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
DPRIVATE
QMARKET QSOCIAL
SPRIVATE
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.
Regulation
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
s e c t i o n
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 good is not rival and not excludable makes the good difficult to produce privately.
Some would know they could derive the benefits from the program without paying for them, because once it is produced, it is too difficult to exclude them. Some would try to take a free ride—derive benefits for something they did not pay for. Let's return to our national defense example.
Suppose the private protection of national defense is actually worth $100 to you. Assume that there are a 100 million households in the United States, each willing to make a $100 contribution for national defense. This would add up to $10 billion.
You might write a check for $100, or you might reason as follows: “If I don't give $100 and everybody else does, I will be equally well protected plus derive the benefits of the $100 in my pocket.” Taking the latter course represents a rational attempt to be a free rider. The rub is that if everyone attempts to take a free ride, the ride will not exist.
The free-rider problem prevents the private market from supplying the efficient amounts of the public goods. That is, little incentive exists for individuals in the private sector to provide public goods because it is so difficult to make a profit due to the free rider problem. Therefore, the government provides important public goods like national defense.
148 CHAPTER EIGHT | Market Failure and Public Choice
Voters may disagree on whether we have too much or too little, but most agree that we must have national defense. If national defense were provided privately and people were asked to pay for the use of national defense, many would be free riders, knowing they could derive the benefits of the good without paying for it. This is why the government provides important public goods, such as national defense.
© Stocktrek/PhotoDisc/Getty One Images
1. A public good is both nonrivalrous in consumption (one person's usage of it does not diminish another's ability to use it) and nonexclusive (no one can be excluded from using it).
2. A free rider is someone who attempts to enjoy the benefits of a good without paying for it.
3. The government provides public goods because the free-rider problem results in underproduction of these goods in the marketplace.
1. How are public goods different from private goods?
2. Why does the free-rider problem arise in the case of public goods?
3. How does the free-rider problem relate to property rights?
4. In what way can government provision of public goods solve the free-rider problem?
s e c t i o n c h e c k
Imperfect Information
s e c t i o n
8.3
_ What are information costs?
_ How does the government disseminate information?
_ Should the government be in the information business?
_ What is asymmetric information?
Information can be treated like most other scarce goods: It is desirable and limited, and people are willing to pay a positive price to obtain it. Just as in any other cost-benefit evaluation, however, individuals will stop searching for information when the cost of obtaining that additional information outweighs the benefit they expect to gain from it.
This is why consumers are willing to spend more time doing research before a car purchase than before buying a tube of toothpaste. Unlike the toothpaste purchase, the consequence of making a mistake when buying a car is significant, so the cost of gathering additional information is relatively small compared to the benefit that can be gained.
However, when information costs to consumers are greater than the perceived benefits, consumers will make less-informed decisions. As the late Nobel laureate George Stigler pointed out years ago, “It is perfectly rational for people to make `poor' decisions if the cost of information necessary to make good decisions exceeds the benefits.” Consider the case of an average consumer who desires to buy a smoke detector. He finds two virtually identical looking smoke detectors, one that costs $50 and another that costs $10. As far as he knows, the two smoke detectors are identical, so he buys the one that costs $10. Unbeknownst to the buyer, however, the less expensive smoke detector is made of lower-quality materials, increasing the likelihood of accidents and product failure. Because he lacked the appropriate information, the buyer made a poorer decision than he might have if he had better information about the quality of the two products.
HOW DOES THE GOVERNMENT DISSEMINATE INFORMATION?
Much legislation passed at the federal as well as the state and local levels in the past 50 years seems directed toward reducing information costs and keeping consumers from making dangerous or worthless purchases. The U.S. Department of Agriculture inspects meat and rates its quality, giving consumers information about meat quality. State and local governments inspect scales used in markets to protect customers from misinformation. The Securities and Exchange Commission attempts to protect investors from unwitting losses by requiring sellers of securities (stocks) to provide certain forms of information, to have training, and so forth.
Another well-established form of consumer protection is occupational licensing laws for professions.
Occupational licenses are required to practice medicine, law, plumbing, marriage counseling, and a wide variety of other services. Proponents of these laws argue that they assure consumers that certain minimal quality standards will be met, thus reducing private information costs. If a doctor has a license, obtained by passing a licensing exam, presumably she has had reasonably good training in medicine. In recent years, consumer groups have pushed for new forms of protection in the form of information, such as warning labels on products that contain possible cancer-causing agents, “truth in lending” laws requiring interest rates and other loan terms to be stated clearly and honestly, laws forcing tire manufacturers to grade their tires according to uniform federal standards, and so on. The federal government has also mandated that producers reveal information like miles per gallon in city and highway driving on new cars and energy usage on electric appliances.
Governmental information services are not limited to purchasers of goods and services, but also extend to suppliers. For decades, the federal government has provided information to farmers on how to produce various types of agricultural products, via a system of county extension agents. Farmers can also obtain government-provided information on weather conditions, prices, projected supplies, and so on. Likewise, suppliers of labor services—workers—can get labor market information through state employment bureaus.
WHAT ARE THE OBJECTIONS TO GOVERNMENT INFORMATION SERVICES?
Few will quarrel with the objective of reducing information costs to consumers and suppliers, permitting more intelligent market decisions and leading to greater satisfaction. However, one can still oppose certain types of governmental action in this
Imperfect Information 149 Sometimes the government requires warning labels on products to inform consumers about the dangers of consuming a particular product. In 1966, Congress began requiring cigarette manufacturers to place specific health warning labels on cigarette packages.
