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Market failure occurs when the benefits and costs cannot be isolated to the individuals and firms making the immediate transactions. These extra benefits and costs are often referred to as “externalities” and they can take any number of forms. We are most familiar with them in the form of environmental damage that occurs in the production process.
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MICRO M 5
Module at a Glance
Topic Overview
We have already seen the negative effects of market imperfections. In this module we look at total
market failure, where the markets cannot be relied upon to even approximate optimal outcomes
even with public regulation. These are the cases of public goods, where the benefits and costs get
separated and where the benefits or costs often get diffused throughout the broader society, where
microeconomic policies are requisite to obtaining more optimal outcomes. Added to this mix is the
increasing concentration of income and wealth and the ability of all to share in the social output.
Here too, policymakers play an increasingly important role in establishing an appropriate balance
through entitlement programs.
Learning Objectives
To recognize the characteristics that make goods public goods. To understand the inherent
problems in public choice processes such as the “free rider problem”, the short term myopia of
political processes, and the problems with voting systems. At the analytical level, this module
presents some new technical challenges and learning opportunities as graphical processes require
rethinking where social benefits and costs are concerned and where externalities play a major role in
resource allocation decisions.
Readings
Text Chapters 16-18
Learning Activities
There are Learning Curve and Homework assignments for Chapters 16 through 18 on the
LaunchPad testing site. ‘Check Your Understanding’ questions in each chapter section.
Discussions
Externalities and public goods are becoming more important in the new global economy where fast
growth of emerging economies is stressing the resource base and an increasingly shared
environment. Increased concentrations of income and wealth and power within and among countries
is making the sharing of the benefits of national and global growth through public policies
increasingly important, especially as the developed economies age and experience shrinking
workforces relative to their retirement populations. The discussion should focus on these major
policy issues and options as they relate to equity and efficiency incentives and the operation of
market processes and microeconomic decisions in the new global economy.
Watch “Saving Capitalism” by Robert Reich on youtube
(https://www.youtube.com/watch?v=0iQYWPXAHow&t=840s) or on Netflix (if you have
it) Netflix Original Saving Capitalism by Robert Reich
Respond to these questions: Who makes the rules of the markets? Do free markets really
exist? How do the rules of the market contribute to increasingly unequal income
distribution?
Respond to this question on your seventh post, the fourth week of the discussion and
respond to your classmates:
What should the rules of the market be? What are your suggestions? (Focus on one or two
suggestions). Do you think individuals can do anything to influence the rules of the market
by contacting your elected representatives?
Respond to this question on your seventh post, the fourth week of the discussion and
respond to your classmates:
Research the proposed tax reform bills recently passed by Congress and proposed in the
Senate (they may have passed by the time you get to this question). How do these effect the
rules of the market? Who gains and who looses?
Instructor’s Commentary
Externalities cause less than optimal resource allocations unless policies are used to cause the
markets to reflect the external costs and benefits. Public goods occur when market processes
completely break down and public decision processes are thus required to enable the benefits to be
had. Beyond externalities and public goods, increasing concentrations of income and wealth
worldwide and the aging of populations in the developed world are making the redistribution of
benefits through entitlement programs paramount microeconomic issues. Geopolitical issues related
to resource shortages and controls and environmental concerns are adding to the mix of
microeconomic policy options. What the new microeconomic structures will look like in the new
global economy, especially with advancing technologies and information systems, is an emerging
economic question.
Market Failure and Public Goods
Market failure occurs when the benefits and costs cannot be isolated to the individuals and firms
making the immediate transactions. These extra benefits and costs are often referred to as
“externalities” and they can take any number of forms. We are most familiar with them in the form of
environmental damage that occurs in the production process. But there are many other examples
such as the benefits of a good education of one individual benefiting the rest of the community or the
potential harm of someone with a contagious disease to the rest of the community.
The “exclusion principle” is the extreme case of the above, where an individual who refuses to pay
for a good cannot be excluded from the benefits of the good. A prime example is national defense.
This is the case of a pure “public good”. In this case market processes completely break down and
the usual course of action is to rely on the public sector to direct the resource allocation process
through executive and legislative decisions. This may involve private sector contractors, as with road
or bridge repair, but the funding is through taxes and public priorities are established at the ballot
box.
