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Unformatted text preview: 106 Chapter 7 Imperfect Competition When everyone follows a strategy that gets them the best results, regardless of what their opponents are doing, economists say the result is a Nash equilibrium. Determining a strategy that takes into account the range of possible actions of competitors is not just about two criminals in a scene out of Law and Order. Polit— ical scientists use game theory to analyze nuclear deterrence. Economists use game theory to analyze oligopoly behavior. It is a powerful tool currently permeating many fields in social science. TRY 14. In each case below, which oligopoly model best describes behavior: col- lusion, Cournot, kinked demand, price leadership, or game theory? ° There are only two fence—building companies in an isolated town. Each company has been in business for years. Although they started out charging different prices, each now charges the same price. Each company has about the same number of jobs per year. 0 In a town with six independent bookstores and one large chain book- store, the independent bookstores struggle to match the low prices offered by the chain bookstore. - Four companies sell a similar product. Each believes that their price cuts will be matched by the competitors. Each also believes their price increases will not be followed by the others. - A business is deciding when to introduce a new model of their product. When making this decision, the business considers when its competitors might introduce their new model. - All the independent sellers of tourist t—shirts agree to charge $10 each for their t—shiits. Chapter 8 Market Failure: Externalities and Public Goods Under perfect competition, profit—maximizing firms produce the amount of output where price equals marginal cost. When conditions are such that firms are not producing this amount of output, economists say there is market failure. In the previous chapter, we looked at imperfect competition as a source of market failure. This chapter considers two additional sources of market failure. The first case is externalities, when individuals who are not party to the transaction bear some costs or receive some benefits. The second case is public goods, where someone can consume a product without paying and without impacting their neighbor’s ability to consume the same product. In both cases, the amount of output produced in unregulated private markets will not equal the optimum amount. KEY TERMS AND CONCEPTS ' - Market failure - Negative externality ° Positive externality - External cost ° Marginal damage cost - Marginal private costs - Private marginal costs - Marginal social cost ' Socially optimal quantity 0 Internalizing the extemality - External benefit ° Marginal social benefit ° Social marginal benefit ° Coase theorem ' Private goods - Rival in consumption - Excludable - Public goods 107 103 Chapter 8 Market Failure: Externalities and Public Goods - Nonrival in consumption ‘ Nonexcludable - Free rider problem KEY EQUATIONS - Marginal social cost - Marginal social benefit KEY GRAPHS ° Negative externality - Positive externality - Public good EXTERNALITIES When Amanda drives her SUV, she pays only some of the costs. Amanda pays for the gas, oil, tolls, parking, and any car taxes. But she doesn’t pay for the carbons her car releases into the air, the congestion her car adds to traffic, nor the asthma attacks her exhaust triggers. This is an example of what economists call a negative externality. When some of the costs of an activity are borne by individuals who are not directly involved in the activity, the people undertak— ing the activity—Amanda, in our exampleware generating negative externalities. Common examples are pollution and global warming. When Josiah paints his house, he receives only some of the benefits. Josiah enjoys the new look of his house and the increase to his property value. But his neighbors also benefit: It is more pleasant to walk by Josiah’s house and their property values have also increased. This is an example of what economists call a positive externality. When some of the benefits of an activity are received by individuals who are not directly involved in the activity, the people undertaking the activity—Josiah, in our example—are generating positive externalities. Common examples of positive externalities are education and driving hybrid cars. Negative and positive externalities generate market failure because the private market, left to its own, will produce the wrong quantity. Amanda doesn’t take into account the costs of her action on others. She will drive more than society wants her to. In general, the pn'vate market produces too much when there are negative externalities. Josiah doesn’t take into account the benefits of his action on his neighbors. He will paint his house less often and spruce up the garden less often than his neighbors would