© 1998 Don Couch Photography
area on the grounds that the costs of providing the information are too high, that the government is disseminating inaccurate or misleading information, or that specialinterest groups have managed to manipulate the regulation to their own advantage, which may not be in the public interest.
Occupational licensing laws, for example, supposedly protect uninformed consumers from getting shoddy services, but these laws may also restrict competition, reducing the supply of workers providing these services and leading to higher prices. Plumbers can gain thousands of dollars in income by sharply limiting the number of competing plumbers. Therefore, some plumbers are willing to pay money and use their time to ensure that occupational licensing of plumbers serves to restrict the supply of plumbers and thus competition. As a consequence of the restrictive licensing, hundreds of thousands of customers might pay $40 or $50 more a year for plumbing services. These consumers either do not know about the effects of these restrictions or do not regard that potential cost to be big enough to make a fuss, so a small pressure group of plumbers could continue to control the licensing board. While it does not always work this way, it is possible that occupational licensing may do more harm than good.
Likewise, economist Sam Peltzman has argued that the Food and Drug Administration (FDA), in its attempts to prevent unsafe drugs from going on sale, has saddled pharmaceutical firms with so much higher information costs in the form of testing of new drugs that the companies have markedly reduced the amount of new life-saving drugs coming on the market. In its attempt to be sure that drugs are 100 percent safe, the FDA forces companies to spend millions of dollars on extremely elaborate testing, even when the drug has clear medical benefits and only a remote possibility of harm. Critics of government involvement argue that the FDA may actually be raising the death and illness rate, not lowering it, because in its effort to keep bad drugs off the market, it also keeps good drugs off the market that may save thousands of lives.
The methods the government uses to change consumer behavior for the good is another controversial issue. For example, years ago, the government decided to warn people of the dangers of cigarette smoking by requiring labeling information on cigarettes. Some would argue, however, that if cigarette smoking is truly as dangerous as alleged, the use of cigarettes should be banned. Taking another philosophical approach, some would condemn the prohibition of something like cigarettes, arguing, “Let adults decide for themselves if they wish to incur the health risks associated with tobacco consumption, as long as they do not impose harm on others.” The “do at your own risk” group believes that government activity should be confined, at most, to providing individuals with information and allowing them to make their own decisions.
Government-provided information, then, can be a good and efficient mechanism for reducing market failure from information costs. On the other hand, excessive governmental information policies can actually worsen the allocation of resources when the information provided is costly, relatively useless, and/or creates other market imperfections, such as a monopoly due to licensing.
Caveat Emptor—“Let the Buyer Beware”
The saying “let the buyer beware” becomes less comforting to many as products become more sophisticated and numerous and consumers have a more difficult time getting objective information to evaluate products. The average consumer, for example, probably does not know the extent to which accidents are likely to be reduced by designing lawn mowers that make it extremely difficult to get a foot caught in the blade. The opportunity costs of the consumer learning about the relative dangers and costs of alternative product designs are very high: Who wants to spend several hours tracking down that kind of information when buying a lawn mower? Many people would not know how to go about retrieving the information in any case. Information costs are very high.
150 CHAPTER EIGHT | Market Failure and Public Choice
Sometimes, rather than providing consumers with information about potentially injurious products and letting them make their own purchasing decisions, the government simply bans the product. Examples include bans on the sale of certain insecticides, such as DDT, which was banned in the United States in 1973. More recently, the government decided to take certain diet drugs off the market, such as fen-phen, which was banned in 1997.
© Galen Rowell/CORBIS
Imperfect Information 151
By Keith Morrison
They've got names like Demon, Medusa, Cyclone—rides that test your nerve, and your stomach. It's a summertime tradition— going to the amusement park or traveling carnival. Every year it seems the thrills get bigger—the chills scarier. Thoughts of safety are like rain clouds at a county fair. After all, you assume the rides have to be inspected, regulated to make sure there's no genuine danger—but think again.
It has become America's golden age of manufactured excitement.
Never before have so many people drawn so many G's—so high, so fast, so often.
For a great many people, the latest jangling attraction is the perfect combination of apparent risk, giddy thrill and no danger at all.
Or almost no danger. In fact, industry experts say, you're more likely to win the lottery—twice—than be hurt on a roller coaster.
But by the end of the summer of 1999, the thrill had an extra edge of fear.
In one terrible week last summer, four people were killed in amusement park accidents. Over the course of the summer a total of six were killed—in California, New York, New Jersey, Virginia and Texas. There were accidents in big tourist parks and small traveling carnivals, and a government accounting revealed that during the previous five years, there had been a 24 percent increase in reported accidents, and an 87 percent increase in emergency room visits.
That's why, even though the odds of being hurt on an amusement park ride are very long, it is perhaps not surprising that some people have begun to ask if this is an industry in need of tighter regulation. Critics charge that the inspection rules at permanent parks and at the traveling carnivals are haphazard at best.
Are people at greater risk than they need to be? Should the federal government regulate park rides? If so, to what extent?
Should parks be required to report their injuries? Will an amusement park that has a history of bad accidents remain in business?
SOURCE: http://www.msnbc.com/news/406816.asp
PARK RIDES: WHO REGULATES AND INSPECTS?
In The NEWS
Should the federal government regulate amusement park rides?
Rank Coaster Park Opened Speed
1st Top Thrill Dragster Cedar Point 2003 120 mph 2nd Dodonpa Fujikyu Highlands 2001 106.8 mph 3rd Superman The Escape Six Flags Magic Mountian 1997 100 mph 3rd Tower of Terror Dreamworld 1997 100 mph 4th Steel Dragon 2000 Nagashima Spa Land 2000 95 mph
SOURCE: http://www.ultimaterollercoaster.com
Top 5 Fastest Roller Coasters in the World SECTION 8.3
EXHIBIT 1
CONSIDER THIS:
This story is really about the pros and cons of government involvement on consumer safety issues.
