See Market/Government Failure

Competitive markets usually perform well when all parties to a transaction pay for the benefits they receive and are compensated for their costs. For example, if you buy a warm coat for protection from cold winter days, the people who produce your coat are paid for this use of their resources. Unfortunately, securing payments for some types of goods is difficult, and identifying those who incur costs can also be a problem. No private firm, for example, could sell you cleaner air by using less-polluting production processes without simultaneously providing cleaner air for your neighbors. Nor could a neighbor privately buy national defense without protecting you.

 

Competitive markets allocate most standard goods so that marginal social benefits equal marginal social costs, as at point a in Figure 2. Allocative failure occurs when equilibrium marginal social benefits and costs diverge. Any market equilibrium except that at point a represents an allocative failure. Improper pricing and output occurs when private markets are afflicted with any of three basic types of problems.

Figure 2

Our monopoly chapter showed how market power may create inefficiency, with suboptimal output and excessive prices. But even competitive markets may yield failures that seem to justify government action. Externalities (pollution is an example) can warp price signals so that production costs or our demands are inaccurately reflected. Another difficulty, the public goods problem, results when shared consumption is possible but people cannot be denied access to the benefits from a good. National defense is an example.

 

Government may correct market failures by (a) promoting competition; (b) modifying the composition of private outputs through taxes, subsidies, or regulations; or (c) directly providing certain goods. (Some cynics argue that ideal adjustments are highly unlikely because government is hopelessly inefficient, but only philosophical anarchists argue that government provision of certain goods never improves efficiency.)

Monopoly Power

Private firms with market power charge higher prices and produce less than the optimal output that would be produced in pure competition. Long-run average cost curves that decline across a wide range of output relative to market demand may make competition inefficient and yield a natural monopoly (many utility companies are examples). Antitrust legislation may curb monopoly power and promote competition, or regulation can steer natural monopolists toward efficient behavior.

Externalities

Some benefits or costs of certain activities spill over to parties not directly involved in the activity. These spillover benefits and costs are externalities.

Externalities are the benefits conferred or costs imposed on a third party not directly participating in a transaction.

 

This type of market inefficiency is common when market prices and outputs fail to reflect these third parties’ preferences. For example, oil refineries emit hydrocarbons and foul the water. Some of these pollutants are absorbed by microorganisms and work their way up the ecological chain, damaging everyone’s health so that people who do not buy oil bear some of the costs of refining it. And the air can become almost impossible to breathe. Most human activities generate externalities, some trivial and some of major concern. Noxious fumes and the noise from takeoffs and landings near airports annoy neighbors and reduce property values, loud rock concerts disrupt nearby residents, and so on. All forms of pollution—chemical, air, noise, and litter—are negative externalities.

 

Pollution and obnoxious billboards would be even more prevalent if markets were unregulated. Commuting would be more dangerous if drivers continually negotiated for the right-of-way, and big city traffic might suffer terminal gridlock. Deadly epidemics might decimate our populace if all immunizations were voluntary. You may have heard of Typhoid Mary, a restaurant worker who infected thousands of people in her day.

 

Negative externalities tend to be ignored when producers decide how much to produce, so the prices charged reflect only the producers’ private costs. Thus, pollution-generating goods tend to be overproduced and underpriced. No government could absolutely prohibit all pollution because such policies would be inconsistent with life—all human activities generate at least some pollution. [Physicists refer to this concept as entropy. The second law of thermodynamics states that every process entails shifts from more organized forms of energy and matter (e.g., coal) into less organized forms (e.g., heat and smoke)]. Trade-offs exist between the cleaner environment most of us would like and the higher levels of consumption most of us desire.

Positive externalities that spill over from an activity may also create inefficiency. For example, Neighborhood Watch programs help suppress burglaries. You are less likely to suffer from a burglary if you are alert, and your neighbors are also less likely to be burglarized. But you may ignore our benefits when you decide how much attention to pay to suspicious characters casing the neighborhood. Thus, positive externalities tend to be ignored in private market decisions, resulting in underproduction and overpricing of the goods that generate positive externalities; the value to society exceeds the costs individuals willingly pay when they are uncompensated for external benefits.

 

Let’s consider negative externalities in more detail. Garbage accumulating around the Slob family’s property is shown in Figure 3. Suppose this family ignores informal social pressure to maintain their home. When they decide how often to have trash hauled away, the Slobs ignore noxious odors, declines in the values of adjacent property, and their neighbors’ exposure to diseases. Unless they are compelled to consider these external costs, the Slobs will choose point a, leaving Q0 garbage around their home, on average, at a private cost of P0 per unit. Society might just legally require them to have all their trash hauled off instantly, but this would ignore benefits to the Slobs (or even ourselves) of being able to let the garbage pile up temporarily instead of having it removed at all times. After all, the Slobs are members of society. What we would like is to ensure that they consider the effects on their neighbors from stockpiling trash.

