Chapter 11 Competition Failure (PDF)

Chapter 11 The Failure of Competition to Control Greed: Social Bads and Social Goods ©1 Chapter 11 competition failure, Interlocutory Microeconomics, July 2023, 8/20/24, 4:29 PM We have seen that perfect competition in...

Chapter 11 The Failure of Competition to Control Greed: Social Bads and Social Goods ©1 Chapter 11 competition failure, Interlocutory Microeconomics, July 2023, 8/20/24, 4:29 PM We have seen that perfect competition in perfect competition markets controls greed. It makes out of the pursuit of private interest a mechanism to promote the public interest. There are however many industries in which the pursuit of private interest does not promote the public interest. As we will explain in this chapter, the reason is not because of a lack of competition like in the case of monopoly. Rather it is because there are not enough sources of greed to help competition control the overall greed mechanism in the economy. The problem is not greed itself; there is plenty of it and more. The problem is the dearth of independent sources of greed. The industries that suffer from dearth of independent and sufficient sources of greed are a) industries that use non privately appropriated natural resources (e.g. air, water, or space) as factors of production and b) industries that produce certain services for which ownership is difficult to establish (e.g. roads, security, health, and flood control). In the first case, those industries generate negative externalities, also known as external diseconomies, or positive externalities, also known as external economies. In both cases, there is a market failure since the markets for trading those products on the basis of self-interest alone will not achieve an efficient allocation of resources or will not even exist. Externalities and Efficient Allocation of Resources A firm (an individual) experiences a negative externality if its minimum long run average cost increases (the quality of her/his life is made worse forcing increasing medical expenditures) because another firm or other individuals, possibly in another industry or country, increase the output of its production and consumption of the product. A fisherman experiences a negative externality when he/she must go further out into the open sea to catch fish in order to avoid fish contaminated by an increase in the amount of deadly sludge dumped into the sea following an increase in the output of or the establishment of a chemical industry. We call pollution a negative externality or generally a social bad. It is a social bad because most people would suffer from it once it is produced. The fisherman’s total cost of catching the same amount of fish increases, causing an increase in the average total cost. Because the fisherman does not own the sea, he/she cannot shift the increased cost to the chemical industry. If somebody owned the sea, her/his greed would force the chemical industry to pay for the use of the sea as a dumping ground. The increase in the long run average cost of the fisherman should actually be attributed to the chemical industry as part of its production costs. In fact, producers or managers of every firm in the chemical industry as well as the fishermen themselves are using and without paying for the services of a natural resource as a factor of production (the natural resource service is its ability to absorb the sludge or effluent and break it down into harmless substances as well as to nurture fish or human beings). Nature requires a very long time to recycle many of the dangerous substances, such as mercury or carbon dioxide, which some industries and consumers generate and dump in the air or water as a by- product of the products they produce and/or consume. The social opportunity cost of using the services of those natural resources, let alone restore them to their natural state, is not zero. If it is not an increase in the long run average cost of some other firms, the opportunity cost is the higher risk of 1Cartago Research and Development, 8/20/24, 4:29 PM Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 2 disease experienced by people who eat the contaminated fish, breath the polluted air, experience a dramatic harmful change in the earth’s atmosphere or its outer space, the hospital costs of treating those who might get sick because of the change, the higher cost of catching non contaminated fish, and the global warming causing destruction of physical and human capital, more severe droughts in some world regions, and increased violence of hurricanes in many regions of the world. For example, in the early sixties at the time the Japanese chemical industry expended rapidly, many Japanese people ate fish containing a dangerous concentration of mercury causing many deaths and the birth of some mentally challenged children. These days, the opportunity cost is much higher and the irony is that those who people who suffer are themselves responsible for their own sufferings but they still refuse to pay for the natural resources services, the products of which they are eager consumers. To survive in a market operating under perfect or monopolistic competitive, the managers of or people who control a firm must produce at the lowest cost possible. Consequently, even if they wanted to, none of them would clean up willingly the sludge or carbon dioxide they produce before dumping its waste into the rivers, the sea, and/or the air. Indeed, if they clean up, their marginal and average costs would be higher and they must charge a price higher than the average cost of the managers of all the other firms who do not clean up. Their customers would desert them and their firm would go bankrupt. If every firm’s managers expect the managers of every other firm to dump sludge in the environment without cleaning it, the best strategy of the former is to do the same. Similarly, for individuals who use cars, trailers, airplanes, cruise ships, etc. None of them would want to pay for the natural resources services or reduce the consumption of those products in order to help themselves and society achieve an efficient allocation of resources. The outcome is a market equilibrium for products, the productions of which produces also heat carbon dioxide and sludge, with self fulfilled expectations, where the managers of every firm, the consumers of many products and government officials of every country, will dump, without cleaning, heat, sludge, chemical waste, and/or carbon dioxide in the atmosphere, in the rivers, in the oceans, and/or even in the outer space around the earth. We call that equilibrium an inferior Nash equilibrium with an inefficient allocation of resources. A long time before politicians or their constituencies realized it, this conclusion led economists, to distinguish between the marginal private cost, marginal external cost, and the marginal social cost of production. The private marginal cost is the sum of a normal profit and explicit costs that producers must pay to their suppliers for the services of labour input, capital input, and intermediate products or raw material that are actually traded. However, Marginal External Cost = Additional cost imposed on society by dumping, without cleaning, chemical sludge and/or carbon dioxide in the land, waterways, oceans, air, or outer space. (1.a) Marginal social cost = Private Marginal Cost + Marginal External Cost (1.b) We note that, in practice, it is very difficult to estimate the marginal external cost. Different people for their different special interest, have different estimates of the marginal external cost of any produced product that causes negative externalities, which makes miserable the life of an economist who argues for an efficient allocation of resources in the presence of negative or positive externalities. Does the Invisible Hand Need the Help of a Visible Hand? Suppose that the marginal external cost is a constant and equal to $4 as shown in column 3 of Table 1. Columns (1)-(2) of Table 1 give the private marginal cost as a function of the level of output. As Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 3 usual, the marginal private cost is increasing with the level of output. Column (4) of Table 1 shows the marginal social cost as the sum of the marginal private cost and the marginal external cost. Table 1 The Marginal Social Cost and the Marginal Private Cost Output Marginal Private Cost External Marginal Cost Marginal Social Cost (1) (2) (3) (4) = (2) + (3) 5 2 4 4 10 4 4 6 15 6 4 8 20 8 4 10 25 10 4 12 As we have learned in previous chapters, the marginal private cost represents the market supply curve in a perfectly competitive market. Curve SS in figure 1 represents both the marginal private cost and the supply curve of the industry. Curve DD is the market demand curve and the marginal social benefit curve. The