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CHAPTER ELEVEN
REGULATION, PUBLIC GOODS,
AND BENEFIT-COST ANALYSIS
OBJECTIVES
1. To examine various market failures due to: monopoly, externalities, and
imperfect information (Market Failures and Regulation).
2. To identify the class of public goods and to determine the optimal amount of
these goods. (Public Goods)
3. To introduce benefit-cost analysis and the net benefit rule. (The Basics of
Benefit-Cost Analysis)
4. To discuss issues of benefit-cost implementation, including valuing benefits and
costs. (Valuing Benefits and Costs)
TEACHING SUGGESTIONS
I. Introduction and Motivation
In previous chapters we have discussed market structure. In this chapter we discuss
the efficiency implications of different market structures and the implications
regarding government intervention. This chapter can be motivated by asking
students whether the government should ever be involved in private markets and, if
so, why. Many students will bring noninterventionist views to the classroom that
can be summarized by the statement that “markets are better”. From this point, the
class discussion can turn on what we mean by “better” and this allows entry into a
general discussion about the characteristics of markets. It is also possible to bring
up examples where markets have broken down:
What about the phone company? or the cable company? (natural monopoly)
What about a polluter? (externalities)
What about the harmful drug thalidomide? (imperfect information)
What about defense? (public goods)
II. Teaching the “Nuts and Bolts”
A. Market Efficiency.
The final section of Chapter 7 examines the characteristics of the ideal perfectly
competitive market. It is worth some time reminding students that in the absence of
externalities perfectly competitive markets deliver efficient levels of output.
(Remind them that the marginal social benefit curve is the demand curve; thus,
when demand equals supply, it follows that MB = MC.) This one idea can take the
student a long way in understanding the effects of monopolization and
externalities.
It is very important to emphasize to students that the type of efficiency that
perfectly competitive markets guarantee is Pareto efficiency. That is, markets do
not guarantee that the distribution of goods and services will be fair.
B. Monopoly and Externalities.
The instructor may wish to spend time reviewing the basics of market failure due
to monopoly (Figure 8.3) and externalities (Figures 11.1 and 11.2). We also like to
emphasize the basic point that whenever price diverges from marginal social cost
there is a potential for inefficiency. This can be demonstrated to the students with
the following simple example. Suppose that there are two goods and that a
consumer is indifferent between them but has the resources only to purchase one of
them. Call these goods widgets and gadgets. Suppose we have the following:
Widget Gadget
Marginal Social Cost 100 125
Price 150 125
The Widget sells in a monopolized market so price is above marginal cost. The
Gadget sells in a competitive market with no externalities. The consumer will
purchase the Gadget. However the consumer would have been just as happy with
the Widget and at a lower cost to society. If both had been sold in competitive
markets then the consumer would have purchased the widget.
Modify this example slightly:
Widget Gadget
Marginal Social Cost 150 125
Price 100 125
In this example the widget and gadget are both sold in competitive markets but
widget production generates pollution while the gadget production does not. In this
case the consumer purchases the Widget. Again, the Gadget gives just as much
utility but at a lower cost to society. (One solution is to tax Widget makers. This
would drive our consumer to buy the gadget. The consumer would spend $25 more
but society, including this consumer, would gain $50 in reduced pollution.)
Advanced Example. Here is a problem discussed by Coase concerning the
efficiency of taxes in resolving the problem of externalities.
Suppose that a train runs through farmland. The railroad has a choice of how
many trains to run a day. If no trains run, the railway’s profit is zero, with 1 train
its annual profit is $100,000, and with two trains its annual profit is $150,000.
Farmers choose how many acres to plant: either 200 acres (this excludes acreage
right next to the tracks) or 250 acres (including acreage next to the tracks). If no
trains run, the farming profit is
$1,000 per acre per year. Unfortunately, sparks from the trains cause damage to
the crops. How much damage depends on the number of trains running and the
amount of acreage planted, according to the table below.
