Market Failure and Public Choice
8 c h a p t e r
MARKET FAILURE
The forces of supply and demand perform an extremely complicated and valuable function. They coordinate the activities of a large and diverse set of buyers and sellers and answer the basic questions of what, how, and for whom. However, before we conclude that markets are always efficient, a caveat or warning is in order. We have concluded that markets are efficient. But we made some assumptions about how markets work. If these assumptions do not hold, our conclusion about efficiency may be flawed. What are the assumptions?
First, in our model of supply and demand, we assumed that markets are perfectly competitive— many buyers and sellers exchanging similar goods in an environment where buyers and sellers can easily enter and exit the market. This is not always true. In some markets, few firms may have control over the market price. When firms can control the market price, we say that they have market power.
This market power can cause inefficiency because it will lead to higher prices and lower quantities than the competitive solution.
Even if the economy is competitive, it is still possible for the market supply and demand curves to wrongly characterize the marginal social benefits and costs of production. Sometimes the market system fails to produce efficient outcomes because of side effects economists call externalities. When there are positive externalities, the private market supplies too little of the good in question (such as education). When there are negative externalities
(such as pollution), the market supplies too much.
Both types of externalities are caused by economic agents—producers and consumers—receiving the wrong signals: The apparent benefits or costs of some action differ from the true social benefits or costs. The producers and consumers are not doing what they do because they are evil; rather, both well-intentioned and ill-intentioned people behave according to the incentives they face. The free market, then, works well in providing most goods but does badly without regulations, taxes, and subsidies in providing others.
A second source of market failure is that competitive markets provide less than the efficient quantity of public goods. A public good is a good or service that someone can consume simultaneously with everyone else even if he or she doesn’t pay for it. For example, everyone enjoys the benefits of national defense and yet it would be very difficult to exclude anyone from receiving these benefits.
The problem is that if consumers know it is too difficult to exclude them, then they could avoid paying their share of the public good (take a free ride) and producers would find it unprofitable to provide the good. Therefore, competitive markets would produce less than the efficient quantity.
Many economists believe that imperfect information also causes market failures. That is, markets would operate more efficiently with better information.
However, economists do agree that information, like other economic goods, is costly to produce. Because neither consumer or producer is going to have perfect information, the question becomes: how much and what quality of information are consumers and producers prepared to pay for?
This chapter examines why unregulated markets do not control adequately for externalities and public goods. We also discuss the problems that arise when there is asymmetric information—a situation in which people who are informed take advantage of those who are uninformed. In the last section, we present a brief overview of public choice—the study of collective decision making.
Let’s begin our discussion with externalities.
EXTERNALITIES
An externality is said to occur whenever there are physical impacts (benefits or costs) of an activity on individuals not directly involved in the activity. If the impact on the outside party is negative, it is
Market Failure and Externalities
s e c t i o n
8.1
_ What is a market failure?
_ What is a negative externality?
_ How are negative externalities internalized?
_ What is a positive externality?
_ How are positive externalities internalized?
142 CHAPTER EIGHT | Market Failure and Public Choice
called a negative externality; if the impact is positive, it is called a positive externality.
NEGATIVE EXTERNALITIES
The classic example of a negative externality is air pollution from a factory, such as a steel mill. If the firm uses clean air in production and returns dirty air to the atmosphere, it has created a negative externality.
The polluted air has “spilled over” to outside parties. Now people in the neighboring communities may experience higher incidences of disease, dirtier houses, and other property damage. Such damages are real costs, but because no one owns the air, the firm does not have to pay for its use, unlike the other resources the firm uses in production. A steel mill has to pay for labor, capital, energy, and raw materials because it must compensate the owners of those inputs for their use. If a firm can avoid paying the costs it imposes on others—the external costs—it has lowered its own costs of production, but not the true costs to society.
Examples of negative externalities are numerous: the roommate who plays his stereo too loud at 2:00 AM, the neighbor’s dog that barks all night long or leaves “messages” on your front lawn, the gardener who runs her leaf blower on full power at 7:00 AM on a Saturday.