intersection point E of the demand curve DD and the supply curve SS represents in this perfect competition market. The equilibrium price is $6 and the equilibrium output and the equilibrium quantity demanded are both equal to 15 units. The competitive equilibrium at E equates the marginal private cost (height of supply curve) to the marginal social benefit (height of demand curve). Note, however, the marginal social cost at 15 units of output is $10 while the marginal social benefit is $6. Thus, from the social point of view, the 15th unit is not worth producing. Figure 1 Perfect Competition is Inefficient in the Presence of Negative Externalities. Because, by firms producing it and consumers consuming it, together they impose on society a loss equal to the $4 excess of the marginal social cost over the marginal social benefit. If society had the Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 4 power to make output and consumption decisions, it would not produce the 15th unit and consumers would not consume it. The units for which the marginal social benefit exceeds the marginal social cost are the first 10 units. All the units between 10 and 15 units involve a dead weight loss as given by the corresponding red bars in figure 1 because their corresponding marginal social benefit is less than their corresponding marginal social cost. The total deadweight loss is equal to the surface of red triangle ACE in figure 1. A similar argument applies to markets that operate under monopolistic competition or they are dominated by an oligopoly or a cartel on the supply side. Only when the industry produces 10 units of this product would it maximize total net social benefit. We conclude: Regardless of the type of market competition, by promoting own interest, producers and consumers alike will not promote the public interest in the presence of negative externalities, In the presence of a negative externality, producers in markets dominated by private interest and greed on both sides will overproduce and consumers will knowingly overconsume. Economists suggested that the reason that perfect competition or other kinds of competition fail to make out of private greed a mechanism to promote the public interest is that no one owns the sea, the air, the outer space or the water. They are all factors of production and every producer uses their services to produce her/his products and every consumer is consuming those products without paying even for covering the depreciation of those freely available factors of production. It follows that if somebody or some institution owned them, he/she it would charge the producers and hence ultimately the consumers for their use according to the corresponding marginal external cost. This would force the marginal private cost of every producer to be equal to the marginal social cost. For example in the case of figure 1, the owner of the sea would charge an amount of 4 dollars per additional unit produced, which is equal to the marginal external cost. Possible Solution 1: Consumers as Owners of Natural Resources For example, we can bestow the ownership of the natural resource on the consumers. Instead of the consumers charging the producers of the product the marginal external cost of $4 per unit of the product, the consumers would reduce their willingness to pay by $4. Their demand curve would shift downwards by $4 from DD to D’D’ as in figure 2. The competitive equilibrium is now given by the intersection point B in figure 2 of the demand curve D’D’ and the supply curve SS. At this new equilibrium, the producers would produce and the consumers would consume 10 units of the product, equal to the quantity produced and the quantity demanded that maximize the total net social benefit, with marginal social benefit = marginal social cost and the equilibrium price equal to $4. While the idea that treats consumers as a coherent organization and bestows on them the ownership of the resource is ingenious, it is not practical. It is not easy for consumers of fish to own collectively the sea or the rivers and in general natural resources and charge to themselves the appropriate marginal external cost for the use of the resource. The trouble is that some or all of them will not charge themselves the marginal external cost and they will attempt to buy more at the cheaper equilibrium price. The transaction costs of the consumers policing each other are so enormous that it would be practically impossible to implement this solution. In any case, that is one of the major reasons these resources are not privately owned. Another reason is that it is not possible to subdivide the earth’s atmosphere, the many great rivers of the earth, and the earth’s oceans and space into small or large pieces so that we can arbitrarily assign ownership to a large or small number of individuals or groups of individuals such as nations. Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 5 Figure 2 Equilibrium When Consumers Own the Natural Resource Price or Marginal External Cost =$ 4 Unit 16 Cost Demand Curve, Marginal Social Benefit Marginal Social Cost Curve 14 Curve D (Willingness to Pay - $4) Curve 12 Consumers own Ressource A 10 S C D' 8 Marginal Private 6 Cost Curve E 4 B D 2 D' S 0 0 5 10 15 20 Quantity 25 Efficient Output Perfect Competition Output Solution 2: Government as Owner of Natural Resources Another solution is to substitute a government for the consumers as the owner of the natural resources. After all, a government is a social institution that is supposed to represent all members of society. This solution amounts to declare the government as the owner of the resource on behalf of society, which it is in fact. That is, we need the visible hand of the government to help the invisible hand promote the public interest while every member of society promotes her/his own interest. Figure 3 Perfect Competition is Inefficient in the Presence of Negative Externalities. Price or Per unit sales tax = $4 = Marginal External Cost Marginal Social Cost Curve = Unit 16 Cost Marginal Private Cost Curve including a $4 per unit Tax 14 Demand Curve, Marginal Social Benefit Curve S' 12 D A 10 S C 8 Marginal Private 6 Cost Curve S' E 4 2 S D 0 0 5 10 15 20 25 Efficient Output Perfect Competition Output with a $4 tax per unit produced Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 6 In other words, provided that it is possible to prevent moral hazard and adverse selection from defeating the purpose, we invest government officials with the authority to represent the interests of society, (including the consumers and producers of all generations past, present, or future) in properly replacing on time the depreciation of the productive capacity of all natural resources due to all kinds of discharges of waste resulting from productive activity. As shown in figure 3, government officials would impose a per unit tax equal to the marginal external cost of $4 and spend the total collected amount of taxes to help natural resources maintain intact their productive ability and protect those members of society who might suffer otherwise. This would shift the marginal private cost curve and hence the supply curve from curve SS upward to curve S’S’ by an amount equal to the marginal external cost of $4 and make the marginal private cost of the producers equal to the marginal social cost. Then, the equilibrium of the market operating under perfect competition would obtain at point C where the marginal social cost is equal to the marginal social benefit with the amount produced and consumed equal to the efficient output of 10 units and the equilibrium price paid by consumers equal to $8 not $6 but the net equilibrium price received by producers is equal to $4 and not $6, as it would be if government did not impose the tax. The government tax helped the perfect competition market achieve an efficient allocation in the present and in the future, provided that the government officials act as specified above. This is an example of a productive sales tax, the imposition of which in the appropriate amount results in an efficient allocation of resources. Contrary to the claims of many economists, this tax is not a sui- generis sales tax and the imposition of all other sales taxes results in an inefficient allocation of resources. Whether the imposition of a sales tax results in an efficient or inefficient allocation of resources depends on the purpose of imposing it and the use by government officials elected or not of the revenue collected from imposing it. Efficient Amount of Externalities In our previous discussion, we made two implicit assumptions. First, we measured implicitly the damage to a natural resource (caused by producers using the services of that natural resource in the production of their products as a factor of production) by a constant marginal benefit that society would