the right of the supply curve), which would cause a lower price and increase output.

2. Social costs, private costs, and externalities.

Since externalities are, by definition, those costs incurred by the buyer or the seller of a market transaction (the costs are incurred by the public, such as polluted waterways), and social costs are equal to private costs and the value of the externalities. Thus, we can distinguish marginal private costs (MPC or MC) from marginal social costs (MSC), which are usually higher than private ones, since marginal social costs incorporate marginal private costs. These distinctions will serve us well when that we discuss the government, the market, and the optional amounts of pollution. These definitions and distinctions support the knowledge of externalities, taxes, and subsidies identified above. For example, social costs will equal private costs when government either taxes negative externalities or subsidizes positive externalities by the amounts of the externalities. In this way, the government hopes to move the markets to some level of efficiency to compensate for market failure.

3. Definitions and nature of efficiency.

Efficiency and it is several implications take up much of advanced microeconomics analysis. For purposes of this review text will discuss only three definitions: technological, allocative and Pareto optimality (sometimes used as a general definition of efficiency). A condition in society where any further improvement in well-being for some people will come at the expense of others is a point of efficiency or optimality. We will discuss that later.

4. Public goods and private goods.

The two major distinctions between public goods and private goods are that private goods are exclusive and distributable and public goods are non-exclusive and nondistributive. These distinctions refer to pure public goods and pure private goods. One can be excluded from the benefits of private good by not being willing or able to pay the price. Also, one more good for me means one less good for you. For public goods, I cannot be excluded from their benefit by refusing to pay for them, and the cost of one more unit of the public gold does not result in one less unit available to someone else. In other words, marginal cost of one more unit of pure public good is a question of great interest. The answer is that the marginal cost in such a situation is equal to 0. In this chapter we will discuss other public goods, including congestible and price - excludable public goods. For example, a bridge or tunnel leading to the city may be a public good (nonexclusive and nondistributive) until rush on commuting hours. At commuting time, the highway carousing takes the form of an externality, since one more car on the congested bridge means less space or slower traffic for the other cars.

5. Other roles of government.

There are many fields for the government to intervene, for example, antitrust for monopolies, provision of information, redistribution of income, etc.

Private goods and public goods

To extend the discussion above, the following are the definitions, uses, and examples of private and public goods. A private good is good that has exclusion and distributive characteristics. That is, one who is unwilling or unable to purchase a good is denied its benefits. Thus, if I am unwilling to pay $20 to purchase a ticket to a major league basketball game, I am denied the fun of watching the game in person (the exclusion characteristic). Also, if there are 40,000 seats available, one wide tickets for me me is one less for someone else ( the distributive characteristic). Private goods are divisible into discrete units such as the example of 40,000 basketball tickets. If private goods have externalities, then there are less efficient or inefficient outcome. Externalities and the government use of taxes and subsidies are discussed later in this chapter.

Measures of efficiency

As started earlier, Pareto efficiency is the general measure of efficiency. First, will define and explain to specific measures of efficiency. We will see how they are related and how they are subsumed under Pareto or general efficiency.

Technological efficiency

The study of microeconomics for the economics of the firm is focused on the efficient allocation of resources. Technological efficiency is the identification of those inputs that have the greatest impact on outputs per dollar of input expenditure. In the simple engineering sense, output / input. We discussed this in the chapter on costs, production, and supply in terms of economies of scale. Economists want to know which production process gets the most output per dollar cost of inputs. We could look at this as a given amount of old port and which input or combination of inputs ( resources) could produce the output at the least cost. The fear has an incentive to find the most cost effective method of production since it can expand profit margins. Technological efficiency allows us a standard to achieve in terms of obtaining increasing returns to our technology. Any improvement in the value of the ratio of output to input will allow us to increase our productivity, or to make more efficient use of resources.

Allocative efficiency

Ideally, every society would like to channel its resources ( land, labour, capital, entrepreneurial ability) so they are most productive and desired uses. Thus, the industries and firms that have the highest productivity are rewarded with higher profits; their profits are the motivation to continue to produce. If consumers are voting with their dollars, the firms will produce the products that consumers are willing and able to purchase.