like. In general, the private market produces too little when there are positive externalities. The usual solution to these problems is government intervention. When neg- ative externalities are present, the government can impose a tax on the activity. When an activity is more expensive, people will do it less. A Graphical Approach: Negative Externality 109 'When there are positive externalities, the government can provide a subsidy, making the activity less expensive. The private market will produce more of the activity. TRY Answers to all “Try” questions are of the back of the book. 1. In each case below, is the activity generating positive externalities, neg- ative externalities, or no externalities? A. A large truck uses its very loud air brakes to slow down as it drives through a residential neighborhood B. A high school teacher takes a summer Class to increase his knowl- edge of the subject area and learn new teaching methods C. A woman wears perfume A GRAPHICAL APPROACH: NEGATIVE EXTERNALITY Imagine that we could put a dollar price on the climate, congestion, and health effects of Amanda’s driving her SUV. For every mile she drives, the climate, congestion, and health effects cost $1. Economists call this cost of a negative externality the external cost or the marginal damage cost. Both phrases are used interchangeably. Amanda takes into account only her private costs. Economists call those costs her marginal private costs or private marginal costs. Some textbooks use one phrase; other books use the other. When Amanda decides how much to drive, she compares simply her marginal private costs and her marginal benefit. She will drive the number of miles where her marginal benefit equals her marginal cost. In Figure 8.1, we label that qp for private optimal quantity. The rest of us want Amanda to take into account the Climate, congestion, and health effects of her driving. The true total cost per mile of Amanda’s driving is captured not just by her marginal private costs. The true total cost——the cost to Amanda and the rest of us—is the sum of her marginal private costs and the marginal damage cost. Economists call that total the marginal social cost. Marginal social cost: marginal private cost + marginal damage cost The socially optimal quantity will be the quantity where marginal benefit equals marginal social cost. In Figure 8.1, the socially optimal quantity is labeled qs. In the presence of negative externalities, the socially optimal quantity is lower than the private optimal quantity. A self—interested individual has no incentive to change their behavior just because it negatively affects hundreds or thousands of strangers. Without interven— tion, the private market will continue to produce too much of an activity, which itself produces negative externalities. 110 Chapter 8 Market Failure: Externalities and Public Goods "Ks. “e M B l l l Cls CIP Quantity of miles driven Figure 8.1 Negative externality. The private optimal quantity is qp, where private marginal benefit (MB) equals private marginal cost (MC). The socially optimal quantity takes into account the marginal damage cost, which here is $1 per mile driven. The socially optimal quantity is qs where marginal benefit (MB) equals social marginal cost (SMC). How can we get Amanda to take into account the climate, congestion, and health effects of her driving? If the government imposes a tax on Amanda’s driving, she will take this cost into account when determining how much to drive. If the tax equals the marginal damage cost, Amanda will then drive the socially optimal number of miles, qs. In general, to force markets that generate negative externalities to produce a socially optimal quantity, the government can impose a tax or penalty equal to the mzu‘ginal damage cost. Economists would say that Amanda is now internalizing the externality. In most cases, the tax reduces but does not eliminate the offending behavior. But if the marginal damage cost is so great that there is no point where Amanda’s private marginal benefit equals or exceeds the marginal social cost, a well—designed tax will eliminate the behavior that creates the negative externality. 2. What is the difference between marginal private cost and marginal social cost? 3. In the presence of negative externalities, why is the private optimum quantity larger than the socially optimum quantity? A Graphical Approach: Positive Externality 111 4. If the marginal damage cost of driving while talking on a cell phone is $10 per occurrence, then what penalty would be the optimal penalty for this activity? A GRAPHICAL APPROACH: POSITIVE EXTERNALITY The approach to a positive externality is similar. Amanda is considering trading in her SUV for a hybrid. Imagine that we could put a dollar value on the climate and health benefits of driving a hybrid. For every mile that Amanda drives her hybrid, the beneficial side effects are valued at $2. This is