obtain if it restored the damage. Second, we assumed that the marginal external cost associated with the damage is constant. Accordingly, a practical economic solution was for the government to charge a unit tax equal to the marginal external cost on each unit produced of the product using the services of that natural resource. The government would then use the proceeds collected from the tax to restore the associated damage sustained by the natural resource. This solution is consistent with the position of some environmental groups who advocate the complete cleanup of pollution. However, further economic analysis suggests that the marginal social benefit from and marginal external cost of restoring the damage caused by producers using natural resources as a factor of production are not constant. Economic analysis shows that the optimal amount of damage that needs to be restored should maximize total net social benefit. For example if the damage caused to the natural resource is pollution, when we clean up one unit of polluted air or water, we obtain a marginal social benefit but must bear a marginal external cost. If the marginal social benefit is greater than the marginal cost of cleaning an additional unit of the earth’s air Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 7 or water, that additional unit is worth cleaning up. Otherwise, it is not worth cleaning the remaining units if the natural forces are able to clean up them quickly enough. Furthermore, in most cases, the government cannot do the cleanup itself. Efficiency requires that the cleanup activity should be subject to perfect competition. For example, the polluters may have a comparative advantage in doing the cleanup by acquiring and installing the appropriate technology. We now have two interesting issues: First: What is the efficient level of output and employment for industries that produce a marginal external cost such as water or air pollution Second: What is the efficient level of repair of the damage to that natural resource the services of which are used as a factor of production. These two issues are intertwined and they are more difficult to understand when we treat them together. We separate them in order to gain a better understanding of each. In the previous section, we treated the first issue. In this section, we suppose that we know the efficient level of output and the corresponding total amount of damage caused to the natural resource such as water or air pollution caused when the services of which are used as a factor of production. Then we investigate the issue of how to find the optimal amount of pollution of air or water to clean up and how it should be achieved. Suppose that the natural resource is air or water and we have two polluting industries. Each industry produces five units of pollution using the corresponding natural resource as a factor of production. Furthermore, suppose that the total optimal level of pollution caused by the two industries is equal to 10 pollution units. Should we force all the firms in both industries to clean up each unit of pollution they produce? We use figure 4 to answer this question. In figure 4, we measure the number of units of pollution or social bads on the horizontal axis from left to right. We measure the number of cleaned up units of pollution on the coloured horizontal green axis going from the right of the green axis to its left. Line BK in figure 4 gives the marginal benefit of cleaning one additional unit of pollution. At 0 units of pollution cleaned and 10 units not cleaned, the marginal social benefit of cleaning the first unit is high and equal to $15. At one unit of cleaned pollution, the marginal social benefit of cleaning the second unit is lower and equal to $14. The decrease in the marginal social benefit from an additional unit cleaned reflects the principle of decreasing marginal utility. When 9 units of pollution are cleaned up, the marginal social benefit from cleaning an additional unit drops to $6. This is consistent with the idea that nature can largely take care of itself if we do not abuse it. Nature’s recycling powers quickly reverse the harm caused by the first units of pollution. Thus, the marginal social benefit curve BK in figure 4 is downward sloping from the right to the left. Obviously different firms in different industries have different marginal costs of cleaning up the pollution they generate. For example, each firm in industry 2 may have a lower marginal cost of cleaning than any firm in industry 1. We order firms according to their marginal cost of cleaning up units of pollution starting at point A in figure 4 with firms that has the lowest marginal cot of cleaning. The marginal cost of cleaning is low at 0 units cleaned (or at 10 non cleaned units) of pollution. Let us order the firms in these industries according to their marginal cost of cleaning units of pollution. Accordingly, firms in Industry 1 generate the first five units of pollutions. Firms in industry 2 generate the last five units of pollution. Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 8 Figure 4 Efficient Amount of Cleaning of Pollution or Social Bads Price or Marginal Social Cost Curve of Unit Benefit Unit Cost 16 Cleaning up Pollution Marginal Social Benefit Curve 15 B of Cleaning Pollution 14 L 13 12 11 E 10 9 8 7 6 K C 5 4 3 2 1 Units of Pollution A 0 0 1 2 3 4 5 6 7 8 9 10 10 8 6 4 3 2 0 Cleaned Units of Pollution Efficient Level of Cleaning = 5 units According to figure 4, at 0 units cleaned and 10 units of pollution remaining, the marginal cost of cleaning up an additional unit is $5. At 2 units cleaned and 8 units of pollution remaining, the marginal cost of cleaning up an additional unit is $7. Thus, the marginal cost of cleaning up an additional unit of pollution rises with the number of units cleaned from $5 for the first unit cleaned by some firm in industry 2 to $15 for the last unit cleaned by some firm in industry 1. With this way of ordering all firms according to their marginal costs of cleaning, we obtain curve CL in figure 4. We call curve CL the marginal social cost curve of cleaning units of pollution. Clearly, from the social point of view, starting on the right hand side of figure 4 at point A with zero units cleaned and 10 units of pollution remaining, it is worth cleaning the first unit. The marginal social benefit of cleaning the first unit is $15 but the marginal social cost is $5. Thus, society would earn a marginal net social benefit such that: Marginal Net Social Benefit = Marginal Social Benefit - Marginal social cost = $15 - $5 = $10. Similarly and from the social point of view, it is worth cleaning up the second unit of pollution because the marginal net social benefit of cleaning it is equal to $14 - $6 = $9, and so on. To maximize the total net social benefit, it is worth cleaning up more units of pollution as long as the marginal social benefit of cleaning an additional unit of pollution is greater than its marginal social cost. As the number of units cleaned increases, the marginal social benefit falls and the marginal social cost rises. The net marginal social benefit from cleaning up an additional unit of pollution falls as the number of cleaned units increases. Thus, the total net social benefit, which is the sum of the net marginal social benefits, keeps increasing, but with decreasing amounts. In figure 4, at 5 units cleaned up (and 5 units of pollution remaining), the marginal social benefit is equal to the marginal social cost and the net marginal social benefit falls to zero. At this level, the total net social benefit stops increasing. Cleaning the sixth unit would produce a marginal social benefit of $9 at a marginal social cost of $11. The net marginal social benefit is 9 - 11 = $-2 < 0. Since the net marginal social benefit is negative, Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 9 the total net social benefit at 6 units cleaned up is lower than at 5 units cleaned up. Thus, the maximum total net social benefit occurs when 5 units of pollution are cleaned up. The optimal or efficient number of units of pollution cleaned is 5 units and the efficient number of units of pollution that remain untreated is equal to 5 units, not zero. This is so because, for the remaining 5 units of pollution, the marginal social cost exceeds the marginal social benefit and nature can take care of itself. The Efficient Policy of Cleaning up Pollution There are many methods of cleaning the efficient number of units of pollution. Not all of them are efficient. We consider two methods: The Fair Policy method and the Economist Policy method. The Fair Policy Method In our example of figure 4, the efficient number of units of pollution that should be cleaned up is not the total number of units of pollution. According to economic theory, the efficient number of units of pollution