Pareto efficiency

The notion is that there is an improvement for society as long as some people are gaining without others losing ground or benefits. Society reaches its optimal point or efficiency went any further improvement for some comes at the expense of others.

As indicated earlier, the competitive market economy, with its price mechanisms, is the best vehicle for efficiency. However, market failure, externalities, and other societal needs give rise to public goods and other forms of government intervention to reach efficiency lost by market failure and externalities. Also, the government may attempt to create perceived need for equity by transferring payments for a redistribution of income.

Public goods

Public goods lack the exclusion and distributive characteristics of private goods, and become public goods by default. Public goods have nonexclusion and nondistributive characteristics. A pure public code would be available for all regardless of any inability or unwillingness to pay. If a person does not approve of taxes being used for national defense and withholds the appropriate percentage of taxes used for that purpose, that person would not be denied any of the benefits of national defense. Pure public goods are non-marketable

since benefits can be denied and because the units of the pure public good are not divisible. Thus, one more citizen who is qualified for a public good comes at zero marginal cost. One more unit of the public good does not come at the cost of one less for me. We cannot divide national defense into discrete units - and even if we could, who would be willing to buy shares of military defence in the marketplace?

Quasi-public goods

However, there are many public goods that have some private good characteristics that make them quasi-public goods. Sometimes, these goods are classified as public good with some private good attributes, such as congestible public goods and price-excludable public goods.

Congestible public goods occur when a public highway, bridge, or tunnel becomes acutely crowded at certain times, such as commuter rush hours. This might mean that at non-rush hours, one more car on the bridge at say, 11:00 a.m. would not tie up traffic or in any way interfere with the normal speed of other vehicles on the bridge ( one more car space for me doesn't mean, in this situation, one less car space for another person - the nondistributive, nondivisible principle). However at around 6:00 p.m. there can be considerable delays in getting on the bridge ( one half hour to 1 hour) and once on the bridge, effective speed is lowered because of the heavy traffic. This is a negative externality. Some economists have suggested that variable trolls be instituted at different times during the day so that during rush hours lower bridge fares would be in effect ( this assumes trolls going both ways on the bridge). These varying rates would more efficiently allocate scarce resources (time, space). Drivers, to a certain extent, would decide whether their time or their money is more important. Thus, the public bridge takes on the distributive characteristics of a private good as it becomes a congestible public good and therefore, officials can "bribe" and laugh drivers to travel an alternate times with the market mechanism, varying prices. Therefore, the city would affect a more efficient solution than that of a private good with externalities. Also, we can have public goods with a price-exclusion feature. For example, the government may make provision for medical insurance for the elderly, but the deductibles and co-pavements may exclude some lower-income elderly from some or all of the benefits of medical insurance and related medical care.

Basis for public goods or government interference with market outcomes

The general case for some government action is a case for efficiency in the event of market failure rents, or externalities, or the case for equity in the event of an unequal distribution of income or a wealth.

Market failure

In the most extreme form, market failure means that the buyer and seller are not able or willing to agree on the terms of the transaction - price, quantity, financing, etc. in the broad social sense, a desired social outcome does not occur. For example, individuals who have the HIV virus may be unable to pay for health care or be the health insurance premium; therefore, the market fails to "clear the market of any surplus or storage" and is there continues to be a demand greater than any willing suppliers of healthcare or health insurance. Market failure also refers to failure of the market mechanisms to achieve optimal or efficient outcomes. Inefficient social outcome would be when marginal social benefits (MSB) equals marginal social costs (MSC). Therefore, market failure to produce official outcomes because a general basis for government intervention. A complete market failure to find the equilibrium for certain gourds is the case for a public good as discussed earlier in this chapter.

Externalities

Another form of market failure is the presence of externalities. Externalities are costs of benefits that are not "captured" by the price mechanisms. For example, a college student does not capture all of the benefits of a college education; some of the benefits would accrue to others in society who might benefit from a lab discovery or a work of art. Conversely, the producer of the product that causes pollution does not incur all of these costs; most of these costs are external to the producer.

