Chapter 13: The Economic Role of Government

Economic Policy, Economic Efficiency, Externalities, Private vs. Public Producers


What are Market Failures?

When private markets do not produce an economically efficient allocation of resources. Basically, when the private market does not maximize total surplus.

What are Some Reasons For Market Failures?

  • Monopolies: May not produce economically efficient amounts of output. However, in some cases, we may need monopolies to realize economies of scale.
  • Externalities: Some products generate costs & benefits that are paid/received by people other than the producers and consumers.
  • Nature of Goods: It may be difficult for private businesses to ensure that consumers pay for certain types of goods.
  • Not Enough Information: Consumers may not have the complete information about the content, quality or safety of products. Examples include drugs, food, airlines, etc. Regulation can enhance information symmetry.
  • Unfair or Inequitable Income Distribution: Government programs & tax systems may be created to make the economy fairer (or at least society’s definition of fair).

External Costs & External Benefits

What are External Costs?

Costs of producing a product that are borne by individuals other than the producer/consumer. Examples include a coal power plant or a run-down house in a neighbourhood.

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Social Cost are the total costs to society. Social costs equal the private costs plus external costs. If there are external costs, the social cost curve will above the market supply curve (since the supply curve is also the marginal cost curve).

Marginal Social Costs is the marginal cost from society’s perspective.

What are External Benefits?

Benefits received by individuals other than the producer/consumer. Examples include shoveled sidewalks, wheel flaps & education.

https://s3.amazonaws.com/thm-monocle-interactive/yCgnIpWevI/ECN13_figure13.4%20(1).pngSocial Benefits are the total benefits to society. Social benefits equal the private benefits plus external benefits. If there are external benefits, the social benefit curve will be above the market demand curve (since the demand curve is also the marginal benefit curve).

Adjusting to External Benefits & External Costs

5 Ways to Increase Allocative Efficiency in Markets with Externalities

  • A tax is placed on the producer, to produce less.
  • A subsidy is given to the producer, to produce more.
  • Government requires producers to produce more.
  • Government requires producers to produce less.
  • In the case of external benefits, the government produces the good.

Imposing a Tax on a Market with External Costs

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Reducing Pollution

How to Achieve Pollution Reduction?

The most common method has been regulation requiring firms to reduce pollution by specified amounts. This is usually the most expensive method to enforce.

A second alternative is to tax pollutants.

A third option is to creation pollution permits which are distributed in the market. This system may end up being the easiest & cheapest to implement.

Private Goods, Public Goods & Common Resources

What are Private Goods?

  • Any product that cannot be consumed by more than 1 person at a time.
  • Producers are able to exclude non-buyers from consuming the product. Examples:

A common trait of non-private goods is that they can be shared without it having its value reduced.

Another is that there are some non-private goods where non-payers always benefit from the product, no matter what. It’s either everyone enjoys the product or no one does, such as national defense.

Another is that there are some non-private goods where non-payers can’t be excluded AND only 1 person can consume the good at a time, such as fish in the ocean.

What are Free Riders?

Those unwilling to pay for a product because they know that, if someone else pays for it, they will be able to enjoy the benefits.

What are Public Goods?

  • Goods that are difficult or impossible to exclude non-buyers from consuming.
  • Local broadcast television & radio programs
  • Street lighting
  • Fireworks
  • Roads
  • Goods that can be consume without interfering with other’s consumption of the same good.

A common trait of public goods is that the marginal cost of providing one more unit may be 0.

Public goods are usually provided by governments. It can also be provided by charity organizations, who often get tax reductions or subsidies from governments. It may even be provided by private firms, who get paid by the government.

What are Common Resources (Common Goods)?

A resource that can be consumed by only 1 producer at a time & is found in environments in which it is difficult to exclude non-payers. Fish in the ocean are an example of common resources.

What is the Tragedy of Commons?

An economic problem in which every individual tries to reap the greatest benefit from a given common resource.

Resources owned by multiple individuals or owned by no one may be overused or quickly exhausted. The solution is common ownership, charging a price, or regulating the rate of consumption. If it’s possible, changing the nature of the resource to become a private good can help as well. Governments can help setting regulatory restrictions or selling permits.

Government Failures

  • Difficulty in Gathering & Interpreting Data: When information is difficult to obtain, or not available, we may not get good data to make an informed decision.
  • Conflicting Goals: Solutions to market inefficiencies are sometimes politically unpopular.
  • Incentives are Sometimes Wrong: If governments force a few to pay for the benefit of many, those few have a stronger incentive to the lobby the government to remove the program than those many who have each have very little incentive to lobby the government to keep the program.
  • Incentives are Sometimes Weak: Politicians have an incentive to pursue popular policies rather than effective ones due to an incentive to get re-elected. Governments don’t have an incentive to cut costs or provide better quality because there’s usually very little competition pressuring them to do so.


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