that society should choose to clean up is half the total number of units of pollution generated. This suggests that every firm in the industry should clean up half of the number of units of pollution it generates. One would think this decision is fair and hence this is the best policy to achieve an efficient allocation of resources. Let us call this method the Fair Policy. We show with the help of figure 5 that this method yields an inefficient allocation of resources. As figure 4, Figure 5 uses the same data relative to the marginal social cost and marginal social benefit and the optimal number of units of cleaned units of pollution. According to the Fair Policy, firms in industry 1 should clean up 2.5 units. To minimize their total cost, firms in industry 1 would clean up units from 2.5 to 5 units. The total cost of cleaning up is the sum of the marginal costs of cleaning these units. This is given in figure 5 by the area of the red trapezoid DEFG = (($10 + $12) x 2.5 units)/2 = $27.5. Similarly, to minimize the total cost of cleaning up, firms in industry 2 would clean up units from 7.5 to 10 units. The total cost of cleaning is the sum of the marginal costs of cleaning these units. This is given in figure 5 by the area of the red trapezoid ACHJ = (($5 + $7) x 2.5 units)/2 = $15. Figure 5 An Inefficient Policy of Cleaning Pollution Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 10 Thus, according to the Fair Policy, the total cost for the whole economy of cleaning the efficient number of units of pollution is equal to $42.5 = (area of DEFG) + (area of ACHJ). The Economist Policy Figures 3 and 4 look like a demand-supply curves diagram for an interesting product. This product is the right to pollute one unit of clean air, when using the services of clean air as a factor of production. Polluting firms are interested in acquiring rights to use the services of clean air to produce their product and in the process pollute those units of clean air so that they do not have to clean them up. The maximum amount they are willing to pay per additional right to pollute one more unit of clean air is the marginal cost of cleaning up the unit that they can avoid doing. If they have to pay more than the marginal cost of cleaning up an additional unit, they would rather clean up that unit themselves. Thus, in figure 5, curve CL of the marginal cost of cleaning one additional polluted unit of air is a demand curve for the rights to use the services of clean air to produce their product without having to clean up the resulting pollution. From the social point of view, every unit of clean air or water has a value. We assume that society owns the natural resource of clean air or water on behalf of all its members. Suppose that society accepts to part with or supply one additional unit of clean air or water to a producer to use its services in production and thereby get it polluted without the producer cleaning the pollution. The producer has thus obtained a right to pollute one additional unit of clean air. Society must then accept to live with the polluted unit and has lost the associated marginal social benefit of that unit until nature cleans it up on its own or it must recover the unit of clean air or water by cleaning it itself possibly with the help of nature and incur the marginal social cost of doing it, It follows that society has a minimum price to supply the right to pollute an additional unit of clean air. This minimum price is equal to the maximum of the marginal social benefit and the marginal social cost of cleaning up itself the additional polluted unit. For simplicity, we assume that the maximum is equal to the marginal social benefit of an additional unit of clean air. Thus, the height of the marginal social benefit curve BK in figure 5 at a given number of polluted units of air or water is the minimum price society would accept to supply one additional right to pollute one Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 11 additional unit of clean air or water when its services are used in production without the polluting producer cleaning up the associated amount of pollution he/she creates.. In other words, curve BK in figure 5 is the supply curve of the rights to pollute additional units of clean air. The higher is the number of rights to pollute that society has supplied and the more units of clean air or water society has supplied to use their services for the production of a product, the lower the number of units of naturally clean air remains, the greater is the minimum price society asks for the right to pollute an additional unit of clean air. It follows that supply curve BK in figure 5 of rights to pollute additional units of clean air is upward sloping. This suggests that there is a market for the rights to pollute units of clean air. The market reaches equilibrium at point E as given by the intersection of the demand curve LC and the supply curve BK in figure 5. The equilibrium price of the right to pollute one unit of clean air is $10 and the equilibrium number of the rights to pollute is 5 units. Given the price of $10, Society is willing to incur the costs of cleaning up or tolerate 5 units of polluted air or water at a price of $10 each. As long as the price is greater than the marginal social benefit from that unit of clean air, society would supply the rights to pollute those units and make up a maximum positive "profit" given in figure 5 by area KEM = (5 * 5)/2 = $12.5. Those firms whose marginal cost of cleaning up their units of pollution is greater than the price of $10 (i.e. firms in industry 1 that create the first 5 units of pollution) would accept to pay the price of $10 to society as represented by its government for the right to pollute one unit. For all rights to pollute units between 0 and 5 units, the willingness to pay of firms in industry 1 for an additional right to pollute one more unit, as given by the height of demand curve LC in figure 5, is greater than the right’s equilibrium price of $10. Firms in industry 1 would purchase the rights to pollute those five units of clean air at a price of $10 and save, by not cleaning up their pollution, a total cost equal to area LME equal to ($5 x 5)/2 = $12.5. For firms in industry 2, which are responsible for the last 5 units from 6 to 10 units of polluted units of clean air or water, the $10 equilibrium price of the right to pollute one unit of clean air or water is greater than their marginal cost of cleaning each one of those units as given by the height of curve LC in figure 5 at units 6 through 10 units. It is in their own interest not to purchase the right to pollute one more unit and to clean up the units of pollution they create. Thus, if we can create a market for the right to pollute units of clean air, we would achieve an efficient allocation of resources. The equilibrium price in the case of figure 5 for the right to pollute one unit is $10. Firms in industry 1 would purchase five rights to pollute 5 units of clean air and create 5 units of pollution. Firms in industry 2 would not purchase no rights to pollute the remaining 5 units clean air. They would clean up their pollution and they would not create the last 5 units of pollution just as required by the efficient solution. This is the Economist Policy. The total cost of cleaning up the last 5 units of pollution as required to maximize the total net social benefit is given in figure 5 by the area of trapezoid ACEF = ((10+ 5)* 5)/2 = $37.5. Recall that the total cost of cleaning up 5 units of pollution according to the Fair Policy is $42.5. Compared to the Fair Policy, the Economist's Policy the corresponding total cost of cleaning up the same optimal number of pollution units is $5 or about 12% lower. In other words, the Economist's Policy is efficient and the Fair policy is inefficient. By imposing a tax of $20 per ton of carbon dioxide emitted, the government of Canada has opted for a solution to the global warning problem similar to that suggested by the Economist Policy. Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 12 Social goods We now turn our attention to a second important exception to the principle that perfect competition can make out of greed a self-controlling mechanism to promote the public interest. This is the case of a producer who cannot recover the average cost of a product because once he/she produces one unit of the product he/she cannot exercise ownership rights over it. For this reason, we call such a product a social good.2 Examples of a social good are: national defence, lighthouses, police protection, flood control, some part of education, disease control, and radio broadcasting. Definition of a Social good A social good is a product that satisfies the following two properties: a) Any consumer can enjoy consuming at the same time every once produced unit of the social good without diminishing the enjoyment by or availability of the social good unit to other consumers. We call this property the nonrival property of the social good, b) It is not physically or otherwise possible to exclude any consumer from enjoying any produced unit of the social good once that unit is produced. We call this property the non-excludability property of the social good, For example, suppose that a dam is built in a valley that is constantly threatened by flooding. Every resident living in the valley would enjoy the protection of the dam at the same time without reducing the enjoyment of others: The dam services satisfy property a) of a social good. The builder of the dam cannot exclude any resident of the valley from enjoying the protection of the dam even if the resident does not pay for it, The dam services satisfy property b) of a social good. Similarly, suppose a lighthouse is built. Every ship owner can use it to navigate safely during storms or at night without preventing other ship owners from enjoying the same service: The lighthouse services satisfy property a) of a social good. After building the lighthouse the builder cannot exclude the owner of any ship from enjoying the services of the lighthouse whether the ship owner pays or not for the services of the lighthouse: The lighthouse services satisfy property b) of a social good. A private producer of such products would go bankrupt because he/she cannot collect from the users enough money to pay for the production costs due to property b). If the product is produced every consumer becomes a free rider. The fuzziness in delimiting property rights combined with the greed of consumers make it impossible for perfect competition to create out of greed a self-controlling mechanism for promoting the public interest. Again, the invisible hand needs the visible hand of the government to control greed and promote the public interest. Note here that the product is not the dam or the lighthouse per se. The services they produce are so diffuse; the producer does not have clear property to them. 2 Most textbook authors call this kind of product a public good. We prefer to use the term social good to refer to this kind of product instead because the word public is used in many contests and it is therefore misleading Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 13 Some argue the best way to provide these social goods is to have the government produce and supply them because the government has the power to tax regardless of the declared benefits that consumers declare they receive from the consumption of such social goods. This solution to the failure of perfect competition to make out of greed a self-controlled mechanism is useful but may prove to be wasteful as well. It is well known that government politicians operate differently from the way perfectly competitive markets operate, It follows that our first task is to find out what is the efficient amount of output of a social good to produce and how to pay for it if government politicians and decision makers have complete information about production costs and the willingness to pay of every consumer. Efficient Output of a Social Good The provision of social goods presents special challenges for markets operating under perfect competition or monopolistic competition. All products that one person can consume and no other person can consume at the same time are private goods. Most products that we encounter in the real world such as apples, chairs, cars, and so on are private goods. For private goods, the production of which does not cause either a positive or negative externality, we know that the efficient amount of their output is that amount at which the marginal social benefit is equal to the marginal social cost. If the market is perfectly competitive and there are no externalities, the market demand curve for the product tells us the marginal social benefit and the market supply curve tells us the marginal social cost. For a social good, property b) of this product precludes the existence of a market for it. Thus we cannot rely on perfectly competitive markets to provide the necessary information and achieve an efficient allocation of resources. Government officials can obtain some information about the marginal social cost based on feasibility studies or their own prejudices and inclinations. However, information about the marginal social benefit is not readily available to government officials. The lack of information poses formidable obstacles to the achievement of an efficient allocation of resources in the case of social goods. To understand this point, we first show how to construct the marginal social benefit curve for a social good if we had access to the required information. Suppose that we have only two consumers: consumer 1 and consumer 2. Table 2 Columns (1) and (2) describe the marginal private benefit of consumer 1 as a function of the number of units consumed of the social good given in column (1). Table 2 Columns (1) and (3) describe the marginal private benefit of consumer 2 as a function of the number of units consumed of the social good given in column (1). As for any private product, the marginal benefit of any consumer is a decreasing function of the number of units consumed. Table 2 Marginal Private and Social Benefits Units Marginal private benefit Marginal Marginal Marginal net social Benefit Social Cost Social Benefit Consumer Consumer 2 1 (1) (2) (3) (4) = (2) +(3) (5) (6) 2 8 10 18 12 6 4 7 9 16 13 3 6 6 8 14 14 0 Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 14 8 5 7 7 15 -3 Property a) of the definition of a social good (which we reproduce below) implies that the enjoyment of any one of the consumers of an additional unit is not reduced when another consumer consumes that same unit at the same time. Property a) of a social good: Every consumer can enjoy consuming a unit of a social good at the same time as other consumers are consuming it without reducing the enjoyment of the other consumers of that same unit, Thus, the marginal social benefit of an additional unit of a social good is equal to the sum of the marginal private benefits of all consumers of that unit of the social good. Columns (1) and (4) of Table 2 give for every available quantity of the social good, the marginal social benefit of an additional unit of the social good as the sum of the corresponding entries in columns (2) and (3). In figure 6, the heights of lines FK and GM represent respectively the marginal private benefits of consumers 1 and 2. At any quantity produced of the social good. The height of line LE in figure 6, which represents the marginal social benefit, is the vertical sum of the heights of lines FK and GM at the quantity of the social good produced. For example, at an output of 4 units of the social good, the marginal private benefit of consumer 1 is given by distance AB and that of consumer 2 is given by distance AC. The marginal social benefit is equal to distance AD = AC + AB = AC + CD, since CD = AB. The efficient output of the social good is that output at which the marginal social benefit, as given in the corresponding entry of column 4 in Table 2, is equal to the marginal social cost, as given by the corresponding entry in column 5 of Table 2. This efficient output is equal to 6 units. The intersection point E of the marginal social benefit curve LE and the marginal social cost curve GE in figure 6 gives the same answer. Figure 6 Marginal Private and Social Benefits of Social Goods Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 15 Marginal Benefit 21 Marginal Cost in $ Marginal Social Marginal Social 20 Marginal Private Benefit Benefit Curve Cost Curve 19 L Curve of 18 17 16 15 D 14 13 E 12 G 11 Consumer 2 10 9 M Consumer 1 8 F C 7 6 B 5 K 4 3 2 N 1 H A 0 O 0 1 2 3 4 5 6 7 8 Quantity As columns (4) and (5) of Table 2 and the corresponding lines LE and GE of figure 6 show, the marginal social benefit is greater than or equal to the marginal social cost at every output of the social good between 0 and 6 units. For all these units the net marginal social benefit is positive or greater than zero. At any output of the social good beyond 6 units, the net marginal social benefit is negative. Thus In this example, the efficient output of the social good that maximizes the total net social benefit is equal to six units. At the optimal output of the social good of 6 units, figure 6 shows that The total private benefit of consumer 1 is equal to area FKHO = $45 = (($9 + $6) x 6 units)/2 The total private benefit of consumer 2 is equal to area GMHO = $57 = (($11 + $8) x 6 units)/2 The total social benefit is equal to the sum of the total private benefits of consumers 1 and 2 and it is equal to $102 = $45 + $57. The total cost of producing the efficient output of 6 units of the social good is