a benefit of Amanda’s activity that the rest of us enjoy. Economists call this an external benefit. Again, Amanda takes into account just her private benefit and private cost. She effectively undervalues the marginal benefit of driving a hybrid because she is not taking into account the climate and health benefits for the rest of us. Amanda will buy and drive a hybrid if her private marginal benefit of doing so exceeds her private marginal cost. Amanda’s private optimum is shown by qp in Figure 8.2. The rest of us want Amanda to take into account the beneficial side effects of owning a hybrid. We want Amanda to take into account both her private marginal benefit and the external benefit. The total is called marginal social benefit or social marginal benefit. Some books use one phrase; some use the other, Marginal social benefit = private marginal benefit + external benefit SMB PMB l I l | l | l ; ClP (is Quantity of output Figure 8.2 Positive externality. The private optimal quantity is qp where private marginal benefit (PMB) equals marginal cost (MC). But in the presence of positive externalities, the social marginal benefit (SMB) exceeds the private marginal benefit. The socially optimal quantity is qs, where social marginal benefit equals marginal cost. , WT , 112 Chapter 8 Market Failure: Externalities and Public Goods The socially optimal quantity is the quantity where marginal social benefit equals marginal cost. In Figure 8.2, the socially optimal quantity is labeled qs. In the presence of positive externalities, the socially optimal quantity is greater than the private optimal quantity. A self-interested individual has no incentive to take positive externalities into account. We can cajole, persuade, argue, advertise. Altruistic individuals may be moved by concern for the environment to change their behavior. But in general, so long as the private benefit falls short of the social benefit, the private optimum will fall short of the social optimum. How can we persuade Amanda to trade in her SUV for an environmentallyw friendly car? Again, the government can play a role. If the government offers a subsidy equal to the external benefit of the hybrid, Amanda’s private optimum will equal the social optimum. She will choose to drive more with the hybrid than with the SUV. Again, economists would say Amanda has internalized the externality. TRY 5. The external benefit of a teacher taking a summer class in her field is $3,000 per class. If teachers have to pay for the entire class themselves, will the optimal private quantity equal the socially optimal quantity? What is the optimal size of the subsidy? 6. Homeowners get a federal income tax break. They can reduce the income that is taxed by the amount they pay in interest on their home loan. Use the concept of positive externalities to explain why the federal government thus subsidizes home ownership. AVOIDING GOVERNMENT INTERVENTION: THE COASE THEOREM In both examples, we relied on the government to impose a tax or offer a subsidy in order to move the private optimum to the social optimum. A tax discourages behavior that generates negative externalities. A subsidy encourages behavior that generates positive externalities. In a few cases, the socially optimal behavior can be achieved without govern- ment intervention. For example, it will cost Josiah $5,000 to paint his house. He is willing to wait several more years and let the paint begin to peel before spending that kind of money. The neighbors are tired of looking out their front windows and seeing peeling paint. They offer to pay half the cost of the paint job. In effect, they have offered Josiah a subsidy. He will get the house painted sooner than he would have without their offer. Marissa practices her drums four hours each day, starting at 6:00 A.M. You work until 11:00 P.M. and want to sleep until 8:00 A.M. You value your sleep and are willing to pay up to $40 a day for peace and quiet. Marissa needs to practice but can be persuaded—for a small fee of $25 per day—to wait until 8:00 AM. You Public Goods 113 offer Marissa $25 per day. You get more sleep; Marissa postpones her practice. No government intervention was needed. Josrah’s paint job and Marissa’s drum practice are examples where private negotiation solves the externality problem. Several conditions must exist for private negotiation to be successful. - There must be relatively few parties to the transaction. You and your neighbor can work something out. Amanda and everyone affected by climate change cannot. There must be well-defined and agreed upon property rights. Josiah has the right to paint or not paint his house. Your neighbor has the right to play her drums. There is no property right to the view of the neighborhood, or to quiet. There must be no impediments to bargaining. Hiring expensive lawyers could be an impediment. A lack of trust between neighbors could be an impedi— ment. But if