Graphing Negative External Costs
Let’s take another look at the steel industry. In Exhibit 1, we see the market for steel. Notice that at each level of output, the first supply curve, SPRIVATE, is lower than the second, SSOCIAL. The reason for this is simple: SPRIVATE only includes the private costs to the firm—the capital, entrepreneurship, land, and labor for which it must pay. However, SSOCIAL includes all of those costs, plus the external costs that production imposes on others. That is, if the firm could somehow be required to compensate society for the damage it causes, it would increase the cost of production for the firm and cause a leftward shift in the supply curve. In Exhibit 1, we see that if the government stepped in and made the firm pay for the external costs, the output of steel would fall to
QSOCIAL, the social optimal (or best) level of output.
From society’s standpoint, QSOCIAL is the best level of output because it represents all the costs (private plus external costs) associated with the production of this good. If the suppliers of steel are not aware of or are not responsible for the external costs, they will tend to produce too much from society’s standpoint.
This means that there is an overallocation of scarce resources to the production of this good.
WHAT CAN THE GOVERNMENT DO TO CORRECT FOR NEGATIVE EXTERNALITIES?
The government can intervene in market decisions in an attempt to take account of these negative externalities.
It may do this by estimating the amount
Market Failure and Externalities 143 There is nothing worse than having a public place spoiled by the inconsiderate behavior of others. Some laws, such as the “pooper scooper” law, are intended to minimize negative externalities in public areas.
SSOCIAL
(with external costs)
SPRIVATE
QSOCIALQMARKET
DPRIVATE
Price of Steel Quantity of Steel
Spillover Costs to Outside Parties Market Equilibrium Social Optimum
Negative Externalities
SECTION 8.1
EXHIBIT 1
When there are negative externalities, the equilibrium market output level, QMARKET, will exceed the socially optimum quantity,
QSOCIAL, and there is an overallocation of scarce resources in the production of this good.
of those external costs and then taxing the manufacturer by that amount, forcing the manufacturer to internalize (bear) the costs.
Pollution Taxes
Pollution taxes are designed to internalize negative externalities. If government could impose a pollution tax equal to the exact size of the external cost, then the firm would produce at the socially desired level of output, QSOCIAL. That is, the tax would shift the supply curve for steel leftward to SSOCIAL
and would provide an incentive for the firm to produce at the social optimum level of output. Additionally, tax revenues would be generated that could be used to compensate those who had suffered damage from the pollution, or that could be used in some other productive way.
Regulation
Alternatively, the government could use regulation.
The government might simply prohibit certain types of activities that cause pollution or force firms to reduce their emissions. The purchase and use of new pollution control devices can also increase the cost of production and shift the supply curve to the left, from SPRIVATE to SSOCIAL.
POSITIVE EXTERNALITIES
Unlike negative externalities, positive externalities benefit others. For some goods, the individual consumer receives all the benefits. If you buy a hamburger, for example, you get all its benefits. On the other hand, consider a company that landscapes its property with beautiful flowers and sculptures. The improved landscaping is not only attractive to the company’s employees, but also it creates a positive externality for those who walk or drive by the company grounds. Another example of a positive externality whose benefits extend beyond just the individual consumer is education. Certainly, when you “buy” an education, you receive many of its benefits: greater future income, more choice of future occupations, and the consumption value of knowing more about life as a result of classroom (and extracurricular) learning. However, these benefits, great as they may be, are not all the benefits associated with your education. You may be less likely to be unemployed or commit crimes, or you may end up curing cancer or solving some other social problem.
These nontrivial benefits are the positive external benefits of education.
The government frequently subsidizes education.
Why? Presumably because the private market does not provide enough. It is argued that the education of a person benefits not only that person but all society because a more informed citizenry can make more intelligent collective decisions that benefit everyone. Here’s another example: Why do public health departments sometimes offer “free” inoculations against certain communicable diseases, such as influenza? Partly because by protecting one group of citizens, everyone gets some protection; if the first citizen does not get the disease, it prevents that person from passing it on to others. Many governmental efforts in the field of health and education are justified on the basis of perceived positive externalities.
Of course, because positive externalities are often difficult to measure, it is hard to empirically demonstrate whether many governmental educational and health programs achieve their intended purposes.
Graphing Positive External Benefits
Let’s take the case of a new vaccine against the common cold. The market for the vaccine is shown in Exhibit 2. The demand curve DPRIVATE represents the prices and quantities that buyers would be willing to pay in the private market to reduce their probability of catching the common cold. The supply curve shows the amounts that suppliers would offer for sale at different prices. However, at the equilibrium market output, QMARKET, the output of vaccinations is far short of the socially optimum level, QSOCIAL. Why? Many people benefit from the vaccines, including those who do not have to pay
144 CHAPTER EIGHT | Market Failure and Public Choice
In the U.S., people deposit large amounts of solid wastes as litter on beaches, campgrounds, highways, and vacant lots. Some of this is removed by government agencies, and some of it biodegrades over many years. There are several solutions to the litter problem.