Proponents of governmental intervention in private market decisions can point to numerous instances where nonintervention has been accompanied by financial or even physical harm to consumers. Citing one example, medical studies suggest that millions are spent annually on herbs and vitamins that may be totally useless, or perhaps harmful, from a health or nutrition standpoint.
In the area of product safety, thousands are injured annually by defective products, be they relatively large adult goods like lawn mowers and power saws or small toys for children. In the past, studies have shown that some children's clothing is highly flammable, that excessively wide slats in cribs have caused death or injury, and so on. Governmental involvement in the market decision has attempted to address these problems.
© Chad Slattery/Stone
It may be argued that strong product liability laws can make it unprofitable for firms to engage in selling dangerous, shoddy merchandise or in deceptive marketing practices. Lawsuits and declining sales would hurt the firm that sells an inferior product.
For example, a major airline crash might cost an airline $50 million to $100 million, so airlines have a very substantial incentive to have safe planes independent of governmental regulation.
Ultimately, the decision of how much governmental consumer protection is a normative one.
Few persons would advocate no governmental involvement, but few would favor the opposite extreme, where products are made and sold according to government specification with little or no decision making either by demanders or private suppliers of products. In between these extremes, there is much room for agreement and disagreement.
ASYMMETRIC INFORMATION AND ADVERSE SELECTION
When the available information is initially distributed in favor of one party relative to another,
asymmetric information is said to exist. One classic example of asymmetric information occurs in the used car market, where the information the seller of a used car has about the car's condition is superior to the information a potential buyer would have. Suppose the seller of a defective used car (a “lemon”) knows the car's defects, but the potential buyer does not. Without incurring significant quality detection costs, like having it inspected by a mechanic, the buyer is at an informational disadvantage relative to the seller. It is rational for the seller to claim that the car is in good shape and has no known defects, but the potential buyer cannot detect whether the car is a lemon or not without incurring costs. If the quality detection costs are sufficiently high, a solution is to price all used cars as if they are average quality.
That is, used cars of the same year, make, and model generally will be offered at the same price, regardless of their known conditions. This means that the seller of a lemon will receive a payment that is more than the car is worth, and the seller of a relatively high-quality car will receive less than the car is worth. However, if a seller of a highquality car does not receive what the car would sell for if the buyer knew its quality, the seller will rationally withdraw the offer to sell the car. Given the logical response of sellers of higher-than-average quality cars, the average quality of used cars on the market will fall, and consequently, many people will avoid buying in the used car market. In other words, the bad cars will drive the good cars out of the market. This phenomenon, where one party enters into an exchange with another party that has more information, is called adverse selection.
This distortion in the used car market resulting from adverse selection can be reduced by the buyer acquiring more information so that the buyer and seller have equal information. In the used car example, this might mean that an individual buyer would demand that an independent mechanic do a detailed inspection of the used car or that the dealership provide an extended warranty. In addition, there are new services like carfax.com where you can pay to find the history of a used car before you buy it.
These services would help in eliminating the adverse selection problem because buyers would have more information about the product they are buying.
The least-cost solution would have sellers reveal their superior information to potential buyers. The problem is that it is not individually rational for the seller to provide a truthful and complete disclosure, and this is known by a potential buyer. Only if the seller is punished for not truthfully revealing exchange- relevant information will a potential buyer perceive the seller's disclosure as truthful.
SIGNALING AND SCREENING
The existence of asymmetric information may give rise to signaling behavior. For example, consider a person looking for a job. The job hunter—the prospective employee—knows much more about the quality of the labor he can provide than the firm does. A potential employer has little knowledge of the candidate's abilities: Is he a hardworking, responsible, skilled worker, or a “slacker”? The firm cannot find this out until much later. That is, there is asymmetric information in the labor market because one party has more information than the other. It would be in the best interest of the job candidate to supply as much valuable information as possible about is personal characteristics that are not on the resume. Therefore, it is rational for prospective job candidates to send signals identifying their unique characteristics. The problem is that some of the candidates will possess superior characteristics, but which candidates? If
152 CHAPTER EIGHT | Market Failure and Public Choice
knowledge and intelligence are important for the job, then years of education is a strong signal in the labor market. Those who have performed well in school and have taken rigorous courses may be the company's best bet. While a college education may increase an individual's productivity, the degree may send a more important signal about the person's intelligence and perseverance. In sum, education may be an important screening device that helps businesses make better choices about prospective employees. More productive workers will likely obtain greater levels of education to signal their productivity to employers in hopes of achieving higher paying jobs.
Signals are important to employers because it cuts hiring costs. It would be very expensive to allow each candidate a “tryout.” Hiring is usually a costly procedure, and to search for, interview, and train each candidate to find out who is the best would be prohibitively costly.
What Is Moral Hazard?
Another information problem associated with the insurance market is called moral hazard. If an individual is fully insured for fire, theft, auto, life, and so on, what incentives will this individual have to take additional precautions from risk? For example, a person with auto insurance may drive less cautiously than would a person without auto insurance.
Insurance companies do, however, try to remedy the adverse selection problem by requiring regular checkups, discounts for nonsmokers, charging different deductibles and different rates for different age and occupational groups, and so on.