Josiah and his neighbors get along well and trust each other, there are no impediments to bargaining. . If these conditions are satisfied, then government intervention is not needed to bring the private optlmum in line with the social optimum. Instead, the parties can negotiate an agreement. This result is called the Coase theorem for the man who conceptualized it, Ronald Coase. TRY 7. For each situation below, does the Coase theorem apply? If not, why not? A. Big trucks are using their very loud air brakes as they drive through your neighborhood. B. Your neighbor’s tree overhangs your house and its debris clogs your drainage system. Your neighbor is a bully who refuses to talk with you. ' C. Your little sister’s high school teacher sometimes takes professional development classes during the summer break. D. Someone who lives in your apartment complex sweeps the walkways each morning, but only in front of his apartment. You wish he would sweep in front of your apartment too. PUBLIC GOODS Up until now, all of the goods or services we’ve considered are private goods. A private good has two characteristics: (1) when you consume a private good, no one else can consume the same private good and (2) you have some way to prevent others from consuming the good if you want to. As you read and highlight this book, no one else can read and highlight the same copy of the book at the same time. Economists say: A private good is 114 Chapter 8 Market Failure: Externalities and Public Goods rival in consumption because your use or consumption of the good prevents—~rivals-—others from consuming the exact same item at the same time. You can prevent others from reading the book simply by keeping it in your book bag or on your desk. Economists say: A private good is excludable because you can exclude others from consuming it. There are some products that satisfy neither characteristic. These products are called public goods. A public good has two characteristics: (1) when you consume a public good, I can consume the same public good at the same time with no impact on your ability to consume the good and (2) you cannot prevent me from consuming the good. TIP The name public good is a bit misleading. Almost every public “good” is actually a service. Nonetheless, economists use the phrase “public good.” When I listen to a radio station, you can listen to the same radio station at the same time. Economists say: A public good is nonrival in consumption because consumption of the good (usually, a service) by one individual does not preclude anyone else from also consuming the good. When police patrols keep a neighborhood free of burglaries, everyone is made safe. We can’t exclude some individuals but not others from the benefits of the police car driving down the street. Economists say: A public good is nonexcludable because no one can be excluded from consuming the good. An unregulated private market will not produce the socially optimal quantity of a public good. This is because self-interested individuals have no incentive to pay for public goods. Economists say: Public goods suffer from the free rider problem. Self-interested individuals can “free ride” on the generosity of others. Once the public good is produced, free riders can consume the good without paying because their consumption cannot be prevented. But if everyone is self—interested and thus no one is willing to pay, the public good won’t be produced at all. Some public goods are produced by the private market because not everyone is motivated purely by self-interest. Public radio and public television are good examples. Public radio stations are generally FM stations at the left end of the dial, which provide news, arts, and cultural programming. Public television brings us programs such as Sesame Street and Between the Lions. Public radio and television stations in the United States conduct fundraising drives several times a year. The station operators interrupt programming and ask listeners to call in and contribute money to keep the station on the air. The station announcers will say “Only 1 in 7 listeners to this station is a current contributor.” That means 6 out of 7 listeners are free—riding on the generosity of others. Depending on the generosity of others works for public radio and television. But it wouldn’t work for all public goods. The usual solution is for the government to tax all who benefit from the public good and to then provide the good. The dilemma the government faces is how much to produce. Public Goods 115 Table 8.1 How Much Would You Pay for a Public Good? —-—-———-———.