Deck 19: Government in the Market Economy

Question 1

Market Imperfections. Markets usually allocate resources in a manner that creates the greatest net benefit to society. An efficient allocation is one that maximizes the net benefits to society. Indicate whether each of the following statements is true or false, and explain your answer.
A. Markets sometimes fail to allocate resources efficiently. Under such circumstances, it always makes sense for the government to impose taxes in the case of negative externalities or subsidies in the case of positive externalities.
B. A negative externality exists when a voluntary market transaction between two parties imposes involuntary costs on a third party.
C. Efficiency mandates that the prices of goods and services reflect all incremental costs of production, including the cost of inputs, the value of producer time and effort, and any spillover effects.
D. With a Pigou tax, the costs that pollution imposes on the public will be considered when the firm decides where to locate a plant, which technologies to use, or how much to produce. E. In all cases, the best remedy for externalities is to define property rights and allow the affected parties to transact privately to achieve mutually beneficial outcomes.

Answer 1

B. True
Externality is a benefit or cost which results from an economic activity and which affect an otherwise unrelated party. A negative externality exists when a voluntary market transaction between two parties imposes involuntary costs on a third party.
C. True
The major aim of prices is to encourage buyer to economize on products and services that are relatively costly to produce and to raise their purchases of goods and services that are in comparison cheap to produce. A key benefit of free-market is that it usually leads to a scenario in which incremental production cost equals price.
Therefore, we can conclude that, efficiency requires the price of goods and services reflect all incremental costs of production, including the cost of inputs, the value of the producer time and effort, and any spillover effects.
D. True
Pigou taxes are imposed to enhance the allocation of resources. They hold the consumers and producers accountable for the full costs of production. Therefore, with an appropriate Pigou tax the costs that pollution imposes on the public will be considered when the firm decides where to locate a plant, which technologies to use, or how much to produce.
E. False
In few cases introducing property rights is costly. Moreover, it is not certain with clearly defined property rights, affected parties will agree on a mutually beneficial outcome. In such a scenario, other forms of government intervention are used including subsidies, taxes, and direct command-and-control regulation.
Therefore, in many cases the best remedy for externalities is not to define property rights and allow the affected parties to transact privately to attain a mutually beneficial outcome.

Question 2

Air pollution costs the United States billions of dollars per year in worker absenteeism, health care, pain and suffering, and loss of life. Discuss some of the costs and benefits of a Pigou tax on air pollution.

Answer 2

Remember, Pigou taxes are supported based on the notion that they can enhance the allocation of resources by holding the consumers and producers accountable for the full costs of production.
But, opponents of Pigou taxes argue that they add to those mark-up prices which create pollution. This additional increase in prices brings down consumer purchasing power. Given the income taxes if labor market is distorted, Pigou taxes can wider the amount of distortion.

Question 3

Negative Externalities. Coal-fired electricity-generating plants emit substantial amounts of sulfur dioxide and particulate pollution into the atmosphere. Concerned citizens are appalled at the aesthetic and environmental implications of such pollution, as well as the potential health hazard to the local population. In analyzing remedies to the current situation, three general methods used to control air pollution are generally considered:
• Regulations-licenses, permits, compulsory standards, and so on.
• Payments -- various types of government aid to help companies install pollution-control equipment. Aid can take the form of forgiven local property taxes, income tax credits, special accelerated depreciation allowances for pollution-control equipment, low-cost government loans, and so on.
• Charges -- excise taxes on polluting fuels (e.g., coal, oil, and so forth), pollution discharge taxes, and other taxes. Answer the following questions in light of these alternative methods of pollution control.
A. Pollution is a negative externality and a major cause of market failure. Explain why markets fail.
B. What is the incentive provided to polluters under each method of pollution control?
C. Who pays for a clean environment under each form of control?
D. On the basis of both efficiency and equity considerations, which form of pollution control is most attractive?