Additionally, those with health insurance may devote less effort and resources to staying healthy than those who are not covered. The problem, of course, is that if the insured are behaving more recklessly than they would if they were not insured, the result might be much higher insurance rates.
The moral hazard arises from the fact that it is costly for the insurer to monitor the behaviors of the insured party. Suppose an individual knew that his car was protected with a “bumper to bumper” warranty. He might have less incentive to take care of the car, despite the manufacturer's contract specifying that the warranty was only valid under “normal wear and tear.” It would be too costly for the manufacturer to detect if a product failure was the consequence of a manufacturing defect or the abuse of the owner-user.
Imperfect Information 153 Asymmetric information occurs when the available information is initially distributed in favor of one party relative to another. In the used car market, the problem of asymmetric information can be reduced if a private seller can show records of regular maintenance and service and dealers can offer extended warranties.
© 21114 PhotoDisc
If individuals know a lot more about their health condition than an insurance company, do we have a case of adverse selection?
Yes. Even after a medical examination, individuals will know more about their health than the insurance company.
That is, the buyers of health insurance have a better idea about their overall body conditions and nutritional habits than the seller, the insurance company. People with greater health problems tend to buy more health insurance than those who are healthy. This drives up the price of health insurance to reflect the costs of sicker-than-average people, which drives people of average health out of the market. So the people who end up buying insurance will be the riskiest group.
ADVERSE SELECTION
USING WHAT YOU'VE LEARNED
A Q
As we have discussed in this chapter, when the market fails, as in the case of an externality or public good , it may be necessary for the government to intervene and make public choices. However, it is possible that government actions in response to externalities may make matter worse. That is, just because markets have failed to generate efficient results does not necessarily mean that government can do a better job—see Exhibit 1. One explanation for this is presented in public choice theory.
WHAT IS PUBLIC CHOICE THEORY?
Public choice theory is the application of economic principles to politics. Public choice economists believe that government actions are an outgrowth of individual behavior. Specifically, they assume that the behavior of individuals in politics, like those in the marketplace, will be influenced by self-interest.
Bureaucrats, politicians, and voters make choices that they believe will yield them expected marginal benefits that are greater than their expected marginal costs. There are, of course, differences between the private sector and the public sector in the “rules of the game.” The self-interest assumption is, however, central to the analysis of behavior in both arenas.
IS SCARCITY ALIVE AND WELL IN THE PUBLIC SECTOR?
The self-interest assumption is not the only similarity between the market and public sectors. For example, scarcity is present in the public sector as well as in the private sector. Public schools and public libraries come at the expense of something else. Competition is also present in the public sector, as different government agencies compete for government funds, and lobbyists compete with each other to get favored legislation through Congress.
154 CHAPTER EIGHT | Market Failure and Public Choice
1. Individuals will search for additional information as long as the expected marginal benefit gained from that information is greater than the expected marginal cost of obtaining it.
2. The government can reduce information costs to consumers and producers, permitting them to make better decisions.
3. Government information policies can be costly if the information provided is inaccurate, misleading, or relatively useless, or results in other market imperfections.
4. Asymmetric information and moral hazard are information problems that can distort market signals.
1. How long should you continue to seek more information before making a decision?
2. How long will you continue to look for a $100 bill you have lost? How does the amount of time you have already spent looking for it affect how much longer you will look?
3. How do substantial warranties offered by sellers of used cars act to help protect buyers from the problem of asymmetric information and adverse selection? Why might too extensive a warranty lead to a moral hazard problem?
4. If where you got your college degree acted as a signaling device to potential employers, why would you want the school from which you graduated to raise its academic standards after you leave?
5. What is the rationale for government provision of information?
6. What are the objections to government provision of information?
7. Why do consumers spend more time researching the purchase of a home than of an electric can opener?
8. If someone argued that we need occupational licensing of gardeners to guarantee that misinformed consumers do not get shoddy service, is that person more likely to be a highly trained gardener or a homeowner who uses a gardening service? Why?
s e c t i o n c h e c k
Public Choice
s e c t i o n
8.4
¡ What is public choice theory?
¡ What is the median voter model?
¡ What is rational ignorance?
¡ Why do special-interest groups arise?
WHAT IS AN INDIVIDUAL-CONSUMPTIONPAYMENT LINK?
In private markets, when a shopper goes to the supermarket to purchase groceries, the shopping cart is filled with many different goods that the consumer presumably wants and is willing to pay for; this reflects the individual-consumptionpayment link. The link breaks down when there is an assortment of political goods that have been decided on by the majority rule. These political goods might include such items as additional national defense, additional money for the space program, new museums, new public schools, increased foreign aid, and so on. While an individual might be willing to pay for some of those goods, it is unlikely that she will want to consume or pay for all of them that have been placed in the political shopping cart.
However, if the majority has decided that these political goods are important, the individual will have to purchase the goods through higher taxes, whether he values the goods or not.
MAJORITY RULE AND THE MEDIAN VOTERS
In a two-party system, the candidate with the most votes wins the election. Because voters are likely to vote for the candidate that holds views similar to theirs, the candidates must pay close attention to the preferences of the majority of voters.
For example, in Exhibit 2 we assume a normal distribution, with a continuum of voter preferences from the liberal left tail to the conservative right tail.
We can see from the figure that only a few are extremely liberal or extremely conservative. A successful campaign would have to address the concerns of the median voters (those in the middle of the distribution in Exhibit 2), resulting in moderate policies.
For example, if one candidate ran a fairly conservative campaign, attracting voters at and to the right of V1, an opponent could win by a landslide by taking a fairly conservative campaign just to the left of this candidate. Alternatively, if the candidate takes a liberal position, say V2, then the opponent can win by taking a position just to the right of that position.
