978-1118808948 Chapter 11 Lecture Note Part 1

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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?