Lecture by: Jacinto F. Fabiosa

Fall 2005

Economic Efficiency and the Role of Government

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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

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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

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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

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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

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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

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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

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Figure 1: The Marginal Benefit From Guitar Lessons

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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

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Figure 2: The Marginal Costs of Guitar Lessons

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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

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Figure 3: Efficiency In The Market For Guitar Lessons

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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

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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

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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

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Figure 4(a): Consumer Surplus in a Small and Large Market for Guitar Lessons

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Figure 4(b): Consumer Surplus in a Small and Large Market for Guitar Lessons

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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

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Figure 5(a): Producer Surplus From Selling Guitar Lessons

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Figure 5(b): Producer Surplus From Selling Guitar Lessons

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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

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Figure 6: Total Net Benefits in aCompetitive Market for Guitar Lessons

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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

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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

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Figure 7(a): Why Price Ceilings and Price Floors Are Inefficient

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Figure 7(b): Why Price Ceilings and Price Floors Are Inefficient

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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

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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)

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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

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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

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Figure 8: Government Infrastructure and Output per Worker

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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

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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

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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

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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

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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

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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

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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

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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?

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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

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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

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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?

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Figure 9: The Welfare Loss fromMonopoly

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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

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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

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Figure 10: Regulating A Natural Monopoly

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Figure 11: A Tax on Producers to Correct a Negative Externality

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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

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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

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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

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Figure 12: A Subsidy for Consumers to Correct a Positive Externality

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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

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Figure 13: Pure Private, Pure Public and Mixed Goods

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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

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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

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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

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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

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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