The connection between externalities and social costs/benefits is through the relationship with private costs and benefits. The private market mechanisms have an equilibrium price, which is where private marginal benefits (MPB) equals to marginal social costs (MSC).

However,on the following graph there is the presence of a positive externality associated with prenatal visits.

A positive externality means the benefits accrued to others as in the case of prenatal visits by woman to a physician. In France, the government has allowed woman these prenatal visits at zero cost. In addition, the woman are paid a nominal sum when they do visit the physician. There is a social benefit of ensuring the health of the mother and the fetus that is not captured in the market equilibrium price of $170. There is externality of $120 (the difference between the marginal social benefits of $290 - .8 on the graph, and the equilibrium price of $170, the value of private marginal benefits). Therefore, the values of the externality are internalised in the price mechanisms as a subsidy. To sum up, marginal social benefits (MSB) equal private marginal benefit (MPB) plus the externality. In this case the subsidy is paid to the consumers in order to effectively lower with the price. In a positive externality, the price is too high and the output is too low ( too few prenatal visits at the market equilibrium of 400,000 visits). With the subsidy, the number of prenatal visits increased to 500,000 at which level, MSC=MSB or optimal (efficient) output.

Government interference is justified so that there is efficient level of output will be obtained. Otherwise, the level of 400,000 prenatal visit is below the optimal level.

With a negative externality (as illustrated below) the market equilibrium price is too low and the market equilibrium quantity is too high.

The use of the tax to correct for this situation reflects this negative externality. Further, the tax equals the value of the negative externality and thus corrects or internalises this externality. With the tax correction, the optimal outcome is achieved at the level of output of the polluting firm, MSB=MSC.

Thus, the price that was too low is now higher and the old board that was too high is now lower. Remember, marginal social cost equal marginal private cost plus tax. The tax, in turn, equals to the value of negative externality.

This negative externality of pollution can also be illustrated in terms of a tolerable level of pollution or that level of water pollution at which MSB=MSC. This is illustrated below, entitled, Pollution, Optimal output, Social costs.

A tolerable level of pollution would be 55% (MSB=MSC); however, the private market equilibrium level of pollution would be 75% pollution (where MPC=MSB). If the government wants to internalise this negative externality, it would text this externality (MSC-MC +tax, where the tax = negative externality). This text will not and pollution but it would pass the external costs to the firm with the likely outcome of a lower level of pollution (55% vs 75%) and a decrease in supply ( MC shifts to the left).

Other basis for government interference

1. Information.

Information might be considered a public good. Since the provision of full information about a good by its manufacturer would come at a cost to the manufacturer without the corresponding benefit at the margin of providing this information, we might expect that this full information will not be forthcoming. Since this information ( nutritional content, fat content, additives, price per unit, etc.) is of social benefit, the government might require appropriate labelling, weights and measure control, price per unit information, warnings, etc. As you know, this information is now mandatory.

2. Meritorious nature

Some goods and services may be of such a meritorious nature as to transcend any economic criteria in the determination of public goods. The United Kingdom has determined that health care services are public goods even though the services possess, to some degree, the private good characteristics of exclusion and distribution.

3. Efficient allocation of resources.

If the ratio of public good benefits/ public good costs is greater than one and if this public ratio is greater than private good benefit/private good cost, then the good should be produced are provided by public means; otherwise, private good benefit/ private good cost is more than public good benefit/ public good cost, the resources in the production of the good would be more sufficiently used in private production, in other words, the case for privatization.

4. Income distribution.

It is a common practice that the poor need some help from the rich or the elder population deserves a part of income of the young. This income redistribution is always done by transfer payments such as Social Security retirement programs, the Earned Income Tax credit, and others.

5. Competitive markets.

The government may use the Federal Trade Commission to correct or penalize films that provide deceptive sales techniques or practices that promote unfair competition. The anti-trust division of the US Department of justice investigates monopolies or mergers that tend to substantially lessen competition or that trend to create monopolies.

6. Stabilization programs.

On the macro side, there are governments stabilization programs to stabilize prices ( fight inflation) order to stabilize the business cycle (promote growth without serious or prolonged contraction or recession). In the United States, discretionary stabilization programs are fiscal and monetary.

Product markets: