Transcript On Economic Efficiency

Economic Efficiency and
the Role of Government
Lecture by: Jacinto F. Fabiosa
Fall 2005
Economic Efficiency and the Role of
Government
• Virtually every disagreement about the economy ultimately leads to
government
– Some disagreements start there as well
• All these disagreements tend to obscure a remarkable degree of
agreement about the economy, and government’s role in it
– Vast majority of goods and services that you buy in stores, over the
internet, or obtain in other ways
• Are provided by private firms—and almost everyone agrees that’s how it should
be
• Widespread agreement that certain goods and services should be
provided by government
– Such as general police protection, the court system, and national defense
• Much of this agreement is based on ideas about economic efficiency
2
The Meaning of Efficiency
• What, exactly, does efficiency mean?
– Economic efficiency is achieved when there is no way to rearrange
the production or allocation of goods in a way that makes one
person better off without making anybody else worse off
• A limited concept in that
– An efficient economy is not necessarily a fair economy
• Why do economists put so much stress on efficiency,
rather than fairness?
– Issues of fairness must be resolved politically
• Economics can make a major contribution to our material
well being by
– Helping us understand the preconditions for economic efficiency,
– Teaching us how we can bring about those preconditions
3
Pareto Improvements
• A trade in which both parties are made better off, and no
one is harmed
• Named after Italian economist, Vilfredo Pareto (1848-1923)
– First systematically explored the issue of economic efficiency
• Helps us arrive at a formal definition of economic efficiency
– Achieved when every possible Pareto improvement is exploited
• Alternatively, we can look at the economy as a whole
– If we discover remaining Pareto improvements that are not occurring
then we would deem the economy economically inefficient
• Perfectly competitive markets tend to be economically
efficient, and
– Well-functioning market economics tend to lie close to the
economically efficient end of the spectrum
4
Side Payments and Pareto
Improvements
• There are more complicated situations in which a Pareto improvement
will come about
– Only if one side makes a special kind of payment to the other—called a
side payment
– Situations in which action will benefit one group and harm another
• If an action creates more total benefits for gainers than total harm to
losers
– Than a side payment exists which—if transferred from gainers to losers—
would make the action a Pareto improvement
• Important implication for economic efficiency
– If there is an action that benefits some more than it harms others, and if an
appropriate side payment can be easily arranged
• Than not taking the action is a waste of an opportunity to make everyone better
off
• When a side payment cannot be made—or for any reason is not
made—then even of action might create greater gain than harm, it
might not be considered fair
5
Markets and Economic Efficiency
• In a market system, firms and consumers are
largely free to produce and consume as they wish,
without anyone orchestrating the process from
above
– Can we expect such unsupervised trading to be
economically efficient?
• Yes—as long as trading takes place in perfectly
competitive markets
– To demonstrate this, we’ll return to the tools we’ve used
to analyze competitive markets
• Demand and supply curves
• But we’ll look at them in a slightly different way
6
Reinterpreting the Demand Curve
• Figure 1 shows a market demand curve for guitar lessons
– Quantity demanded per week at each price
• Also indicates who would be taking each lesson
• Standard way of thinking about a market demand curve
• But we can also view the curve in a different way
– Maximum price someone would be willing to pay for each unit of
good
– Tells us how much that unit is worth to the person who buys it
• Each guitar lesson in the market has a different value
– In part, this is because consumers differ in their incomes and
tastes
• But also—for each individual—value of additional lessons
declines as more lessons are taken
– Height of market demand curve at any quantity shows us value—to
someone—of last unit of good consumed
7
Figure 1: The Marginal Benefit From
Guitar Lessons
8
Reinterpreting the Supply Curve
• Now let’s look at supply side of the market
– Figure 2 shows supply curve for guitar lessons—quantity offered each
week at various prices
– Indicates who would be supplying each lesson
• But supply curve also tells us the minimum price a seller must get in
order to supply that lesson
• Why does it take higher prices to get more lessons?