In this case, it is easy to see that the candidate that takes the median position, VM, is less likely to be defeated. Of course, the distribution does not have
Public Choice 155 “Do you think that people in the government waste a lot of money we pay in taxes, waste some of it, or don't waste very much of it?”
`70 `72 `74 `76 `78 `80 `82 `84 `86 `88 `90 `92 `94 `96 `98 `00
A Lot 69 66 74 74 77 78 66 65 ** 63 67 67 70 59 61 59 Some 26 30 22 20 19 18 29 29 ** 33 30 30 27 39 34 38 Not Very Much 4 2 1 3 2 2 2 4 ** 2 2 2 2 1 4 3 Don't Know 1 2 2 3 2 2 3 2 ** 2 1 1 1 0 1 1
**No data available for 1986.
SOURCE: The National Election Studies
While markets may fail, this does not necessarily mean that the government will always improve economic outcomes.
Do People in Government Waste Tax Money, 1970-2000 (Percent of Population Agreeing)
SECTION 8.4
EXHIBIT 1
Is this person picking the items she wants? Do taxpayers always pay for what they want?
© Stephen Derr/The Image Bank
to be normal or symmetrical; it could be skewed to the right or left. Regardless of the distribution, the successful candidate will still seek out the median voters. In fact, the median voter model predicts there will be a strong tendency for both candidates to pick a position in the middle of distribution, and therefore the election will be very close.
This, of course, does not mean that all politicians will find or even attempt to find the median.
Politicians, for example, may take different positions because they have arrived at different predictions of voter preferences or merely misread the public sentiment, or they may think they have the charisma to change voter preferences.
VOTERS AND SPECIAL-INTEREST GROUPS
Representative democracy has been a successful mechanism for making social choices in many countries. But there are some important differences in the way democracy is ideally supposed to work and how it actually does work.
One of the keys to an efficiently working democracy is a concerned and informed electorate. Everyone is supposed to take time to study the issues and candidates and then carefully weigh the relevant information before deciding how to vote. Although an informed citizenry is desirable from a social point of view, it is not clear that individuals will find it personally desirable to become politically informed.
Obtaining detailed information about issues and candidates is costly. Many issues are very complicated, and a great deal of technical knowledge and information is necessary to make an informed judgment on them. To find out what candidates are really going to do requires a lot more than listening to their campaign slogans. It requires studying their past voting records, reading a great deal that has been written either by or about them, and asking them questions at public meetings. Taking the time and trouble to do these things—and more—is the cost that each eligible voter has to pay personally for the benefits of being politically informed. This might help to explain why the majority of individuals cannot identify their congressional representatives and most likely have little idea about their representative's views on Social Security, health care, tariffs and agricultural policies.
For many people, the costs of becoming politically informed are high, while the benefits are low.
As a result, most people limit their quest for political information to listening to the radio on the way to work, conversations with friends, casual reading, and other things they normally do anyway. Even though most people in society might be better off if everyone became more informed, it isn't worth the cost for most individuals to make an effort to become informed themselves. Public choice economists refer to this lack of incentive to be informed as rational ignorance. People will generally make
156 CHAPTER EIGHT | Market Failure and Public Choice
V2 VM
Number of Voters Political Positions
Conservative V1 Liberal
The Median Voter SECTION 8.4
EXHIBIT 2
The median voter model predicts that there will be a strong tendency for both candidates to pick a position in the middle of the distribution, such as VM, and that the election will be very close.
much more informed decisions as buyers than as voters. For example, you are likely to gather more information when making a decision on a car purchase than when you are deciding between candidates in an upcoming election. An uninformed decision on a car purchase will most likely impact your life much more than an uninformed decision on a candidate, especially since your vote will most likely not impact the outcome of the election.
The fact that one vote, especially in a state or national election, is highly unlikely to affect the outcome of the election may explain why some citizens choose not to vote. Many events may change the net benefits for voting like: candidates and issues on the ballot, weather, and distance to the polling booths. For example, we would certainly expect fewer voters to turn out at the polls on the day of a blizzard, as the blizzard would change the net benefits. We would also expect more voters at the polls if the election was predicted to be a close one, as emotions run higher and voters may perceive their individual vote to be more significant.
If the cost of being an informed voter is high and the benefits low, why do people vote? Many people vote for reasons other than affecting the outcome of the election. They vote because they believe in the democratic process and because of civic pride. In other words, they perceive the benefits they derive from being involved in the political process outweigh the costs.
Furthermore, rational ignorance does not imply that people should not vote, it is merely one explanation for why some people do not vote. The point that public choice economists are makintg is that some people will vote only if they perceive that their vote will make a difference and will not vote if they think their vote will not make a difference.
Special-Interest Groups?
While many voters might be uninformed about specific issues, others have a large stake in being politically informed. For example, individuals may have a strong motivation to organize a special-interest group. These groups may have intense feeling and interest in particular issues that may be inconsistent with the general public. However, as a group, these individuals are more likely to influence decision makers and have a far greater impact on the outcome of a political decision than they would with their individual votes.
If the special-interest group is successful in getting everyone else to pay for a project that benefits them, the cost will be spread over such a large number of taxpayers that the amount any one person will have to pay is negligible. There isn't much motivation for an individual citizen to spend time and effort to resist an interest group, even if she had a guarantee that this resistance would be effective.
For example, many taxpayers and consumers are unaware of the federal subsidy to sugar growers.
