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Rationale for the Existence of Rationale for the Existence of GovernmentGovernmentRationale for the Existence of Rationale for the Existence of GovernmentGovernment
Certain goods and services would not exist unless we make a collective effort to produce them.
The government can help make collective decisions about paying for goods that generate spillover benefits.
Spillover Benefits & Public GoodsSpillover Benefits & Public GoodsSpillover Benefits & Public GoodsSpillover Benefits & Public Goods
A market with spillover benefits is inefficient, so there is an opportunity for government to promote efficiency.
Spillover PRINCIPLE
For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.
Spillover PRINCIPLE
For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.
Spillover Benefits: An ExampleSpillover Benefits: An ExampleSpillover Benefits: An ExampleSpillover Benefits: An Example
Number of people 100,000
Benefit per person $5
Total benefit of dam(100,000 x $5)
$500,000
Assumed total cost of dam (greater than personal benefit of $5)
$200,000
Tax per person $2
Tax revenue(100,000 x $2)
$200,000
In this example, if each person considers only the personal benefit relative to the cost of the dam, no dam will be built.
Since everyone will support a tax per person that is less than the benefit per person, the government can use its taxing power to provide a good that would otherwise not be provided.
Public GoodsPublic GoodsPublic GoodsPublic Goods Public goods are nonrival in
consumption (available for everyone to consume) and nonexcludable (it is impractical to exclude people who don’t pay).
Private goods are rival in consumption (only one person can consume the good), and excludable (it is possible to exclude a person who does not pay for the good).
Private Goods With Spillover BenefitsPrivate Goods With Spillover BenefitsPrivate Goods With Spillover BenefitsPrivate Goods With Spillover Benefits
workplace spillover benefits; and Civic spillovers benefits
■ Thus, the government should adopt policies to encourage people to become educated.
■ Local governments provide free primary and secondary education. States subsidize higher education, and the federal government provides financial aid to students in private and public schools.
Spillover CostsSpillover CostsSpillover CostsSpillover Costs Just as the government has a role in
markets with spillover benefits, the government also plays a role in markets with spillover costs (or externality).
Spillover PRINCIPLE
For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.
Spillover PRINCIPLE
For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.
Advantages of a Pollution TaxAdvantages of a Pollution TaxAdvantages of a Pollution TaxAdvantages of a Pollution Tax
The economist’s response to a pollution problem is to impose a pollution tax (internalize the pollution externality).
A pollution tax that is equal to the spillover cost per unit of waste forces firms to pay for the waste they generate, causing firms to produce less of the polluting good.
The tax also encourages firms to spend money to abate pollution.
The Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution Tax
This table shows the hypothetical cost per ton of paper with varying amounts of pollution.
Tax per gallon of waste = $4
Waste per Ton (gallons)
Production Cost per
Ton
Tax Cost per Ton
Total Cost per Ton
5 $60 $20 $80
4 61 16 77
3 64 12 76
2 71 8 79
1 86 4 90
0 116 0 116
As the firm decreases its waste, the cost of production rises because additional efforts to decrease waste become progressively more expensive.
The Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution Tax
As the firm continues to decrease the volume of waste, the production cost increases while the tax cost decreases.
Waste per Ton (gallons)
Production Cost per
Ton
Tax Cost per Ton
Total Cost per Ton
5 $60 $20 $80
4 61 16 77
3 64 12 76
2 71 8 79
1 86 4 90
0 116 0 116
The total cost per ton of paper is minimized at $76 and 3 gallons of waste.
The typical firm will decrease its waste from 5 to 3 gallons. This result is consistent with the marginal principle.
The Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution Tax
As long as the marginal benefit ($4 savings in taxes per gallon of waste reduced) exceeds the marginal cost (or extra production cost from cutting back a gallon of waste), the firm should continue to scale back its waste.
Waste per Ton (gallons)
Production cost per
Ton
Tax cost per Ton
Total Cost per Ton
5 $60 $20 $80
4 61 16 77
3 64 12 76
2 71 8 79
1 86 4 90
0 116 0 116
Beyond 3 gallons, the additional production cost exceeds the additional tax savings.
The Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution Tax
The tax shifts the supply curve leftward.
The tax is partially shifted to consumers in the form of a higher price, and they respond by consuming less.
The price of paper increases from $60 to $68 per ton.
The Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution TaxThe Firm’s Response to a Pollution Tax
The pollution tax affects the total volume of waste dumped in two ways:
Abatement: there is less waste per ton of paper—3 instead of 5 gallons per ton
Lower output: the industry produces less paper—80 instead of 100 tons per day
Traditional Regulation: Command and Traditional Regulation: Command and ControlControlTraditional Regulation: Command and Traditional Regulation: Command and ControlControl An alternative to a pollution tax is a
system of regulations that control the amount of pollution generated by each firm.
The label for a traditional regulatory policy is a command-and-control policy.
In the paper example, the government would simply mandate firms to produce no more than, say, 4 gallons of waste per ton of paper.
Traditional Regulation: Command and Traditional Regulation: Command and ControlControlTraditional Regulation: Command and Traditional Regulation: Command and ControlControl
A single abatement technology is likely to be efficient for some firms but not for others.
There is no incentive to cut the volume of waste below the maximum volume, or develop better abatement technologies.
A problem with the regulatory policy is that the mandated abatement technology is unlikely to be the most efficient for two reasons:
Global Warming and a Carbon TaxGlobal Warming and a Carbon TaxGlobal Warming and a Carbon TaxGlobal Warming and a Carbon Tax
Carbon dioxide is by far the most important greenhouse gas.
In the last century, we have blown out more carbon than plants have been able to suck in, and the volume of carbon dioxide in the atmosphere has increased by 25%.
A carbon tax is a tax based on fuel’s carbon content
Coase Bargaining: An exampleCoase Bargaining: An exampleCoase Bargaining: An exampleCoase Bargaining: An example Consider a lake shared by a steel mill and
a fishing firm; The mill initially dumps 5 tons of waste
into the lake which reduces the fish harvest;
The marginal cost of abatement increases with the level of abatement (from h to m);
The marginal benefit of abatement by the fishing firm decrease (increases) as the level of Abatement increases (decreases) as indicated by the movement from b to g.
Coase Bargaining: An exampleCoase Bargaining: An exampleCoase Bargaining: An exampleCoase Bargaining: An example
Marginal Costof abatement
Marginal benefitof abatement
23
14
32
5 Abatement (tons)0 Waste (tons)
41
1
57
9
1113
17
$The MB of pollution
abatement Equals the increase in the fish harvest,
While the MC equals the additional abatement cost.
Using the marginal principle, the efficient level is 3 tons.
Coase bargaining generates the efficient abatement level.If the steel mill owns the lake, the fishing firm will pay the steel mill to abate 3 tons. If the fishing firm owns the
lake, the steel mill will pay the fishing firm no to abate
The Consequences of Global WarmingThe Consequences of Global WarmingThe Consequences of Global WarmingThe Consequences of Global Warming
A doubling of atmospheric carbon dioxide in about 60 years will increase global temperatures, although it is unclear by how much.
Most scientists expect total rainfall to increase, with an overall negative effect on agriculture because less rainfall is expected in areas with fertile soil and more rainfall in areas with less productive soil.
Glaciers will melt, raising sea levels and inundating the amount of land available for agriculture or living space.
Effects of a Carbon Tax on the Market Effects of a Carbon Tax on the Market for Coalfor CoalEffects of a Carbon Tax on the Market Effects of a Carbon Tax on the Market for Coalfor Coal
A carbon tax will add to the expenses incurred by coal producers. So some suppliers will leave the market.
The supply of coal shifts to the left and the coal tax results in an increase in the price per ton of coal and a smaller quantity produced.
Imperfect Information and Imperfect Information and Disappearing MarketsDisappearing MarketsImperfect Information and Imperfect Information and Disappearing MarketsDisappearing Markets
A mixed market is a market where low-quality goods and high-quality goods are mixed together.