– Because offering lessons is costly to guitar teachers
• As any one teacher devotes more and more time to giving lessons,
opportunity cost of his time will rise
– Giving more lessons means less time left for other activities
– As leftover time becomes scarcer, value of each remaining hour rises
• Height of market supply curve at any quantity shows additional cost—
to some producer—of each unit of good supplied
9
Figure 2: The Marginal Costs of Guitar
Lessons
10
The Efficient Quantity of a Good
• Figure 3 combines supply and demand curves for guitar lessons
– Whenever—at some quantity—demand curve is higher than supply curve
• Value of last unit to consumer is greater than its additional cost to some
producer
• Whenever demand curve lies above supply curve, producing the
lesson is a Pareto improvement
– Whenever demand curve lies below supply curve, producing the lesson
cannot be a Pareto improvement
– Efficient quantity of guitar lessons—the quantity at which all Pareto
improvements are exploited—is where the demand curve and supply
curve intersect
– At this quantity, value of the last good produced will be equal to—or
possibly a tiny bit greater than—the cost of providing it
• Efficient quantity of a good is quantity at which market demand curve and
market supply curves intersect
11
Figure 3: Efficiency In The Market For
Guitar Lessons
12
Perfect Competition and Efficiency
• In a well-functioning, perfectly competitive market,
equilibrium quantity is also efficient quantity
– If we leave producers and consumers alone to trade
with each other as they wish
– Market will exploit every opportunity to make someone
better off that doesn’t harm anyone else
• As long as market is working well, and it’s perfectly competitive
• Types of goods produced in competitive markets
will reflect consumer preferences
– If a good has such low value—relative to its cost—that
demand curve lies below supply curve at all quantities,
it will not be provided
13
Perfect Competition and Efficiency
• The notion that perfect competition—where many
buyers and sellers each try to do the best for
themselves—actually delivers an efficient
economy is one of the most important ideas in
economics
– Adam Smith coined term ‘invisible hand’ to describe the
force that leads a competitive economy relentlessly and
automatically toward economic efficiency
• Recognize the end promoted by invisible hand as
economically efficient outcome
14
Consumer Surplus
• Useful to measure the benefits that producers and
consumers receive from their economic activities
• A buyer’s consumer surplus on a unit of a good
– Difference between its value to buyer and what buyer
actually pays for the unit
• Total consumer surplus enjoyed by all consumers
in a market is called market consumer surplus
– Sum of consumer surplus on all units
– Market consumer surplus at any price—measured in
dollars—is total area under market demand curve and
above market price
15
Figure 4(a): Consumer Surplus in a Small and Large
Market for Guitar Lessons
16
Figure 4(b): Consumer Surplus in a Small and Large
Market for Guitar Lessons
17
Producer Surplus
• An individual seller’s producer surplus on a unit of
a good
– Difference between what seller actually gets and
additional cost of providing it
• Total producer surplus gained by all sellers in a
market is called market producer surplus
– Found by adding up producer surplus gained by all
sellers in market
– Market producer surplus at any price—measured in
dollars—is total area above market supply curve and
below market price
18
Figure 5(a): Producer Surplus From
Selling Guitar Lessons
19
Figure 5(b): Producer Surplus From
Selling Guitar Lessons
20
Total Net Benefits in a Market
• Measure total net benefits gained in a
market as
– Sum of consumer and producer surplus in that
market
• In Figure 6
– Blue shaded area represents market consumer
surplus
– Pink shaded area is market producer surplus
– Total shaded area represents total net benefits
21
Figure 6: Total Net Benefits in a
Competitive Market for Guitar Lessons
22
Perfect Competition and Efficiency: The
Total Benefits View
• Each time we make a Pareto improvement in a market
– We make at least one party better off and make no one else worse
off
– Therefore, a Pareto improvement will increase total net benefits
available in a market
– Thus, we have a new way of viewing efficiency
• A market is efficient when sum of producer and consumer surplus is
maximized in that market
• In a well-functioning, perfectly competitive market
– Equilibrium quantity provides maximum possible benefit to buyers
and sellers combined, and is the efficient quantity
23
A Price Ceiling
• Creates greater harm for sellers than gains for