The subsidy is estimated to cost consumers over $1 billion a year or less than $5 per person. However, the gain from the subsidy is estimated to be over $100,000 per sugar grower. At that price, few customers are going to invest the time and money to fight this issue. However, the effort to keep the subsidy is surely enough to get sugar growers to make trips to Washington, D.C. and help in political campaigns.
WHAT IS THE BEST WAY TO CONTROL GOVERNMENT?
According to public choice economists, the best hope for controlling government is by presenting a political package that calls for a simultaneous reduction in many programs. No special-interest group will be willing to sacrifice its program if it expects to be required to continue paying for the programs of others. However, if government has grown to the point where people feel they are not getting their money's worth for the taxes they pay, many groups will be willing to see their programs reduced—if it means some savings on the taxes paid to support everyone else's programs.
Public Choice 157 Why is voter turnout frequently so low? Will the turnout be greater when voters perceive the elections to be closer? Why do some choose not to vote at all?
© Mark Richards/PhotoEdit
158 CHAPTER EIGHT | Market Failure and Public Choice
By Roger G. Noll
WASHINGTON—Even at a time when major league sports have become a cartoon of financial excess, the proposed new home for the Yankees is breathtaking in its audacity. Excluding land value, a multipurpose mausoleum on Manhattan's West Side would cost a billion dollars.
Independent studies of sports facilities invariably conclude that they provide no significant economic benefits. A sports team does increase overall income in a community slightly, but the increase never offsets the stadium's financing and operating costs.
And because a team
has relatively few (but very highly paid) employees, it usually causes overall employment in a city to fall because it can drive other entertainment businesses to cut back or close.
Stadiums are bad investments, which is why the teams themselves are never willing to pay for them. New York City would generate more cash by putting the money in a savings account.
SOURCE: Roger G. Noll, New York Times, April 11, 1996, p. A17.
WILD PITCH
In The NEWS
CONSIDER THIS:
Many big cities have either built or are planning to build big sports arenas, largely at taxpayers' expense. According to proponents, the new sports arenas will bring recognition and fame to the city, and this will benefit everyone who lives in the city because they will be living in a more prestigious community.
Hence, everyone in the city should contribute to the sports arena, whether they go to the games or not.
However, the people who receive the primary benefits from a better sports arena are first, the owners; second, the players; and third, those who frequent it to watch ball games.
Further, it's easy to prevent a fan from receiving this benefit if he or she doesn't pay at the gate. The assertion that everyone would benefit from the arena whether he or she goes to the games or not must be questioned. A sports arena will generate growth and congestion that many people will find undesirable.
To these people, being forced to pay for a big sports center makes no sense.
Perhaps some people who never go to a sporting event feel a little bit better just knowing they can. This is what economists call option demand. But does this justify commandeering funds from everyone in the city to build a sports arena?
What about fine restaurants? Certainly, fine restaurants enhance the reputation of the city. Many people are happy to know that one is nearby, waiting to serve them, whether they visit it or not. However, most people would find a proposal to publicly finance restaurants very farfetched. If desirable side effects justified government subsidies, well-kept yards, car washes, toothpaste, deodorants, and smiles would all qualify for a handout.
Regardless of the desirability of requiring the public to pay for certain projects, it should be noted that specialinterest groups expend a lot of effort to get subsidies for those projects from which they receive enjoyment and profit. Many of these efforts have been successful; the sports arena example is only one of many. The more “cultured,” and usually wealthier, members of many cities have managed to obtain government support for symphonies, operas, ballet, and the performing arts in general. The stated justification for requiring everyone to pay for entertainment that caters primarily to the tastes of the rich is similar to that given for subsidizing sports arenas. Supposedly, everyone in a community will benefit, even those who prefer to sit home with a can of beer and watch all-star wrestling on television.
© Eric Riberrg/AP Photo
And because a team
Summary 159
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If a market activity has a negative physical impact on an outside party, that side effect is called a negative externality. The government can use taxes or other forms of regulation to correct the overallocation problem associated with negative externalities. If a market activity has a positive physical impact on an outside party, that side effect is called a positive externality.
The government can provide subsidies or other forms of regulation to correct the underallocation problem associated with positive externalities.
A public good is both nonrivalrous in consumption (one person's usage of it does not diminish another's ability to use it) and nonexcludable (no one can be excluded from using it). A free rider is someone who attempts to enjoy the benefits of a good without paying for it. The government provides public goods because the free-rider problem results in underproduction of these goods in the marketplace.
The government can reduce information costs to consumers and producers, permitting them to make better decisions. Government information policies can be costly if the information provided is inaccurate, misleading, or relatively useless, or results in other market imperfections. Asymmetric information and moral hazard are information problems that can distort market signals.
Public choice theory is the theory that the behavior of individuals in politics, like that in the marketplace, is influenced by self-interest.
Summar y
1. Public choice theory is the theory that the behavior of individuals in politics, like that in the marketplace, is influenced by self-interest.
2. Rational ignorance is the condition in which voters tend to be relatively uninformed about political issues because of high information costs and low benefits of being politically informed.
3. A special-interest group is a political pressure group formed by individuals with a common political objective.
4. Special-interest groups are more likely to have an impact on the outcome of a social decision than their members would if they voted individually.
1. What principles does the public choice analysis of government behavior share with the economic analysis of market behavior?
2. Why is there a strong tendency for candidates to pick positions in the middle of the distribution of voter preferences?
3. Why is it rational to be relatively less informed about most political choices than about your own market choices?
4. Why can't the majority of citizens effectively counter the political power of special-interest groups?
5. According to public choice theorists, what is the primary advantage of government? What is the biggest threat from the government?