Stiffer fines and penalties and more aggressive monitoring could be employed. Alternatively, through education and civic pride, individuals and groups could be encouraged to pick up trash.
© Sami Sarkis/PhotoDisc/Getty One Images
for them; they are now less likely to be infected because others took the vaccine. If we could add the benefits derived by nonpaying consumers, the demand curve would shift to the right, from DPRIVATE
to DSOCIAL. The greater level of output, QSOCIAL, that would result if DSOCIAL were the observed demand reflects the socially optimal output level.
However, because producers are unable to collect payments from all those who are benefiting from the good or service, the market has a tendency to underproduce. In this case, the market is not producing enough vaccinations from society’s standpoint.
In this case, there is an underallocation of resources because from society’s standpoint, too little of this good or service is being produced (production is QMARKET rather than QSOCIAL).
WHAT CAN THE GOVERNMENT DO TO CORRECT FOR POSITIVE EXTERNALITIES?
How could society correct for this market failure?
Two particular methods of achieving the higher preferred output are subsidies and regulation.
Subsidies
Government could give a subsidy—either give refunds to individuals who receive an inoculation or provide an incentive for businesses to give their employees “free” inoculations at the office. If the subsidy was exactly equal to the external benefit of inoculation, the demand curve would shift from
DPRIVATE to DSOCIAL, resulting in an efficient level of output, QSOCIAL.
Market Failure and Externalities 145 Systems like this use a hidden radio transmitter to help owners retrieve their stolen cars. If the devices also help law enforcement break up “rings” of car thieves, they will have spillover benefits (positive externalities) for car owners who do not own the devices because they will reduce the probability of their car being stolen.
Reprinted with permission from LoJack, Westwood MA. www.lojack.com
QMARKET QSOCIAL
Price of Vaccination Quantity of Vaccine
DSOCIAL (with external benefits) Spillover Benefits to Outside Parties Social Optimum Market Equilibrium
Positive Externalities SECTION 8.1
EXHIBIT 2
The private demand curve plus external benefits is presented by the demand curve, DSOCIAL. This demand curve is to the right of the private demand curve, DPRIVATE. The market equilibrium output, QMARKET, falls short of the desired social level of output, QSOCIAL. The market produces too little of the good or service.
The government could also pass a regulation requiring each person to get an inoculation. This would also shift the demand curve to the right toward the efficient level of output.
In summary, when there are positive externalities, the private market supplies too little of the good in question (such as education or inoculations for communicable diseases). When there are negative externalities, the market supplies too much. In either case, buyers and sellers are receiving the wrong signals. The producers and consumers are not doing what they do because they are evil; rather, whether well-intentioned or ill-intentioned, they are behaving according to the incentives they face. The free market, then, works fine in providing most goods, but it functions less well without regulations, taxes, and subsidies in providing others.
NONGOVERNMENTAL SOLUTIONS TO EXTERNALITIES
Sometimes the externality problems can be handled by individuals without the intervention of government, and people may decide to take steps
146 CHAPTER EIGHT | Market Failure and Public Choice
WHEN CHILDREN SHOULD BE SCREENED AND NOT HEARD
We live in increasingly intolerant times. Signs proliferate demanding no smoking, no spitting, no parking, even no walking . . . Smoking, once prohibited only in a few train carriages or sections of aircraft, is now banned totally in many offices, on most public transport and even in many bars. Posh clubs and restaurants have long had “no jeans” rules, but these days you can be too smart. Some London hostelries have “no suits” policies, for fear that boisterous city traders in suits might spoil the atmosphere. Environmentalists have long demanded all sorts of bans on cars. Mobile telephones are the latest target: some trains, airlines lounges, restaurants and even golf courses are being designated as “no phone” areas.
If intolerance really has to be the spirit of this age, The Economist would like to suggest restrictions on another source of noise pollution, children. Lest you dismiss this as mere prejudice, we can even produce a good economic argument for it.
