185-191, 231-249, and 415-328

Market Failure and the Role of Government A. Externalities type of market failure a. Negative externalities i. Ex: Pollution ii. Supply side market failure iii. Marginal social cost 1. Supply is less 2. Includes externalities 3. More desirable and more efficient iv. Marginal private cost 1. Supply is greater 2. Does not include externalities v. Shaded triangle represents efficiency loss from overproduction vi. Remedies reduce supply! 1. Regulation is expensive 2. Direct taxing is best/simpler b. Positive externalities i. Ex: Vaccination ii. Demand side market failure iii. Trying to increase 3rd party benefit despite higher price iv. Marginal social benefit 1. Demand is greater 2. Includes externalities 3. More desirable v. Marginal private benefit 1. Demand is less 2. Does not include externalities vi. Shaded triangle represents efficiency loss from underproduction vii. Remedies increase demand! 1. Advertising 2. Government subsidize if people dont want to pay high price B. Public Goods a. Public vs. Private goods i. Pure private goods: Excludable (price tag) and No Shared Consumption 1. You can keep people from using it 2. Creates scarcity 3. Entrepreneurs have incentive to make 4. Examples: Haircuts, all food, shot/vaccine ii. Pure public goods: Not excludable and Shared consumption 1. Cannot be depleted a. MC of producing 1 more unit is 0 b. If P = MC, P = 0 c. Its hard to charge for these goods 2. Examples: Public park, library, national defense, Street lights b. In the middle: i. Private, not pure, (still can make a profit) 1. Toll goods, theatres, cable TV, parks, toll roads, amusement park, college, electric power ii. Public, not pure (still no price tag)

1. Congested roads, fish taken from the ocean c. Free Rider: Consume without payment, means less incentive for business i. Downloading illegally, skipping out on the toll, peeking into movie d. Privatization: Transfer from public to private ownership i. Must be excludable ii. Example: Ambulance service e. Provision of public goods i. Resources are scarce (Think pie graph, public good is less than one fourth) ii. When do we provide public goods? 1. Look at MB of providing public goods and the MC of foregoing private goods 2. Downside, its tough to calculate MB and MC 3. Public good occurs when private firms have no financial inventive (profit motive) C. Public policy to promote competition a. Antitrust policy b. Regulation D. Income distribution a. Equity b. Sources of income inequality Pigovian Tax Coase Theorem - Lets Make a Deal - Private solution to negative externality o Mutually beneficial Internalizing the externality o Low transaction costs Comm. Costs Legally binding agreement How long? INFORMATION FAILURE Leon Problem A. Adverse Selection: a. Advantage to seller (used car) or Advantage to buyer (health insurance) b. We assume something wrong in a good like a used car i. Drives prices down c. Hospital assumes we are hiding bad health conditions i. Drives prices up B. Asymmetric Information a. Financial markets b. How we get around it i. Truth in labeling laws, car facts C. Moral Hazard a. Would lead someone to have riskier behavior (ex: helmet laws) b. Mostly with insurance i. If you have it, youll be riskier 1. Medical malpractice insurance 2. Guaranteed contracts for pro-athletes 3. Unemployment insurance 4. Gov insurance on bank deposits D. There is also a cost (time) of getting the necessary information

Is it rational for government leaders to favor special interests over the general public interest? YES Why are politicians mainly in the middle of the road? Median voter hypothesis Must appeal to swing voters and independents Are people irrational or rational when they spend little time evaluating candidates before they vote and when they dont vote? They are using rational ignorance Time is a resource as well What is the effect of bureaucratic entrepreneurs on government? Their main goal is power Less efficient Unnecessary rules and regulations Public Finance - Efficiency and fairness are mutually exclusive Expenditures and Taxes - Gov is %20 of GDP - Net taxes = tax revenue + transfer payment (Medicare, Medicaid, etc) + any kind of other income Government Finance - Government purchases and transfers o Purchases are exhaustive o Transfers, unemployment, social security, etc. are NOT exhaustive Government Revenues - Taxes - Propriety income - Sale of bonds (aka borrowing) Crowding out - None during recession o Government borrowing in a recession is good o Government borrowing during full employment is BAD Federal Government Finance - 4 main areas of expenditure o Interest on public debt 5% o Income security and pensions 35% o Healthcare 22% o National Defense 19% The only one that is not mandatory o Other expenses 19% Understanding the Tax system Tax Base: Measure of value that determines how much tax is paid Example: Income/property value in $ Tax Structure: Specifies how the tax depends on the tax base Example: 2% tax on assessed value of home) PA sales Tax: Base = consumption of taxable goods (minus goods that are tax exempt) Structure = 6% of taxable goods Could lower tax% if expand tax base by putting a tax base on tax exempt things like gum

3 main types of tax structure: - Proportional = same % for all people, flat tax - Progressive = based on income, % gives up as income goes up - Regressive tax = more you make, lower percentage you pay Major types of taxes in USA Federal income tax progressive tax, biggest source of income Payroll tax Sales Tax (excise tax) Profits Tax Property Tax Wealth Tax (example: inheritance tax) Excise Tax Graphs - Consumer pays more of the tax as the demand curve becomes more inelastic Allocating resources between present and future - Need balance between current consumption (present) and investment (future) - Profit motive accomplishes this through the interest rate o Invest when its low, put off investment when its high - Interest rate used as a tool of monetary policy among other things - Bird in the hand mentality - Investment presents greater risk to investor - Current consumption may result in irreversible decisions Government Failure What is the optimal degree of government intervention? Ideological differences? Political considerations always ignore economic realities Agency Capture Cost disease - Particular to labor intensive services - Have not gotten more efficient in delivering certain services, therefore cost has far outpaced inflation As productivity increases lead to higher wages in manufacturing, service wages must go up to continue to attract workers Test: chapters 9, 12, 20 Externalities Public vs. private goods Questions on each failure Know graph for excise taxes How much paid by consumer and producer