Answer 3

During production, companies sometimes harm the environment by adding noise, water and air pollution without suitable charges for such damages firms economic incentives are not properly reflected.
B. Under rules and regulations, producers generally have an incentive to involve in legal procedure to avoid regulatory costs.
Under a scheme of payments, producers generally have an incentive to reduce the flow of pollution and enhance economic performance.
Under imposition of penalties or fines, firms have an economic incentive to reduce the flow of pollution to avoid charges.
C. Under rules and regulations and imposition of penalties or fines, producers, consumers, employees and stockholders all pays for a clean environment.
Under a scheme of payments, to encourage flow of pollution reduction society pays to a firm for a clean environment.
D. On the basis of efficiency consideration, a scheme of payments is preferred over imposition of penalties or fines and rules and regulations because from efficiency point of view, cost of clean-up environment must be paid by those who derive maximum benefit from it.
On the basis of equity consideration, imposition of penalties or fines and rules and regulations over rules a scheme of payments because from an equity viewpoint all parties treated to be equal.

Question 4

What role does the price elasticity of demand play in determining the short-run effects of regulations that increase fixed costs? What if they lead to increased variable costs?

Question 5

What is the essential difference between public and private goods? Give some examples of each and some examples of goods and services that involve elements of both.

Question 6

Incidence of Regulation Costs. The Smokey Mountain Coal Company sells coal to electric utilities in the southeast. Unfortunately, Smokey's coal has a high particulate content, and, therefore, the company is adversely affected by state and local regulations governing smoke and dust emissions at its customers' electricity-generating plants. Smokey's total and marginal cost relations are
TC = $1,000,000 + $5 Q + $0.0001 Q 2
MC = ? TC/ ? Q = $5 + $0.0002 Q
where Q is tons of coal produced per month and TC includes a risk-adjusted normal rate of return on investment.
A. Calculate Smokey's profit at the profit-maximizing activity level if prices in the industry are stable at $25 per ton and therefore P = MR = $25.
B. Calculate Smokey's optimal price, output, and profit levels if a new state regulation results in a $5 per ton cost increase that can be fully passed on to customers.
C. Determine the effect on output and profit if Smokey must fully absorb the $5 per ton cost increase.

Question 7

In the 1880s, cattlemen in the American West crowded more and more animals onto common grazing land to feed a growing nation. Cattlemen contended, "None of us knows anything about grass outside of the fact that there is lots of it, and we aim to get it while the getting is good." Explain this attitude as a manifestation of the tragedy of the commons, and discuss how to solve the problem. Does resolving the cattlemen's dilemma of the 1880s suggest how the world today can save the African elephant?

Question 8

Social Rate of Discount. Because resources for social programs and public-sector investment projects come from private-sector consumption and/or investment, economists typically advocate the use of a social rate of discount that reflects this private-sector opportunity cost. A good estimate of the opportunity cost of funds diverted from private consumption is the rate of return on government securities that is available to individual investors. Similarly, the average rate of return on private investments can be taken as the opportunity cost of private-sector investment funds.
A. Should pretax or after-tax rates of return be used to estimate the opportunity cost of resources diverted from the private sector to fund social programs or public-sector investment projects? Why?
B. Assume that the rate of return on long-term government bonds is 8 percent, a typical aftertax return on investment in the private sector is 10 percent, the marginal corporate and individual tax rate is 30 percent, and consumption averages 95 percent of total income. Based on the information provided, calculate an economically appropriate social rate of discount.

Question 9

Does the fact that public decisions are sometimes made by self-interested politicians and bureaucrats undermine the efficiency of public-sector decision making?

Question 10

A pipeline break reduced the supply of gasoline to the Phoenix, Arizona, area in August 2003. Press reports indicated that some stations ran out of gasoline, consumers waited in line for hours, and some drivers started following gasoline tankers as they made their deliveries. Explain the efficiency and equity considerations tied to a competitive-market allocation of supply versus government-controlled rationing in such circumstances.

