1

Section 14: Market Failure and the Role of Government

Module 74: Introduction to Externalities (pages 724-729)

1. Terms:
a. marginal social cost of pollution: additional cost imposed on society by additional pollution

b. marginal social benefit of pollution: additional benefit gained by society from additional pollution

c. socially optimal quantity of pollution: the amount of pollution society would choose if all the pros
and cons of pollution were accounted for

d. external cost: an uncompensated cost that a firm/person puts on another; a negative externality

e. external benefit: benefit that someone gives to someone else without getting compensation;
positive externalities

f. externalities: aka external costs/benefits

g. Coase theorem: the economy can reach an efficient solution if the transaction costs are low
enough; even if externalities exist

h. transaction costs: the costs to individuals of making a deal

i. internalize the externalities: when individuals take external costs/benefits into account

2. Why is some pollution good?
Pollution is a side effect of some activities that provide beneficial things for society; the
presence of pollution means that we have these things.

3. How should society decide how much pollution to allow?
The amount of pollution to allow should be where the marginal social cost of pollution equals the
marginal social benefit of pollution.

4. Draw a graph to show how society decides how much pollution to allow. Include MSB, MSC,
and Qopt. SEE FIGURE 74.1

5. Does an unregulated market yield the socially optimum quantity of pollution? Explain.
An unregulated market doesn't create the socially optimum quantity of pollution. Firms who
benefit from pollution (ie factories) will have no incentive to weigh the marginal social cost, and
will think only of profits.

6. What are some examples of external costs (negative externalities)?
Traffic during rush hour

7. Why can’t individuals always internalize externalities (as in the Coase Theorum example)?
High transaction costs may hinder people from sealing efficient deals.

2
Module 75: Externalities and Public Policy (pages 731-740)

1. Terms:
a. environmental standards: rules that protect the environment by limiting what producers and
consumers can do

b. emissions tax: tax that depends on the amount of pollution a business creates

c. Pigouvian taxes: taxes create to decrease external costs

d. tradable emissions permits: licenses to release a specific amount of pollutants; these can be
bought/sold by polluters.

e. marginal private benefit: marginal benefit that is consistently given to the consumers of a good,
excluding any external benefits

f. marginal social benefit of a good: MPB but for the whole of society.

g. marginal external benefit: addition to external benefits created by an additional unit of the good.

h. Pigouvian subsidy: payment to encourage activity that creates external benefits

i. technology spillover: an external benefit; happens when knowledge spreads between people
and firms

j. marginal private cost: marginal cost of creating that good, excluding external costs

k. marginal social cost of a good: MPC but for society

l. marginal external cost: increase in external cost created by an additional unit of the good

m. network externality: a good is subject to it when the value of the good to an individual is greater
when others use it a lot

2. What laws/policies has government put into place to fix the problem of pollution?
Clean Air Act (1970)- sulfur dioxide rules; decreased how bad acid rain was

3. Why are emissions taxes more efficient than environmental standards?
The taxes make sure that the marginal benefit of pollution is equal for all kinds of pollution; the
standards don't guaruntee that.

4. What is the problem with using taxes as a solution for negative externalities?
The best level to set the taxes at is hard to determine. Too low → environment doesn't improve,
but too high → inefficent to businesses

5. Explain how the cap-in-trade program works to decrease pollution.
It ensures that pollution is reduced in the cheapest possible way.

3
6. What do firms have an incentive to do with both emissions taxes and tradable permits?
The taxes and permits provide incentives for the firms to use technology that emits less pollution.

7. What are some examples of positive externalities?
Neighborhood gardens can be enjoyed by all; bird-feeders help support the bird population

8. Draw a graph to show the inefficiency of a positive externality. SEE FIGURE 75.3(a)

9. MSB = MPB + MEB

10. What does the demand curve represent? What does the MSB represent?
The demand curve shows the demand of the good; it represents the marginal private benefit.
The MSB is the marginal social benefit; its curve is the D curve shifted up by the marginal
external benefit (MEB).

11. What can government do in the presence of a positive externality (not enough of a good
produced/ consumed)?
The government can give firms subsidies to help encourage more production.

12. MSC = MPC + MEC

13. What does a supply curve represent?
The supply curve is the MSC curve shifted down by MEC; it's the MPC.

14. What does the MSC curve represent?
The MSC curve is the marginal external cost.

15. What does Twitter have to do with network externality?
Twitter is essentially a network externality. Its value comes from the fact that people use it; if no
one used it except for you, you would have no one to tweet to, and no one one would read your
content. It would have no value. Also, the more people that use it, the better.

Module 76: Public Goods (pages 743-752)

1. Terms:

a. excludable: a good is excludable if the supplier can prevent those who don’t pay for it from
consuming; nonexcludable: supplier can’t prevent consumption by those who don’t pay

b. rival in consumption: if the same unit of the good can’t be consumed by multiple people at the
same time; nonrival in consumption: multiple people can consume at the same time

c. private good: a good that is excludable and a rival in consumption; public good: a nonexcludable,
nonrival in competition good

d. free-rider problem: applies to nonexcludable goods; some have no incentive to pay and they get
the same benefits as those who do pay

4

e. common resource: nonexcludable and rival in competition; everyone consumes a lot, and
there’s less for everyone else

f. overuse: when people ignore how their usage makes it so that fewer people can use the good

g. artificially scarce goods: an excludable good that is nonrival in competition

2. List four types of goods and then describe the characteristics of each.
Private goods: Rival, excludable; ie chocolate
Common resources: Rival, nonexcludable; ie clean water
Artificially scarce goods: Nonrival, excludable; ie computer software
Public goods: Nonrival, nonexcludable; ie police, parks

3. Why are markets usually the best means for a society to deliver goods and services?
Markets are efficient, except when there is market failure (ie market power, externalities).

4. Why does the freerider problem exist?
Some people have no incentive to pay, since others are perfectly willing to.

5. What leads to “inefficiently low production”?
No one is willing to pay for a higher quantity, so producers will not supply as much.

6. What leads to “inefficiently low consumption”?
When a consumer buys a nonrival good for more than $0, P > MC (MC = 0). People are less
willing to buy the good, and they won’t consume as much of the good.

7. What type of good is the only one to be produced and consumed efficiently in a market
economy? Private goods

8. Who provides public goods?
The government, volunteers, private interests; however, it’s generally better/more assured when
the government provides the public good.

9. How does government decide how much of a public good to make available?
MSB = MSC

10. What are the three ways to make people internalize the costs of their use of common
resources?
Tax/regulate the use of the good, force suppliers to hold licenses, make the good excludable
and only give property rights to certain people

11. Explain how price and efficiency applies in a situation where a good is made artificially scarce.
P > MC, therefore the buying/selling of the artificially scarce good is inefficient.

Module 77: Public Policy to Promote Competition (pages 754-758)

1. Terms:
5
a. marginal cost of pricing: when monopoly’s P = MC to achieve efficiency

b. average cost pricing: when monopoly’s P = average cost so that firm doesn’t lose money

2. What is the goal the public policies that regulate monopolies and oligopolies?
To increase competition (lower prices, increase quantity/quality)

3. What are the two provisions of the Sherman Anti-Trust Act (1890)? What federal government
agency enforces the law?
You can’t restrain interstate trade, and no part of interstate commerce can’t be monopolized.
The Department of Justice enforces the law.

4. What does the Clayton Anti-Trust Act (1914) prohibit?
The Clay Anti-Trust Act prohibits price discrimination, anticompetitive
practices/mergers/acquisitions and interlocking directorates

5. How does the Federal Trade Commission Act help promote fair competition?
It made price fixing, output restrictions and manmade barriers to entry illegal.

6. What is a natural monopoly?
A natural monopoly is when economies of scale make having one firm in the market efficient.

7. What are the goals when regulating natural monopolies?
Keep the low ATC but get rid of the inefficiency.

8. How do subsidies work to deal with the negative effects of a natural monopoly? Focus on why a
subsidy would be necessary.
The monopoly focuses on the downward-sloping part of its curve. The firm would lose the
difference between P and ATC, and they would lose money in the long run.

9. What is an alternative to subsidy? Explain.
The government can set the price where D = ATC, and the firm breaks even.

10. What makes it difficult to set public policy regulating monopolies (imperfect competition)?
It’s hard to set the price at the exact point where D = ATC.

Module 78: Income Inequality and Income Distribution (pages 761-772)

1. Terms:
a. poverty threshold: annual income below which a family is officially labeled as poor

b. poverty rate: percentage of people with incomes less than the poverty threshold

c. mean household income: the average household income

d. median household income: the income in the middle of the income distribution

e. Gini coefficient: summarizes a country’s level of income inequality based on how unequal
6
income is distributed

f. means-tested: program available only to those with less than a certain income

g. in-kind benefits: benefit given in terms of goods

h. negative income tax: a program that supplements the income of those with low incomes

2. Who are the poor? Think statistics. Think about the connection between race and gender.
Though many are Hispanic or African-American, there is still a significant amount of poor white
people. Female-led homes are more likely to be poor, and most of the poor work either part-time
or not at all.

3. What does “working poor” mean?
The “working poor” are those whose incomes are less than or equal to the poverty threshold.

4. What are the causes and consequences of poverty?
Causes: lack of education, insufficient grasp of English, racial/gender discrimination, bad luck
Consequences: lack of health care (can affect future ability to learn and work), lack of stable
shelter (disruptive work/school schedules), children can suffer from learning disabilities

5. Read “The Impeccable Logic of Early Childhood Intervention Programs.” How do early
childhood intervention programs promote the general welfare of all?


6. What government agency gathers and compiles income data on Americans? Explain how they
organize the data on distribution of income in America.


7. Why do economists prefer using median income rather than mean income when evaluating
income inequality?


8. What does a Gini coefficient of zero mean? What does a Gini coefficient of one mean?


9. Read “Long-term Trends in Income Inequality in the US.”
a. Why do some call our current economy a “new Gilded Age”?


b. What is causing rising income inequality in America?


10. Why is it important to look at income data that covers 10+ years rather than a “snapshot” year?


11. Describe the means-tested anti-poverty programs in the US.
a.
7


b.


c.


d.

12. Describe the non-means tested anti-poverty programs in the US.
a.


b.


13. Evaluate the effectiveness of Federal Anti-Poverty programs.


14. Why is there debate about federal anti-poverty programs? (Think: trade-offs)


15. Define: notch