Annual lost farming profits due to sparks
200 acres 250 acres
0 Trains $0 $0
1 Train $60,000 $120,000
2 Trains $120,000 $240,000
a. Summing the profits (and losses) of both farmers and the railway (taking
into account spark losses), how many trains and how many acres maximize
social efficiency (that is, maximize joint profits)?
b. If the train company does not have to pay for the damage its trains cause
the farmer, how many trains will it run and how many acres will the farmer
plant? (Suppose that, because of the large number of farmers, negotiated
side payments will not happen.)
c. If the government imposes a tax on the train company equal to the dollar
value of destroyed crops, how many trains will the train company run and
how many acres will the farmers plant? (Again, assume no side payments.)
d. Does imposing the tax result in social efficiency? Explain.
A Pollution Game. To convince students of the externality problem, the instructor
might consider using the game described on the next page. Most students follow
their self-interest and choose not to buy pollution control equipment. (Note that it
is sometimes useful to play the game twice because some students do not get the
hang of it the first time.) After students play the game, you might raise the issue of
legislation requiring all persons to buy pollution control equipment and let the
students debate this legislation.
POLLUTION GAME
Clean air is worth 100 to you. The amount of clean air that you get will be
determined by the proportion of the class that chooses to buy pollution control
equipment. For example, if half the class chooses to buy pollution control
equipment then you will receive 50 points for clean air. Pollution control
equipment costs 10. If you choose to buy pollution control equipment, 10 will be
subtracted from your score. Thus your score depends on what you do and what
your classmates do. For example, if you choose to buy pollution control equipment
and 40% of the class buys pollution control equipment then you will receive 30
points. If you choose not to buy pollution control equipment and 35% of the class
buys pollution control equipment then you will receive 35 points.
Make a choice (check one):
_____I choose to buy pollution control equipment.
_____I choose not to buy pollution control equipment
Score: _______ (to be determined later)
C. Public Goods and Services.
A good way to introduce this general topic is to ask students to list examples of
goods and services traditionally provided by government (and usually financed
from tax revenues). Ask students to think of government at all levels – federal,
state, and local. A blackboard list should look something like the one on the next
page. In the course of making the list, students usually suggest other government
functions as well. Some functions – macroeconomic policy, and redistribution
policies – are beyond the present scope of concern. Others such as regulation (EPA,
OSHA, and so on) occupy a middle ground between public provision and purely
private markets. Regulatory examples can be listed on a separate blackboard.
With the list of goods and services in place, you can then ask questions aimed
at exploring the economic basis for public provision. Which examples seem to be
pure public goods (non-rival and non-exclusive)? In the absence of public
provision, would private firms provide the good or service in a market setting?
(Could firms do so profitably?) Remember to make the point that not all
government provided goods are public in the economic sense. (Public housing is a
case in point.) Not all public goods are supplied or built by the government.
National highways are controlled by the government but built (and possibly
operated) by private firms.
Examples of Public Goods and Services
1. National Defense
2. Police, Fire, and Sewer
3. The Criminal Justice and Legal System
4. Public Education (State and Local Level)
5. NASA, Government Sponsored Scientific Research
6. National Parks, Government-Owned Land
7. Public Transit
8. Public Housing
9. Entitlement (or Transfer) Programs
Medicare, Medicaid, Social Security
Unemployment Insurance, and so on.
D. Benefit-Cost Analysis
Public Investment in a Bridge. This example provides a nice “bridge” between the
topics of public goods and benefit-cost analysis. The example shows that the public
management of the bridge (at an efficient price, P = MC = 0) is superior to: (a) The
“private” status quo (a monopoly ferry charging Pm = $2), (b) a regulated ferry (PR
= AC = $1), and (c) a privately-controlled bridge (which is unprofitable, see Check
Station 5). Thus, it brings together most of the themes of the chapter. In addition, it
provides plenty of practice in benefit-cost analysis – calculating consumer surplus
triangles and discounting. We feel that this is an example worth repeating in class.
Students do not have much of a problem with the net-benefit rule as a general
principle. In fact, they have a tendency to accept it quite uncritically. Accordingly,
it is useful to lead a discussion of the difference between efficiency and equity
concerns. We believe that equity issues are important. Benefit-cost analysis
assumes that such issues are unimportant because they will balance out in the long
run or unimportant because equity issues should be addressed in some other arena,
for example, through taxation. We feel it is important to check constantly to
determine whether such assumptions are likely to hold. It is therefore good when
doing benefit-cost analysis at least to note what the likely distributional
consequences will be. What are the benefits? What are the costs? What is the net
benefit? What are the equity consequences?