6. Why are college students better informed about their own teachers' and schools' policies than about national education issues?
7. How can you be forced to pay for something you do not want to “buy” in the political sector? Is this sometimes good?
8. Why do you think news reporters are more informed than average citizens about public policy issues?
s e c t i o n c h e c k
160 CHAPTER EIGHT | Market Failure and Public Choice
externality 142 negative externality 143 positive externality 143 public goods 147 private goods 147 free rider 148 asymmetric information 152 adverse selection 152 moral hazard 153 rational ignorance 156 special-interest group 157
K e y Ter m s a n d C o n c e p t s
1. Indicate which of the following activities create a positive externality, a negative externality, or no externality at all:
a. During a live theater performance, an audience member's cell phone loudly rings.
b. You are given a flu shot.
c. You purchase and drink a soda during a break from class.
d. A college fraternity and sorority clean up trash along a two-mile stretch on the highway.
e. A firm dumps chemical waste into a local water reservoir.
f. The person down the hall in your dorm plays a Britney Spears CD loudly while you are trying to sleep.
2. Is a lighthouse a public good if it benefits many ship owners? What if it primarily benefits ships going to a port nearby?
3. Why do you think buffaloes became almost completely extinct on the Great Plains but cattle did not? Why is it possible that you can buy a buffalo burger in a store or diner today?
4. What kind of problems does the government face when trying to perform a benefit-cost analysis of whether and/or how much of a public project to produce?
5. How does a TV broadcast have characteristics of a public good? What about cable services like HBO?
6. If the government did not require firms to disclose the content of food products and nutritional information on packaging, how might individuals gather this information? Weigh the costs and benefits to an individual of obtaining such information. Why might it be more efficient for the government to gather or compel disclosure of food product information than for individuals to gather such information by themselves?
7. How would the adverse selection problem arise in the insurance market? How is it like the “lemon” used-car problem?
REVIEW QUESTIONS
CHAPTER 8: MARKET FAILURE AND PUBLIC CHOICE
8.1: Market Failure and Externalities
1. Why are externalities also called spillover effects?
An externality exists whenever the benefits or costs of an activity impacts individuals outside the market mechanism. That is, some of the effects spill over to those who have not voluntarily agreed to bear them or compensate others for them, unlike the voluntary exchange of the market.
2. How are externalities related to property rights?
Externalities involve goods for which there are not clearly defined property rights. For example, if you could demand, and receive, compensation for the costs that dirtier air imposes on SC-12 Section Check Answers you, you would have an effective property right to clean air, which you would give up voluntarily only if you were sufficiently compensated. But if your voluntary agreement is required, the effect is no longer an externality, but is internalized by the market mechanism.
3. How do external costs affect the price and output of a polluting activity?
Since the owner of a firm that pollutes does not have to bear the external costs of pollution, he can ignore those real costs of pollution to society. The result is that the private costs he must pay are less than the true social costs of production, so that the market output of the polluting activity is greater, and the resulting market price less, than it would be if producers did have to bear the external costs of production.
4. How can the government intervene to force producers to internalize external costs?
If the government could impose on producers a tax or fee, equal to the external costs imposed on people without their consent, producers would have to take into account those costs. The result would be that those costs were no longer external costs, but internalized by producers.
5. How does internalizing the external costs improve efficiency?
Internalizing external costs eliminates those trades where the marginal benefits to society (measured by the willingness to pay along the market demand curve) exceeded the private marginal costs, but were less than the social marginal costs (including the external costs). The resulting net gain in efficiency is that illustrated by the triangle in Exhibit 1 in this section.
6. How do external benefits affect the output of an activity that causes them?
External benefits are benefits that spill over to others, because the party responsible need not be paid for those benefits.
Therefore, some of the benefits of an activity to society will be ignored by the relevant decision makers in this case, and the result will be a smaller output and a higher price for goods that generate external benefits to others.
7. How can the government intervene to force external benefits to be internalized?
Just as taxes can be used to internalize external costs imposed on others, subsidies can be used to internalize external benefits generated for others.
8. Why do most cities have more stringent noise laws for the early morning and late evening hours than for during the day?
The external costs to others from loud noises in residential areas early in the morning and late in the evening are higher, because residents are home and trying to sleep, than when many people are gone at work or already awake in the daytime.
Given those higher potential external costs, most cities impose more restrictive noise laws for nighttime hours to reduce them.
8.2: Public Goods 1. How are public goods different from private goods?
Private goods are rival in consumption (we can't both consume the same unit of a good) and exclusive (non-payers can be prevented from consuming the good unless they pay for it). Public goods are non-rival in consumption (more than one person can consume the same good) and nonexclusive (non-payers can't be effectively kept from consuming the good, even if they don't voluntarily pay for it).
2. Why does the free-rider problem arise in the case of public goods?
The free-rider problem arises in the case of public goods because people cannot be prevented from enjoying the benefits of public goods once they are provided. Therefore, people have an incentive to not voluntarily pay for those benefits, making it very difficult or even impossible to finance the efficient quantity of public goods through voluntary market arrangements.
3. How does the free-rider problem relate to property rights?
The free-rider problem arises in cases where property rights to goods are not easy to prescribe and enforce-cases such as externalities and public goods.
4. In what way can government provision of public goods solve the free-rider problem?
The government can overcome the free-rider problem by forcing people to pay for the provision of a public good through taxes.
8.3: Imperfect Information 1. How long should you continue to seek more information before making a decision?