buyers
– Reduces total net benefits in the market in a perfectly
competitive market
• Welfare loss in a market is dollar value of potential
benefits not achieved due to inefficiency in that
market
• Although a price ceiling may benefit consumers as
a group it will always reduce total net benefits in
the market
24
Figure 7(a): Why Price Ceilings and
Price Floors Are Inefficient
25
Figure 7(b): Why Price Ceilings and
Price Floors Are Inefficient
26
Calculating the Welfare Loss
• Let’s calculate dollar value of welfare loss caused
by price ceiling
– Area of unshaded triangle formed by areas D and E
together
• From high school algebra, area of any triangle is ½ x base x
height
• Welfare loss = ½ x base x height = ½ x $8 x 2,000
= $8,000
• When this market is delivering only 2,000 lessons
per week instead of the efficient 4,000
– Guitar teachers and students together lose $8,000 in
potential benefits per week or
– Welfare loss would be 52 weeks x $8,000 per week =
$416,000 per year
27
A Price Floor
• In a perfectly competitive market, the price
floor will always shrink total net benefits
• Reduces total benefits in market (causes a
welfare loss)
28
The Efficiency Role of Government
• When a well-functioning, perfectly competitive market is
permitted to reach its equilibrium, the outcome is efficient
– No opportunities for mutual gain remain unexploited
– Any government intervention that changes the market quantity
(say, a price ceiling or a price floor) will create inefficiency—a
welfare loss
• But government can—and does—contribute to the
economic efficiency of markets
– Provides infrastructure that permits markets to function
• Physical infrastructure—bridges, airports, waterways, and buildings
• Institutional infrastructure—laws, courts, and regulatory agencies
– Stepping in when markets are not working properly
• When they leave Pareto improvements unexploited and therefore fail
to achieve economic efficiency
29
The Institutional Infrastructure of a
Market Economy
• Americans take their institutional infrastructure almost completely for
granted
• In some countries
– Police are more likely to steal from citizens than to protect them from
thievery
– People have no effective rights to their own property
– If a person is injured by a drunk driver, there may be no system for
compensating her or punishing the driver
– Powerful mafias exist that extort protection money by threatening to shut
down businesses or physically harm their owners
• In nations with highly developed and stable legal infrastructures, such
incidents are the exception
• When countries are divided into three groups, according to the quality of
their institutional infrastructure
– There is a strong relation between infrastructure and output per worker
30
Figure 8: Government Infrastructure and
Output per Worker
31
The Legal System: Criminal Law
• The backbone of a market economy’s institutional
infrastructure is the legal system
• Criminal law
– While criminal law has important moral and ethical
dimensions
• Central economic function is to limit exchanges to voluntary
ones
– By making most involuntary exchanges illegal, criminal
law helps to channel our energies into exchanges and
productive activities that benefit all parties involved—
Pareto improvements
• In this way, criminal law contributes to economic efficiency
32
Property Law
• Property law gives people precisely defined, enforceable
rights over things they own
• When property rights are poorly defined
– Much time and energy are wasted in disputes about ownership
• People spend time trying to capture resources from others
– Time that could have been spent producing valuable goods and services
• Property law contributes to economic efficiency by
increasing total production
– Raising total benefits that markets can provide by reducing
disputes about property
– Channeling resources into production
33
Contract Law
• In countries in which contract law is less well
defined or less strictly enforced, investors would
worry that they would not be able to collect their
share
• A contract is a mutual promise
– Often one party does something first and the other
party promises to do something later
• Contracts play a special role in a market economy
– Without them, only Pareto improvements involving
simultaneous exchange could take place
• You get a bag of apples from a farmer and simultaneously hand
over some money
34
Contract Law
• Contracts enable us to make exchanges that take place over time and
in which one person must act first
– In this way, contracts help society enjoy the full benefits of specialization
and exchange
• Legal enforcement of contacts is not the only force that makes people