On the other hand, any number of goods and services provided by the public sector are not pure
public goods based on the above definition. Examples include: public golf courses, state parks,
public schools, and even toll highways. A big controversy currently exists over national health care.
In all of these cases people not willing to pay can be excluded, though they often are not.
Entitlements
Entitlements such as Medicaid, Medicare and Social Security are becoming increasingly large parts
of state and federal budgets as incomes and wealth become increasingly concentrated and as aging
populations in developed countries are supported by relatively smaller workforces. The growth of
these entitlement programs is not being reflected properly in budget projections and many fear that
the economy will not be able to afford the promises made by its leaders.
Multiple choice
1. If drivers decide to make phone calls without considering the costs imposed on others, the:
marginal social cost curve will lie below the marginal cost of production curve.
marginal social benefit curve will lie below the marginal social cost curve.
number of phone calls made while driving will be more than the socially optimal
quantity.
number of phone calls made while driving will be fewer than the socially optimal
quantity.
2. Given the general agreement that pollution is undesirable and social welfare is increased by
reducing pollution, the optimal level of pollution in a society is:
the level that minimizes the average total cost of producing the product that generates
the pollution.
the level that reduces the marginal social costs of pollution to zero.
zero.
the level at which the marginal social cost is equal to the marginal social benefit.
3. The efficient rate of emissions occurs when:
the marginal social benefits of pollution exceed the marginal social costs of pollution.
there is absolutely no damage done to a pristine environment.
the change in social benefits and the change in social costs due to an additional unit of
emissions are equal.
government forbids all pollution no matter what the cost.
4. According to the Coase theorem, when negative externalities are present, a market will:
reach an efficient solution only if the government intervenes in the market.
always reach an efficient solution.
reach an efficient solution only if the negative externalities are offset by positive
externalities.
reach an efficient solution if transaction costs are low and property rights are welldefined.
5.
Reference: Ref 16-2
(Table: Coal Mine Pollution) The table Coal Mine Pollution shows the marginal social
benefit and cost of various amounts of pollution from a coal mine. The efficient quantity of
pollution is _____ tons.
8
2
4
0
6.
Reference: Ref 16-2
(Table: Coal Mine Pollution) The table Coal Mine Pollution shows the marginal social
benefit and cost of various amounts of pollution from a coal mine. If 5 tons of pollution is
produced:
the efficient amount of pollution is produced.
not enough pollution is produced.
the socially optimum amount of pollution is produced.
too much pollution is produced.
7. Your community requires the sewage treatment plant to process raw sewage so that it is safe
to return the water to the environment. This is:
a tradable emissions permit.
an environmental standard.
an emissions tax.
the Coase theorem.
8. For the same amount of pollution emitted, an emissions tax is said to be more efficient than
an environmental standard because all polluters:
emit pollution up to the point at which the marginal benefit of polluting is equal to the
emissions tax.
pay the same total tax bill for their pollution.
emit the same amount of pollution, regardless of the marginal benefit of polluting.
reduce pollution emissions to zero.
9. Which of the following is an environmental policy based on tradable emission permits?
allowing companies to buy and sell the right to a certain level of emissions
paying companies $1 for each 10% reduction in emissions
a charge to companies of $1 for every 100 units of pollutants emitted
ignoring pollution and letting private markets operate without government interference
10. External benefits are associated with the production of batteries. Without government
regulation, the market will:
produce too many batteries.
price batteries above the marginal social cost.
price batteries at less than the marginal social benefit.
price batteries at less than the marginal social cost.
11.
Reference: Ref 16-7
(Table: Externalities from Parks) The table Externalities from Parks shows the marginal
social benefit and the marginal social cost of preserving various amounts of land in a city
for a public park. If 1 acre is dedicated to the park, the park is:
the socially optimum size.
too large.
too small.
the efficient size.
