Microeconomics: Market Failures & Intervention

• Unit Six of Microeconomics focuses on market failures and government intervention.

Allocative Efficiency

• Allocative efficiency occurs when resources are distributed to maximize societal welfare.
• This happens when Marginal Social Benefit (MSB) equals Marginal Social Cost (MSC).
• Marginal Social Benefit (MSB) is the total benefit to society from producing or consuming an additional unit of a good.
• Marginal Social Cost (MSC) is the cost to society from producing or consuming an additional unit.
• A graph depicts an upward sloping MSC intersecting with a downward sloping MSB.
• The equilibrium point on this graph signifies allocative efficiency (Q3).
• Deadweight loss occurs when production is either above or below the socially optimal level.

Externalities

• Externalities are costs or benefits that affect third parties not involved in the production or consumption of a good.
• Externalities can be negative or positive.

Negative Externalities

• Negative externalities include pollution from factories, traffic congestion, and secondhand smoke.
• Negative externalities can lead to overproduction (QE).
• The market price fails to reflect the true social cost.
• Qo (where MSB = MSC) is the socially optimal output.

Positive Externalities

• Positive externalities include vaccinations leading to herd immunity and public education benefits.
• The demand curve reflects the marginal private benefit without accounting for external benefits.
• This leads to underproduction if not addressed.

Addressing Externalities

• Government intervention for negative externalities includes:
• Per Unit Tax: Set equal to the marginal external cost, shifting the supply curve upward to reduce production to the socially optimal level.
• Pollution Permits: Issued to control the overall amount of pollution.
• Solutions for positive externalities often involve:
• Subsidies: Per unit subsidies granted to consumers or producers can encourage increased production and consumption.
• Subsidies shift the demand curve upwards to achieve optimal output.

Public Goods

• Public goods are non-rivalrous, meaning one person’s use does not reduce availability for others.
• Public goods are non-excludable, meaning it’s impossible to prevent anyone from using them.
• Examples of public goods are national defense and public parks.
• Due to the free-rider problem, these goods are typically underproduced in a free market.
• Government provision is often necessary for public goods.

Government Controls on Markets

• Types of government intervention:
• Subsidies: Influence market prices by shifting the supply curve to the right, increasing equilibrium quantity.
• Taxes: Alter supply negatively when a per-unit tax is levied, increasing prices and decreasing output.
• Natural Monopolies: Can suffer from significant inefficiencies when left unregulated.
• The government can impose price ceilings at socially optimal points to mitigate deadweight loss in natural monopolies.

Income Inequality and Taxation

• Lorenz Curve: Illustrates the distribution of income within an economy.
• Its proximity to the line of equality represents the degree of income equality.
• Gini Coefficient: A statistical measure of income inequality ranging from 0 (perfect equality) to 1 (total inequality).
• Impact of Taxes:
• Progressive Taxes: Higher rates for wealthier individuals, moving the Lorenz Curve inward towards equality.
• Regressive Taxes: Disproportionately affect lower-income individuals, pushing the curve outward and exacerbating inequality.
• Proportional Taxes: Same percentage for all income levels, having a neutral impact on the Lorenz Curve.

Conclusion

• Government intervention can correct market failures.
• Government intervention ensures more efficient allocation of resources.
• Government intervention addresses externalities.