Smoking, driving and mobile phones all cause what economists call “negative externalities.” That is, the costs of these activities to other people tend to exceed the costs to the individuals of their proclivities. The invisible hand of the market fumbles, leading resources astray. Thus, because a driver’s private motoring costs do not reflect the costs he imposes on others in the form of pollution and congestion, he uses the car more than is socially desirable. Likewise, it is argued, smokers take too little care to ensure that their acrid fumes do not damage other people around them.
Governments typically respond to such market failures in two ways. One is higher taxes, to make polluters pay the full cost of their anti-social behavior. The other is regulations, such as emission standards or bans on smoking in public places.
Both approaches might work for children.
For children, just like cigarettes or mobile phones, clearly impose a negative externality on people who are near them.
Anybody who has suffered a 12-hour flight with a bawling baby in the row immediately ahead or a bored youngster viciously kicking their seat from behind will grasp this as quickly as they would love to grasp the youngster’s neck. Here is a clear case of market failure: parents do not bear the full costs (indeed, young babies travel free).
CHILD-FREE ZONES
The solution is obvious. All airlines, trains and restaurants should create child-free zones. Put all those children at the back of the plane and parents might make more effort to minimize their noise pollution. And instead of letting children pay less and babies go free, they should be charged (or taxed) more than adults, with the revenues used to subsidize seats immediately in front of the war-zone. . . .
As more women choose not to have children and the number of older people without young children increases, the demand for child-free travel will expand. Well, yes, it is a bit intolerant —but why shouldn’t parents be treated as badly as smokers? And at least there is an obvious airline to pioneer the scheme: Virgin.
SOURCE: The Economist, December 3, 1998. http://www.economist.com/ PrinterFriendly.cfm?Story_ID=178005
MUM’S THE WORD
In The NEWS
WHAT IS A PUBLIC GOOD?
Externalities are not the only culprit behind resource misallocations. A public good is another source of market failure. As used by economists, this term refers not to how these particular goods are purchased—by a government agency rather than some private economic agent—but to the properties that characterize them. A private good
such as a cheeseburger has two critical properties in this context; it is rival and excludable. First, a cheeseburger is rival in consumption because if one person eats a particular cheeseburger nobody else can eat the same cheeseburger. Second, a cheeseburger is excludable. Everyone except the person who bought the cheeseburger is excluded from consuming it. Most goods and services in the economy are private goods.
Unlike private goods, the consumption of public goods is neither rival nor excludable. A public good is not rival because everyone can consume the good simultaneously; that is, one person’s use of it does not diminish another’s ability to use it. A public good is also not excludable because once the good is produced it is prohibitively costly to exon their own to minimize negative externalities.
Moral and social codes may prevent some people from littering, driving gas-guzzling cars, or using gas-powered mowers and log-burning fireplaces.
The same self-regulation also applies to positive externalities. Philanthropists, for example, frequently donate money to public and private schools. In part, this must be because they view the positive externalities from education as a good buy for their charitable dollars.
Public Goods 147 People may take steps on their own to minimize negative externalities.
For example, some people might use batterypowered mowers, or even old-fashioned push mowers, rather than gasoline mowers.
1. If a market activity has a negative physical impact on an outside party, that side effect is called a negative externality.
2. The government can use taxes or other forms of regulation to correct the overallocation problem associated with negative externalities.
3. If a market activity has a positive physical impact on an outside party, that side effect is called a positive externality.
4. The government can provide subsidies or other forms of regulation to correct the underallocation problem associated with positive externalities.
1. Why are externalities also called spillover effects?
2. How are externalities related to property rights?
3. How do external costs affect the price and output of a polluting activity?
4. How can the government intervene to force producers to internalize external costs?
5. How does internalizing the external costs improve efficiency?
6. How do external benefits affect the output of an activity that causes them?
7. How can the government intervene to force external benefits to be internalized?
8. Why do most cities have more stringent noise laws for the early morning and late evening hours than for during the day?
s e c t i o n c h e c k
Public Goods
8.2
_ What is a public good?
_ What is the free-rider problem?
_ Why does the government provide public goods?
INFORMATION IS SCARCE
It is assumed that persons buying or selling goods in the marketplace are acting in a manner that maximizes their satisfaction, or utility. For consumers to do this, however, they must have accurate information about the quality and characteristics of the goods and services in question. And this is not always the case.
clude anyone from consuming the good. Consider national defense. Everyone enjoys the benefits of national defense, (not rival) and it would be too costly to exclude anyone from those benefits (not excludable).
PUBLIC GOODS AND THE FREE-RIDER PROBLEM
The fact that a public g...
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