CHAPTER 28



CHAPTER 28

Government and Market Failure

SUMMARY

1. WHAT IS ECONOMIC FREEDOM?

• Economic freedom is the degree to which individuals are able to engage in voluntary transactions without government involvement. Preview

• The index of economic freedom is a measure of the involvement of government in an economy.

2. What are externalitiesis a market failure?

• 1. A market failure occurs when the market is not able to reach the equilibrium that is most efficient, when resources are not allocated to their highest-valued use. Preview §1

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• 2. The government is often called upon to resolve market failures. Preview §1

• 3. A freely functioning market results in resources being allocated to their highest-valued use. When something occurs that leads resources not to be so allocated, we say that a market failure has resulted. Preview §1

3. What are externalities?

• 4. Private benefits of a transaction are the gains from trade that the individuals involved in the transaction achieve. Private costs are the opportunity costs that the individuals involved in the transaction must bear. §1

• 5. Social costs and benefits are the total costs and benefits created by a transaction. When some costs are borne by those who are not involved in the private transaction, a negative externality occurs, so that social costs exceed private costs. When some benefits are received by those who are not involved in the private transaction, a positive externality occurs, so that social benefits exceed private benefits. §1

• 6. When social costs and benefits are not equal to private costs and benefits, the market outcome is either over-utilization or under- utilization: resources are not allocated to their most highly valued use. §1.a

• 7. There are several approaches to reducing the inefficiencies created by externalities. One approach is to impose a tax on the individual or institutions creating the externality. In another approach, the government requires or commands that those creating negative externalities reduce the amount created or that more production of positive externalities occur. In yet another, the government creates a market for the negative externalities by establishing ownership of the right to create the negative externality and allowing that ownership to be exchanged. §1.b.1–§1.b.3

• 8. The Coase theorem states that as long as private property rights can be established, private individuals will be able to solve an externality problem without government intervention. §1.c

4. Why are chickens not listed as an endangered species?

Why did the hippie communes established in the 1960s disappear?

• . Chickens are privately owned. A market failure problem occurs when no one owns something or when everyone owns something. The list of endangered species are species not privately owned. Private ownership was abolished in the communes; the idea was that everyone would own everything and that all would contribute what they could. §2.a

• 10. Common ownership results in a market failure. Too much of the commonly owned good is consumed, and not enough is produced. §2.a

• 11. The solution to a common ownership problem is to create private property rights in any case where such rights can be created. §2.c.1

5. Why do governments create, own, and run national parks?

• 12. One approach taken to resolve common ownership problems is for the government to claim ownership of the common good and to provide it as the government defines. §3.a

• 13. Private property rights provide ownership. In order to buy or sell something, one must be able to decide how that something is to be used. §3.a

• 14. Without private property rights, anyone can claim partial ownership of an item and thereby consume that item. Without private ownership, no one would be willing to purchase an item, since others could consume that item. §3.a

• 15. Free riding means that one person will contribute less than what that person expects to get in return because the person expects others to make up the difference. §3.a

• 16. People free-ride because they can—their self-interest tells them to get the most for the least. §3.a

• 17. The problem with free riding is that if many people or everyone free-rides, nothing gets done. §3.a

• 18. Solutions to public good problems include private provision of the public good and government provision of the good. §3.b

6. Why are ingredients required to be listed on food packaging?

What is the reason the government requires the listing of ingredients on food packaging?

• 19. When buyers have less information than sellers, a situation can arise in which high-quality products are driven out of the market, leaving just low-quality products. This is called adverse selection. §4.a

• 20. When buyers have more information than sellers about a particular item, buyers may alter their behavior with regard to that item once they have purchased it. For instance, once someone is insured, that person may act differently, taking on more risk. This is called moral hazard. §4.b

• 21. Problems of adverse selection and moral hazard are often resolved privately through copayments, deductibles, and other such arrangements that reduce the incentives to change behavior or not reveal information. §4.c

7. What is rent seekingIs government the best way to solve market failure problems?

• 22. Since the government has no competition, it is generally less efficient than the private market. §5

• 23. Government failures may result from logrolling and rent seeking. §5

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