Government Policy and Market Failures

1
Government Policy and Market Failures

• Chapter 15

2
Introduction

• There are two cases where the market does not
  yield an appropriate outcome
• Market failure, where the market fails to produce
  an efficient outcome, and
• Market outcome failure, where the market outcome,
  although efficient, is not socially optimal.

3
Introduction

• The private market framework presented so far may
  be called the invisible hand framework.
• Invisible hand framework perfectly competitive
  markets lead individuals who maximize their own
  benefit to make voluntary choices these choices
  also turn out to be in societys best interest.

4
Market Failures

• A market failure occurs when the invisible hand
  pushes in such a way that individual decisions do
  not lead to socially desirable outcomes.

5
Market Failures

• Any time a market failure exists, there is a
  reason for possible government intervention to
  improve the outcome.

6
Market Failures

• Because the politics of implementing the solution
  often leads to further problems, government
  intervention may not necessarily improve the
  situation.
• If government intervention does not improve the
  outcome, this result is often called government
  failure.

7
Government Policy and Intervention

• Review from Chapter 7

8
Taxation and Government

• Tax revenues are the source for the financial
  resources that the government spends to provide
  people with public goods and other beneficial
  services.

9
Taxation and Government

• Different types of Taxes used
• Income Taxes
• Employment Insurance Premiums
• Sales taxes Provincial sales taxes and the GST
• Property taxes
• Excise taxes

10
The Costs of Taxation

• When government raises taxes, there is a loss of
  consumer and producer surplus that is not gained
  by government.
• This is known as deadweight loss.

11
The Costs of Taxation

• Graphically the deadweight loss is shown on a
  supply-demand curve as the welfare loss triangle.

• The welfare loss triangle a geometric
  representation of the welfare loss in terms of
  misallocated resources caused by a deviation from
  a supply-demand equilibrium.

12
The Costs of Taxation Fig. 7-2, p 162
Price
13
The Benefits of Taxation

• Measuring the benefits of these goods is
  difficult since they are often provided at a zero
  price.

14
Two Principles of Taxation

• Government follows two general principles when
  deciding about taxation
• The benefit principle and
• The ability-to-pay principle

15
Two Principles of Taxation

• The benefit principle states that the individuals
  who receive the benefit of the good or service
  should pay the cost (opportunity cost) of the
  resources used to produce the good.
• Examples are gasoline taxes and airport taxes,
  both paid by travelers.

16
Two Principles of Taxation

• The ability-to-pay principle states that
  individuals who are most able to bear the burden
  of the tax should pay the tax.

• The best example of this is a progressive tax,
  such as the Canadian income tax.

17
Who Bears the Burden of a Tax?

• The person who physically pays the tax is not
  necessarily the person who bears the burden of
  the tax.
• The burden of the tax depends on relative
  elasticity.

18
Burden Depends on Relative Elasticity

• The tax burden is greater if a person cannot
  easily change their behaviour.
• The more inelastic ones relative supply and
  demand, the larger the tax burden one will bear.

19
Burden Depends on Relative Elasticity

• If demand is more inelastic than supply,
  consumers will pay the higher share.
• If supply is more inelastic than demand,
  suppliers will pay the higher share.

20
Who Bears the Burden of a Tax? Fig. 7-3a, p 166
Supplier Pays Tax
Price
Consumer pays
Supplier pays
21
Who Bears the Burden of a Tax? Fig. 7-3b, p 166
Demand is inelastic
Price
Consumer pays

22
Who Bears the Burden of a Tax? Fig. 7-3c, p 166
Consumer Pays Tax
Price
Consumer pays
Supplier pays
23
Employment Insurance Premiums

• Both employer and employee contribute to the
  Employment Insurance.
• The burden falls mainly on employees because, on
  average, labour supply is less elastic than
  labour demand.

24
Burden of the Employment Insurance Premium, Fig.
7-4, p 168
25
Sales Taxes

• Sales taxes are those paid by retailers on the
  basis of their sales revenue.
• Since sales taxes are broadly defined, most
  consumers have little ability to substitute.
• Demand is inelastic so consumers bear the greater
  burden of the tax.

26
Sales Taxes

• Some Canadians can substitute away from
  consumption in Canada by traveling abroad.

• With the growth of the Internet, many more are
  now able to access tax-free jurisdictions
  (cyberspace) and also substitute away from
  Canadian consumption taxes.

27
Government Intervention

• Taxation is but one way in which government
  affects our lives.
• Other forms of government intervention include
  price controls.

