Chapter Fourteen: The Market Mechanism: Shortcomings and Remedies

What Does the Market Do Poorly? Market economies suffer from severe business fluctuations The market distributes income unequally Where markets are monopolized, they allocate resources inefficiently The market deals poorly with the side effects of many economic activities The market cannot readily provide public goods, such as national defense The market may do a poor job of allocating resources between the present and the future The market mechanism makes public and personal services increasingly expensive and this often induces socially damaging countermeasures by the government Efficient Resource Allocation: A Review Basic problem of resource allocation is deciding how much of each commodity the economy should produce MC is the resources cost caused by producing another unit of the commodity, IF P = MC, consumers will be using societys resources in the most effective way. If a commoditys price is above its marginal cost, the economy will tend to produce less of that item than would maximize consumer benefits. The opposite will occur if an items price is below its marginal cost. Externalities: Getting the Prices Wrong Beneficial Externality: If the activity causes incidental benefits to others not directly involved in the activity and no corresponding compensation is provided to or paid by those who generate the externality. Ex. gardens Detrimental Externality: If the activity causes incidental damages to others not directly involved in the activity and no corresponding compensation is provided to or paid by those who generate the externality. Ex. pollution The price system achieves efficiency by rewarding producers who serve consumers well at the lowest possible cost Externalities and Inefficiency Marginal Social Cost (MSC): The sum of its MPC plus the incidental cost (positive or negative) that is borne by others Marginal Private Cost (MPC): Share of an activitys marginal cost that is paid for by the persons who carry out the activity When a firms activities generate detrimental externalities, its MSC will be greater than its MPC. Therefore, the firms output must be too bug because the market will yield and output at which consumers MU is smaller than MSC. Smaller outputs than those that maximize profits will be socially desirable. Competition compels firms to make extensive use of resources for which they are not required to pay. Where the firms activity generates beneficial externalities, free markets will produce too little output. Society would be better off with larger output levels. An industry that generates detrimental externalities will have a MSC higher than its MPC. If the price is equal to a firms own marginal price cost, it will therefore be below the true marginal cost to society. The market mechanism thereby tends to encourage inefficiently large outputs of products that cause detrimental externalities. The opposite is true of products that cause beneficial externalitiesprice industry will prove inefficiently small quantities of these products Externalities Are Everywhere At a factory that hires unskilled laborers are provides them with training produces an external benefit of better workers for future employers Pollution by factors, cars, etc. is a detrimental externality Market economies often have dirty air and rivers and suffer from the effects of improperly disposed toxic wastes.

Government Policy and Externalities Some ideas are to provide subsidies to firms that generate a beneficial externality and tax firms that generate a detrimental externality. This approach is difficult to carry out because social costs are difficult to estimate since they are so widely diffused throughout the community Provision of Public Goods Public Good: A commodity or service whose benefits are not depleted by an additional user and from which it is generally difficult or impossible to exclude people, even if the people are unwilling to pay for benefits Private Good: A commodity characterized by both excludability and depletability Depletable: A commodity if it is used up when someone consumes it Excludability: A commodity if someone who does not pay for it can be kept from enjoying it It is usually not possible to charge a price for a pure public good because people cannot be excluded from enjoying its benefits. It may also be undesirable to charge a price for it because that would discourage some people from benefitting, even though using a public good does not deplete its supply. For both of these reasons, government supplies many public goods. Without government intervention, public goods would not be provided. The Role of the Interest Rate You can analyze a PPF curve to find the allocation of resources between present and future. The interest rate determines the opportunity cost to a recipient who gets money at some future date instead of now. The lower the interest rate, the lower the opportunity cost. Low interest rates will persuade people to invest more now in factories because these investments yield a large portion of their benefits in the future. Thus, more resources will be devoted to the future if interest rates are low. Similarly, high interest rates make durable investment, with future benefits less attractive. Therefore, high interest rates tend to increase the use of resources for current output at the expense of reduced future outputs. How Does it Work in Practice? Interest rates are also used to deal with business fluctuations The market may devote too large a proportion of the economys resources to immediate consumption Another reason why the free market may not invest enough for the future is that investment projects (construction) are much greater risk to the individual investor than to the community as a whole Many economists believe that irreversible decisions have a special significance and must not be left entirely to the decisions of private firms and individuals, that is, to the market Market Failure and Government Failure In any event, even where government action is appropriate, we must consider marketlike instruments to correct market mechanism deficiencies. The Cost Disease of the Service Sector The quality of a variety of public and private services has decreased worldwide Cost of personal services such as education and health care are also increasing Health care costs are rising faster than a countrys rate of inflation Inefficiencies in government management, political corruption, and the cost disease of personal services are the cause of the increase of these services Cost disease stems from the basic nature of personal services. Most services require direct contact between those who provide the services and those who consume it. The quality deteriorates if less time is provided from doctors, etc. In the long run, wages for all workers throughout the economy tend to go up and down together The cost disease analysis portends a future in which the services of doctors, teachers, etc is mass produced and impersonal

Some Other Sources of Market Failure Imperfect information Rent seeking - Rent Seeking: Unproductive activity in the pursuit of economic profitin other words, profit in excess of competitive earnings Moral hazard - Moral Hazard: The tendency of insurance to discourage policyholders from protecting themselves from risk