keep promises
– Parents, religious organizations, and schools teach people that keeping
promises is a moral obligation
– A reputation for failing to keep promises would be harmful to a business or
a person
• While socialization and concern over reputation are important,
contracts and the infrastructure for enforcing them play vital role in
making economy more efficient
• Because of contract law, people are more willing to take a chance with
a new business
– Since they know that they have a law behind them if new business
reneges on a deal
35
Tort Law
• Deals with interactions among strangers or people not
linked by contracts
• Specifically, a tort is a wrongful act—such as
manufacturing an unsafe product—that causes harm to
someone, and for which the injured person can seek
remedy in court
– Tort law defines types of harm for which someone can seek legal
remedy
• And what sorts of compensation the injured person can expect
• When people and business are held responsible for
injuries they cause, they act more carefully
• Also protects against fraud
– In which a seller of something—a product, a business, shares of
stock—lies to the buyer in order to make the sale
36
Antitrust Law
• Designed to prevent business from making agreements or
engaging in other behavior that limits competition and
harms consumers
– Operates in three areas
• Agreements among competitors
– U.S. antitrust law—expressed in Section 1 of Sherman Act—prohibits
“contracts, combinations, or conspiracies” among competing firms that
would harm consumers by raising prices
• Monopolization
– Section 2 of Sherman Act Makes it illegal to monopolize or attempt to
monopolize a market
• Mergers
– In a merger, two firms combine to form one new firm
» The result is to increase the danger of higher prices from oligopoly or
monopoly
» Mergers of this type are often blocked by U.S. government based on
Section 7 of Clayton Act
37
Regulation
• Important part of the institutional infrastructure that
supports a market economy
– Under regulation, a government agency—such as the Food and
Drug Administration (FDA), the Environmental Protection Agency
(EPA), or a state public utilities commission—has power to direct
business to take specific actions
• In addition to protecting public safety and health
– Regulation is also used to help markets function more efficiently
• Regulation differs from use of legal procedures in a
fundamental way
– Regulators reach deep into the operations of business to tell them
what to do
• While legal procedures typically result in fines or other penalties if
businesses do something wrong
38
Law and Regulation in Perspective
• Invisible hand of market system cannot
operate on its own
– Legal system, along with regulatory agencies,
creates an environment in which invisible hand
can do its job
– Almost every Pareto improvement that we can
think of relies on legal and regulatory
infrastructure
• But what about cases where law and regulation don’t
seem to be working perfectly?
– Does this mean that our institutional infrastructure is failing
us?
39
Law and Regulation in Perspective
• Yes…and no
– While instances like these are never welcome, society has chosen
not to eliminate them entirely
– Must balance benefits—safer products, reduced crime—against
costs
• A legal and regulatory system that ensured the complete
elimination of crime, unsafe products, and other
unwelcome activities would be less efficient than a system
that tolerated some amount of these activities
– An efficient infrastructure must consider the costs, as well as the
benefits, of achieving our legal and regulatory goals
40
Market Failures
• Another vitally important role for government
– To intervene in situations of market failure
• When a market equilibrium—even with the proper institutional
support—is economically inefficient
• General types of market failures to which
economists have devoted a lot of attention
– Monopoly power
– Externalities
– Public goods
• While economists and policy-makers agree in
theory on what causes a market failure
– Dealing with real-world market failures remains one of
the most controversial aspects of government policy
41
Monopoly and Monopoly Power
• A firm has monopoly power when it can influence
the price that it charges for its product
– A market with just one seller, or a few oligopolists who
cooperate and behave as a monopoly, is a more
serious market failure
• Monopoly and imperfectly competitive markets—
in which firms charge a single price greater than
marginal cost—are generally inefficient
– Price is too high, and output is too low, to maximize net
benefits in market
• What can government do to make this monopoly
market more efficient?
