Government Goals & PolicyGovernment Goals & Policy

Government Intervention: 1) Market Failure 2) When the market fails to perform in line with the

goals that we have for performance then there is a role for government policy

1. Eg) equitable distribution of income when markets fail to achieve social goals for equity,

government policy is called for; eg, government redistribution programs

Measuring Economic Inequality Poverty:

is a situation where a family’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary.

is a relative concept. In Canada, poverty is measured by using a low-

income cutoff.low-income cutoff is the income level at which

a family spends 54.7 percent of its income on food, shelter, and clothing.

The Sources of Economic Inequality

The combination of higher demand and lower supply for high-skilled workers relative to low-skilled workers creates a higher equilibrium wage rate for those workers who have attained greater levels of human capital.

Income Redistribution In Canada, governments use three main ways to

redistribute income to reduce the degree of economic inequality: Income taxes Income maintenance programs

Social security programsEmployment Insurance programWelfare programs

Subsidized services.education

Income Redistribution: Leads to “The Big Tradeoff” between equity and

efficiency Income redistribution can be inefficient for three

reasons:The process of redistribution uses resourcesTaxes create deadweight lossTaxes weaken the incentive to work, save,

and invest

Government Goals & Policy

1. Ensure an equitable distribution of income when markets fail to achieve social goals

for equity, government policy is called for; eg, government redistribution programs

2. Ensure the legal framework• Provide a legal system

Define property rights

Establish legal rules of behaviour

3. Ensure economy wide stability & growth Macro economic policy

Economic Functions of Government4. Ensure efficiency Markets sometimes fail to achieve “efficiency”

in the use and allocation of society’s resources

Government policy action when…..

Markets Fail: 1.) Imperfect Competition Market failure occurs if markets are not

competitive regulation of monopoly anti-combines legislation

Market Failure: 2.) Public Goods

Market failure occurs when markets fail to provide Public Goods Private Goods: can be consumed by only one

individual at a time: are both rival and excludable

Public goods: can be consumed simultaneously by everyone, that is, no one can be excluded once the good is produced, & no one’s consumption reduces the amount available for another.

Public goods: can be consumed simultaneously by everyone, that is, no one can be excluded once the good is produced, & no one’s consumption reduces the amount available for another.

1) Nonrival Consumption by one person does not

decrease consumption by another.Television show

2) NonexcludableIt is impossible, or extremely costly, to

prevent someone from benefiting from the good once it is produced.National defence

Market Failure: Public Goods

Market Failure: Public Goods Since people enjoy the benefits without paying, markets

fail to produce public goods

non excludable free ridersa free rider is a person who receives the benefit of a good but avoids paying for it.

Public goods create a free-rider problem because the quantity of the good that a person is able to consume is not influenced by the amount the person pays for the good...so why pay anything at all?

government provision e.g.fireworks

Public Goods The marginal benefit of a public good to an individual

is the increase in total benefit that results from a one-unit increase in the quantity provided. The marginal benefit of a public good diminishes with the level of the good provided.

Everyone can consume each unit of a public good, which means the marginal benefit for the economy is the sum of marginal benefits of each person at each quantity.

Benefits of a Public Good

Quantity (number of fireworks displays)Quantity (number of fireworks displays)

Lisa's Marginal Benefit

Max's Marginal Benefit

Quantity (number of Quantity (number of fireworks displays)fireworks displays)

Mar

gin

al

ben

efit

$M

arg

ina

l b

enef

it$

00 11 22 33 44

44

66

88

1010

MBMBLL

55

Mar

gin

al

ben

efit

$M

arg

ina

l b

enef

it$

00 11 22 33 44

44

66

88

MBMBMM

55

Figure shows how the marginal benefits of a public good are summed at each quantity of the good provided. Part (a) shows Lisa’s

marginal benefit. Part (b) shows Max’s

marginal benefit.

1010

1414

Quantity (number of fireworks displays)Quantity (number of fireworks displays)

Ma

rgin

al b

ene

fit

$M

arg

inal

ben

efi

t $

Benefits of a Public GoodBenefits of a Public Good

00 11 22 33 44 55

1818

Economy's Marginal Benefit

MBMB

The economy’s marginal benefit of a public good is the sum over the individuals at each quantity of the good provided.

The economy’s marginal benefit curve for a public good is the vertical sum of each individual’s marginal benefit curve.

