Unit IV: Market Failures and the Role of the Government 1

Unit IV: Market Failures and the Role of the Government

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When should the government get involved in the economy?

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Worker Safety Laws Barber Shop Licenses

Every society needs to decide how much government involvement is desirable

Bank Bailouts

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What is the Free Market?

(Capitalism)

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5 Characteristics of Free Markets1. Little government involvement in the economy.

(Laissez Faire = Let it be) 2. Individuals OWN resources and determine what to

produce, how to produce, and who gets it.3. The opportunity to make PROFIT gives people

INCENTIVE to produce quality items efficiently.4. Wide variety of goods available to consumers. 5. Competition and Self-Interest work together to

regulate the economy.

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The government’s job is to enforce contracts, secure property rights, and defend the country.

Example of the INVISIBLE HANDof the free market:

If society wants computers and people are willing to pay high prices then… •Businesses have the INCENTIVE to start making computers to earn PROFIT.•This leads to more COMPETITION….•Which means lower prices, better quality, and more product variety. •To maintain profits, firms find most efficient way to produce goods and services.

The government doesn’t need to get involved since the needs of society are automatically met.

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Does the Free Market ever FAIL to meet society’s

needs?7

What is a Market Failure?•A situation in which the free-market system fails to satisfy society’s wants.

(When the invisible hand doesn’t work.)•Private markets do not efficiently bring about the allocation of resources.

What’s the result…

The government must step in to satisfy society’s wants.

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How does the free market FAIL?

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The Four Market Failures

We will focus on four different market failures:1. Public Goods2. Externalities (third person side effects)3. Monopolies4. Unfair distribution of income

In each of the above situations,the government steps in to

allocate resources efficiently.

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Assume society's optimal level in the market is Q0 and that government purposely shifts the market supply curve from S to S1 in diagram. Which of the following is NOT true:

A) the government is correcting spillover costs B) at Qe the good is being overproduced C) the government could be taxing producers

D) at Qe, the Marginal Social Benefit is greater than than the Marginal Social Cost

E) the government is fixing a market failure

Market Failure #1: PUBLIC GOODS

If there was no government, how would schools, parks, and freeways be different? Would there be enough to meet our needs?

Public Goods

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Or, would people be forced to pay out of pocket for needed

services? Such as paying the fire department to put out your house

fire

Why must the government provide public goods and services?•It is impractical for the free-market to provide these goods because there is little opportunity to earn profit.•This is due to the Free-Rider Problem

Free Riders are individuals that benefit without paying.

Public Goods

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What’s wrong with this picture?

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The Free Rider Problem

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Examples: 1. People who download music illegally2. People who watch a street performer and don’t pay 3. Teenagers that live at home and don’t have a job

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•Canadian Military Spending: $19 Billion

•US Military Spending: $711 Billion

Why doesn’t Canada spend more on their

military?

Does anyone free ride off you?2014 MILITARY SPENDING

•Free-Riders keep firms from making profits.•If left to the free market, essential services would be under produced.

To solve the problem, the government can: 1. Find new ways to punish free-riders.2. Use tax dollars to provide the service to everyone.

What’s wrong with Free Riders?

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The Final Exam•I am willing to give an 100% on the final exam to whichever class gives me $1000.

•Everyone in the class will get 100% even if each student doesn’t pay.

•Who is willing to pay?•What about those that refuse to pay?

Solution?EVERYONE pays a mandatory tax

and all receive the same benefits.19

Definition of Public Goods

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To be considered a true public good, it must meet two criteria:1. Nonexclusion

Definition of Public Goods

2. Shared Consumption (Nonrivalry)

•Everyone can use the good.•Cannot exclude people from enjoying the benefits (even if they don’t pay). •Ex: National Defense

•One person’s consumption of a good does not reduce the usefulness to others.

•Ex: National Parks21

Identify which of the following areTRUE public goods

(have non-exclusion and non-rival consumption):

1. Hamburgers2. Satellite TV 3. Free Public Education4. Homes5. Street lights6. Highways

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