A market will break down, or the high-quality goods will tend to disappear, if either buyers or sellers are unable to distinguish between low-quality goods and high-quality goods.
Asymmetric InformationAsymmetric InformationAsymmetric InformationAsymmetric Information
In the model of supply and demand, the efficiency of markets is based on the assumption that buyers and sellers are fully informed.
If one side of the market, either buyers or sellers, has better information than the other, we say that there is asymmetric information in that market.
The Mixed Market for Used Cars—The Mixed Market for Used Cars—Lemons and PlumsLemons and PlumsThe Mixed Market for Used Cars—The Mixed Market for Used Cars—Lemons and PlumsLemons and Plums
If buyers cannot distinguish between lemons (low-quality cars) and plums (high-quality cars), both will be sold together, in a mixed market, for the same price.
In such a market, the odds of getting a plum are small. The high-quality goods will tend to disappear, and in the extreme case, will be completely nonexistent.
Ignorant Consumers and Knowledgeable Ignorant Consumers and Knowledgeable SellersSellersIgnorant Consumers and Knowledgeable Ignorant Consumers and Knowledgeable SellersSellers To determine the price in a mixed
market we must answer these questions:
How much is the consumer willing to pay for a plum—a high-quality car?
How much is the consumer willing to pay for a lemon—a low-quality car?
What is the chance that a used car purchased in the mixed market will be a lemon?
Equilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed Market
Suppose that a consumer believes that the chances of getting a lemon are 50% (neutral expectations).
To determine whether the actual chance of getting a lemon is greater or less than the expected chance, consider the assumptions in the following table:
Equilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed Market
Under neutral expectations (50%), consumers will underestimate the chance of getting a lemon (80%).
Equilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed MarketEquilibrium Outcome in the Mixed Market
Under pessimistic expectations, the actual chance of getting a lemon is the same as the expected chance (100%).
The higher the chance of getting a lemon, the lower the price consumers are willing to pay.
Under pessimistic expectations, the price of used cars decreases.
PessimisticExpectations
Assumed chance of lemon 100%
Willingness to pay for lemon
$2,000
Willingness to pay for plum $4,000
Willingness to pay for used car (value of a lemon)
Equilibrium Outcome in the Mixed Equilibrium Outcome in the Mixed Market for Used CarsMarket for Used CarsEquilibrium Outcome in the Mixed Equilibrium Outcome in the Mixed Market for Used CarsMarket for Used Cars
When consumers’ expectations are consistent with their actual experiences, the equilibrium price of used cars is $2,000, and the plums will disappear from the market.
Adverse selection is the result of the dynamics of asymmetric information (one side has better information than the other), which generates a downward spiral of price and quantity:
A decrease in price decreases the quantity of plums supplied, decreasing the price further when buyers realize that most cars are lemons, which leads to even fewer plums on the market.
The domination of the used-car market by lemons is an
example of the adverse-selection problem. The
quality of the goods left in the market is adverse, or
Thin Market for PlumsThin Market for PlumsThin Market for PlumsThin Market for Plums
It is possible that asymmetric information generates a thin market—one in which some high-quality goods are sold, but fewer than would be sold in a market with perfect information.
Thin Market for PlumsThin Market for PlumsThin Market for PlumsThin Market for Plums
If the supply of plums starts at $1,800, it is possible that the market will have a small number of plums when it reaches equilibrium: 2 plums and 18 lemons sold at $2,200 each.
Moral hazard is a situation that encourages risky behavior.
Insurance causes people to take greater risks. They don’t buy a fire extinguisher, or tend to drive recklessly. These are unobserved actions that increase the probability of a grim outcome.
The moral hazard is pervasive. The availability of insurance, for example, decreases investment in prevention programs that reduce risk.
Deposit insurance causes a moral hazard problem. With insurance available, depositors are less likely to evaluate the performance and riskiness of the financial institution.