Consider the following hypothetical question. Suppose an anti-pollution agent
could be released in the atmosphere and completely absorb all the air pollution in a
metropolitan area. Would this be an unambiguously good thing for everyone? Most
students respond with a loud and confident yes. Obviously, eliminating all
pollution at a nominal cost would generate enormous benefits in the aggregate.
Nonetheless, some people might lose. With pollution eliminated, urban rents would
most certainly increase,
making low-income renters worse off. (Dry cleaners would be adversely affected
and companies in the pollution abatement business would be devastated.) The point
is that almost any public program (even one unimaginably beneficial) can have
some adverse equity consequences.
Valuing benefits and costs. In most cases, market prices provide the correct
values for benefits and costs. One can get a good discussion going here. Usually
market prices are the best we can do. However, they are far from perfect. Markets
may not be competitive. If not, the price is likely to be higher than marginal social
cost. There could be negative externalities. In this case, price may be less than
marginal social costs. Taxes, government regulation and liability rules may also
cause price distortions. Also, as mentioned in the text, the price of an unemployed
resource may not reflect its cost. Labor, in the time of recession, is a prime
example. Also, perfectly competitive markets do not guarantee equity. Prices in a
market are more likely to represent the tastes of the haves and less those of the
have-nots. For example, in a society where resources are more evenly divided one
would expect to find systematic price differences, for example, the prices of rare
paintings could well be lower. Nevertheless, market price is usually the best we can
do.
For non-marketed goods there are a variety of valuation techniques, including
indirect market measures. One area that students are quite willing to debate
involves risks to human life. In general, students feel that it is impossible to put a
value on human life. A discussion will help to convince them that we make
decisions every day that involve safety risks. For example, every time we get in a
car to go to a movie we risk both our lives and others’ lives. The gain is the simple
enjoyment of going to a movie. Construction workers are exposed to risks (even of
death) in building major projects (skyscrapers and bridges). When the government
decides that cars do not have to be constructed out of 1/2” steel plate, we know that
the result will be some additional fatalities. Students should eventually be
convinced that the risk to human life can be priced.
III. Discussion Assignments
1. Automobiles and Safety, reproduced on the next two pages makes for an
interesting discussion assignment. The instructor should distribute the page to
students and pose the question: Are the benefits of air bags worth the cost?
Suggested Answer
The information on numbers of lives saved and cost of installation implies a cost
per life ranging between $1,500,000 ($12 billion/8,000) and $4,500,000 ($18
billion/4,000). Since most studies estimate the value of a life in the neighborhood
of $5 million or greater, it would appear that an air bag program would generate a
significant positive net benefit. This is before accounting for the benefits associated
with injuries prevented. The valuation of injuries is complicated and painstaking.
As a rough cut, however, we simply note that several studies have estimated that
each fatality prevented is accompanied by reduced injuries equal in value of .5 of a
fatality. Adding in this additional benefit further improves the benefit-cost
calculation.
Installation of air bags would appear to generate significant net benefits. But this
does not justify the immediate implementation of a mandatory program. The real
issue is whether safety is best served via air bags, by other competing programs, or
through the private market. For instance, passive seat belts would save nearly as
many lives as air bags – assuming they are universally used – at a much lower cost.
However, the case for or against passive constraints rests squarely on predictions of
personal behavior – whether a sufficient percentage of car owners will use the
devices. A still more difficult question is whether the private market is best
qualified to respond to the potential demand for safer automobiles. It is natural to
ask: If air bags generate such large benefits, why did it take so long for consumers
to demand, and suppliers to offer, air bags as an equipment option? Twenty-five
years ago, there seemed to be little response in this area by U.S. auto
manufacturers. But since the early 1990’s, the “Big Three” automakers have made
sophisticated air bags (front, side and, curtain models) standard features of new
models.
