Week 5 Flashcards
Public goods - Introduction
In the perfectly competitive market, property rights are assumed to be perfectly defined and enforced. This implies goods and services are excludable and rivalrous in consumption.
In reality, many goods and services are associated with property rights problems:
No-excludable
Non-rivarlous
Non-excludable
Once produced, no one can be prevented from using the good
Non-rivalrous
One persons use of the good does not diminish other peoples use
Rivalrous excludable goods
Private goods
Congested Toll road
Rivalrous non-excludable goods
Common resources
Congested non-toll road
non-Rivalrous non-excludable goods
Public goods
No toll non congested road
non-Rivalrous excludable goods
Club goods
Non-congested toll road
People seldom break a line while waiting for checkout in a supermarket. This is an example of a ______ to solve an externality
Social enforcement mechanism
Do Private goods and club goods present market failure
Private goods and club goods do not present market failure – they have prices attached to them.
Do Public goods and common resources present market failure
Public goods and common resources present market failure – externalities arise because something of value has no price attached:
If a person were to provide a public good, for e.g. national defence, others would be better off and yet they are not charged for this benefit;
If a person uses a common resources, for e.g. fish in the ocean, others would be worse off and yet they are not compensated for this loss.
Public goods and common resources present market failure – externalities arise because something of value has no price attached
What happens due to these externalities
Due to these externalities, private decisions about production and consumption can lead to inefficient outcomes (market failure).
Government intervention (public solutions) can potentially correct inefficiency and raise economic well-being.
Public goods
Public goods are goods that are non-excludable and non-rivalrous
Some examples: fireworks displays, lighthouses, national defence, basic research (knowledge), free-to-air TV and radio.
Due to these two features, people have an incentive to be free riders
Free rider
A person who receives the benefit of a good but avoids paying for it
The free rider problem
The free rider problem
The existence of free riders lead to the under-provision of public goods in the market (the free rider problem).
The market fails to provide the efficient outcome because those who gain a benefit from consuming the public good do not compensate the supplier for the production costs. Hence, the supplier has no incentive to provide the good.
The government can remedy this problem by providing or subsidising the public good and paying for it with tax revenue, to make everyone better off. This is a public solution.
Public goods public solutions
National defence
Basic research (knowledge)
Fighting poverty
National defence
one of the most expensive public goods.
Solution: People may disagree on the appropriate levels, but most will agree that some government spending on defence is necessary.
Basic research (knowledge)
– general knowledge is a public good; profit seeking firms have incentive to free ride on the knowledge created by others.
Solution: Government subsidises the basic research carried out by universities and other research organisations (this is a corrective subsidy on the positive externality generated).
Fighting poverty
everyone prefers living in a society without poverty, but fighting poverty is not a ‘good’ that private actions will adequately provide.
Solution: Many government programs are aimed at helping the poor, for e.g. unemployment benefits, old-age pensions, disability support, funded by tax revenue.
Cost-benefit analysis
A study that compares the costs and benefits to society of providing a public good.
Before providing a public good, government conducts a cost-benefit analysis to determine whether it is efficient to do so.
Public goods private solutions
Free-to-air TV and radio - non-excludable and non-rivalrous, yet provided by private firms as for-profit business. For e.g. Freeview.
Public goods private solutions
Free to air TV
How is revenue generated, when consumers enjoy for free?
Solution: broadcasters sells a complementary, private good i.e. advertising. Sells airtime to advertisers.
Advertisers are willing to pay more if their ads are shown during a program that has many viewers. This gives broadcasters incentive to show programs that viewers want to watch. Hence, viewer demand drives what is shown.
Other examples of the private provision of public goods:
search engines e.g. Google and Bing; and video sharing sites e.g. YouTube and Vimeo. These are funded by the revenue from the ads displayed on the webpages.
Common resources
goods that are non excludable but rivalrous
Some examples: clean air and climate change, oil deposits, congested non-toll roads, fish, whales and other wildlife
The tragedy of the commons refers to the overgrazing of communal land surrounding medieval English villages.
The tragedy of the commons
A parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole
The tragedy of the commons explained
Each family in the village has the right to graze sheep on the commons. When one family’s flock grazes on the common land, it reduces the quality of the land available for other families. Because people neglect this negative externality when deciding how many sheep to own, the result is an excessive number of sheep. Overgrazing eventually damages the land’s ability to replenish itself, destroying the common resource for all families in the village.