Figure 3

Demand curve D reflects the Slobs’ gains from littering their home, tidying up only occasionally instead of being fastidious at all times. The MSC curve reflects losses from litter suffered by both the Slobs and their neighbors, with the MC curve reflecting only the Slobs’ marginal private cost. Suppose the Slobs could legally store trash, and the vertical distance bc between the cost curves represents the external costs that the Slobs are inflicting on their neighbors. Their neighbors would willingly pay this amount to them to reduce trash accumulation to socially optimal level Q1. If neighbors could legally limit the Slobs’ debris, this vertical distance is the price the neighbors would charge the Slobs for accumulating garbage. Note that the optimal amount of trash is not zero. After all, we all keep a little garbage on hand, even on days when garbage is collected.

 

How to deal with externalities is addressed in detail in our chapter on environmental quality. It is time to examine the market failure that seems to require the most of government—the public goods problem.

Public Goods

A desire for more shoes can be cured by a trip to a shoe store. But suppose you want more public parks or a stronger national defense. If you voluntarily send a check to the National Park Service or the Department of Defense, even if they spend your money wisely you will not have appreciably better access to parks or be noticeably better defended. The problem is that these are examples of public goods. Public goods are both nonrival, because people can consume the same units of such goods simultaneously, and nonexclusive, because denying people access to such goods is prohibitively expensive.

A public good can be enjoyed by numerous individuals at the same time (nonrivalry); once a public good is available, denying access to a consumer is prohibitively expensive (nonexclusion).

Prisons are examples of public goods because keeping violent criminals behind bars makes the world safer for the rest of us. We need not compete with each other to use public goods once they are produced because public goods do not involve rivalry. Most goods are private goods that are rival and exclusive.

• Rivalry and Nonrivalry  

Consumption exhausts a rival good so that no one else can consume the same unit. No one else can consume a particular apple if you eat it first. You cannot use my ski pants if I am wearing them. Food and clothing are rival goods. We can, however, enjoy the same TV program without rivalry. When your TV receives signals, it does not affect the signals to mine. A police patrol can simultaneously protect both you and your neighbor from burglars. Police protection and TV broadcasts are examples of nonrival goods.

 

Because consuming a rival good such as an apple uses up scarce resources, it is efficient that consumers pay for each unit consumed. On the other hand, for such nonrival goods as TV broadcast signals, hours spent in front of the TV do not diminish those signals. Compelling people to pay for TV signals based on their level of consumption would discourage consumption without any offsetting benefit, thus introducing inefficiency. (Although some critics of the tube would disagree.)

• Exclusion and Nonexclusion  

Restaurants can refuse to serve you unless you wear a shirt and shoes. A theater can require you to buy a ticket before seeing a film. Movies and meals are exclusive goods. But if the Air Force protects you from attacks by foreign enemies, your neighbor is protected automatically. The Air Force cannot guard you against attack and not protect your neighbor. National defense is a nonexclusive good. Nonexclusion occurs whenever it is prohibitively expensive to prevent people from enjoying a good once it is provided.

 

Government provides most public goods. For example, our legal system enables all of us to resolve most disputes without constantly resorting to violence. Other public goods include traffic lights, weather reports, AIDS research, democratic government, and national defense. Once the military is maintained and ready, every person in the United States consumes defense services simultaneously, and we all receive this protection whether we pay taxes or not, and whether we want it or not! An important note: public provision does not require public production. For example, government increasingly relies on private contractors to maintain streets, collect trash, and staff our prisons and public hospitals. Table 1 summarizes the four basic categories of goods and services.

TABLE ONE MISSING@!@@@!@!@!

Providing for Public Goods

Nonexclusive and nonrival goods differ markedly from private goods, so constructing demand curves for public goods requires a different approach than does construction of market demand curves for private goods.

• Private vs. Public Demands  
Recall that market demands for most goods are horizontal summations of individual demand curves: the quantities demanded at each price are summed. This is how the individual demands of Alan and Beth for lobsters, a private good, are summed in Panel A of Figure 4. The total demand for a public good, however, is a vertical summation of individual demand curves, as shown in Panel B. We all gain by having extra police patrols cruising our neighborhood at night, so our demand for this extra surveillance reflects the dollar amount we would collectively pay for it. A total demand curve for a public good is constructed by adding the funds we each would willingly pay for each possible amount of the good.

Figure4

• Optimal Public Goods  

     How do we ascertain how much of a public good to provide? Alan’s (A) and Beth’s (B) individual demands for police patrols are shown together with their total demand curve in Panel B of Figure 4. We assume that neither is trying to be a free rider, so both reveal their demands for police patrols. The total demand is the vertical summation of Alan’s and Beth’s demands. Suppose that costs are $6 per patrol. If three patrols are provided each night, Alan values each patrol at $4, while Beth values each at $2. The $6 cost per patrol could be covered if each paid in proportion to their gains [($4 x3) + ($2 x3) = $18].

Contrast this with optimal provision of private goods in Panel A; each individual pays the same price per unit, but each consumes different amounts. Alan consumes 35 pounds of lobster annually at $2 per pound, while Beth buys only 25 pounds at that price.

 

The preceding solution to public goods assumes that individuals willingly reveal their preferences. Further, it suggests that we could pay for these public goods by taxing individuals in proportion to the benefits received. This benefit approach is not, however, easily translated into the real world of taxes, nor is it the primary basis of taxation.