Question 11

Benefit-Cost Analysis. Highway crashes continue to claim the lives of thousands of Americans. Grim statistics underscore the need for better laws, stricter enforcement, and safer driving behavior. In 2006, approximately 43,300 persons died on the nation's highways. Alcoholrelated fatalities accounted for 41.4 percent of the total. The majority of passenger vehicle occupants killed in crashes were not wearing safety belts.
As a practical matter, it is important to recognize that most highway fatalities are preventable. Using current technology, highway fatalities could be substantially reduced by draconian laws against drunk driving, mandatory seat belts, and strictly enforced speed limits. Needless to say, popular opposition would be intense. Speed limits as high as 75 mph on major highways are popular because consumers derive significant economic and social benefits from swift automobile transportation. However, by failing to sharply reduce or eliminate highway fatalities, speed limit policy places a finite and measurable value on human life.
A. From an economic standpoint, explain how public policy sets a dollar value on human life. Is it efficient to do so?
B. Are there equity considerations one must weigh in judging the fairness of dollar estimates of the value of human life?

Question 12

In 1848, the idea of cost-benefit analysis originated with a French engineer by the name of Jules Dupuit. Economists argue that underlying calculations of costs and benefits must be based upon actual market behavior and not based upon consumer and producer surveys or "informed estimates." Why?

Question 13

Privatization. In Massachusetts, a state education law authorized the establishment of charter schools. Charter schools are public schools that receive state funding as well as some measure of autonomy from local school boards and the rules that govern conventional schools. As a result, students and educators in Boston face the ready prospect of classrooms with politicians as lecturers, academic instruction aided by yoga, school doors open from dawn to dusk, and public schools run on a for-profit basis.
Charter schools already are operating in Minnesota and California, and five other states promise to join the trend with recently enacted charter-school legislation. Advocates of such schools argue that they provide badly needed competition for existing public schools. Under the charter-school concept, anyone with a good education idea gets access to government funding, so long as they can attract and effectively train students.
A. Explain how breaking the public-school monopoly on access to public funding could help improve the quality of public- and private-school primary education.
B. Explain why primary-school privatization might not create such benefits.

Question 14

To measure public project desirability, positive and negative aspects of the project must be expressed in terms of a common monetary unit. Explain the importance of the present value concept in benefit/ cost ratio calculations using a 5 percent interest rate assumption and a 5-year project life.

Question 15

Economics of Health Care. The United States spends more per person on health care than any other country in the world. Still, recent studies show that the United States ranks relatively low in the overall quality of health care provided. France is often described as providing its citizens with the globe's best health care. Japan wins the distinction as having the world's healthiest people. Although good at expensive care, like open-heart surgery, the U.S. health care delivery system is often described as poor at low-cost preventive care.
A. Explain the role of public and private insurance in making the demand for health care different from the demand for many other services.
B. Consumers buy health care to improve their health and well-being, but research suggests only a weak connection between health care spending and health. Explain why there might be only a weak link between health care expenditures and health.
C. Why is health care spending rising rapidly on a worldwide basis? Is robust growth in health care spending likely to continue?

Question 16

The former chairman of the Federal Communications Commission heralded Voice over Internet Protocol, or VoIP, as "the most important shift in the entire history of modern communications since the invention of the telephone." Using cheap computer software and the Internet, VoIP offers consumers bargain-priced voice and data communication services. In the process, VoIP threatens to make obsolete the regional Bell operating companies' (RBOCs) $125 billion investment in conventional telephone networks. Explain the risks involved with regulatory policies that encourage or discourage VoIP adoption. What should the government do?

Question 17

Health Care Reform. Public support dropped for a Medicare prescription-drug law endorsed by President George W. Bush and passed by a Republican-controlled Congress following withering criticism from Democrats. Democrats were upset that the law prevented Medicare from negotiating lower prices from drug manufacturers and prohibited the purchase of cheaper medicines from Canada. The Congressional Budget Office projected the 10-year cost at $395 billion, but Medicare officials quickly raised that figure to $534 billion over 10 years. Meanwhile, conservatives argued that expensive drug benefits will encourage employers to drop existing coverage for retirees.
A. Explain how Medicare prescription-drug benefits might have the unintended effect of increasing drug prices.
B. Explain how Medicare prescription-drug benefits might affect the supply of new and innovative drugs.

Question 18

"Regulation is often proposed on the basis of equity considerations and opposed on the basis of efficiency considerations. As a result, the regulation versus deregulation controversy is not easily resolved." Discuss this statement.