12. Figure: Efficiency and Pollution
Reference: Ref 16-9
(Figure: Efficiency and Pollution) Look at the figure Efficiency and Pollution. If the
government imposed an environmental standard that did not allow the quantity of pollution
to exceed 20 tons, there would be:
a socially optimal quantity of pollution.
too little pollution, because its marginal social benefit would exceed its marginal
social cost.
too much pollution, because any pollution is too much from an economist’s
perspective.
too much pollution, because its marginal social cost would exceed its marginal social
benefit.
13. Figure: Model of a Competitive Market
Reference: Ref 16-11
(Figure: Model of a Competitive Market) Given the figure Model of a Competitive Market,
if there are external costs, a tax imposed on sellers will:
have no effect on the equilibrium price.
decrease the equilibrium price.
decrease the equilibrium quantity.
increase the equilibrium quantity.
14. Figure: The Quantity of Pollution
Reference: Ref 16-14
(Figure: The Quantity of Pollution) Look at the table The Quantity of Pollution. If the
amount of pollution emitted is 150:
the production of pollution is not socially optimal.
this economy is producing at the socially optimal level of pollution.
this economy would benefit by increasing production of this good.
the marginal social benefit is greater than the marginal social cost of pollution.
15. Both emissions taxes and tradable emissions permits:
encourage more pollution.
are usually less effective than environmental standards.
work only if they are coupled with environmental standards.
are efficient cost-minimizing methods of pollution reduction.
16. A good is subject to a network externality when:
the value of the good is determined only by marginal private benefits.
the value of the good to an individual is less when a large number of other people also
use the good.
a good yields negative externalities.
an increase in the number of other people using the good increases its value to an
individual.
17. Network externalities are often:
a reason for natural monopolies.
separate from positive feedback.
less likely to occur in the communications or technology industries than in other
industries.
not likely to move toward market domination.
18. The marginal social benefit received from pollution is equal to its marginal social cost in
the market for highly polished glass. In this situation:
firms in the market produce too much pollution.
firms in the market produce the socially optimal level of pollution.
firms in the market produce too little pollution.
society’s well-being can be improved if the quantity of pollution decreases.
19.
The diagram below shows the marginal social benefit (MSB) and the marginal social cost
(MSC) curves associated with air pollution.
Part 1: Identify the marginal social benefit (MSB) and the marginal social cost (MSC)
curves by assigning the appropriate labels to the two curves.
Part 2: Use the vertical drop line tool to identify the socially optimal quantity of pollution in
this case. Label this point Qopt. Make sure that the highest point of the drop line for Qopt is
placed on the MSB curve.
Part 3: Suppose Congress decides it now wants to achieve the socially optimal level of
pollution with a tradable emissions permit program. The government issues permits but
finds that the equilibrium price per permit is $250. Use the vertical drop line tool to
illustrate what level of pollution will result with the permits. Label this point Qp. Make sure
to place the highest point of the drop line for Qp on the MSB curve.
20.
Malaria is a contagious disease spread by mosquitoes. Mosquitoes bite an infected person
and pass the disease along by biting an uninfected person. In developing nations, the
spread of malaria can be diminished if people sleep underneath mosquito nets draped over
beds. The accompanying graph shows the market supply and demand for mosquito nets.
Part 1: Use the copy tool to draw a curve showing the marginal social benefit (MSB) from
the use of mosquito nets.
Part 2: Use a vertical drop line to identify the socially optimal quantity, and label it Qopt.
Make sure that the highest point of the drop line for Qopt is placed on the supply curve.
Suppose a Pigouvian subsidy is used to completely internalize the external benefit.
Part 3: Use a horizontal drop line to identify the price that suppliers would receive after
the subsidy. Label it Ps.
Part 4: Use a horizontal drop line to identify the price that consumers would pay after the
subsidy. Label it Pc.
1. When Joe watched a television movie, his viewing was _____ in consumption because other
people _____ able to view the movie at the same time Joe did.
nonrival; were not
rival; were not
nonrival; were
rival; were
2. Whether or not they pay for them, people cannot be excluded from receiving the benefits of:
public goods.
either public goods or common resources.
common resources.
private goods.
3. The best example of a good that is excludable in consumption is:
a bicycle.
an ocean.
a park.
national defense.