42
Figure 9: The Welfare Loss from
Monopoly
43
Anti-trust Law as a Remedy
• In the case of the guitar-lesson monopoly, there may be a
solution
– Since this market would function very well under competitive
conditions, the government could use anti-trust law to break the
monopoly into several competing firms
• But breaking up a monopoly would not make sense when the market
would perform even worse with more competition
• Monopolies that arise from patents and copyrights, provide
an incentive for artistic creations and scientific discovery
• Monopoly power that arises from network externalities
offers benefits that would be hard to achieve under more
competitive conditions
• When a monopoly arises as a natural monopoly
– Using anti-trust law to break it up or even to prevent its formation in
the first place is a poor remedy
44
The Special Case of Natural Monopoly
• A natural monopoly exists when, due to economies of
scale, one firm can produce for the entire market at a
lower cost per unit than can two or more firms
– If government steps aside, such a market will naturally evolve
toward monopoly
• If breaking up a natural monopoly is not advisable, what
can government do to bring us closer to economic
efficiency?
– One option is public ownership and operation
• Public takeover of private business is rare, except when certain
conditions are present
– That leaves one other option
• Regulation
45
Figure 10: Regulating A Natural
Monopoly
46
Regulation of Natural Monopoly
• Under regulation, a government agency digs deep
into the operations of a business and takes some
of the firm’s decisions under its own control
– In the case of a natural monopoly, regulators are
interested in achieving economic efficiency, which they
do by telling the firm what price it can charge
• At first glance, you might think that natural
monopoly regulators have an easy job
• Unfortunately, it’s not that easy
– There is the matter of information
• Regulators must be able to trace out firm’s MC curve as well as
market demand curve
47
Regulation of Natural Monopoly
• Even with perfect information about
monopolist’s cost and demand curves,
regulators have a serious problem
– Look again at Figure 7—notice that MC curve
lies everywhere below LRATC curve
– Problem for regulators
• If they set the efficient price of $15 so that buyers
demand efficient quantity of 100,000, firm’s cost per
unit is greater than $15
– Firm will suffer a loss
– In long-run, it will go out of business
48
Regulation of Natural Monopoly
• Leaves regulatory agency with two alternatives
– Set prices to MC and subsidize the monopoly from the general
budget, to make up for the loss
• In practice, however, regulators in market economies
around the world have usually chosen a different solution
– Regulators determine a price that gives owners a “fair rate of
return” for funds they’ve put into the monopoly
– Should give monopoly what economists call normal profit
• Profit just high enough to cover all of the owners’ opportunity costs,
including the foregone interest of their own funds
• What price will accomplish this?
– A fair rate of return is already built into LRATC curve
– This strategy—called average cost pricing—is the most common
solution chosen by regulators of natural monopolies
49
Regulation of Natural Monopoly
• With average cost pricing, regulators strive to set price
equal to cost per unit where LRATC curve crosses
demand curve
– At this price, the natural monopoly makes zero economic profit
• Which provides its owners with a fair rate of return, and keeps the
monopoly in business
• Average cost pricing is not a perfect solution
– Does not quite make the market efficient
– Provides little or no incentive for the natural monopoly to
economize on capital
• Tendency of regulated natural monopolies to overinvest in capital is
known as the Averch-Johnson effect, after the two economists who
first explained it
• Averch-Johnson effect is a specific example of a more general idea
– When a firm is not striving to maximize profit (in this case, because the
government is guaranteeing a specific rate of return)
» Firm need not economize on costs
50
Externalities
• When a private action has side effects that
affect other people in important ways, we
have the problem of externalities
– By-product of a good or activity that affects
someone not immediately involved in
transaction
51
The Private Solution to a Negative
Externality
• Under certain conditions, inefficiency that
would be caused by a negative externality
will automatically be resolved by the parties
themselves
– The outcome is the efficient outcome
• Achieves maximization of total net benefits possible
in the situation
52
The Coase Theorem
• What if building a theater would create $100,000 of benefits for some
but $70,000 worth of harm for others?
