Instructor: Jeroen Jon De Leon

Chapter 15, Lieberman and Hall

Chapter 15: Governments Role in Economic Efficiency
Government provides infrastructures: (1) Physical (e.g. roads, bridges, public buildings); and (2)
Institutional (Legal System and Regulations)
Legal system ways in which it supports markets and helps us achieve economic efficiency; imposes
fines or other penalties when business violates the law
Regulations directs businesses to take specific actions and prohibits other actions, often on a case-bycase basis
Types of Law
(a) Criminal Law prohibits actions that harm others, including theft, robbery, fraud, assault,
murder, etc.
(b) Contract Law establishes rules for writing and enforcing contracts and penalties for failure to
fulfill
(c) Property Law establishes rules for private ownership of land and other assets; ensures the
rewards from assets accrue to the owners
(d) Tort Law allows those harmed by dangerous activities or products to sue for damages
(e) Anti-trust Law prevents business behavior that limits competition at the expense of
consumers
Market Failure occurs when a market even with the proper institutional support is economically
inefficient
Types of Market Failures
(A) Monopoly Markets government limits market power by preventing the monopolization of
markets; Anti-trust law operates in three areas:
a. Agreements among competitors
b. Monopolization
i. Sherman Act of 1890 prohibits contracts, combinations or conspiracies
among competing firms that would harm consumers by raising prices
c. Mergers
i. Clayton Act of 1914 blocks mergers
Government copes with Market Power in: (1) patents and copyrights; and (2) Natural Monopoly
(1) The government tries to balance two conflicting interests: (a) providing incentives to make new
discoveries; and (2) keeping prices low so that the efficient quantity will be provided
(2) Natural monopolies are regulated through: (a) Marginal cost pricing; and (b) Average cost
pricing
a. Marginal cost pricing setting a monopolys regulated price equal to its marginal cost of
production at the efficient quantity

Instructor: Jeroen Jon De Leon

Chapter 15, Lieberman and Hall
b. Average cost pricing setting a monopolys regulated price equal to long-run average
cost where the LRATC curve crosses the market demand curve; the natural monopoly
makes zero economic profit
(B) Externalities a by-product of consuming or producing a good that affects someone other than
the buyer or seller
Coase Theorem when a side payment can be arranged without cost, the market will solve an
externality problem and create the efficient outcome on its own; the allocation of legal rights
determines gains and losses among the parties, but does not affect the action taken
A market with a negative externality will produce more than the efficient quantity of the
good, creating a deadweight loss
A market with a positive externality will produce less than the efficient quantity, creating a
deadweight loss
Regulation of Negative Externality

Market Based approach #1: TAXES

o A tax on each unit of good equal to the external harm it causes can correct a negative
externality
Market Based approach #2: TRADABLE PERMITS
o A system of tradable permits for pollution can make quantity of polluting goods
efficient; tradable permits [1] assure that total production is allocated efficiently among
the producers
o [1] Tradable permits a license that allows a company to release a unit of pollution into
the environment over some period of time

Regulation of Positive Externality

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

(C) Public Goods are goods or services that are difficult for the (private) market to provide; requires
direct involvement of the government
Public Goods versus Private Goods

A good that is both rivalrous[2] and excludable[3] is a pure private good

A good that is both nonrival and nonexcludable is a pure public good
[2] a situation in which one persons consumption of a unit of a good or service means that no
one else can consume that unit
[3] the ability to exclude those who do not pay for a good from consuming it
Free-rider problem when everyone tries to enjoy the benefits of a nonexcludable good
without paying, so private firms cannot provide it

Instructor: Jeroen Jon De Leon

Chapter 15, Lieberman and Hall

Mixed goods they share features of both public and private goods: (a) Marketable public
good[4]; and (b) Common resources[5]
[4] an excludable and nonrival good; will require a price of zero
[5] a nonexcludable and rival good; will require a positive price
Tragedy of the commons occur when rivalrous but nonexcludable goods are overused, to the
detriment of all

(D) Asymmetric Information a situation in which one party to a transaction has relevant information
not known by the other party
Types of Asymmetric Information:
Adverse Selection a situation in which asymmetric information about quality eliminates highquality goods from the market
Moral Hazard when someone is protected from paying the full cost of their harmful actions
and acts irresponsibly, making the harmful consequence more likely
Principal-agent Problem when one party (the principal) hires another (agent), who in turn can
pursue goals that conflict with the principals because of asymmetric information
Government Failure a situation in which government falls victim to the same types of problems that
cause market failures in the private company