4. If a good is subject to the free-rider problem and an inefficiently low level of production
when left to the private market, the good must be a(n):
private good.
common resource.
artificially scarce good.
public good.
5. Figure: Traffic Lights in Plymouth
Reference: Ref 17-1
(Figure: Traffic Lights in Plymouth) Look at the figure Traffic Lights in Plymouth.
Plymouth has 1,000 residents. Each of the residents has the same individual marginal benefit
per traffic light. Without government intervention, the town will have _____ traffic lights.
4
0
12
8
6. No individual is willing to pay for the efficient quantity of a public good, because the
marginal benefit to an individual _____ the marginal social benefit.
equals
exceeds
may be equal to or greater than
is less than
7. Figure: Market Failure
Reference: Ref 17-12
(Figure: Market Failure) In the figure Market Failure, where is the equilibrium for a
competitive market?
H
J
I
K
8. Figure: Market Failure
Reference: Ref 17-12
(Figure: Market Failure) Look at the figure Market Failure. Suppose it represents the demand
for and marginal cost per pound of shrimp in the bay. The additional cost of the shrimp due
to the depletion of the common resource is equal to AC. Without government intervention,
the market will produce _____ pounds of shrimp.
0
E
F
G
9. A market produces too much of a good when the price of the good is:
greater than the marginal social cost of providing it.
equal to the marginal social cost of providing it.
equal to 1.
less than the marginal social cost of providing it.
10. Scenario: Alexander and Vanessa
Alexander and Vanessa benefit from scientific research. Alexander’s marginal private
benefit from such research is given by the equation P = 200 – Q, where Q refers to the
amount of research undertaken and P is the price Alexander is willing to pay for such
research. Vanessa’s marginal private benefit from such research is given by the equation P
= 100 – Q. The marginal social cost of engaging in such research is constant at $100.
Reference: Ref 17-15
(Scenario: Alexander and Vanessa) Refer to the scenario Alexander and Vanessa. If the
socially optimal level of scientific research is produced and if both Vanessa and Alexander
are truthful in disclosing the marginal private benefits they expect to receive from this
research, what is the price per unit of research that Vanessa is willing to pay?
$100
$300
$50
$0
11. An example of a common resource is:
fishing in the ocean.
any type of public good.
any private good that is monopolized.
coffee sold in coffee shops.
12. After many years, a small community builds a toll road but discovers it is little used. If it
wishes the road to be used at the socially optimal level, the community should:
set the toll equal to $1.
build another toll road.
set the toll lower.
set the toll higher.
13. Assigning property rights helps to correct the problems associated with common resources:
because it allows the government to determine the amount that would lead to the
socially optimal amount.
because it allows property owners to exclude users and to manage the resource more
efficiently.
because it makes the good nonrival in consumption.
and therefore allows the market to better assess the marginal social benefits.
14. The best example of a good whose consumption is NOT excludable is:
national defense.
a bicycle.
a yard.
a house.
15.
Reference: Ref 17-3
(Table: Security in a Residential Community) Look at the table Security in a Residential
Community. The marginal cost of hiring the second security guard is _____, and the
marginal social benefit is _____.
$150; $600
$450; $600
$150; $200
$450; $1,800
16.
Reference: Ref 17-10
(Table: Marginal Benefit, Cost, and Consumer Surplus) The table Marginal Benefit, Cost,
and Consumer Surplus shows six consumers’ willingness to pay for one iTunes download.
If the marginal social cost is constant at $0, then the efficient price is _____ and consumer
surplus is _____.
$4; $33
$5; $32
$1; $36
$0; $37
17. Common resources tend to be overused because:
individuals tend to ignore the cost to others of their use of the resource.
the marginal cost of allowing one more unit of consumption is zero.
the individual marginal cost is greater than the marginal social cost.
common resources are nonrival and nonexcludable.
18. One way the government of Alaska could prevent an inefficiently large production of crab
fishing would be to:
sell exclusive licenses for the right to fish.
subsidize fishermen to encourage competition.
offer tax breaks for more efficient boats.
allow competition from foreign fishermen.
19.
Bob and Nancy live in a new housing development and woul …
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