• Whether the theater will or will not be built depends entirely on
whether it is the efficient or inefficient outcome
– Regardless of who holds the legal rights
– Negative externality is solved by market
– No government intervention is required, other than the initial assignment of
legal rights
• Rather surprising result is known as the Coase Theorem—named after
economist Ronald Coase
– States that private market will solve externality problem on its own, always
arriving at the efficient outcome
• When side payments can be negotiated and arranged without cost
– While initial distribution of legal rights will determine allocation of gains and
losses among the parties, it will not affect action taken
53
The Coase Theorem
• Requires that side payments can be arranged without cost—or, in
practice, that cost is so low relative to gains or losses at stake that it
doesn’t matter
– This requirement is most likely to be satisfied when all of the following
conditions are present
• Legal rights are clearly established
• Legal rights can be easily transferred
• The number of people involved is very small
• Unfortunately, many real world situations do not satisfy these
conditions
• Biggest problem is applying Coase theorem to many real-world
externalities is the third condition
– Often, a large number of people are involved
• When many people are involved, achieving efficiency with side
payments is plagued by an often insoluble problem
– Free rider problem
54
The Free Rider Problem
• Occurs when efficient outcome requires a side
payment but individual gainers—each obligated to
pay a small share of the side payment—will not
contribute
• If extensive enough—can shrink the side payment
until it isn’t large enough to compensate losers
and still leave gainers better off
• Stands in the way of many Pareto improvements
– One of the main reasons why we typically turn to
government to deal with important externalities that
affect many people
55
Market Externalities and Government
Solutions
• A competitive market has many buyers and sellers
– When a negative externality affects a market, the private solution is
unlikely to work
• A market with a negative externality associated with
producing or consuming a good will produce more than the
efficient quantity
– Creating a welfare loss
• Unfortunately, with so many people involved, it would take
too much time and trouble for individual producers and
consumers to arrange appropriate side payments and
production cutbacks
– In any case, free rider problem would effectively destroy the
arrangement
– Efficient outcome requires government intervention in the market
56
Figure 11: A Tax on Producers to Correct
a Negative Externality
57
Taxing a Negative Externality
•
•
Government could use a tax on producers to move gasoline market to point B
Payment of the externality tax is shared between consumers and producers,
as is the payment of any tax, and will depend on elasticities of supply and
demand
– A tax on each unit of a good, equal to the external harm it causes, can correct a
negative externality and bring market to an efficient output level
•
Consider the logic of this result
– Tax cures the inefficiency because it forces market to internalize the externality
• To take account of the harm caused by gasoline
•
•
Suggests that a tax on consumers of gasoline would work just as well as a tax
on producers
Taxes to correct negative externalities have been used in countries around the
world
– In United States, however, taxes designed to correct negative externalities are less
common
58
Regulation and Tradable Permits
• A tax is not only way to correct a negative externality
– Government can also use regulation to move a market closer to
the efficient point
• In last two decades, U.S. government has relied
increasingly on an innovative technique to reduce several
types of pollution
– Tradable permits
• License that allows a company to release a unit of pollution into the
environment over some period of time
– Firms can trade their permits in an organized market
• Left to itself, a market with a negative externality will
produce too much output
– Taxes, regulation, and tradable permits are examples of
government intervention to decrease output toward efficient level
59
Dealing with a Positive Externality
• What about the case of a positive externality?