As with any other choice, one should continue to seek more information before making a decision as long as the expected marginal benefits from having added information exceeds the marginal expected costs of acquiring that information. This implies that it is often rational to be less than completely informed when making decisions.
2. How long will you continue to look for a $100 bill you have lost? How does the amount of time you have already spent looking for it affect how much longer you will look?
Say that you value your time at $20 an hour. You will look for the $100 bill as long as you expect to find it within the next 5 hours, because the expected benefits of search outweigh the expected costs of search in that case. In some cases, that might involve not searching at all, and in others, it could result in searching for a total of more than five hours.
The time you have already spent looking does not directly affect how much longer you will look, because those costs are now sunk, and so no longer relevant to decisionmaking.
However, if you (rationally) search the most likely places first, unsuccessful search in those places will lower the probability that you will find the $100 bill in the next 5 hours, and so can indirectly reduce how many additional hours you would be willing to search.
3. How do substantial warranties offered by sellers of used cars act to help protect buyers from the problem of asymmetric information and adverse selection? Why might too extensive a warranty lead to a moral hazard problem?
In the used car market, the seller has superior information about the car's condition, placing the buyer at an information disadvantage. It also increases the chance that the car being sold is a “lemon.” A substantial warranty can provide the buyer with valuable additional information about the condition of the car, reducing both asymmetric information and adverse selection problems.
Too extensive a warranty (e.g., an unlimited “bumper to bumper” warranty) will give the buyer less incentive to take Section Check Answers SC-13 care of the car, since he is effectively insured against the damage that lack of care would cause.
4. If where you got your college degree acted as a signaling device to potential employers, why would you want the school you graduated from to raise its academic standards after you leave?
If an employer used your college's academic reputation as a signal of your likely “quality” as a potential employee, you want the school to raise its standards after you graduate, because that will improve the average quality of its graduates, improving the quality it signals about you to an employer.
5. What is the rationale for government provision of information?
In some cases, the government might be able to gather or communicate information at lower costs than citizens could otherwise. By lowering information costs, more information is acquired before choices are made, and citizens benefit by making better informed choices (i.e., making fewer mistakes).
6. What are the objections to government provision of information?
Government provided information may be more costly to acquire than through market channels, it may be inaccurate or misleading, and it can be manipulated by special interest groups for their own advantages rather than to benefit consumers.
7. Why do consumers spend more time researching the purchase of a home purchase than of an electric can opener?
The likely benefits from an additional hour researching the purchase of a home is likely to be far larger, whether in terms of a better price or a better match for your preferences, than the likely benefits from spending that hour researching an electric can opener purchase.
8. If someone argued that we need occupational licensing of gardeners to guarantee that misinformed consumers don't get shoddy service, is that person more likely to be a highly trained gardener or a homeowner who uses a gardening service?
Why?
Occupational licensing has very often been advocated by existing producers of the services involved as a way to reduce competition from potential new producers who would otherwise enter and reduce the profits of the existing producers.
Most homeowners, on the other hand, feel sufficiently protected from serious problems with gardening services because of the market information conveyed by gardeners' reputations and the large number of alternative gardeners available.
8.4: Public Choice 1. What principles does the public choice analysis of government behavior share with the economic analysis of market behavior?
Public choice analysis of government behavior is based on the principle that the behavior of individuals in politics, just like that in the marketplace, is influenced by self-interest. That is, it applies basic economic theory to politics, looking for differences in incentives to explain people's behavior.
2. Why is there a strong tendency for candidates to pick positions in the middle of the distribution of voter preferences?
This is the result of the median voter model, because the candidate closer to the median is likely to attract a majority of the votes.
3. Why is it rational to be relatively less informed about most political choices than about your own market choices?
It is rational to be relatively less informed about most political choices because the costs of becoming more informed about political issues tend to be higher and the benefits of becoming more informed about political choices tends to be lower than for your own market choices.
4. Why can't the majority of citizens effectively counter the political power of special interest groups?
The majority of citizens can't effectively counter the political power of special interest groups because even if the special interest group is successful in getting everyone else to pay for a project that benefits it, the cost to each citizen will be small.
In fact, this cost is very likely far smaller than the cost to a member of the majority of becoming informed and active to successfully oppose it.
5. According to public choice theorists, what is the primary advantage of government? What is the biggest threat from the government?
The primary advantage of government is its ability to establish a legal and economic environment that provides general opportunity for people to benefit from their own efforts through productive cooperation with others. The biggest threat from government is the risk that its power can be captured by special interests and used to advance their objectives at the expense of the general public.
6. Why are college students better informed about their own teachers' and schools' policies than about national education issues?
The benefits from “local knowledge” of teachers and school policies can be large, say, in a higher GPA, and the costs of acquiring that information is typically low for those on campus.
On the other hand, the benefits from being more informed on national educational issues are typically much lower, because your actions are very unlikely to change those policies, and the cost of acquiring that information can be very large for what are far more complex national educational issues. The result is that students are better informed about their own teachers and school policies than national educational issues.
7. How can you be forced to pay for something you do not want to “buy” in the political sector? Is this sometimes good?
The government can use its power to tax to force you to pay for services they provide, even if you do not want to pay for those services. This can be useful, such as in overcoming the free rider problem in financing public goods or solving externality problems, as well as bad, as in the case of special interest dominance.
8. Why do you think news reporters are more informed than average citizens about public policy issues?
The benefits news reporters receive from being more informed about public policy issues are greater than for most citizens, because being better informed allows reporters to do a better job, which they benefit from in the form of higher wages, greater honors, and so forth. Because the benefits of being better informed are typically higher for news reporters, they are better informed than average citizens.