equal to the area under the marginal cost curve GE between 0 and 6 units = area GEHO = $75 = (($11 + $14) x 6 units) / 2. Clearly the total social benefit is greater than the total social cost and the efficient output is worth producing and consuming. The problem is how to implement this solution. A Theoretical Solution: An Honest government and Honest Consumers Suppose that a government agency was set up for the production of the social good and its officials have perfect information about the marginal benefit of every consumer as given in Table 2 and the production technology of the social good. Furthermore, suppose that the officials of the government agency are instructed to behave like a producer and supplier operating in a perfectly competitive market. It follows that the output of the social good that the government agency officials should produce and supply is equal to six units and charge a price for the social good equal to its marginal social cost at six units, a marginal cost which is equal to $14 according to the data given in Table 2 and as given by Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 16 the ordinate of the intersection point E of the marginal social benefit curve LE and the marginal social cost curve GE. The problem is how would the government agency officials get this price. They should not charge each consumer a price equal to the marginal cost. None of the consumers would want to consume that much of 6 units of the social good. By definition of a social good, both consumers can enjoy the consumption of any same quantity of the social good at the same time. Now, in a market for a non-social good operating under perfect competition, every consumer pays a price equal to his/her marginal private benefit. By analogy, it follows that, at a quantity produced and consumed of 6 units of the social good, consumer 1 and consumer 2 should be charged respectively a price equal to their respective marginal private benefits equal to $6 and $8 respectively, as given by the corresponding entries of Table 2 of columns (1) and (2) and columns (1) and (3). The equilibrium total price per unit of the social good is equal to the sum $14 of the two marginal private benefits. This equilibrium total price is equal to the marginal social cost at the efficient amount of the output and consumption of the social good. By charging an equilibrium total price of $14 for each unit produced and consumed, the government agency officials collect a total revenue equal to $84 = $14 X 6 units. On the other hand the total cost of producing the efficient output of 6 units of the social good is equal to $75. The total revenue exceeds the total cost, leaving an economic profit equal to $9, The government agency officials in charge of the production of the social good would be able to produce the efficient amount of the social good. The government agency officials and the consumers would behave like the suppliers and consumers operating in a perfectly competitive market. The problem is how to get such detailed information about the private marginal benefits of every consumer in the economy. One way is for the officials of the government agency to run a survey asking every consumer to provide honestly a schedule of her/his marginal private benefit. This is possible if each consumer is honest and provides such detailed information knowing well that he/she has to pay a price for each produced unit of the social good equal to her/his marginal private benefit at the efficient output of the social good. The real world is much different. Information problem A major problem of any producer and supplier of a social good is how to pay for the recurrent total cost of producing the optimal amount or any amount of the social good. To decide about the output and pay for the recurrent total cost of this product, he/she needs to know the marginal private benefit schedule of every consumer of the product in addition to her/his production function and the various costs of production. The problem is how to get such a detailed information when Every consumer is selfish and knows perfectly well the properties a) and b) of a social good and Every consumer knows that he/she will be charged a price equal to her/his marginal private benefit. In the real world, every member of society knows that the number of the other members of society is very large. Thus there is a temptation for every consumer of the social good not to disclose her/his true marginal benefit schedule to the government officials and hope others will pay according to their marginal benefit to cover the production cost of the social good, The reason is that once any given amount of the social good is produced, he/she could consume at the same time almost the same amount of the social good even if he/she does not pay for it and it is not possible to exclude her/him even if he/she does not pay at all. The temptation not to pay and yet enjoy the consumption of the social good is called the Free Rider Problem Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 17 Given that none of the other consumers succumb to reveal her/his marginal benefit schedule and everyone knows this fact, none of them would reveal and commit to pay. We have a low level Nash Equilibrium and the social good would not be produced. The Free Rider Problem To illustrate the Free rider problem, we replace figure 6 by figure 7 where we keep the marginal social benefit LE and the marginal social cost curve GE unchanged as shown in figure 7. We alter the marginal private benefit curve of consumer 1 so that her/his marginal private benefit curve is now curve AC in figure 7. We replace consumer 2 with a large number of consumers other than consumer 1 so that the vertical sum of their marginal private benefit curves yields curve FH. We can easily check that the vertical sum of the marginal private curves FH and AC yields the marginal social benefit curve LE, as it was the case in figure 6 Figure 7 The Free Rider Problem Marginal Benefit 21 Marginal Cost in $ Marginal Social 20 Marginal Private Benefit L Benefit Curve 19 Curve of all other Consumers 18 17 F Marginal Social 16 Cost Curve 15 E 14 13 D 12 H 11 10 G 9 8 7 6 Marginal Private Benefit 5 Curve of Consumer 1 4 A 3 2 B M C 1 0 O0 1 2 3 4 K 5 J 6 7 8 Quantity Suppose that the officials of the government agency could get every consumer of the social good to reveal her/his true marginal private benefit, Then they will produce the efficient amount of the social good as given by the abscissa 6 units of point E in figure 7 where the marginal social benefit curve LE intersects the marginal social cost curve GE. They will charge a price of $1 to consumer 1 and they will charge all the other consumers combined a price $13 to get a total price of $14, equal to the marginal social benefit and the marginal social cost at 6 units of the social good. At this efficient amount of production of the social good, consumer 1 would consume 6 units of the social good and enjoy a total net private benefit equal to the surface of area ACM = $6 = ($2 x 6 units)/ 2. Suppose that every other consumer reveals correctly his or her marginal private benefit curve. However, consumer 1 realizes that instead of revealing her/his true marginal private benefit curve AC Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 18 as in figure 7, he/she declares that her/his marginal private benefit is identically equal to zero. Then, he/she will have to pay nothing for consuming any quantity of the social good if produced and he/she will be able to consume that quantity if produced. Now, the marginal private benefit curve FE of all the other consumers becomes the incorrect marginal social benefit curve. The optimal amount to produce of the social good by the government agency officials is now 5 units and the equilibrium total price is $13.5 as given by the intersection point D of the incorrect marginal social benefit curve FE and the marginal social cost curve GE in figure 7, with everyone, but consumer 1, being charged a price equal to her/his marginal private benefit. Consequently, every consumer will suffer a reduction of her/his amount of the consumption of the social good. Every consumer, other than consumer 1, will suffer a fall in her/his total net benefit. In contrast, the total net benefit of consumer is now given by the surface of area ABKO in figure 7 which is equal to $11.25 = (($3 + $1.5) x 5 units) /2. This amount of her/his consumer surplus or total net benefit is more than double what he/she would enjoy had /he/she revealed her true marginal private benefit curve. He/she is a free rider and the temptation is great. Practical Implications of the Free Rider Dilemma The fact that in this case consumer 1 is a free rider would be tolerable if no other consumer would do the same and if the number of other consumers is large. If