___________~_____________ How much would you pay for that # drives through drive through the neighborhood? neighborhood Sarah Diego Taylor You 1 35 10 $ 1 2 $5 $6 2 7 4 3 4 3 5 O l 2 4 2 0 O 0 5 O 0 0 0 When the police drive down your street at night, their presence protects on from burglaries. How many times a night should the police drive down your strget‘? The answer depends on the marginal benefit that you and your neighbors receive from the police patrol and on the marginal cost of those patrols. The socially optimal 3:231:31; at: 1:3 (gsscid 1s the quantity where the soc1al marginal benefit equals the How do we value the marginal benefit? The marginal benefit is burglaries prevented. But we can’t compare the number of burglaries prevented with the dollar cost of patrols. We first need to evaluate marginal benefit and marginal cost in the same terms—dollars. What is the dollar benefit of the police patrols“? You and your neighbors each receive a survey. How much are you willinc to pay per night if the police drive through your neighborhood once twice thre: times'lYour answers describe how much you value police protection. Your neithor Sarah IS Willing to pay $10 for the police patrol’s first drive through the nei afibor— hood, $7 for the second, $5 for the third, $2 for the fourth, and thinks angthin beyond four times a night is unnecessary. Another neighbor has a differeni/ willfix ingness to .pay. And yours is different still. Table 8.1 shows the survey results What 13 the total marginal benefit to the neighborhood? The answer is found b summing the individual marginal benefits. Add across the rows. The marginal hen): efit to the neighborhood of the police driving through one time per nioht is $10 + $12+$5 + $6=$33. The marginal benefit of the second drive through the neiah— borhood per night is $7+$4+$3 + $4=$18. The marginal benefit? of the third pass through is $5 + $O+ $1 +$2=$8. The marginal benefit of the fourth drive through is just $2 And there is no mar inal b ' I . U enefit to fift ' neighborhood per night. D a h duve through the TIP With public goods, total demand is the sum of the amount each individual would pay for some quantity of the good. Add up the dollars for public goods. With private goods, total demand is the sum of the quantity each individual would purchase at some price of the good. Add up the quantities for private goods. 116 Chapter 8 Market Failure: Extemalities and Public Goods $ 12 A Diego 10 __ Individual marginal benefit curves 8 0‘ You 6 7- e O " 4 TTaylor 2 __ 1 2 3 4 5 # drives through neighborhood $ Figure 8.3 Public goods. The total marginal benefit curve for a 3 public good is the sum, for each quan— l tity, of the individual marginal benefit i 7 curves. The socially optimal quan— 1 2 3 4 5 # drives tity of output is the output where total through marginal benefit (MB) equals marginal neighborhood cost (MC), How many times should the police patrol the neighborhood per night? The answer depends on the comparison of marginal benefit and marginal cost. Suppose the marginal cost is $13 per drive through the neighborhood. Then the police should drive through the neighborhood twice per night. If instead the marginal cost was $5 per drive, the patrol should come through three times per night. Figure 8.3 illustrates. The total marginal benefit in the bottom panel is found by summing vertically the individual marginal benefit curves in the top panel. The socially optimal quantity is where total marginal benefit equals marginal cost. TRY 8. For each activity below, is it rival or nonrival in consumption? Is it excludable or nonexcludable? A. A concert in a very large public park B. A concert in an indoor sports arena Public Goods 117 C. A beautiful sunset D. A broadcast on HBO E. Military protection 9. What is a free rider? 10. A small town has a church building that is large enough to seat everyone in town. Everyone is welcome to attend the church. However, there is no resident preacher. The townspeople can hire a circuit rider—a preacher who comes to town one, two, three, or four Sundays per month. The preacher asks for $300 per Sunday. Someone surveys the townspeople and finds their willingness to pay is as follows: ° 10 people are willing to pay $10 each for the first visit per month, $5 each for a second visit in a month, $2 each for a third visit in a month, and are unwilling to pay for a fourth visit in a month - 40 people are willing to pay $5 each for the first visit per month, $1 each for a second visit in a month, and are unwilling to pay for a third or fourth visit in a month - 30 people are willing to pay $5 each for the first Visit per month, but are unwilling to pay anything else. For how many Sundays per month will the townspeople hire the circuit rider? , _ 77W¢_#<'rmz~—~~r~rmvi , Microeconomics as a Second Language Martha L. Olney WILEY John Wiley & Sons, Inc. ...
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This note was uploaded on 05/09/2009 for the course ECON 2302 taught by Professor Mcfarlin during the Spring '06 term at University of Texas at Dallas, Richardson.

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review ch8 - 106 Chapter 7 Imperfect Competition When...

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