Chapter 5: Market Failure:

A Role for Government

 Market Failure
 A market failure occurs when the
competitive market system (1) does not
allocate any resources whatsoever to the
production of certain goods, or (2) either
underallocates or overallocates resources
to the production of certain goods.
 When private markets fail, government
involvement may arise.

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 Private Goods
 Private goods are those that people
individually buy and consume and that
private firms can profitably provide
because they keep people who do not pay
from receiving the benefits.
 Two characteristics of private goods are:
 Rivalry (in consumption)
 Excludability

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 Efficient Allocation
 Competition among firms to produce the
private goods that consumers demand
forces them to use the best technology
and the right combination of productive
resources.
 This results in productive efficiency: the
production of a good in the least cost way.
 Firms that are not productively efficient face
competition from lower cost firms.

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 Efficient Allocation
Competitive markets also produce
allocative efficiency: the production of
the “right” mix of products (minimum-cost
production assumed).
 Firms will produce goods and services that are
highly valued by society ensuring that
resources are allocate efficiently.

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 Public Goods
 Public goods are those that everyone can
simultaneously consume and from which
no one can be excluded, even if they do
not pay.
 Two characteristics of public goods are:
 Nonrivalry (in consumption)
 Nonexcludability

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 Public Goods
 Nonrivalry and nonexcludability create a
free-rider problem; once a producer has
provided a public good, everyone including
nonpayers can obtain the benefit.
 This makes it impossible for firms to gather
resources and profitably provide the good.
 In order to have the good, society must direct
the government to provide it. Surveys and
public votes may be used to determine the
demand for a public good.

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 Comparing Marginal Benefit
to Marginal Cost
 Determining the “right” amount of a public
good will depend on the marginal benefit
and the marginal cost of providing it.
 Marginal benefit (MB) is the added benefit or
utility from the production of one more unit.
 Marginal cost (MC) is the extra cost of
producing one more unit.
 The optimal quantity occurs when the MB
equals the MC of the last good provided.

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 Externalities
 An externality occurs when some of the
costs or the benefits of a good are passed on
to or “spill over to” someone other than the
immediate buyer or seller.
 Externalities can be positive or negative and
can affect production or consumption.

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 Negative Externalities
 Negative externalities, or spillover costs, are
production or consumption costs that affect a
third party without compensation.
 When negative externalities occur, the
producers’ supply curve lies to the right of
the full-cost supply curve.
 The equilibrium output is greater than the optimal
output; resources are overallocated to the
production of this commodity.

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 Positive Externalities
 Positive externalities are spillover production
or consumption benefits conferred on third
parties without compensation from them.
 When positive externalities occur, the market
demand curve lies to the left of the full-
benefits demand curve.
 The equilibrium output is less than the optimal
output; the market fails to produce enough of the
good.

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 Externalities

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 Individual Bargaining:
The Coase Theorem
 According to the Coase Theorem, private
solutions can remedy positive or negative
externalities without government involvement
if:
(1) private property is clearly defined
(2) the number of people involved is small
(3) bargaining costs are negligible

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 Liability Rules and Lawsuits
 When property rights are clearly established
but private negotiations to an externality
problem are not possible, government can
protect private property from damage through
liability laws, and the damage recovery
system through which they give rise.
 Parties suffering from negative externalities done
by other parties can sue for compensation.

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 Government Intervention
 When externalities affect large numbers of
consumers, government intervention may be
needed to achieve economic efficiency.
 For negative externalities, direct controls (pass
legislation limiting an activity) and specific taxes
can be used to counter the spillover costs.
 For positive externalities, government can provide
subsidies to buyers or sellers or provide the
product for free or for a minimal charge.

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 Government Intervention
Direct controls and taxes raise the marginal
cost of production of firms.
 This causes the supply curve to shift to the left,
thus correcting the overallocation of resources
cause by negative externalities. Output is
reduced to its optimal level.

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 Government Intervention

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 Government Intervention
 There are three options to correct the
underallocation of resources:
 Subsidies to buyers
 Subsidies to sellers
 Government provision of quasi-public goods
 Subsidizing consumers causes the demand
curve to shift rightward whereas subsidies to
producers shifts the supply curve rightward.

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 Government Intervention

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 A Market-Based Approach
A market-based approach is one that limits
government action and creates a market for
externality rights.

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 Financing the Public Sector:
Taxation
 In order to make available public and quasi-
public goods, government must free up
resources from the production of private
goods.
 By levying taxes on households and businesses,
thus reducing their incomes and spending, the
private demand for products decreases, as does
the private demand for resources.
 Taxes shift resources from private to public use.

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 Appropriating the Tax Burden
 The “tax burden” is the total cost of taxes
imposed on society.
 Government must determine how to
appropriate the tax burden among the
citizens.
 Two basic principles on how the economy’s
tax burden should be assigned include:
 Benefits-Received
 Ability to Pay

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 Benefits Received versus
Ability to Pay
 The benefits-received principle is the idea
that people who receive the benefit from
government-provided goods and services
should pay the taxes required to finance
them.
 The ability-to-pay principle is the idea that
people who have greater income should pay
a greater proportion of it as taxes than those
who have less income.

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 Progressive, Proportional,
and Regressive Taxes
 Taxes are classified as progressive,
proportional, or regressive, depending on the
relationship between average tax rate (total
tax paid as a percentage of income) and
marginal tax rate (the rate paid on each
additional dollar of income).

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 Progressive, Proportional,
and Regressive Taxes
 A progressive tax is one whose average tax
rate increases as the taxpayer’s income
increases.
 A regressive tax is a tax whose average tax
rate decreases as the taxpayer’s income
increases.
 A proportional tax is a tax whoa average tax
rate remains constant as the taxpayer’s
income increases.

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 Progressive, Proportional,
and Regressive Taxes
 In general, progressive taxes fall relatively
more heavily on high-income households
while regressive taxes are those that fall
relatively more heavily on the poor.

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 Tax Progressivity in the U.S.
 The majority view of economists is as
follows:
 The Federal tax system is progressive.
 The state and local tax structures are largely
regressive. A general sales tax and property
taxes are regressive with respect to income.
 The overall U.S. tax system is slightly
progressive.

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 Government’s Role:
A Qualification
 In addition to correcting externalities and
providing public goods, government also sets
the rules and regulations for the economy,
redistributes income when desirable, and
takes macroeconomic actions to stabilize the
economy.

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