every consumer behaves the same way as consume 1, the resulting incorrect marginal social benefit would be identically equal to zero and the government agency officials will not produce the social good, every consumer loses. In this case a private producer would also not venture to produce any amount of the social good. The trouble is twofold. First, the private producer must be able to discriminate among consumers and set a price for each consumer according to her declared marginal private benefit. In any market, the number of consumer is very large. Consumer preferences change continuously over time so that the costs of maintaining the records are prohibitive. Note however with the help of the great Artificial Intelligence, this is not an insurmountable problem anymore. Furthermore, there is the danger that the producer, and we can have only one, may exploit his position to act like a monopoly, Artificial Intelligence or not. Secondly, even if the costs of maintaining the records are negligible and the producer will act like if he/she is a price taker and under perfect competition, there is no cheat proof way of collecting the information about the marginal private benefits of individual consumers. Most consumers would not reveal their marginal benefits if they know that the producer will charge them according to their revelations, poor Artificial Intelligence in this case. Finally, there is the case that some social good consumers are honest. At every quantity of the social good, the sum of the marginal private benefits of those consumers who are honest may fall short of the total cost of producing that quantity of the social product, most likely due to large economies of scale in the production of the social good. The free rider problem precludes the production of social goods by private producers or a government agency. Government and the free rider problem The government agency officials are in no better position than a private producer to solve the free rider problem and produce the optimal amount of the social good. Yet every consumer knows that it is better to produce some quantity of the social good rather than not produce it. Every consumer realizes that the government agency officials need the help of the government apparatus to get around the free rider problem because in a democratic society the government has the power to Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 19 choose the quantity of the social good to produce and to tax subject to the approval of the majority of consumers, if there is no corruption and logrolling in the election process of government officials. One-way to get some information about the marginal benefits indirectly, although inaccurately, is to use the voting mechanism. The alternatives the consumers would vote on would be a few different packages of quantities of the social good and corresponding per unit taxes based on the marginal cost schedule and the corresponding total social cost. For each alternative, the total taxes collected would cover the production cost of the corresponding quantities. Since every consumer is forced to pay a share of the total cost, he/she whether honest or not has the incentive to choose, if he/she does not form a coalition that votes in block, the best non-zero amount of the social good to produce and consume, This is the case in Switzerland, where there is a referendum on all important government decisions separately, In Switzerland, the productions and consumptions of social goods are much closer to their efficient levels. In other developed democratic countries, when people take voting decisions at the same time, every consumer knows that if he/she seriously undervalues her marginal private benefit, then the social good would not be produced at all and he/she would not maximize her own utility. Different candidates who compete for a government office will offer different packages of quantities of the social good and corresponding head taxes to cover the corresponding total production cost. Many factors enter in determining the size of the package offered by a. candidate. Since every voter is a consumer of the social good, we expect that the package of every candidate will promise a positive quantity produced of the social good. Since one of the candidates to the government office must win and everyone must pay a head tax to produce a certain quantity of the social good to be produced, we expect that every consumer would have the incentive to vote for an alternative with a positive quantity of the social good that is closest to her/his best choice of the amount of social good and all other goods and services based on her/his total utility subject to her budget constraint, Otherwise, if the consumer chooses to misrepresent her marginal private benefit of the social good and votes for a zero quantity of the social good, he/she may end up paying the head tax for choice he/she does not like The quantity of the social good specified in the package of the vote winner will not be equal to the efficient amount. However, some amount of the social good will be produced. This is better for everyone than a complete failure to produce the social good as a consequence of the free rider problem. This is a practical way to make available a reasonable amount of some critical social goods available for consumption rather than society ending up with no such goods available at all. This is also the raison d’etre of all types of governments since the appearance of human civilization in any region of the on earth. Conclusions Positive and negative externalities constitute a major challenge to market based economies. Perfect competition markets generate an efficient allocation of resources only under the following conditions: The products that are produced and exchanged are Private Their production or consumption does not result in negative and/or positive externalities A product is a private product if Only the person who pays the equilibrium price for a unit of it can enjoy consuming it and no other person can consume that same unit of the product A unit of the product is excludable in the sense that only a person who pays for it will be able to consume it to the exclusion of any other person. Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 20 A negative externality occurs when the production and/ or consumption of an additional unit of a product by a producer and/or consumers causes the minimum average cost and the corresponding marginal cost of the producer of another product to increase and/or damage to other members of society such as in the case of air or water pollution. The marginal external cost is the increase in the marginal cost of the producers of other products or damage to the welfare of other members of society. A positive externality occurs when the production and/or consumption of an additional unit of a product by its producer causes the minimum average cost and the corresponding marginal cost of the producer of another product to decrease The marginal external benefit is the decrease in the marginal cost of producers of other products and/or the increase in the welfare of other society members. In the case of a negative externality, the marginal social cost is equal to the marginal private cost paid for by the producers of the product plus the marginal external cost. At the equilibrium of the market for a product subject to a negative externality, the marginal social benefit is lower than the marginal social cost. There is overproduction of the product the production of which causes a negative externality and a corresponding deadweight loss. In the case of a positive externality, the marginal social cost is equal to the marginal private cost paid for by the producers of the product minus the marginal external benefit. At the equilibrium of the market for a product subject to a positive externality, the marginal social benefit is higher than the marginal social cost because the former is equal to the equilibrium price and hence equal to the marginal private cost, which in turn is higher than the marginal social cost. There is underproduction of the product the production of which causes a positive externality and a corresponding dead weight loss. One way to induce the market of a product, the production of which generates a negative externality, achieve an efficient allocation of resources is for the government to impose a unit sales tax on the product ideally equal to the marginal external cost at equilibrium. The government should use the proceeds of the colleted tax to help lower the marginal cost of the other products the production of which suffer from the marginal external cost due to the negative externality. The imposition of an appropriate unit tax alone results in a reduction in the production and consumption of a product the production of which generates a