Common resources private solutions
Overgrazing on the commons
Clean air and climate change
Oil deposits
Overgrazing on the commons
the community can prevent the tragedy in a number of ways.
Solution: regulate the number of sheep in each family’s flock or divide up the land among the families.
Clean air and climate change
greenhouse gasses emitted in one country spread around the world contributing to climate change in every country. When a government in one country regulates emissions, it considers only its own environment, not the effects on other countries.
Solution: the Coase Theorem suggests that nations can enter into a treaty (e.g. the Kyoto Protocol) which commits them to reduce their own emissions. The treaty behaves like contract, internalising the externality.
Oil deposits
a large oil field lies under many properties with different owners. Any of the owners can extract the oil, but when one owner extracts oil, less is available for the others. Because each owner who drills a well imposes a negative externality on the other owners, the benefit to society of drilling a well is less than the benefit to the owner who drills it. If owners of the properties decide individually how many oil wells to drill, they will drill too many.
Solution: some type of joint action or agreement among the owners is necessary to solve the problem and ensure that oil is extracted at lowest cost.
common resources public solutions
Congested roads
Many species of animals
Congested roads
- yield a negative externality. When one person drives on the road, it becomes more crowded, and other people must drive more slowly.
Solution: Government levies a toll or a congestion charge. A toll is a corrective tax on the externality of congestion. Sometimes congestion is a problem only at rush hour. Government can charge higher tolls at rush hour as an incentive for drivers to alter their schedules.
Many species of animals (fish, whale, other wildlife)
– are common resources. Fish, for instance, have commercial value, and anyone can go to the ocean and catch whatever is available. Each person has little incentive to maintain the species for the next year. Just as excessive grazing can destroy the commons, excessive fishing can destroy marine populations.
Solution: ??
The fish problems
Two problems prevent successful Government regulation of fish stocks:
many countries have access to the oceans, so any solution would require international cooperation among countries that hold different values;
because the oceans are so vast, enforcing any agreement is difficult.
Government intervention
Governments intervene in markets to correct market failures, such as inequality, externalities and public goods. Objective: to restore efficiency and increase economic well-being of society.
Government can intervene:
Directly – by controlling prices in the markets
Indirectly – by taxing and/or subsiding demand and supply
Some policy tools used by
government:
Price controls
Taxes
Subsidies
Price controls
Inequality and fighting poverty are market failures.
Governments can directly control prices in different markets by using price ceilings and price floors to ensure all members of society enjoy a certain standard of living.
Price ceiling
A legal maximum on the price at which a good can be sold
Price floor
A legal minimum on the price at which a goo can be sold
Binding price ceiling
A binding price ceiling is set below the equilibrium price.
What do price ceilings result in
Price ceilings result in shortages of the good, as the market cannot achieve equilibrium.
How are price ceiling shortages managed
To manage the shortage, some mechanism for rationing the good will naturally develop, for e.g. queuing. In the case of rent control, landlords may be discouraged from maintaining their buildings.
When is a price ceiling binding
A price ceiling is only binding if set below the equilibrium price. If set above, it is non-binding as it does not prevent the market from achieving equilibrium.
Binding price floor
A binding price floor is set above the equilibrium price.
What do price floors result in
Price floors result in surpluses of the good. Some sellers are able to sell their goods at the higher price, but others will not be able to.
What do price floor surpluses result in
Some method for rationing will naturally develop, for e.g. appealing to the personal biases of the buyers. In the case of minimum wage, the surplus is unemployment. Rationing may lead to discriminatory hiring practices in the labour market.
When is a price floor binding
A price floor is only binding if set above the equilibrium price. If set below, it is non-binding as it does not prevent the market from achieving equilibrium.
Price controls: price ceiling
Photo in favourites 18/8/18
Price controls: price floor
Photo in favourites 18/8/18
Taxes
A tax is a payment to government, from buyers or sellers, for each unit of good that is bought or sold.
Government taxes firms and households in different markets.
Tax incidence
The study of who bears the burden of taxation, the degree to which buyers and sellers will be worse off due to tax.