Market Failure: Public GoodsEfficient Provision

Government should provide the efficient quantity of a public good: up to the point where :

MB = MC, ie. MSB=MSC

•At the efficient quantity, the marginal social benefit for the community is equal to the marginal social cost for the community.

MC=MSC

MB=MSB

Quantity (number of fireworks displays

Mar

gina

l ben

efit

0 1

The Efficient Quantity of a Public Good

MBEfficientuse ofresources

Marginal Benefit & Marginal Cost The marginal benefit

curve, MB, is the one we derived = MSB.

The marginal cost curve, MC, is just like the MC curve for a private good.

The efficient quantity is where marginal benefit equals marginal cost.

Market failure occurs when all the relevant costs and benefits are not registered by the market

Externality:

Cost or Benefit resulting from some activity or transaction that is imposed on parties outside the activity or transaction; that is not registered by the market

Market Failure: 3.) Externaility

Externalities: Positive and Negative Market transactions reflect individual consumer and

firm marginal private benefits and marginal private costs respectively.

Efficiency requires:

the marginal social benefit and the marginal social cost be equalized.

If MPCMSC &/or MPBMSB, then markets will fail to achieve efficiency

Market Failure: External Benefits

Pric

e of

Flu

Sho

ts

Quantity of Flu Shots per Year

S

D1

D2

P1

Q1

E

Without external benefits registered:1) Too few influenza shots are given2) Demand = D1

P2

Q2

E1

With external benefits:1) More shots are given at a higher price2) Demand shifts to D2

D1

Too little is produced, price too low when external benefits are not accounted for in the market

MSC

Market Failure: External CostsMPC

MSB

Pric

e of

Ste

el p

er T

onne

P1 E

Q1

Private costs only1) Residents incur cost of pollution2) Supply = S1

A

Q2

P2

E1

Internalize external cost:1) Steel mill pays the the cost of pollution2) Supply shifts to S2

Quantity of Steel per Year

Too much produced, price too low when external costs are not accounted for in the market: third parties bear part of the costs

Negative Externalities: Pollution

Pollution is an old problem and is faced by both rich industrial countries and poor developing countries.

It is an economic problem that is coped with by balancing benefits and costs, using policies that internalize the external costs of production.

Negative Externalities: Pollution Public Policy For Externalities in the case of

Pollution 1.)Regulation (command and control) 2.)Taxes (negative externalities) 3) Subsidies (positive externalities)

Tax equal to the marginal external costs. In equilibrium then P = MSC.

The company with the lowest cost of reducing pollution, will choose to reduce, to avoid the tax

Supply of Good Xwhen costs includeonly internal costs

Public Policy: Tax = External Cost

Quantity of Good X per Time Period

Pric

e of

Goo

d X

per

Uni

t

S1 = MC (excluding externalities)

D

P1

Q1

Supply of Good Xwhen costs = social cost

S2 MC (including externalities)

Q2

P2

In the case of a negative externality, the efficient amount of production is achieved through a tax=external costs

Tax=External Cost of Pollution

External Costs: Public Policy: Tax

Taxes provide incentives for producers or consumers to cut back on an activity that creates external costs.

Taxing an externality does not eliminate all pollution. Taxes force decision makers to consider the full costs of their decisions: internalize the externality.

External Costs: Public Policy: Tax Taxes, have two advantages over

regulation because of their incentive effects:

they give owners an economic incentive to reduce pollution – avoid the tax,

they bring about a given amount of pollution reduction in the most efficient – least costly – way possible.

Public Policy: 3.) Emission Charges

7

10

15

0 5 10 15 20

MB

MSC

Emissions (millions of tonnes per year)

Co

st a

nd b

ene

fit o

f wa

ste

(dol

lars

per

ton

ne

)

Efficient price $10per tonne at efficient qn of 10M Tonnes/yr

At an emission level of

15MTonnes MSC($15) >

MB($7)

External Costs: Public Policy: Marketable Permits

4)Tradable Pollution Rights Trading pollution rights in

essence creates a new scarce resource - pollution permits. The price will be set by the

forces of demand and supply.

The firms that can reduce pollution only at high cost will be willing to pay the most for pollution permits, others will reduce pollution for less cost.

Supply Pollution Permits

D Pollution Permits

Qn (pollution)

Priceof Polltion $

7

10

15

0 20 40 60 80

MSB

MSC

Efficient Price

Society’sMSC & MSB

ofPollution

Abatement

Amount of pollution abatement %

Optimal Amount of Pollution

Optimal(social)amount ofpollution