negative externality. This reduction is not enough to achieve an overall efficient allocation of resources. For example in the case of the negative externality associated with air or water pollution, it is better for society to charge a price per unit of pollutants emitted. Some producers of the products that generate the negative externality will internalize the external cost by cleaning up the pollutants rather than discharging them in the air or water. Some other producers of such products may prefer to pay the price and in this case too they will internalize the external cost and produce less of the product generating the negative externality. In practice, it is hard to guess the correct price per unit of pollutants emitted. The collected taxes should not be retuned to consumers but should be earmarked for spending on additional cleanup of the world’s air and water or for dealing with negative health consequences or damage to the productive capacity in the country or in other countries of the remaining uncleaned units of pollution. A social good is a product that satisfies the following two properties: Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 21 a) Any consumer can enjoy consuming at the same time every once produced unit of it without diminishing the enjoyment by or availability of the social good unit to other consumers. We call this property the nonrival property of the social good, b) It is not physically or otherwise possible to exclude any consumer from enjoying any produced unit of it once that unit is produced. We call this property the non-excludability property of the social good, At any given quantity of the social good, the social marginal benefit of an additional unit of a social good is the sum of the marginal private benefit of every consumer. At equilibrium, the quantity of the social good produced is equal to the same amount consumed of the social good by every consumer. In order for this equilibrium to result in an efficient allocation of resources, it must be such that at the equilibrium quantity produced and consumed of the social good: a) The marginal social benefit is equal to the marginal social cost b) The price that each consumer pays must be equal to her/his marginal private benefit at the equilibrium quantity produced and consumed of the social good c) The total sum of the prices paid by all consumer must be equal to the marginal social cost In order to produce the efficient amount of the social good, any producer of the social good must know the marginal private benefit of every consumer and charge each consumer a price equal to her/his marginal private benefit. In practice it is impossible for the producer to have that detailed information since every consumer has an incentive not to reveal her true marginal private benefit knowing that her total payment for the social good is directly proportional to her marginal private benefit. In addition, once a certain quantity of the social good is produced, everyone can enjoy consuming it without having to pay for it. There is a problem of too many free riders. No prospective producer would produce any quantity of the social good. The pursuit of private interest does not promote the public interest. Markets are not a solution to the problem of the lack of social goods. One second-best solution is for government elected officials to create an agency to produce a quantity of the social good and charge a head tax to be paid by everyone. In a democratic society, to produce a quantity as close as possible to an efficient quantity of the public good, every candidate to a government office would propose a platform indicating a combination of the amount of social goods to produce and the corresponding head tax to pay for it. The quantity of the social good that will actually be produced and the head tax to pay for its total production cost are respectively the quantity and the head tax proposed by the successful candidate for the government office in the election for that office. End Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 22 A Combination A careful examination of the idea of using the voting procedure to produce the correct amount of the social good reveals that the government does not have to produce the social good. It can farm it out to a private concern and pay a price equal to average cost. To pay the private concerns, the government would collect the taxes. The government becomes an interface between the consumers and the producer. To get the lowest cost producer, the government would auction periodically the licenses to produce the social good. Again this policy is not corruption free. The case where everyone is honest and reveals her/his marginal benefit schedule for the social good is incompatible with the assumption that every consumer is selfish In the real world, many government agencies solve the problem by borrowing to pay for the production cost but then they must either tax or create inflation. As we shall see presently, their production decisions and their methods of financing do not result in an efficient allocation of resources because they will never have the required information to do it and they are subject to moral hazard problems. Use the services of the additional unit of clean air or water for production of a product without cleaning the resulting pollution of the unit. In other words, society is supplying the right to pollute an additional unit of clean air or water to the producer of the product when he/she uses the services of the additional unit of clean air or water. Furthermore, society would not incur the cost of cleaning the additional unit unless its marginal benefit from recovering the clean unit of air or water is greater or equal to the additional cost of cleaning it. The minimum price society accepts for supplying the right to pollute an additional unit of clean air or water by using its services for production is Is equal to the marginal social benefit from having an additional unit of clean air or water. Those who suffer from pollution would not accept the sell the rights to pollute the first five units of clean air or to add the last 5 units of pollution from 6 to 10. The compensation $10 they would receive for the right to pollute each one of those units of clean air is less than the marginal benefit given by the corresponding height of curve BK. They would not sell the right to pollute those units. They would insist that firms in industry 2 should clean up their pollution. Clearly, firms in industry 2 would oblige. Suppose that government officials organize this activity like a market for a private good. Units Marginal private benefit Marginal Marginal Marginal net social Benefit Social Cost Social Benefit Consumer Consumer 2 1 (1) (2) (3) (4) = (2) +(3) (5) (6) 2 8 10 16 4 12 4 7 8 13 7 6 6 6 6 10 10 0 Chapter 11 competition failure, Introductory Microeconomics, July 2023, 8/20/2024 4:29 PM 11- 23 8 5 4 7 13 -6 Society’s willingness to pay for an additional unit product, The supply curve is the line representing the marginal social cost in figure 6. According to figure 6, the equilibrium point of the supply and demand is point E. At E, The equilibrium price is equal to $10 and the equilibrium quantity is 6 units. The equilibrium quantity is equal to the efficient amount of the social good. The private producer would ask each consumer to pay according to the marginal benefit of the last unit consumed just like for a private good. For example, the private producer could ask consumer 1 to pay HK = $4 and consumer 2 to pay HM = $6 for each unit consumed. In this way, the private producer of the social good would get a "price" of $10 for each unit of the social good. If he/she behaves like a perfectly competitive firm, he/she would maximize total profit setting price equal to marginal cost. The output that would equate the marginal cost to the price of 10 is 6 units. Total profit = total revenue – Total cost = 6*10 – 33 = $27. The private producer would produce the efficient amount of the social good. The trouble with this policy is twofold. Finally, most consumers are rational. Even if a group of consumers are honest and reveal their true marginal private benefit schedules, they knows that others will not. There is a free rider problem whenever consumer thinks that he/she can enjoy the consumption of a social good without paying anything. Suppose the government imposes on each consumer a tax equal to total production cost of the social good that is $16.5. Consumer 1 will enjoy a positive net benefit of $16.5 and consumer 2 a positive net benefit of $37.5. In this way, society can produce the efficient amount of the social good and enjoy it. This policy requires however that the government knows the consumers marginal benefit curves and the marginal social cost. Knowing the latter is not difficult knowing the former is.