Taxes fulfill two functions:
Provide government with the resources required for intervention, for e.g. government uses tax revenue to provide or subsidise public goods;
Corrective measure to internalise externalities, for e.g. government can tax activities that have negative externalities an amount equaling its external cost.
Taxes: tax incidence on buyers
The government requires buyers to pay a tax of $0.50 on each unit purchased.
What happens to the demand and supply curves
This shifts demand to the left (demand falls) by the amount of the tax.
Taxes: tax incidence on buyers
The government requires buyers to pay a tax of $0.50 on each unit purchased.
what is the effect of the tax
The tax creates a wedge between the price buyers effectively pay ($3.30), and the price sellers receive ($2.80).
Although the tax is levied on buyers, the burden of the tax falls on both buyers and sellers. The price buyers pay is $0.30 higher than before, the price sellers receive is $0.20 lower than before.
Moreover, the quantity traded falls (100 to 90).
Taxes: tax incidence on buyers
photo in favourites 19/8/18
Taxes: tax incidence on sellers
The government requires sellers to pay a tax of $0.50 on each unit sold.
what is the effect of the tax
This shifts supply to the left (supply falls) by the amount of the tax. Otherwise, the effects are identical to tax incidence on buyers.
How taxes affect market outcomes:
Taxes discourage market activity:
When a good is taxed, the quantity traded falls;
Buyers pay more for the good and sellers receive less.
The tax burden
Buyers and sellers share the tax burden. It does not matter who the tax is levied on. The effects on the market and the tax incidence are identical.
Taxes: Supply is elastic
Because supply is elastic, the price sellers receive does not fall much, so sellers bear only a small burden. In contrast, the price buyers pay rises substantially, so buyers bear most of the tax burden.
Taxes: Supply is elastic illustrated
photo in favourites 19/8/18
Taxes: tax incidence on buyers
photo in favourites 19/8/18
Taxes: Demand is elastic
Because demand is elastic, the price buyers pay does not rise much, so buyers bear only a small burden. In contrast, the price sellers receive falls substantially, so sellers bear most of the tax burden.
Taxes: Demand is elastic
Illustrated
photo in favourites 19/8/18
Subsidy
A payment from government to buyers or sellers for each unit of good that is bought or sold. Government sometimes subsidises firms and households in different markets.
Subsidies fulfill two functions:
It can be regarded as negative taxes, for e.g. government subsidises the provision of public goods;
Corrective measure to internalise externalities, for e.g. government can subsidise activities that have positive externalities an amount equaling its external benefit.
Subsidies: subsidy incidence on sellers
The government pays sellers a subsidy of $1.00 for each unit sold
What happens to the supply and demand curve
This shifts supply to the right (supply increases) by the amount of the subsidy.
Subsidies: subsidy incidence on sellers
The government pays sellers a subsidy of $1.00 for each unit sold
What does the subsidy cause
Like a tax, the subsidy creates a wedge between the price buyers pay ($2.40), and the price sellers receive ($3.40).
In this case the subsidy is paid to sellers, yet the benefits are enjoyed by both buyers and sellers. The price buyers pay is lower than before and the price sellers receive is higher. Moreover, the quantity traded rises as a result of the subsidy.
The market outcomes are identical if the subsidy is paid to buyers
How subsidies affect market outcomes:
Subsidies encourage market activity:
When a good is subsidised, the quantity traded rises;
Buyers pay less for the good and sellers receive more (the government makes up the difference).
The benefit of subsidies
Buyers and sellers share the benefit. It does not matter who receives the subsidy. The effects on the market and the subsidy incidence are identical.
Subsidies: subsidy incidence on sellers
photo in favourites 19/8/18
the First Home Owner Grant scheme
Under this scheme, to assist first time home buyers, the government pays buyers a subsidy of $7000 when they purchased their first home.
the First Home Owner Grant scheme
Elasticity
The demand of first home buyers for housing tends to be relatively elastic. The supply of housing tends to be relatively inelastic.
Subsidies: application - who benefits from the First Home Owner Grant scheme?
The subsidy creates a wedge between the price paid by buyers and the price received by sellers.
The price buyers pay does not fall much, so buyers gain a small benefit. In contrast, the price sellers receive rises substantially, indicating that sellers gain most of the benefit.