– By-product of an activity or a service benefits other parties, rather than
harms them
• A market with a positive externality associated with producing or
consuming a good will produce less than the efficient quantity, creating
a welfare loss
• A subsidy on each unit of a good, equal to the external benefits it
creates, can correct a positive externality and bring the market to an
efficient output level
• If a good is rivalrous, efficiency requires that people pay a price for its
use
– In the absence of any market failure, private provision will lead to efficient
level of production
• If a good is excludable, it can be provided by private market
60
Figure 12: A Subsidy for Consumers to
Correct a Positive Externality
61
Public Goods
• Pure private good
– One that is both rivalrous and excludable
– In absence of any significant market failure, private firms will provide these
goods at close to efficient levels
• When a good is nonexcludable, people have an incentive to become
free riders
– To let others pay for the good, so they can enjoy it without paying
• When a good is nonexcludable, private sector will generally be unable
to provide it
– In most cases, if we want such a good, government must provide it
• When a good or service is nonrivalrous, market cannot provide it
efficiently
– Rather, to achieve economic efficiency, good or service would have to be
provided free of charge
• Pure public good
– One that is both nonrivalrous and nonexcludable
62
Figure 13: Pure Private, Pure Public and
Mixed Goods
63
Mixed Goods
• Goods that appear in upper right and lower
left corners of Figure 13 can be called
mixed goods
– Share features of both public and private goods
• These goods are becoming increasingly
important in our society
– Are responsible for some growing tension and
controversy
64
Excludable But Nonrivalrous Goods
• Goods near lower left hand corner are excludable but
nonrivalrous
– Includes most information products
– Software is an essentially nonrivalrous good, but an excludable
one
• Neither pure public nor pure private
– Digital music files are another example of this type of mixed good
• Currently, music remains somewhat excludable
– It is against the law to make copyrighted music available online
– Many people—either because of respect for the law, fear of getting
caught, lack of technical expertise, or scarce time—still prefer to buy their
music from a store or online shipping service
– Music industry is desperately looking for ways to achieve greater
excludability
• Has not yet found a good solution
65
Nonexcludable But Rivalrous Goods
• Tragedy of commons occurs when rivalrous but nonexcludable goods
are overuse to detriment of all
• An economy with well-functioning, perfectly competitive markets tends
to be economically efficient
– Many types of government involvement are needed to ensure that markets
function well and to deal with market failures
• Cases of government involvement are not without controversy
– Debates about public education, Social Security, international trade, and
immigration center on questions of proper role for government
• Some of the disagreement is over government’s role in bringing about
a more fair economy
– Also debate about the government’s role in bringing about economic
efficiency
66
Nonexcludable But Rivalrous Goods
•
Information problems
– While government may be able to move us closer to efficiency, it can also fall short
or overshoot based on inaccurate information
•
Incentive problems for government
– Government officials are agents of the general public, and are supposed to serve
public interest
• However, they can be influenced by lobbies for special interest groups
•
•
•
In order for government to have the funds it needs to support markets and do
other things, it must raise revenue through taxes
Inherent problem with provision of public goods that almost guarantees
dissatisfaction about them
Other important roles for government besides fostering efficiency
– Equity, fairness, justice, and more
•
Anyone studying role of government in the economies is struck by one glaring
fact
– Most economic activity is carried out among private individuals
67
Using the Theory: Traffic as a Market
Failure
• Almost everyone in United States has been caught in a
traffic jam in some large town or city at some point in their
lives
• Problem in most cities is getting worse
– Consider London, for example
• Traffic congestion has worsened dramatically in recent decades,
especially in the historic inner city
• Traffic is an externality problem
– When you decide to take your car onto a city street, your decision
is based on the costs and benefits to you
• Traffic can be viewed as a mixed good
– Can the government solve the problem?
• Some cities, such as New York, do charge tolls for cars that enter via
bridges or tunnels
– But entry tolls are problematic, and are rarely set high enough to solve the
problem
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Using the Theory: Traffic as a Market
Failure
• A bigger problem
– Political damage to any elected representative who would propose
a fee high enough to be efficient for a good that has traditionally
been free
• All of this conventional political wisdom may have changed
in early 2003
– In early 2003, Ken Livingstone, the Mayor of London, decided to
take a chance
• His administration established a 5£ (about $8) per day user fee on any
automobile that appeared in the 8 square mile boundary of London’s
inner city
• On the first day the fee applied, traffic dropped about 25%
– 60,000 fewer cars entered the area than on a normal day
– Officials in New York, Paris, Los Angeles, and other large cities
around the world have been studying London’s success
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