28
Price Ceiling

• A price ceiling is a government-set maximum price
  which the market price cannot exceed.
• Generally, the price ceiling is set below market
  equilibrium price.
• It is an implicit tax on producers and an
  implicit subsidy to consumers.

29
Price Ceiling

• Price ceiling causes a loss in producer and
  consumer surpluses that is identical to the
  welfare loss from taxation.

30
Effect of Price Ceiling, Fig. 7-5a, p 170
A
B
C
E
D
F
Excess demand
31
Price Floors

• A price floor is a government-set minimum price.
• Price floors transfer surplus from consumers to
  producers.
• They can be seen as a tax on consumers and a
  subsidy to producers.

32
Effect of Price Floor, Fig. 7-5b, p 170
Excess supply
A
B
C
E
D
F
33
The Difference Between Taxes and Price Controls

• The effects of taxation and price controls are
  similar.
• Both taxes and price controls create deadweight
  losses.

34
The Difference Between Taxes and Price Controls

• However, price ceilings create shortages and
  taxes do not.
• Shortages may create black markets.
• Alternative methods of allocation develop because
  there is an imbalance between quantity demanded
  and quantity supplied.

35
Rent Seeking, Politics, and Elasticities

• Price controls reduce total producer and consumer
  surpluses.
• Governments institute them because people care
  more about their own surplus than they do about
  total surplus.

36
Rent Seeking, Politics, and Elasticities

• If consumers hold the balance of political power,
  there will be strong pressures to create price
  ceilings.

• If suppliers hold the political power, there will
  be strong pressures to create price floors.

37
Rent Seeking, Politics, and Elasticities

• An enormous amount of time and resources is spent
  in attempts to transfer surplus from one set of
  individuals to another.

• This activity is called rent seeking.

38
Rent Seeking, Politics, and Elasticities

• Public choice economists integrate an economic
  analysis of politics with their analysis of the
  economy.

• They argue that often the taxes and the benefits
  of government programs offset each other and do
  not help society significantly.

39
Inelastic Demand and Incentives to Restrict Supply

• When demand is inelastic, producers have
  incentives to lobby the government to restrict
  supply.
• Farming is a good example.
• Advances in productivity increase supply but they
  result in lower prices.

40
Inelastic Demand and Incentives to Restrict Supply

• Since food has few substitutes, its demand is
  inelastic.
• Inelastic demand means that prices fall faster
  than a rise in quantity sold.
• Revenues fall, and farmers are worse off.

41
Inelastic Demand and Incentives to Restrict Supply

• Because of the increase in supply, and inelastic
  demand, farmers are losing revenue.
• There is an enormous incentive for farmers to
  encourage government to restrict supply or create
  a price floor.

42
Inelastic Demand and Incentives to Restrict
Supply Fig. 7-6, p 171
A
B
43
The Long-Run Problems of Price Controls

• In the long run, supply and demand tend to be
  much more elastic than in the short run.
• Therefore, price controls will cause large
  shortages or surpluses in the long run.

44
Long-Run and Short-Run Effects of Price Controls,
Fig. 7-7, p 172
Price
Quantity
45
Government Intervention

• End of review from Chapter 7

46
Market Failures

• Some sources of market failure are
• Externalities
• Public goods, and
• Asymmetric information.

47
Externalities

• Externalities are defined as the effect of a
  decision on a third party that is not taken into
  account by the decision-maker.
• Externalities can be both positive and negative.

48
Externalities

• Negative externalities occur when a market
  transaction has a detrimental effect on others.

• Examples of negative externalities include
  second-hand smoke, water pollution, and carbon
  monoxide emissions.

49
Externalities

• Positive externalities occur when market
  transaction has a beneficial effect on others.

• Examples of positive externalities include
  innovation and education.

50
Negative Externalities

• When there is a negative externality, the social
  marginal cost is greater than the private
  marginal cost.
• The competitive price will therefore be too low
  to maximize social welfare.

51
Negative Externalities

• Social marginal cost includes all the marginal
  costs borne by society.

52
Negative Externalities

• Social marginal cost is calculated by adding the
  negative externalities associated with production
  to the private marginal costs of that production.

53
The Effect of a Negative Externality, Fig. 15-1,
p 322
C
54
Positive Externalities

• Private trades can benefit third parties not
  involved in the trade.
• Social marginal benefit equals the private
  marginal benefit of consuming a good or service
  plus the positive externalities resulting from
  consuming that good or service.

55
A Positive Externality, Fig. 15-2, p 323
B
56
Government Policy and Market Failures

• Chapter 15 continued